As with most technological services, there is a cost to accepting credit and debit cards. Part of this cost is known as the interchange fee. Interchange fees are the fees that an acquiring bank pays an issuing bank to process credit or debit transactions.

An acquiring bank is a merchant account provider (First American Payment Systems) that processes and charges for the credit card transactions. An issuing bank (Bank of America) is a company that distributes credit cards and collects interchange fees.

Let’s start from the beginning: Merchants do not pay interchange directly. A merchant accepts credit card payment from a consumer and a percentage of the purchase amount is collected to pay merchant dues and fees. That percentage is then distributed to the acquiring bank, the issuing bank and the credit card authority (Visa and MasterCard, for example).

Example: A retail store (Archie’s Gardenland) that processes payments through First American Payment Systems (the acquiring bank) accepts a Bank of America-issued Visa credit card to make a sale. Archie’s Gardenland will pay First American Payment Systems a processing fee. First American Payment Systems will then pay a portion of that processing fee, the interchange fee, to Bank of America and Visa.

Retail Store Sale: $150
Retailer keeps: $147

The remaining $3 is the merchant discount and fees, which is divided among the issuing bank (Bank of America), the credit card authority (Visa), and the retailer’s merchant account provider (First American Payment Systems).

Card issuing bank gets: $2.41 (Interchange Fee)
Credit card company gets: $0.15825 (Assessment)
Retailer’s merchant account provider gets: $0.43175 (Merchant Dues & Fees Remainder)

(As an aside, ATM transactions work conversely: The interchange fee is paid to the merchant account provider.)

While controversy often surrounds interchange fees, which are set by the card authorities, in the end, the fee ensures that each involved party receives an appropriate amount to cover its costs and risks.

Resources:

http://en.wikipedia.org/wiki/Interchange_fee#Overview
http://usa.visa.com/merchants/operations/interchange_rates.html
http://www.mastercard.com/us/merchant/support/interchange_rates.html