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Financial literacy
8 min

What is a direct debit and how does it work?

Learn what Direct Debit is, how it differs from other payment methods, its pros and cons, important rules, and common misconceptions in this detailed guide.

Sergey Bukrinski Head of Content
Published at
Smiling male shopkeeper in a beige shirt and apron holding a credit card inside a small grocery store or market. Fresh produce like tomatoes, apples, and squash are displayed on wooden shelves in the background.

In 2023, direct debit payments (or ACH payments) made up 13% of all consumer payments in the US. 

Direct debit is an increasingly common payment method for bill payments, including recurring bills, subscriptions, memberships, and other ongoing service charges.

Why? Because direct debit payments are safe, secure, and convenient for both customers and businesses. Let’s explore more.

What is Direct Debit?

Direct debit is a payment method where the payer authorizes a business to withdraw funds from their bank account on a specific date or periodically on a set schedule. 

The payment occurs automatically at the pre-agreed time, without any action needed on the part of the payer. The payment amount is not necessarily the same amount every time. For example, a monthly electric bill paid by direct debit will fluctuate depending on how much electricity the customer used during the payment period.

Direct debit is commonly used for:

  • Recurring payments, such as utilities, rent, insurance, and loan payments
  • Predictable payments, such as weekly, monthly or annual subscriptions 
  • Ongoing accounts, such as vendor payments and restaurant tabs

In the US, direct debits are handled via the ACH network, so they are a type of ACH payment.

How It Differs From Other Payment Methods

Direct debit payments, also known as auto-pay, automatic transfer, or ACH withdrawal, are a popular payment choice, alongside other methods such as checks, credit cards, standing orders, or wire transfer. Let’s explore how direct debits are different from these other payments types:

  • One-time authorization: Customers must authorize a business to set up a direct debit in order to withdraw funds from their account. Other payments, such as credit card or check, do not give a business access to the customer’s bank account, and therefore do not require pre-authorization of any kind.
  • No action required by the payer: Once a direct debit is set up and authorized, the customer does not have to do anything to pay the business. The business debits the payment amount automatically at the pre-agreed date or time period.
  • Lower transaction fees: Direct debits have lower fees than other payment methods, including credit card, but especially checks and wire transfers.

Comparison table showing the benefits of Direct Debit versus other payment methods (Check, Credit Card, Wire Transfer, and Standing Order). Direct Debit is marked as the only method that meets all listed criteria: automatic, digital, one-time payee authorization, ongoing access to payer’s bank, no future approval needed, variable payment amounts, and lower transaction fees. Other methods meet few or none of the criteria.

How Does Direct Debit Work?

Direct debit is a “set it and forget it” payment method, which makes it extremely convenient for customers and business alikef. Let’s explore a step-by-step overview of how direct debit works:

  1. The payer authorizes the payee (i.e. a utility company or subscription service) to set up a direct debit and access their account. Typically, this is done over the phone or online. The payer must sign a written permission form that contains their name, address, bank account details, and the dates or schedule for direct debit withdrawals (i.e. monthly).
  2. At the appointed date, the payment is automatically requested by the payee (i.e. the business) via their bank or ACH network. 
  3. The payer’s bank is notified of the payment request, and automated checks verify that the payment is authorized. 
  4. The authorization to pull the funds from the payee’s account is given, and the ACH payment processing system activates the withdrawal. Direct debit payments occur en masse in batches, so the transaction occurs in the next available batch.
  5. The transaction undergoes the clearing process between the two financial institutions. Once the payment is cleared (this can take up to two business days), the direct debit transaction is complete. The customer’s account is debited, and the business’s account is credited with the payment amount.

Note that this all occurs automatically, without the payer’s intervention. The payer may receive a notification via email or text message that the payment was made, or they may simply see the withdrawal on their bank statement or online account after it occurs.

Direct Debit Pros and Cons

Like any other payment method, the direct debit payment method has its advantages and disadvantages.

Pros

Convenient

Once a direct debit is set up, it is completely automatic and requires no effort or input from the payer.

