How Does Payment Processing Work? 2023 Small Business Guide
This article is part of a larger series on Payments.
Payment processing refers to the steps initiated by a business to accept credit card payments. The process is simple and automatic—taking only seconds. It starts from the swipe, dip, tap, or manual input of customer payment details at the merchant’s point of sale and involves the verification of those details, approval or denial of the transaction, and settlement.
If you need some background on what a payment processor is and the differences between a payment processor and a merchant account, expand the section below. Otherwise, let’s jump into the payment processing steps and how to set up payment processing for your business.
A payment processor is a service provider that handles all the tasks needed to ensure payment transfer. It includes one or more means of capturing payment information, such as credit cards, bank transfers (ACH), and digital wallets.
A credit card processor specifically refers to payment processors that allow merchants to accept credit and debit card transactions. Almost all payment processors offer this service, which is why the terms are often used interchangeably.
A merchant account is an intermediate business bank account where a customer’s payment is sent before it goes to your own account. Payment processors also provide businesses with these in order to start accepting payments.
There are two types of payment processors—each offering different types of merchant accounts:
- A payment processor (also called a payment facilitator) provides aggregate merchant accounts. This is best for small businesses and startups.
- A merchant services provider provides a dedicated merchant account. This type is ideal for more established businesses.
This is why these terms are used alternately—we often do it, in fact. Though they’re technically different behind the scenes, in practicality, they’re used the same way because most modern solutions do both. Learn more about merchant accounts.
Payment Processing in 3 Steps
To understand how payment processing works, we’ll need to discuss three steps—authentication of the account details, authorization of the payment, and settlement of the transaction. It’s also helpful to understand the entities, or actors, involved:
Merchant: The small business selling products and/or services to the end customer; they’re the ones receiving money. | ISO/MSP: The Independent Sales Organization (also known as Member Service Provider) is a liaison between the card-issuing bank and the merchant. |
Customer: The individual or business who is making the purchase; they’re the ones providing money. | Issuing bank: The financial institution that provides the customer with their credit or debit card. |
Merchant bank: The financial institution where the merchant keeps its funds. | Card association: Visa, MasterCard, American Express, and Discover are examples of card associations. |
Payment gateway: The technology that allows merchants to securely accept credit card payments from customers. | Point of sale (POS) system: You might use your POS system’s card reader or payment processing tools to accomplish steps along the way. |
Step 1: Authentication
Though they happen nearly simultaneously and behind the scenes, payment authentication and authorization are two separate steps at the start of the transaction.
Payment authentication is the process of verifying the customer account. When the card payment is swiped at the terminal or entered online, the details, like the customer’s name and card number, are sent to the merchant acquiring bank. The merchant’s bank then forwards these details to the customer’s card issuing bank to verify that the details are accurate to prevent fraudulent transactions.
Step 2: Authorization
Credit card authorization is the transaction approval or denial process that happens nearly instantly at the point of sale. Once the account is authenticated, the customer’s card issuing bank approves or denies the transaction, which is then passed to the merchant acquiring bank and, finally, the merchant.
This is when you’ll see “Authorized” or “Declined” indicated at the point of sale. If the transaction is approved, the merchant will receive an authorization number.
At this point, the merchant’s POS or payment terminal can start the process of batching and sending out approved transactions for payment.
Step 3: Settlement
The settlement process is when the merchant actually gets paid. Many merchant services will batch and process transactions automatically, but depending on your processor, you may need to manually batch and settle transactions at each terminal at the end of the day. Either way, you’ll want to monitor all of your statements to make sure there are no outstanding authorized payments.
How to Set Up Payment Processing for Your Small Business
1. Choose a Payment Processor
Not all payment processors are considered equal. While many payment processors work with multiple industries, some are better suited for specific types of business, offering better deals and tools.
Here are some things to consider:
- Price is only one factor. Look at the tools they offer—point-of-sale (POS) systems, dedicated merchant accounts, and discounts for special situations (like nonprofits). Also, check whether they require a contract or charge month-to-month.
- Reputation is important. A good price won’t mean anything if the payment processor isn’t reliable or you are stuck with hidden fees. Do your research. We offer reviews, but also read user reviews and get recommendations from others in your field.
- Find top-notch security. It’s important to keep your business and customer data secure. Look for PCI-compliant payment technology and other safeguards such as chargeback protection and address verification systems (AVS).
