Disrupting the Billable Hour Model with Artificial Intelligence
Artificial intelligence (AI) solutions are transforming the way people work in many industries, and the legal industry is no exception. Although adoption of AI has been slow in the legal industry, law firms are now investing heavily in AI. In fact, spending on AI by law firms has doubled in the past two years, from 1-2 percent of the firms’ total technology budgets to 4-5 percent of the budgets.
Attorneys are using AI solutions to work more efficiently. AI can assist lawyers in performing electronic discovery, due diligence, legal research, and predictive analytics. Many of these tasks are extremely labor intensive, and they have historically been performed manually by junior attorneys on a billable hour basis.
The only options to increase profitability in the traditional billable hour model are to increase the number of hours that their attorneys work, or increase their hourly rates, or cut expenses
Utilizing AI to assist in these tasks enables attorneys to scale their work with increased speed and improved accuracy and work product. Although, we are not at point where an AI agent can replace an attorney, these changes in the practice are impacting how legal services are priced and consumed.
Law firms have historically billed for legal services primarily on and time and materials basis. Every hour that an attorney spends on the matter is billed to the client at an agreed rate. In addition to the significant expense on labor-intensive projects, a significant disadvantage to clients in the time and materials approach to legal services is the lack of predictability of spending for legal services.
Although the time and materials approach to providing legal services is generally advantageous to firms, one disadvantage is that firm profitability is tied directly to the number of hours of attorney work it can produce. The only options to increase profitability in the traditional billable hour model are to increase the number of hours that their attorneys work, or increase their hourly rates, or cut expenses.
Firms have taken all three approaches to improve profitability, but with an emphasis on raising rates. Over the past two decades, these increases in hourly rates have dramatically outpaced inflation. In fact, rates for lawyers had an average increase of 3.62 percent per year between the year 2000 and 2018, more than 50 percent faster than the rate of increase of overall inflation during the same period (2.10 percent).
The Impact on Clients
Despite this ongoing increase in rates, the demand for legal services has continued to rise. Today, clients are struggling to reduce legal costs in the face of increasing rates and an increasing need for legal services.
Clients have responded to increasing hourly rates with a variety of tactics to drive down legal costs, such as asking for discounts, using RFPs to acquire legal services, and using their procurement departments to try to force down rates. These tactics may have limited success. For example, sometimes as the cost of legal services is forced down, the quality may decline as well. Regardless, as rates go down, the profitability of law firms reliant on the billable hour also declines, which may result in prioritization of fully billable work of other clients over the reduced rate work.
AI Enabled Legal Services Pricing
Sophisticated law firms have realized that legal AI solutions enable them to change their billing model to meet their clients’ needs (cost certainty and cost control) while still maintaining firm profitability. These firms are now offering fixed fee or portfolio fee pricing to their clients on projects where they are able to leverage AI tools.
With AI enabled pricing analyses, and the utilization of AI solutions to perform tasks that were previously labor-intensive, law firms are able to mitigate and accept the risk of cost overruns on projects. This enables law firms to price legal services on a fixed fee basis for a project or portfolio of work, rather by the billable hour. These fee arrangements are popping in both litigation and transactional practices, and at AmLaw 50 firms as well as smaller firms.
The billable hour is the entrenched model for charging for legal services. However, the market pressures to find satisfactory alternatives are significant. Legal AI solutions are providing law firms with an alternative that satisfies the clients’ need for high quality legal services at a predictable and reasonable price, while enabling the firms to maintain their own margins. Such solutions create an alignment of incentives between the firms and the clients.
Not all firms are going to be able to successfully leverage AI solutions to enable new fee structures for their clients. To be successful law firms will need to capture relevant data, build project management and technology implementation skills, and most importantly (and hardest) obtain buy-in and adoption from attorneys.
Despite the challenges, firms are increasing their utilization. Those that are able to leverage AI solutions to price and perform projects and portfolios of work on a fixed fee basis are able to better meet their clients’ needs while remaining profitable. This is a significant competitive advantage enabled through the use of AI.