Received severance pay under VRS? Check how much of it is tax-free

VRS lets an employee retire from service before the normal retirement age and, in doing so, receive a lump sum payment from the employer.

Under the income-tax rules, a portion of the compensation received by an employee opting for VRS can qualify for tax exemption, subject to certain conditions and limits. 

If you have recently opted for VRS or are considering it, understanding how much of your severance pay is tax-free can help you estimate your actual post-tax payout and plan your finances better.

How much of severance pay under VRS is tax-free?

Voluntary Retirement Scheme (VRS) compensation received on or before March 31, 2026, is governed by Section 10(10C) of the Income Tax Act, 1961. For compensation received on or after April 1, 2026, the applicable provision is Section 19 of the Income Tax Act, 2025, effective from the tax year 2026-27. 

Under Section 19 of the Income-tax Act, 2025, compensation received under a Voluntary Retirement Scheme (or a voluntary separation scheme in the case of a public sector company) is exempt up to Rs 5 lakh. 

If the total received is Rs 5 lakh or less, the whole amount is exempt; anything above the stated limit is taxable as salary. The exemption can be claimed only once in a lifetime and cannot be claimed again if VRS is availed a second time.

According to CA Chandni Anandan, Tax Expert at ClearTax, the compensation must be paid under a scheme framed by the employer, and the employee must satisfy the following conditions under Rule 2BA of the Income-tax Rules, 1962: 

(i) the employee has completed 10 years of service or attained 40 years of age (this condition does not apply to a public sector company employee receiving compensation under the PSU’s voluntary separation scheme);

(ii) it covers all employees, including workers and executives, of a company, authority or co-operative society, except directors; 

(iii) the scheme is drawn up to result in an overall reduction in the employee strength; 

(iv) the vacancy created is not to be filled; 

(v) the retiring employee is not employed in another company or concern of the same management; 

(vi) the amount does not exceed three months’ salary for each completed year of service, or salary at retirement multiplied by the balance months of service left before superannuation.

The exemption is available only to employees of specified employers: a public sector company, any other company, a local authority, a co-operative society, a university, an IIT, a notified management institute, and the State or Central Government. So employees of any company (other than directors) are covered, but it is not a blanket exemption for every type of employer. 

“The exemption applies under both the old and new tax regimes. Finally, where relief under Section 89 has been claimed on the VRS amount, the Section 19 exemption cannot be claimed on the same amount,” Anandan stated.

The exemption applies to the amount “received or receivable,” so it holds whether the compensation is paid at once or in installments. The Rs 5 lakh ceiling, however, applies to the aggregate across all instalments, not to each one. 

Each retirement benefit is governed by its own exemption provision and limit; gratuity, leave encashment, and provident fund are computed separately under their respective rules, independently of the Rs 5 lakh VRS exemption. 

“Age or service length determines eligibility (10 years of service or 40 years of age), and the exempt amount itself is capped by a formula based on salary and completed years of service, all subject to the overall ceiling,” according to Anandan.

What key conditions must an employee satisfy to claim the exemption?

• The compensation must be paid under a scheme meeting Rule 2BA.
• The employee must have completed the applicable years of service.
• The scheme must reduce overall employee strength.
• The vacancy must not be refilled.
• The employee must not join another concern of the same management.
• The amount must stay within the three-months-per-completed-year (or balance-months) limit.

What should taxpayers mention while filing their ITR?

While filing, the exempt portion should be reported under the exempt-income/allowances field, and only the taxable balance should be carried into salary income, consistent with Form 16. 

The VRS scheme document or offer letter, Form 16 showing how the employer treated the amount, the compensation computation, proof that the scheme complies with Rule 2BA, and evidence of completed years of service or age. 

An employee should check Part B of Form 16 to see that the employer has shown the VRS compensation, applied the Rs 5 lakh exemption, and carried only the balance into taxable salary; then reconcile it against the AIS and Form 26AS and re-run the exemption computation. 

What are the most common mistakes employees make?

Employees opting for VRS often focus on the lump-sum payout but overlook the tax implications and eligibility conditions. Here are some common mistakes that can reduce the tax benefits or lead to unexpected tax liability.

• Assuming the entire compensation is exempt regardless of the Rs 5 lakh cap.
• Claiming both the Section 19 exemption and Section 89 relief on the same amount.
• Claiming the exemption more than once in a lifetime.
• Overlooking whether the scheme actually meets the Rule 2BA conditions.

Disclaimer: This article is for informational purposes only and does not constitute professional tax advice. Tax laws and regimes are subject to frequent changes by the government. Readers should verify details with official Income Tax Department notifications or consult a Chartered Accountant before making any financial decisions.  

Every financial journey has a turning point. What’s yours?

Financial Express is launching a new series highlighting real experiences with money, investments, and the taxman. Did a sudden tax rule catch you off guard? Did a piece of financial advice change your life? Your story could provide invaluable, practical lessons for thousands of fellow taxpayers. Share your experience with us. We respect your privacy: no stories will be featured without a direct conversation and your full consent. Thank you.