Palo Alto isn't spiking its water rates just yet, but residents concerned about rising bills should hold their applause for now.

The City Council was scheduled to approve a new water-rate schedule that would raise rates by an average of 12.5 percent. The council held a public hearing on the rate changes last week and Monday night was scheduled to approve the new rates as part of their adoption of the 2012 budget.

But while the council approved most of the budget without a hitch, members put the brakes on the proposed water-rate increase after Councilman Greg Scharff said the proposed rates would violate Proposition 218, which requires water rates to be consistent with the cost of providing service.

The rates proposed by the Utilities Department, with input from the Utilities Advisory Commission and the council's Finance Committee, included new tiers for heaviest water users in both the residential and commercial customer classes. Currently, there are two tiers for residential and one tier for commercial customers. Under the proposal, which seeks to encourage conservation, the residential customers in the new third tier would pay more per gallon than other customers. So would commercial customers in the new second tier.

But Scharff and the council agreed that the new tiers would conflict with state law and asked staff to come back with a different rate structure. The council voted 7-1, with Gail Price dissenting and Nancy Shepherd absent, to support Scharff's proposal.

"I think it's really important that we move in right direction on Proposition 218," Scharff said.

Though the delay gives concerned ratepayers a temporary reprieve from higher rates, any sense of victory is likely to be short-lived. The council still expects to approve higher rates later this summer, though the way in which these rates are distributed among customers would change.

Palo Alto's Water Fund is facing a $6.2 million budget gap because of the spiking cost of wholesale water. The city's water-supply costs are projected to rise by 37 percent in the next fiscal year and to double by 2016, according to the Utilities Department. The increases are driven largely by a $4.6 billion infrastructure-repair project undertaken by the San Francisco Public Utilities Commission, the city's water supplier.

The council decision to revise the water rates appeared to surprise city staff. City Manager James Keene told the council that its new direction on water rates is a "rather significant change from what you've been considering." Utilities Director Valerie Fong said staff is a "little bit confused" by the council's proposal, which she said appears to conflict with previous direction. Utilities staff is schedule to return to the council with a new proposal on Aug. 1.

Councilman Greg Schmid proposed adopting the proposed rates for six months and then taking a fresh look at the rate structure next spring. This, he said, would give the council time to figure out ways to resolve its two conflicting goals: to comply with state law and to encourage conservation. His proposal fizzled by a 3-5 vote, with Vice Mayor Yiaway Yeh and Price supporting it.

Councilman Pat Burt pointed out that the council's decision to further revise the water rates is unlikely to satisfy the 120 or so customers who had sent in letters protesting the rate hike. The only people who would likely benefit from the next revision are the heaviest users who would have been in the third tier.

Burt agreed, however, that the city needs to make sure it complies with state law when setting the new water rates.

"If Proposition 218 didn't exist, I think we'd have a different discussion about the merits of tiered rates for conservation, but Proposition 218 does exist," Burt said.