Public authorities will have to pay contractors within 30 days or face financial penalties, as part of an amendment to the Late Payments Directive tabled by the European Commission.
The move is part of legislative commitments made last year under the Small Business Act and is expected to benefit SMEs that win public contracts by improving cash flow.
Local authorities, national governments and European agencies will have to pay compensation for recovery costs, and flat-rate interest of 5% of the amount due, which kicks in from day one of the delay.
The EU executive said late payments remain a problem across Europe, and urged public authorities to lead by example by settling their bills within 30 days.
Commission Vice-President Günter Verheugen, responsible for enterprise and industry, stated that the move would help alleviate some of the pressure of the credit crisis.
"Late payment by public administrations should be no longer tolerated. Today's proposal provides an important impetus to overcome the economic crisis by helping to avoid further bankruptcies and promoting businesses' cash flow in order to reinforce the competitiveness of European enterprises in the long term," he said.
UEAPME, which represents European craft and SME employers, welcomed the proposal, but said it could be further improved.
It said the compensation rights for recovery costs and the plan to allow creditors to charge interest for late payments would be an incentive for public authorities to pay on time.
However, the group was critical of the decision to exclude business-to-consumer transactions from the scope of the proposal, saying this would leave small businesses vulnerable to late payments from private customers.
"Despite the good intentions and the laudable efforts made by Commissioner Verheugen, today's proposal is less than ideal for small businesses," said its secretary-general, Andrea Benassi.
He said SMEs are increasingly concerned about payments from private customers, particularly in the present economic climate, and expressed dissatisfaction with the inclusion of a clause which allows public authorities to extend payment terms "when objectively justifiable".
Benassi called on the European Parliament and European Council to redress what he sees as the current shortcomings.
There was a positive reaction from Eurochambres Secretary-General Arnaldo Abruzzini, however, who called for the proposal to be adopted before the end of 2009.
He said that although the amendment is limited in scope, it represents "an important step in concretely helping European businesses, especially smaller ones, which are strangled by payment delays on one hand and difficulty of accessing credit from banks on the other".
Abruzzini said a survey by Eurochambres had shown that "payment times from the public sector have increased for 43% of respondents, and the situation is even worse from private clients, with 60% of companies suffering from longer payment delays".
- The proposal will be examined under the co-decision procedure.