How a Bitcoin Transaction Works?

Introduction

Have you ever wondered what happens behind the scenes when you send Bitcoin to someone? How does the network know you have enough Bitcoin? How does it verify the transaction is valid? How do miners decide which transactions to include in a block?

This guide will explain how Bitcoin transactions work in a technical but still accessible way. You'll understand concepts like inputs, outputs, UTXOs, digital signatures, and fees. Our goal is to teach you to understand transactions in practice, not just in theory.

We'll use real examples with fictional values to illustrate each concept. By the end of this guide, you'll be able to read a Bitcoin transaction on a blockchain explorer and understand exactly what's happening.

Fundamental Concepts

What is a Bitcoin Transaction?

A Bitcoin transaction is a value transfer on the blockchain that moves Bitcoins from one or more source addresses to one or more destination addresses.

Unlike traditional banking systems, Bitcoin doesn't use "accounts" with balances. Instead, it uses a system of unspent coins (UTXOs) that are transferred from one person to another.

Main characteristics:

Transactions are atomic (either complete fully or fail completely)
Cannot be modified after confirmation
Are public and verifiable by anyone
Are irreversible (once confirmed)

UTXO: Unspent Transaction Outputs

UTXO (Unspent Transaction Output) are "coins" of Bitcoin that were received in a previous transaction but haven't been spent yet.

Think of UTXOs as physical cash bills:

When someone pays you, you receive one or more "bills" (UTXOs)
Each bill has a specific value
To pay someone, you need to "give" one or more bills
You may need to give a large bill and receive change

Practical example:

John has 0.5 BTC (received in a previous transaction)
Mary has 0.3 BTC (received in another transaction)
Peter has 1.2 BTC (received in another transaction)

Each of these values is a different UTXO. When Peter wants to send 0.8 BTC to Ann, he needs to use his 1.2 BTC UTXO and create two outputs: 0.8 BTC for Ann and 0.4 BTC change for himself.

Inputs and Outputs

Inputs are references to previous UTXOs being "spent" in the transaction. Outputs are new UTXOs being created in the transaction.

Basic structure:

Bitcoin Transaction
├── Inputs (entries - UTXOs being spent)
│   ├── Input 1: reference to previous transaction + value
│   └── Input 2: reference to previous transaction + value
├── Outputs (exits - new UTXOs being created)
│   ├── Output 1: destination address + value
│   └── Output 2: change address + value
└── Fee: difference between inputs and outputs

Anatomy of a Bitcoin Transaction

Transaction Components

1. Version:

Protocol version number
Indicates which rules the transaction follows

2. Inputs:

List of UTXOs being spent
Each input references a previous transaction
Includes unlocking script (signature)

3. Outputs:

List of new UTXOs being created
Each output specifies address and value
Includes locking script (conditions to spend)

4. Locktime:

Timestamp or block number
Transaction is only valid after this time/block
Usually is 0 (valid immediately)

Practical Example: Simple Transaction

Let's follow a transaction from start to finish with fictional values:

Initial situation:

Ann has 0.5 BTC received in transaction ABC123 (UTXO)
Ann wants to send 0.3 BTC to Carlos
Network fee: 0.0001 BTC

Transaction created:

Transaction XYZ789
├── Input
│   └── Input 1:
│       ├── Reference: ABC123, output 0 (0.5 BTC)
│       └── Signature: [Ann's signature]
├── Outputs
│   ├── Output 0: Carlos's Address (0.3 BTC)
│   └── Output 1: Ann's Address (0.1999 BTC - change)
└── Fee: 0.0001 BTC (0.5 - 0.3 - 0.1999)

What happens:

Ann uses her 0.5 BTC UTXO (input)
Creates output of 0.3 BTC for Carlos
Creates output of 0.1999 BTC change for herself
Fee of 0.1 mBTC (0.0001 BTC) is paid to miners
Total: 0.5 BTC (input) = 0.3 BTC + 0.1999 BTC + 0.0001 BTC (outputs + fee)

After confirmation:

Ann's 0.5 BTC UTXO is marked as "spent"
New UTXO of 0.3 BTC is created for Carlos (can be spent)
New UTXO of 0.1999 BTC is created for Ann as change

Inputs

What Are Inputs?

