What is prorated billing, and how does it work? | Stripe (2024)

Prorated billing is a method of bill calculation based on a partial period of service rather than a full billing cycle. It lets customers pay for the portion of the service period they use and not the entire service period, which makes billing more accurate. For example, if a customer subscribes to a service that charges $30 per month but they begin the subscription on the 15th day of a 30-day month, they will pay only $15 for that first month.

Implementing this kind of billing can benefit businesses in the global digital subscription industry, which was valued at $928 billion in 2022 and is forecast to reach $4.6 trillion by 2031. Below, we’ll cover the basics of prorated charges, how to integrate prorated billing into subscription models, and best practices for managing prorated billing.

What’s in this article?

• How do prorated charges work?
  
• How to calculate prorated charges
  
• How prorated billing benefits businesses
  
• How to use prorated billing with subscription models
  
• Common scenarios for prorated billing
  
• Best practices for prorated billing
  

How do prorated charges work?

Prorated charges ensure customers pay for only the service they receive. If they sign up, cancel, or make changes to their plan partway through a billing cycle, they do not pay for the entire billing cycle. Prorated charges can improve customer satisfaction by aligning billing with usage and charging customers for only what they use. Prorated billing is popular with telecom and utility companies, subscription services, and landlords.

How to calculate prorated charges

Calculating prorated charges involves a formula that businesses can adapt depending on the terms of the service or lease agreement. Here’s a method to calculate prorated charges:

• Determine the full billing rate: This is the regular charge for a full billing cycle. For example, if it’s a monthly billing cycle, use the rate charged each month.
  
• Establish the billing cycle length: Identify the number of days in the full billing cycle. For monthly services, this might be 30 or 31 days, depending on the month, or a standardised 30 days.
  

• Calculate the daily rate: Divide the full billing amount by the total number of days in the billing cycle:

  • Full Billing Amount / Number of Days in Billing Cycle = Daily Rate

    This gives you the charge per day.

• Determine the number of days of service: Count how many days during the billing cycle the service is or was used by the customer.

• Calculate the prorated charge: Multiply the daily rate by the number of days of service:

  • Daily Rate × Number of Days of Service = Prorated Charge
    
  • For example, a customer subscribes to a service that costs $90 per month on the 10th day of a 30-day month.
    

  • Full billing amount: $90

    Billing cycle length: 30 days

    Daily rate: 90 / 30 = $3 per day

    Days of service in the first month: From the 10th to the 30th = 21 days

    Prorated charge: 3 x 21 = $63

  • The prorated charge for the first month is $63.

How prorated billing benefits businesses

Prorated billing can boost a business’s reputation, make it easier to acquire customers, and facilitate a more consistent cash flow. Here’s how prorated billing benefits businesses:

• Customer acquisition: Prorated billing makes services more accessible, letting a potential customer begin their billing period anytime within a billing cycle. This flexibility removes barriers that might deter potential customers and can lead to higher customer acquisition.

• Business reputation: Prorated billing demonstrates a commitment to fairness and ensures customers pay for only the time they use a service. This can make a business more attractive: new customers can begin using services at any point without feeling financially penalised.

• Upselling: Prorated billing makes it easier to encourage customers to upgrade services mid-cycle because they know they’ll pay for only the remaining portion of the billing cycle.

• Cash flow: Billing customers throughout the month on whatever day they signed up for the service – rather than in a single surge at the beginning or end of the month – can create a more consistent cash flow.

How to use prorated billing with subscription models

Prorated billing is commonly paired with subscription models because charges occur at regular intervals and customers might sign up in the middle of a billing period. Here’s how to integrate prorated billing into your subscription service:

Define your proration policy

• Proration unit: Decide whether you’ll prorate daily, weekly, or monthly. Daily proration offers the greatest precision, while monthly proration might be simpler to implement for annual subscriptions.

• Rounding rules: Establish rules for rounding prorated amounts (e.g., to the nearest pound or penny) to simplify calculations and prevent fractional charges.

• Mid-cycle changes: Determine how you’ll handle mid-cycle changes such as upgrades, downgrades, or cancellations. Will you credit or refund the unused portion or carry it over to the next cycle?

• Taxes: Determine how you’ll handle taxes for prorated charges. Depending on your jurisdiction, you might need to adjust tax calculations based on the prorated amount.

• Discounts: If you offer discounts, decide how you’ll apply these to prorated charges. You could prorate the discount along with the subscription cost or apply it as a fixed amount.

Choose a billing system

• Automated solutions: Consider using subscription billing software or a platform that supports automated prorated billing. This can reduce manual effort and minimise errors.

• Customisation: If you choose to use a custom-built solution, ensure your developers understand the proration logic and can integrate it with your billing system.

