One of the biggest problems in the legal profession is that many lawyers have little understanding of the economics of running a law firm. They know how to research cases, draft pleadings, take depositions, and argue in court. However, when it comes to understanding what it actually costs to operate a law practice, many lawyers are surprisingly uninformed. This is particularly concerning because law firms are businesses, and like any business, they must generate enough revenue to cover their expenses, pay their employees, and remain financially sustainable.

Part of the problem begins in law school. Law schools spend three years teaching students how to think like lawyers. They teach contracts, torts, constitutional law, civil procedure, evidence, and other substantive subjects. Those are important topics, but most law schools do a poor job teaching students how to run a financially sustainable law practice. Many lawyers graduate without understanding payroll, overhead, cash flow, collections, marketing expenses, employer taxes, or profit margins. They may have little idea how much revenue an attorney must generate to justify their compensation.

This lack of financial understanding often follows attorneys throughout their careers. Some lawyers believe that if they earn $100,000 annually and generate $100,000 or $150,000 in revenue, they are doing their part. They assume that because they have generated enough revenue to cover their salary, the firm should be satisfied. Unfortunately, that thinking misses the boat badly. A law firm cannot survive simply by generating enough money to cover its lawyers’ salaries. There are numerous other expenses that must be paid, and unlike an associate attorney who receives a regular paycheck, the law firm owner must ensure there is enough money to pay everyone and everything else.

This is where the traditional rule of thirds comes into play. Understanding this concept is essential not only for law firm owners but also for associate attorneys who want to understand how their work contributes to the financial health of the organization.

What is the rule of thirds in a law firm?

The rule of thirds is a traditional guideline for understanding attorney compensation and law firm profitability. Under this approach, approximately one-third of the revenue generated by an attorney goes toward attorney compensation, one-third goes toward overhead and operating expenses, and one-third remains for profit, reinvestment, and financial reserves.

For example, suppose an attorney generates $300,000 in collected revenue during a year. Under the traditional rule of thirds, approximately $100,000 would be allocated toward attorney compensation, $100,000 toward operating expenses, and $100,000 would remain as an operating margin before any additional expenses not already included in the calculation.

This is a simplified model, not a universal compensation formula. Actual allocations vary depending on practice area, staffing, benefits, marketing costs, and the firm’s business model. Some firms operate with higher overhead, while others maintain relatively lean operations. Nevertheless, the underlying principle is important: the money an attorney generates does not belong entirely to that attorney, and the difference between collections and salary is not automatically profit.

Understanding this relationship is particularly important when determining associate compensation. Law firm owners must consider the revenue an attorney can realistically generate, the support the attorney requires, and the expenses associated with the position. Compensation decisions cannot be based solely on what an attorney would like to earn or what another firm is reportedly paying.

Covering your salary is not enough

Consider an associate attorney who earns $120,000 annually. The attorney generates $150,000 in collected revenue and believes they have made the firm $30,000. On the surface, the calculation seems simple. The firm collected $150,000, the attorney earned $120,000, and therefore the firm supposedly made $30,000.

But that is not how the economics work. The attorney’s salary is only one of the expenses the firm incurs to employ that lawyer. The firm may also be paying for health insurance, retirement benefits, employer payroll taxes, professional liability insurance, bar dues, continuing legal education, computer equipment, office space, legal research subscriptions, and administrative support. That does not even account for the money spent attracting the clients whose cases the attorney handles.

Once these expenses are considered, an attorney generating $150,000 while earning $120,000 may actually be losing the firm a substantial amount of money. Yet some attorneys become frustrated when law firm management raises concerns about their productivity. They may think they have covered their salary and wonder what more the firm expects. The answer is that the firm must cover far more than their salary.

This misunderstanding can become particularly problematic when attorneys fail to meet productivity expectations. As discussed in my article on the myth of not having enough work to meet billable-hour expectations, attorneys must take responsibility for moving their cases forward, identifying necessary work, and recording their time accurately. Productivity expectations are not simply arbitrary numbers created by management. They are connected to the economics of keeping the practice financially viable.

