Gratuity, Leave Encashment and PF: What Is Taxable When You Leave

When you leave a job — whether through resignation, retirement or retrenchment — you typically receive three large payments: gratuity, leave encashment and your Provident Fund balance. Each one has a different tax treatment, and getting this wrong can cost you thousands of rupees in unnecessary tax or, worse, a penalty notice. The short answer: gratuity is mostly exempt up to ₹20 lakh, PF is tax-free after five years of service, and leave encashment is partly exempt depending on your employer type. Here is exactly how each works for FY 2026-27.

Gratuity Taxation: The Complete Picture

Gratuity is governed by Section 10(10) of the Income Tax Act. How much is exempt depends on whether your employer is covered under the Payment of Gratuity Act, 1972 or not.

Employers Covered Under the Gratuity Act

If your employer has 10 or more employees, the Payment of Gratuity Act applies. The exemption is the least of these three amounts:

• Actual gratuity received
• ₹20,00,000 (the statutory ceiling, enhanced in 2018 and still applicable for FY 2026-27)
• 15 days' salary for every completed year of service (salary = last drawn basic + DA, and a month is counted as 26 working days)

Employers NOT Covered Under the Gratuity Act

The exemption is the least of:

• Actual gratuity received
• ₹20,00,000
• Half a month's average salary for every completed year of service (average salary = average of last 10 months' basic + DA)

The excess over the exempt amount is added to your salary income and taxed at your slab rate. Government employees receive the entire gratuity tax-free without any formula calculation.

Worked Example — Gratuity Taxation

Rajan is a private-sector employee covered under the Gratuity Act. He retires after 22 years and 7 months of service. His last drawn basic salary is ₹80,000 per month. His employer pays him a gratuity of ₹15,00,000.

So Rajan must include ₹4,84,615 in his taxable salary for the year. If he had served a few more years or his employer paid exactly the formula amount, the entire sum would have been exempt. Use the Gratuity Calculator to check the exempt amount for your own numbers instantly.

Leave Encashment Taxation

Section 10(10AA) governs this. The rules split clearly by employer type.

For private-sector employees encashing leave at retirement or resignation, the exemption is the least of:

1. Actual leave encashment received
2. ₹25,00,000 (enhanced limit notified by the government; verify the notification applicable for your year of receipt)
3. Ten months' average salary (average of last 10 months' basic + DA)
4. Cash equivalent of earned leave standing to credit, restricted to 30 days per year of service

Any amount above the exempt limit is taxable as salary income. If you encash leave while still employed — for example, during a vacation — the entire amount is taxable in that year, no exemption applies.

EPF and Taxation on Withdrawal

Your Employees' Provident Fund balance has three components: employee contribution, employer contribution, and interest. The tax treatment differs by how long you have contributed.

After 5 Continuous Years of Service

Withdrawal is fully exempt under Section 10(12). The five years can span multiple employers if you transferred your PF balance rather than withdrawing it. This is the most important point people miss.

Before 5 Continuous Years of Service

The entire withdrawal — employee contribution (to the extent a deduction was claimed under Section 80C), employer contribution, and all interest — becomes taxable. The employer deducts TDS at 10% if the withdrawal exceeds ₹50,000 and you submit PAN; without PAN, TDS is at the maximum marginal rate. The income is added to your gross total income and taxed at your applicable slab.

High-Earning Employees: The EPFO Interest Tax

From FY 2021-22 onwards, interest on employee contributions exceeding ₹2.5 lakh per year to EPF is taxable. For employees where the employer does not contribute (i.e., government employees with GPF), the threshold is ₹5 lakh. This is a separate annual tax event, not just a withdrawal issue.

TDS You Should Expect

• Gratuity: Employers deduct TDS on the taxable portion as part of salary TDS (Form 16 will reflect this).
• Leave encashment: Same — included in salary TDS by the employer.
• EPF withdrawal before 5 years: EPFO deducts TDS at 10% (with PAN) on withdrawals above ₹50,000. File Form 15G / 15H if your total income is below the taxable threshold to avoid this deduction.

Common Mistakes That Lead to Tax Notices

1. Counting service years incorrectly for gratuity. Many employees (and even HR departments) round up every fraction of a year. The Payment of Gratuity Act rounds up only if the fraction exceeds six months. Using the wrong number inflates the exempt amount on your return, which can trigger a scrutiny notice.
2. Treating PF transfer as withdrawal. If you change jobs and transfer your PF to the new employer's account via the EPFO portal, the service period continues unbroken. Many people panic and withdraw, unknowingly triggering full taxation on the amount plus losing the five-year continuity.
3. Claiming leave encashment exemption on resignation from a private job. The exemption under Section 10(10AA) for private employees applies at superannuation or retirement. Resignation does attract the exemption formula too, but leave encashed during service (e.g., casual encashment while employed) does not — people confuse these two situations.
4. Missing the ₹20 lakh lifetime cap on gratuity exemption. If you have worked at multiple employers and claimed gratuity exemption earlier, the ₹20 lakh ceiling is a lifetime limit across all employers combined. A second employer's gratuity may be partly or fully taxable even if it looks small on its own.
5. Not filing Form 15G before EPF withdrawal. If your income for the year is below the basic exemption limit, you can submit Form 15G (or Form 15H if you are a senior citizen) to the EPFO so no TDS is deducted. Forgetting this means waiting for a refund — which can take a year or more.

Which ITR Form to Use and When to Report

All three receipts — gratuity, leave encashment and PF withdrawal — are reported in the year of receipt, not the year of leaving. They appear under Schedule S (Salary) in your ITR. The exempt portions are claimed in the exemption schedule. Use ITR-1 if your total income (including taxable portions) is within ₹50 lakh and all income is from salary or one house property. Use ITR-2 if you have capital gains or multiple properties. Ensure your Form 26AS and AIS show the TDS correctly before filing — mismatches are the primary trigger for notices on separation payments.

Frequently asked questions

Is gratuity taxable if I resign before retirement?

Yes, the same tax rules apply regardless of whether you resign, retire or are retrenched. The exemption under Section 10(10) is calculated the same way — actual gratuity received, the formula amount, and the ₹20 lakh ceiling — and the least of the three is exempt. The cause of leaving does not change the calculation.

What happens to the tax on EPF if I switch jobs and withdraw instead of transferring?

If you withdraw your EPF balance before completing five continuous years of service (counting across employers only if you transfer, not withdraw), the full withdrawal is taxable. The employee contributions on which you claimed 80C deduction, the employer's contributions, and all interest are added to your income for that year and taxed at your slab rate. TDS is also deducted by EPFO at 10% if the amount exceeds ₹50,000.

Can I claim both gratuity exemption and leave encashment exemption in the same year?

Yes. The two exemptions are independent of each other. Section 10(10) covers gratuity and Section 10(10AA) covers leave encashment. You can claim both in the year you leave employment, subject to their individual limits and conditions. They do not reduce or offset each other.

I worked at two companies in my career and received gratuity from both. Is the ₹20 lakh limit applied per employer?

No — the ₹20 lakh exemption under Section 10(10) is a lifetime aggregate limit across all employers. If you claimed, say, ₹8 lakh as exempt gratuity from your first employer, only ₹12 lakh of exemption remains available from subsequent employers. You must track this yourself and declare it correctly in your ITR.

General information for FY 2026-27, not professional advice for your specific case. Rules change — verify against the latest notification or ask a KyaTax expert.
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