Calculate prorated charges

• Formula: The basic formula for prorated charges is:

  • (Total Subscription Cost / Total Days in Billing Cycle) x Number of Days Used
    

• Plan changes: For plan changes, calculate the prorated cost for each plan and adjust the charges accordingly. Consider offering partial credits or carrying over unused portions.

Communicate with customers

• Proration policy: Communicate your proration policy to customers up front. Explain how you calculate prorated charges and how it affects their billing.

• Invoice details: Include a breakdown of prorated charges on invoices.

• Customer support: Provide accessible customer support to address any questions or concerns about proration.

Test and monitor functionality

• Test cases: Create test scenarios to cover different billing cycles, plan changes, and cancellation dates. For each scenario, confirm that your system calculates and applies prorated charges accurately.

• User feedback: Gather feedback from early adopters or beta users to identify any issues or areas for improvement.

• Performance metrics: Monitor key metrics such as customer acquisition, churn, and average revenue per user (ARPU) to assess the impact of prorated billing on your business.

• Policy and billing updates: Based on your data and customer feedback, adjust your proration policy or billing system as needed.

Common scenarios for prorated billing

Prorated billing is a common tool across a variety of industries and scenarios. Here are some scenarios in which prorated billing is particularly useful:

• Mid-month sign-ups: When a customer signs up for a service in the middle of a billing cycle, they will pay for only the portion of the cycle during which they use the service. This is common with subscription services such as streaming platforms, software-as-a-service (SaaS) products, or gym memberships.

• Service cancellations: If a customer cancels a service before the end of their billing period, prorated billing can calculate their refund for the unused portion of the billing period. Customers regard this practice as fair, and it can improve the business’s reputation.

• Plan upgrades or downgrades: When a customer changes their subscription level – whether they upgrade to a higher tier with more features or downgrade to a less expensive option – prorated billing reflects this change, charging customers for the time they used each service level.

• Seasonal or temporary services: When services are seasonal or provided temporarily – such as heating, ventilation, and air conditioning (HVAC) services or landscaping – prorated billing lets businesses charge customers for partial months at the beginning or end of the season.

• New feature or service additions: If a business introduces new features or services that customers can add to their existing subscriptions, prorated billing lets customers begin enjoying the new additions immediately while paying for only the remaining portion of the billing cycle.

• Real estate and utility billing: In real estate, tenants who move partway through the month often pay prorated rent. Similarly, utility companies frequently use prorated billing to charge for services that start or stop mid-cycle.

• Telecommunications services: Telecom companies often apply prorated billing when customers alter their service packages or when additional services such as international calling plans are added after the billing cycle has started.

• Trial periods turning into subscriptions: When a trial period ends and the customer transitions into a paid subscription, prorated billing can align the new subscription’s charges with the standard billing cycle.

Best practices for prorated billing

Though prorated billing offers benefits for businesses and customers, businesses must manage customer expectations carefully to prevent confusion and dissatisfaction. Here are some best practices:

Communicating business policies

• Proration policy: Explain your proration policy on your website, in your terms of service, and during the sign-up process. Consider using visual aids such as diagrams or examples to illustrate how you calculate prorated charges. Use plain language, and avoid jargon.
  
• Refund policies: Outline your refund policy for prorated charges, including timelines and conditions.
  
• Cancellation policy: Communicate how you will handle cancellations mid-cycle, including any applicable fees or credits.
  
• Plan changes: Explain how plan changes will affect prorated charges and how you will handle unused portions.
  

Customer outreach

• Proactive communication: Send email notifications or reminders before and after billing cycles, especially when proration is involved, to keep customers informed.
  
• Highlight value: Emphasise the value and benefits of your product or service to reinforce the justification for prorated charges.
  
• Positive reinforcement: Thank customers for their understanding and patience regarding prorated billing.
  

Invoicing

• Breakdown of charges: Provide a detailed breakdown of charges on invoices. This breakdown should show the original cost, the prorated amount, and any applicable taxes or fees. Briefly explain the proration calculation on the invoice to make it easy for customers to understand.
  

Customer support

• Dedicated team: Have a dedicated customer support team trained to handle proration-related inquiries, resolve issues, and listen to customer concerns with empathy and understanding.
  
• Multiple channels: Offer a variety of support channels such as phone, email, or live chat to make it easy for customers to get help.
  

Tech solutions

• Billing software: Invest in reliable billing software that can automate proration calculations, generate invoices, and manage subscriptions.
  
• Customer portals: Provide a self-service portal where customers can view their billing history, update payment information, and manage their subscriptions.
  
• Communication tools: Use email marketing, SMS notifications, or in-app messages to keep customers informed about their billing and any proration adjustments.