Payroll is one of the largest expenses of running a law firm

Payroll is frequently one of the largest expenses of operating a law firm, and it extends far beyond associate attorney salaries. Depending on the size and structure of the practice, a firm may employ partners, associates, paralegals, legal assistants, receptionists, intake personnel, billing specialists, accounting employees, human resources professionals, recruiters, marketing personnel, office managers, and technology support staff.

Even a relatively small firm needs administrative assistance to function effectively. Lawyers cannot reasonably expect to handle every telephone call, prepare every document, maintain the technology, process payroll, perform accounting, manage client accounts, and simultaneously practice law at a high level. Larger firms require even more infrastructure, particularly when they operate multiple offices or serve clients across different jurisdictions.

These employees are essential to the operation of the practice, but many do not directly generate billable revenue. Their compensation must be funded through the revenue generated by the firm’s legal services. This is one reason why an attorney’s collections must substantially exceed their salary.

There is also the issue of staffing during slow periods. A law firm cannot simply stop paying employees when collections decline. Payroll obligations continue even when attorneys take vacations, clients delay payments, or new business slows down. Owners must plan for these fluctuations and maintain sufficient working capital to meet their obligations.

Employer payroll taxes and benefits add to the cost

Another expense many lawyers overlook is the cost of employing someone beyond their base salary. If an associate attorney earns $100,000 annually, the firm’s actual employment cost is not simply $100,000. The firm must generally pay employer Social Security and Medicare taxes, along with applicable unemployment taxes and workers’ compensation costs. It may also contribute toward health insurance, dental and vision benefits, retirement plans, disability coverage, and other employee benefits.

Employer Social Security and Medicare taxes generally amount to 7.65 percent of covered wages up to the applicable Social Security wage base, with the Medicare portion continuing beyond that threshold. Thus, an attorney earning $100,000 can cost the firm at least $107,650 before considering health insurance, retirement benefits, unemployment taxes, and other employment expenses.

Depending on the benefit package, the total cost can be substantially higher. A firm offering competitive health insurance, retirement contributions, and other benefits may spend thousands of additional dollars annually on each attorney. Those expenses are real, and they must be paid whether the attorney understands them or not.

This becomes particularly important when attorneys compare compensation packages or negotiate salary increases. An attorney may focus exclusively on base salary without recognizing the additional financial commitment the firm makes through benefits and other employment costs. Law firm owners must consider the entire compensation package rather than simply the number appearing on the employee’s paycheck.

Office rent, technology, and insurance are not free

Lawyers sometimes take their working environment for granted. They arrive at an office with furniture, computers, telephones, printers, conference rooms, reception areas, and internet access. They use legal research platforms, document management systems, case management software, email systems, and electronic filing tools. They expect those systems to work, and understandably so. However, everything costs money.

Office rent can be a significant expense, especially for firms maintaining locations in multiple markets. Beyond base rent, firms may incur common-area maintenance charges, utilities, cleaning expenses, repairs, security costs, and furniture replacement. Technology costs can also be substantial. Modern firms need reliable computers, cybersecurity protections, cloud storage, legal research tools, case management systems, billing software, and technical support.

Insurance represents another significant expense. Professional liability insurance, general liability coverage, property insurance, workers’ compensation, cyber insurance, and other policies may be necessary to protect the practice. The cost of these policies can increase as a firm grows, adds employees, or expands into additional jurisdictions.

None of these expenses disappears when an attorney has a slow month. The landlord still expects rent, the insurance company still expects premiums, and software vendors still expect payment. This is why law firm owners must understand the difference between fixed and variable expenses. A firm with substantial fixed overhead cannot simply reduce its financial obligations whenever revenue declines.

Even relatively small technology decisions can add up when multiplied across numerous employees. In my earlier article about cost-saving office software for law firms, I discussed how software licensing costs can become significant as a firm grows. The broader lesson remains relevant: owners must evaluate expenses individually while also considering their cumulative impact on the firm’s financial performance.

