Inflation Adjustment Clause

Written by: Patrick Shaunessy

19 minute read

What is an inflation adjustment clause?

An inflation (or cost of living) adjustment clause is a contractual provision that requires prices or other monetary amounts to be adjusted periodically based on the relative change in value of one or more established price indices. The price index (or indices) selected for a particular contract (each a reference index) will depend on a number of factors, including the nature of the agreement, the parties involved, and the type of goods or services being transacted. The purpose of the inflation adjustment clause is to safeguard, as much as possible, certain prices, fees, rents, expenses, etc. from the value-eroding effects of inflation over a contract’s term through a prescribed adjustment mechanism.

Why does the inflation adjustment clause matter?

The prices of goods and services fluctuate all the time. Generally speaking, inflation exists when the price (and only the price) of a good or service increases over a given period. For example, if a shirt costs $10 one month and $11 the next, but the fabric, style and other factors that contribute to its overall value remain the same, then the $1 appreciation in price represents inflation. Price indices - such as the U.S. Consumer Price Index - approximate the general rate of inflation for a given economy (or subset thereof) by tracking fluctuations in the price of a basket of representative goods and services over time. Because money is typically used to facilitate transactions involving goods and services, the negative effects of inflation are most readily observed through the deterioration in its purchasing power. That is, when an economy is experiencing inflation, a given amount of money will buy a smaller quantity of the same goods and services from one period to the next.

For companies supplying goods or services (sellers), the inflation adjustment clause helps preserve the purchasing power of money they earn from sales during periods when input costs are rising. On the other hand, for companies buying goods or services (buyers), the opposite is true. And buyers - especially those who have limited ability to pass cost increases on to their customers - may find that the purchasing power of money they earn from sales deteriorates during periods when input costs are rising. Yet, very few companies are exclusively buyers or sellers. Most occupy both positions. Companies therefore need to have an understanding of how inflation is addressed in all their contracts to assess their net exposure. This will allow them to make informed decisions about managing overall inflation risk, including, where possible, terminating existing contracts with unfavorable inflation terms and negotiating appropriate safeguards into the inflation terms of new contracts.

How do you review the inflation adjustment clause in contracts?

As the examples below illustrate, inflation adjustment clauses are not always conveniently located in their own clearly marked section of an agreement. Where the presence of an inflation adjustment clause is not apparent from a scan of an agreement’s section headings (including headings like those in examples 1, 4, 6, 7 and 10 below, which use more generic price adjustment language), try checking the definitions section to see whether there is a defined term for a reference index (e.g., “CPI”, “PPI”, etc.). This is generally a strong indicator that the agreement contains some form of inflation adjustment clause, and searching for that defined term can help a reviewer locate it more efficiently.

After locating all the inflation adjustment language in each agreement, important information to consider when reviewing these provisions includes:

