Bill Hammond of the Empire Center (a New York-focused think tank) has brought much-needed attention to a budget gimmick the federal government approved late in 2023 for California’s Medicaid program that will send $19.4 billion in additional federal funds to the state over four years. The maneuver is such a glaring example of Medicaid’s flawed financing rules that the details deserve additional scrutiny.

Under federal law, states administer Medicaid and then bill the federal government for a portion of what they spend. The federal share is usually determined by the standard federal medical assistance percentage (FMAP) formula, which is 50 percent for California. The federal government pays higher, non-standard FMAPs for some services and populations in all of the states including 90 percent for the Affordable Care Act’s Medicaid expansion. On average, the federal government pays for about 65 percent of total Medicaid spending.

Beginning in the 1980s, states figured out that provider-focused taxes allowed them to push more costs onto the federal budget. States use the revenue from these taxes to pay higher Medicaid fees to the affected providers or insurers, which leaves them no worse off while also triggering more federal matching funds. The net effect is cost neutrality for the providers and insurers (in the simplest formulations of the maneuver), higher Medicaid spending for the federal government, and lower Medicaid costs for the states.

In the early 1990s, both Congress and the agency administering Medicaid (then known as the Health Care Financing Administration and later renamed the Centers for Medicare and Medicaid Services, or CMS) took steps to curtail these abuses without eliminating them altogether. CMS still uses the rules written at that time to block the most blatant shell games. In general, the taxes states use for Medicaid are supposed to be general in nature and not written to specifically target providers of services or insurers based on their Medicaid revenue.

For several years prior to 2023, California imposed a monthly per capita fee on insurance enrollment in managed care organizations, or MCOs. In the state’s 2022-2023 fiscal year, the tax was $55.00. For 2023-2024, the state legislature agreed to more than triple it, to $182.50.

The MCO tax does apply to enrollees in non-Medicaid coverage but is much lower ($1.75 per month in 2023-2024).

In a release announcing the tax, the state reassured insurers that its plan would not put a dent in their bottom lines because it also “[i]ncreases the rates the state pays to Medi-Cal managed care plans” and thus “there is no impact”.

CMS’s current rules would seem to disallow taxes such as the one designed by California because it is “non-uniform,” meaning it applies a differential rate based on a measure of Medicaid participation. However, the rules also allow for a waiver if the state can pass a statistical test designed to screen out egregious cases. The test is based on the ratio of two coefficients calculated in least squares linear regression equations examining the relationship between the taxes owed by the affected providers and the degree of their Medicaid involvement. One equation looks at the taxes owed if the tax in question was broad-based and not Medicaid-specific (B1); the other (B2) uses the actual taxes owed by the affected entities based on the tax as approved by the state. CMS approves waivers of non-uniform taxes if this statistical test shows the relationship between taxes owed and Medicaid participation is stronger under the assumption of a uniform tax than with the taxes owed under the state plan. In other words, if B1 is greater than B2, the waiver is approved.

Based on the design of California’s MCO tax, one might have expected it to fail this test. However, CMS stated in a letter that it passed and was therefore approved through December 2026.

Without access to the actual data, it is not possible to know what manipulations allowed California to evade CMS’s rules. Some clues might be that the tax applies only to monthly MCO enrollment from 2022 instead of the actual enrollment levels in the applicable tax years, and additionally that the tax does not apply to monthly enrollment below 1,250,001 or above 4,000,000. There are also other unspecified “adjustments” that could affect tax liabilities and therefore also the statistical test used to assess its validity.

In approving California’s request, CMS said (in so many words) that it believes the MCO tax violates the spirit, if not the letter, of the current rules, and therefore the agency will try to block its extension beyond 2026. That may not be easy. Other states, including New York, want in on the game too. When states get used to receiving free federal money, they become reluctant to give it up.

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