When can I level up?

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Currently, my group of traveling companions and I have received enough xp to level up and we are between encounters. We've just finished clearing out a zombie dungeon then we emerged and see another group. We haven't rolled initiative yet, are we allowed to level up?
There are no particular rules about when levelling up occurs.  As far as I know, it's typical to do so either between sessions (because it can take a while), or during an extended rest.
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Yeah, there aren't any real rules on this so just ask your DM if it's okay to level up in mid adventure.

Many like to have you wait until you take an extended rest because then you don't have to worry about what happens to hit points, surges, etc. when you're not at full resources.  Most DMs I know only award XP at the end of a session and regardless of whether you're still in the middle of an adventure or not, they only want you to level up between sessions.  I have played with DMs that let people level up in the middle of a session but I generally don't recommend it because it leads to distracted and rushed players who make choices that they want to go back and change later.

Personally, as a DM I tend to fix things so that levelling up occurs between adventures while an extended rest happens.

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I read in the Rules Compendium that your level usually takes place immedicately when you hit the proper xp amount.  However, no party group is going to wait for you to level your toon up... so you might bring an already leveled up character for the times that you are close to leveling.  That way you can simply switch out your leveled toon.

Edit:  And you can always adjust your characters Hitpoints and surges to fit the proper setting from what you had in the session. 
Yeah, there're no rules.  You level whenever really.  Our group lately hasn't really done much in terms of counting exp we just level whenever the DM tells us to.  So usually it's between sessions so it doesn't matter.  Sometimes we level up inbetween but only a level so it doesn't actually take that long to level up one level especially if it's a level that you don't gain anything but a power in.
DMG p.121: "Some DMs let characters gain the benefits of a new level as soon as they have the required XP to reach that level, while others prefer to wait until the characters take an extended rest or even until the end of a session before letting characters level up."


Since levelling can take some time, most DM's handled XP at the end of the session; this is also a RPGA/LFR standard.
The Rule Compendium is pretty straightforward but seem more like a description of how mechanically this function rather than the rate of advancement:

RC 85 Gaining Levels: Each time a character defeat a monster, overcome a noncombat encounter or completes a quest, the Dungeon Master awards experience points. When the character ear enought experience points, he or she reaches a new level. 


The Dungeon Master's Guide has always been pretty flexible on when leveling up:

DMG 121 Leveling Up: Some DMs let characters gain the benefits of a new level as soon as they have the required XP to reach that level, while others prefer to wait until the characters take an extended rest or even until the end of a session before letting characters level up. That decision is entirely up to you. If your players are particularly slow about advancing their characters and are taking a long time to pore over the options available to them, it might be best to wait until the end of a session. If leveling up would completely shatter the pace of the session, put it off until they take an extended rest at least.  


Personally, i favor leveling up after a session not to break the flow of game play, but can do so during Short Rest, not to have PC rush for an Extended Rest just so they can level up.
Yeah my group still has to be walked through the leveling up process, so we only level after an extended rest.  The even levels take a long time for everyone to raise all the numbers by one.  Also the feat selection.  They never know what they want.  Probably makes all the characters very suboptimal because they just randomly pick what sounds good.
fwiw: the previous D&D standard was:
- 1e PHB.106 "as he or she completes adventures and returns to an established base of operations, the Dungeon Master will aword experience points to the character"
- 3e PHB.58 "The DM assigns XP to the characters at the end of each adventure" 
etc.

   I always let the players know when they're close to levelling (if they aren't keeping track themselves) and have a standing housrule that you need to submit to me the proposed changes to your character before you level up, or you don't get to do so. Players in my games are well aware that they should have considered and chosen any new feats, powers or gear by the time the oportunity to acquire them comes up.
 
 I almost always wait until the end of a session to allow the party to level up. The only exception I make is when the party reaches an appropriate narrative point in the story during the middle of a session and all the players already have the new higher-level versions of their character sheets in hand and ready to go.

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RC 85 Gaining Levels: Each time a character defeat a monster, overcome a noncombat encounter or completes a quest, the Dungeon Master awards experience points. When the character ear enought experience points, he or she reaches a new level.

I think the idea of you getting the gold halo mid-fight as you down a minion that gives you the 25 XP you needed and gaining HP/an extra power is absolutely hilarious, but you should probably just wait till the end of the night/between games.

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