Tax on Severance Pay, Notice Pay and Layoff Compensation in India (AY 2026-27)

A layoff arrives with a spreadsheet attached. Three months of fixed pay, gratuity, whatever leave you had left, maybe a month of insurance continuation, and a number at the bottom that looks like a cushion.

Then the final settlement lands in your account and roughly a third of the cushion is missing.

That gap is almost never an employer error. Severance is taxed as salary, it is usually paid in one lump, and one lump pushes you into a higher slab than your monthly payslip ever did. This guide walks through what is taxable, the four exemptions that genuinely reduce the bill, and the relief most people never claim because the form has to be filed before the return.

Everything Is Salary Until a Section Says Otherwise

Section 17(3) of the Income-tax Act defines "profits in lieu of salary" to include any compensation due to or received from an employer in connection with the termination of your employment or a modification of its terms.

That definition is deliberately wide, and the label on your settlement letter has no effect on it. Ex gratia, goodwill payment, separation allowance, severance, retention bonus release, transition support: all of it is salary in the eyes of the Act.

So the correct question is never "is my ex gratia taxable". It is "does a specific exemption cover any part of this package", and there are exactly four worth checking.

The Four Exemptions That Actually Apply

That last column matters more than most people expect. The new regime removed HRA, LTA and most Chapter VI-A deductions, but it left these four exit-related exemptions untouched. A laid-off employee on the default new regime keeps every one of them, plus the ₹75,000 standard deduction on salary.

Gratuity: ₹20 lakh, not ₹25 lakh

For a private-sector employee covered by the Payment of Gratuity Act, the exempt amount is the least of:

1. Gratuity actually received
2. ₹20 lakh (the limit notified in 2019, and still the limit for AY 2026-27)
3. Last drawn basic plus DA x 15/26 x completed years of service

The ₹25 lakh figure that circulates online is the central government's own retirement gratuity ceiling, which was raised in 2024. Central and state government employees have fully exempt gratuity anyway, so the number is irrelevant to them and wrong for you. The full gratuity, EPF and pension breakdown covers the not-covered-by-the-Act variant, where the formula uses half a month's average salary instead.

One condition catches people in a layoff specifically: gratuity normally needs five years of continuous service. Where employment ends because of death or disablement, that condition falls away. It does not fall away merely because the separation was involuntary.

Retrenchment compensation: real, but narrow

Section 10(10B) exempts the least of the amount computed under Section 25F(b) of the Industrial Disputes Act (broadly 15 days' average pay for each completed year of continuous service), ₹5,00,000, or the amount actually received.

The catch is who qualifies. Section 10(10B) is written around a "workman" as the Industrial Disputes Act defines the term, which turns on the nature of the work rather than the size of the salary. Employees in supervisory or managerial roles are generally outside it, and most tech and corporate layoffs are settled without anyone invoking this section at all.

If your separation letter cites retrenchment under the ID Act, or a state labour department was involved, check it. Otherwise assume the package is fully taxable and treat the exemption as an upside.

VRS: only if the scheme meets Rule 2BA

Section 10(10C) exempts up to ₹5 lakh, but only where the scheme satisfies Rule 2BA. The scheme must apply to employees aged over 40 or with more than 10 years of service, must result in an overall reduction in headcount, the vacancy must not be refilled, and you must not be re-employed in the same group.

A layoff is not automatically a VRS. If your employer ran a formal voluntary separation programme, ask HR in writing whether it was notified as a Rule 2BA scheme, because that single sentence is worth up to ₹1.5 lakh in tax at the 30% slab.

Two further limits: the exemption is available once in your working life, and if you claim it you cannot also claim Section 89 relief on the same amount.

Notice Pay Cuts Both Ways

Notice pay received (the employer pays you three months instead of asking you to serve them) is ordinary taxable salary with TDS under Section 192. No exemption applies.

Notice pay recovered (you resign, do not serve, and the employer deducts the shortfall from your settlement) is messier. Section 16 contains no explicit deduction for it, so many employers report the gross figure in Form 16 and leave you taxed on money you never received.

Tribunals have taken the sensible view here, most cited being the Ahmedabad ITAT decision in Nandinho Rebello (2017), which held that only the salary actually received should be taxed. Practically:

• Ask payroll to report the net salary in Form 16 before it is issued, which is far easier than arguing later
• If Form 16 already shows gross, keep the full-and-final statement showing the recovery line
• Expect the return to differ from Form 16 and be ready to explain it if a Section 143(1) intimation queries the gap

A Worked Example

Priya, 11 years with a private employer, laid off on 30 September 2025. Basic plus DA of ₹1,00,000 a month, fixed monthly gross of ₹1,50,000. She stays on the new regime and finds no job for the rest of FY 2025-26.

Tax under the new regime slabs for FY 2025-26: nil to ₹4 lakh, 5% to ₹8 lakh, 10% to ₹12 lakh, then 15%. That works out to ₹71,250, plus 4% cess, so ₹74,100.

Two things are worth noticing.

Her taxable income is ₹75,000 above the ₹12 lakh rebate threshold, so the Section 87A rebate is gone and a package ₹75,000 smaller would have been entirely tax-free. And ₹7.84 lakh of her ₹15.34 lakh package was exempt, which only happened because the gratuity and leave encashment were computed and reported correctly rather than dumped into taxable salary.

Section 89 Relief: The Form Nobody Files

If your compensation on termination covers several years of service, spreading it across those years can cost less tax than taking it in one. Rule 21A allows exactly that, provided you had at least three years of continuous service and the unexpired portion of your employment was three years or more.

The mechanics are the same as for salary arrears, which the Section 89 and Form 10E guide sets out step by step.

The trap is procedural. Form 10E must be filed on the portal before you file the return. File it after, and the CPC disallows the relief in the intimation, and you are back to a rectification you could have avoided in ten minutes.

The Rest of the Layoff Year

EPF. Withdrawing before five years of continuous service makes the accumulated balance taxable, with TDS at 10% above ₹50,000. There is an exception where service ends because the employer's business is discontinued or for reasons beyond the employee's control, which some layoffs will satisfy. Transferring the balance keeps the clock running and is usually the cheaper choice.

ESOPs. Unvested options normally lapse on the last working day, and vested ones carry a short exercise window. Exercising triggers perquisite tax on fair value minus exercise price at that date, payable while you are out of work. See the ESOP and RSU taxation guide before deciding.

Advance tax. A lump sum in September with no salary afterwards frequently leaves TDS short of the actual liability, and Sections 234B and 234C charge interest for it. Check the position before the 15 December instalment.

Health cover. Group insurance usually lapses within days. If you buy an individual policy and are on the old regime, that premium is deductible under Section 80D.

File even if the year looks small. Six months of salary plus exempt components often lands below the taxable threshold once the ₹75,000 standard deduction is applied, which means the TDS already deducted comes back as a refund. It only comes back if you file.

When you do file, exempt components go into the "allowances to the extent exempt under Section 10" block of the salary schedule, tagged to the right sub-section, not netted off silently against gross salary. Reading them off a Form 16 that lumps everything into one line is where most self-filed returns go wrong, and it is the reconciliation 49Tax handles automatically from the Form 16 and AIS together.

The Takeaway

Before you sign the settlement, get three things in writing from HR: the split between severance and each exempt component, whether any voluntary separation scheme was notified under Rule 2BA, and whether Form 16 will report notice pay recovery net or gross.

All three are trivial for HR to answer in the week you leave, and effectively impossible to fix in July when the return is due.