What is a Chargeback?

Scott StoneChargeback Basics26 Comments

What is a Chargeback

We even had to ask ourselves that question. Don’t get me wrong. We have experience with managing disputes and chargebacks. Our dispute management software would be useless if we didn’t have it. But answering the question, “What is a chargeback?” because the process can be simple or complex. It depends on the chargeback and the reason code that issued it. Let’s look at the definition first, and we’ll build it up step-by-step:

What is a chargeback?

  1. A chargeback is a transaction reversal meant to serve as a form of consumer protection from fraudulent activity committed by both merchants and individuals.
  2. A demand by a credit-card provider for a retailer to make good the loss on a fraudulent or disputed transaction.

Cardholders will file disputes with their issuing bank, which are also called “issuers”. Afterwards, the acquirer will debit the transaction amount from the merchant’s account. The merchant will need to provide compelling evidence in order to disprove the dispute. Some examples involve proving her innocence from fraudulent activity or reassuring her due diligence with processing.

The funds will return to the merchant if the evidence favors an overturn of the cardholder’s dispute. But a cardholder can issue a second chargeback. This is scenario is called pre-arbitration. And cardholders may issue arbitration if, for example, they are determined to prove they were fraud victims.

In this post, we’ll build upon the definition of chargeback. We’re going to explain the parties involved in the chargeback process. Yes, we already have a post that explains this process. But we’re using this opportunity to explore different areas that extend the chargeback’s definition. Here, we’ll explain the role of chargebacks as a lagging indicator. Then we’ll explain the different types of fraud. Afterwards, we’ll provide a (simplified) version of the chargeback the process. We’ll end this post with a look on chargeback prevention and chargeback resolution. Enjoy!

  1. Parties in the Chargeback Process
  2. Chargebacks as a Lagging Indicator
  3. Chargebacks and Types of Fraud
  4. The Chargeback Process – Simplified
  5. Potential Outcomes of a Chargeback
  6. Merchant Losses to Chargebacks
  7. Chargeback Prevention
  8. Chargeback Resolution

Parties in the Chargeback Process

The Customer

The customer is a cardholder who made a purchase with a particular merchant. This person may have seen a transaction on a billing statement that is not recognizable. It could be an unfamiliar merchant or an unknown merchant descriptor. Each card network guarantees zero-fraud liability to its cardholders.

Issuing Bank

The issuing bank (or the issuer) provides payment cards to the cardholder. Some examples include credit and debit cards. The issuer is ‘the underwriter’ of the account and is responsible to disperse funds from the customer to the merchant.

Note: The customer’s balance and authorization is managed by the issuer’s processor.

Issuing Bank Processor

The issuer’s processor verifies the customers’ account balances. It’ll either authorize or deny transaction requests that are received through the card network.

Card Network

Visa, MasterCard, American Express, and Discover are the four major card networks. Each network provides the transactional pipeline that transfers payments between issuers and acquirers. The card networks also manage the settlement process between both parties. Basically, these networks provide the data connection and flow the funds through FedWire. That’s the pipeline between the customer and the merchant.

Note: American Express and Discover have a unique role. These card networks are also issuers and acquirers. That means the customer and the merchant are their clients. Visa and MasterCard are strictly card networks.

Acquiring Bank

The acquiring bank (or the “acquirer”) is the institution responsible for acquiring authorization through the card network. It receive funds on the merchant’s behalf from the customer’s issuing bank. During this process, the acquirer will settle the funds collected from the processing fees, network fees, and interchange fees.

Merchant Account Processor

The merchant account processor is a company that partners with an acquirer to process payments on behalf of the merchant. Merchants typically have a closer relationship with their account processor than their acquirer. A merchant’s processor and acquiring bank can be, and often are, the same institution.

Merchant Commercial Bank Account

The acquirer will soon receive the funds from the issuer through the card network’s settlement process. The funds will be deposited to the merchant commercial bank account. The merchant commercial bank account is the ultimate destination of funds transferred from a cardholder. And it is the source of funds when a chargeback is issued. When that happens, the funds are automatically withdrawn from the merchant commercial bank account by the acquirer. And the funds will be moved back to the issuer/cardholder’s account.

