1. Separate the employer’s payment from the tax calculation
A final settlement can include gratuity, earned leave encashment, voluntary retirement or retrenchment compensation, and provident fund proceeds. Check each amount separately. A labour law entitlement, an employer’s policy and the income tax exemption can produce different amounts.
The examples below use the Income-tax Act, 1961 for payments in financial years through FY 2025–26. The retirement exemptions described for that period are available under either tax regime when the conditions are met. For tax years beginning on or after 1 April 2026, consult section 19 of the Income-tax Act, 2025 for salary deductions relating to these benefits, section 157 for tax relief, and the applicable notifications and rules. Do not confuse AY 2026–27 under the earlier Act with Tax Year 2026–27 under the new Act.
2. Which payment qualifies?
| Payment | Historical provision | How to calculate the exempt amount |
|---|---|---|
| Government and similar qualifying gratuity | Section 10(10)(i) | Qualifying payments under the specified government, defence or similar schemes are fully exempt. Employment with a PSU by itself does not establish that treatment. |
| Statutory gratuity under the 1972 Act | Section 10(10)(ii) | For a monthly rated employee, take the lowest of the actual payment, the applicable ceiling, and last drawn qualifying wages × 15/26 × eligible years. Count a final part-year only if it exceeds six months. Special rules apply to seasonal and piece-rated workers. |
| Other gratuity | Section 10(10)(iii) | Take the lowest of actual gratuity, the available notified ceiling, and half a month’s average qualifying salary per completed year. Ignore part-years. Use the average for the ten months immediately preceding the month of the event. |
| Earned leave paid on retirement or resignation | Section 10(10AA) | Qualifying Central or State Government payments are fully exempt. For other employees take the lowest of actual payment, available ceiling, ten months’ average qualifying salary, and the cash value of eligible unused earned leave. |
| Leave paid while employment continues | Sections 15 and 17 | Ordinary in-service encashment is taxable as salary. The retirement exemption does not apply. |
| Voluntary retirement | Section 10(10C), Rule 2BA | Up to ₹5 lakh, once, for a qualifying employer and scheme; the exemption and section 89 relief cannot both be claimed for VRS. |
| Retrenchment | Section 10(10B) | For a qualifying workman, ordinarily the least of actual qualifying compensation, the amount computed under the referenced retrenchment formula, and ₹5 lakh. Check whether a separately approved scheme applies. Ordinary resignation or a negotiated exit is not automatically retrenchment. |
| Recognised provident fund settlement | Section 10(12), Fourth Schedule Part A, Rule 8; section 192A | Apply the service, transfer and termination tests. Separately account for any interest taxable on excess employee contributions. |
3. Gratuity: choose the right wage base
Under the 1972 Act, the common monthly rated formula used last drawn wages including dearness allowance, but excluding bonus, commission, HRA, overtime and other allowances. Exactly 14 years and six months counted as 14 years; 14 years, six months and one day counted as 15. Under the historical tax formula for other gratuity, 14 years and 11 months still counts as 14. For that formula, the department’s guidance includes basic pay, DA where it forms part of retirement benefits, and qualifying turnover-based commission.
The Code on Social Security, 2020 gratuity framework applies from 21 November 2025, as the Ministry of Labour explains. Use the applicable wage definition in section 2(88), including the rule for specified exclusions exceeding the prescribed proportion of remuneration, rather than treating all allowances as excluded. Chapter V generally requires five years of continuous service for ordinary retirement or resignation; the Code contains exceptions for death, disablement and expiry of fixed-term employment, among others. Do not treat four years plus 240 or 190 days as an automatic nationwide entitlement. Check the statutory continuous-service test and controlling authority for the facts and jurisdiction.
4. Leave encashment: apply all four limits
Notification 31/2023 raised the non-government ceiling from ₹3 lakh to ₹25 lakh for qualifying retirements from 1 April 2023. Prior exemptions reduce the available ceiling, and simultaneous settlements do not create a fresh ceiling per employer. Compute average qualifying monthly salary over the ten months immediately preceding the departure. For historical purposes, this generally means basic pay, eligible DA and qualifying turnover-based commission.
Use the employer’s earned-leave ledger. For the tax calculation, entitlement is restricted to the lower of actual entitlement and 30 days for each completed year of actual service. Reconcile leave taken and prior encashments so that only eligible leave still standing to credit is valued. Apply the other limits even if the employer’s payment falls below ₹25 lakh. A qualifying resignation can fall within retirement otherwise than on superannuation; an encashment during continuing employment is different.
5. Six worked examples
1. Statutory gratuity and the excess paid by the employer
To illustrate the historical 1972 Act formula, assume Rajesh retired on 20 November 2025, before the new gratuity framework took effect, after 16 years, eight months and 12 days. He receives ₹18.50 lakh. His basic pay of ₹1.30 lakh and DA of ₹26,000 make qualifying monthly wages of ₹1.56 lakh. HRA of ₹65,000 and special allowance of ₹40,000 are excluded on these historical facts. His qualifying service rounds to 17 years. The formula gives ₹1.56 lakh × 15/26 × 17 = ₹15.30 lakh. Assuming no prior exemption and a ₹20 lakh ceiling, ₹15.30 lakh is exempt and ₹3.20 lakh is taxable. Check section 89 relief separately; it depends on the tax comparison.
