Payment processing — what it is, how it works, and how to choose

Guide to payment processing

Payment processing allows businesses to accept debit or credit card transactions online or in person. With ecommerce and digital transactions increasing, payment processing has become a necessity.

The right payment processing fee structure and integration can impact your margins for the better. But choosing the right option isn’t easy if you’re not familiar with payment processing.

By the end of this post you’ll know how payment processing works, the relevant terms you need to understand, and important points to consider when choosing a suitable payment processor for your business.

More specifically, this post will cover:

What is payment processing?

Payment processing is the system that allows businesses to accept electronic payments, including debit and credit card transactions.

Payment processing consists of two parts.

  1. A payment gateway that securely transmits a customer’s payment information to financial institutions.
  2. A payment processor or vendor that transfers money from the customer to the merchant.

This system is critical to businesses everywhere since most people make digital payments. According to the 2021 Diary of Consumer Payment Choice, credit and debit cards are used for over 50% of purchases by consumers today.

To understand payment processing, you need a basic idea of what happens each time your customer taps, swipes, or enters their card details.

Payment processing terminology

Before learning the logistics behind the payment processing system, it’s helpful to define relevant terms.

Payment processing terminology

What is a point of sale system?

A point of sale (POS) system is the combination of hardware and software that enables customers to make purchases. It also helps businesses track sales. POS hardware — like a cash register, card terminal, or digital sales cart — is combined with software to facilitate the transfer of funds from customer to merchant.

The system also tracks critical transaction data like the date and time of a purchase — and includes any applicable sales tax.

What is a payment gateway?

The payment gateway is a tool that securely reads customer payment data and communicates it to the merchant’s financial institution. It verifies that the customer has enough funds in their account to make a purchase and transfers those funds to the merchant’s bank account.

The payment gateway also protects customer information from attack during a transaction by encrypting data before sending it through the credit card network. The buyer’s credit card information receives complex coding so fraudsters can’t access it as the data travels throughout the payment chain.

What is an acquirer?

An acquirer — also known as an acquiring bank — is a financial institution that receives money from a customer’s card network and deposits it to a dedicated merchant account. This merchant account is where the money goes at the end of the purchase process.

The acquirer holds a merchant’s payments and acts as an intermediary between the merchant and payment card networks.

What is an issuer?

The issuer — or issuing bank — is the financial institution that provides the payment card to the customer. It’s also the source of funds for customer transactions.

The issuer acts as a gatekeeper for the transaction. The issuing bank ensures the request for payment from a merchant is legitimate and verifies that the customer has enough money to cover the purchase. Once this information is confirmed, the issuer releases the customer’s funds to make the payment.

What is a merchant account?

A merchant account is a bank account for businesses that allow them to accept and process electronic payments, including those from payment cards. This is where the money is deposited once the transaction is complete.

To open a merchant account, you must have a business license and meet criteria set by the issuer. For example, before deciding to issue a merchant account, a bank will evaluate your financial history, how long your business has been open, and your risk of fraud.

How does payment processing work?

Payment processing includes a complex chain of actions that must flow seamlessly throughout the day. Just a single disruption in this chain can lead to lost sales and dissatisfied customers.

Payment processing occurs in two distinct phases — authorization and settlement. Consider an example of a typical transaction where a customer buys a product online or in person through a POS system.

  1. During the authorization phase, the payment gateway checks with the issuing bank to ensure the customer has authorized the purchase and has enough funds to complete it.
  2. Once this information has been confirmed, the settlement phase begins. The customer’s bank transfers funds for the purchase to a payment processor . The payment processor forwards these funds to the merchant’s account minus transaction fees.

How to choose a payment processor

The type of payment processor you choose depends on your sales volume, where your transactions take place, and the products or services you offer. Some payment processors are better suited to handle certain types of transactions, like mobile payments. Others offer capabilities that are necessary for other businesses, like allowing your customers to enter their credit card numbers manually.

Think about the steps your customers need to take to complete a purchase and then determine the features you need from your payment processor.

Three processor pricing models

Three processor pricing models

The right payment processor will also be cost-effective. The cost to process each payment is small but can add up, especially if your business deals with many purchases each day. When evaluating payment processors for your business, consider which fee structure is the best deal for your business. The right pricing model for you will depend on the nature of your business.

If you’re a small brick-and-mortar business that occasionally sells items online, a tiered pricing structure can get you the lowest rates associated with in-person sales. If you’re a large business with a profitable ecommerce store, an interchange-plus pricing scheme could be a cost-effective solution.

You’ll also want to determine if a payment processor will charge fees for your subscription or any equipment provided.

1. Interchange-plus

The plus in interchange-plus refers to an additional fee that payment processors charge on top of the interchange fee. The additional fee covers the payment processor’s operations costs and provides them with a profit.

This amount is based on a fixed set of rates that may be applied to a transaction depending on the circumstances. The time the customer made the purchase, the card that was used, and whether the transaction was automated or not are a few factors. Premium credit cards are also typically more expensive to process than less exclusive ones.

Interchange fees are generally 1 to 3% of the overall transaction price. They also include a set dollar amount in cents for each transaction. The amount your business will pay for each transaction will vary with the interchange rate.

2. Flat-rate

Flat-rate processing blends the variable interchange rate into one flat fee for all transactions. A flat-rate fee structure might add 2% of the purchase price plus an additional 10 cents. Some businesses prefer flat-rate processing because it makes the fee easier to predict and simplifies revenue forecasting.

This simplified take on payment processing fees is ideal for smaller businesses and startups, which may not have the resources to apply a different interchange rate to every transaction. The downside is you typically won’t get the best possible rate for each type of debit or credit card payment you process compared to an interchange-plus fee structure.

3. Tiered

Tiered pricing, also known as bundled pricing, charges a fixed amount per transaction on different types of purchases. All transactions are classified into three tiers according to their risk — qualified, mid-qualified, and non-qualified — and assigned a corresponding fee.

Under a tiered payment processing system, an in-person debit card purchase may be categorized as a qualified transaction. This is a safe transaction that might warrant a processing fee as low as 1% of the total transaction plus $0.10. However, a riskier online credit card purchase might be considered a non-qualified purchase. In this scenario, your business could be charged 3% of the total transaction fee plus $0.15.

Which payment processor is right for you?

There’s an ever-growing list of payment processors you can choose from. When choosing a payment processor, consider how well it integrates with your store. Some work better for brick-and-mortar retailers while others are best suited for ecommerce.

If you’re pursuing both in-person and online strategies, consider an integrated payment processor and ecommerce platform.

Getting started with payment processing

There’s no denying that most businesses need a payment processor to accept debit and credit cards. Whether you’re just starting your ecommerce store or you need a more effective system to handle in-person card transactions, there’s a payment processing solution for your business.

Start by analyzing your business needs. Consider how many of your sales are online or in-person and the volume of each. Knowing the answers to these questions can help you gauge how much you’ll spend on payment processing and what services you’ll need.

Streamline your payment processing with Adobe Commerce, a flexible and scalable ecommerce platform that handles all your payment processing needs. Commerce allows you to build multichannel B2B and B2C payment processing solutions that integrate with PayPal and Venmo and offers a range of payment options to make purchasing easy for your audiences — no matter where they are or what method of digital payment they prefer.

Take a product tour or watch the Adobe Commerce overview to learn more about how you can streamline digital payments and drive more revenue.