How Does Payment Processing Work?

Payment processing involves several different steps, depending on the payment method used, with the end goal of transferring funds electronically from a customer’s issuing bank to a merchant to pay for goods and services.

When payments were mostly made offline, payment processing typically involved a point-of-sale (POS) system consisting of hardware and software, along with an accounts receivable employee and a bookkeeper who reconciled the accounts.

Today, payment processing has expanded to include online payments, which are typically recorded directly on the merchant’s dashboard and fed automatically into the merchant’s bookkeeping software.

The Key Players in the Payment Process

Whether online or offline, there are several people and institutions involved in an electronic payment process that all play an important role:

• The customer. This is the person who wishes to purchase goods or services from the merchant.

• The merchant. This is the business owner who will receive payment from the customer in exchange for goods and services.

• The payment terminal. This is the hardware or software into which the customer will enter their payment details.

• The payment gateway. The payment gateway is the portal through which the payment request is passed electronically from the merchant to other parties.

• The merchant’s payment processor. The merchant’s payment processor is the company that handles transactions on behalf of the merchant.

• The acquiring bank or merchant bank. This is the financial institution that receives payments on behalf of the merchant and is responsible for issuing refunds and settling chargebacks.

• The customer’s payment service provider. This is a third party that handles payments on behalf of the customer, using a stored balance or the customer’s credit card or bank account.

• The card networks. These are the networks that issue credit and debit cards to account holders. The main networks include Visa, MasterCard, Discover and American Express.

• The customer’s issuing bank. This is the bank that issued the customer a credit or debit card and settles credit payments on the customer’s behalf. The issuing bank is also responsible for protecting the customer’s interests and can force a chargeback from the merchant’s acquiring bank under certain circumstances.

How Payment Processing Works Step by Step

So, you know the players involved, but how does payment processing work in practical terms?

Step 1: The Customer Enters His or Her Payment Information

To initiate any electronic payment, the customer enters his or her payment information into a payment terminal—either a virtual terminal like an e-commerce checkout or a card reader in a physical store.

Depending on the payment method used, this could involve one of several different actions:

• For debit and credit card transactions, the customer will swipe, dip or tap the card onto a card reader or enter the card number, cardholder name and card verification value (CVV) into an online checkout.

• For bank transfers, the customer either logs in to his or her online banking platform and sends the funds to the merchant’s business bank account or provides his or her bank account details to the merchant, who debits the bank account for the specified amount.

• For buy-now-pay-later (BNPL) transactions, the customer selects the BNPL option and enters his or her card details into the relevant fields. The BNPL provider credits the merchant with the specified amount and the provider debits the customer’s card in a series of equal instalments.

Step 2: This Information Is Encrypted and Routed through the Payment Network

Once the customer’s card or payment information has been entered into the physical or virtual terminal (except for bank transfers, which are processed directly through the banking system), the data is “hashed” or scrambled for security and a token sent through the payment gateway through the payment network in the following order:

1. The merchant’s payment processor
2. The merchant’s acquiring bank
3. The card network
4. The issuing bank

At each stage of the process, security checks are performed to see whether the card has been blacklisted (as a fraudster’s card). Credit card address verification service and identity checks may also be performed. Once the request reaches the issuing bank, the bank checks whether the card:

• Is valid (i.e. unexpired)
• Has sufficient funds for the payment
• Hasn’t been blocked for suspected fraudulent activity

If everything is ok, the issuing bank sends an “authorised” or “success” message back through the payment network—at which point each institution involved in the payment process deducts a fee—and a “success” message is displayed to the customer and the merchant at the point of sale.

Step 3: The Merchant Authenticates the Transactions

Usually once per day, the merchant looks through all of the transactions and clears them for processing as a batch. If any transactions were flagged as potentially suspicious, the merchant will either accept or block those payments at this time.

Step 4: The Issuing Bank Transfers the Funds to the Merchant Account

Once the transactions are authenticated, the acquiring bank will request the funds from the issuing banks and receive settlement minus the fees taken out by the issuing bank and card networks.

Step 5: The Funds Are Paid Out to the Merchant

Once all of the funds have been settled to the merchant account, the merchant’s acquiring bank deducts the merchant payment processor’s fees and transfers the balance to the merchant’s bank account.

Step 6: The Customer Repays the Issuing Bank or other Lender

If the customer used a credit card or BNPL for the purchase, he or she will receive a bill and repay the lender for the amount owed.

Different Kinds of Payment Processors and Merchant Accounts

While the players mentioned are necessary for all credit and debit card transactions, there are different kinds of payment service providers that are more suited to different kinds of businesses.

Merchant Services Provider

A merchant account services provider works with registered businesses, providing each business with a merchant account and a unique merchant identification number (MIN). Merchant services providers offer comprehensive merchant services such as sales reports, customisable fraud scrub, chargeback mitigation and recurring billing.

Aggregated Merchant Account Provider

The other kind of payment processor offers online payment processing services on behalf of merchants under a single shared merchant account. Examples include PayPal, Magento, Stripe, Sage Pay and Block (formerly Square). With this kind of account, merchants don’t need a business number to accept payments but generally pay higher per-transaction fees and run the risk of having their accounts frozen without warning.

Once It’s Set Up, Payment Processing Is Quick and Easy

While there’s a lot involved in processing an electronic transaction, the process is ultimately quick—taking place in seconds—and generally very secure. According to the FIS Global Payments Report, published in March 2022 (p.11), cashless payments now account for 82% of transactions around the world. Moreover, electronic payment methods allow you to sell to customers who are located in other countries.

If you are ready to accept electronic payments in your physical or online store, look for a payment processor that offers the best services and rates for your business model and industry, offers secure payment processing for your business and has a comprehensive suite of merchant services that can help you grow your sales.