/>iOn May 12, 2025, the Centers for Medicare & Medicaid Services (CMS) issued a proposed rule that would impose an additional requirement to federal Medicaid regulations in order for non-broad-based and uniform health care-related taxes to be allowed as a means of state financing of Medicaid services—a common strategy to increase provider reimbursement using primarily federal funds without a significant impact on state budgets.
According to CMS, the new requirement would disqualify eight current health care-related tax programs in seven states and would preclude additional tax programs that cannot meet the new requirement. The proposed rule represents just the latest action taken by the federal government to curtail funding mechanisms states use to maximize federal contributions it perceives as inappropriate and to curtail federal outlays for state Medicaid programs.
Background on Health Care-Related Taxes
State-administered Medicaid programs are jointly financed by the federal and state governments. States make payments for services, and the federal government then provides matching funds based on a specific formula that varies by state, eligibility group, and expenditure category. The federal government’s share, known as the federal financial participation (FFP) of a state’s Medicaid expenditures for services used by people other than non-disabled adults is at least 50 percent but can be higher for states with lower average per capita income (as high as 77 percent for one state in federal Fiscal Year 2026). Federal law similarly sets a minimum state contribution of 40 percent to the non-federal share for health care services, with states allowed to use other funds, including health care-related taxes, to raise the remaining 60 percent of the non-federal share. CMS had emphasized that a state’s responsibility for a substantial portion of the non-federal Medicaid program expenditures incentivizes the state to monitor and operate its program competently and efficiently.
States may finance their non-federal share through their general funds, revenue from health care-related taxes, provider-related donations, intergovernmental transfers from units of state or local governments, and certified public expenditures. Health care-related taxes are frequently used to fund the non-federal share of Medicaid expenditures to hospitals, nursing homes, and other providers under supplemental payment and directed payment programs that offset low Medicaid base rates or address federal and state policy goals, such as offsetting uncompensated care costs. In order to qualify for a matching FFP, health care-related taxes must meet certain regulatory requirements. These requirements are largely aimed at ensuring that such taxes are not derived to an inappropriate extent from the very taxpayers—such as health care providers with high Medicaid volumes—that benefit from the increased Medicaid reimbursement financed by those taxes. To the extent that nearly all impacted taxpayers receive Medicaid reimbursement that exceeds the taxes they pay to fund the non-federal share, the federal government is effectively financing as much as 100 percent of the Medicaid expenditures supported by the tax program, with little or no state contribution.
Under current regulations, health care-related taxes may be imposed on certain permissible classes of items or services, such as inpatient hospital services, outpatient hospital services, and nursing facility services. The taxes must be broad-based (i.e., imposed on all non-governmental providers in the permissible class) and uniform (i.e., the same amount or rate of tax must be applied across the permissible class), and may not have provisions that directly or indirectly guarantee to hold taxpayers harmless for all or any portion of the tax amount through increased reimbursement. For state tax programs that are not broad-based and uniform under these requirements, states may obtain a waiver from those two requirements if the net impact of the tax is nevertheless “generally redistributive.” CMS has historically interpreted “generally redistributive” to mean “the tendency of a State’s tax and payment program to derive revenues from taxes imposed on non-Medicaid services in a class and to use these revenues as the State’s share of Medicaid payments.”
Current Statistical Tests to Determine Whether a Tax Is “Generally Redistributive”
Federal regulations currently use statistical tests to determine whether a non-broad-based or non-uniform state tax program is “generally redistributive.” The so-called “P1/P2 test” is used to evaluate a tax that is not broad-based because it excludes certain providers in the permissible class, and the so-called “B1/B2” test is used to evaluate a tax that is non-uniform because it applies different rates to different tax rate groups of providers within the permissible class.
Under the P1/P2 test, the proportion of tax revenue applicable to Medicaid if the tax were broad-based and applied to all providers or activities within the class (P1) is divided by the proportion of the tax revenue applicable to Medicaid under the tax program for which the state seeks a waiver (P2). Although there are some exceptions, generally, this quotient must be at least 1 in order for a non-broad-based tax to be regarded as “generally redistributive.”
The B1/B2 test compares the slope of two linear regressions that measure the relationship between providers’ additional Medicaid units (i.e., the units that are subject to the tax, such as Medicaid bed-days, charges, or revenue) and the taxes they pay. The slope derived from the first linear regression (B1) shows the rate at which taxes increase with each additional Medicaid unit if the tax were broad-based and uniform. The slope derived from the second linear regression (B2) shows the rate at which taxes increase for each additional Medicaid unit for the tax program for which a waiver is sought. With certain exceptions, generally, if the B1/B2 quotient is at least 1, the non-uniform tax will be regarded as “generally redistributive.”
