Mobile Strip
Home / Blog / Leave Encashment: Calculation, Taxation and Rule

Leave Encashment: Calculation, Taxation and Rule

26 min read

leave encashment rules

 

Leave encashment is an often-ignored employment benefit, despite being a significant accrued component in the overall employee remuneration over the course of their professional life. This year, Indian labor laws have mandated leave encashment for unutilized leaves by employees.  

As a result, employees can now. While considering the benefits of leave encashment, it is also necessary to factor in its computation method. Besides, the impact of taxation on the encashed leave, and the way the relevant laws and policies are structured needs a closer understanding. This post is aimed at simplifying the complexities surrounding leave encashment for HR professionals. 

What is Leave Encashment? 

At its core, leave encashment is the option to receive monetary compensation for unutilized leaves. Usually, it comes into effect when an employee resigns, is terminated, or retires. The availability of leave encashment can vary among employers, with some offering it annually.  

Additionally, leave encashment clauses can also vary depending on the employer as well as the geography’s local laws, which only underscores the need for a deeper understanding of relevant statutory regulations. 

Several laws influence leave encashment. For instance, in the case of members of the All-India Services (AIS), the rules stipulated by the All-India Services Act, 1951 are pivotal. However, when it comes to leave encashment, All India Services (Conditions of Service—Residuary Matters) Rules, 1960 is the relevant act.  

Similarly, termination and resignation can also add layers of complexity, and there are distinct rules dictating the tax implications and eligibility criteria during these transitions.  

What are the types of leaves? 

types of leaves

Employees can apply for diverse types of leave. These are meant to cater to various life events and circumstances. Here is a simplified overview of the primary types of leaves: 

1. Annual Leave 

Every employee is eligible for a specific number of paid leaves every year. This is communicated at the time of joining the organization. To avail annual leave, employees must inform their manager in writing in advance (usually at least 15 days prior) to availing annual leave.  

2. Casual Leave 

This type of leave is used for personal reasons and allows employees to take short breaks without loss of pay. 

The number of casual leaves and the factors that govern eligibility for leave encashment may vary based on the organization’s policies. 

3. Sick/Medical Leave 

This type of leave is meant for health-related issues. Medical leave allows employees to take time off without losing their pay. 

Organizations often have specific policies governing the number of medical leaves and their eligibility for encashment. 

4. Maternity Leave 

Maternity leave provides female employees with extended paid leaves during pregnancy and childbirth. 

The duration and conditions of maternity leave are regulated by labor laws and is not considered for leave encashment. 

5. Paternity Leave 

Paternity leave is designed to provide male employees with paid time off around the birth of their child. 

Similar to maternity leave, the conditions and duration of paternity leave are subject to organizational policies and legal regulations. 

6. Paid Time Off (PTO) 

This type of leave includes categories such as Vacation Leave, Casual Leave, Sick Leave, and a Company Break Period. 

Employees can apply for PTO leave after the approval of their reporting managers subject to business needs. 

7. Vacation Leave 

In India, employees are granted 1.25 vacation leaves every month, totaling to 15 days per calendar year. Unused leaves carry over to the next year up to a maximum of 45 days. 

Approval and scheduling require prior approval from reporting managers and are also subject to business needs. Any remaining balance is encashed upon termination. 

8. Casual Leave 

India employees receive 8 days of paid casual time off per calendar year, lapsing if unused.  

9. Sick Leave 

In India, employees can usually avail up to 10 days of paid sick time per calendar year. Prior notification to the reporting manager is a requirement. 

10. Company Break Period / Winter Break 

In specific instances, companies may offer their employees a winter break with 5 days of casual time-off deducted for wage payment. If no casual time-off is available, deductions occur from vacation/annual leave. 

This kind of leave involves automatic deductions with no separate leave application required. 

11. Leave Without Pay (LWP) 

Leave without pay is usually granted at the discretion of the employee’s reporting hierarchy. During LWP, employees receive no compensation but continue to be eligible for benefits. LWP extending beyond 30 days is usually classified as Leave of Absence. 

This kind of leave requires approval, and employees must exhaust any accrued PTO before participating in leave without pay. 