Payment Gateway

The payment gateway does the complex work of building secure connections to merchant account processors. It acts as a “virtual” credit card terminal allows a merchant to submit payments to a processor via the internet. It is often analogized as a virtual credit card terminal. Payment gateways also provide fraud filters, recurring billing payments, and other valuable functionalities to assist ecommerce companies.

The Merchant

A business, company, brand, service provider, or other relevant party who provides a good or service in exchange for payment.


Chargebacks as a Lagging Indicator

No one likes getting chargebacks, but they actually do provide valuable insights that can directly help improve business operations. Every chargeback processed is assigned an appropriate reason code that most accurately represents the grounds for the cardholder’s dispute. Merchants will see some breakdown of reason codes unique to their own business, but we found our own breakdown based on the millions chargebacks processed.

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While seeing a smattering of different reason codes might not translate into actionable insights for your business, seeing patterns or the same reason code frequently should send up red flags. Each reason code ‘bucket’ should set the direction for which you delve into deeper.

Overwhelming Amount of Fraud / No Authorization Reason Codes?

If you experience a disproportionate amount of chargebacks coded under Fraud or No Authorization reason codes, you need to take a look at your front-end fraud prevention solutions. Do you have enough safeguards in place to stop transactions that are obviously fraudulent? You need the basics; including CVV and AVS. But you can also consider adding automated transaction scoring, rules-based filters, geolocation, device ID, device fingerprinting, or 3D secure tools. Your front-end fraud prevention should be strong enough to protect your business from being pillaged by a large-scale attack.

Absolutely ZERO Fraud / No Authorization Reason Codes?

Strict fraud prevention solutions block legitimate transactions and alienate real customers. While you don’t want to see a disproportionate amount of fraud-related reason codes, seeing none at all can also indicate a problem. If you aren’t letting any fraudulent transactions through, how rigorous is your front-end fraud protection? Letting some fraud through is acceptable, as you can recover the revenue via responding to chargebacks. Adopt a Goldilocks approach when it comes to fraud-related reason code: not too much, not too little, but just the right amount.

Lots of Cancel Recurring Billing Chargebacks?

Subscription services, SaaS providers, and lots of other merchants use recurring billing as the preferred method of payment collection. When done correctly, this approach is great for guaranteeing a customer lifetime duration and ongoing revenue streams. However, when done incorrectly, merchants using recurring billing can anger and frustrate a lot of customers. This anger and frustration appears to merchants as Cancel Recurring Billing reason codes. If your chargeback ecosystem is dominated by these types of reason codes, it’s a good indicator that your customer communication needs attention. Is it clear when users sign up that billing will occur monthly? Are you emailing users to remind them of invoice dates? When it comes to recurring billing, over-communication with the customer is always preferred.

Mostly Product / Services Related Reason Codes?

Product or service related reason codes have a few different subsets, each of which are important to monitor as lagging indicators. As a merchant, if you see a disproportionate of chargebacks coded under reason codes related to shipping, then you definitely need to revisit operations here. Are you sending tracking information to the customer? Are there problems with a particular shipping provider? Identifying these issues will help you know where to place resources in order to improve.

The other large subset of product or service related reason codes deal with the product not meeting expectations of the customer set by the merchant. Most often, this points to inadequate, insufficient, or downright incorrect product descriptions on the website. If you’re seeing an influx of product-not-as-described reason codes, you should immediately look at your product descriptions. Is every specification the customer could need provided? Are there enough photos and views? Can you incorporate customer reviews onto the product page to help set expectations?

Reason codes are an overlooked goldmine for merchants looking to improve their overall business operations. But, you need to know what the codes actually mean. Download our free Reason Code Encyclopedia and keep it handy. It contains every single reason code from MasterCard, Visa, Discover, and American Express, their definition, additional insight, and real world examples.