Perceived Loophole in Statistical Tests
In the proposed rule, CMS expresses concern that some states have been utilizing tax structures that are not sufficiently redistributive, even though they pass the B1/B2 test. In particular, CMS says that states have been able to manipulate B2 by selectively excluding a few large providers with high Medicaid utilization from a health care-related tax, but including them in the regression calculation, which then alters the slope of the line of the regression in a way that allows the state to pass the statistical test while simultaneously imposing outsized burden on the Medicaid program. CMS also identifies other means by which states have undermined the B1/B2 test, such as by imposing tax rates on Medicaid-taxable units that are much higher than comparable commercial taxable units.
CMS indicates that it is aware of seven states with eight tax programs that exploit the statistical loophole under the B1/B2 test. CMS reports that, in connection with some of the recently approved waivers for tax programs that exploit the statistical loophole, it has advised states of its concern, including through “companion letters” explaining why CMS believed that the tax programs did not meet the spirit of the law, and warning the states that it was contemplating rulemaking to address its concerns. CMS estimates that the current total annual tax collection by the programs that exploit the statistical loophole is approximately $23.6 billion, but also expresses concern about the potential proliferation of additional programs.
In a press release announcing the proposed rule, CMS identified California, Michigan, Massachusetts, and New York as among the seven states with tax programs it regards as problematic. In a fact sheet it released, CMS asserts that these seven states impose higher taxes primarily on the Medicaid business of managed care organizations (MCOs), although one such tax is on hospitals. CMS also claims in its fact sheet that these tax programs free up state money that is used for other purposes, pointing specifically to California’s funding to expand health care coverage for illegal immigrants.
Proposed Regulatory Changes
To address the statistical loophole, CMS proposes to add an additional requirement to demonstrate that a health care-related tax is generally redistributive. To obtain a waiver from the broad-based or uniform requirements, the tax would still have to meet the applicable statistical test described above, but under the proposed rule, it would also have to meet the additional requirement.
The additional requirement is applied to each permissible class and includes provisions that test both those taxes that refer to Medicaid explicitly and those that do not refer to Medicaid explicitly, furnishing examples illustrating the application of the new requirement. For taxes that refer to Medicaid explicitly, CMS proposes that a tax would not be generally redistributive if the tax rate imposed on any taxpayer or tax rate group based upon its Medicaid taxable units is higher than the tax rate imposed on any taxpayer or tax rate group based upon its non-Medicaid taxable units.
CMS’s example of a non-redistributive tax that would violate this requirement is an MCO tax where Medicaid member-months are taxed $200 per member-month and non-Medicaid member-months are taxed $20 per member-month. In addition, for taxes that do not refer to Medicaid explicitly, CMS proposes that a tax would not be generally redistributive if the tax rate imposed on any taxpayer or tax rate group explicitly defined by its relatively lower volume or percentage of Medicaid taxable units is lower than the tax rate imposed on any other taxpayer or tax rate group defined by its relatively higher volume or percentage of Medicaid taxable units.
One example of a program not meeting this requirement is a tax on nursing facilities with more than 40 Medicaid-paid bed-days of $200 per bed-day, while nursing facilities with 40 or fewer Medicaid-paid bed-days are taxed $20 per bed-day. A second example describes a tax on hospitals with less than 5 percent Medicaid utilization at 2 percent of net patient service revenue for inpatient hospital services, while all other hospitals are taxed at 4 percent of net patient service revenue for inpatient hospital services.
For taxes that do not refer to Medicaid explicitly, CMS proposes that if the state tax program uses a substitute definition, measure, attribute, or the like as a proxy for Medicaid in order to impose a higher tax rate on Medicaid taxable units than on non-Medicaid taxable units, then the program would not be generally redistributive.
CMS articulates two examples of such non-compliant programs. The first example describes a tax on inpatient hospital service discharges that imposes a $10 rate per discharge associated with beneficiaries covered by a joint federal and state health care program and a $5 rate per discharge associated with individuals not covered by a joint federal and state health care program—without using the term Medicaid. The second example specifies that a tax on hospitals located in counties with an average income less than 230 percent of the federal poverty level of $10 per inpatient hospital discharge, while hospitals in all other counties are taxed at $5 per inpatient hospital discharge—which CMS says would be redistributive because a higher tax rate would be imposed on the tax rate group that is likely to involve more Medicaid taxable units, due to the use of a Medicaid eligibility criterion (income) to distinguish the tax rate groups.
