Why the payout is not income
Start with the standalone policies, because that is what most critical-illness and mediclaim cover is. When an insurer pays you on a health or critical-illness claim, it is compensating you for a loss, a medical event, not paying you a return on an investment or a wage for work. Indian income tax charges income under defined heads, salary, house property, business, capital gains, other sources, and a compensation-for-loss receipt of this kind fits none of them. So it is not that a section exempts it; there is no head of income to bring it in under in the first place. It is a capital receipt, and it stays outside your taxable income.
That is why you will not find a neat exemption clause for a mediclaim payout, and do not need one. The money simply is not income. You should still keep the policy document and the claim settlement letter, because a large bank credit can trigger a matching query, and the answer to that query is the paperwork showing it was an insurance settlement.
The one case with a real condition: a life-policy rider
There is a second route a payout can take, and it does carry a condition. Where the critical-illness cover is a rider attached to a life-insurance policy rather than a standalone health plan, the payout is exempt under Section 10(10D), the same clause that exempts life-insurance proceeds. That exemption is not unconditional: for policies issued after April 2012, if the annual premium exceeds 10 per cent of the sum assured, 15 per cent where the cover is for a disability or a specified critical illness, the proceeds lose the exemption and become taxable.
In practice a genuine health or critical-illness cover has a premium far below those caps, so the exemption holds. The cap bites on investment-heavy insurance policies dressed up with a small life cover, not on protection cover. A death benefit, separately, stays exempt regardless of the premium. So for an illness payout the only question is whether it is a standalone policy, outside income entirely, or a life-linked one, exempt as long as the premium stayed within the cap.
The confusion that makes people worry: the employer medical allowance
The reason this question comes up so often is a genuine but unrelated rule that people half-remember. Employers used to pay a medical reimbursement of up to ₹15,000 a year tax-free; that specific exemption was withdrawn from 2018-19 and folded into the standard deduction, so a fixed medical allowance paid as part of salary is now fully taxable. That is a salary-perquisite rule, about money your employer pays you, and it has nothing to do with a payout an insurance company pays you on a claim.
One related point does sit on the employer side: if your employer paid the premium on your health cover and did not show it as a perquisite, the treatment of the eventual payout can be questioned. But for an ordinary policy you pay for yourself, the allowance rule simply does not apply, and mixing the two up is what turns a tax-free settlement into a needless worry.
What you can now claim as a resident: 80D and 80DDB
A health event is exactly when two medical deductions start to matter, and the move back sharpens both. Under Section 80D you can deduct the health-insurance premium you pay, up to ₹25,000, which an NRI could already claim; being resident lifts that to ₹50,000 where the insured, you or a parent, is a senior citizen, with a small amount within it for a preventive check. Under Section 80DDB you can deduct the cost of treating a specified disease, cancer, chronic kidney failure and others on the notified list, up to ₹40,000, or ₹1,00,000 where the patient is a senior, reduced by anything an insurer or employer reimbursed. This one really was shut to you as an NRI, because 80DDB needs the patient to be resident.
Both live on the old regime, so they only help if the old-versus-new comparison lands on the old side. 80DDB also depends on a certificate from the right specialist confirming the diagnosis. These reliefs are reorganised into Chapter VIII of the Income-tax Act 2025 but carry the same effect.
A worked example: Sunil's critical-illness claim
Sunil moved back to Bengaluru two years ago and last year was diagnosed with cancer. His standalone critical-illness policy paid out ₹20,00,000, and his mediclaim separately met ₹6,00,000 of hospital bills. When the ₹20 lakh hit his account he assumed he would owe tax on it and braced for a big bill.
He owed nothing on the payout. The ₹20,00,000 is a standalone critical-illness settlement, a capital receipt compensating him for the illness, so it is not income and is not taxed; the ₹6,00,000 mediclaim reimbursement is likewise outside income. What Sunil could do on the tax side was claim, on the old regime, his ₹50,000 80D senior health premium and, under 80DDB, up to ₹1,00,000 of the treatment cost his insurance did not cover. His CA kept the settlement letters ready against any matching query and made sure the deductions he was newly entitled to as a resident were actually claimed.