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Chargebacks and Types of Fraud

Chargebacks are a natural part of doing business and every merchant will have a portion of legitimate chargebacks, filed under valid reason codes, by cardholders who are entitled to a refund. However, almost 80 percent of chargebacks are proven to be chargeback fraud or friendly fraud after compelling responses have been provided.

True Fraud (Unauthorized Use)

The unauthorized use of card is a result of compromised payment card info. This could originate from data breaches, card skimming, identity theft and other nefarious scams used by fraudsters. The fraudulent purchase is either caught by the issuer or is later disputed by the cardholder, which results in the card account being closed and a new account number and card being issued to the customer. For example, many of the cards stolen from Home Depot and Target resulted in thousands of fraudulent purchases that merchants would eventually see as a chargeback.

Friendly Fraud

Friendly fraud might not seem so friendly, but this expression is used to group cardholders who initiate chargebacks with no malicious intent. Simple forgetfulness, family members making unknown purchases, and misunderstandings of merchant return policies can all be at the root of friendly fraud. For example, a son asks his Mom if he can use the card to order a limited edition pair Nike’s from a boutique retailer. When Dad reviews the bill he doesn’t recognize the retailer’s name and thinks it’s fraud.

Chargeback Fraud

Chargeback fraud is the fraudulent request for a return or refund in the form of a chargeback. The transaction passed fraud prevention, but is disputed by the cardholder in an attempt to regain the transaction dollar amount while retaining the product or services rendered. There are thousands of stories illustrating instances of chargeback fraud. From Twitter users bragging about getting free pizza by using chargebacks at Domino’s, to Twitch users using chargebacks to recant donations made to streamers.

According to LexisNexis True Cost of Fraud study, among ecommerce merchants, these three types of fraud represent more than three quarters of total fraud losses. Lost or stolen merchandise accounts for the remaining quarter. Friendly fraud and chargeback fraud are responsible for 56 percent of a merchant’s fraud losses.

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The Chargeback Process – Simplified

The process is similar to legal proceedings, where both parties, in this case a cardholder and a merchant, are given the chance to offer evidence in support of their claims. Retrieval requests sometimes precede an actual chargeback. Here, the merchant is asked to provide basic transactional documentation to quickly validate or disprove a potentially fraudulent situation.

Without a doubt, the process is skewed in favor of the cardholder. But, by gathering compelling evidence and responding to the dispute, merchants are able to win cases of friendly fraud and chargeback fraud while building better models to bolster front-end fraud protection.

Step 1:

A customer (cardholder) files a dispute by contacting his or her issuing bank about a particular transaction. These complaints are typically submitted via phone or online form.
Chargeback Process Step 1

Step 2:

The issuing bank reviews the disputed transaction to determine whether or not to send the chargeback to the card network.

  • If the dispute is not valid, as determined by the issuing bank, the process ends.
  • If the dispute is valid, the process continues to the card network.

Chargeback-Process-Step-Two

Step 3:

The issuing bank provides an immediate credit to the customer for the disputed amount and the networks initiate the flow of funds from the merchant commercial bank account back to the issuing bank.

Chargeback Process Step Three

Step 4:

The issuing bank submits posts the chargeback to the card network, who passes it to the acquiring bank. Fees are incurred here that are eventually passed to the merchant.

Chargeback Process Step Four

Step 5:

The acquiring bank receives the chargeback and passes it along to the merchant. It typically contains instructions to gather compelling evidence that directly relates to the chargeback reason code. This communication occurs via merchant account processors online portal or an offline letter.

Chargeback Process Step Seven

Step 6:

Here, the merchant chooses whether or not to respond to the chargeback.

  • If the merchant choses to respond, compelling evidence is gathered relating to the transaction and the customer. Including, but certainly not limited to, date/time stamp, device, shipping verification, address verification, CVV match, device fingerprinting, geolocation, past transactional history, any subsequent transactions from the customer, any communication with customer, and other data.
  • If the merchant chooses not to respond, the process is completed and the chargeback is ruled in favor of the customer.

Step 7:

The acquiring bank reviews the compelling evidence and passes the information to the card network, who then passes it to the issuing bank, on behalf of the merchant.

