Leave encashment is the conversion of accrued but unused paid leave into a cash payment. It most commonly occurs when an employee’s employment ends and the employer is required to pay out unused annual leave. However, some employers and Modern Awards permit periodic leave encashment during employment, allowing employees to cash out a portion of their leave while still working. The tax treatment of leave encashment varies by jurisdiction and depends on whether the payment is made during employment or upon termination.
Key Takeaways
- Employers must pay out accrued annual leave on termination in Australia (NES) and the UK (Employment Rights Act 1996)
- Periodic leave encashment during employment is permitted under some Modern Awards but not universally
- The tax treatment of leave encashment differs between payments made during employment (taxable as income) and payments made on termination (potentially tax-free up to a threshold in some jurisdictions)
What Leave Encashment Means for Employers
Leave encashment creates both a legal obligation and a financial planning consideration. In Australia, the NES requires employers to pay out accrued annual leave when employment ends, whether by resignation, dismissal or redundancy. This is calculated at the employee’s base rate of pay, excluding overtime, penalties and loadings unless the applicable Modern Award specifies otherwise.
For employers, large encashment liabilities can create significant financial exposure. An employee with 20 days of unused annual leave and a base rate of $80,000 per year represents approximately $6,200 in encashment liability. Multiply this across a large workforce and the cumulative liability becomes material to the balance sheet.
Periodic leave encashment, where permitted, can reduce this liability by allowing employees to cash out leave during employment. In Australia, some Modern Awards allow employees to cash out a minimum of 10 days of annual leave per year, provided the employee agrees and the cash-out is at the applicable rate. Employers should ensure the cash-out does not reduce the employee’s leave balance below the statutory minimum.
In the US, there is no federal requirement to pay out unused leave, but several states (including California, Illinois and Colorado) require payout of accrued vacation or PTO upon termination. In the UK, employers must pay out all accrued statutory annual leave on termination.
Leave Encashment Rules by Region
| Country | Rule | Detail |
|---|---|---|
| UK | Employment Rights Act 1996 | All accrued statutory annual leave must be paid out on termination at the normal rate of pay |
| AU | NES s.90 | Accrued annual leave must be paid out on termination at the base rate; some awards allow periodic cash-out during employment |
| US | State laws vary | No federal requirement; states like CA, CO and IL require payout of accrued vacation/PTO; others do not |
How Leave Encashment Works in Practice
A Sydney professional services firm with 150 employees tracks leave balances through integrated payroll software. When an employee, Chris, resigns after eight years, his final pay includes payment for 32 days of accrued annual leave. His base rate is $45 per hour, so the encashment amount is 32 x 8 x $45 = $11,520.
The firm also offers periodic leave encashment, allowing employees to cash out up to 10 days per year. A senior consultant, Priya, takes advantage of this to cash out 8 days of leave, receiving $2,880 in her next pay run. Her leave balance is reduced by 8 days, but she retains the remaining accrued leave for future use.
The firm’s payroll system calculates encashment at the base rate only, excluding overtime and penalty rates. This is consistent with the NES, though some Modern Awards may require inclusion of additional components. The payroll team runs an annual liability report showing the total accrued leave across the workforce, which is reported in the financial statements.
Common Mistakes with Leave Encashment
- Paying encashment at a rate that includes overtime or penalties when the NES or applicable award requires only the base rate
- Not paying out accrued annual leave on termination, which is a breach of the NES in Australia and the Employment Rights Act in the UK
- Allowing periodic leave encashment without checking whether the applicable Modern Award permits it
- Failing to report encashment liabilities in the financial statements, leading to understated employee benefit provisions
- Not updating the employee’s leave balance in real time after an encashment, creating discrepancies between the payroll system and the leave records
FAQ
What is leave encashment?
Leave encashment is the process of converting accrued but unused leave into a cash payment. It typically occurs when employment ends, but some employers and Modern Awards allow periodic encashment during employment.
Is leave encashment tax-free?
In most jurisdictions, leave encashment is taxable as ordinary income during employment. In the US, some states provide a tax exemption for leave encashment on termination up to a certain amount. In Australia, leave encashment on termination is generally taxable.
Can I cash out leave while still employed?
In Australia, periodic leave encashment is permitted under some Modern Awards, typically with a minimum of 10 days cashed out per year. In the UK, there is no statutory right to cash out leave during employment. In the US, it depends on the employer’s policy and state law.
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