What is Prorated Billing and How it Works?

If you are pricing, revenue or product leader seeking to understand how to strategize and implement prorated billing, then this blog is for you.
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Imagine you went to a deli, and ordered half a sandwich. You wouldn’t be paying for the whole sandwich when you just ordered half, right? That’s exactly what proration in billing means. 

Customers expect to pay “in proportion” to how much they use your product and the utility they obtain from it. 

If there isn’t an option to pause a subscription, when they want to, upgrade or downgrade their plan at any point or have to pay for days even when they don’t use the product, what’s going to stop users from cancelling their subscription and switching to a competitor that provides that benefit. 

Once the flexibility and convenience factor is gone, you will find it challenging to retain clients for a longer period. SaaS buyers are less focused on buying new software and more focused on making sure they have the best deal possible. 

This is why prorated billing is a must-have feature in your subscription stack. 

In this article, we will be talking about everything you need to know about prorated billing—from how it works to implementing it for your subscription business. 

TL;DR

  • Prorated billing is proportion-based billing that only charges your customer on the basis of the time they utilised your product. 
  • Today, most SaaS companies like Slack, Twilio or Google Console adopts a fair billing policy for its customers, 
  • You should prorate your customer’s bill when they cancel or switch their subscription (upgrades or downgrades). 
  • Customers now prefer brands that promote usage-based billing because of its flexibility to switch tiers and add/remove subscriptions elements based on their requirements. 

What is prorated billing? 

The term “prorate” is a latin word for “pro rata” which means “in proportion” in english. Prorated billing means invoicing customers based on the proportion of the service consumed during a billing cycle. It’s similar to the “pay as you go” model. 

With adoption of usage-based billing nearly doubling in the past five years, it’s fair to say that the “pay as you go” model has become normalised. Today, three out of five SaaS businesses have adopted some form of USB—allowing users to start with little to no cost and pay according to the usage. 

Source

Based on Mckinsey analysis for replenishment subscriptions—consumers do not have inherent love for subscriptions. If anything, they want a great end-to-end experience and tangible benefits, especially the flexibility to cancel even before pulling out their credit cards. 

Without prorated billing, you’ll quickly realise that your business is ill-equipped to handle complex invoices, providing fair usage-based charges. 

For instance, if a customer wants to upgrade or downgrade their to a new plan or cancel a subscription in the middle of a billing cycle. Without calculating a prorated amount, the customer would either be paying more and getting less or using a higher tier service for less price. 

What is an example of a prorated billing? 

Pricing has always remained a moving target for all practical purposes. As your customer’s optics for value involve, it must go through continuous iterations. Prorated billing focuses more on outcomes and less on features to justify its impact on customer’s business rather than merely charging for additional capacity. 

As SaaS businesses increasingly become multi-product, a one-pricing model may seem unrealistic. Prorated billing requires businesses to track usage across timelines, usage and value metrics accurately. 

Let’s take a peek at how popular SaaS businesses handle prorated billing- 

Slack 

Slack has already figured out their prorated billing with their fair-billing policy. The platform pricing is subjected to change as per user, regardless of how many people are actively using the app. On the other hand, Slack doesn't bill users who aren’t using the platform. And, if someone you have already paid for becomes inactive, your account will be credited pro-rata for unused time. 

The short version:

  • Slack’s billing policy applies to all SaaS subscriptions and add-ons purchased via the Slack website. 
  • When you purchase a paid subscription, you’ll be billed for all active members. If all members become inactive, you'll be billed for a minimum for one member, unless users downgrade their plan. 
  • To calculate the pro rata credit amount, Slack will divide the cost per member by the number of days in the month, then multiply by the remaining number of days in the month. 

For instance, if you have purchased a Pro subscription and are paying $8.75 per user/ monthly. 15 days into the billing cycle, if a member becomes inactive then Slack will be obliged to credit the pro rata amount. 

($8.75 ÷ 30 days) x (15 days) = $4.38 (will be credited as pro rata amount)

Twilio 

Twilio offers two paid plans: Pay-as-you-go and Monthly Recurring Charges (MRCs). Twillio’s phone numbers are billed via a Monthly Recurring Charge (MRC) from the time they are provisioned. Users are billed for the full-monthly price of the phone number upfront regardless of its usage. 

When users use Twillio’s phone number’s capabilities (make a phone call or send a message), they are charged on pay-as-you-go pricing. If users don’t make any phone calls, or use any calling capabilities, they will only be charged for the phone number. 

Here’s a bill with additional voice usage:

Here’s a bill with no voice usage. As you can see Twilio has only charged the user for monthly phone numbers and no extra calling fee. 

Google Workspace 

Users using Google Workspace’s flexible plan can claim pro rata during upgrade, downgrade or cancellation. In this option, customers will be paid on the basis of their daily usage of the services during the preceding month. 

Admins can easily:

  • Add or remove users during the billing cycle. 
  • Switch your subscription.
  • Upgrade/downgrade your account
  • Add a new subscription, like the Google Workspace Additional Storage or Vault add-on.

Google Workspace will use prorated billing to calculate charges only for days the service was consumed. After your subscription is cancelled, you are billed at the start of the next month for any outstanding charge of your account. 

How to calculate prorated billing? 