Inputs are references to outputs from previous transactions being spent in the current transaction.

Each input contains:

Hash of previous transaction: Identifies which transaction contains the UTXO
Output index: Which output from that transaction is being used
Unlocking script: Signature and public key that prove ownership

Input Structure

Input {
    previous_output: {
        hash: "abc123...",      // Hash of previous transaction
        index: 0                 // Which output to use (0 = first)
    },
    script_sig: "[signature]",  // Unlocking script
    sequence: 0xffffffff         // Used for replace-by-fee
}

Multiple Input Example

Situation:

Mary wants to send 0.8 BTC to John
Mary has two UTXOs:
- UTXO 1: 0.5 BTC from transaction DEF456
- UTXO 2: 0.4 BTC from transaction GHI789

Transaction created:

Transaction JKL012
├── Inputs
│   ├── Input 1:
│   │   ├── Reference: DEF456, output 0 (0.5 BTC)
│   │   └── Signature: [Mary's signature]
│   └── Input 2:
│       ├── Reference: GHI789, output 0 (0.4 BTC)
│       └── Signature: [Mary's signature]
├── Outputs
│   ├── Output 0: John's Address (0.8 BTC)
│   └── Output 1: Mary's Address (0.0999 BTC - change)
└── Fee: 0.0001 BTC

Total inputs: 0.5 + 0.4 = 0.9 BTC Total outputs: 0.8 + 0.0999 = 0.8999 BTC Fee: 0.9 - 0.8999 = 0.0001 BTC

Unlocking Script (ScriptSig)

ScriptSig is the script that "unlocks" the UTXO, proving you have the right to spend it.

Most common types:

1. Pay-to-PubKeyHash (P2PKH):

Traditional format
Requires signature and public key
Script: <signature> <public key>

2. Pay-to-ScriptHash (P2SH):

For addresses starting with "3"
Allows more complex scripts
Requires redeem script and data

3. Pay-to-Witness-PubKeyHash (P2WPKH):

For SegWit addresses (bc1...)
Signature is separated (witness data)
Lower fee cost

Outputs

What Are Outputs?

Outputs are new UTXOs being created in the transaction. They specify where Bitcoin should go and in what amount.

Each output contains:

Value: Amount of Bitcoin (in satoshis)
Locking script: Conditions that must be met to spend this output

Output Structure

Output {
    value: 30000000,              // 0.3 BTC in satoshis
    script_pubkey: "[script]"     // Locking script
}

Types of Outputs

1. Pay-to-PubKeyHash (P2PKH):

Addresses starting with "1"
Script: OP_DUP OP_HASH160 <public key hash> OP_EQUALVERIFY OP_CHECKSIG

2. Pay-to-ScriptHash (P2SH):

Addresses starting with "3"
Script: OP_HASH160 <script hash> OP_EQUAL

3. Pay-to-Witness-PubKeyHash (P2WPKH):

SegWit addresses starting with "bc1"
Script: OP_0 <public key hash>
More efficient (lower fees)

Example: Transaction with Multiple Outputs

Situation:

Peter wants to send Bitcoin to 3 people:
- 0.2 BTC to Alice
- 0.15 BTC to Bob
- 0.1 BTC to Charlie
Peter has 0.5 BTC in one UTXO

Transaction created:

Transaction MNO345
├── Input
│   └── Input 1: Peter's 0.5 BTC UTXO
├── Outputs
│   ├── Output 0: Alice's Address (0.2 BTC)
│   ├── Output 1: Bob's Address (0.15 BTC)
│   ├── Output 2: Charlie's Address (0.1 BTC)
│   └── Output 3: Peter's Address (0.0499 BTC - change)
└── Fee: 0.0001 BTC

Validation:

Input: 0.5 BTC
Outputs: 0.2 + 0.15 + 0.1 + 0.0499 = 0.4999 BTC
Fee: 0.0001 BTC
Total: 0.5 BTC ✓

UTXO: Unspent Transaction Output System

How UTXOs Work

UTXO system is different from account system:

Account System (Banks):

You have an account with balance: 1.0 BTC
To send 0.3 BTC, balance decreases to 0.7 BTC
Simple and intuitive

