Two lump sums arrive when you leave a job after a long stint: gratuity, a statutory thank-you of roughly half a month's pay for every year served, and leave encashment, the cash value of the leave you never took. Both can be large - a fifteen-year employee on a ₹1 lakh basic receives about ₹8.7 lakh of gratuity - and both are substantially tax-free, but under formulas that most people (and some payroll teams) get wrong. This guide sets out the exemption for each, shows the calculation on real numbers, and flags the points that catch people: the five-year rule, the lifetime cap, and the difference between encashing leave while working and on leaving.
First: both exemptions apply in the new regime
Gratuity and leave-encashment exemptions live in Section 10, not in Chapter VI-A. The new regime under Section 115BAC removes most Chapter VI-A deductions and several Section 10 allowances (HRA, LTA), but it specifically keeps the exemptions for gratuity under 10(10), leave encashment under 10(10AA), commuted pension under 10(10A) and retrenchment compensation under 10(10B). So the regime you are on makes no difference here - the exempt portion is exempt either way, and only the excess is added to your salary and taxed at slab.
Gratuity: who is entitled and how much
Under the Payment of Gratuity Act 1972, any establishment with 10 or more employees must pay gratuity to an employee who leaves after five years of continuous service (the condition is waived on death or disablement). Resignation, retirement and termination all qualify. The statutory formula is:
Gratuity = (last drawn basic + DA) × 15 ÷ 26 × completed years of service
where a final part-year of six months or more counts as a full year. The "15/26" is fifteen days' pay for each year, with a month taken as 26 working days. Many employers pay more than the statutory minimum; the formula is the floor, and the tax exemption is computed on the formula regardless of what was paid.
Example. Last basic + DA ₹1,00,000 a month; 15 years and 7 months of service (counts as 16 years):
₹1,00,000 × 15 ÷ 26 × 16 = ₹9,23,077.
How much gratuity is tax-free
| Employee type | Exempt amount |
|---|---|
| Central / state government, defence, local authority | Fully exempt, no limit |
| Private sector, covered by the Payment of Gratuity Act | Least of: (a) actual gratuity received, (b) the 15/26 formula amount, (c) ₹20,00,000 |
| Private sector, not covered by the Act (small establishments, some seasonal employers) | Least of: (a) actual received, (b) half a month's average salary (last 10 months) for each completed year - part years ignored, (c) ₹20,00,000 |
The ₹20 lakh figure is a lifetime limit across all employers. If you received ₹8 lakh of exempt gratuity from a previous job, only ₹12 lakh of exemption remains for the next one.
Continuing the example. The employer pays ₹10 lakh (a little above the formula). Exempt = least of ₹10,00,000 / ₹9,23,077 / ₹20,00,000 = ₹9,23,077. Taxable = ₹76,923, added to salary. At the 30% band that costs about ₹24,000.
Gratuity received by a nominee on an employee's death is fully exempt in the nominee's hands.
Leave encashment: ₹25 lakh exempt, but only on leaving
Leave encashment is paid for earned leave you did not take. The tax treatment depends entirely on when it is paid:
- While still employed (many companies let you encash leave annually): fully taxable as salary in the year received. Relief under Section 89 may soften the slab impact.
- On retirement or resignation: exempt under Section 10(10AA), fully for government employees, and for everyone else up to the least of four amounts:
- Actual leave encashment received
- ₹25,00,000 (raised from ₹3 lakh with effect from 1 April 2023 - a limit that had not moved since 2002)
- 10 months' average salary (basic + DA, averaged over the last 10 months)
- Cash equivalent of unavailed leave, calculated at a maximum of 30 days of leave per completed year of service, valued at the average salary
Limb 4 is the one that binds for most people. If your employer credits 40 days of leave a year and you have 400 days accumulated over 12 years, the exemption is computed on 360 days (30 × 12) - the other 40 days' encashment is taxable.
The ₹25 lakh cap is also a lifetime limit across employers. It applies to the exemption claimed, not to the amount received.
Worked example: leaving after 12 years
Meenal resigns after 12 years and 4 months. Her average basic + DA over the last 10 months is ₹90,000 a month (₹3,000 a day on a 30-day month). She has 380 days of unavailed leave; her employer credits 36 days a year and pays her ₹11,40,000 for all 380 days.
| Limb | Computation | Amount |
|---|---|---|
| 1. Actual received | 380 days × ₹3,000 | ₹11,40,000 |
| 2. Statutory cap | ₹25,00,000 | |
| 3. 10 months' average salary | ₹90,000 × 10 | ₹9,00,000 |
| 4. Leave at 30 days per year | 30 × 12 completed years = 360 days × ₹3,000 | ₹10,80,000 |
| Exempt (least) | ₹9,00,000 | |
| Taxable | ₹11,40,000 − ₹9,00,000 | ₹2,40,000 |
Limb 3 - ten months' salary - turns out to be the binding one, which is common for long-serving employees with big leave balances. The taxable ₹2,40,000 is added to salary in the year of resignation. If it pushes her into a higher band than usual, Section 89 relief (Form 10E, filed online before the return) recomputes the tax as if the income had been spread over the years it was earned, and refunds the difference.
Points that catch people out
- Leaving at 4 years 10 months. No statutory gratuity - the Act requires five years. Courts have held that 4 years and 240 days in the fifth year can qualify in establishments working a 6-day week, but employers do not always apply it. If you are close, it is worth checking your notice period end date.
- Gratuity shown in Form 16 as fully taxable. It happens when payroll pays out without computing the exemption. Compute it yourself and claim the exempt amount in the ITR under Section 10(10); keep the gratuity computation from HR.
- Encashing leave every year. It is fully taxable each time, and it depletes the balance that would have been exempt on leaving. If your employer allows carry-forward, letting leave accumulate is more tax-efficient - up to 30 days a year, beyond which the exemption stops growing.
- Two exits in one year. The lifetime caps apply across both. Track what you have claimed.
- Basic vs CTC. Both formulas use basic + DA, not gross. A high-basic salary structure produces larger gratuity and leave encashment - and larger exemptions.
Work out the exempt amount with the formulas above, add only the taxable excess to your salary in the calculator, and see the tax for the year you leave.
Calculate your exit-year tax →Frequently asked questions
Is gratuity taxable?
Government employees' gratuity is fully exempt. For private-sector employees covered by the Payment of Gratuity Act, the exemption is the least of the actual amount, the 15/26 formula amount, and ₹20 lakh (lifetime). Anything above the exempt figure is taxed as salary.
What is the gratuity formula?
Last drawn basic plus dearness allowance × 15 ÷ 26 × completed years of service, with a final part-year of six months or more rounded up to a full year. Five years of continuous service is required, except on death or disablement.
Is leave encashment taxable?
Leave encashed while in service is fully taxable. On retirement or resignation it is exempt for government employees, and for others up to the least of the amount received, ₹25 lakh, 10 months' average salary, and the cash value of leave at 30 days per year of service.
Do the gratuity and leave encashment exemptions apply in the new tax regime?
Yes. Both are Section 10 exemptions that the new regime keeps, unlike HRA and LTA. The exempt portion is tax-free under either regime.
Is the ₹20 lakh gratuity limit per employer?
No, it is a lifetime limit on exempt gratuity across all employers. Exempt gratuity claimed from an earlier employer reduces what remains for the next. The ₹25 lakh leave encashment limit works the same way.
What is Section 89 relief?
A recomputation that spreads arrears or a lump sum (like taxable leave encashment) over the years it relates to, so a one-time payment does not push you into a higher slab. Claim it by filing Form 10E online before submitting the ITR.