diff --git a/erpnext/selling/doctype/selling_settings/selling_settings.json b/erpnext/selling/doctype/selling_settings/selling_settings.json
index 45ad7d95a1..045227f0aa 100644
--- a/erpnext/selling/doctype/selling_settings/selling_settings.json
+++ b/erpnext/selling/doctype/selling_settings/selling_settings.json
@@ -29,6 +29,7 @@
   "allow_multiple_items",
   "allow_against_multiple_purchase_orders",
   "allow_sales_order_creation_for_expired_quotation",
+  "dont_reserve_sales_order_qty_on_sales_return",
   "hide_tax_id",
   "enable_discount_accounting"
  ],
@@ -186,6 +187,12 @@
    "fieldname": "over_order_allowance",
    "fieldtype": "Float",
    "label": "Over Order Allowance (%)"
+  },
+  {
+   "default": "0",
+   "fieldname": "dont_reserve_sales_order_qty_on_sales_return",
+   "fieldtype": "Check",
+   "label": "Don't Reserve Sales Order Qty on Sales Return"
   }
  ],
  "icon": "fa fa-cog",
@@ -193,7 +200,7 @@
  "index_web_pages_for_search": 1,
  "issingle": 1,
  "links": [],
- "modified": "2023-03-03 11:16:54.333615",
+ "modified": "2023-02-04 12:37:53.380857",
  "modified_by": "Administrator",
  "module": "Selling",
  "name": "Selling Settings",
@@ -222,4 +229,4 @@
  "sort_order": "DESC",
  "states": [],
  "track_changes": 1
-}
\ No newline at end of file
+}
diff --git a/erpnext/stock/doctype/delivery_note/test_delivery_note.py b/erpnext/stock/doctype/delivery_note/test_delivery_note.py
index 903e2af3cb..22d813562b 100644
--- a/erpnext/stock/doctype/delivery_note/test_delivery_note.py
+++ b/erpnext/stock/doctype/delivery_note/test_delivery_note.py
@@ -1180,6 +1180,53 @@ class TestDeliveryNote(FrappeTestCase):
 
 		self.assertTrue(return_dn.docstatus == 1)
 
+	def test_reserve_qty_on_sales_return(self):
+		frappe.db.set_single_value("Selling Settings", "dont_reserve_sales_order_qty_on_sales_return", 0)
+		self.reserved_qty_check()
+
+	def test_dont_reserve_qty_on_sales_return(self):
+		frappe.db.set_single_value("Selling Settings", "dont_reserve_sales_order_qty_on_sales_return", 1)
+		self.reserved_qty_check()
+
+	def reserved_qty_check(self):
+		from erpnext.controllers.sales_and_purchase_return import make_return_doc
+		from erpnext.selling.doctype.sales_order.sales_order import make_delivery_note
+		from erpnext.stock.stock_balance import get_reserved_qty
+
+		dont_reserve_qty = frappe.db.get_single_value(
+			"Selling Settings", "dont_reserve_sales_order_qty_on_sales_return"
+		)
+
+		item = make_item().name
+		warehouse = "_Test Warehouse - _TC"
+		qty_to_reserve = 5
+
+		so = make_sales_order(item_code=item, qty=qty_to_reserve)
+
+		# Make qty avl for test.
+		make_stock_entry(item_code=item, to_warehouse=warehouse, qty=10, basic_rate=100)
+
+		# Test that item qty has been reserved on submit of sales order.
+		self.assertEqual(get_reserved_qty(item, warehouse), qty_to_reserve)
+
+		dn = make_delivery_note(so.name)
+		dn.save().submit()
+
+		# Test that item qty is no longer reserved since qty has been delivered.
+		self.assertEqual(get_reserved_qty(item, warehouse), 0)
+
+		dn_return = make_return_doc("Delivery Note", dn.name)
+		dn_return.save().submit()
+
+		returned = frappe.get_doc("Delivery Note", dn_return.name)
+		returned.update_prevdoc_status()
+
+		# Test that item qty is not reserved on sales return, if selling setting don't reserve qty is checked.
+		self.assertEqual(get_reserved_qty(item, warehouse), 0 if dont_reserve_qty else qty_to_reserve)
+
+	def tearDown(self):
+		frappe.db.set_single_value("Selling Settings", "dont_reserve_sales_order_qty_on_sales_return", 0)
+
 
 def create_delivery_note(**args):
 	dn = frappe.new_doc("Delivery Note")
diff --git a/erpnext/stock/stock_balance.py b/erpnext/stock/stock_balance.py
index 439ed7a8e0..e3cbb43d8b 100644
--- a/erpnext/stock/stock_balance.py
+++ b/erpnext/stock/stock_balance.py
@@ -94,10 +94,13 @@ def get_balance_qty_from_sle(item_code, warehouse):
 
 
 def get_reserved_qty(item_code, warehouse):
+	dont_reserve_on_return = frappe.get_cached_value(
+		"Selling Settings", "Selling Settings", "dont_reserve_sales_order_qty_on_sales_return"
+	)
 	reserved_qty = frappe.db.sql(
-		"""
+		f"""
 		select
-			sum(dnpi_qty * ((so_item_qty - so_item_delivered_qty) / so_item_qty))
+			sum(dnpi_qty * ((so_item_qty - so_item_delivered_qty - if(dont_reserve_qty_on_return, so_item_returned_qty, 0)) / so_item_qty))
 		from
 			(
 				(select
@@ -112,6 +115,12 @@ def get_reserved_qty(item_code, warehouse):
 						where name = dnpi.parent_detail_docname
 						and delivered_by_supplier = 0
 					) as so_item_delivered_qty,
+					(
+						select returned_qty from `tabSales Order Item`
+						where name = dnpi.parent_detail_docname
+						and delivered_by_supplier = 0
+					) as so_item_returned_qty,
+					{dont_reserve_on_return} as dont_reserve_qty_on_return,
 					parent, name
 				from
 				(
@@ -125,7 +134,9 @@ def get_reserved_qty(item_code, warehouse):
 				) dnpi)
 			union
 				(select stock_qty as dnpi_qty, qty as so_item_qty,
-					delivered_qty as so_item_delivered_qty, parent, name
+					delivered_qty as so_item_delivered_qty,
+					returned_qty as so_item_returned_qty,
+					{dont_reserve_on_return}, parent, name
 				from `tabSales Order Item` so_item
 				where item_code = %s and warehouse = %s
 				and (so_item.delivered_by_supplier is null or so_item.delivered_by_supplier = 0)