What Is an Escalator Clause? Definition, How It Works and Example

What Is an Escalator Clause?

An escalator clause is a contract provision that allows for an automatic increase in the agreed-upon wages or prices if certain conditions change while the contract is in effect.

An adjustment to a labor contract may be triggered by an increase in the inflation rate. An adjustment to a business-to-business contract may be triggered by an increase in expenses necessary to fulfill the agreement. A landlord may demand an escalation clause in a long-term rental agreement to cover any tax increases or a substantial change in market conditions.

The escalator clause is also known as an escalation clause.

How an Escalator Clause Works

The main purpose of an escalator clause is to allow people to commit to long-term contracts without worrying that changes in external circumstances could hurt them. It ensures that contracts remain fair to all parties involved.

Escalator clauses are often championed by labor unions, which demand that wage increases in employment contracts be tied to the rate of inflation. They also are common in the business contracts of companies that supply goods or services with costs that are prone to wild fluctuations. For example, shipping charges can swing dramatically depending on volatile oil prices.

Escalator Clauses in Rental Contracts

Landlords might favor escalator clauses for residential and commercial contracts. If rents are increasing rapidly, a landlord may hesitate to sign a long-term rental agreement or lease, since they could lose out on higher rents.

An escalator clause allows rent to increase by a specified amount each period, allowing the landlord to benefit from current market conditions and the renter to secure a long-term arrangement.

Sometimes escalator clauses include a cap on the allowed increases. Escalator clauses may also contain de-escalation provisions, which allow for a price decrease if certain costs decline.

Criticism of Escalator Clauses

Escalator clauses are not favored by everyone, particularly those that are forced to cover the cost of any increases in wages or prices.

In particular, their use in employment contracts has become controversial. Unions argue that these provisions are necessary to protect workers against a potential loss of purchasing power over time.

Some economists argue that escalator clauses worsen the inflation that they are created to relieve.

If wages automatically keep climbing, central banks can struggle to stabilize prices. Companies that are unable to pass on higher costs to their customers make up the losses by laying off staff. This argues that the provisions can be self-defeating.

Example of an Escalator Clause

In real estate, an escalator clause may be attached to an offer on a home, indicating that the potential buyer is willing to increase the bid should higher offers be received.

For instance, if a buyer makes an offer of $400,000, an escalator clause could specify that if a higher offer comes in, the buyer will beat it by $3,000, but only up to $430,000. This would mean that if an offer of $405,000 is tabled, the escalator clause would trigger a new offer of $408,000. On the other hand, if a competing offer comes in at $429,000, the escalator clause would not allow for a new offer adding $3,000 since the clause specifies a cap of $430,000.

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