Understanding Leave Encashment: Calculations, Tax Implications, and Regulations

Understanding Leave Encashment: Calculations, Tax Implications, and Regulations

Leave encashment has often been ignored by employers and employees alike. Despite the component having an attractive employee benefit and occupying an overall employee remuneration, it has lost its significance over the course of time.  However, the recent Indian labour laws have mandated leave encashment that may affect its use.

How Leave Encashment Can Affect Your Organization?

The India Government is gearing up to implement the four new labour laws that will affect take-home pay, EPF contribution, number of paid leaves, and maximum working hours. And in the Occupational Safety, Health and Working Conditions Code, under one of the labour laws states that an employee can’t accumulate more than 30 days of paid leave in a calendar year. Thus, employees can encash their leaves. 

However, considering the benefits of leave encashment, it is mandatory to comprehend its benefits and what are the factors to be kept in mind while computing it. Therefore, it is critical to closely understand the laws and policies and their impacts of taxation on the encashed leaves.  

What is Leave Encashment?

Leave encashment is the amount of money an employee receives from an employer for unused leaves. The policy states that the employer is responsible to clear the employees dues through cash or or adjusting leaves for the next calendar year. Additionally, an employee’s leaves are to be reimbursed and provided in full and final after their resignation or termination. 

The leave encashment policy differs from organization to organization, and the rules however may vary. Likewise, some companies may pay for leaves unused, while some might adjust in the calendar year. The 1948 Factories Act, the amount of unavailed leaves and bonuses must be settled by the 7th or 10th of the following month. 

What are the types of leaves?

To encash leaves, employees need to apply for diverse types of leaves that cater to various life events and circumstances. However, there are many types of leaves that may vary from company to company. Let us have a look at the simplified overview at the primary types of leaves: 

  • Casual Leaves: These are available for 7 to 10 days. Employees may avail them for personal reasons and encashment for them may vary from company to company.  
  • Privilege Leaves: An employee can avail earned or privilege leaves with prior notice to the authority. These leaves can be encashed after a specific period. 
  • Medical Leaves: If employees are unable to work due to health problems, they apply for medical leaves. The maximum number of medical leaves vary from organization to organization, and so do its policies. 
  • Maternity Leaves: These are available to female employees only and may range from 3 months to 6 months during pregnancy. An employee can ask for an extension, but no payment is made for the extended period. However, these leaves can’t be encashed by employees. 
  • Sabbatical: Employees can take leaves for upskilling and expanding their current knowledge. Companies can ask employees to enroll themselves for a course and reimburse their leaves. 
  • Holiday Leaves: These are leaves provided by the employer and no salary is deducted for the leaves. The maximum number of such leaves can vary from one company to another. 

Is Leave Encashment Taxable?

Any leave that is available after the end of the service due to resignation or retirement can be encashed. When the leaves are encashed during the service period, it becomes fully taxable and can be a part of income. However, one can claim some relief under Section 89 of the Income Tax Act. 

Conditions of Exemption 

Leave encashment at retirement or resignation can be availed with certain partial and complete exemptions. The conditions of exemption are:

  • For employees of the Central and State Govern, the leave encashment can be excused from taxation.
  • Leaves are entirely exempted if any legal heir has encashed leaves on behalf of a deceased employee. 
  • The government employees get exemption based on the computation provided in Section 10 (10AA)ii. 

Calculations for Leave Encashment in India

Let us dive deeper to understand how leave encashment can be calculated using a practical example. Mr. Abhijeet, retiring after dedicating 25 years of service to his company. The formula is:

  • Leave Encashment Amount=Number of Leave Days×Daily Wage

Daily wage is commonly calculated as the monthly salary divided by the number of working days in a month. Employers may have variations in the method used for calculating daily wages, and it’s important for employees to refer to company policies for precise calculations.

  • Throughout his tenure, he has been entitled to 25 days of paid leave annually,  which makes it 625 leaves over the years.
  • During this period, he already used 100 of these leaves, that would make the unused paid leaves 500 days. 
  • By the end of his service, his monthly compensation accounts for ₹ 50,000 per month. 

The computation of leave encashment is calculated by multiplying the number of unused leave days by the daly salary rate, it is as follows: 

Salary per day Total monthly salary/ no. of days in a month salary per day= 50,000/30 = ₹1667

The leave encashment amount can be determined as:

= no. of unused leave days * salary per day leave encashment received 

= 500 *1667

= ₹ 8, 33, 500

Hence, Mr. Abhijeet is eligible for a  ₹ 8, 33, 500 as leave encashment. 

Benefits of Leave Encashment

1. Financial Flexibility

Employees can get more flexibility to receive an additional component in a salary, when needed providing a financial cushion during unexpected expenses. This helps people plan their finances more smartly and effectively.

2. Encourage Leave Utilization 

Leave encashment policies often encourage employees to leverage their leaves regularly that would lead to a balanced work-life. Besides providing financial incentives, employers empower employees to take necessary breaks and not accumulate excessive leave balances. 

3. Retirement Planning

Leaves encashment becomes particularly significant after retirement. Employees can use it as an employee benefit retirement plan. 

4. Tax Efficiency 

While leaves encashment is taxable in India, as we have discussed above, employees are subject to specific exemptions 

5. Employee Satisfaction 

Offering leave encashment leads to overall employee satisfaction and it shows employer values work-life balance and takes care of financial needs. Satisfied employees are likely to be more productive, engaged, and loyal to the company. 

Conclusion

To wrap up the blog, leave encashment offers a flexible leave application that promotes work-life balance and serves as a valuable retirement plan component. Understanding the calculations, tax implications, regulations are crucial to make a more informed decision. Likewise, our SkizzleHR, an HRMS software solution offers payroll software and time & attendance software to accommodate these changes. Our modules allow companies to create their own policies and rules and streamline all their HR processes effectively and efficiently.

If you are willing to learn more, 

Contact us now!

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