What is the merchant discount rate and how does it work?

Key takeaways:

• The merchant discount rate (or MDR) is a fee that merchants pay to payment processing companies on debit or credit card transactions to cover the costs of processing transactions. It usually falls between one and three percent of the total transaction amount.

• Merchant discount rates are offered in a variety of different pricing models, such as flat-rate pricing, tiered pricing, and subscription pricing. Different pricing models work for different businesses based on their size, transaction volume, average transaction amount, and industry.

• Merchant discount rates are influenced by payment processors, card networks, issuing banks and financial regulatory bodies.

• Choosing a payment processing provider that offers cost-effective options like a lower merchant discount rate can help businesses to decrease their transaction costs and improve their overall bottom line.

The merchant discount rate (MDR) is the ‘cut’ that companies take from digital payment transactions that have been made possible by their software.

For any company that accepts credit and debit card payments, this is one of two major costs that impact every transaction. The other is interchange fees. These charges are set by the financial institutions that facilitate card payment processing. Here you’ll learn about how and why merchants are charged these fees and how a modern payment processor can help you reduce them.

What is the merchant discount rate?

The merchant discount rate is a fee that businesses pay to a payment processing company on debit or credit card transactions. It’s also commonly referred to as the transaction discount rate, and is typically a percentage of the transaction value (usually between one and three percent) that is deducted from the total sale amount.

Merchant discount rates are used by these payment processing companies to cover costs relating to their digital infrastructure, general operational expenses, their security measures, and, of course, their profits as a business.

The MDR is typically split among several entities involved in the transaction, such as:

• The issuing bank (issuer): The bank that issued the customer’s card

• The acquiring bank (acquirer): The merchant’s bank that processes the payment

• The card network (e.g. Visa, MasterCard): The network that facilitates communication between the issuing and acquiring banks

• The payment gateway/processor: If applicable, the service handling the online or card-not-present transactions

The total MDR usually consists of several elements, such as:

• The interchange fee: The fee paid to the issuing bank for each transaction. This is the largest portion of the MDR.

• The acquirer’s fee: A fee charged by the acquiring bank for processing the payment

• The card network fee: A small fee paid to the card network

• Payment gateway/processor fee: If applicable, a fee for the payment processor or gateway

How does the merchant discount rate work?

The way merchant discount rates work may differ depending on who is processing the card payment. However, there’s a standard sequence of events that will occur when a customer makes a payment using their credit or debit card.

• Merchant’s payment processor receives the transaction: When a transaction is initiated, the payment processor (or ‘acquirer’) handles the routing of the payment through the card networks, and communicates with the issuer (the bank or financial institution that issued the card to the consumer).

• The transaction is authorised: The issuer verifies the customer’s card details to ensure there are sufficient funds, either approving or denying the request. If approved, the acquirer then sends the approval to the merchant’s payment gateway of choice.

• Payment confirmed: The merchant then completes the sale and the customer receives a confirmation of their purchase. The acquirer will then deposit the payment into the merchant’s account, deducting and withholding the merchant discount rate percentage amount from this payment.

As you can see, the acquirer keeps only a small part of the MDR for themselves to cover their own fees and infrastructure. The rest is transferred back to the card issuer and card network to compensate them for their roles in the electronic transaction.

Types of merchant discount rates

Merchant discount rates can vary based on several factors, including the type of payment method the customer has used, the transaction amount, the industry the purchase has been made within, and the chosen payment processor. Below are the main types of pricing models for MDRs.

Flat-rate pricing

A merchant discount rate charged at flat-rate pricing will remain the same percentage for every transaction, regardless of the payment method or transaction amount. For example, the MDR may be set at 2.5 percent, so the merchant will pay 2.5 percent, whether the transaction was worth $5.00 or $5,000. This pricing model can be beneficial for merchants operating with small-to-medium sized businesses or those with low transaction volumes.

Tiered pricing

In a tiered merchant discount rate structure, the fee will vary depending on the type of card used (e.g. whether it’s a debit, credit, or premium card that has been used by the customer) or the risk associated with the transaction (e.g. whether it was made online or in-store). For risk assessment, each tier will have its own category, such as "qualified," "mid-qualified," or "non-qualified." For card-based assessment, the rate on a standard debit card may be 1.5 percent, and the rate may increase to three percent for a premium credit card. This model can be simpler to understand and work with, however it may lead to higher costs if many transactions fall into higher-cost tiers.