12. Bereavement Leave 

Depending on the organization policy, an employee may be granted up to 20 days of bereavement leave. This leave includes pay and is granted in the event of death of specified family members. It is necessary to immediately notify the manager. 

13. Leave of Absence (Medical LOA, Personal LOA) 

Depending on the organization policy, regular employees may be eligible for a Leave of Absence, subject to written approval from the manager. Extensions beyond 30 days could impact benefits. 

Benefits of Leave Encashment: A comprehensive look 

We will now take a closer look at leave encashment benefits from both perspectives – employees and employers. 

Employee Perspective 

1. Financial Flexibility: For employees, the fundamental benefit is greater financial flexibility. It serves as a tangible monetary benefit that is otherwise lost. Moreover, it addresses the immediate financial needs or aspirations of the employee. 

2. Enhanced Work-Life Balance: By choosing to encash leave instead of taking time off, employees can maintain an optimal work-life balance. This flexibility empowers individuals to align their professional and personal commitments more effectively. 

3. Retirement: The option to encash accrued leave becomes particularly significant during retirement. A surprise lumpsum received in later years can be a boost for retirees, adding to their financial security. 

4. Tax Implications: Depending on the authority and specific circumstances, the tax treatment of leave encashment varies. Understanding these implications allows employees to make informed decisions about when and how to utilize this benefit. 

Employer Perspective 

1. Increased Productivity: From an employer standpoint, leave encashment assures employees that there is a reward for not taking time off work. As employees choose to remain at work and encash their leave, the available man-days increase, thereby positively impacting productivity. 

2. Cost Management: Despite increasing costs in the short term, leave encashment offers a transparent and manageable way to manage employee benefits. This clarity in cost management allows companies to plan and budget effectively. 

3. Avoidance of Work Disruptions: In key positions or critical operations, employee absence can lead to disruptions. Encouraging leave encashment, especially in such roles, helps organizations avoid unexpected work stoppages and ensures continuity in operations. 

4. Employee Satisfaction and Retention: Offering the option of leave encashment contributes to employee satisfaction. It reflects a commitment to flexibility and recognizes varying needs of the workforce, potentially enhancing employee retention. 

5. Actuarial Valuation Insight: Understanding the financial implications of leave encashment involves actuarial valuation. This involves assessing the liability associated with leave encashment, considering factors such as leave consumption rates, employee age, and dynamic leave accrual. 

Eligibility of leave encashment: Navigating the path to financial flexibility 

Leave encashment is a valuable benefit that bridges the realms of work and financial wellbeing. It is subject to specific eligibility criteria that align with organizational policies and regulations. 

1. Employment Tenure 

Usually, employees become eligible for leave encashment after completing a specific duration of service, often measured in years. This tenure-based criterion ensures that the benefit is extended to committed and long-serving individuals. 

2. Company Policies 

Each organization defines its policies regarding leave encashment eligibility. These policies outline the conditions under which employees can avail themselves of this benefit, considering factors such as job roles, hierarchical levels, and the overall structure of the company. 

3. Accumulated Leave Balances 

Eligibility often hinges on the accumulation of leave balances. Employees may be required to accrue a minimum number of leave days before becoming eligible for leave encashment. This ensures that the benefit is proportionate to the commitment and dedication demonstrated through accrued leave. 

4. Regulatory Compliance 

In certain jurisdictions, labor laws or industry regulations prescribe eligibility criteria for leave encashment. Organizations must adhere to these legal frameworks to ensure equitable and lawful distribution of benefits among eligible employees. 

5. Retirement or Separation 

Eligibility for leave encashment may also be linked to specific events, such as retirement or voluntary separation. In such cases, employees become eligible to encash their accrued leave as part of the transition to the next phase of their professional journey. 

6. Annual Leave Quotas 

Some companies establish annual leave quotas as a prerequisite to being eligible for leave encashment. This approach ensures a consistent and fair distribution of the benefit, preventing misuse while encouraging employees to utilize their allotted leave responsibly. 

Navigating the eligibility criteria for leave encashment requires a nuanced understanding of organizational policies, industry norms, and legal frameworks. Employees who familiarize themselves with these criteria will be able to make more informed decisions related to their work-life equation.  

