The three-way "least of" rule
Section 10(13A) of the Income Tax Act exempts the smallest of three amounts from tax — not the full HRA you receive. The three amounts are: (1) the actual HRA received from your employer, (2) rent actually paid minus 10% of your basic salary, and (3) 50% of basic salary if you live in a metro city (Delhi, Mumbai, Kolkata, Chennai), or 40% if you live elsewhere. Whichever of these three is smallest is what's tax-free — the rest of your HRA is added to your taxable income.
A worked example — metro vs non-metro
Consider a basic salary of ₹6,00,000/year, HRA received of ₹3,00,000/year, and rent paid of ₹3,60,000/year. Rent minus 10% of basic is ₹3,60,000 − ₹60,000 = ₹3,00,000. In a metro city, 50% of basic is ₹3,00,000 — so all three figures (HRA received, rent-based limit, and metro limit) happen to equal ₹3,00,000, and the entire HRA is exempt.
With the identical salary, HRA, and rent but living in a non-metro city, the third limit drops to 40% of basic — ₹2,40,000. Now the least of the three is ₹2,40,000, so ₹2,40,000 is exempt and the remaining ₹60,000 of HRA is added to taxable income — purely because of the city classification, with nothing else changed.
What if you don't pay rent, or pay very little?
If you pay no rent (e.g. you live in your own home or with family without paying them), your rent-paid figure is ₹0, making the "rent minus 10% of basic" limit ₹0 or negative (treated as ₹0) — so your HRA exemption is ₹0, and your entire HRA is taxable, regardless of how much HRA your employer pays you.
If you pay rent to a parent, that rent can qualify for the exemption (with proper rent receipts and the parent declaring it as rental income), but rent paid to a spouse generally doesn't qualify, since income tax law doesn't recognize that as a genuine landlord-tenant arrangement.
Only available under the old tax regime
HRA exemption is one of the deductions not available under the new tax regime — if you've opted for the new regime, your full HRA is taxable regardless of rent paid or city. This is one of the specific trade-offs to weigh when choosing between the two regimes, especially if you pay significant rent in a metro city.
What you need to claim it
Keep rent receipts and, for rent above ₹1,00,000/year, your landlord's PAN — most employers require this documentation before including the exemption in your monthly TDS calculation, and it's needed regardless when filing your return.