The prorated charges are calculated by determining the amount owned by the customer for the number of days they used your service. 

Here’s how to calculate your prorated charges:

Step- 1 Take the monthly price of your subscription service and divide it by the number of days in the month. This will give you the daily fee amount of your service. 

Step-2 Now, take the daily charge amount and multiply it by the number of days service was consumed. This will give you the total amount the customer is liable to pay in proportion to the service they have consumed. 

Proration happens in three ways, when a customer decides to either upgrade/ downgrade or cancel a subscription. 

Proration with upgrades: 

When a subscription is upgraded, the customer will be charged in proportion to the days spent in both the plans. 

For instance, you have a $20 (sliver) and $50 (gold) per month plan. Customer A decides 15 days into the month they want to upgrade the plan. Calculate prorated charges. 

= ($50 x .5) - ($20 / .5) = $15 in prorated charges.

Now, this is how you bill Customer A for the next month

Proration with downgrades:

When a customer downgrades a pan, the customer has paid more than the expected value. The remaining credit needs to be adjusted in the next invoice with the downgraded plan. 

Let’s continue with the above example, however this customer decides to downgrade the plan from $50/month to $20/month. Calculate prorated charges. 

= ($50 x .5) - ($20 / .5) = $15 in prorated charges (excess).

Proration with cancellations:

When a customer decides to cancel a subscription, they are to be refunded for their unused time on the plan. 

For instance, if Customer A decides to cancel their subscription of the Gold plan ($50) at the middle of the month. You are then liable to pay them for the remaining 15 days they haven’t used your service. 

Calculate prorated charges. 

= ($50 x .5)= $25  in prorated charges (excess).

Why do businesses need a prorated billing system? 

If you’re just starting out with a subscription business, it might seem like a lot of hassle to set up proration billing. Why not just disable the option to switch plans /mid-cycle and set up non-prorated billing? And several businesses do this. But is it worth it?

Here, are some benefits of adopting a prorated billing system for you customers:

1. Customer retention

According to Vendr, the Customer Acquisition Cost (CAC) is at an all time high and has doubled since 2020. It takes companies 48 months to pay back their cost of acquisition as compared to 21 months in 2020. 

Many buyers have implemented a more stringent approach for approving new purchases. It's a lot more difficult to get new customers than it was a decade back and you don't upset customers by excluding them on features like prorated billing. 

2. Fair usage-based pricing

Prorated billing is a commitment to fairness and transparency. It ensures that the customers are only billed for what they use. This encourages users to switch tiers and add/remove subscriptions elements based on their requirements. Businesses on the other hand, will feel more confident of their billing system and allow them to be adaptable and responsive to their customers needs. 

3. Reduce customer churn 

Customers like to pay for services based on their utility and usage. That’s why SaaS businesses charged by consumption have increased over the years. Today, most products like Twilio, Zapier, Webflow, Hotjar offer usage-based pricing. The flexibility to switch between plans, add/remove subscriptions or even cancel the service at any moment gives users the confidence to sign up and try the product first-hand leading to less customer churn. 

For instance, many customers are upset with Bubble’s no prorated billing policy and think it's an injustice for customers. You can read the thread here. 

How to implement prorated charges? 

Prorated billing is harder than it looks here. In real life, customers won’t make changes to their subscription at a 15-day or 30-day mark. The actual calculations for pricing are much more complex. Also, consider the intrinsically different nature of recognizing revenue. You can’t bill someone for services that haven't been used for the day. 

Imagine if you need to do this for hundreds or even thousands of customers every month with absolute accuracy. This can take a huge chunk of time for the accounts to ensure your business doesn’t miss out on any payment or overcharge a customer. 

That’s why adopting a modern billing solution comes handy. 

With Zenskar, we have developed a solution that fully automates your business's financial operations from end to end. It provides unlimited flexibility that can handle any pricing plans and contract terms to quickly calculate your prorated charges. 

Zenskar also automates revenue recognition to accurately recognise and charge fair rates to the customers. This reduces the risk of human error with recurring billings and allows your business to focus on sustainable and scalable growth. 

Wrapping up 

Prorated billing isn’t any rocket science but a way of billing that ensures both parties (subscription-based business and the customer) are treated fairly and neither of them have to pay too much or too little for the agreed services no matter what changes are made in the billing cycle. 

Use a dedicated subscription billing software to help you keep track of  refunds, upgrades, downloads and cancellation. It will automatically calculate prorated charges and create invoices according to the updated billing system. 

That’s exactly what Zenskar does for SaaS businesses. Curious to learn more? Book a demo, and we'll show you how Zenskar can automate your billing options.

Frequently Asked Questions (FAQs)

1. What is prorated billing? 

Prorated billing means invoicing customers based on the proportion of the service consumed during a billing cycle. 

2. Why is prorated billing important for subscription-based businesses?

Prorated billing is a commitment to fairness and transparency. It ensures that the customers are only billed for what they use. This encourages users to switch tiers and add/remove subscriptions elements based on their requirements. Businesses on the other hand, will feel more confident of their billing system and allow them to be adaptable and responsive to their customers needs. 

3. When to prorate your customer’s bill? 

You should prorate your customer’s bill when they cancel or switch their subscription (upgrades or downgrades).

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