  • If the issuing bank determines the merchant’s compelling evidence proves the chargeback is not valid, the issuing bank will decline the chargeback and pull the funds from the issuing bank back into the merchant commercial bank account (via the acquiring bank). This process can take many weeks. (i.e. The merchant won.)
  • If the issuing bank determines the compelling evidence does not prove the transactions validity, the process ends and funds remain with the issuing bank/customer. (i.e. The merchant lost.)

Conditional Additional Steps Following Step 7

Step 8:

The customer is given the option to chargeback the transaction again. (Visa refers to this as pre-arbitration, MasterCard calls it a second chargeback.) The entire process begins again.

Step 9:

If the merchant wins the pre-arbitration/second chargeback, the issuing bank can push to arbitration. Which automatically incurs a $250 fee for the merchant. In full arbitration, if the merchant wins the chargeback, they’ll receive the $250 back. However, if they lose, the merchant is assessed an additional $250 fee.

The duration of the chargeback process is dependent on whichever Visa, MasterCard, American Express or Discover reason code was used. On average, the process can last one month or as long as six months.

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Potential Outcomes of a Chargeback

Every chargeback ends in one of three outcomes. The chargeback was either actual fraud, chargeback/friendly fraud, or product/service issues.

Chargeback Responses Recover Lost Revenue

When you receive a chargeback, it’s either coded under a fraud reason code or a non-fraud reason code. However, even though some chargebacks are coded as fraud, responses often prove that they were not fraud. Instead chargeback fraud or friendly fraud was the source.

Unfortunately, the categorization of fraud leads many merchants to simply ignore the chargeback, writing them off as un-winnable cases of fraud. Which couldn’t be further from the truth! By responding to these chargebacks, it’s revealed that more than three quarters of chargebacks are really chargeback fraud or friendly fraud.

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Merchant Losses to Chargebacks

When chargebacks are lost, merchants lose money—the amount disputed, the chargeback fee and the cost of whatever was sold. Merchants lose the time and money it took during the selling, ordering, packaging and delivering processes of the product. In 2016, ecommerce merchants can expect to lose a combined total of nearly $7 billion in revenue from chargebacks and individually 1.47 percent of total revenue.

If a merchant’s chargeback ratio is more than 1 percent, processors can increase fees for chargeback occurrences and even refuse to process payments for the merchant account. Unfortunately, the very nature of some products and services lead processors to consider them “risky.” These high-risk merchants are often turned down by credit card processors, who simply don’t want to deal with the amount of chargebacks that are common in the industry.

Controlling the chargeback ratio should be the top priority of “high-risk” merchants. Which is easier said than done! Once a chargeback reaches the card network, your ratio is impacted. When you consider that the majority of merchants don’t know about a chargeback until it hits their monthly statement, it’s no surprise that high-risk merchants can feel particularly helpless.

Alerts in the Chargeback Process

Chargeback Alerts give you the opportunity to prevent fees, immediately blacklist a customer, and take action to remedy the situation before a chargeback is received and recorded against your merchant account by card networks. A good alert program includes all participating issuers.


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Preventing Chargebacks

First and foremost, be an honest merchant. Produce quality products, accurately describe what you’re selling, and strive provide the best customer service in your industry. To avoid chargebacks, merchants should consider the following:

  • Excellent customer service
  • A customer centric return policy
  • Detailed and accurate product descriptions
  • Set realistic expectations of the product/service results
  • Easy to find shipping/tracking information
  • Document conversations with customers

Responding to Chargebacks

Be prepared for receiving a chargeback, because they will happen. Understand the possible chargeback reasons—currently there are over 151 different chargeback reason codes among the top four networks—and have plans in place for how you’ll react to the different reasons.

A free chargeback reporting solution is a great way for merchants to start to understand and eventually manage the chargeback process. If you field a handful of chargebacks a month, a simple solution will help you recover lost revenue.

The landscape changes when you start dealing with hundreds of chargebacks a month. Scaling internal chargeback management is not easy; it takes valuable resources away from your core competency. Instead, consider investing in outsourcing the process to professionals.