  1. Frequency of adjustment. When considering frequency, be sure to note whether the adjustment happens only once or is recurring. To illustrate, examples 1 and 5 below are one-time adjustments; whereas examples 2, 3, 4 and 6 below are recurring. Recurring inflation adjustments are typically made annually or quarterly, though some agreements may specify more frequent adjustments. As the examples below illustrate, annual adjustments are often based on the year-over-year change in a reference index at or around the beginning of the calendar year. Similarly, quarterly adjustments are often aligned with calendar quarters. All else equal, more frequent inflation adjustments can make prices and other relevant amounts more volatile, which may be disadvantageous from a budgeting perspective.
  2. Direction of adjustment. Because the rate of inflation does not always increase from year to year, be sure to confirm whether the inflation adjustment contemplates (i) increases only or (ii) both increases and decreases in accordance with the direction of change in the value of the reference index. Examples 1, 3 and 4 below, for instance, limit the adjustment to increases only, meaning that the party paying the adjusted amount does not get the benefit of a lower price in years where the change in the value of the reference index is negative. Furthermore, example 4 below takes the extra step of mandating that the base rent will be subject to a minimum 3% annual increase regardless of the change in the CPI index, which is good for the landlord but bad for the tenant when actual inflation is below this threshold. Example 6 below, on the other hand, specifically contemplates both increases and decreases, a feature which makes the clause more equitable for both parties.
  3. Caps on the adjustment. The inflation adjustment clause may specify a limit (or cap) on the amount of the adjustment permitted in any given year. Example 2 below, for instance, states that the annual adjustment to the Service Fee shall never be more than the lesser of (i) the annual increase in the EU Consumer Price Index and (ii) 3%. The cap in this case helps the licensee estimate the maximum Service Fee it can expect to pay in a given Renewal Period, thereby introducing a degree of financial certainty to the arrangement; but, at the same time, the cap hurts the licensor/service provider during periods where the rate of inflation is higher than 3%. Similarly, example 4 below caps the annual increase in base rent at 5%, which is good for the tenant but bad for the landlord when the actual change in inflation is greater than this amount.
  4. Reference index. The reference index will typically be defined in the inflation adjustment clause, though in some cases, like example 1 below, it may be defined only in the definitions section of the agreement. Although many agreements use some form of consumer price index as the reference index, alternatives such as a producer price index may be used instead (see examples 3 and 6 below). Note that in agreements with complex inflation adjustment terms more than one reference index may be used. In addition to the type of index, be sure to note any other defining characteristics such as geography or industry. The reference index in example 3 below, for instance, is the U.S. Producer Price Index for the Merchant Wholesalers, Nondurable Goods subsector. A reference index that is confined to a particular region, municipality or industry sector/subsector may be more volatile than a comparable broad-based index, meaning any amounts adjusted by the more narrowly-defined index may also be more volatile (and the magnitude of the adjustments greater). Finally, take note of any base year for the reference index as this also affects how the inflation adjustment is computed. To illustrate, consider the inflation adjustment formula in example 6 below, which sets 2000 as the base year for the reference index (incidentally, that agreement was signed in 2002). This means that the inflation adjustment applied to the $500,000 legal fee reimbursement will be the total cumulative increase in the CPI-U index between the year 2000 and the year in which the Change in Control event occurs.
  5. Formulas. Some inflation adjustment clauses include a formula for computing the adjustment. Examples 5 and 6 below, for instance, include relatively simple formulas for computing the inflation adjustment. Other agreements, however, have more complex formulas that may involve many variables and/or reference indices. In such cases, be sure to review the formula carefully to understand how the inflation adjustment should be calculated. Having a firm grasp on the mechanics of any such formula helps reduce the risk that computational errors will be made and/or that they will go undetected.

As with the review of any contractual provision, it’s also important to be aware of other provisions that may affect the interpretation of inflation adjustment clauses. As noted above, the definitions section of the agreement may contain the definition of the reference index (and, in some cases, other relevant defined terms). Where an inflation adjustment applies to items such as purchase price, fees and rent, the pricing terms of commercial agreements or the rent terms of commercial leases should provide additional details of the amounts subject to the adjustment. The term section provides useful information about when the term begins and how long it lasts, which may be relevant if the timing of the inflation adjustment is tied to the term of the agreement rather than a calendar period. Finally, when considering terminating a contract with an unfavourable inflation adjustment clause, check the termination section for termination for convenience language as well as any information about the consequences of termination (e.g., termination fees, ongoing obligations after termination, etc.).

Software that uses AI to identify and extract inflation adjustment clauses (as well as other terms that may affect their interpretation) can accelerate the work of finding these provisions and enable a more comprehensive review than can otherwise be done manually.

Examples of the Inflation Adjustment Clause

Below are some examples of inflation adjustment clauses from different kinds of agreements. While these examples do not necessarily cover the full range of inflation adjustment clauses one may encounter, they are meant to illustrate the degree to which these provisions can vary from contract to contract. Where an example includes broader contextual language, the inflation adjustment clause is highlighted in bold.

Example 1: From a Manufacturing Agreement

1.7. “CPI” shall mean the “Price Index for all Urban Consumers, U.S. city average, all items, for the then immediately preceding 12-month period” as published by the US Government…

4.2. Adjustments to Product Fees. The Product Fees shall be escalated on January 1, 2009 by the then current increase in CPI. Adjustments to Product Fees shall be effective January 1st and shall apply to all shipments of Product made on or after January 1st.

