How Should A Law Firm Apply Partial Payments?

Unless a client specifically tells your firm how to apply partial payments, there is a logical sequence in how funds should be applied. When a client pays only part of an invoice, the payment should be applied to hard costs first, then soft costs, and fees last. Hard costs are cash your firm already paid out on the client’s behalf, so recovering them comes first. Fees come last because they’re what the firm earned, not money it fronted.

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What is a payment waterfall?

A payment waterfall is the order in which a payment is applied across the charges on an invoice. A typical law firm invoice carries three kinds of charges: hard costs, like filing fees and expert invoices, paid to outside parties on the client’s behalf; soft costs, like copying and printing, that recover internal overhead; and fees for attorney and staff time.

When a client pays in full, the order doesn’t matter. When a client pays part of the balance, which happens regularly, the order decides which charges are paid and which are still outstanding.

Why hard costs come first

Hard costs are the only part of the invoice where the firm has made payments to external vendors on behalf of the client. Every unrecovered dollar is cash the firm already spent, sitting on the balance sheet as a receivable. Applying payments there first gets that cash back before anything else.

Soft costs come next. They’re internal, but they reimburse expenses the firm has already absorbed on behalf of the client.

Fees come last. They’re the firm’s revenue, and they’re the part of the invoice the firm is best positioned to recover later, whether through continued billing or collections.

What usually goes wrong

Two approaches are common, and both quietly cost the firm.

The first is applying payments to fees first. It feels natural, since fees are usually the largest number on the invoice. But it leaves hard costs unpaid. If the client stops paying, the firm has collected its fees and is left holding costs it fronted, which eventually get written off.

The second is splitting each payment proportionately across every charge on the invoice. It looks fair, and some billing systems are set up this way. But it leaves a sliver of every charge unpaid, so no cost is ever fully recovered and the outstanding balances become harder to track.

What it costs the firm

Cash stays tied up. Costs the firm fronted sit unrecovered while fee income is booked.

Compensation gets paid on the wrong dollars. If attorney compensation or bonuses are tied to fee collections, applying payments to fees first pays out compensation on cash that should have repaid the firm’s costs.

Taxable income can come sooner. For a cash-basis firm, a payment applied to fees is generally income when received, while a payment applied to hard costs simply reduces a receivable. Applying payments to fees first can accelerate taxable income.

Write-offs grow at matter close. The costs left unpaid on every partially paid invoice add up, and they surface all at once when a matter closes or a client stops paying.

How to tell how your firm applies payments

Pull a recent invoice that was partially paid and look at what still shows as open. If fees are paid and costs remain open, payments are going to fees first. If every line shows a small remaining balance, they’re being split proportionately.

Then check your engagement letter. It should state how payments are applied. That sets expectations with the client from the start and gives the firm firmer footing if a balance ever goes to collections.

Proper payment application is part of how we manage invoicing and receivables for our clients. If you’re not sure how your system applies partial payments, we’re happy to take a look.