Marketing and client acquisition are often overlooked

Perhaps one of the most misunderstood expenses in law firms is marketing. Some attorneys assume clients simply appear at the office. They receive a new case assignment and begin working, but they may have little idea how the client found the firm or how much money the firm spent generating that opportunity.

In reality, acquiring clients can be expensive. Law firms may invest heavily in search engine optimization, pay-per-click advertising, websites, online directories, television, radio, community outreach, and other marketing activities. They may also employ intake personnel to answer calls, schedule consultations, follow up with prospective clients, and assist with the retention process.

Not every prospective client retains the firm. A law firm may generate numerous inquiries and conduct multiple consultations before securing one paying client. All of those expenses must be absorbed by the cases that ultimately generate revenue. This is particularly important when attorneys receive most or all their work through the firm’s marketing and intake systems rather than originating clients themselves.

The firm has already invested substantial resources before the attorney begins performing legal work. Attorneys who do not understand this may underestimate how much revenue they must generate to make their position financially sustainable.

Client acquisition also illustrates why law firms must evaluate both the cost of generating new business and the ability of attorneys to convert consultations into retained clients. A firm can spend substantial money generating leads, but if those opportunities are not handled effectively, the investment may never produce a return.

Taxes can create significant financial pressure

Taxes are another area where lawyers frequently misunderstand law firm economics. Law firms must handle payroll taxes and required withholding, along with applicable state and local business taxes, franchise taxes, gross receipts taxes, or other obligations depending on the firm’s structure and jurisdictions.

The owners may also face substantial federal and state income taxes on the firm’s taxable earnings. For pass-through entities, taxable income may be allocated to owners even when the business retains cash rather than distributing it. This can create situations where a law firm reports substantial taxable income while the owners still need cash to satisfy their personal tax obligations.

It is important to distinguish income taxes and owner tax distributions from ordinary operating expenses when calculating accounting profit. However, these obligations remain significant considerations in financial planning and cash management. A firm can appear profitable on paper while still experiencing serious cash flow pressure.

Owners must also consider the timing of tax payments, quarterly estimated payments, and the relationship between taxable income and available cash. Simply looking at the operating account balance without considering upcoming tax obligations can create a misleading picture of the firm’s financial position.

The American Bar Association’s article on financial resilience for law firm owners addresses the importance of financial controls, cash reserves, and preparing for unexpected business disruptions. These are essential responsibilities for owners who want their firms to remain financially stable.

Billed revenue is not the same as collected revenue

Another mistake lawyers make is assuming that billed revenue is the same as collected revenue. It is not. Suppose an attorney bills $350,000 in legal fees during the year. That sounds impressive, but if the firm only collects $250,000, the attorney has not generated $350,000 in cash receipts.

The remaining $100,000 may be tied up in accounts receivable, disputed invoices, write-offs, or unpaid client balances. Under a collections-based rule-of-thirds model, the calculation would begin with the $250,000 actually collected. One-third would be approximately $83,333. If that attorney earns $125,000 annually, the salary alone consumes 50 percent of collected revenue before benefits, support staff, marketing, and other overhead.

That may be financially unsustainable depending on the firm’s other economics. This is why law firms must track both billable hours and collections. An attorney who bills substantial time but consistently fails to collect may not be contributing as much financially as the billing numbers suggest.

The American Bar Association has discussed this problem in its article on how law firms should approach collections for financial success. Effective collections begin with clear fee agreements, accurate timekeeping, understandable invoices, and regular client communication. Firms cannot wait until accounts receivable become unmanageable before addressing payment issues.

Similarly, the ABA’s discussion of identifying leaks in a law firm’s billing process demonstrates how money can be lost through inefficient billing and collection practices. For law firm owners, improving collections can be just as important as generating additional billable hours.

What happens when attorneys generate only enough to cover their salaries?

Consider a hypothetical law firm with ten associate attorneys. Each attorney earns $100,000 annually, and each generates $125,000 in collected revenue. The firm would collect $1,250,000 annually while paying $1,000,000 in associate salaries.