As organizations continue to evolve their leave policies, staying abreast of updates ensures employees can maximize the benefits aligned with their dedicated service. 

What is the Process of Leave Encashment? 

leave encashment process

Understanding the leave encashment process is crucial for employees seeking to leverage this valuable aspect of their employment. 

1. Accumulation of Untaken Leaves 

Employees accrue leaves throughout the year, encompassing annual leave, casual leave, and other applicable types. If these leaves remain untaken by the end of the year, the option to encash them becomes available. 

2. Employee Initiation 

The process typically commences with the employee expressing their intent to encash accrued leave. This initiation can involve formal communication with the HR department or following specific protocols outlined by the organization. 

3. Leave Balances Assessment 

The HR or payroll department assesses the employee’s leave balances, determining the number of days available for encashment. This evaluation ensures accuracy in the calculation of the monetary benefit to be disbursed. 

4. Monetary Valuation 

The monetary value of the leave days is calculated based on the employee’s salary or a predetermined formula established by the organization. This valuation is a crucial step in determining the financial impact of leave encashment. 

5. Approval Process 

The request for leave encashment often undergoes an approval process, involving relevant authorities within the organization. This step ensures compliance with company policies and prevents misuse of the leave encashment benefit. 

6. Disbursement of Funds 

Once approved, the funds equivalent to the calculated leave encashment value are disbursed to the employee. This amount is usually included in the regular salary cycle or as a separate disbursement, depending on organizational practices. 

7. Tax Implications 

Employees should be aware of the tax implications associated with leave encashment, as the disbursed amount may be subject to income tax. Understanding these implications ensures transparency in financial planning. 

Leave encashment, a process designed to provide financial flexibility, underscores the employer’s commitment to holistic employee well-being. By navigating this process with clarity and adherence to organizational guidelines, employees can harness the financial benefits accrued through their untaken leaves. 

Is Leave Encashment Taxable? 

taxation of leave encashment

Understanding the tax implications of leave encashment is crucial, and the tax treatment varies based on specific circumstances. 

1. Deceased Employee 

The tax treatment for leave salary received after the death of an employee depends on the individual’s tax status at the time of demise. 

Specific guidelines govern the taxation of leave encashment in case of a deceased employee. 

2. Retirement 

Leave encashment at the time of retirement enjoys certain tax exemptions. 

Employees of Central or State Government receive full exemption under section 10(10AA)(i) of the Income Tax Act for the period of earned leave at the time of retirement. 

Other employees have exemptions up to the least of certain conditions, including 30 days leave for every year of service, 10 months’ average salary, the government-specified amount (currently ₹3 Lakh), or the actual received amount. 

3. Government Employees 

Government employees, both Central and State, benefit from favorable tax treatment on leave encashment, with full exemption at the time of retirement. 

4. Private Sector Employees (Non-Government) 

Non-government employees have limitations on tax exemptions for leave encashment at retirement, subject to specified conditions. 

The present ceiling of ₹3 Lakh was set about 20 years ago and is a point of discussion for potential revision. 

5. Public Sector Undertakings (PSU) 

Tax treatment for leave encashment in PSUs aligns with that of private sector employees, with considerations based on the specified limits. 

Expert Insights 

As per tax laws, payments for encashment of earned leaves at the time of retirement are exempt from tax, subject to specified limits. 

The term ‘retirement’ is interpreted broadly, potentially including resignations, making leave encashment upon resignation eligible for exemption, subject to specific calculations and limits. 

Any prior exemptions claimed influence the total limit available in subsequent employments. 

Currently, the overall leave encashment exemption during an employee’s lifetime cannot exceed the total specified limit (presently ₹25 lakh). 

Understanding the nuances of taxation related to leave encashment ensures employees make informed decisions based on their specific circumstances. 

Conditions of Exemption from Tax 

Understanding the conditions and limits associated with tax exemptions for leave encashment is crucial for employees, varying across different scenarios. 

1. Deceased Employee 

Tax exemption conditions for leave encashment received on behalf of a deceased employee depend on the individual’s tax status at the time of demise. 

Specific guidelines govern the taxation of leave encashment in case of a deceased employee. 

