Of course, bitcoins will not be issued in banknotes. There is no point in this and in general it contradicts the ideas of Bitcoin. Why spend money printing banknotes?
ATMs are working very simply. You give the ATM paper money (dollars, euros, or other currencies that accept this ATM) and it transfers the bitcoins to the wallet address you specify. There are also ATMs with the help of which you can transfer Bitcoins from your Bitcoin wallet to fiat currency, which the ATM will issue to you.
There are different versions of ATMs that have different specifications.