What is the meaning of liquidated damages? When you sign a contract, it will typically include a section that outlines the amount of money, or liquidated damages, that one party will pay to the other if the contract is breached or if one of the parties takes legal action.

Definition of Liquidated Damages

Liquidated damages are the amount of money that both parties in a contract agree upon if a breach of contract occurs or legal action arises as a result of the contract breach. If one of the parties breaches the contract, it agrees to pay the liquidated damages to the other party. Liquidated damages are generally only applicable to contractual agreements, which separates them from punitive and actual damages.

The parties involved in a contract will typically agree on the amount of liquidated damages at the time the contract is signed and include the details in the agreement. Those signing the contract may also choose to include information on what types of actions would require that one party pay liquidated damages to the other party. For example, if a software developer agreed to deliver a set number of widgets but couldn't deliver that number and/or couldn't meet the deadline, that developer might have to pay liquidated damages.

At-Large Damages

Some contracts include an agreement between the two parties that outlines what situations require the payment of liquidated damages, but that doesn't state the specific dollar amount of those damages. In this case, the amount is considered to be "at large," so a judge will make the determination of how much must be paid if one of the parties takes legal action. In other cases, the amount of liquidated damages is based on the down payment or deposit. This amount could also be a percentage of the total contract.

The party that doesn't default on or breach the contract may take legal action to receive liquidated damages, although this usually requires proof written into the contract that liquidated damages are not specified. However, if the party taking legal action can prove that the amount was too high or too low, a judge may alter the amount of the required payment. This usually indicates that the contract contained a misunderstanding, was fraudulent, or was written unfairly. 

Damages are liquidated when either of the following applies:

  • If no known rules apply to outline the certainty of the damages, whether due to the case circumstances or the nature of the contract's subject
  • If the tenor of the agreement and the nature of the case indicate that the damages are calculated and adjusted fairly between the involved parties

This payment is to compensate for an injury, detriment, or loss to an individual, the individual's property, or his or her rights, based on a stipulation in a contract or an award by a judge. A contract that includes details about promised performance or exchange of money will usually include a stipulation concerning liquidated damages. This stipulation exists to determine a set amount of money that will be paid if one of the involved parties fails to deliver on the promised terms.

When Liquidated Damages Apply

Liquidated damages only apply when:

  • The contract doesn't specifically quantify the injury or the amount of damages required.
  • The contract structures damages to function as damages but not as a penalty.
  • The amount of harm anticipated as a result of the breach of contract is reasonable.

The liquidated damages provision in an agreement must be reasonable, based on the actual or anticipated harm that occurs as a result of the breach. If the amount is unreasonably high, it will not be enforceable, based on the public policy of penalty.

Including Liquidated Damages in a Contract

When drafting a contract, if you plan to include a section on liquidated damages, you will need to make a logical, well-founded estimate to make sure it can be enforced. This amount should be an estimate of the full extent of injury that could happen in the event of a contract breach. 

Liquidated damages protect both parties when they enter into their contract, regardless of the relationship between them. A contract between employer and employee or buyer and seller could include a section about liquidated damages. This term refers to a variety of damages that could result if a contract is breached. 

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