Best Merchant Accounts & Payment Processors at a Glance
 |  |  |  | |
|---|---|---|---|---|
Best for | All-around, mobile | Online sales and integrations | Cheapest option for established businesses | |
Monthly fees | $0 | $0 | $0 | $25–$30 |
In-person fees | 2.6% + 10 cents | 2.7% + 5 cents | From Interchange + 0.3% + 8 cents (capped at $6) | 2.69%–4.25%, depending on risk |
Online transaction fees | 2.9% + 30 cents | 2.9% + 30 cents | From Interchange + 0.5% + 25 cents (capped at $6) | 2.69%–4.25%, depending on risk |
Chargeback fees | $0 | $0 | $15 | $15 |
POS | ✓ | 3rd party | ✓ | ✓ |
Card readers | ✓ | ✓ | ✓ | ✓ |
Mobile app | ✓ | 3rd party | ✓ | ✕ |
Want to learn more? See our guide to the best merchant services to find one that’s right for you, and to see how we determined the best options. If price is your main concern, consider one of the cheapest credit card processing companies for small business or a processor with no monthly fee.
2. Integrate Your Payment Processor
When selecting your payment processing platform, it’s critical to ensure it meshes well with your existing tech stack, or suite of business tools and tech. If you’re hard-set on a specific payment processor, but it won’t integrate with your website or POS, for example, be prepared to migrate to a new website platform or POS.
3. Run a Test Transaction
Before launching your new payment portal to the public, do a test run with a dummy purchase and your own business credit card. This will help you flag any errors, saving your customers the frustration.
Part of your testing process should also include training or onboarding for any staff who needs to use the interface as part of their role.
4. Launch Your New Payment Process
Once tested, you’re ready to launch your new payment processing tool. Push it live and let the payments roll in!
How Much Does Payment Processing Cost?
Payment processors typically charge anywhere from 2%–5% per transaction, with 2%–3% being the most common. Some, like Square, charge a flat rate. This means every transaction of a certain type is assessed the same fee, regardless of the credit card.
Others, like Helcim, charge interchange-plus. This takes the interchange fee charged by the credit card companies and adds an additional percentage or flat amount per transaction. It’s generally cheaper than a flat rate but varies from card to card and even type of credit card (Platinum vs Gold, for example).
Some payment processors charge a monthly fee in return for lower rates, especially when dealing with high-volume sales. If you have sales of greater than $20,000, this could save you money. (Some flat-rate processors, like Stripe, also have discounts for high-volume customers.)
Some payment processors charge different rates or have an add-on fee for international payments. Finally, some add fees for additional items, like a virtual terminal or fraud prevention.
Learn more in our guide to credit card processing fees.
Dealing With Chargebacks
Chargebacks happen when a customer questions a transaction and asks their bank or credit card to reverse it. Sometimes, the customer has buyer’s remorse, dislikes the product, or does not recognize the purchase. Other times, it’s because someone stole their card or payment information and made an unauthorized purchase.
Regardless of the reason, they can get expensive for merchants. Chargebacks911 estimates that by 2023, chargebacks will cost merchants an average of $191. Many payment processors charge chargeback fees. Others, however, waive these fees or even offer chargeback protection, where they cover chargebacks due to fraud or friendly fraud.
There are things you can do to prevent or lessen the possibility of chargebacks. We offer tips for fighting fraud and other causes of chargebacks. Also, consider using a chargeback protection service if your payment provider does not include it.
How Payment Processing Works Frequently Asked Questions (FAQs)
Online payment processing works almost exactly the same as in-person payment processing, just with a few additional layers. Online payment processing requires a payment gateway that acts as the intermediary between your website and payment processor that collects and tokenizes payment information for security. Most online payment processors have gateway functionality built-in, so in most cases, there is no need for a separate gateway.
While the authentication and authorization of card payment transactions is basically immediate, the settlement process takes longer. Most businesses see funds from payment processing in their bank accounts two to three business days after the transaction. Although, some processors like Square will deposit funds immediately for a fee.
Other types of transactions, like ACH and check payments, can take longer to clear.
The point of sale (POS) is the process where a customer pays for goods and the merchant rings up the transaction. POS systems are the software and hardware that manages transactions. The best POS systems also enable small businesses to manage inventory, customer relationship management, and track sales, among other functions.
Bottom Line
Payment processing is vital for merchants that sell items online or in person. Payment processors transmit the customer payment information to the credit card company or payment association (like Google Wallet) for authentication and authorization, and once approved, enact the transfer of funds into your merchant account for later transfer to your business account. It’s a quick and often invisible process.
