Is leave encashment taxable when I cash in my unused leave?

What does the law say?

Section 12(2)(a) of the Income Tax Ordinance, 2001 defines salary to include “any pay, wages or other remuneration provided to an employee, including leave pay, payment in lieu of leave”. Money paid to you for leave you did not take is a payment in lieu of leave. It is therefore salary and taxable under the head “Salary”, unless an exemption applies.

The Second Schedule, Part I, clause (19) provides one exemption:

Any sum representing encashment of leave preparatory to retirement of a member of the Armed Forces of Pakistan or an employee of the Federal Government or a Provincial Government.

Two conditions must both be met for clause (19):

1. Who: a member of the Armed Forces of Pakistan, or an employee of the Federal Government or a Provincial Government.
2. When: the encashment is of leave preparatory to retirement.

Nothing else in the clause widens it to private employers, companies, banks or other bodies.

How does it work in practice?

For a private sector employee, encashed leave is added to the rest of your salary for the tax year. Your employer deducts tax on it under section 149, re-estimating your annual salary in the month of payment and correcting “any excess deduction or deficiency arising out of any previous deduction”. The rates are the clause (2) table of Division I, Part I of the First Schedule, which for tax year 2027 runs from 0% up to Rs. 600,000 to 35% above Rs. 7,000,000.

For a federal or provincial government employee or a member of the armed forces, a sum representing encashment of leave preparatory to retirement is exempt under clause (19), so it is not part of taxable salary.

Worked example (illustrative figures)

Usman is an IT officer at a private bank in Islamabad. His figures are made up; the rates are the tax year 2027 rates.

• Monthly salary: Rs. 180,000, so annual salary before encashment Rs. 2,160,000
• In March he encashes 20 days of unused leave for Rs. 120,000

Tax without the encashment

• Slab: Rs. 1,200,001 to Rs. 2,200,000, so Rs. 6,000 + 11% of the amount over Rs. 1,200,000
• Rs. 6,000 + (11% x Rs. 960,000 = Rs. 105,600) = Rs. 111,600

Tax with the encashment

• Annual salary: Rs. 2,160,000 + Rs. 120,000 = Rs. 2,280,000
• Slab: Rs. 2,200,001 to Rs. 3,200,000, so Rs. 116,000 + 20% of the amount over Rs. 2,200,000
• Rs. 116,000 + (20% x Rs. 80,000 = Rs. 16,000) = Rs. 132,000

Extra tax caused by the encashment: Rs. 132,000 - Rs. 111,600 = Rs. 20,400

Check by slab: the first Rs. 40,000 of the encashment (taking salary from Rs. 2,160,000 to Rs. 2,200,000) is taxed at 11% = Rs. 4,400, and the remaining Rs. 80,000 at 20% = Rs. 16,000. Total Rs. 20,400.

Comparison: a provincial government employee

Farah, a Grade 17 officer of a provincial education department, retires and receives Rs. 900,000 as encashment of leave preparatory to retirement. Under clause (19) that sum is exempt. It is not added to her taxable salary, and no tax arises on it.

What if I am a government employee but not retiring?

Clause (19) speaks only of encashment “preparatory to retirement”. Leave encashed during service, or in circumstances that are not preparatory to retirement, is not described by that clause, so it falls back to section 12(2)(a) as payment in lieu of leave. The clause does not define “preparatory to retirement”; if your case is borderline, the wording of the clause and any government leave rules that apply to you are what matter, and those rules are not in this corpus.

What if I work for a state-owned company or autonomous body?

The clause names “an employee of the Federal Government or a Provincial Government”. It does not mention corporations, authorities or companies owned by government. Whether an employee of such a body counts as an employee of the Federal or a Provincial Government is not answered by the clause itself. This page does not resolve that question.

What if the encashment is paid on termination?

Section 12(2)(e)(iii) separately covers amounts received on termination of employment, such as redundancy compensation and golden handshakes, and section 12(6) lets an employee elect a special averaged rate for those. The Ordinance does not say whether a leave encashment paid at the same time falls under that termination provision or remains a payment in lieu of leave under section 12(2)(a). This page does not resolve that point; see the page on golden handshake and severance pay.

Common mistakes

• “All leave encashment at retirement is tax free.” Clause (19) applies only to armed forces members and federal or provincial government employees. A private employee retiring from a company gets no exemption under it.
• “Encashment is taxed at a flat rate.” It is added to salary and taxed at the ordinary slab rates, so the extra tax depends on which slab your total salary reaches.
• “Leave pay is different from leave encashment.” Section 12(2)(a) lists both “leave pay” and “payment in lieu of leave” as salary.

What to check in the official text

Read section 12(2)(a) and clause (19) of Part I of the Second Schedule in the Income Tax Ordinance amended to 30 June 2026. Check how your payslip or final settlement describes the payment, and whether your employer is a federal or provincial government department.