CMS Final Rule Closes Medicaid Loophole

The Centers for Medicare & Medicaid Services (CMS) finalized a Medicaid rule, last week, which closes an especially egregious loophole that allowed states to extract additional federal funding through Medicaid provider taxes. The rule – which we supported in a comment letter, reinforces and implements a provision of the One Big Beautiful Bill Act (OBBBA). The Congressional Budget Office (CBO) estimates this provision will save $35 billion through Fiscal Year (FY) 2034. CMS estimates the provision will save $78 billion (in 2027 dollars) through FY 2036 in their base scenario, and nearly $313 billion compared to a scenario where exploitation of the loophole continues and proliferates across more states.

Under the Medicaid program, the federal government helps finance state health care spending with a matching rate calculated based on the Federal Medical Assistance Percentage (FMAP). As we’ve shown before, states are able to inflate this federal match by applying a tax to health care providers and using that revenue to increase (federally matched) payments made to those very same providers. Prior to OBBBA, the use of these provider taxes had become increasingly common and costly, with certain rules in place to limit provider taxes from being too large or too direct of a quid-pro-quo.

The Preserving Medicaid Funding for Vulnerable Populations-Closing a Health Care-Related Tax Loophole rule closes a particularly egregious loophole that has allowed several states to get around the requirement that provider taxes redistribute Medicaid funds to a range of providers, not just the ones that paid the tax. Currently, CMS uses a statistical test to determine the validity of provider taxes, but the test is vulnerable to outliers. States have taken advantage of this vulnerability by levying extremely high taxes on Medicaid services relative to non-Medicaid services.

For example, California taxes Medicaid services at a rate over 100 times higher than non-Medicaid services. California then uses the tax revenue to pay the same Medicaid service providers, payments that are matched with federal funds. As a second example, CMS found that in another unnamed state, Medicaid services make up about 50% of the taxable services but bear over 94% of the tax burden.

Although this practice is not yet widespread, CMS has already identified seven states whose provider taxes exploit this loophole. CMS believes that without action, more states would have joined these seven, and the existing seven would look to raise even higher revenues from their provider taxes.

To shut down this practice, CMS’ newly finalized rule adds additional criteria to its statistical test that identify and disallow these state provider taxes. This rule implements and reinforces legislative language closing this loophole under OBBBA. As we explained in our comment letter, this would make it significantly more difficult for states to implement provider taxes that disproportionately impact Medicaid providers. Crucially, the rule requires that states with these tax schemes in place fully reverse them, even if they were previously approved by CMS.

Closing this loophole will work in conjunction with other reforms passed in OBBBA that curtail the use of provider taxes and state-directed payments (SDPs), and will help prevent states from unfairly drawing down extra federal funding far beyond what is envisioned under their FMAP match. In total, CBO estimated OBBBA’s Medicaid financing scheme provisions will save the federal government nearly $370 billion through FY 2034. CMS’ estimates would likely be far higher.

CMS and Congress should be commended for closing this loophole and restricting states’ use of provider taxes. However, there is more work still to be done. Congress could go further to prevent states’ abuse of Medicaid financing gimmicks especially for nursing facilities and Medicaid non-expansion states, both of which were exempted from OBBBA provider tax limits. Closing these gaps could save tens of billions more. Over time, Congress could also consider fully phasing out provider taxes and addressing other financing schemes such as Intergovernmental Transfers (IGTs).

Policymakers have made strides to improve Medicaid financing and should use the momentum to continue reforming policies that shift costs to the federal government. With the high and rising cost of health care affecting all federal health programs, lawmakers should consider reforms that would help shore up the programs for years to come.