Profits in Lieu of Salary: Termination, Joining and Retirement Payments (Income Tax Act 2025)

"Profits in lieu of salary" are payments linked to a job that are not ordinary monthly pay but are still taxed under the head Salaries. Section 18(1) of the Income-tax Act, 2025 covers three groups: compensation for termination or a change in terms of employment, amounts received from any person before joining or after leaving a job, and certain payments from an employer, a former employer or a provident fund. Section 16(f) puts them inside "salary", so they are added to your other salary income for the tax year.

This guide explains what each group means, what section 18(2) leaves out, how the Act softens the tax on a lump sum (section 19 deduction and section 157 relief), and what the employer must report. Every point is traced to the Act (as amended by the Finance Act, 2026) and the Income-tax Rules, 2026. Last reviewed on 10 November 2026.

What are profits in lieu of salary under section 18?

Section 18(1) says the term "includes" the items below. The word "includes" means the list is a floor, not a full stop. The tax is on amounts due or received, so the right to the money can trigger tax even if it has not been paid yet.

Clause	Payment	From whom
18(1)(a)	Compensation at or in connection with the termination of employment, or the modification of its terms and conditions	Employer or former employer
18(1)(b)(i)	Any amount, lump sum or otherwise, before the assessee joins employment	Any person (the future employer)
18(1)(b)(ii)	Any amount, lump sum or otherwise, after the employment has ended	Any person (the former employer)
18(1)(c)(i)	Any payment due or received	Employer or former employer
18(1)(c)(ii)	Any payment from a provident or other fund, to the extent it is not the assessee's own contributions or interest on them	Provident or other fund
18(1)(c)(iii)	Any sum under a Keyman insurance policy, including bonus allocated on it	Insurer

Is termination or severance compensation taxable?

Yes. Section 18(1)(a) brings in compensation due to or received by the assessee from the employer or former employer at or in connection with the termination of employment, or a change in its terms. It is taxed as salary in the tax year it is due or received, together with the rest of the salary income.

Two parts of the Act can reduce the bite. Section 19(1), Table Sl. No. 12 gives a deduction for voluntary retirement or voluntary separation schemes. Section 157 lets you ask for relief when a lump sum pushes you into a higher rate. Both are covered below.

Are joining bonuses and payments after leaving a job taxable?

Section 18(1)(b) reaches amounts from any person, not just the employer, and it does not matter whether the amount is a lump sum or paid in parts. A payment received before you join that person's employment is covered by clause (b)(i). A payment received after your employment with that person has ended is covered by clause (b)(ii). The Act does not look at what the payment is called, so a signing amount, a payment for a notice period waiver or a payment for staying away from a competitor are all tested against this clause. Whether a particular payment falls inside it depends on the facts and the agreement.

What does section 18(1)(c) cover: employer payments, provident fund and Keyman policies?

Clause (c) picks up three kinds of payment:

• any payment due to or received from an employer or former employer;
• any payment from a provident or other fund, but only to the extent it is not made up of your own contributions or the interest on them. The employer's side of the fund can therefore be salary; and
• any sum received under a Keyman insurance policy, including bonus allocated on the policy.

Under Schedule II, Note 1(c), a Keyman insurance policy is a life insurance policy taken by a person on the life of another, where that other person is or was an employee of, or is or was connected in any manner with the business of, the first person. It includes a policy assigned to someone at any time during its term, with or without consideration. Schedule II, Sl. No. 2(c)(ii) also says a Keyman policy sum cannot be excluded as an ordinary life insurance payout.