Low fees

Direct debits, like all ACH payments, have fairly low transaction costs, especially compared to ACH vs wire transfer or checks.

Ongoing and reliable

Direct debit is ideal for predictable and recurring payments. The customer knows that the payment will be withdrawn from their account at regular intervals and ensures they won’t miss payments or pay late.

Cons

Risk of insufficient funds

Direct debit withdrawals happen automatically, without the payer necessarily paying attention. If the payer’s account does not have enough available funds to cover the charge, this causes  rejected payments, loss of service, penalties, and damage to their reputation.

Must keep track of payments

The payer must track their direct debit payments closely to ensure that there are no errors, such as a business withdrawing too much or too little.

Chargebacks

For businesses receiving direct debit payments, customers disputing payments and requesting chargebacks can be a big problem. Chargebacks are more likely to occur when the customer does not need to provide prior approval for an individual payment.

Graphic titled “Direct Debit: Pros & Cons” with two columns. The “Pros” column lists: 1) Set-and-forget for both parties, 2) Lower transaction fees than checks or cards, 3) Perfect for recurring and predictable payments. The “Cons” column lists: 1) Can lead to rejections and penalties, 2) Need to monitor for billing errors, 3) Higher risk for businesses due to lack of per-payment approvals.

Types of Direct Debit

There are several types of direct debit that are suitable for different payments and circumstances, including:

  • Fixed debit: A fixed direct debit is set at the same amount for every payment. It is suitable for charges that do not change, such as rent or subscriptions.
  • Variable debit: A variable direct debit has a fixed payment schedule, however the payment amount can fluctuate. This is useful for payments that are regular but the amount varies, such as utility bills or other usage-based service payments.
  • One-off direct debit: A direct debit can also be made for a one-time payment. The payee only has authorization to withdraw funds one time, for a specific amount.

Important Direct Debit Rules You Should Know

For business owners who are looking to use direct debit to receive customer payments automatically, here are three key rules to follow:

  • Set up a system for obtaining authorization: Businesses must receive official authorization to initiate direct debits. Create a process for securing authorization that is clear and efficient for both parties.
  • Provide advance notice of changes: If the payment schedule or amount is set to change, it is ethical practice to notify the customer in advance of the withdrawal. Not doing so puts you at risk of disputes, chargebacks, and legal problems.
  • Stick to the agreed schedule: Direct debits are a binding agreement between a business and the customer. Businesses must initiate withdrawals within the agreed time frames to ensure compliance with the contract, and must give advance notice each time they collect a paymentThis is also important to manage accounts payable efficiently and to maintain customer trust.

Common Misconceptions About Direct Debit

Let’s clear up some myths around direct debit:

Direct debits are fixed payments.

False. Direct debits can be for a fixed amount or a different amount every time.

Direct debit is a risky payment method.

False. Direct debits are quite secure. In the US, they are managed via the ACH network, which is a safe way to pay. Direct debit offers consumer protection, meaning that payers can get funds returned if there is an error in the transaction.

Direct debit and debit card are the same.

False. A debit card uses the card payments system, while direct debit is a bank transfer and does not involve a card of any type. There’s also no direct debit option on credit cards—those are recurring payments—but you can pay your credit card balance each month with direct debit.

Customers don’t like to pay with direct debit.

False. More consumers are turning to ACH or direct debit for recurring payments, including gym memberships, subscriptions, utility bills, and more.

Is your business using direct debit yet?

Now that you know what direct debit is and how it works, you might want to consider initiating direct debit for your business. You can choose to receive customer payments via direct debit, which is an effective way to get paid regularly, reliably and on time. Conversely, you can choose to pay your recurring bills and subscriptions via direct debit. These automated payments will take some of the load off your accounting team.

Set up direct debit (ACH) payments via Melio and get very affordable fees: just 50 cents per transaction if your business pays via direct debit/bank account, or 0.5% up to a maximum of $10 for receiving ACH direct debits.

*This blog post is intended for informational purposes only and is not intended as financial advice.
**Melio does not provide legal, tax or accounting advice, and you should consult with a professional advisor before making any financial decisions.

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