By Megan Doyle
How do payment processors work? They help businesses accommodate more customers and payment methods while also making payments safer and easier. But not without cost—they also introduce a layer of complexity, and fees, to what was once a simple exchange of cash for goods.
Payment processors act as intermediaries between businesses and financial institutions, enabling both e-commerce and brick-and-mortar businesses to accept various payment methods.1 At a basic level, payment processors evaluate a transaction’s validity in real-time by contacting the customer’s issuing bank.2 Although businesses must pay to use a payment processor, the more payment methods a business accepts the more customers it can accommodate—potentially increasing revenue.3
Businesses can enter into an agreement with a payment processor alone, but payment processing solutions can also be integrated with point-of-sale (POS) systems. In other words, businesses can choose to use one payment processing company with a separate POS provider, or they can choose an all-in-one solution that offers both the POS system and payment processing services. These one-stop shops—sometimes known as payment services providers—can help a business keep all of its payment data in one place, which can ultimately save time, decrease error, and reduce costs.4
It’s worth noting that payment processors are not to be confused with payment gateways, which is a merchant service that facilitates e-commerce transactions—although you can’t generally have one without the other. It’s often described as the online equivalent of a physical POS in a brick-and-mortar store. A payment gateway lets e-commerce merchants process payments by securely transmitting customer payment information to the merchant’s payment processor for authorization. In other words, a payment gateway is a buffer between the merchant website and the payment processor.5
To further understand how a payment processor works, it’s good to be familiar with a few key terms. Besides the merchant and shopper, a typical transaction would involve a:
Here is a basic example of how a payment processor fits into a standard business-to-consumer (B2C) transaction:6
A shopper chooses an item to purchase from a merchant, whether in-person or online. At check out, the shopper might swipe a card, scan a mobile device, or manually enter payment information at the POS or online payment gateway. The shopper’s payment information is then transmitted to the payment processor, which then evaluates the transaction’s validity by communicating with both the issuing and acquiring banks. If approved, the acquiring bank settles the transaction. Finally, the payment processor ensures the funds are transmitted into the merchant’s account.
Payment processors usually are necessary for businesses that want to accept multiple payment methods, but they have a cost. Several fees are involved to pay each entity connected with the transaction. Payment processing fees can get complicated, since each fee might be composed of several other rates and fees. Nevertheless, here are some of the common fees:7
It is also worth noting that payment processors usually offer several different pricing models. Tiered models tend to be the most expensive—the pricing breakdown is not always transparent and there can be hidden fees.8 More transparent pricing structures include interchange-plus, which itemizes all fees in a monthly statement, and flat-rate, which charges the merchant a flat monthly fee and a flat per-transaction fee.9
Since “nothing is 100 percent safe in this technologically rich and complicated environment,” outsourcing to a payment processor requires trust, according to Jeff Korte of the Financial Services Information Sharing and Analysis Center.10 To maintain security between customers and merchants, payment processors are held to strict standards and regulations.
For businesses looking to use a payment processor, there are several standard fraud prevention mechanisms to be aware of. These include EMV chip technology, Payment Card Industry Data Security Standard (PCI DSS) compliance certifications, advanced encryption, and tokenization. EMV secures sensitive data within a credit or debit card’s chip and magnetic strip.11 PCI DSS is a third-party security certification that is regularly updated to maintain network security, secure cardholder information, and more. Tokenization replaces sensitive customer data with a completely random number, and encryption runs data through an algorithm to make customer data indecipherable by unauthorized users.12
As digital payment methods begin to replace cash, experts suggest that businesses have little choice but to use payment processors to accommodate the varying payment needs of a wide customer base. Although payment processors make transactions easier and safer for businesses and customers alike, the transaction process—and fee breakdown—can be complicated.
Megan Doyle is a business technology writer and researcher based in Wantagh, NY, whose work focuses primarily on financial services technology.
1. “How to choose the right payment processor for your business,” Mobile Payments Today; https://www.mobilepaymentstoday.com/blogs/how-to-choose-the-right-payment-processor-for-your-business/
2. “How Does the Payment Processing Industry Work? Understanding the Infrastructure and Process,” Avangate Blog; http://blog.avangate.com/how-does-the-payment-processing-industry-work/
3. “How to choose the right payment processor for your business,” Mobile Payments Today; https://www.mobilepaymentstoday.com/blogs/how-to-choose-the-right-payment-processor-for-your-business/
5. “What Are Payment Gateways and Payment Processors?,” Business2Community; https://www.business2community.com/strategy/payment-gateways-payment-processors-01777693#8cm2sDDRilkhhqDM.99
6. “What is a payment processor: 3 Important terms to know,” Worldpay; https://www.vantiv.com/vantage-point/payments-basics/what-is-a-payment-processor
7. “Credit Card Processing Fees: The Complete Guide,” Fundera; https://www.fundera.com/blog/credit-card-processing-fees
8. “(Evil) Tiered Pricing Merchant Account Services,” CardFellow; https://www.cardfellow.com/blog/tiered-pricing-merchant-account-services/
9. “How to choose the right payment processor for your business,” Mobile Payments Today; https://www.mobilepaymentstoday.com/blogs/how-to-choose-the-right-payment-processor-for-your-business/
10. “For Small Business, Security Matters: How To Find a Payment Partner You Can Trust,” Forbes; https://www.forbes.com/sites/usbank/2019/06/28/for-small-business-security-matters-how-to-find-a-payment-partner-you-can-trust/#6063c0e72b0f
11. “How to choose the right payment processor for your business,” Mobile Payments Today; https://www.mobilepaymentstoday.com/blogs/how-to-choose-the-right-payment-processor-for-your-business/
12. “What is Credit Card Tokenization?,” Merchant Maverick; https://www.merchantmaverick.com/what-is-credit-card-tokenization/#Tokenization_vs_Encryption