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The Decal Tool crushes your picture to a handful of colours, but before uploading it blends the result with a few "blend layer" PNGs it reads from scripts/items/custom_texture_blend_layers/ — a paper texture for the Objector, a guide for Flair!. Anything in tf/custom/<folder>/ overrides game files, so if your full-colour picture sits there under the layer's name, the tool blends your picture into the decal and uploads that. Everyone sees it.
That is why the picture must be exactly 128 × 128, why it must carry the exact file name, and why the game must be started after the file is in place. Transparent pixels come out black. The Objector also gets its small blood stains and wood grain drawn on top, as with any decal.
Clan Pride and the Photo Badge have no blend layer in the game's item definitions, so there is no file trick for them; the badge page still gives you a correctly sized picture, nothing more. Method documented by the community over the years — see the Colored Decals guide, the 2026 updated guide and the TF2 wiki. Template masks from the TF2 wiki (CC BY 3.0).