Usage-based pricing is all the rage right now.

I understand why companies love it. The math looks incredible on paper.

But for most consumer companies, it's probably a bad idea.

For those who implement it, or a version of it, it’s harder than you think.

For those unfamiliar, usage-based pricing is the concept that you charge per usage of the product as opposed to a flat fee per month.

Blockbuster video charging you for every movie you rent = usage based pricing

Netflix allowing you to stream as much as you want = flat fee pricing.

While the vast majority of software products are flat fee and for good reason, more companies are exploring usage based pricing.

Why is that?

If you can make it work, usage-based pricing can massively increase your revenue and your company valuation.

This is driven by unlocking what’s called “net negative churn” which is only possible with some form of usage based pricing.

Net negative churn means if you sign up a cohort of users this year that pays you $100, next year they're worth more than $100.

Not less. More.

This means instead of churning revenue from every group of users that sign up each month, you are gaining revenue.

This has a massive impact on your ARR and valuation.

Usage based pricing is common in web hosting and storage industries.

You can see this in Snowflake’s public filings that they hit 178% net revenue retention at its peak. That means for every $100 they signed up, they were making $178 from that same cohort a year on.

They trade at a 16-17x price to earnings multiple whereas the “average” SaaS company is close to 7x ARR.

Understandably, if you run a company that could potentially unlock net negative churn, you’re probably feeling some pressure to do so.

On the product side, usage based pricing also elegantly solves multiple difficult problems at once.

One of the hardest problems when you design a paywall or multiple tiers of a product is making the difference easy to understand.

As the saying goes, "a confused mind never buys."

Centering your product around usage makes (most) of this problem go away.

In the Twilio example below it's really easy to see the difference between the tiers when they're based on usage.

The user can mentally calculate where they are and understand what's right for them

A really good mental test if your monetization system works is "Do the users who get the most value from your product end up paying you the most?”

If the answer is no, then something in your monetization system is off.

Usage based pricing both helps fix this problem and inherently self selects for good personas.

Company and customer incentives should be aligned but they are frequently not.

It's really easy for product teams to get lost down meaningless rabbit holes and ignore the core value of the product.

With usage based pricing:

Now when your teams get lost in things that don't drive usage, you feel that pain financially

So what's the problem?

Even if usage-based pricing makes sense for your market, there are real costs.

It makes user activation much harder. Every click feels like it costs money. Users hesitate instead of exploring freely. Hesitation kills habit formation. And habit formation is how you fight churn.

The hardest part of growing a product is activating users early. If you add friction to that journey with usage anxiety, you hurt retention downstream.

It adds massive complexity in your product and company

You now have to figure out:

Additionally it triggers a lot of organizational complexity

Every one of these needs to be designed, built, documented, and supported. It's a tax you pay forever.

I think that pure usage-based pricing only works when three things are true:

To me, point #3 is the key one.

If everyone is already offering a flat fee, it's tough for you to go usage-based unless you have a massive differentiator.

Because of these factors, its more common in some industries vs others:

Usage Based Pricing Dominates

Flat/Subscription Pricing Dominates

In all of these cases, customers intuitively understand there's a real cost.

Nobody expects unlimited electricity for $50 a month.

Here's how I'd think about your choices:

For the vast majority of consumer companies, you should do number three.

In certain high usage scenarios, you can use #2 if you can execute on it well.

My favorite version of #2 is using it as the line between a free and paid product.

If you are an up-and-coming company that is still working on core product development, I would start with a clear line between free/trial and paid.

Once you start to understand your personas, you can add additional tiers on top of paid based on usage numbers.

Good luck out there

Dan