What is a Payment Gateway and How Does It Work?

Nearly nine out of ten consumers across the U.S. and Europe made digital payments in the last year—and the methods for doing so continue to become more complex.

Digital transactions present a challenge to merchants and marketplaces via the need to securely initiate a payment and transmit the payment data. Payment gateways offer the solution by encrypting the data at checkout and facilitating communication between the relevant financial entities (i.e. banks). 

Gateways are so much more than just transactional tools. Without them, modern commerce would be neither as efficient nor as convenient as it is today. 

As digital and cashless payments become the standard, the role of payment gateways in driving commerce forward has become ever more critical.

What is a Payment Gateway?

Payment gateways enable secure transactions between a merchant and financial institutions, such as banks and payment processors. Acting as an intermediary between the customer’s banking provider and the merchant’s checkout system, gateways serve the same role as a physical point-of-sale (POS) system that you would find in a traditional brick-and-mortar store. 

Validating a transaction before it’s formally approved and the funds are withdrawn from the customer’s account is a necessary step that prevents lost revenue and chargebacks. Unlike in-person payments, however, online and digital payments cannot rely on traditional verification methods, like chip reading or card tapping capabilities found on more modern POS devices. 

Payment gateways handle these identity verification tasks for you, employing security protocols like 3D Secure to ensure customers are who they say. 

Gateways can also be the key to offering customers their preferred payment methods. A payment gateway can support multiple different types of payment options beyond just card payments, including digital wallets and bank transfers. Integrating specific gateways that support the payment methods you need is an essential component to meeting customer expectations and entering new markets. 

Your chosen payment gateway (or gateways, if you choose the multi-provider approach—more on that later) can perform many vital functions in your payment process, including:

• Encryption and authorization: The gateway encrypts the customer payment information entered at checkout, protecting it throughout the data transmission process as it travels to the relevant financial entities. After encryption, payment gateways send the data to your business’s acquiring bank to initiate communication with the customer’s issuing bank or payment processor, who will determine whether to approve or deny the transaction.  
• Real-time transaction data: Payment gateways help to compile key data and information on your payment process, such as recent transaction histories or chargeback rates. You can use this information to make real-time improvements to your payment performance and adjust your gateway strategy as needed based on the strengths and pitfalls of your current system. The easy access to data gateway can provides also proves useful for compliance reporting. 
• Fraud prevention: Payment gateways use a variety of advanced fraud protections to verify customer identities and flag suspicious behaviors. Tools like address verification systems (AVS) add an extra layer of protection to your payment process by cross-checking the customer’s billing address with the one on-file with their card issuer. 

The payment gateways you select for your business can have a tremendous impact on your ability to expand your operations globally and reach new subsets of customers. Not only can your gateway dictate what currencies and payment methods you can accept but it can also influence the quality of your customers’ checkout and payment experiences. 

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How Do Payment Gateways Work?

Payment gateways are the front-end component of any digital payment system. 

The main responsibility of a gateway is to send customer payment information to the appropriate financial institutions, which includes the merchant’s acquiring bank. Once those entities approve or deny a transaction, that notification is sent back to the payment gateway to relay to the customer and merchant. 

For in-person payments, a POS terminal performs the tasks necessary to connect the merchant’s payment to the payment processing network. Payment gateways handle these tasks for card-not-present transactions that occur online or otherwise electronically. They typically use APIs to connect to and communicate with payment and banking networks. 

The full breakdown of how payment gateways work is as follows:

1. A transaction is initiated. Either the customer or the merchant can initiate a transaction. In customer-initiated transactions, the customer enters their payment information (such as their card number or digital wallet connection) on a checkout page. Merchant-initiated transactions use payment data on file to complete recurring payments where the customer has already entered and saved their information in the system, such as subscriptions.
2. The payment gateway encrypts the data. After the transaction is initiated, the gateway jumps into action to protect the customer’s payment data with encryption. Gateways use specific security protocols to keep transactional data safe from unauthorized access and theft. 
3. Transaction data is sent out. With the payment data successfully encrypted, the payment gateway sends the payment request first to the merchant’s acquiring bank, which then routes the information to the customer’s issuing bank or payment processor. 
4. An authorization decision is made. Once the issuer or payment processor receives the transaction data, they assess the validity of the request. The transaction details are cross-checked with the customer’s identity verification information, as well as the customer’s financial information (such as their current account balance). If everything checks out, the issuer or processor sends an approval back to the gateway. 
5. The gateway communicates the decision. Whether approved or denied, the final status of the transaction is given to the payment gateway, which must then communicate that decision to the merchant’s payment system. An approved transaction is completed, while a denied payment may require additional intervention from the customer. 

Choosing Payment Gateway Providers Depends on Regional Requirements

Where your business operates impacts which payment gateways are ideal for your transactions.

Many different factors influence the effectiveness of a specific gateway, with some gateways offering better cost and efficiency advantages in certain regions that others cannot. 