UTXO System (Bitcoin):

You have separate UTXOs: [0.5 BTC, 0.3 BTC, 0.2 BTC]
To send 0.3 BTC, you use one UTXO or combine several
More complex, but more flexible

Example: UTXO Tracking

Transaction history:

Transaction 1 (block 100):

Alice receives 1.0 BTC from a previous transaction
Creates UTXO: Alice has 1.0 BTC (UTXO A)

Transaction 2 (block 150):

Alice sends 0.4 BTC to Bob
Uses UTXO A (1.0 BTC) as input
Creates outputs:
- Bob receives 0.4 BTC (UTXO B)
- Alice receives 0.5999 BTC change (UTXO C)
UTXO A is marked as spent

Transaction 3 (block 200):

Alice sends 0.2 BTC to Carlos
Uses UTXO C (0.5999 BTC) as input
Creates outputs:
- Carlos receives 0.2 BTC (UTXO D)
- Alice receives 0.3998 BTC change (UTXO E)
UTXO C is marked as spent

Current state:

Unspent UTXOs:
- UTXO B: Bob has 0.4 BTC
- UTXO D: Carlos has 0.2 BTC
- UTXO E: Alice has 0.3998 BTC

UTXOs and Privacy

Each UTXO can be tracked:

Blockchain is public
UTXOs can be connected
Cluster analysis can identify relationships

Best practices for privacy:

Use new addresses for each receipt
Don't reuse addresses
Consider using CoinJoin to mix UTXOs
Separate UTXOs from different sources

Digital Signatures

How Signatures Work

Digital signature proves you have the private key controlling the UTXO, without revealing the private key.

Process:

You create transaction
Transaction hash is created
You sign hash with your private key
Signature is included in input
Network verifies signature using public key

ECDSA: Signature Algorithm

Bitcoin uses ECDSA (Elliptic Curve Digital Signature Algorithm):

Elliptic curve: secp256k1
Generates key pair (private and public)
Signature is a pair of numbers (r, s)

Characteristics:

Signature is deterministic (same key + same message = same signature)
But Bitcoin uses random nonce for security
Signature is unique and cannot be forged

Signing Process

Step by step:

Create transaction:
- Define inputs and outputs
- Calculate fees
- Create transaction structure
Create hash to sign:
- Transaction hash (minus unlocking scripts)
- Includes inputs, outputs, locktime
Sign with private key:
- Use ECDSA to sign hash
- Generate pair (r, s)
Include signature in input:
- Add unlocking script
- Include signature and public key
Broadcast to network:
- Send transaction to Bitcoin nodes
- Nodes verify and propagate

Signature Verification

Network verifies if signature is valid:

Extracts signature from input
Extracts public key from input
Recreates hash that was signed
Verifies if signature matches hash and public key
If valid, transaction can proceed

If signature is invalid:

Transaction is rejected
Never enters mempool
Won't be included in block

Example: Signature in Practice

Transaction to be signed:

Ann wants to send 0.5 BTC to Carlos
Uses UTXO of 1.0 BTC

Process:

Ann's wallet creates transaction structure
Transaction hash is calculated: hash123...
Wallet signs hash123... with Ann's private key
Signature generated: (r=abc..., s=def...)
Input includes:
- Reference to UTXO
- ScriptSig with signature and Ann's public key

Verification:

Bitcoin nodes extract signature and public key
Recreate transaction hash
Verify if signature is valid
If valid, transaction is accepted

Transaction Fees

How Fees Work

Transaction fee is the difference between total value of inputs and total value of outputs.

Fee = Sum of all inputs - Sum of all outputs

Why it exists:

Incentivizes miners to include transaction in block
Prevents spam on network
Prioritizes important transactions

Fee Calculation

Fee is not explicitly defined:

You don't say "I want to pay 0.0001 BTC fee"
Instead, you define output values
Fee is what "remains"

Example:

Input: 1.0 BTC
Output to recipient: 0.999 BTC
Implicit fee: 1.0 - 0.999 = 0.001 BTC (1 mBTC)

Fee by Size (sat/vB)

Fee is based on transaction size in bytes, not transferred value.