2. Retirement 

Leave encashment because of retirement is tax exempt. However, it is subject to specific conditions. Retirement does not refer solely to superannuation (occurring at an old age) but can also cover cases of resigning from the job. 

In the case of Central or State governments, the entire leave encashment amount received is exempt, without limits or conditions. 

3. Government Employees 

Government employees, both Central and State, benefit from favorable tax treatment on leave encashment, with full exemption at the time of retirement. 

4. Private Sector Employees (Non-Government) 

In the case of non-government employees, various tax exemption conditions apply for leave encashment. While computing exemption for leave encashment, it cannot exceed 30 days for each year of service.  

In addition, it cannot exceed 10 months. Exemption is calculated based on the average salary drawn within the 10 months preceding retirement. An overall cap on the exemption amount is notified by the government. 

5. Public Sector Undertakings (PSU) 

Tax treatment for leave encashment in PSUs aligns with that of private sector employees, with considerations based on specified limits. 

Exemptions under 10(10AA) 

Section 10(10AA) of the Income Tax Act provides the framework for exemptions related to leave encashment. 

The exemptions differ for government and non-government employees, with specific criteria. 

Exemption Limit 

The recent notification increased the exemption cap on leave encashment from ₹3 lakh to ₹25 lakh (effective from April 1, 2023). This enhanced limit is aimed to bridge a long-standing disparity between government and non-government employees. 

Calculation of Leave Encashment 

Using the Leave Encashment Formula ,

To understand how leave encashment is calculated, let us consider the example of Ms. Aisha, a dedicated employee retiring after two decades of service. Throughout her illustrious career, she accumulated an annual leave entitlement of 30 days, resulting in a total of 600 earned leave days over the years. 

She utilized 200 days of leave during her tenure leaving her with an unutilized leave balance of 400 days. When she retires, her monthly compensation including a basic salary and a dearness allowance (DA) sums up to a total monthly package of ₹40,000. 

The Leave Encashment is calculated using the following formula: 

Cash Equivalent = ((Basic Pay + DA)/30) x No. of earned leave (capped at 10)

Aisha’s total monthly salary (Basic Pay + DA) is ₹40,000. The number of earned leave days are 400 (maxed at 10 days per the formula) Aisha’s total monthly salary (Basic Pay + DA) is ₹40,000. The number of earned leave days are 400 (maxed at 10 days per the formula) 

Calculation: 

Salary per day = (Total monthly salary/Number of Days in a month) = 40,000/30 = ₹1,333.33 (approximately) 

Effectively, the leave encashment amount works out to: 

Leave Encashment Received = Number of Unutilized Leave Days × Salary per Day 

 Leave encashment received = 400 × 1,333.33 = ₹5,33,332.00 (approximately) 

Therefore, Ms. Aisha is eligible for a leave encashment payment of approximately ₹5,33,332.00 upon her retirement. This computation ensures a fair and transparent calculation based on the established leave encashment formula, providing employees with a clear understanding of their entitlements. 

Automated Leave Encashment with Keka HR 

Keka Leave Management Software takes the hassle out of leave encashments by seamlessly integrating with our payroll engine. With the capability to configure encashment rules and customize formulas with different salary components, Keka simplifies the entire process. 

Key Features: 

1. Configurable Encashment Rule 

Define your organization’s encashment rules effortlessly. Customize formulas based on different salary components to ensure accuracy. 

2. Mundane Math Made Easy 

Let Keka manage intricate calculations, eliminating the need for manual effort. Simply set your rules, and the system takes care of the rest for all your employees. 

3. Seniority-based Leave Accrual 

Easily configure accrual rates based on probation and experience. Keka automates the accrual process, ensuring accuracy and efficiency. 

4. Loss of Pay Integration 

Seamlessly integrate with payroll for automated arrear calculations. Define rules, and Keka ensures accurate loss of pay calculations. 

5. Loss of Pay Reversal Arrears 

Effortlessly cancel an employee’s unpaid leave from the past with a single button. Keka automatically encashes it in the payroll, streamlining the process. 

6. Leave Carry Over Simplified 

Set leave carry-over rules and let Keka manage encashments and carry-overs into the following years. Ensure a smooth transition of leave balances without manual intervention. 

