Gratuity and leave encashment are two of the most common lump-sum payments employees receive on leaving a job — whether through retirement, resignation, or termination. Both have specific tax exemption rules, but the exemption limits and conditions differ significantly between government and private sector employees.
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. It is governed by the Payment of Gratuity Act, 1972 for most establishments, though some employers offer gratuity outside this Act as well.
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.
⚠ The ₹25 lakh leave encashment limit is a lifetime aggregate across all employers — if you've already claimed exemption against this limit with a previous employer, the remaining limit reduces accordingly when you leave a subsequent employer.
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.
Frequently Asked Questions
Is gratuity received before completing 5 years of service taxable? ▼
If an employee leaves before completing 5 years of continuous service (the minimum eligibility under the Payment of Gratuity Act, except in cases of death or disablement), they are generally not entitled to gratuity at all from the employer. If an employer voluntarily pays an amount in such a case, its tax treatment would typically fall outside the Section 10(10) exemption framework and may be taxed as a regular receipt.
Does the new tax regime affect gratuity and leave encashment exemptions? ▼
No. The exemptions under Section 10(10) for gratuity and Section 10(10AA) for leave encashment are retained under the new tax regime (Section 115BAC) — these are not part of the deductions/exemptions that get withdrawn when opting for the new regime.
Is leave encashment received during service (not on leaving the job) taxable? ▼
Yes. Leave encashment availed while still in employment is fully taxable as "Profits in lieu of salary" under the head Income from Salary, for both government and private sector employees. The Section 10(10AA) exemption applies only to leave encashment received at the time of retirement, resignation, or termination.