How does the royalty system work for iTunes, etc.?

By-the-download. From CD Baby's digital distribution FAQ:

Every company is different, but the average is 60 cents per song downloaded, $6.50 per full-album download, and up to 1 cent (yep, some companies pay fractions of a cent) per listen or stream (when people listen to your song as if on a radio station, but don't download or buy it).

Different services pay differently--some pay the mechanicals (that's the songwriting royalties) directly to the writers, others include it in their check to the label and the label then includes it in mechanical payments it makes. But as with anything, they're required to pay the flat satutory rate, 8.5 cents per song in the US, unless some separate arrangement has been reached. I assume mechanical licenses acquired by the label carry over to digital downloads, but I sort of consciously avoided getting too involved in that.

Mike's giving you the artist royalty rate, not the mechanical/songwriting rate.

Just to be clear about this... let's use this "for instance":

Are you saying that when I download "Radio Radio" by Elvis Costello from iTunes for 99c, that 8.5 cents are due to Elvis as the songwriter plus 60 cents due to Elvis Costello & the Attractions (as performers, split between themselves or not according to the group's internal arrangement)? And that means that the remaining 30.5 cents split between iTunes and whichever label owns the recording?

as if!
http://www.musicbizacademy.com/articles/dl_newmedia.htm

Wow--thanks for the info!

Yes, thanks. I didn't think those numbers could possibly be right. So a better breakdown for the above example would be more like:

99c
-> 34.0c to Apple
-> 08.5c to songwriter
-> 08.8c to artist
-> 02.2c to producer
leaving
-> 45.5c to label.

Wow!