Merchant Discount Rate (MDR) And The Future Of UPI
Source: Indian Express
GS III: Indian Economy – Financial Inclusion
Overview
- UPI has become a major digital public infrastructure, processing over 24,000 crore transactions annually, largely involving small-value payments.
- UPI transactions are kept free for users and merchants, with the government supporting banks and payment providers through incentives.
- Imposing MDR could increase costs for small merchants and consumers, potentially encouraging a shift back to cash.
- Instead of MDR, savings from reduced cash handling, currency management and banking costs could partly fund the UPI ecosystem.
- A transparent, formula-based funding mechanism can ensure UPI remains affordable while making its infrastructure financially sustainable.
Why in the News?
The debate over Merchant Discount Rate (MDR) on UPI transactions has gained renewed importance after Parliament amended the legal framework governing charges on BHIM-UPI and RuPay.
News in Brief
- In 2025–26, UPI processed over 24,000 crore transactions, worth around ₹314 lakh crore, accounting for about 85% of India’s digital retail payments and nearly half of the world’s real-time payments.
- UPI is predominantly used for small-value transactions: the average transaction is around ₹1,000, while about 86% of merchant transactions are below ₹500.
- The government currently supports the zero-MDR model through incentives to banks and payment service providers; however, this support is projected to decline from about ₹1,631 crore two years earlier to around ₹437 crore.
- Experts argues that imposing MDR would be the wrong solution because digitization itself generates savings for the government and banks, which could instead be used to fund UPI.
Key Highlights
UPI as Digital Public Infrastructure
- After Aadhaar created a digital identity layer, UPI became one of India’s most visible digital public infrastructure platforms.
- Unlike a proprietary company product, UPI is an open, protocol-based public infrastructure.
- Before UPI, individual banks operated closed payment applications.
- UPI required banks to open their APIs to a common interoperable protocol, allowing money to move between accounts in different banks instantly.
- It has therefore emerged as a common language for digital money, and its model is being studied and adopted internationally.
Why MDR is considered inappropriate for UPI
- MDR originated largely in the card-payment ecosystem, where,
- Issuing bank, acquiring bank and payment network share the fee.
- Physical POS terminals involve infrastructure costs.
- Card payments involve credit/default-related risks.
- UPI is fundamentally different,
- The customer’s mobile phone acts as the point-of-sale device.
- The customer already bears the cost of the device and data connection.
- There is no physical card or POS terminal.
- There is no comparable credit risk.
- Settlement is instantaneous.
- Therefore, the argument is that MDR represents an inherited pricing model from the card ecosystem rather than a cost-based requirement for UPI.
How UPI costs are actually distributed
- When A pays B,
- A’s bank makes the debit entry.
- B’s bank makes the corresponding credit entry.
- NPCI operates the switching and settlement infrastructure.
- Experts estimates that NPCI runs the system for roughly ₹500 crore a year, or around two paise per transaction.
- Thus, the argument is that the underlying transaction cost has become extremely small compared with traditional cash/card infrastructure.
Zero MDR does not mean zero cost
- Banks and payment providers still incur genuine costs.
- Under zero MDR:
- They do not directly earn transaction fees from UPI payments.
- The government has therefore used an incentive mechanism to bridge the funding gap.
- But as UPI volumes continue to grow, the article argues that this support mechanism should be reconsidered.
Why not impose MDR?
UPI is highly price-sensitive
- UPI is used extensively by:
- Vegetable vendors
- Auto drivers
- Kirana shops
- Small merchants
- Consumers making low-value payments
- Since most transactions are small, even a modest charge can affect adoption.
- Experts argues that if digital payment becomes even ₹1 costlier than cash, some users may return to cash.
Impact of a 0.3% MDR
- Experts estimates that even a 0.3% charge on merchant payments could extract around ₹27,000 crore annually from a thin-margin retail economy.
- A merchant may:
- Pass the cost to consumers as a “2% extra for digital” charge, or
- Refuse digital payments altogether.
- This could slow or reverse India’s transition towards a less-cash economy.
Why charging only large merchants may not solve the problem
- Restricting MDR to large merchants may appear attractive, but the article argues that it provides no permanent protection because:
- Merchant thresholds can change.
- Definitions of “large merchant” can change.
- Businesses may restructure transactions to fall below thresholds.
- Hence, a universal, transparent funding mechanism is preferable.
Suggested Reform: Fund UPI from the Savings It Generates
Savings for the Government
- The Reserve Bank of India spends roughly ₹5,000–6,400 crore annually on printing currency notes.
- This is before accounting for the additional costs of,
- Storing cash
- Transporting cash
- Managing cash
- Handling physical currency
- Experts argues that if UPI reduces these costs, part of the resulting savings could support the digital payment infrastructure.
Savings for Banks
- Different payment channels impose different costs on banks,
- Bank-counter transaction- ₹40–50
- ATM withdrawal- About ₹19 in interchange cost
- UPI transaction – A small fraction of the above
- UPI also keeps money within bank accounts rather than physically sitting as cash.
- This increases the deposit base and low-cost funds available to banks, supporting their ability to lend and earn through their spread.
The proposed funding principle
The central argument is:
- Do not recover UPI’s cost from merchants and consumers through MDR; instead, return a small, defined share of the savings created by digitization to those who operate the payment infrastructure.
- This could function like a transparent, formula-based public support mechanism, rather than a transaction charge.
Legal/Policy Dimension
- Amendment to the Payment and Settlement Systems Act
- The article notes that the Taxation and Other Laws (Amendment) Bill, 2024 amended Section 10A of the Payment and Settlement Systems Act.
- Earlier, the provision barred charges on,
- BHIM-UPI
- RuPay
- The amendment replaces the absolute bar with an enabling provision, allowing the government to notify in future which payment modes may carry charges.
Why Keeping UPI Free Matters
- India has created a system of real-time, instant and universal digital payments that has brought millions of people into the formal economy.
- Its underlying social bargain is- Digital payment should not cost more than cash.
- Introducing MDR could undermine this bargain, particularly for small merchants and low-income consumers
Conclusion
UPI has become a critical pillar of India’s digital economy, and keeping it affordable is essential for sustaining financial inclusion and reducing cash dependence.
Rather than imposing MDR on users and merchants, a transparent, formula-based funding mechanism using part of the savings generated through digitization can ensure the long-term sustainability of UPI while preserving its character as a public digital infrastructure.
UPSC Prelims and Mains Practice Question
Consider the following statements regarding UPI and MDR:
- UPI is an interoperable, real-time payment infrastructure operated by NPCI.
- MDR originated primarily in the card-payment ecosystem and involves charges associated with processing merchant payments.
- The recent amendment imposes MDR on all UPI transactions.
Which of the statements given above are correct?
A) 1 and 2 only
B) 2 and 3 only
C) 1 and 3 only
D) 1,2 and 3
Answer: 1and 2 only.
Mains Practice Question
Q. UPI has transformed India’s digital payment ecosystem by combining interoperability, instant settlement and low transaction costs. Examine the challenges of maintaining a zero-MDR model and discuss alternative mechanisms for sustainably financing UPI infrastructure. (250 Words)
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