For employees facing a layoff, the immediate concern may be the loss of a job. But when the severance cheque arrives, there is another question: how much of it will actually be left after tax?
The answer depends on what exactly is included in the exit package.
Is severance pay taxable?
Yes. Compensation received by an employee in connection with the termination of employment is generally treated as “profits in lieu of salary.”
That means the severance amount is added to the employee’s income for the relevant financial year and taxed at the applicable income-tax slab rate, along with surcharge and health and education cess, where applicable.
Under the Income-tax Act, 2025, such compensation continues to fall within the scope of profits in lieu of salary under Section 18(1).
So, for example, if an employee receives three months’ salary as compensation specifically for being laid off, that amount doesn’t automatically become tax-free simply because it is labelled “severance.”
What about the ₹5 lakh VRS exemption?
This is where an important distinction comes in.
Compensation received under a qualifying voluntary retirement scheme, or VRS, can be eligible for an exemption of up to ₹5 lakh under Rule 19(1) of the Income-tax Rules, 2025, subject to the prescribed conditions.
But an employer laying off workers isn’t the same as employees leaving under a qualifying VRS.
That means the ₹5 lakh VRS exemption would generally not apply to ordinary termination-related severance, such as compensation paid to employees affected by layoffs.
Your entire exit package may not be taxed the same way
A full-and-final settlement can contain several different components, and they shouldn’t necessarily be treated as one big severance payment for tax purposes.
Apart from termination compensation, the payout could include notice pay, gratuity and payment for unused leave.
Gratuity can qualify for a separate tax exemption. For private-sector employees covered by the Payment of Gratuity Act, the exemption is subject to the prescribed limit of ₹20 lakh. Gratuity received by government employees is fully exempt.
Leave encashment can also receive separate tax treatment. For non-government employees, leave encashment received on retirement or termination can qualify for exemption up to ₹25 lakh, subject to the applicable conditions and calculation rules. Government employees generally receive a full exemption.
Any amount that doesn’t qualify for an exemption becomes taxable.
Why the breakup of your settlement matters
Suppose an employee receives ₹10 lakh while leaving a company. Calling the entire ₹10 lakh an “exit package” doesn’t tell you how much tax is due.
If part of that amount is termination compensation, another part is eligible gratuity and another represents leave encashment, each component may have a different tax treatment.
Employees should therefore check that their termination or relieving documents and full-and-final settlement clearly break down the amounts paid as severance, notice pay, gratuity, leave encashment and other components.
That breakup can determine which exemptions can be claimed and how much of the final payout ultimately becomes taxable.
