The Varkud satellite ribozyme catalyses site-specific RNA cleavage and ligation, and serves as an important model system to understand RNA catalysis. Here, we combine stereospecific phosphorothioate substitution, precision nucleobase mutation and linear free-energy relationship measurements with molecular dynamics, molecular solvation theory and ab initio quantum mechanical/molecular mechanical free-energy simulations to gain insight into the catalysis. Through this confluence of theory and experiment, we unify the existing body of structural and functional data to unveil the catalytic mechanism in unprecedented detail, including the degree of proton transfer in the transition state. Further, we provide evidence for a critical Mg2+ in the active site that interacts with the scissile phosphate and anchors the general base guanine in position for nucleophile activation. This novel role for Mg2+ adds to the diversity of known catalytic RNA strategies and unifies functional features observed in the Varkud satellite, hairpin and hammerhead ribozyme classes.