7. Effortless Loss of Pay Calculation 

Define policies and rules aligned with organizational regulations. Keka automates the loss of pay calculation, saving time and reducing errors. 

8. Streamlined Leave Carry Over Rules 

Configure your own leave carry-over rules and policies. From leave encashment to carry-over, Keka ensures compliance with your organizational guidelines. 

Keka Payroll Software has revolutionized the Indian payroll industry, simplifying enterprise payroll management. With a focus on user-friendly design and powerful automation, Keka ensures that managing leave encashments and payroll integration is not only efficient but also stress-free. 

FAQs 

1. What is leave encashment? 

Leave encashment refers to the compensation employees receive from their employers for untaken leaves. It becomes part of the final settlement during retirement or resignation, providing financial value for unused leave days. 

2. How many leaves can be encashed? 

The number of leaves that can be encashed varies, typically subject to the company’s policy. Employees should refer to their company’s leave policy to understand the maximum limit on leave encashment. 

3. Can casual leave be encashed? 

Yes, casual leave can be encashed, but the process and eligibility criteria depend on the company’s policies. It often involves notifying the employer and adhering to specific guidelines outlined in the company’s leave encashment policy. 

4. What is the leave encashment formula? 

The leave encashment formula is a straightforward calculation: Cash equivalent = [(Basic Salary + Dearness Allowance) / 30] * No. of Earned Leaves. Understanding this formula helps employees estimate their leave encashment amount. 

5. How is leave encashment calculated? 

To calculate leave encashment, multiply the number of unutilized leave days by the daily salary rate, following the formula: Cash equivalent = [(Basic Salary + Dearness Allowance) / 30] * No. of Earned Leaves. This straightforward calculation empowers employees to gauge their potential leave encashment. 

6. Is leave encashment taxable for bank employees? 

The taxability of leave encashment for bank employees varies based on individual circumstances and tax regulations. Seeking advice from a tax professional is recommended to understand the specific tax implications for bank employees. 

7. Is leave encashment taxable for Government employees? 

Leave encashment for Government employees is fully exempt from taxation, as per Section 10(10AA)(ii) of the Income Tax Act. This exemption provides a financial benefit to government employees during retirement or resignation. 

8. Is leave encashment taxable for Private employees? 

Yes, leave encashment is taxable for private employees. The amount received is part of their income and is subject to income tax. Understanding this tax implication helps private employees plan accordingly. 

9. Is leave encashment taxable after resignation? 

Leave encashment received after resignation is taxable. The specific tax treatment may vary, and employees must consider individual circumstances and seek professional guidance to manage tax implications effectively. 

10. Is leave encashment taxable after Termination? 

Leave encashment after termination is typically taxable. Understanding the tax treatment of leave encashment in such situations is essential, and employees must seek professional advice to navigate tax obligations after termination. 

Table of Contents

    Meet the author

    Keka Editorial Team

    A bunch of inspired, creative and ambitious youngsters- that’s Keka’s editorial team for you. We have a thirst to learn new subjects and curate diverse pieces for our readers. Our deep understanding and knowledge of Human Resources has enabled us to answer almost every question pertaining to this department. If not seen finding ways to simplify the HR world, they can be found striking conversations with anyone and everyone , petting dogs, obsessing over gadgets, or baking cakes.

    Email

    Thank you for Subscribing!

    Related articles

    How to Manage Leave of Employees
    Keka Editorial Team 13 min read

    What&#s the one thing that drives an HR team so crazy that they want to quit their jobs A company&#s outdated strategy for managing leaves could be the clincher Outdated tools or human errors can lead to inaccurate data This makes executive tasks like leave management and payroll extremely challengi

    13 Types of Leave Offered By Companies in India
    Anwesha Panja 27 min read

    The complete knowledge of leaves and it's types help employees in every field plan their schedules better. Explore the various major leave types in this blog!

    How To Design A Leave Policy In India: For All Company Sizes
    Anwesha Panja 27 min read

    When it comes to designing a leave policy it is observed that a lot of HR Managersexecutives often design policies based on their experience in the past organizations

    cookie image

    By clicking “Accept", you consent to our website's use of cookies to give you the most relevant experience by remembering your preferences and repeat visits. You may visit "cookie policy” to know more about cookies we use.