You pay ₹1,000 with a credit card. Almost immediately, you receive a message on your phone: you have received a cashback of ₹20. The sense of having got something extra is close to you getting back some of the money the bank lent you: the card appears more generous than cash, debit or UPI. The frequent and seemingly obligatory use of the card transforms ordinary purchases into achievements.
The ₹20 you thought you saw, however, was not actually on the other side of the POS terminal. Some of it, in fact, was taken out when the card was swiped.
What the Merchant Gets
A bank card transaction is a many-headed beast involving multiple parties. The acquiring bank, which processes payments on behalf of the merchant, the card network, the issuing bank, which gives the card and approves the payment, all expect to get paid. As a result, the amount that goes to the merchant's account is lower than what appears on the bill. The difference, known as the merchant discount rate (MDR) is collected from the merchant, apportioned between the card network, issuing and acquiring banks.
The Reserve Bank of India refers to the share paid to the issuer as the interchange fee: “MDR is the compensation charged to a merchant for processing debit and credit card transactions. Interchange fee refers to the compensation payable to an issuing bank by an acquiring bank for a transaction.”
The quantum of the interchange fee varies depending on the type of card, merchant, banks and networks involved. Cards with rich rewards programmes tend to carry a higher fee as the issuing bank seeks compensation for the expenses incurred in cashbacks, rewards, lounge access and the like. This is not the only incentive for interchange, though; annual fees, interest and other charges also contribute. Who gets the cashback is obvious. Who gets it from is less so.
Why the Cashback Isn't Always a Good Deal for the Merchant
Let p be the price of a good, say, a shirt. Imagine a merchant selling this shirt to three different customers using three different payment methods: cash, UPI QR code and a rewards-linked credit card. The price of the good, though, will be the same for all three customers.
Not anymore it won't be. If accepting cards comes at a cost to the merchant, it makes economic sense for them to build this cost into the final price. As a result, the cash or UPI-paying customer ends up subsidising the rewards-linked payment method. A 2026 study by the National Bureau of Economic Research found that exactly this happens in the US, where interchange fees finance rewards programmes. "Uniform pricing is associated with cash and debit card customers indirectly subsidizing credit card customers through cross-subsidization," the study found. "... However, the equal pricing is less straightforward than the proportional one because different consumers buy different goods at different merchants." (National Bureau of Economic Research)
It is important to note that the study relates to the US context, where UPI-like instantaneous payments have not taken off. In India, too, the dynamics are likely to be somewhat different, given that most debit card transactions have been freed of MDR since January 1, 2020: "UPI and RuPay debit card transactions settled on or after January 1, 2020, have a zero MDR," notes the Reserve Bank of India.
As a result, for the customer, an ordinary UPI transaction and a rewards-linked credit card swipe are both seamless. Behind the scenes, however, things are entirely different. A bank that issues a rewards-linked credit card has a much clearer monetization of the swipe than the one that processes a UPI payment with zero MDR. Partly for this reason, banks push for credit cards even as free UPI infrastructure undercuts their efforts at capturing interchange fees.
It is this competition for the customer that has turned the payment screen into a battleground: the acquiring bank wants to encourage cheaper modes of payment, the issuing bank tries to steer the customer towards its rewards-linked product, while the customer is trying to choose the payment method that offers the richest rewards. All three parties are looking at the same ₹1,000 in the shirt and see different opportunities for profit.
Rewards Encourage Spending
2% doesn't sound like much. Spending with a rewards-linked card turns every purchase into a ticket to a reward, albeit a small one. This can be an important motivation: a customer may be incentivised to pay with a rewards-linked card to redeem points for a gift or pay off an annual fee, or to qualify for a reward tier upgrade. The ability to earn frequent flyer miles, vouchers or hotel upgrades transforms the choice of a payment instrument into a choice between alternate lifestyles.
The very visibility of the reward is the reason why the ₹20 cashback appears so valuable to the customer. The same ₹20, however, is hidden from the eyes of the merchant, who will factor in its cost when setting the final price.
That's not to say rewards-linked cards are a bad deal for the customer. They can be an excellent value proposition for someone who pays off their dues in full and doesn't overextend their credit, and for whom the rewards outweigh the annual fee. It only takes one careless swipe to turn the entire rewards-linked purchase into an interest trap: the value of the cashbacks is invariably in single digits, while interest rates on unpaid dues are often north of 30%. The bank doesn't need every customer to fall into an interest trap; it only needs enough to make up for the cashbacks, rewards, interchange and other expenses.
Someone is Paying for that Airport Lounge
Modern-day credit cards are essentially bundles of rewards. Cashbacks, lounge access, frequent flyer miles, discounts at specific partners, hotel upgrades – there is rarely an onus on the customer to pay for them directly. Hidden beneath layers of complexity, the cost of these perks is apportioned among merchants, card networks, annual fee-paying customers, customers who utilise the cashback option, and those who end up subsidising them through inflated prices or by utilising the rewards programme.
Rewards cards are therefore simultaneously an incredible value proposition and a trap: while an individual customer may get rich rewards by using one particular card, these rewards are made possible by the combined sacrifices of many others. The next time you see ₹20 in your rewards wallet, ask yourself: who paid for it? After you have found the answer, ask yourself if it might have been a good deal for everyone involved after all.