Leave Encashment Calculation and Taxation with Examples

Did you know you can encash your paid leaves when you retire or resign from a company? 
According to Indian labour laws, every employee has the right to take a specific number of paid holidays each year, which are also included in the benefits provided by their company. You can encash some of these leaves if you do not use them.

Let's understand the different types of leave encashment and the process for leave encashment calculation.

What is Leave Encashment?

You have worked in a company for the last two years and have 20 paid leaves pending. If your salary is ₹31,000 per month, your daily income will be ₹1,000. You can encash the 20 unused paid leaves at ₹1,000 for each day. So, you will get ₹20,000 extra at the time of your resignation or retirement. 
When an employee resigns or retires, the full and final settlement includes the individual's accrued leaves.

The Different Types of Leaves

1. Casual Leave

Casual leave refers to paid leave given to employees, which can be utilised when they require a few days off due to unexpected/unforeseen personal circumstances. It is typically the most commonly used leave category among employees.

2. Privilege Leave

This is one of the most flexible and employee-friendly office leaves. These leaves are paid, which means an employee can enjoy these leaves without any salary deductions. These leaves are encashable, and employees can get paid instead of using these leaves.

3. Medical Leave

Employees may ask for medical leave if ill health barricades them from working. The number of medical leaves may vary from one company to the other. These leaves are neither carried forward nor encashed.

4. Maternity Leave

Any pregnant employee is eligible for maternity leave. According to the Maternity Benefit Act of 1961, a first or second-time mother is entitled to a maternity leave of 6 months or 26 weeks. The mother can take a maternity leave of 3 months or 12 weeks for subsequent children. This leave is fully paid, and the employer must provide the mother's full salary during this period.

Is Leave Encashment Subject to Taxation? 

During your employment journey, any leave encashed goes directly into the taxable column of your salary income—no exceptions. But there's a silver lining: Section 89 of the Income Tax Act offers potential relief that might soften the blow to your wallet. This provision recognises that a lump sum payment shouldn't necessarily push you into a higher tax bracket for that year.

Leave Encashment Calculation with an Example

Let's delve into the leave encashment calculation using a practical example involving Mr Rajeev, who is retiring after dedicating 20 years of service to his company.

• Throughout his tenure, he was entitled to 25 days of paid leave annually, accumulating a total of 500 days of leave over the years.
• During this period, Mr Rajeev has already availed himself of 150 days of paid leave, leaving him with an unutilised leave balance of 350 days.
• At the time of his retirement, Mr. Rajeev's monthly compensation includes a basic salary along with a dearness allowance (DA), amounting to a total of ₹35,000 per month.

The computation of leave encashment hinges on multiplying the number of unutilized leave days by the daily salary rate, which is calculated as follows:

Now, the leave encashment amount can be determined as:

Hence, Mr. Rajeev is eligible for a leave encashment payment of ₹4,08,450.

Leave Encashment Exemption & Taxation

When a Central or State Government employee retires or resigns, any leave encashment they get is entirely exempt. Legal heirs of a deceased employee who gets leave encashment are also wholly exempt.

Any leave may be redeemed while still on the job, upon retirement, or upon resignation. It is fully taxed when encashed during the service period and counts as salary income. However, Section 89 of the Income Tax Act allows for some relief to be claimed.

To ascertain the tax implications, we need to evaluate the tax exemption, which is the least of the following:

• The amount specified by the government.
• The actual leave encashment received.
• The average salary for the last 10 months (10 months × monthly salary).
• One day's salary multiplied by the difference between 30 (days in a month) and the unutilized days of leave.
   

How Does Leave Encashment Exemption Apply to an Employee?
 

• Every person who receives a salary has a specific number of paid leave days provided by their employer every year
• Most firms permit their workers to carry over unused paid leaves
• When an employee resigns or retires, the employer is responsible for compensating for any remaining leaves by the company's policy
• A leave encashment policy might differ from one employer to the other

Leave Encashment Taxation Exemption Calculation with an Example

Let us take the same example in consideration and calculate the tax exemption for Mr Rajeev.

Therefore, Mr. Rajeev's taxable leave encashment, categorized as 'income from salary,' amounts to ₹1,08,450.

Conclusion

It is essential to know that paid leaves can be encashed when retiring or resigning from a company. Indian labour laws give employees the right to a specific number of paid holidays each year, which can be included in their benefits. If any of these leaves remain unused, employees can encash them. Leave encashment policies may vary among employers. Regarding taxation, leave encashment may be exempt for certain individuals, such as government employees and their legal heirs. Understanding the provisions and regulations related to leave encashment can help employees make informed decisions and utilise their benefits effectively.

Frequently Asked Questions

1. What is the formula to calculate leave?

The leave encashment formula is [(Basic Salary + Dearness Allowance) / 30] * Number of EL or earned leaves.

2. How are 10 days of leave encashment calculated?

Cash equivalent is calculated as follows: (Pay admissible on the date of claiming the Leave Travel Concession + Dearness Allowance admissible on that date/30) * Number of days EL, with a maximum of 10 days at once. The House Rent Allowance is not considered when calculating the cash equivalent according to the formula above.

3. How to calculate encashment exemption?

Employees working for non-government organisations are only exempt to the extent of the lowest of the following:

• The actual amount of paid leave
• Average compensation for the past 10 months
• For each year of service that has been completed, salary per day * unused leave (taking the annual maximum of 30 days off into consideration)

The above-mentioned compensation consists of a base salary, a dearness allowance, and commissions calculated as a fixed percentage of the employee's secured turnover.

5. How much leave encashment is exempt from income tax?

The exemption limit for leave encashment from income tax in India is currently set at ₹25,00,000. Any amount received as leave encashment up to this limit is exempt from income tax.