Factors affecting size:

Number of inputs (more inputs = larger transaction)
Number of outputs (more outputs = larger transaction)
Script type (SegWit = smaller)
Signature length

Fee expressed in:

sat/vB (satoshis per virtual byte)
Higher sat/vB = faster confirmation

Example: Fee Calculation

Simple transaction:

1 input (traditional P2PKH)
2 outputs (recipient + change)
Size: ~250 bytes
Chosen fee: 10 sat/vB

Calculation:

Total fee: 250 bytes × 10 sat/vB = 2,500 satoshis
Fee in BTC: 0.000025 BTC

Complex transaction:

5 inputs (traditional P2PKH)
3 outputs
Size: ~1,250 bytes
Chosen fee: 15 sat/vB

Calculation:

Total fee: 1,250 bytes × 15 sat/vB = 18,750 satoshis
Fee in BTC: 0.0001875 BTC

Observe: Same fee per byte, but larger transaction pays more total.

Fee Optimization

How to reduce fees:

1. Use SegWit:

Addresses starting with "bc1"
Signatures separated (witness data)
Smaller transactions = lower fees
Can save 30-40%

2. Combine UTXOs:

Fewer inputs generally = smaller transaction
But be careful: many small UTXOs can be expensive to spend
Balance number of UTXOs

3. Avoid very small outputs:

Small outputs increase transaction size
Consider sending larger amounts at once

4. Choose low traffic times:

Weekends may have lower fees
Peak hours have higher fees

Mempool and Fees

Mempool is the "queue" of transactions waiting for confirmation:

How it works:

Transactions are sent to mempool
Miners choose which to include in next block
Usually prioritize transactions with higher fee (sat/vB)
Transactions with very low fee may wait long time

Strategies:

High fee: Confirms in ~10 minutes
Medium fee: Confirms in 1-3 hours
Low fee: May wait hours or days

During congestion:

Many transactions competing
Fees increase
Low fee transactions may get "stuck"

Complete Example: Tracking a Transaction

Let's follow a complete transaction from start to finish:

Initial Situation

UTXO state:

Robert has:
- UTXO 1: 0.8 BTC (from transaction ABC123)
- UTXO 2: 0.5 BTC (from transaction DEF456)
Robert's total: 1.3 BTC

Transaction to Be Created

Objective: Robert wants to send 1.0 BTC to Juliana

Challenge: No individual UTXO has 1.0 BTC, so needs to combine

Transaction Creation

Robert's wallet creates transaction:

Transaction GHI789
├── Version: 2
├── Inputs
│   ├── Input 0:
│   │   ├── previous_output: {
│   │   │   hash: "abc123...",
│   │   │   index: 0
│   │   │   },
│   │   └── script_sig: "[Robert's signature for UTXO 1]"
│   └── Input 1:
│       ├── previous_output: {
│       │   hash: "def456...",
│       │   index: 0
│       │   },
│       └── script_sig: "[Robert's signature for UTXO 2]"
├── Outputs
│   ├── Output 0:
│   │   ├── value: 100000000 (1.0 BTC in satoshis)
│   │   └── script_pubkey: "[Juliana's address]"
│   └── Output 1:
│       ├── value: 29999000 (0.29999 BTC in satoshis - change)
│       └── script_pubkey: "[Robert's address]"
├── Locktime: 0
└── Implicit fee: 0.00001 BTC (1.3 - 1.0 - 0.29999)

Transaction Validation

Bitcoin nodes verify:

Verify inputs:
- UTXO 1 exists? ✓
- UTXO 2 exists? ✓
- Already spent? ✗ (no, they're available)
Verify signatures:
- Input 0 signature valid? ✓
- Input 1 signature valid? ✓
- Robert controls both UTXOs? ✓
Verify values:
- Total inputs: 0.8 + 0.5 = 1.3 BTC ✓
- Total outputs: 1.0 + 0.29999 = 1.29999 BTC ✓
- Fee: 1.3 - 1.29999 = 0.00001 BTC ✓
- Fee > 0? ✓
Verify scripts:
- Locking scripts valid? ✓
- Unlocking scripts correct? ✓

Result: Transaction valid! ✓

Broadcast and Mempool

Transaction is sent to network:

