Tax on Severance Pay in India: Section 10(10B), Section 89 Relief & the Refund Most Laid-Off Employees Never Claim (AY 2026-27)

Getting laid off is hard enough. Then the severance lands in your account — 3, 4, 6 months of pay in one lump sum — and a big chunk vanishes as TDS. Most people accept this as unavoidable. It often isn't. Indian tax law has specific reliefs for retrenchment compensation and lump-sum payouts that neither your employer's payroll team nor the ITR portal will apply for you automatically. This guide explains each one in plain language, for AY 2026-27.

First, understand what your "severance" actually contains

Your full and final settlement is not one payment — it's several components stapled together, and each one is taxed differently:

• Retrenchment / severance compensation — the "X months of pay" part. Partially exempt under Section 10(10B), explained below.
• Notice pay (pay in lieu of notice) — fully taxable as salary. No exemption.
• Leave encashment — exempt up to ₹25 lakh (for non-government employees, computed per the Section 10(10AA) formula). Anything beyond is taxable.
• Gratuity — if you completed the qualifying service, exempt up to ₹20 lakh under Section 10(10) for employees covered by the Payment of Gratuity Act.
• Ex gratia / "goodwill" amounts — taxable as profits in lieu of salary under Section 17(3), unless they fit within one of the exemptions above.
• Pending variable pay, reimbursements — taxed the same as regular salary.

Ask HR for a component-wise breakup of your full and final settlement in writing. Without it, you cannot claim any of the exemptions below correctly — and after a layoff, getting documents from an ex-employer only gets harder with time.

Relief #1: Section 10(10B) — the retrenchment compensation exemption

If your exit qualifies as retrenchment (the employer terminated you — you did not resign), compensation received is exempt up to the least of the following:

• The amount calculated under the Industrial Disputes Act formula — roughly 15 days' average pay for every completed year of service (part of a year beyond 6 months counts as a full year);
• ₹5,00,000 (the notified ceiling); or
• The actual amount received.

Example: 8 years of service, last drawn average pay ₹1,20,000/month, severance received ₹6,00,000. The ID Act formula gives 15 days × 8 years = roughly ₹4,80,000. The least of (₹4,80,000, ₹5,00,000, ₹6,00,000) is ₹4,80,000 — exempt. Only ₹1,20,000 of the severance is taxable.

The trap to know about: Section 10(10B) applies to retrenchment. If you signed paperwork describing your exit as a "voluntary resignation" — a condition some companies attach to enhanced severance packages — you may have signed away your eligibility for this exemption along with other protections. If you're reading this before signing such a clause, factor the tax cost into the decision, and consider getting the document reviewed by a lawyer first. (For voluntary retirement schemes, a separate exemption exists under Section 10(10C), also capped at ₹5 lakh, with its own conditions.)

Relief #2: Section 89 — relief when a lump sum pushes you into higher slabs

Severance bunches income that relates to years of service into a single year, shoving you into higher tax slabs for that one year. Section 89(1) fixes exactly this: it recomputes your tax as if the amount were spread across the relevant years, and gives you the difference as relief.

The step nobody tells you about: to claim Section 89 relief, you must file Form 10E online on the e-filing portal before submitting your ITR (Login → e-File → Income Tax Forms → File Income Tax Forms → Form 10E). Claim the relief in your ITR without filing Form 10E and the department will disallow it and send you a demand notice — this is one of the most common automated adjustments. The order matters: Form 10E first, ITR second.

Relief #3: the exemptions payroll may have missed

Check your final Form 16 carefully against these:

• Leave encashment — was the Section 10(10AA) exemption applied, or was the entire amount taxed?
• Gratuity — was the Section 10(10) exemption applied?
• Section 10(10B) — payroll teams processing hundreds of exits frequently skip this one entirely and deduct TDS on the full severance.

Here's the important part: even if your employer taxed everything and the Form 16 shows no exemptions, you can still claim them in your ITR. The Form 16 is your employer's report of what they did — it does not limit what you're legally entitled to. Claim the correct exempt amounts in the return, keep your settlement breakup and appointment/termination letters as proof, and the excess TDS comes back as a refund.

How this plays with the new tax regime (AY 2026-27)

The new regime is the default this year, and the Section 87A rebate makes total income up to ₹12 lakh effectively tax-free (₹12.75 lakh for salaried, after the ₹75,000 standard deduction). If you were laid off partway through FY 2025-26, your salary-plus-taxable-severance total may well land under that line — meaning your entire TDS could be refundable. Note that the exemptions discussed above (10(10B), 10(10AA), 10(10)) reduce your gross income and are distinct from the regime choice — they apply under both regimes. Run the numbers both ways before filing; salaried taxpayers can pick either regime each year, provided the return is filed by the due date.

Reporting it in the ITR: a quick map

• Exempt portions (10(10B), 10(10AA), 10(10)) go under exempt income / allowances to the extent exempt under Section 10 in the salary schedule.
• The taxable remainder stays within income from salary.
• Section 89 relief appears in the tax computation section — after Form 10E is filed.
• TDS on the severance is claimed like any salary TDS — verify it in Form 26AS. Changed jobs after the layoff? You have two Form 16s and a second set of pitfalls — see our companion guide on filing with two Form 16s.

The 60-second version

Get the component-wise settlement breakup in writing. Retrenchment compensation: exempt up to the least of the ID Act formula / ₹5 lakh / amount received — but "voluntary resignation" paperwork can cost you this. Leave encashment exempt up to ₹25 lakh; gratuity up to ₹20 lakh. Lump sum pushed you into a higher slab? Section 89 relief — but file Form 10E before the ITR. And if your employer over-deducted TDS, claim the exemptions in your return anyway and take the refund. Deadline: July 31, 2026.

This article is general information for AY 2026-27, not tax advice. Severance taxation depends on your employment terms, the nature of your exit, and amounts involved — for significant sums, a one-time consultation with a chartered accountant will usually pay for itself.