Income Tax: Got Severance Pay After Layoff? This Is How It Is Taxed

Losing a job can be a stressful experience, but a severance package can offer some financial cushion during the transition. There is often confusion regarding the taxation of severance pay under Indian tax laws. Is it fully taxable, partially exempt or completely tax-free? Understanding how severance pay is taxed can help laid-off employees plan their finances better and avoid surprises during tax season.

Severance pay is a form of compensation provided by an employer to an employee upon termination of employment, often due to layoffs or downsizing. It is usually given as a lump sum and may include accrued leave encashment, notice pay and other termination-related benefits.

Severance pay received by a laid-off employee is taxable in India and is considered part of “income from salary” under the Income Tax Act, 1961. However, the tax treatment can vary based on factors such as the nature of the severance, whether the employee worked in the private sector or government, and the reasons for termination.

A common question among recipients is whether these payments are taxable and if any exemptions apply.

Until March 2019, such payments were often classified as “capital receipts” since they were one-time transactions, and many taxpayers argued they should not be taxed as income. This led to disputes between employees and the tax authorities.

Under Section 17(3)(i) of the Income Tax Act, severance pay is now taxed as “Profits in Lieu of Salary.” The law underwent a change from April 1, 2019, following the Union Budget 2018. This update clarified that any compensation received for termination or modification of contractual terms related to business is taxable as business income under Section 28(ii).

Additionally, to prevent tax evasion where severance pay is received from third parties rather than the employer, such payments are taxed under “Income from Other Sources” as per Section 56(2).

Certain components of severance pay may qualify for tax exemptions. For instance, gratuity payments are exempt up to a specified limit under Section 10(10) of the Income Tax Act. Leave encashment also enjoys tax benefits — while government employees can claim full exemption up to defined limits, private sector employees are eligible for partial exemptions. Additionally, compensation received under Voluntary Retirement Schemes (VRS) is exempt from tax up to Rs 5 lakh as per Section 10(10C). Moreover, under Section 89, employees can seek tax relief on any advance salary or arrears received, including severance pay, helping to reduce the overall tax burden in applicable cases.

While severance pay provides some financial relief, it usually comes with a tax obligation. It is important for recipients to understand the tax implications of different components of their severance package. Consulting a tax professional can help maximise available exemptions and ensure accurate filing of income tax returns.