A reactive power cost allocation method based on power tracing principle is presented here. A new solution is proposed to solve the problem of bidirectional reactive power flow to enable the application of power tracing method to reactive power flow. Reactive power supplied by the line charging capacitance is considered to be a separate reactive source and accordingly reactive load and loss are also allocated to it. Total system reactive demand including load and loss is first allocated to all the sources, viz, generators, synchronous condensers, capacitors and line charging capacitance and finally these sources are offered the revenue for supplying this power according to the pricing structure adopted. In the present work a quadratic reactive cost function is adopted for the generators and all other sources are considered to have a fixed cost per unit MVar supplied, which is calculated from the installation cost of the respective reactive power source. The work is demonstrated on IEEE standard test systems and a practical Indian grid system. (C) 2012 Elsevier Ltd. All rights reserved.