Leave Encashment

What is Leave Encashment?

Leave encashment is the process of receiving an amount of cash in exchange for an employee’s unused paid leaves in a year. Employees can save their unused leave or vacation time and receive money when they retire or leave their jobs.

Companies often allow employees to carry over unused paid leave from one year to another. Employees can also choose to get paid for their unused vacation time instead of taking time off for holidays, providing a financial cushion for the future.

However, the money received for these unused leaves and vacation time is taxable, although there are ways to qualify for exemptions. At retirement, government employees are exempted from taxation while they encash their leaves.

According to some regulations, non-government employees can be exempted from taxation during leave encashment. We’ll learn more about them in the following sections.

What are the types of leaves?

There are 14 different types of leaves that companies provide employees in India. Each of them has been described below:

1. Privilege/Earned/Paid Leave

  • Entitlement: 21 working days per calendar year.
  • Encashment: Paid leaves can be encashed, accumulated or carried over to the next financial year.

Privilege leave is intended for rest, recuperation, spending time with family, and personal activities. A minimum of 4 days are needed to be availed for L.T.A. claims. Extensions are not generally granted except for emergencies. Employees must inform in advance and get approval.

Note: Employees can encash a maximum of 50% of their earned leaves or 30 days of earned leave, whichever is lower.

2. Casual Leave

  • Entitlement: 6 casual leaves per calendar year.
  • Encashment: Cannot be accumulated or encashed.

Casual leaves can be used for emergencies or unforeseen situations. Maximum 3 days at a stretch. In case of unplanned absence, you must inform the line manager in advance or immediately on return.

3. Sick Leave

  • Entitlement: 7 sick leave days per calendar year.
  • Encashment: Sick leave cannot be accumulated or encashed.

Sick leaves can be extended with manager approval in case of prolonged illness. Medical certificate required for leaves over 3 days. Misuse can lead to disciplinary action.

4. Maternity Leave

  • Entitlement: Total of 26 weeks twice in the service tenure. Additional 6 weeks for specific situations.
  • Encashment: Cannot be encashed.

Maternity leaves follow the provisions of the Maternity Benefit Act, of 1961. It can be combined with a leave balance against Privilege Leave or Sick Leave if needed for medical reasons.

5. Paternity Leave

  • Entitlement: 15 paternity leave days per child for up to 2 children (excluding holidays & weekends).
  • Encashment: Cannot be accumulated or encashed.

Paternity leaves are available for male employees when their spouse gives birth or is under medical supervision due to a maternity-related situation.

6. Medical Leave

  • Entitlement: Usually 3-8 days per year (varies by company).
  • Encashment: Cannot be accumulated or encashed.

It is granted to employees in case of illness, injury, or medical reasons, allowing time off for recovery and treatment.

7. Bereavement/Compassionate Leave

  • Entitlement: Varies by company, usually 3-5 days.
  • Encashment: Cannot be accumulated or encashed.

Allows employees to cope with the loss of a family member, providing the necessary time to grieve and handle funeral arrangements.

8. Compensatory Leave

  • Entitlement: Earned through working extra hours or on non-working days.
  • Encashment: Cannot be encashed.

Given to employees who work additional hours beyond their regular schedule, providing them with compensatory time off for their extra efforts.

9. Floater Leave

  • Entitlement: Usually 2 days per year.
  • Encashment: Cannot be encashed

Allows employees to take time off for religious or cultural observances not covered by national holidays, promoting inclusivity.

10. National Holidays

  • Entitlement: Mandated by the government; specific dates vary annually.
  • Encashment: Cannot be encashed.

These are official public holidays recognized by the government, providing a day off for citizens to celebrate national events and festivals.

11. Marriage Leave

  • Entitlement: Typically 5-10 days (varies by company).
  • Encashment: Cannot be encashed.

Marriage leaves are given to employees on the occasion of their wedding, allowing them to celebrate and manage wedding-related activities.

12. Sabbatical Leave

  • Entitlement: Sabbatical leave generally unpaid and requires prior approval.
  • Encashment: Cannot be encashed.

A long-term leave, usually lasting for several months, allows employees to take a break for personal reasons, further education, or career exploration.

13. Unpaid Leave

  • Entitlement: Variable, determined by the employee’s request and company policies.
  • Encashment: Cannot be encashed.

Unpaid leave allows employees to take time off without pay when they have exhausted their paid leave entitlements.

14. Other Special Leaves

  • Entitlement: Specific to each company; varies based on policies.
  • Encashment: Depends upon the specific company and policies.