2. A 42-day leave policy and the 30-day tax limit
Sunita leaves after 12 years and nine months, with ₹1.50 lakh average monthly qualifying salary and no prior exemption. The employer grants 42 days a year: 12 × 42 = 504 days. After 204 days taken she encashes 300 days, receiving ₹15 lakh at ₹5,000 per day. The tax entitlement is 12 × 30 = 360 days; after 204 days taken, 156 days (5.2 months) remain. The four amounts are ₹15 lakh actual, ₹25 lakh ceiling, ₹15 lakh for ten months’ salary, and ₹7.80 lakh for eligible leave. The exemption is ₹7.80 lakh and ₹7.20 lakh is taxable.
3. Prior exemptions across two employers
Arjun’s 2018 settlement included ₹6.50 lakh previously exempt gratuity and ₹2.80 lakh previously exempt leave encashment. In January 2026, his second employer pays ₹18 lakh and ₹24 lakh respectively. Assume the applicable formulas otherwise support the stated amounts and the gratuity is subject to the cumulative ceiling. The remaining gratuity limit is ₹20 lakh − ₹6.50 lakh = ₹13.50 lakh, leaving ₹4.50 lakh taxable. The remaining leave ceiling is ₹25 lakh − ₹2.80 lakh = ₹22.20 lakh, leaving ₹1.80 lakh taxable.
4. Payments to a widow after death in service
The widow receives ₹32 lakh described as gratuity and ₹18 lakh of leave salary. The department’s guidance treats leave salary paid to a legal heir as exempt on these facts; it does not use the employee’s own ₹25 lakh retirement ceiling. Verify the ₹32 lakh separately: if it is all contractual or statutory gratuity subject to a ₹20 lakh ceiling, and the formula supports that ceiling, ₹12 lakh remains outside the gratuity exemption. If the employer can document a genuinely separate gratuitous or compensatory payment because the employee died in service, review CBDT Circular 573 for that separate payment. Do not simply relabel excess gratuity.
5. A ₹35 lakh VRS package
A 51-year-old manager with 18 years of service receives ₹35 lakh under an assumed qualifying Rule 2BA scheme. He claims the ₹5 lakh exemption, leaving ₹30 lakh taxable, and cannot also take section 89 relief on the VRS amount. If every rupee of the ₹5 lakh would otherwise have been taxed at 30% plus 4% cess with no surcharge, the illustrative saving is ₹1.56 lakh. That comparison does not establish the actual saving where slabs, relief or surcharge differ.
6. EPF service across two employers
Kriti worked two years and six months at Startup A and three years at Company B. The earlier recognised PF balance was actually transferred. Rule 8’s explanation allows the earlier service to count: 30 + 36 = 66 months. Assuming a qualifying historical settlement, the ₹14 lakh eligible accumulated balance meets the five-year test and does not attract section 192A withholding; separately taxable interest remains separate. Rule 8(ii) covers specified involuntary cessations before five years, such as ill-health or contraction of the employer’s business. Confirm eligibility to withdraw under the applicable PF scheme separately.
6. Frequently asked questions
1. Are 15 days of leave encashed during employment exempt?
No. A routine encashment during ongoing employment is salary. Do not assume that it qualifies for tax relief merely because it relates to leave.
2. Do the limits reset after a job change?
No for payments subject to the relevant cumulative ceiling. Reconcile exemptions previously allowed and any payments from multiple employers in the same year. Keep qualifying government payments separate.
3. Can I deduct notice pay recovered in my final settlement?
There is no general separate deduction under section 16. Identify salary legally due or paid and distinguish a reduction in salary never due from a later recovery against salary already earned. Check the contract, payroll records and Form 16; a payroll label is not conclusive. Review any new employer reimbursement separately.
4. How does relief on taxable gratuity work?
For historical section 89 claims, Rule 21A(3) compares the relevant average tax rates using two prior years for service of at least five but under 15 years, or three prior years for service of 15 years or more. Relief depends on a favourable comparison. Use Form 10E for the historical Act; for the 2025 Act use section 157 and the applicable rules and form. Do not apply the gratuity spreading formula automatically to leave encashment.
5. Do fixed-term workers qualify after one year?
The Ministry’s guidance addresses direct fixed-term employees under the Code on Social Security. Check a qualifying fixed-term contract, at least one year under the contract, the reason for cessation and the pro-rata statutory amount. The labour entitlement and income tax treatment are separate tests; do not apply the ordinary completed-year formula to all fixed-term payments.
6. Where do I disclose the amounts?
For the applicable historical ITR, reconcile the employer’s Form 16 and final settlement. Use the salary and section 10 exemption fields in the relevant utility (Schedule S in ITR-2), following the form’s gross and exempt reporting structure. Keep the exemption calculation and supporting records.
Sources
- Income-tax Act, 1961: sections 10, 17, 89, 115BAC and 192A; Fourth Schedule
- Income-tax Act, 2025: sections 19, 157 and 202
- CBDT Notification 16/2019: gratuity ceiling
- Ministry of Finance: Notification 31/2023 and the leave encashment ceiling
- Gazette copy: Notification 31/2023
- Income Tax Department: computation of retirement benefits
- CBDT Circular 573: payments to legal heirs on death in service
- Income Tax Department: salary guidance, including leave salary paid to heirs
- Ministry of Labour and Employment: gratuity, wages and fixed-term employment FAQs
- Bombay High Court: CIT v. D.P. Malhotra on leave encashment at resignation
- Income Tax Department: Rule 21A computation
- Income Tax Department: Form 10E user manual