Example 2: From a Software License and Services Agreement

  1. Annual Support Fees. The initial annual Support Fee shall be stated in the Order Form. Fees for Support are due and payable annually in advance. The annual Support Fee for any Renewal Period shall not be less than the initial annual Support Fee and shall only increase from the previous year’s Support Fee by not more than the change in the EU Consumer Price Index over the same period, but in any case not more than 3%.

Example 3: From an Outsourcing Services Agreement

3.4 Producer Price Index Changes. The fees set forth on Schedule B that are expressed in dollars (but not percentages) shall be adjusted annually to reflect increases in the Producer Price Index for Merchant Wholesalers, Nondurable Goods, published by the United States Bureau of Labor Statistics (the “PPI-MW”). The adjustment shall be effective on the first day of the month following the publication by the Bureau after each one year anniversary of the Effective Date and shall not exceed [] percent ([]%). By way of example only, if the Effective Date is January 1, 2011, the adjustment would be effective on February 1, 2012 following publication of the PPI-MW on or about January 15, 2012. Each of the fees set forth on Schedule B shall be multiplied by the percent increase in the PPI-MW during each prior twelve-month period (for purposes of such calculation, the fees shall be the fees set forth on a revised Schedule B provided to the Company on an annual basis). An example of the calculation of the increase is set forth on Schedule J. If publication of the PPI-MW ceases, or if the PPI-MW otherwise becomes unavailable or is altered in such a way as to be unusable, the parties shall agree on the use of an appropriate substitute index published by the Bureau or any successor agency.

Example 4: From a Commercial Lease Agreement

B. ADJUSTED ANNUAL RENT: The base rent shall be adjusted for each lease year, as of the first day of January, in proportion to the increase in the Consumer Price Index as of January 1st, to the CPI index at the commencement date of this lease. The standard for measuring such adjustments shall be the Consumer Price Index, United States average on all items and commodity groups, issued by the Bureau of Labor Statistics of the United States, hereinafter referred to as the “Index”. The “Index” for the first month of the first term of this lease shall be the comparison number from which future adjustments are made. Notwithstanding anything contained herein to the contrary the annual minimum base rent adjustment shall be Three Percent (3%) for each lease year and the maximum adjustment to base rent shall be Five Percent (5%) for each lease year.

Example 5: From a Severance Agreement

7(c) COST OF LIVING ADJUSTMENT FOR CAP ON LEGAL FEE REIMBURSEMENT. Upon the occurrence of a Change in Control, the $500,000 cap on legal fee reimbursement provided by Section 7(b) will be subject to a cost of living adjustment equal to the value of the expression A x B, in which expression:

A = $500,000, and

B = Cost of living adjustment or inflation factor. This is computed by dividing the Consumer Price Index for All Urban Consumers (“CPI-U”) prepared by the U.S. Bureau of Labor Statistics, or any successor thereto, for the CPI-U for January of the year during which the Change in Control occurs by the CPI-U for January 2000.

The cost of living adjustment provided in this Paragraph 7(c) shall be considered to be part of the Officer’s payment of legal fees for purposes of this Agreement.

Example 6: From a Supply Agreement

PRICE REVISION: The Base Price will be subject to an annual adjustment, commencing on January 1, 2004. The Base Price will be adjusted upward or downward each year based upon the change in the Producer Price Index for Chemical and Allied Products (PPI - WPU06) base value, as published by the Bureau of Labor Statistics of the U.S. Department of Labor. The parties agree that the PPI factor adjustment will begin at the average for July 1, 2001 to June 30, 2002 at 149.3.

