What is Payment Processing and How Does it Work?

The term “payment processing” is something that sounds relatively straightforward. Yet there are so many nuances and components that happen behind the scenes for payment processing to work. 

Payment processing makes it easy for merchants to get paid and for consumers to purchase goods or services. Funds change hands in fractions of a second through a simple swipe, dip, or tap—without anyone having to count out exact change or make cash deposits at the bank.

While roughly 11.7 million US businesses accept credit cards, I still consult with so many business owners who really don’t understand the basic concepts of payment processing, which is what inspired me to write this guide. I’ve spent nearly a decade in the payments space, so I know a thing or two about how all of this works—and I want to share my knowledge with you.

We’ll start with a high-level overview of payment processing before breaking down the details of how it works. Let’s dive in.

What is Payment Processing?

Payment processing is the operation that enables the acceptance of credit cards, debit cards, and other payments at a business. It includes all activities related to non-cash transactions facilitated through a payment processor or merchant services provider. 

Payment processing refers to a sequence of actions that moves money between a payer (customer) and a payee (business). This sequence includes payment authorization, verification, and settlement through an electronic payment system. 

Examples of transactions that require payment processing include:

• Credit card payments
• Debit card payments
• ACH payments
• Wire transfers
• E-check payments
• Mobile payments
• Digital wallet payments

With all of these examples, a payment processor acts as an intermediary between the issuing bank (customer’s bank) and the acquiring bank (merchant’s bank).

Cash payments don’t fall into the payment processing umbrella because nothing needs to be processed. Consumers and merchants can exchange goods or services without an electronic funds transfer that requires the help of other financial institutions. 

But as soon as a transaction requires a third party to validate funds, approve the transaction, and move money electronically between a customer and business—payment processing occurs. 

Key Components of Payment Processing

Payment processing encompasses a range of individuals, entities, and organizations—all working together to facilitate secure and seamless transactions. Here are those key components and their respective roles:

• Customer — The customer, also known as the cardholder (for debit and credit card transactions) is the individual or entity that’s paying for goods or services. The customer is not always a person, as it can also be another business for B2B transactions.
• Merchant — The merchant is the business that’s accepting payments from the customer.
• Pay Method — This is the way in which the customer chooses to pay for the goods or services, which can be a credit card, debit card, digital wallet, ACH payment, mobile payment, or some other form of electronic transfer. 
• Payment Processor — The processor or merchant services provider is a third-party entity responsible for handling all technical components of the transaction. They validate the payment credentials, obtain authorization, and handle all communication between the banks and card networks. 
• Payment Gateway — Payment gateway services capture and transmit payment data through the processor and acquiring bank. 
• Acquirer — Also known as the acquiring bank, the acquirer is a financial institution representing the merchant. The acquiring bank receives payments on behalf of the merchant and moves settled funds into the merchant account before ultimately depositing money into the merchant’s bank account.  
• Issuer — Also known as the issuing bank, this is the financial institution that provides the customer with their payment method (such as a credit or debit card). The issuer authorizes or declines transactions based on available funds and the customer’s account status. 
• Card Network — The card networks (Visa, Mastercard, Amex, and Discover) establish the regulations and infrastructure for processing transactions using cards with their brands on them, which vary slightly by card network. They also set interchange rates, which are paid by the merchant for each transaction. 
• POS System — The POS (point-of-sale) system can be a physical or digital platform that initiates the transaction. A credit card terminal for a brick-and-mortar retailer would be considered part of a POS system. 

All of these components work together and play a crucial role in payment processing. Without them, payment processing would not be possible. 

How Payment Processing Works

In addition to the key components, there are several steps involved in payment processing. Here’s a high-level overview of how it works:

Step 1 — Transaction Initiated

The transaction gets initiated when a customer presents payment details to a merchant. Tapping a credit or debit card at an in-store terminal or entering payment information into an ecommerce site are both examples of how a transaction could be initiated. 

Step 2 — Payment Gateway Submission

Once the payment is initiated, the information gets submitted through the payment gateway—which connects the payment portal with the processor. The gateway encrypts the data and ensures everything is transmitted safely between the processor and acquiring bank.

Step 3 — Authorization

The payment processor receives the data submission from the payment gateway and forwards those details through the card network to the issuing bank. It’s the issuing bank’s responsibility to confirm that the customer’s account is valid and there are sufficient funds or sufficient credit available to cover the transaction. Then the issuing bank sends an authorization response to either approve or decline the transaction. 

Step 4 — Sale Completed

If approved, the merchant completes the transaction by providing the customer with the goods or services that they’ve paid for. If declined, the merchant can try again or request another form of payment.

Step 5 — Settlement

At the end of each business day, the merchant sends a batch of all approved transactions to their payment processor for settlement. The acquiring bank (merchant’s bank) requests the funds from the issuing banks (customer’s banks). Then the issuers transfer funds to the acquiring bank before depositing them into the merchant account, which usually happens within one to three business days. 

Payment Processing vs. Credit Card Processing

The terms “payment processing” and “credit card processing” are often used interchangeably. However, the two are not one in the same. Here’s the difference.

Credit card processing is one type of payment processing—meaning every credit card transaction, whether in-person or online, requires payment processing to move funds from the cardholder to the merchant. 

But the term “credit card processing” can’t be used as a synonym for payment processing because there are other types of payment processing that don’t involve credit cards.

For example, let’s say a customer uses a debit card, ACH payment, or electronic check to pay a merchant. These are all types of payment processing, but they aren’t considered credit card processing. 

What’s the Difference Between Payment Processing and a Payment Processor?

Payment processing refers to the complete procedure and actions required for businesses to accept payments. But it’s not tied to any particular card network, financial institution, or merchant services provider. 

A payment processor is a specific type of organization that provides the technology, hardware, and infrastructure required for businesses to accept payments. They handle all of the steps to verify that the card is active and has sufficient funds to cover the transaction before moving money from the issuing bank to the acquiring bank.

Processors facilitate authorization and settlement and work with all other players in the process to ensure the money gets moved swiftly and securely. 

Many payment processors double as merchant account providers. These are holding accounts where money gets moved before getting deposited into a traditional business bank account. 

Final Thoughts

Payment processing is crucial for all businesses in the modern era. Without it, businesses would be forced to accept cash as their only method of payment—which isn’t realistic in today’s day and age, especially for online brands. 

Not only does payment processing make things easier for businesses, but it also adds convenience to the buying process for consumers. Customers can make payments using their preferred payment method in a matter of seconds, regardless of the transaction environment. 

While the end result of payment processing is straightforward and easy to understand (money moves from the customer to the business), what’s happening behind the scenes is quite complex. 

I hope this guide helps you understand how all of this works in greater detail. But if you still have questions or need something clarified, just reach out and I’ll be happy to explain further. 

My team can even provide you with a free audit and analysis to see if you’re overpaying for payment processing. We can help you save money without switching processors.