What is left out of profits in lieu of salary? (Section 18(2))

Section 18(2) says the clause (c) payments do not include a payment referred to in:

Reference	What it is
Schedule II, Sl. No. 3	Payment from a provident fund to which the Provident Funds Act, 1925 applies, or another provident fund set up and notified by the Central Government
Schedule II, Sl. No. 4	Accumulated balance due and payable to an employee in a recognised provident fund, to the extent provided in paragraph 8 of Part A of Schedule XI
Schedule II, Sl. No. 8	Payment from an approved superannuation fund, in the situations listed there (death, commutation of annuity on retirement, refund of contributions, transfer to a pension scheme under section 124)
Schedule III, Sl. No. 11	Special allowance from the employer for rent actually paid on residential accommodation, to the extent prescribed

Schedule II items carry their own conditions. For example, interest on the employee's contribution above Rs 2,50,000 in a tax year (Rs 5,00,000 where the employer makes no contribution) is not excluded for contributions made on or after 1 April 2021. Read the Schedule row before assuming a payout is free of tax.

Is the voluntary retirement (VRS) amount taxable?

It is part of the amount received on termination, so it is first taxable. Section 19(1), Table Sl. No. 12 then gives a deduction equal to the lower of the compensation received and Rs 5,00,000 for an amount received or receivable on voluntary retirement or termination of service under a qualifying scheme. The conditions are:

• The scheme must be for employees of the bodies listed in section 19(2)(h): a public sector company (under a scheme of voluntary separation), any other company, a statutory authority, a local authority, a co-operative society, a University, an IIT, the Central or a State Government, or an institution notified by the Central Government.
• Under rule 20(2), the scheme must apply to an employee who has completed ten years of service or forty years of age (not required for a public sector company's voluntary separation scheme under rule 20(3)), cover all employees except directors, reduce the overall strength, leave the vacancy unfilled and bar re-employment in a concern of the same management.
• The amount must not exceed A = 3 x N x S or B = M x S, where N is completed years of service, M is the months left before superannuation and S is salary at retirement (basic salary plus dearness allowance if the terms of employment so provide, per rule 20(4)).
• Once the deduction is allowed in a tax year, it cannot be claimed for any other tax year (section 19(2)(e)(ii)).
• Section 157(2) bars section 157 relief on any income for which this deduction has been claimed.

How are gratuity, leave encashment and commuted pension taxed on retirement?

Retirement payments are salary too, but section 19(1) gives deductions for them. The table summarises the Table entries; where a limit is "notified", the figure is fixed by Central Government notification, so check the current notification.

Payment	Deduction (section 19(1), Table)
Death-cum-retirement gratuity, or defence retiring gratuity (Sl. No. 3, 4)	Entire amount
Gratuity under the Payment of Gratuity Act, 1972 (Sl. No. 5)	Amount received, capped at the amount worked out under section 4(2) and (3) of that Act
Any other gratuity on retirement, incapacity or termination (Sl. No. 6)	Least of actual gratuity, the notified amount, and half a month's salary for each completed year of service (average salary of the preceding ten months)
Commuted pension: government and similar schemes (Sl. No. 7), Schedule VII fund (Sl. No. 9)	Entire amount
Commuted pension from any other employer (Sl. No. 8)	Commuted value of one-third of the pension if gratuity was received, otherwise one-half
Leave encashment at retirement: Central or State Government employee (Sl. No. 13)	Entire amount
Leave encashment at retirement: any other employee (Sl. No. 14)	Least of cash equivalent of earned leave (up to 30 days per year of service), 10 x average monthly salary of the preceding ten months, the notified amount, and the actual payment

Under section 19(2)(a) and (f), the notified limits for gratuity (Sl. No. 6) and leave encashment (Sl. No. 14) are used up across tax years: the deduction is A - B, where B is what was already allowed in earlier years. For both, "salary" means basic plus dearness allowance if the terms of employment so provide (section 19(2)(b)). Leave encashment received while still in service is not covered by these entries.

What about compensation to a workman on retrenchment?

A related deduction sits in section 19(1), Table Sl. No. 10: compensation received by a workman at the time of retrenchment is deductible to the minimum of (a) the compensation received, (b) the amount calculated under section 25F(b) of the Industrial Disputes Act, 1947, and (c) an amount, not less than Rs 50,000, notified by the Central Government. Section 19(2)(c) treats compensation on closure of the undertaking, and on certain transfers of ownership or management, as received at the time of retrenchment. Sl. No. 11 allows the full compensation where it is paid under a scheme approved by the Central Government.