The calculation of the adjusted Product price is as follows:

Price200(alpha) = Base Price + PPI Escalation

PPI Escalation = Base Price x (PPI200(alpha) /149.3)

Example 7: From a Terminal Storage and Throughput Agreement

“Index” means the average Consumer Price Index, All Items Indexes, All Urban Consumers applicable to Dallas, Texas, published by the Bureau of Labor Statistics of the United States Department of Labor, for the most recently completed twelve-month period immediately preceding the most current Contract Year. If a substantial change is made in the Index, then the Index shall be adjusted to reflect the value that would have been obtained if no such change has been made. If the Index is no longer published, then a reliable cost of living indicator from the United States Government or a reputable financial publication shall be substituted, and shall thereafter be deemed to be the Index for the purpose of calculating adjustments to the Throughput Fee or the Adjusted Throughput Fee…

4.5 Adjustments to Throughput Fees. At the beginning of each Contract Year, starting January 1, 2005, the Throughput Fee shall be recalculated using a factor that is 80% of the year-over-year percentage change in the Index (the “Adjusted Throughput Fee”). The year-over-year percentage change in the Index shall be calculated by taking the quotient of the Adjustment Year Index over the Base Year Index minus one.

Example 8: From a SaaS Agreement

6.2 Fees During Renewal Terms. Service Provider’s Fees are fixed during the Initial Term. Service Provider fees for Renewal Terms shall escalate annually as of each anniversary of the Effective Date of the Service Order by the amount of the increase in the Consumer Price Index - All Urban Consumers of the Bureau of Labor Statistics of the U.S. Department of Labor for U.S. for All Items with Base Years 1982-1984=100. Those increases will be measured applying the twelve (12) month period ending in the month for which the most recent index results are available as of that anniversary of the Effective Date.

Example 9: From a Trucking Transportation Services Agreement

(d) The Tank Usage Rate, the Trucking Rate, and the Shortfall Rate shall be adjusted annually on the first day of the Month in which the anniversary date of the Effective Date falls, by a percentage equal to the change in the CPI-U (All Urban Consumers), as reported by the U.S. Bureau of Labor Statistics.

Example 10: From a Manufacturing Services Agreement

3.15 Automatic Pricing Adjustments. Commencing on the first anniversary of the Effective Time and on each anniversary of the Effective Time thereafter, the prices set forth in Schedule A or E (as modified from time to time pursuant to Section 3.16 or 3.19) may be increased by greater of (i) three percent (3%) or (ii) the percentage change in the index as described below, which increase shall be effective upon written notification from Manufacturer to Company. Any changes to the price will be based on the percentage change in the Industrial Product Price Index by North American Industry Classification System (NAICS) 329-0077 in the category Pharmaceutical and Medicine Manufacturing [3254]. For purposes of the percentage change calculation, the index value for the preceding December and the December prior will be used.

Example 11: From a License Agreement

EXHIBIT: COLA Adjustment

All amounts subject to adjustment by COLA will be increased (or, in the case of the Credit only, decreased, as applicable) on January 1, of each Annual Period in the proportion that the CPI (as defined below) figure last published immediately preceding such date bears to the CPI figure last published immediately preceding January 1 of the prior Annual Period. “CPI” shall mean the Consumer Price Index (All Urban) - Apparel Commodities (including footwear) (1982/1984 = 1) published by the United States Government Bureau of Labor Statistics or its successor.

Example 12: From a Manufacturing and Supply Agreement

“Pharmaceutical Producer Price Index” means the “Producer Price Index — Pharmaceutical Preparations” (Code PCU3254I 2325412) published by the U.S. Bureau of Labor Statistics or, if same is no longer published, the successor index published by the U.S. Bureau of Labor Statistics…

(ii) For each 12 month period commencing July 1, 2019 and on July 1 of each year thereafter, the Transfer Price in effect as of the immediately preceding June 30 shall be automatically increased for existing and new purchase orders (regardless of when placed) requesting delivery on or after August 1 of such new 12 month period by the cumulative percentage increase, if any, in the Pharmaceutical Producer Price Index during the twelve months ended May 31 immediately preceding such date. Once the Transfer Price for a twelve month period has been set as aforesaid, it shall not be affected by revisions to the Pharmaceutical Producer Price Index for the 12 month period ended May 31, which was the basis of determination; provided, however, that in calculating the adjustment to the Transfer Price for the next subsequent 12 month period commencing on July 1, the Pharmaceutical Producer Price Index as of the beginning of the 12 month period ended May 31 preceding such date, shall be the same figure as was used as the end of the 12 month period for the prior year’s calculation regardless of any subsequent revisions made by the Bureau of Labor Statistics thereto.