At first glance, the firm appears to have $250,000 remaining. However, that money must cover employer payroll taxes, benefits, paralegals, legal assistants, administrative personnel, rent, insurance, marketing, technology, and all other operating expenses. For a conventional ten-attorney firm with offices and support staff, $250,000 would likely be insufficient to cover those costs.

The firm could therefore be losing a substantial amount of money despite every attorney generating more revenue than their salary. This is the problem with attorneys believing that merely covering their salary is sufficient. Multiply that misunderstanding across an entire law firm, and the financial consequences can be severe.

The problem can become even more significant when firms expand without understanding their economics. Adding attorneys, offices, or support staff may increase revenue, but those additions can also increase expenses faster than collections. Growth that does not produce adequate margins can weaken a firm rather than strengthen it.

Law firm owners cannot afford to miss the boat

Associate attorneys may not always appreciate the financial pressures facing law firm owners. They receive a paycheck every two weeks and may assume the business is financially healthy as long as the firm continues operating. But law firm owners do not have that luxury. Owners must make payroll whether collections are strong or weak, and they must pay rent, insurance, software vendors, and other obligations even when clients fail to pay their bills.

Owners must also deal with employee turnover, unexpected expenses, slow periods, and the possibility that major investments will not generate the expected return. They must ensure the firm has sufficient cash reserves to withstand financial difficulties. When the firm loses money, the owner generally bears the consequences, and there may be no guaranteed paycheck for the owner. In some situations, owners may have to contribute personal funds, borrow money, or reduce their own compensation to keep the firm operating.

This is why understanding law firm economics is not optional for those who own and manage a practice. If owners consistently pay attorneys more than the firm can afford, fail to monitor collections, ignore overhead, or underestimate taxes and payroll obligations, the firm can find itself in serious financial trouble.

A law firm can grow in revenue while becoming less profitable. It can hire more attorneys while generating less cash. It can appear successful from the outside while struggling to meet financial obligations. Revenue growth is not the same thing as financial success, and law firm owners who fail to recognize that distinction can put the entire organization at risk.

The ABA’s article on the financial aspects of practicing law reinforces the importance of educating attorneys about billing, collections, overhead, and financial performance. This knowledge should not be limited to a firm’s accounting department or managing partners. Attorneys at every level benefit from understanding the financial realities of the practice.

The rule of thirds is a guide, not an absolute rule

The traditional rule of thirds is useful, but it should not be treated as an inflexible requirement. Different law firms have different economic structures. A small firm with minimal office expenses, little advertising, and substantial attorney-originated business may operate with a different compensation ratio than a larger firm with numerous offices and significant marketing expenditures.

Practice areas also matter. A family law firm handling contested domestic relations litigation may have a very different cost structure than a personal injury firm operating on contingency fees or a corporate firm handling large commercial transactions. Even within the same practice area, firms may differ significantly in their use of paralegals, support staff, technology, and advertising.

Some firms may reasonably compensate attorneys at more than one-third of their collected revenue. Others may need to keep compensation closer to 20 or 25 percent because of substantial overhead and client acquisition expenses. The correct percentage depends on the firm’s actual financial results and business model.

The goal is not to follow a mathematical formula blindly. The goal is to understand the financial relationship between attorney compensation, collections, operating expenses, and profitability. Owners should use actual financial statements, payroll records, and collection data to determine whether their compensation structures are sustainable.

Pricing decisions also affect the equation. In my article on the case for taking fewer clients and charging more, I discussed how simply increasing case volume is not always the best strategy. Firms must evaluate whether their fees, staffing, and service model produce enough revenue to support the quality of representation they intend to provide.

Law firms need profit to survive and grow

Some attorneys view law firm profit as money that simply goes into the owner’s pocket. That is an oversimplification. Profit is necessary for a law firm to remain financially healthy, and it serves several important purposes beyond providing compensation to ownership.

