Gratuity and Leave Encashment: Tax Exemption Rules Explained

Gratuity: What It Is

Gratuity is a lump-sum benefit paid by an employer to an employee in recognition of services rendered, typically on retirement, resignation (after a minimum qualifying period), death, or disablement. For gratuity entitlement/calculation after implementation of the Labour Codes on 21 November 2025, the Code on Social Security, 2020 framework must be checked. Income-tax exemption remains a separate tax-law computation, and legacy tax provisions may still refer to categories historically linked to the Payment of Gratuity Act.

Tax Exemption on Gratuity — Section 10(10)

The tax treatment depends on the employee's category:

• Government employees: Gratuity received is fully exempt from tax, with no upper limit.
• Private sector employees covered under the Payment of Gratuity Act: Exemption is the least of: (a) actual gratuity received, (b) ₹20 lakh (the current statutory limit), or (c) 15 days' salary (based on last drawn salary) for each completed year of service (or part thereof exceeding 6 months), calculated using a 26-day month.
• Private sector employees NOT covered under the Act: Exemption is the least of: (a) actual gratuity received, (b) ₹20 lakh, or (c) half-month's average salary (last 10 months) for each completed year of service.

Gratuity Calculation Formula (Covered Employees)

For employees covered under the Payment of Gratuity Act, the standard formula is:

Gratuity = (Last drawn salary × 15 × number of completed years of service) / 26

"Salary" here generally means basic pay plus dearness allowance. A year of service is "completed" once it crosses 6 months — so 4 years and 7 months counts as 5 years for this calculation.

Leave Encashment: What It Is

Leave encashment refers to the payment received for unused/accumulated leave — either during service (encashed while still employed) or at the time of leaving the job (retirement, resignation, or otherwise).

Tax Exemption on Leave Encashment — Section 10(10AA)

• Government employees: Leave encashment received at retirement is fully exempt.
• Private sector employees (at retirement/resignation): Exemption is the least of: (a) actual amount received, (b) ₹25 lakh (the current cumulative limit across employers during the employee's lifetime), (c) 10 months' average salary (based on average salary of last 10 months), or (d) cash equivalent of leave to the employee's credit, calculated on the basis of a maximum of 30 days' leave for every completed year of service.
• Leave encashment received WHILE in service (not at the time of leaving): Fully taxable as "Profits in lieu of salary", regardless of employer type.

Worked Example: Gratuity on Retirement (Private, Covered Employee)

An employee retires after 22 years and 7 months of service, with a last drawn basic + DA of ₹80,000/month. Completed years (rounding up since 7 months > 6 months) = 23 years.

Gratuity per formula = (₹80,000 × 15 × 23) / 26 = ₹10,61,538

Since this is less than ₹20 lakh and less than the actual amount received (assume employer pays exactly this), the entire ₹10,61,538 is exempt from tax under Section 10(10).

What Happens on Resignation (Not Retirement)?

For gratuity, the exemption rules under Section 10(10) apply the same way whether the employee resigns or retires — as long as the minimum qualifying service period (generally 5 years under the Payment of Gratuity Act, with exceptions for death/disablement) is met. For leave encashment, the Section 10(10AA) exemption similarly applies "at the time of retirement or otherwise" — so resignation also qualifies, subject to the same limits.