Given that the new requirement would disqualify some existing health care-related tax programs, CMS proposes a transition period, but only for those states that did not obtain their health care-related tax waiver within a two-year cutoff period. States that did obtain the waiver within the last two years of the effective date of the final rule would not be eligible for the transition period, and any tax collections made under the applicable waiver after the effective date of the final regulations would not count toward the FFP match. States that obtained a waiver more than two years before the effective date would need to submit a new waiver proposal for a tax that meets the new requirement, with an effective date no later than the start of the first state fiscal year beginning at least one year from the effective date of the final regulations. CMS explains that states with more recently approved waivers are not entitled to a transition period because they were on notice regarding CMS’s concerns about the statistical loophole and therefore assumed the risk that CMS would issue corrective regulations. Despite the specifics of its transition proposal, CMS solicits comments on several aspects, including the length of the transition period, whether the two-year cutoff for transition period eligibility should be altered, and whether the transition period lengths should vary by permissible class.
Analysis and Recommendations
Although the proposed rule would affect health care-related tax programs in only seven states, it would also limit the flexibility of all states to design new programs to fund the non-federal share of Medicaid expenditures. The inability to design programs that comply with federal regulatory requirements may prevent states from adequately reimbursing health care providers for their services and jeopardize some health care providers’ sustainability.
Health care providers, individually or in concert with their trade associations, should consider providing input on the proposed rule. This is particularly true for providers in the seven states with health care-related tax programs that would be disqualified, although providers in other states could also be affected by their states’ inability to design new health care-related taxes that are permissible under current regulations. CMS will accept public comments until July 14, 2025.
Health care providers in the seven states with health care-related tax programs that would be disqualified by the proposed rule should also begin working with their state Medicaid agencies in designing adjustments to the tax programs that would enable them to meet the new requirement. Health care providers in other states should be cognizant of the proposed new requirement as they evaluate future health care-related tax proposals in their states.
Further, the proposed rule comes at a time when Congress is considering, through a budget reconciliation bill, significant cuts in Medicaid spending through work requirements, eligibility testing, a moratorium on all new health care-related taxes, and other means. The budget reconciliation bill that passed the House of Representatives on May 22, 2025, also includes provisions aimed at closing the statistical loophole that is the subject of the proposed rule. At a time when states and Medicaid providers face the possibility of severe reductions in Medicaid funding, closing the loophole, whether by statute or regulation, will make it more difficult for states to maintain or initiate certain tax programs needed to support their Medicaid programs and could therefore jeopardize funding for Medicaid services in those states. Medicaid providers will need to plan for the potential reductions in Medicaid funding, not only from those that may arise from the proposed rule, but also from Congressional action.
Medicaid providers should also continue to be vigilant in evaluating the financing mechanisms used to fund the non-federal share of expenditures under Medicaid programs in which they participate. The proposed rule represents just the latest action in CMS’s attempts to suppress arrangements used to finance the non-federal share of Medicaid expenditures that CMS considers inappropriate cost-shifting to the federal government.
For example, in February 2023, CMS issued an Informational Bulletin asserting that private redistribution arrangements among taxpayers violate the “hold harmless” restriction in the health care-related tax regulations and stating that CMS intends to investigate potential redistribution arrangements. (In a March 2024 Informational Bulletin, CMS said that, until January 1, 2028, it will not take enforcement action against states that have such arrangements in place as of the date of the Informational Bulletin.) Previously, in 2019, CMS issued a proposed Medicaid Fiscal Accountability Regulation (MFAR) that would have significantly tightened regulations concerning health care-related taxes (including addressing the statistical loophole), bona fide provider donations, intergovernmental transfers, and certified public expenditures. The MFAR was withdrawn in 2021, but CMS’s concern about inappropriate state financing arrangements has continued. In 2016, CMS disallowed the FFP for supplemental Medicaid payments made to certain private hospitals in Texas based on the state’s use of allegedly improper provider donations to fund the non-federal share of those expenditures. The state is challenging that disallowance in a federal court case that is still pending. Because a disallowance could lead to a recoupment of Medicaid reimbursement by the state, and because involvement in an improper arrangement to fund the non-federal share of a state’s Medicaid expenditure could lead to False Claims Act allegations, providers need to carefully evaluate the financing mechanisms used to fund such expenditures.