Geographic location as a whole is one of the most important factors to consider when making your gateway choices. For your primary gateway (where your payments are routed to first), you want a solution that can support the local payments in your target regions. European businesses or those operating in Europe, for example, need gateways that can support regional payment rails like SEPA and comply with regional compliance requirements, like PSD3 or GDPR. 

It's also critical to consider the specific types of payment methods your customers want to access. 

Although credit and debit card payments maintain their early-earned dominance, alternatives like digital wallets and Buy Now, Pay Later solutions are gaining substantial traction. WorldPay’s Global Payments Report 2024 shows that digital wallets are the fastest-growing payment method globally across all shopping channels, accounting for 50% of e-commerce spending worldwide in 2023.

It’s also pertinent to consider the integration capabilities of different payment gateways. You need gateways that can easily connect to your platform and checkout process via API to give customers a seamless and reliable payment experience. 

Is a Gateway the Same as a Payment Processor?

Payment gateways and payment processors both have important roles to play in a digital transaction and can oftentimes be mistaken for one another. Though they work together to complete a payment, gateways and processors have differing jobs in the payment flow. 

Gateways handle the initial and final transfers of information between the merchant’s payment system and the relevant banks and financial institutions. 

A payment gateway must have the ability to securely encrypt and transmit payment data arriving from a variety of different sources and in the form of diverse payment methods and currencies. Acting as a virtual point of sale (POS), gateways handle several key aspects of initial payment security, including customer authentication through features like 3D Secure or biometric authentication.

Meanwhile, a payment processor plays a more behind-the-scenes role by helping to actually move funds. Processors receive payment requests from gateways and then communicate with the issuing bank to authorize and settle the transaction. The processor’s main responsibility is to move the money from the customer’s account to the merchant account, ensuring the amount is accurate and approved.

Gateways focus on enhancing the user experience and providing immediate information security, while processors are tasked with more complex risk management tasks necessary to securely move money between two accounts. That’s not to say gateways don’t also deal with security—it has more to do with the actual tasks at hand and how fraud risks need to be addressed in either scenario.

For payment gateways, security measures center around preventing fraudulent transactions and protecting payment data. Gateways use encryption protocols and customer identity verification checks to ensure all payments are properly authorized. Security for a payment processor is slightly different. Payment processors hold greater power in their ability to access funds and communicate directly with the customer’s issuing bank, making security stricter and more complex. 

Another key distinction between gateways and processors is their respective relationships with businesses. Gateways integrate with a business’s platform or website, acting as a tool through which merchants and marketplaces can facilitate payments. On the other hand, processors are less like service providers and more like partners to businesses, allowing them to authorize and settle transactions. 

Can You Use Multiple Payment Gateways?

Yes—and you should.

Integrating multiple payment gateways into your transaction system gives you a much higher degree of operational efficiency and resilience. Rather than having only one gateway to which you can route transactions, you should opt for a multi-provider strategy with automatic rerouting capabilities that can send failed transactions to a secondary gateway to be retried.

But, how?

To use more than one payment gateway in your process, you first need the right technical foundation, such as an open payments platform. Open payments platforms offer several key advantages for adopting a multi-gateway strategy, such as:

• Streamlined integrations into one central platform environment, eliminating the need to manage multiple relationships with different payment gateway providers.
• Smart routing capabilities that can automatically retry a failed payment at a secondary gateway based on which gateways have the highest chance of a success for a specific transaction.
• Connections to a wide array of payment methods, payment rails, and currencies to allow fast and simple entry into new markets and retention of a global audience. 
• Predefined criteria for routing and managing transactions based on the conditions that can best meet the needs of each payment. 

The Cost of a Payment Gateway

The cost of your payment gateways comes down to how well you optimize them. 

Relying on a single gateway provider can give rise to operational problems. Should that gateway experience an outage or downtime, you can lose significant revenue while the gateway is offline. Moreover, a downed gateway can upset your customers and disrupt their checkout experience, potentially driving them to competitors who can offer smoother payments.

A multi-provider gateway strategy supported by open payments technologies can address these single-provider issues, all while increasing your revenue and reducing costs. 

With multiple gateways integrated with your payment environment, you can strategically route transactions based on factors like the highest cost efficiency. Secondary gateways give you the freedom to sidestep lofty processing fees for specific payment methods or regions. 

Open Payments Can Improve Your Payment Gateway Strategy

Why choose just one payment gateway when you can have many?

Payment market trends have shifted to a multi-gateway approach. 

A 2024 research report shows many factors impacting the diversification of the payment gateways, including the rising popularity of digital payments and e-commerce. With the payment gateway market set to hit more than $37 billion in 2032, adopting an effective multi-gateway strategy is a necessity for embracing the rising popularity of open payments.

At Spreedly, our open payments platform is all about combining the powers of payment orchestration with an open integration environment. We offer connections to leading payment gateways, including big-name brands like Stripe and PayPal, as well as region-specific options.

Book a Spreedly demo now to discover the flexibility of open payments.  

Download the Multiple Payment Gateways eBook Below