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As per Regulation EC No 810 of the EU (Schengen) Visa Code, an applicant must present proof of air travel and onward journey to the final destination to get a Schengen visa. In simpler terms, this is a draft (reserved but not purchased) flight reservation showing your round trip or plans of returning to your home country ('proof of onward travel').
You can use this tool to get a flight itinerary ('dummy tickets') that would suffice air travel requirements for your Schengen visa application, and the Atlys Hotel Reservations Tool to get evidence of proof of accommodation.
The EU (and Schengen) is the world's largest tourism market with a large influx of tourists from across the world, especially Asia & Americas. In order to sustain high levels of tourism, the Schengen countries are strict on ensuring that tourists do not settle in their countries illegally. Therefore, proof of air travel in the form of flight bookings (paid or otherwise) indicates that the applicant has plans to stay for a fixed duration in the Schengen states and intends to go back to their home country.
Additionally, it also serves as a bearing point to determine the length of your visa. Finally, embassies also use this to determine which country should be issuing you a Schengen visa. So, for instance, if you are going to Germany for ten days and Spain for three days, then based on your flight details, you can only apply for a Schengen visa to Germany (maximum length of stay). This evidence can also be used to determine if you are overstaying your stipulated stay in the Schengen countries.
You do not. The EU law code and Schengen embassies strongly advise you not to pay for flights until you get your visa. As per the Schengen embassies, they want to see evidence of reserved itineraries. However, there is no such thing as reserved anymore. You can't book a flight ticket without paying the full price for it. The Atlys tool is public - you can now use Atlys to get a flight itinerary ('dummy flight ticket') that would qualify as the evidence required for your visa. You'll get a roundtrip flight itinerary that fits your travel dates & travel plans. The itinerary consists of actual flight numbers, airports (IATA codes), timings, return tickets, and prices. The booking code/reservation number (also known as PNR) is an Atlys-specific code. In the rare event that the embassy wishes to confirm your tickets, there won't be any problems. You no longer have to take the risk of paying for flights without a visa on hand.
You can show evidence of all travel. However, the primary evidence that the Schengen embassies care about is air tickets to and from the Schengen area (and not within).
As per EU law, you only need to show a sample itinerary. In addition, the embassies cannot call the airline to confirm their reservation. However, your tickets should consist of actual flights. Embassies issuing you a visa believe that you will stick to a similar, if not the same, itinerary after you get the visa. For most applicants, the visa's duration is within the departure and return dates.
The Schengen visa application requires a travel itinerary, including airline tickets (dummy air tickets suffice), hotel bookings, travel insurance, cover letter, a confirmed visa interview appointment, and a filled Schengen application form.
You can find out about the full visa requirements here.
As per the Schengen code, you are supposed to get a draft flight itinerary. The itinerary generated by Atlys is reserved but not purchased. In earlier times, this is similar to a travel agency reserving your travel tickets & stay but not purchasing until you pay. By not paying for your flights and hotels until you get your visa approved, you can avoid heavy cancellation fees.