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How Does Payment Processing Work?

4 Jul 2024

The global market for digital payments is expected to reach US$11.53tn this year. So, companies of all shapes and sizes need to understand just how complex the fundamentals behind payment processing are to stay competitive and offer their customers a simple, secure and convenient way to pay.

As a business owner that's all about accepting payments, payment processing can play a very important role when it comes to managing your cash flow, enhancing your customer satisfaction and preventing fraud risks. As the industry evolves, businesses need to stay up to date with industry trends, security standards, and regulations so that they can adapt.

In this complete guide, we're giving you the 411 on all things payment processing, including its components, how it works, the best practices you can carry out for your company, and why you need to choose the right payment provider to help. By getting a handle on these concepts, you can make more informed and important decisions about your payment processing strategies and payment solutions. Let's get started.

What is payment processing? 

Payment processing is the process of securely moving funds from one party to another. It usually includes confirming, validating, and completing transactions through electronic payment methods.

Now, there are different kinds of transactions that fall under payment processing (we're talking credit and debit cards, electronic fund transfers, mobile payments, digital wallets, and cryptocurrencies.) A lot of stakeholders like banks, financial institutions, payment processors, technology companies, businesses, and regulatory agencies work together to create and oversee these payment systems.

Why businesses should consider payment processing systems important 

By now, you should have a decent understanding of what payment processing is. Now, let's chat about why payment processing is a big deal for businesses like yours. Here are some perks:

Improve your cash flow management

Imagine getting your payments faster. That's what good payment systems do. They speed up the process, so you have money in your pocket sooner.Payment processing systems are important for businesses because they streamline transactions by reducing the time between making a sale and receiving the payment, thereby improving cash flow management.

Enhance your customer satisfaction 

Happy customers mean repeat business. When you make it easy for people to pay, whether they're in your store or shopping online, they're more likely to come back. Plus, they'll feel much safer knowing that their payments are secure.

Reduce any potential fraud threat

Nobody likes dealing with fraud. Payment processing systems come with built-in security measures to protect you and your customers. It's like having a guard at the door, keeping your transactions safe from unauthorized access.

Better control of operations when you integrate your payments into your point of sale 

When everything works together smoothly, your business runs like a well-oiled machine. Integrating payments with your point of sale system means fewer mistakes, faster

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Elements in the payment processing flow 

Payment processing has multiple elements that work together. These elements help to enable secure, stable, and seamless transactions between your business and your customer. These elements include:

The customer

This is the person, or the entity that initiates the payment for your goods or your services. They'll provide the much-needed payment info (by putting their pin number into a card machine / paying by link / putting in their details online) and also authorization to complete the transaction. The customer's involvement is extremely important as they're the source of funds for the payment.

The merchant

The merchant is essentially the business entity that sells products or services (in this case that's you). They've got a merchant account (read more on what a merchant account is in our handy guide here), which allows them to accept different kinds of payment methods and also lets them receive funds from customers. Merchants are another important player that facilitates transactions and they also have the goods or services on offer in exchange for payment.

The payment method

Now, the payment method is the specific way the customer chooses to pay. So this is things like credit cards, debit card payments, digital wallets, bank transfers, and other electronic payment options. If you're a business owner, offering lots of different types of payment methods helps with customer convenience and expands your business's reach.

Point of sale system

This is the POS hardware and POS software used to process payments at the physical or digital point of sale. Here at Epos Now, we offer a range of retail POS systems and hospitality POS systems, tailored to your business. They help enable merchants to accept payments, manage inventory, generate receipts, and track sales data.

The payment gateway

Now onto the payment gateway. What is this, you ask? It's a secure and safe technology that facilitates the transfer of payment information between the customer, merchant, and payment processor. It encrypts sensitive data to prevent unauthorized access during transmission.

The payment processor

The payment processor is a third-party entity that manages the actual transaction process, including authorization, settlement, and fund transfer. They communicate between the merchant, acquiring bank, credit card networks, and issuing banks to facilitate smooth payment processing (learn more about third-party payment processors).

Acquiring bank

The acquiring bank, also known as the merchant bank or merchant acquiring bank, processes payment transactions on behalf of the merchant. They're responsible for receiving funds from the customer's bank and depositing them into the merchant's account. Check out our guide on merchant acquirers to learn more!

Card network 

You've likely heard of Visa, Mastercard, American Express, or Discover. These are your card networks or credit card companies. They connect issuing banks, acquiring banks, merchants, and cardholders in the payment ecosystem and provide the infrastructure and rules for processing card-based transactions, including authorization, clearing, and settlement.