Can you get relief when a lump sum pushes you into a higher rate? (Section 157)

Where termination compensation (or other arrears) is taxed at a higher rate than would otherwise apply, section 157(1) lets you apply to the Assessing Officer for relief. For compensation received from the employer at or in connection with termination, rule 73(1), Sl. No. 4 gives relief only where there has been continuous service of at least three years and the unexpired term of employment is also at least three years.

The relief is C x (R1 - RAvg), where C is the compensation, R1 is the average tax rate on your total income including it in the year received, and RAvg is the average of the rates for the three preceding tax years, each recomputed with one-third of the compensation added. Relief arises only if R1 is higher than RAvg. To claim it, furnish Form No. 39 on or before the due date under section 263(1)(c) (rule 73(3)). An employee of a company, co-operative society, local authority, university or similar body may also give Form 39 to the person who pays the salary (rule 73(4)).

Worked example 1: termination compensation added to salary (tax year 2026-27)

Assumptions: Kavita earns Rs 1,00,000 a month. Her employer ends her job on 30 September 2026 and pays Rs 9,00,000 as compensation for termination. Tax is computed under section 202(1), so the standard deduction under section 19(1), Sl. No. 2(a) is Rs 75,000. The compensation is under section 18(1)(a) and is not a VRS payment. She has no other salary in the year.

Step	Item	Rs
1	Salary for six months: 6 x 1,00,000	6,00,000
2	Profits in lieu of salary, section 18(1)(a)	9,00,000
3	Gross salary: 6,00,000 + 9,00,000	15,00,000
4	Less standard deduction, section 19(1), Sl. No. 2(a)	75,000
5	Income under Salaries: 15,00,000 - 75,000	14,25,000

The compensation is not taxed separately. It raises her income under Salaries to Rs 14,25,000, and the slab rates apply to that total.

Worked example 2: VRS deduction (tax year 2026-27)

Assumptions: Rahul works for a company with a qualifying voluntary retirement scheme that meets rule 20. He has 22 completed years of service, 8 years (96 months) before superannuation, and a salary at retirement (basic plus dearness allowance, as per his terms) of Rs 80,000. He receives Rs 18,00,000.

Step	Item	Rs
1	Rule 20(2)(vi) check, A = 3 x N x S = 3 x 22 x 80,000	52,80,000
2	Rule 20(2)(vi) check, B = M x S = 96 x 80,000	76,80,000
3	Amount received, which is within both limits	18,00,000
4	Deduction: lower of 18,00,000 and 5,00,000	5,00,000
5	Taxable portion: 18,00,000 - 5,00,000	13,00,000

The Rs 13,00,000 is added to his other salary. Because he has used the deduction, section 157 relief is not available on this amount.

Worked example 3: section 157 relief on termination compensation

Assumptions: Meena has 9 years of continuous service and 4 years left on her fixed-term contract. Her employer pays her Rs 12,00,000 on early termination in tax year 2026-27. The rates below are illustrative only: R1 = 20%, and for the three preceding years, with one-third of the compensation (Rs 4,00,000) added to each year's income, R2 = 10%, R3 = 12% and R4 = 14%.

Step	Item	Value
1	Service 9 years (at least 3) and unexpired term 4 years (at least 3): rule 73(1), Sl. No. 4 applies	Yes
2	RAvg = (10% + 12% + 14%) / 3	12%
3	R1 exceeds RAvg: 20% - 12%	8%
4	Relief = C x (R1 - RAvg) = 12,00,000 x 8%	Rs 96,000

In a real case the average rates come from recomputing the tax for each year, so use the actual figures from the returns. The claim goes in Form 39.

