How Merchant Services Work: A Step-by-Step Look

Merchant services enable businesses to accept electronic payments like credit and debit cards, and digital methods. They are integral to modern commerce, facilitating secure and efficient transactions by bridging the gap between a customer’s payment and a merchant’s bank account. Accepting electronic payments offers benefits such as increased processing speed, enhanced security, and streamlined financial operations, important for businesses to meet consumer expectations.

Participants in Payment Processing

Electronic payment transactions involve several key entities, each with a distinct role in ensuring the successful transfer of funds.

The process begins with the merchant, the business offering goods or services and accepting electronic payment. They use various tools to initiate transactions.

The customer or cardholder is the individual making the purchase, providing their credit or debit card details to the merchant.

A key intermediary is the payment processor, also known as a merchant service provider. This company facilitates electronic transactions, acting as a data conduit between the merchant, banks, and card networks. Payment processors handle authorization, capture, and settlement, ensuring secure and quick transfers of funds.

The acquiring bank is the financial institution that maintains the merchant’s bank account and processes electronic transactions. It acquires funds from the cardholder’s bank and deposits them into the merchant’s account once a transaction is approved.

Conversely, the issuing bank is the financial institution that provides the customer with their credit or debit card. This bank is responsible for approving or declining transactions based on the cardholder’s account status and available funds.

Connecting these banking institutions are the card networks, such as Visa, Mastercard, American Express, and Discover. These global networks provide the infrastructure for electronic payments, linking issuing and acquiring banks. They establish transaction rules and standards, facilitating communication and payment information exchange.

The Payment Transaction Flow

The journey of an electronic payment, from customer initiation to funds reaching the merchant’s account, involves a precise sequence of steps.

The process begins with initiation, where the customer presents their card or payment method to the merchant. This can occur in person at a point-of-sale terminal or online via an e-commerce website. The payment information is then securely captured by the merchant’s system.

Following initiation, an authorization request is sent. The merchant’s system transmits transaction data to their payment processor, which forwards it to the acquiring bank and then through the card network to the issuing bank. The issuing bank verifies the card’s validity, confirms funds or credit, and performs fraud checks.

The issuing bank then sends an authorization response back through the card network, the acquiring bank, and the payment processor to the merchant. This response indicates whether the transaction is approved or declined, often accompanied by an authorization code for approvals or an error code for declines. If approved, a temporary hold for the transaction amount is placed on the customer’s account, earmarking the funds for the merchant. The actual movement of money does not occur at this stage.

At the end of a business day, or at regular intervals, the merchant performs batching by sending all approved transactions to their payment processor. This process, often referred to as settlement, involves the processor compiling these transactions and submitting them to the acquiring bank. The acquiring bank then requests the funds from the respective issuing banks via the card networks.

Finally, funding occurs as the issuing bank transfers the necessary funds to the acquiring bank. The card network facilitates this transfer, moving the money from the cardholder’s bank to the merchant’s bank. Once the acquiring bank receives these funds, it deposits the net amount, after deducting applicable fees, into the merchant’s bank account. This entire process, from initiation to funding, completes within one to three business days, though authorization itself happens in seconds.

Tools for Accepting Payments

Businesses rely on specialized tools to facilitate electronic payment acceptance across various environments.

For in-person transactions, Point-of-Sale (POS) systems are widely used. These systems combine hardware (terminals, card readers, receipt printers) with software for sales, inventory, and customer information. A POS system serves as the central hub for processing in-store payments, capturing and transmitting card data for authorization.

For online businesses, payment gateways are important. This service securely transmits transaction data from a website or mobile app to the payment processor. It acts as a digital POS terminal, encrypting sensitive customer information and ensuring its safe passage between the merchant’s platform and financial institutions. Payment gateways play a key role in e-commerce by authorizing and processing online payments.

Dedicated card readers and terminals read card data and connect to a POS system or payment processor. These devices support magnetic stripe swipes, EMV chip inserts, and contactless taps using Near Field Communication (NFC) technology. They are important for securely capturing card details from customers in a physical retail setting.

Virtual terminals offer a flexible solution for remote payments, like over the phone or mail orders. These web-based interfaces allow merchants to manually enter customer card details into a secure online portal. The virtual terminal sends this information to the payment processor, enabling transactions without physical card presence. This tool is useful for businesses without a physical storefront or those taking off-site orders.

Mobile payment solutions empower businesses to accept electronic payments using smartphones or tablets. These solutions often involve mobile applications paired with small, portable card readers that plug into or wirelessly connect to the mobile device. This allows for payment acceptance on the go, providing flexibility for businesses like food trucks, mobile service providers, or pop-up shops.

Costs of Merchant Services

Accepting electronic payments involves various costs, categorized into several fee types and pricing models.

The largest component of merchant service fees is interchange fees. These are transaction fees paid by the acquiring bank to the issuing bank for each transaction. They compensate the issuing bank for card issuance, transaction processing, and fraud risks. Set by card networks, these fees vary based on card type, transaction method, and merchant industry. In the U.S., average credit card interchange fees can be around 2% of the transaction value, plus a fixed amount, ranging from 1.5% to 3.5%.

In addition to interchange fees, assessment fees (card brand fees) are charged by card networks (e.g., Visa, Mastercard) for using their infrastructure. These fees cover operational costs and are a small percentage of each transaction, often 0.13% to 0.15%. Unlike interchange fees, assessment fees are non-negotiable and apply to every transaction processed.

Processor markup or fees represent the charges from the payment processor or merchant service provider for their services. These fees can include per-transaction fees, monthly service fees, and other administrative charges such as PCI compliance fees or statement fees. Processor fees vary widely among providers and can be structured in different ways, such as a flat fee per transaction (e.g., $0.10–$0.30) or a percentage markup.

Merchants encounter different pricing models for these fees. In an interchange-plus model, the processor adds a fixed markup (a percentage and/or a per-transaction fee) directly to the fluctuating interchange and assessment fees. This model is often considered transparent because the merchant can see the distinct interchange and assessment costs separate from the processor’s markup.

Another common model is tiered pricing, where transactions are grouped into different rate categories: qualified, mid-qualified, and non-qualified. Each tier has a different processing rate, with qualified transactions having the lowest rates and non-qualified transactions the highest. Transactions can be downgraded to higher-cost tiers for various reasons, such as using a rewards card, keying in card details manually, or processing international cards.

A third model is flat-rate pricing, which charges a single, fixed percentage and/or a per-transaction fee for all transactions, regardless of card type or transaction method. This model offers simplicity and predictability in processing costs, making it appealing for some businesses. For instance, a flat rate might be 2.5% plus $0.30 per transaction.