Robert sends transaction GHI789 to nearby nodes
Nodes verify (as above)
If valid, propagate to other nodes
Transaction enters mempool
Miners see transaction

In mempool:

Fee: 0.00001 BTC
Size: ~500 bytes
Fee per byte: ~20 sat/vB
Priority: Medium-High (depending on congestion)

Mining and Confirmation

Miner chooses to include transaction:

Miner sees transaction in mempool
Fee is acceptable (20 sat/vB)
Includes in block being mined

Block is mined:

Block #800,000 contains transaction GHI789
Block is added to blockchain
Transaction receives first confirmation

State After Confirmation

Old UTXOs:

UTXO 1 (0.8 BTC) from Robert: ❌ SPENT
UTXO 2 (0.5 BTC) from Robert: ❌ SPENT

New UTXOs created:

UTXO 3 (1.0 BTC) for Juliana: ✅ AVAILABLE
UTXO 4 (0.29999 BTC) for Robert (change): ✅ AVAILABLE

Updated balance:

Robert: 0.29999 BTC (change)
Juliana: 1.0 BTC (received)

Reading Transactions on Blockchain Explorer

What to Look For

When viewing a transaction on explorer:

1. Transaction ID/Hash:

Unique identifier
Example: abc123def456...

2. Inputs:

How many UTXOs are being spent
Value of each input
Source addresses

3. Outputs:

How many new UTXOs are being created
Value of each output
Destination addresses

4. Fee:

Total paid in fee
Fee per byte (if shown)

5. Confirmations:

How many blocks since transaction
More confirmations = more secure

Example: Interpreting a Transaction

Transaction on explorer:

Transaction: 7a8b9c1d2e3f...
Status: Confirmed (6 confirmations)

Inputs:
├── 0.5 BTC from 1A1zP1eP5QGefi2DMPTfTL5SLmv7DivfNa
└── 0.3 BTC from 1BvBMSEYstWetqTFn5Au4m4GFg7xJaNVN2

Outputs:
├── 0.7 BTC to 1C4hvzGJdqkUqXx...
└── 0.099 BTC to 1A1zP1eP5QGefi2DMPTfTL5SLmv7DivfNa

Fee: 0.001 BTC
Size: 374 bytes

Interpretation:

Someone combined two UTXOs (0.5 + 0.3 = 0.8 BTC)
Sent 0.7 BTC to someone
Received 0.099 BTC change (same address as first input)
Paid 0.001 BTC fee
Transaction is confirmed (secure)

Frequently Asked Questions

Why does Bitcoin use UTXO instead of accounts?

UTXO allows:

Better privacy (each transaction can use new addresses)
Greater parallelism (multiple transactions can be processed simultaneously)
Simpler verification (don't need to check entire history)
Better origin tracking

What happens if I send more than I have?

Transaction will be rejected. Nodes verify that:

Sum of inputs ≥ sum of outputs
All UTXOs exist and haven't been spent
You have permission to spend (valid signature)

Can I cancel a transaction?

No, after sent and confirmed, it cannot be canceled. Before confirmation, you can try:

Replace-by-Fee (RBF): Send new transaction with higher fee
Child Pays for Parent (CPFP): Create child transaction that pays higher fee

Why do fees vary so much?

Fees depend on:

Network congestion (many transactions = higher fees)
Your transaction size (more inputs/outputs = larger)
Urgency (higher fee = faster confirmation)

What is dust?

Dust are very small outputs (usually < 546 satoshis) that aren't worth spending because fee would be higher than value. Many wallets don't create dust outputs.

Conclusion

Now you understand how Bitcoin transactions work in practice. The main concepts are:

UTXOs are "unspent coins" - different system from bank accounts
Inputs spend previous UTXOs - reference past transactions
Outputs create new UTXOs - specify destination and value
Signatures prove ownership - without revealing private key
Fees are the difference - between inputs and outputs, based on size

Understanding Bitcoin transactions gives you power to:

Verify transactions manually
Optimize fees
Understand why some transactions are more expensive
Improve privacy
Debug problems

Continue exploring transactions on blockchain explorer. The more you practice, the more intuitive it becomes. The UTXO system may seem complex initially, but it's an elegant solution that enables a truly decentralized financial system.