Is your account receivable team overloaded by the number of ACH and wire transfers they have to manually reconcile against invoices they’ve sent?
Are you tired of seeing the line item for transfer fees slowly climbing and looking for a better way to manage payments?
Or maybe you just want to offer customers an easy way to pay with their credit card.
In any case, you’re going to need to know a little bit about payment processing.
In this article, we’re going to dig into all things payment processing. We’ll explain what it is and why it's important, the components involved, and how to minimize the associated costs.
What is payment processing?
Payment processing is a term that refers to the sequence of actions required to safely and securely transfer money from a payer to a payee.
Generally speaking, this process involves authorization, verification, and settlement of financial transactions entirely through electronic payment systems.
These payment processing systems can handle various types of financial transactions, such as:
- Processing credit and debit cards
- Automated clearing house (ACH) transfers
- Electronic funds transfers (EFTs)
- Mobile payments
- Digital wallets and cryptocurrencies
Why is payment processing an important business operation?
Effective payment processing systems facilitate smooth transactions.
They help you as a business receive funds from your customers in a pain-free and simple manner.
For example, you might use a payment processor to allow customers to pay via credit card, meaning payments can be verified immediately.
Payment processing systems are equally helpful for you as a purchaser of goods and services, enabling your accounts payable teams to pay supplier invoices more easily and take advantage of early payment discounts.
The components of payment processing
Payment processing is a really broad workflow that involves a bunch of different components working together effectively and efficiently to facilitate transactions between businesses and their customers.
The payment processor (to be discussed shortly) is one of these components, but it is far from the only one.
Here’s a list of the various components that must work together to facilitate effective payment processing:
Customer
The person or business that is paying for the goods or services and initiates the payment process.
Merchant
The business or service provider who is accepting payment from that customer.
Payment method
The format in which the customer wishes to make payment (e.g., credit card).
Point-of-sale (POS) system
The platform (digital or physical) where the transaction takes place. This might be via a mobile app (digital) or a retail store’s POS terminal (physical).
Payment gateway
A service provider that captures and transmits payment data from that POS system to the payment process or acquiring bank (see below), encrypting and securing data during that transaction process.
Payment processor
A third-party organization that handles technical facets of the payment.
This includes validating payment, obtaining the necessary authorization to withdraw funds, and facilitating communication between the customer and merchant banks.
Acquiring bank, or acquirer
The merchant’s bank or financial institution that receives the payment.
The issuing bank, or issuer
The customer’s bank or financial institution that approves or finalizes the transaction.
Card network
Card companies (like Visa or Mastercard) that set up infrastructure for processing transactions and establish rules and standards.
Payment security
Certain technologies and standards — for example, the Payment Card Industry Data Security Standard (PCI DSS) — that protect against fraud, prevent data breaches, and help keep transaction data safe.
Merchant accounts and payment service provider accounts
When it comes to receiving money as a merchant, there are two types of accounts you can choose to use.
Merchant accounts
A merchant account is basically a bank account that you hold with a financial institution, such as Chase or Bank of America.
You can opt to receive funds here, but the downside is that it can usually take a few days for funds from a customer payment to become available in your account.
The benefit is that you generally have more control over your account.
Payment service provider accounts
A payment service provider account is like a shell bank account that you hold with a payment service provider like Toast or Square.
You don’t directly own a merchant account with a financial institution. Instead, that company has one, and it collects payments on behalf of your business and maintains a subsidiary account on its platform for your use.
These tools provide faster access to funds, but it does mean you cede certain aspects of control.
For instance, a payment services provider could disrupt access to your account if it deems your business to be too risky.
The payment processing workflow
Now that you’ve got an understanding of the different components involved in payment processing let's walk through how they work in sync and how they process customer payments.
- Initiation of transaction. The customer initiates the payment, which begins when they enter their payment information, such as entering their credit card details to purchase from an ecommerce website.
- Payment gateway. Once the customer information is submitted, it gets transmitted securely to the payment gateway. This gateway acts as the bridge between the customers, the merchant, and the payment process. It encrypts the transaction data and transmits it to the payment processor.
- Authorization of transaction. Once the payment processor has received the relevant data from the payment gateway, it validates the information and forwards the details to the acquiring bank and card network. The card network also validates and authorizes the payment.
- Issuing-bank verification. The card network talks to the issuing bank, providing the transaction details. The issuing bank then completes verification checks, such as confirming there is sufficient account balance or credit limit, and then approves or denies the payment.
- Authorization response. The issuing bank sends over that response (approved or declined) to the acquiring bank, which forwards it to the payment process. The payment process sends it to the payment gateway, which communicates the result to the POS system or online platform where the transaction was initiated.
- Completion of transaction. If the payment is approved, the merchant will provide the goods or services. If not, it may request an alternative method of payment from the customer.
- Transaction settlement. At the close of each business day, the merchant sends a batch of approved transactions over to either that payment processor or the acquiring bank. That bank requests the funds from the issuing bank via the card network.
- Reconciliation and reporting. The merchant reconciles those settled transactions with its internal sales records, as well as any fees it may be charged by the likes of the acquiring bank or payment processor.
The importance of security in payment processing
Security is one of the most important aspects of the payment processing workflow, for both the customer and the merchant.
Whenever a transaction takes place, sensitive payment data exchanges hands a number of times, between parties such as the card network, the two parties’ banks, the payment gateway, and more.
For this reason, its critical that these organizations are experts in data encryption, and maintain compliance with standards such as PCI DSS (Payment Card Industry Data Security Standard).
Doing so allows these payment processing providers to:
- Protect against fraudulent payments
- Prevent data breaches and cyberattacks
- Mitigate consumer identify theft
- Maintain trust and reputation in the marketplace
Quick tips for minimizing the costs associated with payment processing
Payment processing (especially where it involves credit card transactions) can be an expensive affair.
As you’ve seen from the payment process workflow discussed above, there are a number of different service providers involved.
Each obviously needs to make a profit in their own way, meaning fees are always involved. Though sometimes one piece of the puzzle pays fees to another (rather than charging you directly), these are almost always passed on to either the merchant or the customer.
With this in mind, here are a few helpful tips for cutting payment processing costs:
- Choose your payment gateway carefully. Look for transparent pricing structures without hidden fees. Look hard at reviews about customer support and rate transparency before you buy.
- Use your negotiation power. Headline rates are always up for negotiation, especially if you’re processing a high volume of payments. The worst you can end up with is a no.
- Leverage interchange-plus pricing. This pricing model provides more transparency into pricing by separating card network interchange fees from the processor’s markup, often resulting in lower overall costs.
- Optimize your payment methods. Do what you can do encourage customers to use lower-cost payment methods (e.g. promote ACH over credit cards).
- Avoid card-not-present transactions. These typically have higher processing fees due ot the increased risk of fraud.
- Minimize chargebacks. Work on product quality, customer support, and accuracy of marketing to minimize refunds and reduce the number of refunds you have to process.
Make payment processing easy with BILL
BILL, our financial operations platform, is the perfect partner for processing customer payments.
You can use BILL as a payment gateway for ACH payments or accept credit card payment with low processing fees.
Plus, with powerful account payable and receivable automation, you’ll speed up internal workflows and further cut costs.
