How Does Payment Processing Work?
Meaghan has provided content and guidance for indie retailers as the editor for a number of retail publications and a speaker at trade shows. She is Fit Small Business’s authority on retail and ecommerce.
Karina Fabian writes and reviews business software, services, and topics for starting a business, startups, and small businesses. She has more than seven years of business writing experience.
This article is part of a larger series on Payments.
As a business owner, payment processing is actually simple and automatic, taking only seconds. It starts with a swipe, dip, tap, or manual input of payment information and ends with money in your account. Let’s break it down:
Primary Payment Processing Steps
The full credit card processing procedure—from when a customer presents a payment card to when the funds are deposited into your business bank account—involves authenticating the account, authorizing the payment, and settling the transaction.
Step 1: Authentication
Though they happen near 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.
To fully understand how credit card processing works, it’s helpful to understand who’s involved:
- Merchant: The small business that is selling products and/or services to the end customer; they are the ones receiving money.
- Customer: The individual or business who is making the purchase; they are the ones providing money in exchange for products and/or services from the merchant.
- Merchant bank: The financial institution where the merchant keeps their funds.
- Payment gateway: Technology that allows merchants to securely accept credit card payments from customers.
- ISO/MSP: The Independent Sales Organization (also known as Member Service Provider) is a liaison between the card-issuing bank and the merchant.
- Issuing bank: The financial institution that provides the customer with their credit or debit card.
- Card association: Visa, MasterCard, American Express, and Discover are card associations.
How Much Does Payment Processing Cost?
Payment processors 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.
What About 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.
Choosing a Payment Processor
Now that you have a good understanding of what payment processing is and how it works, you can make an informed decision when choosing the best payment processor. Here are some things to consider:
- 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.
- Price is only one consideration. 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.
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 | 2.69%–4.25%, depending on risk |
Online transaction fees | 2.9% + 30 cents | 2.9% + 30 cents | From Interchange + 0.5% + 25 cents | 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 businesses, or a processor with no monthly fee.
Payment Processing Frequently Asked Questions (FAQ)
What is a payment processor?
A payment processor is simply the means by which an electronic sale is processed. It starts when a customer puts in their payment information and ends when the money is put into your merchant account. Payment processors handle all the tasks needed to ensure the transfer, including transmitting payment information, verifying accounts, authorizing the transfer, and ensuring the money is properly deposited.
Payment processors include one or more means for capturing payment information. PayPal, for example, lets you program buttons for use online. Square, meanwhile, offers a full, free POS system. Stripe excels at integrations that let you take payments from a multitude of programs. Most offer virtual terminals or sales pages you can add to a website.
What’s the difference between a payment processor and a merchant account?
A merchant account is an intermediate business bank account that a customer’s payment is sent to before it goes to your own account. A payment processor facilitates the payments.
Sometimes, you see these words used interchangeably—we often do it, in fact. That’s because most merchant account services include payment processing in their offerings, and many payment processors offer a shared merchant account, from which they then pay out funds to your business account.
Though they are technically different behind the scenes, in practicality, they are used the same way because most modern solutions do both. As a small business, you won’t need separate accounts.
How does online payment processing work?
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.
Learn more about payment gateways and whether you need one for your business.
How long does processing payments take?
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.
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.
