Ever looked at a gift card and thought, “If I’m paying $25 for this gift card, and it’s worth $25, how is this business making any money?” Obviously gift cards cost money to produce, ship, and maintain. This article covers how gift cards work for a consumer, how businesses make money off of them and the behind-the-scenes technical aspects of an average gift card program. So, how do gift cards work?
Before we get started, we’ll need to cover some basic terminology; there are two types of gift cards: open loop cards and closed loop cards. Open loop cards look like a credit card and are accepted nearly everywhere. If you’ve seen a Visa® gift card before, that’s an example of an open loop gift card. Closed loop cards are cards that only work at one store, or with one corporation’s brands. These are the cards you see for Amazon, Walmart and Target next to the checkout register in grocery stores. They typically have a magnetic stripe on the back and can be swiped just like a credit card, but some are simply scanned like a UPC or manually redeemed.
If you have an open loop card, you might be wondering “How does my gift card work?” The answer is that it will behave almost exactly like a credit card; swipe it, the total will be deducted from the balance and you’ll be able to walk out with your purchases. There are some exceptions: for example, fuel purchases. Gas stations will preauthorize cards swiped at the pump for up to $100 or more, since they don’t know what the final purchase price will be and they want to be sure the card can cover the cost. This can cause a gift card with a lower balance to be declined; the solution is to prepay with the card inside first. Finally, some gift cards might not be accepted in certain locations because of special restrictions. For example, most open loop cards are not accepted at an ATM, MoneyGram, or PayPal because these services could be abused to launder money.
For closed loop cards, you’re stuck with a particular merchant. However, companies with several brands will often honor gift cards at all of their affiliated brand locations; for example, a Red Lobster gift card can be used at Olive Garden, or any other Darden Group restaurant. If you still can’t find an appealing place to shop, you can always sell your gift card to a gift card exchange: we are one of many sites who buy gift cards. Depending on the card and the site, you can get back as much as 92% of the face value.
Businesses earn a return from gift cards in a few different ways; here are three of the most important:
Gift cards let loyal customers refer other potentially like-minded consumers to a business. The consumer who purchases the card will usually evangelize a product, service or brand that a business offers as part of the gift-giving process. The cash on the card provides an incentive for the recipient to visit the issuing merchant and test-drive a company’s product or service. If they don’t like it, the business is only out the cost of producing the card, which they usually can absorb with the margin of the purchased product or service, and the customer is only losing the time it took them to experience the process. This makes a gift card a very low cost, low risk proposition for a business looking to bring in new customers, and a cheap alternative to traditional advertising. Plus, gift cards tend to be very ‘sticky;’ consumers hold on to them for a while and can be reminded about a business every time they open their wallet. They’re almost like miniature billboards.
On open loop cards, most issuers charge a small, up-front fee to cover the cost of production and processing fees. Since closed loop cards live on brand’s internal systems, there are no third party fees to offset, so cards can be sold at face value. The cost of producing the physical cards is made up for in the margins of the product purchased. Additionally, if a gift card is either never or only partially redeemed after a few years from purchase, the business can charge a small fee against the remaining balance. For more on these fees, read Mark Romanelli’s piece about recent gift card legislation. This means a customer who spends under the balance of the card can eventually provide a small return for a business.
Gift cards usually come in neatly rounded balances, like $25, $50, or $100 dollars; however, sales tax typically makes spending exactly $25 hard to do. Most customers will find something else they want and then pay a little more to ensure they spend the entirety of the card in one visit. This means the business earns additional marginal revenue from those customers (typically around 20%).
Open loop cards require a bank, which securely holds the funds, a network, like Visa, that connects all the banks and the merchants, a processor, who processes and routes the transactions, and a seller or manager, like GiftCards.com, who works with the banks to offer the cards and manage customer needs. When an open loop card is purchased, the purchaser determines the denomination of the card. They are then charged that denomination, along with any fees the issuer assesses. The cash is held by the bank, which will disperse it via the processor to the merchants at which the card is eventually used. Once the card is approved, it is produced and mailed to the intended recipient. The recipient will activate the card, typically either by phone or online. Then, they can begin to spend the card’s balance. Whenever the card is swiped, the processor confirms the card has a high enough balance to cover the transaction. It then checks a merchant identifier that tags along with the transaction, to ensure that there are no restrictions on the card being used at the location it was swiped. If everything clears, it will deduct the total of the transaction from the balance from the card and send it to the merchant.
Closed loop cards are a little more nuanced. Depending on the merchant, the funds might be held in different locations, but generally they fall under the same domain as the rest of the business’s internal accounting. These cards will only work within the merchants’ systems. Although, that doesn’t mean they can’t be used at different brands; remember the Red Lobster card being used at Olive Garden example? Generally, they operate with a magnetic stripe, like a credit card, although smaller businesses might opt for a card that they can scan in with a bar code. Most modern POS systems are equipped so that any merchant can set-up a closed loop system and process the cards using the same technology, but some systems require a different piece of technology, such as a separate scanner, in order to work.
So, there you have it; the ins-and-outs of how gift cards work. For a consumer, gift cards, especially open loop cards, offer an easy and convenient way to shop at businesses they love. There can be some painful moments – having to pay inside at a gas station, for example – but with a little preparation, those snafus can be easily avoided. For businesses, gift cards offer a cost-efficient way to introduce new customers to your products, give customers a “sticky” piece of collateral that will live in their wallets for a long time, and encourage customers to spend a little more when they visit your locations. Gift cards work by cooperation between an issuer, a bank, and a processor, who operate together to process transactions as they come through the card.
~~ Dan Wilkerson