CMS proposes rule to curb Medicaid provider tax loophole

CMS is targeting a “loophole” in Medicaid provider taxes with changes it says would reduce Medicaid funding by $52 billion over the next five years.

The May 12 proposed rule from CMS would create new limits on how states use provider taxes to finance their share of Medicaid. It targets the mechanism states use to evaluate whether a tax is “generally redistributive.” CMS said seven states, so far, have designed their provider taxes to comply with the letter of the law while circumventing its intent.

Central to the proposed rule is a restriction on states’ ability to use differential provider tax rates and exemptions, applying to both existing and future arrangements, said Morgan Craven, a director at ATI Advisory.

“This would be especially impactful in states that rely heavily on non-uniform, non-broad-based tax structures that have required CMS waivers,” she said.

Among the seven states currently using the practice, CMS called out are California, Michigan, Massachusetts and New York. Those states have used tiered hospital taxes and heavier taxes on Medicaid managed care organizations’ (MCO) structures, many of which have deviated from federal requirements and have historically required CMS waiver approvals, Craven said.

“States are gaming the system—creating complex tax schemes that shift their responsibility to invest in Medicaid and rob federal taxpayers,” Mehmet Oz, MD, administrator of CMS, said in a release. “This proposed rule stops the shell game and ensures federal Medicaid dollars go where they’re needed most—to pay for health care for vulnerable Americans who rely on this program, not to plug state budget holes or bankroll benefits for noncitizens.”

CMS said such funding arrangements allow states to benefit from a budget surplus to reinvest in unrelated programs — including the $8.5 billion program in California to cover more than 1.6 million illegal immigrants and other non-citizens.

Effect of the rule

“While many note that the rule aligns with longstanding statutory principles (uniformity, broad-based tests, hold-harmless), the practical effect would be significant, as it would meaningfully alter or disrupt Medicaid financing strategies in states that have long relied on previously approved provider tax waivers,” Craven said.

Based on existing and expected use of the approach targeted by the rule, CMS projected savings from the rule changes from 2026 to 2030 of:

• $33.2 billion in federal Medicaid spending
• $18.8 billion in state spending

The proposed rule said it would target seven states with eight Medicaid funding arrangements, including seven with MCO provider taxes and one with a hospital provider tax.

However, MCO tax waivers often generate revenue that funds hospital-directed payments, Craven said.

“Although only one waiver is explicitly hospital tax–focused, many MCO tax waivers effectively support hospital payment structures through the managed care rate-setting process,” Craven said.

The provider taxes are paired with state-directed payments (SDPs) to fund the non-federal share of Medicaid funding. That allows states to enhance provider reimbursement without increasing state general fund spending, she said.

The proposed rule comes as Congress is advancing a budget reconciliation package that also targets a stricter definition of generally redistributive with respect to tax payments, referring to criteria used to ensure taxes assessed on providers or Medicaid MCOs aren’t linked to their Medicaid revenue (any such arrangement is generally impermissible, according to longstanding statutory language). The bill also would create tighter limits on rates used in SDPs and bar new or increased Medicaid provider taxes.

“While debate over these structures is not new, we’re seeing a convergence of interest across both regulatory and legislative fronts — through this proposed rule and the Medicaid financing provisions in the House reconciliation bill,” Craven said. “Given this dual focus, further federal action in this space seems likely in the near term.”

Why proposed now

The targeting of Medicaid provider taxes comes as states increasingly have come to rely on them to fund their portion of Medicaid’s joint federal-state funding structure.

The taxes of 19 provider classes — such as hospitals and MCOs — have been adopted by every state, except Alaska. Provider taxes on hospitals and nursing facilities will allow states to collect at least $83.7 billion in federal funding for their Medicaid programs in FY26, according to one projection.

CMS says states have been manipulating a test that aims to prevent abuse of provider taxes.

Previously, the Bush and Obama administrations had targeted provider taxes, but Congress rejected those proposals. A broader range of provider tax reforms were proposed in the first Trump administration, but the Biden administration withdrew them before they were implemented.

CMS explicitly framed the change as preserving Medicaid for its traditional beneficiaries and preventing states from using it to allow them to fund other spending, such as coverage for illegal immigrants.

“Some states have exploited these tax loopholes to take money from federal taxpayers and then simultaneously spent ‘state’ money on new benefits for illegal immigrants,” said a CMS release. “This regulatory move is projected to save taxpayers more than $30 billion over five years and continues CMS’ work in ensuring this vital safety net continues to be available for the country’s most vulnerable populations in the future.”

As of April 2025, seven states (California, Colorado, Illinois, Minnesota, New York, Oregon, Washington) plus D.C. have also expanded fully state-funded coverage to some income-eligible adults regardless of immigration status, according to a KFF analysis.

In one of those states, California, the governor recently proposed (subscription required) scaling back coverage for 1.6 million undocumented immigrants. The change was projected to save the state $6.5 billion by the FY28-FY29 fiscal year and help close a $12 billion budget deficit.