Supplying transmission losses economically under bilateral contract is a challenge for power engineers. In this study, penalised quoted cost (PQC) based approach is proposed where generators will participate for supplying the transmission losses which may be incurred from their customers through their bilateral contracts in a deregulated electricity market. The loss supplying generators will quote the cost and the quantum of real power that can be supplied by them to independent system operator (ISO) in a day-ahead market. This study presents a lucid approach for loss allocation economically by ranking the loss supplying generators based on their PQC. Penalty factor for each loss supplying generator is calculated using the loss coefficients. ISO will meet the losses due to bilateral contracts in an economical way by selecting the generators with minimum PQC and the associated cost is allocated to the individual transactions based on loss contribution fraction. The proposed algorithm is tested using a sample four-bus system and IEEE 30 bus system using MATLAB R2014a. This method is based on the participation of generators and their given quotation in transmission loss allocation process. The study gives both the real power loss/cost allocation to the generators and for individual transactions. © The Institution of Engineering and Technology 2016.