The transition to the New Labour Codes represents a fundamental shift in how Indian organizations manage employee benefits and statutory compliance. One of the most significant changes involves leave encashment—specifically how leave is accrued, carried forward, and valued at the time of payout. Understanding these nuances is vital for HR practitioners and payroll managers to ensure future-proof compliance.
Under the new labour codes, specifically the OSH Code, employees are entitled to encash earned leave exceeding 30 days at the end of each calendar year. The calculation is based on the revised definition of ‘Wages,’ which ensures that allowances exceeding 50% of total remuneration are included in the basic pay for calculation purposes, potentially increasing the payout amount.
The Unified Definition of Wages
The most critical component of the leave encashment calculation rule as per new labour codes is the standardized definition of “Wages.” Previously, different acts used varying definitions, leading to confusion and inconsistent payouts. The Code on Wages, 2019, streamlines this by categorizing components into three parts: inclusions, exclusions, and a 50% threshold limit.
Wages now primarily include basic pay, dearness allowance (DA), and retaining allowance. However, if the sum of excluded components (such as HRA, overtime, and conveyance) exceeds 50% of the total remuneration, the excess amount is added back to the “Wages.” This ensures that the base used for leave encashment is substantial and reflects the employee’s actual earning capacity. This shift is a core part of the new labour code impact on payroll across all industrial sectors.
Leave Entitlement under the OSH Code
The Occupational Safety, Health and Working Conditions (OSH) Code, 2020, governs the rules for leave and annual holidays. It replaces several legacy laws, including the Factories Act, 1948, and various state-specific Shops and Establishments Acts. The new framework introduces a more flexible yet regulated approach to leave accumulation.
- Eligibility: An employee becomes eligible for earned leave (annual leave with wages) after working for 180 days in a calendar year, a reduction from the previous 240-day requirement.
- Accrual Rate: One day of leave for every 20 days of work performed.
- Carry Forward Limit: Employees can carry forward up to 30 days of earned leave to the succeeding year.
The Rule for Annual Leave Encashment
A major departure from previous practices is the provision for annual encashment. Under the OSH Code, if an employee has accumulated leave exceeding the 30-day limit at the end of the calendar year, they have the right to encash the excess leave. This prevents the “use it or lose it” scenario that often disadvantaged workers in the past.
Organizations must now update their leave policies to accommodate this yearly settlement. While the New Wage Code 2019 defines the financial base, the OSH Code dictates the timing and right to encashment. This ensures liquidity for the employee and prevents the buildup of massive leave liabilities on the company’s balance sheet.
| Feature | Legacy Laws (Factories/Shops Act) | New Labour Codes (OSH & Wages) |
|---|---|---|
| Work Days for Eligibility | 240 days | 180 days |
| Maximum Carry Forward | Varies by state (usually 30-45 days) | 30 days (standardized) | Usually at termination or retirement | Option to encash excess over 30 days annually |
| Calculation Base | Basic + DA (mostly) | Wages (subject to 50% inclusion rule) |
Step-by-Step Calculation Formula
To calculate leave encashment under the new rules, payroll departments must follow a specific sequence to determine the “Daily Wage Rate” based on the new definition of wages.
Step 1: Determine the Monthly Wage
Calculate the total remuneration. If exclusions (HRA, bonus, etc.) are more than 50% of the total, add the surplus to the Basic + DA. This total is your “Wage” for calculation.
Step 2: Calculate Daily Wage
The daily wage is typically derived by dividing the monthly Wage by 26 (the standard number of working days in a month for statutory calculations).
Step 3: Apply the Encashable Days
Identify the number of days exceeding the 30-day carry-forward limit or the total leave balance in case of full and final settlement.
Formula:
Leave Encashment = [(Basic + DA + Adjusted Allowances) / 26] × Number of Encashable Days
Encashment at Separation (Resignation or Retirement)
When an employee leaves the organization, the rules for full and final settlement apply. The OSH Code mandates that the payment for unavailed leave must be made within two working days of the employee’s last day. This is a strict timeline compared to previous practices where settlements often took 30 to 45 days.
For employees in the public sector or those governed by specific pay commissions, these rules align with broader reforms seen in the official government guidelines on labour reforms. It is important to note that while the codes provide a statutory floor, employers are free to offer more generous leave policies, provided they do not fall below these minimum requirements.
Common Misconceptions and Clarifications
There is frequent confusion regarding whether the 30-day limit applies to the total balance or just the carry-forward. The OSH Code specifies that an employee can carry forward up to 30 days. If the balance at the end of the year is 45 days, the employee can encash 15 days and carry forward 30. If the employee chooses not to encash, the treatment of the excess 15 days depends on the specific rules framed by the State Government, though the general intent is to encourage encashment or utilization.
Another point of clarity involves the “Daily Wage.” For workers paid on a piece-rate basis, the daily wage is calculated based on the average of their full-time earnings over the preceding three months of actual work.
Tax Implications on Encashment
While the Labour Codes change the calculation and entitlement, the taxation of leave encashment is governed by the Income Tax Act. For non-government employees, the exemption limit for leave encashment at the time of retirement or resignation was significantly increased to ₹25 lakh in recent budgets. Annual encashment while in service, however, remains fully taxable as part of “Salary” in the year of receipt.
Organizations should ensure that their payroll systems are configured to distinguish between annual encashment (fully taxable) and terminal encashment (eligible for exemptions under Section 10(10AA)) to avoid withholding tax errors.
Implementation Checklist for Employers
- Review and redefine “Wages” in the payroll system to comply with the 50% rule.
- Update leave policy documents to reflect the 180-day eligibility and 30-day carry-forward limit.
- Establish a process for year-end encashment of leaves exceeding the statutory limit.
- Train HR and finance teams on the two-day settlement mandate for departing employees.
- Audit existing leave balances to prepare for the transition once the codes are fully notified by the respective state governments.
By aligning internal policies with the leave encashment calculation rule as per new labour codes, businesses can mitigate legal risks and provide better transparency to their workforce. For further details on statutory calculations, referring to the Ministry of Labour and Employment portal is recommended for the latest notification updates.