Interchange-plus pricing

With interchange-plus pricing, the merchant pays the interchange fee (the fee set by the card networks and paid to the card-issuing bank) as well as a fixed markup by the payment processor. For example, if the interchange fee for a transaction is 1.5 percent and then the processor adds a 0.5 percent markup, the total MDR would be two percent. This model is often preferred by larger businesses with higher transaction volumes, as it typically results in lower overall costs and offers more transparency (making reporting easier). It's transparent as merchants know the exact cost of the interchange fee and the processor's markup upfront, however it might be more complex to calculate.

Blended-rate pricing

The blended-rate pricing model combines different types of transactions and cards into an average percentage rate. It simplifies billing by providing one flat rate for all transactions, even if some transactions would normally fall into higher or lower tiers. It can be beneficial for smaller merchants who want the simplicity of not having to deal with multiple fee levels or a complex fee structure.

Subscription-based pricing

Merchants may pay a fixed monthly or annual fee for their payment processing at a lower rate or without additional per-transaction fees. This might include a set number of transactions or unlimited transaction processing as part of the plan. The subscription-based model can be beneficial for small to medium-sized businesses that have a predictable volume of transactions and want to avoid fluctuating costs.

Who sets merchant discount rates?

There are several players who have an impact in setting merchant discount rates, including payment processors, issuing banks, card networks like Visa and Mastercard, and financial regulatory bodies.

• Payment processors (acquirers): The primary entity for setting merchant discount rates, acquirers will determine the base MDR based on their overhead costs, their chosen price for their services, and factors about the merchant such as size, industry and amount of risk. Payment processors need to account for the interchange rates and assessment fees that card networks charge, as these fees are non-negotiable and make up the majority of the merchant discount rate. However, the processor markup portion of the discount rate is 100% negotiable and up to the business to decide if they want to engage with. Some merchant service providers will charge far more than they need to for the merchant discount rate.

• Card networks: Networks like Visa, Mastercard and American Express have a key role in setting merchant discount rates, as they impact the interchange fees that the merchant’s bank must pay to the issuing bank. The interchange fee is the largest portion of the MDR and card networks will regularly adjust their interchange fee schedules, therefore impacting MDRs. Interchange fees usually hover around 1.50 percent to 2.50 percent, however this number can vary based on business type, the Merchant Category Code (MCC), industry, card type, and total processing volume.

• Issuing banks: Issuing banks also impact merchant discount rates through their interchange fees, as well as through the types of cards consumers are using. For example, a credit card with a rewards program may come with a higher interchange fee, which would in turn impact the total MDR.

• Financial regulatory bodies: Regulatory agencies don’t have directly set merchant discount rates, however they can have an impact through regulating the fees that card networks, acquirers and issuers are allowed to charge.

What’s the difference between merchant discount rates and interchange rates?

The difference between merchant discount rates and interchange rates is that MDRs are the total fee a merchant pays to a payment processor for handling card transactions (encompassing the interchange rate, fees from card networks and the payment processor’s fee).

Interchange fees, on the other hand, are a component of the MDR paid by the acquirer to the card issuer to compensate them for the risk and cost of the services they offer to the cardholder. Interchange fees are set by payment card networks (e.g. Visa, Mastercard, JCB) and are variable.

Different factors, such as the type of card used, the nature of the transaction, and the risk involved, influence the interchange fee. In some cases, for instance with American Express and Discover cards, the card issuer and card network are the same. There are several factors that influence interchange fees, including transaction type, business size and industry type.

How your business can reduce the MDR

As well as choosing flat-rate or the interchange-plus as your merchant discount rate pricing model, you can also reduce your MDR and other costs associated with electronic card transactions by:

• Using certain security features, such as 3D Secure authentication (3DS) and tokenisation to reduce your interchange rate.

• Cutting the cost of processing cross-border transactions by choosing a payment processor that offers competitive exchange rates or allows like-for-like settlement in multiple currencies.

• Entering pre-chargeback programmes that could help you reduce the cost of payment disputes.

Choosing a cost-effective payment provider

Airwallex offers secure and cost-effective payment processing and acquiring services to help your business grow internationally. With Airwallex as your payment provider, you’ll be able to collect, settle and store payments in multiple currencies, avoiding unnecessary currency conversion fees and reducing your overall business costs.

Airwallex also helps you reduce the costs associated with fraud and chargebacks whilst boosting checkout acceptance rate, thanks to Smart 3DS 2 authentication, pre-chargeback programs, and our machine-learning powered payment optimisation engine.

Learn more about Airwallex online payment solution, to save money on every transaction, keeping more in your pocket to help scale your business.