Real-life examples

• Ravi gets a joining payment. A company offers Ravi Rs 2,00,000 in March, before he starts in April. The payment is received before he joined employment with that person, so section 18(1)(b)(i) applies and it is treated as salary income.
• Sunita receives a payment after she resigns. Her former employer pays her an amount two months after her last working day under an exit agreement. It is received after cessation of employment with that person, so it falls under section 18(1)(b)(ii).
• Imran leaves a small company that held a Keyman policy on his life. The company assigned the policy to him, and he later receives the maturity sum. A Keyman policy includes one assigned to another person during its term. The sum under section 18(1)(c)(iii) is salary income, and the policy cannot use the ordinary life insurance exclusion in Schedule II, Sl. No. 2.
• Anita takes a payout from an approved superannuation fund. If it is paid in a case listed in Schedule II, Sl. No. 8, such as a payment to her in commutation of an annuity on retirement at or after a specified age, section 18(2)(c) excludes it from section 18(1)(c).

What must the employer do?

Section 392(1) requires the person paying salary to deduct tax at the average rate of income-tax, based on the rates in force for the tax year of payment and the employee's estimated salary income for that year. Section 392(5)(a) also requires the payer to furnish a statement, in the prescribed form and manner, with correct and complete particulars of perquisites or profits in lieu of salary paid, along with their value. For a full walk-through of salary TDS, see our guide to TDS on salary under the 2025 Act, and for the basics of the head, see income from salary.

What are the common mistakes?

• Treating a termination payment as exempt. It is taxable under section 18(1)(a) unless a specific deduction such as section 19(1), Sl. No. 10 or 12 applies.
• Forgetting the VRS conditions. The Rs 5,00,000 limit applies only to a scheme that meets section 19(2)(e) and (h) and rule 20.
• Claiming relief and the VRS deduction on the same amount. Section 157(2) bars relief on income for which the VRS deduction is claimed.
• Ignoring payments from a third party. Section 18(1)(b) applies to any person, not only the employer.
• Missing Form 39. Relief under section 157 needs the form by the due date under section 263(1)(c); it is not given automatically.
• Reading the whole provident fund payout as salary. Only the part that is not your own contributions or interest on them falls in clause (c)(ii), and 18(2) carves out the Schedule II payments.

Quick reference

Item	Limit or condition	Where
VRS or voluntary separation deduction	Lower of compensation received and Rs 5,00,000	Section 19(1), Sl. No. 12
Workman retrenchment deduction	Lowest of compensation, section 25F(b) amount and a notified amount (not less than Rs 50,000)	Section 19(1), Sl. No. 10
Relief on termination compensation	Service of 3 years or more and unexpired term of 3 years or more	Rule 73(1), Sl. No. 4
Claim form for section 157 relief	Form No. 39	Rule 73(3), (4)

Where this is in the Act

• Section 18(1) and (2): profits in lieu of salary, and what is left out
• Section 16(f): salary includes profits in lieu of, or in addition to, salary
• Section 19(1), Table Sl. No. 10, 11, 12 and section 19(2)(c), (e), (h): retrenchment and VRS deductions
• Section 157: relief for arrears, advance salary and profits in lieu of salary
• Schedule II, Note 1(c): Keyman insurance policy; Schedule II, Sl. No. 3, 4, 8; Schedule III, Sl. No. 11
• Section 392(1) and (5)(a): employer's deduction and statement
• Rule 20: VRS scheme conditions; rule 73: relief computation and Form 39

How do CA firms keep track of this?

Lump-sum exits tend to arrive late in the year, often after the client's salary projections are done. Finexo's practice management software for CAs lets you track deadlines and client documents such as Form 39 and exit agreements in one place. It does not compute tax or file forms for you.

This article explains the Income-tax Act, 2025 (as amended by the Finance Act, 2026) and the Income-tax Rules, 2026. It is general information, not tax advice. Confirm the position for a specific case with a qualified chartered accountant.