CMS establishes tighter limits on the structure of Medicaid tax arrangements

Nearly seven months after passage of the legislation known as the One Big Beautiful Bill Act (OBBBA), finalized regulations from CMS apply additional constraints to the use of healthcare taxes as a Medicaid funding source.

A rule set for formal publication Feb. 2 is intended to create Medicaid savings in part by reducing the matching funds paid by the federal government. A handful of states have been using skewed tax arrangements to boost their Medicaid spending and thereby draw additional federal funds, according to CMS. They use those payments to compensate the Medicaid entities, including managed care organizations (MCOs) and providers, that paid the taxes.

The agency also said more states likely will soon try the same thing unless new restrictions are instituted.

“Over time, states have gradually shifted their Medicaid financing responsibility to federal taxpayers through gimmicks such as this,” CMS wrote in a news release, adding that the federal share of Medicaid financing rose from 57% to 64.5% between 2012 and 2024.

With the new rule, CMS is looking to close a technical loophole in the statistical model that factors into regulatory approval of tax arrangements. In 2024, tax structures capitalizing on the loophole caused Medicaid to bear roughly $8.7 billion more in tax-related burden across seven states than it would have if the arrangements had met statutory requirements, the final rule states.

As a result of the changes, CMS estimates reductions in Medicaid expenditures of $78.2 billion in federal spending and $46.9 billion in state spending over a 10-year budgetary window starting in 2027.

How the loophole affects Medicaid taxes

With the new rule, CMS is closing a loophole that the agency says seven states have used to generate additional funding. Specifically, the rule seeks to more enforce the generally redistributive criterion, which says states cannot levy higher taxes on Medicaid-focused business (e.g., by taxing one MCO or hospital at a higher rate than another based on Medicaid revenue, enrollment or volumes).

“Tax rates imposed on Medicaid-taxable units are often much higher, sometimes more than one hundred times higher, when compared with similar commercial taxable units,” CMS wrote in the rule.

CMS said the new rule would affect taxes on Medicaid MCOs in California, Massachusetts, Michigan and New York. An analysis by KFF reports that Illinois, Ohio and West Virginia appear to be among the group of states as well. MCO taxes are the biggest target of the new rule because they tend to diverge most drastically from the statutory guidelines.

One hospital tax and one skilled nursing facility tax among those states also would be subject to the new restrictions (CMS did not say which of the seven states have the two provider taxes in question). Stakeholders who gave feedback on the rule during the comment period suggested that CMS consider applying the new regulations to MCO taxes while refraining from stricter oversight on provider taxes, given the lower frequency and lesser severity of instances where the loophole is an issue.

“One of our guiding principles for addressing the loophole was to close it entirely,” the agency responded. “To exclude certain permissible classes from this policy would not achieve that goal.”

What the rule means for the Medicaid reimbursement landscape

Perhaps the most consequential part of the rule is that any future tax arrangement will not be approved unless the state seeking authorization demonstrates adherence with the tightened criteria.

The rule “would also limit the flexibility of all states to design new programs to fund the non-federal share of Medicaid expenditures,” according to a 2025 analysis by Epstein Becker Green about the proposed version of the rule. “The inability to design programs that comply with federal regulatory requirements may prevent states from adequately reimbursing healthcare providers for their services and jeopardize some healthcare providers’ sustainability.”

CMS lists examples of arrangements that would be impermissible under the new rule. For instance, states cannot vary the tax rate on hospitals depending on whether the Medicaid share of a hospital’s patient population is over a certain threshold. Nor can states circumvent the generally redistributive requirement by removing references to Medicaid in language about the arrangement (e.g., by instead referring to a “joint federal and state healthcare program”).

Examples of approaches that can still work under the regulations include taxing providers differently based on number of inpatient bed days. Such categorization can be authorized because it is not based on payer mix, CMS wrote.

The time frame for Medicaid entities to comply

Compliance timelines include the end of state FY28 for provider taxes. MCO taxes face a tighter deadline of Jan. 1, 2027, if they were approved within the last two years. Those that were approved more than two years ago have until the start of state FY27.

The timeline for the provider taxes is longer than what was stipulated in the proposed rule and represents one of the few accommodations CMS made in response to concerns expressed by stakeholders. Commenters “stated that without longer transition periods, states would be unable to revise their provider tax structures, resulting in reduced provider services and reduced access to care for beneficiaries,” according to a summary of the comments.

The OBBBA prohibits new or modified Medicaid tax arrangements unless submitted before July 4, 2025, and in FY28 starts phasing down the maximum amount that Medicaid entities can be taxed in expansion states. The new regulations potentially will affect how much revenue can be raised by grandfathered taxes before FY28, and commenters on the proposed rule said states could face challenges in amending their loophole taxes under the OBBBA limits.

Other OBBBA provisions mirror the newly finalized rule regarding the requirement for taxes to be generally redistributive. CMS issued the proposed version of the rule two months before the OBBBA became law, but the legislation makes the changes statutory.

Providers project an adverse impact

In comments on the proposed rule, healthcare stakeholders said the new regulations would reduce overall Medicaid funding and provider payments, with implications for safety-net hospitals, skilled nursing facilities and rural healthcare access.

“Provider participation in Medicaid would be impacted due to the unsustainable financial margins,” and services that could be especially affected include pediatric hospital care, maternal care, behavioral healthcare, and care for people with developmental disabilities, according to a summary of the comments. Another concern cited was the impact on state funding for Medicare graduate medical education.

In response, CMS emphasized that only a small subset of taxes is likely to need modifying.

“Nothing about this final rule changes the ability of a state to collect healthcare-related tax revenue and to use such revenue from permissible taxes as the non-federal share of Medicaid expenditures, or to make Medicaid payments at existing levels,” the agency wrote.

CMS added that it will “work closely with states to support the implementation process and maintain open communication with Medicaid directors, provider associations and managed care organizations to ensure compliance and minimize disruption.”