Taxation of Leave Encashment

Leave Encashment Received During Service

When an individual receives leave encashment while employed, the entire amount becomes taxable as part of their salary. Hence, it becomes taxable. However, they have the option to claim tax benefits under Section 89 and Form 10E of the IT Act, 1961.

Leave Encashment at Retirement or Resignation

For government employees

The entirety of the leave encashment amount remains tax-free.

For non-government employees

Taxation depends on specific rules outlined in Section 10(10AA) of the Income Tax Act. The exempted amount is determined by the least of:

  • The actual leave encashment received.
  • 10 months’ average salary.
  • Cash equivalent of unutilized earned leave, capped at 30 days per year of service.

Leave Encashment for Legal Heirs of a Deceased Employee

In the case of a deceased employee, whether from the government or non-government sector, the entire leave encashment amount is exempt from taxation.

Latest Update (Effective from April 1, 2023)

As of April 1, 2023, there is a new tax exemption limit of ₹25 lakh on leave encashment for non-government employees in the private sector.

This means they are not liable to pay tax on leave encashment amounts up to ₹25 lakh, provided they meet the specified conditions in Section 10 of the Income Tax Act.

Government employees, on the other hand, continue to enjoy complete tax exemption on their leave encashment amounts.

SituationTaxation
Leave Encashment During ServiceThe Entire amount is taxable as salary. Tax benefits under Section 89 and Form 10E are available.
Leave Encashment at Retirement/Resignation (Government Employees)The entire amount is tax-free.
Leave Encashment at Retirement/Resignation (Non-Government Employees)Taxable amount: Lesser of actual leave encashment, 10 months’ average salary, or cash equivalent of unutilized earned leave (capped at 30 days/year of service).
Leave Encashment for Legal Heirs of Deceased EmployeeThe entire amount is tax-free.
Latest Update (from April 1, 2023)₹25 lakh tax exemption limit on leave encashment for non-government employees in the private sector, subject to conditions in Section 10. Government employees are exempt from tax.

Leave Encashment Calculation

Formula

The basic formula used for calculating the leave encashment amount is:

[(Average Basic salary + Average Dearness Allowance) / 30] * No. of Earned Leaves

In this formula:

  • Average Basic Salary: The average monthly basic salary of the employee.
  • Average Dearness Allowance: The average monthly dearness allowance received by the employee.
  • Number of Earned Leaves: The total number of earned leave days accumulated by the employee.

The formula calculates the daily salary of the employee (combining basic salary and dearness allowance), divides it by 30 (assuming a month has 30 days), and then multiplies it by the number of earned leave days to determine the leave encashment amount.

Calculation

Assumed details:

  • Years of Service: 20 years
  • Annual Leave Entitlement: 35 days
  • Leaves Utilized: 120 days
  • Monthly Salary (including dearness allowance): ₹50,000
ParameterCalculation
Total Leave Entitlement20 years × 35 days/year = 700 days
Leave Balance700 days − 120 days utilized = 580 days
Monthly Salary₹50,000
Salary per DayMonthly Salary / 30 = 50,000/30 = ₹1,666.67
Leave Encashment Amount₹1,666.67 × 580 days = ₹9,66,670

Calculation of Exempt Amount

Given Government Exemption: ₹3,00,000

ParameterCalculation
Actual Leave Encashment₹9,66,670
Average Salary (10 months)(Monthly Salary × 10) / 30 = (50,000 × 10) / 30 

= ₹1,66,666.67

Maximum Leave Days (30/year)30 days/year × 20 years = 600 days
Utilized Leave Days120 days
One Day’s SalaryMonthly Salary / 30 = 50,000 / 30 = ₹1,666.67
Exempt Amount CalculationOne Day’s Salary × (Maximum Leave Days − Utilized Leave Days)

= ₹1,666.67 × (600−120) = ₹8,00,000

Exempt Amount Calculation

The least of the calculated amounts:

  • The government exemption amount: ₹3,00,000
  • The calculated amount based on one day’s salary multiplied by 480 days: ₹8,00,000

Hence, the government exemption amount of ₹3,00,000 will be considered here.

Taxable Amount

₹9,66,670 (Leave Encashment Amount) − ₹3,00,000 (Exempt Amount) = ₹6,66,670

Therefore, in this example, the taxable amount of leave encashment is ₹6,66,670 after considering the government exemption and the calculation based on utilized leave days.

Leave Encashment Exemption Example

Let’s take an example employee, Sanya. She retired after 15 years of service with an annual leave entitlement of 25 days. She used 200 days and had a remaining balance of 175 days. Her monthly salary, including basic and dearness allowance, was ₹35,000.

Sanya received a leave encashment amounting to ₹2,04,166.75 based on her remaining leave days and daily salary.