The issuer bank 

The issuer bank is the financial institution that issues payment methods like  credit or debit cards to customers. They manage cardholder accounts, authorize transactions, and process payments on behalf of the cardholders.

Payment security 

Payment security is the measures and protocols designed to protect payment information from unauthorized access, fraud, and data breaches. We're talking encryption, tokenization, PCI DSS compliance, fraud detection tools, and secure authentication methods.

Settlement and reconciliation

Now to the last stage of the payment process, the settlement and reconciliation stage. This is where funds are transferred between the merchant, acquiring bank, and credit card networks. Settlement is the actual transfer of funds from the customer's bank to the merchant's account, while reconciliation involves matching transaction records, resolving discrepancies, and balancing accounts.

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How does payment processing work? 

Now the payment processing process has lots of different steps, as well as multiple parties. Here's an overlook of how it works:

The transaction processing starts

The customer makes a payment by sharing their payment information (they can do this with a credit card, debit card or any other payment method) at the POS system in a store, or online via a platform like an e-commerce website or mobile app.

TIP: Want to learn more about how to accept credit card payments, check out our handy guide today.

Payment gateway acts as a bridge for all the entities involved

Now that the customer has submitted their payment information, it's then sent securely to the payment gateway. This works like a bridge between the customer, the company and the payment processor. The payment gateway is in charge of encrypting the transaction data and making sure the data is transmitted safely to the payment processor or the acquiring bank.

Transaction authorization 

After you make a payment, the payment processor checks the details you provided through the payment gateway. Then, it shares this info with the acquiring bank, which checks with the card network to make sure everything's legit and approves the transaction.

Issuing-bank verification 

Once the card network knows you want to buy something, it asks the issuing bank to verify your account and see if you have enough money or credit available. Your bank also looks for any potential risks. Based on this, your bank decides whether to proceed with the purchase.

Payment authorization response

Your bank quickly sends back a response—either a thumbs-up (approved) or a thumbs-down (declined)—through the card network to the acquiring bank. This information then goes back through the payment processor and reaches the gateway, which tells the business's system whether your purchase is good to go or not.

Billing process completed 

If all is good and your bank gives the green light, the business delivers the goods or services to you. But if the bank says no, the business might ask you to use another payment method.

Transaction settlement or reconciliation

At the end of the day, the business batches up all the approved transactions and sends them to the payment processor or acquiring bank for payment. The acquiring bank asks your bank (through the card network) for the money, and your bank transfers it. Then, the acquiring bank puts the cash in the business's account, usually within a few days.

Best-practice advice about payment processing for business

Implementing best practices in payment processing can really boost customer satisfaction, reduce fraud risks, and keep your business in line with industry rules. Plus, sticking to these practices helps you build efficient internal processes that save time and prevent mistakes. Here are some top payment-processing best practices for businesses:

Use a reliable and secure payment processing system

The first thing you're going to want to do is invest in a trustworthy retail POS or hospitality POS system that will keep your transactions safe and sound. Remember to keep your software and hardware updated. You need to be doing this regularly so that you stay ahead of any potential vulnerabilities that you come across. You'll also want to choose reputable payment processors and gateways known for their security and reliability.

Empower your business with PCI DSS knowledge 

Do you know much about Payment Card Industry Data Security Standard (PCI DSS) requirements? If you answered no to that question, we're here to let you know that you should and it's probably time to start familiarizing yourself with it. Following the standards will help you protect your customer's payment information and prevent data breaches. Stay in the know about PCI compliance and implement necessary measures to protect your sensitive data.

Monitor and enhance your payment security

Use fraud prevention tools and technologies to seek out and prevent fraudulent activities. You need to regularly review transactions for any suspicious activity and take immediate action when necessary. Maintain clear refund and chargeback policies to handle disputes effectively and protect your business interests.

Frequently asked questions about payment processing

How does online payment processing work? 

When you make a payment online, your payment info gets all locked up and sent safely to a payment gateway. This gateway then passes the info to a payment processor, which chats with your bank to make sure the payment's legit. Once it gets the thumbs-up, the money zooms into the merchant's account.

How do banks process payments?

Banks get the lowdown on transactions from merchants or payment processors. They check everything—like your account status and if you've got enough cash. Banks then chat with other banks in the mix (like the acquiring bank and card networks) to give the go-ahead and settle the payment. It's all about keeping things smooth and secure between accounts.

How long does payment processing take? 

Well, it depends. Credit and debit card payments? Usually quick, happening in seconds to a few minutes. But if you're doing a bank transfer or ACH payment, it might take 1-3 business days to wrap things up. Each situation's different, though, based on what payment method you're using and the banks involved.