Example 13: From a SaaS Agreement

3.1. Term. This Agreement shall commence upon execution hereof and shall continue for five (5) years from the date upon which Client begins using Vendor Connected Retailer Software to process live data (the “Initial Term”). During the Initial Term, the SaaS Fees may be increased each year after the second year of the Initial Term, by up to the greater of either (i) the increase in the Consumer Price Index (All Items, Montreal) over the previous year (“CPI”) plus two percent (2%). The foregoing cap on increases shall not apply to increases in respect of Third Party costs including, but not limited to, costs associated with Third Party licenses, maintenance and POS hardware maintenance. Client may terminate this Agreement at the expiration of the Initial Term by providing written notice to Vendor not less than one hundred and eighty (180) days prior to the end of the Initial Term, such termination to take effect at the expiration of the Initial Term, while Vendor may terminate this Agreement at the expiration of the Initial Term by providing written notice to the Client not less than one (1) year prior to the end of the Initial Term, such termination to take effect at the expiry of the Initial Term. Notwithstanding anything to the contrary, Client may terminate this Agreement after the end of the third year of the Initial Term by providing written notice to Vendor not less than one hundred and eighty (180) days prior to the end of the third year of the Initial Term. In such event, Client shall pay Vendor an amount equal to fifty percent (50%) of the then current annual SAAS fees for the remaining two years of the Initial Term.

3.2. Automatic Renewal. This Agreement shall automatically renew for successive renewal terms of twelve (12) months (“Renewal Term(s)”) unless terminated as permitted hereunder. The SaaS Fees may be increased each year by up to the greater of either (i) the increase in the Consumer Price Index (All Items, Montreal) over the previous year (“CPI”) plus two percent (2%). The foregoing cap on increases shall not apply to increases in respect of Third Party costs including, but not limited to, costs associated with Third Party licenses, maintenance and POS hardware maintenance. Either party may terminate this Agreement at the expiration of the then current Renewal Term by providing written notice to the other party of not less than one hundred and eighty (180) days prior to the end of the then current Renewal Term. For avoidance of doubt, termination shall be effective at the expiration of the then current Renewal Term.

Example 14: From a Commercial Lease Agreement

  1. OPTION TO EXTEND LEASE. Provided that Lessee is not then in default, Lessee shall have the option to extend the term of this lease for two (2) separate and successive periods of 3 years each by giving written notice of its intention to extend the lease at least thirty (30) days prior to the expiration of the initial term, or if the initial term has been extended, at least thirty (30) days prior to the expiration of the extended term. The base rental for the first renewal term shall be the base rental for the initial term as stated in Paragraph 5(a) adjusted by the average Consumer Price Index for the Philadelphia Region for the six (6) month period immediately prior to the renewal date, payable in equal monthly installments. The base rental for the second renewal term shall be the base rental for the first renewal term as stated in Paragraph 5(a) adjusted by the average Consumer Price Index for the Philadelphia Region for the six (6) month period immediately prior to the renewal date, payable in equal monthly installments. All of the provisions of this Lease, including the provisions of Paragraph 5(a) shall be applicable with respect to any renewal term.

Example 15: From an Employment Agreement

2.1 Base Salary. A salary at the rate of $200,000 per year (the “Base Salary”), effective as of the Effective Date. The Base Salary shall be payable in installments consistent with the Company’s payroll schedule. The Base Salary shall be subject to adjustment annually by the Board for increases, if any, in the Consumer Price Index for the most proximate geographic area in which Executive is then employed (as published by the United States Department of Labor for the immediately preceding calendar year) and will be reviewed each year during the Company’s annual salary review and the Company may, in its sole discretion, increase the Base Salary as a result of any such review.