Profits can help fund cash reserves for slow periods, new office locations, technology improvements, employee training, additional staff, better employee benefits, debt repayment, and unexpected financial obligations. They also provide a return to owners who have invested capital and assumed the risks of operating the business.

A firm that consistently operates without sufficient profit may have difficulty investing in its future. It may struggle to retain employees, improve benefits, upgrade technology, or withstand temporary reductions in revenue. Owners are entitled to seek a reasonable return on the capital they invest and the risks they assume, but that does not mean every dollar of profit should be distributed.

A responsible law firm must balance owner compensation with reinvestment and long-term financial stability. That requires financial discipline, realistic budgeting, and an understanding of how decisions involving compensation, hiring, marketing, and expansion affect the bottom line.

The ABA’s article on navigating economic uncertainty and maximizing law firm profit addresses the importance of tracking financial performance, reducing write-offs, improving collections, and identifying inefficiencies. These are all part of maintaining a healthy profit margin rather than focusing exclusively on gross revenue.

Law schools should do a better job teaching law firm economics

One of the changes I would like to see in legal education is a much greater emphasis on the business of practicing law. Law schools understandably focus on teaching students substantive law and developing their analytical abilities. However, many graduates will eventually work for private law firms, become partners, or open their own practices. They need to understand more than legal research and courtroom advocacy.

Law schools should teach basic concepts involving law firm budgets, financial statements, payroll, employer taxes, collections, profit margins, attorney compensation, billing practices, accounts receivable, marketing expenses, and cash flow. Students should understand how law firms generate revenue, what it costs to employ attorneys, and why profitability matters.

These subjects should not be treated as unimportant simply because they are not tested on the bar examination. Understanding law firm economics can help attorneys become better employees, more effective managers, and more successful owners. It may also reduce the unrealistic expectations that sometimes develop between associate attorneys and law firm leadership.

A lawyer who understands the actual cost of running a practice is better equipped to appreciate why productivity expectations exist. That lawyer is also more likely to understand the financial consequences of poor billing practices, inadequate collections, excessive overhead, and inefficient case management.

The legal profession would benefit from attorneys entering practice with a more realistic understanding of the business responsibilities associated with providing legal services.

Every lawyer should understand the numbers

Lawyers do not necessarily need to become accountants, but they should understand the basic economics of the organization where they work. They should know that salaries are only one component of the firm’s expenses and that billable hours do not automatically translate into collected revenue. They should recognize that marketing, support personnel, technology, insurance, taxes, and office expenses must be paid before a firm can determine its true profitability.

Attorneys should also appreciate that financial sustainability benefits everyone. A financially healthy law firm is better positioned to provide stable employment, competitive compensation, quality benefits, modern technology, and effective representation for its clients. Conversely, a financially unhealthy law firm may eventually face difficult decisions involving compensation freezes, layoffs, office closures, or worse.

Lawyers who want successful careers should take an interest in understanding these realities. This is particularly true for attorneys who aspire to become partners or eventually own their own practices. They cannot expect to manage a successful business if they do not understand what it costs to operate one.

Conclusion: The rule of thirds is about financial reality

The traditional rule of thirds is not a perfect formula, but it teaches an essential lesson about the economics of practicing law. An attorney’s salary is only part of the cost of employing that attorney. A law firm must also pay support staff, payroll taxes, benefits, rent, insurance, marketing expenses, technology costs, and numerous other obligations. The firm must generate enough revenue to cover those expenses, maintain adequate reserves, and earn a reasonable profit.

Too many attorneys believe that generating enough revenue to cover their salary means they are financially successful. That thinking misses the boat because it ignores the expenses necessary to support their work and keep the business operating.

Law firm owners cannot afford to make the same mistake. If they do not understand their expenses, monitor their collections, establish reasonable compensation structures, and protect their profit margins, their firms can quickly find themselves in financial difficulty. Ultimately, the rule of thirds is not simply about how much an attorney should be paid. It is about understanding what it actually takes to operate a financially sustainable law firm.