According to the exemption rules, she could be exempted up to the least of three criteria:

  • Average salary of 10 months (₹3,00,000)
  • 250 days of leave (15 years of service minus days utilized)
  • ₹2,50,000 (calculated as one day’s salary multiplied by the remaining leave days)

In Sanya’s case, the exempted amount calculated using the one-day’s salary method (₹2,50,000) is the lowest.

Therefore, her taxable leave encashment amount is negative.
₹2,04,166.75 – ₹2,50,000 = – ₹45,833.25)

This means that she doesn’t have to pay tax on her leave encashment as it falls below the exempted limit after considering her average salary and utilized leave days.

What is a Leave Encashment Policy?

A leave encashment policy is a set of rules created by employers. It explains how employees can get paid for their unused leave days, typically at the end of the year or when they leave the company due to termination, retirement, or resignation.

A leave encashment policy includes:

  • Calculation: It explains how leave pay is calculated, often based on accrued days.
  • Eligibility: The policy states who qualifies for leave encashment, considering factors like tenure.
  • Maximum Days: It specifies the cap on encashable leave days.
  • Application: It outlines the process for employees to request encashment.
  • Tax Details: It provides information on tax implications and exemptions.

Objective of Leave Encashment Policy

The aim is to establish clear guidelines for leave encashment. It deals with encouraging employees to take planned breaks while providing financial support for their social obligations and expenses during their leave. This policy also seeks to minimize extended absences, which can strain staffing needs.

Scope of Leave Encashment Policy

This policy applies to all permanent employees of the company. However, specific exclusions may be in place for certain categories of employees.

Leave Encashment Rules

For Central Government Employees

Central government employees can choose to encash their earned leave once in a calendar year. However, they can only encash up to 50% of their earned leave balance or a maximum of 30 days, whichever is lower. This policy allows employees to convert their unused leave into monetary compensation, providing financial flexibility.

For Private Sector Employees

Private employees have the option to carry forward their unused leave days from one year to the next. Later, they can request payment for these unused leaves. Every employee is eligible for this benefit, providing a way to receive monetary compensation for their unused time off.

For Government Employees

A government employee can convert earned leave to cash for up to 10 days. This can be done when the employee takes leave for personal travel or when their family does, as long as certain conditions are met.

For Retired Individuals

On retirement, an employee is allowed to avail for encashment of unused portion of the paid or earned leaves.

However, leave encashment is a perk provided through the CCS (Leave) Rules and is distinct from pension benefits. Government employees can receive payment for their accumulated Earned Leave/Half Pay Leave upon retirement, up to a maximum of 300 days.

For Deceased Persons

In the case of a deceased person, the leave salary for earned leave standing to their credit will be paid to the nominee(s) designated for receiving Provident Fund and Gratuity. If there is no nominee, the payment will be made to the legal heir(s) of the deceased individual.

Frequently Asked Questions

1. What is the maximum exemption for leave encashment?

The tax exemption limit for leave encashment was raised to INR 25,00,000 in the 2023 finance budget, up from Rs 3,00,000. Any amount beyond this limit is taxable. The calculation for the exempt leave encashment follows guidelines outlined in Section 10(10AA).

2. Is leave encashment compulsory?

No, leave encashment is not a compulsory option. Many employers allow employees to carry over unused leaves in the following years.

3. What is the leave encashment limit in Budget 2023?

According to Budget 2023, the leave encashment limit has been set to INR 25 lakhs. The limit was Rs. 3 lakh since 2002 and has now been raised due to the overall rise in salary incomes.

4. Can leave encashment be taken in advance?

Leave encashment can be done at the time of a new financial year, at retirement, or at resignation. It cannot be encashed in advance. It can be done only once a year. Encashment policies can differ across organizations.

5. Is annual leave an encashment?

Annual leave is paid time off provided to employees from organizations. Hence, yes, it can be encashed in accordance with the company policies.

6. Is leave encashment tax-free?

No, leave encashment is not tax-free. It is taxable, and the tax depends on when it is received. If employees receive leave encashment while employed, the amount is fully taxable and is considered part of their ‘Income from Salary’. However, certain tax benefits can be claimed under Section 89 of the Income Tax Act.

7. What is the difference between leave salary and leave encashment?

Leave salary and leave encashment are almost the same things. Leave Salary is accumulated over time and can be encashed at a later date as part of leave encashment.

8. Can leave encashment be part of CTC?

No, leave encashment cannot be a part of the CTC. However, it can be taken under termination benefits or an internal part of CTC. It is a payment received by the employee in place of entitled but unused leave days. It is compensation for extra work done by the employee.

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