How Congress Can Put a Stop to States’ Provider Tax Schemes in Medicaid and Save Billions

Overview  

The Medicaid program was originally designed to provide a safety net for truly needy Americans—including seniors, low-income children, and individuals with disabilities.¹ However, ObamaCare expansion opened the door to a new class of able-bodied adults, causing enrollment and spending on the program to skyrocket.² Restrictions on removing ineligible enrollees during and after the COVID-19 pandemic further spiked enrollment to a record-high 100 million in 2023.³

While Medicaid enrollment has declined somewhat as these pandemic-era restrictions on removing ineligible enrollees were rolled back, there are still 10 million more people enrolled in Medicaid today than there were before the pandemic.⁴ In fact, there are still 8.7 million more people on the program today than when government-imposed lockdowns spiked the national unemployment rate to nearly 15 percent.⁵

Skyrocketing enrollment has driven massive increases in spending. Federal Medicaid costs have grown by more than 60 percent since 2019 and are on track to reach more than $1 trillion per year in the next decade.^6-8 Federal spending on Medicaid is now expected to top $8.6 trillion over the next 10 years.⁹

Medicaid was established as a state-federal partnership, in which the state runs the program and is responsible for a percentage of costs, and the federal government pays the remaining share of the costs.¹⁰ The split is determined by the federal medical assistance percentage (FMAP) formula, which is based on a state’s per capita income compared to the national average.¹¹ The formula is supposed to ensure that lower-income states get a larger share of federal funding compared to higher-income states.¹²

If a state has a 50 percent FMAP, $1 of state spending on Medicaid yields an additional $1 of federal matching funds. If a state has a 75 percent FMAP, $1 of state spending results in $3 in federal matching funds. This open-ended structure gives states an incentive to increase their Medicaid spending at the expense of other budget priorities, because Medicaid spending can yield an essentially unlimited federal match.¹³

The federal portion of Medicaid expenses has risen substantially in recent years. Between 2000 and 2013, federal taxpayers covered roughly 57 percent of Medicaid costs on average.¹⁴ By 2023, the federal share of Medicaid costs had risen to 69 percent, largely driven by the 90 percent FMAP for able-bodied adults enrolled through ObamaCare expansion.^15-16

However, despite this structure that already requires the federal government to fund a large share of Medicaid, states are using provider tax schemes to shift even more of their costs to federal taxpayers.¹⁷ These provider tax arrangements contribute to surging Medicaid costs without benefiting the truly needy.

Provider tax schemes are used to divert even more federal funding to states

Although states used to finance virtually all of the state share of Medicaid costs through general funds (GF), they have increasingly shifted to other sources for the state share.^18-24 By 2024, nearly one-third of the “state” share was actually being financed through other, non-GF sources.²⁵

The primary source of these other funds states use to pay for their share of Medicaid costs is revenue raised from special taxes on health care providers such as hospitals and managed care organizations (MCOs), which most states pay to manage their Medicaid programs instead of paying providers directly.^26-27 These taxes are essentially money laundering, shifting funds between providers and states to make the federal government responsible for increased
Medicaid spending.²⁸

Provider taxes are used to some degree in nearly every state.²⁹ Under these arrangements, health care providers are charged a special tax or fee.³⁰ The revenue generated by the tax is used to pay the same providers for Medicaid services.³¹ The return of this money to health care providers is counted toward the state share of Medicaid spending, which entitles the state to more federal funding for Medicaid.³² Health care providers receive what they paid in these provider taxes back in Medicaid payments, and states generate additional revenue from federal matching funds.³³ This shifts the burden of the tax to the federal government and allows the state to retain the excess revenue for non-Medicaid purposes.³⁴

In theory, these provider taxes have statutory limits.³⁵ In 1986, the U.S. Department of Health and Human Services (HHS) began taking steps to block states from misusing provider taxes as state matching funds.³⁶ Auditors at HHS had discovered that provider taxes had simply “substituted existing state monies” in several states.³⁷ By 1988, Congress had imposed a temporary moratorium on HHS regulations that would crack down on the abuse.³⁸ In 1991, the Bush administration proposed regulations that would have excluded Medicaid costs funded by provider taxes from receiving the federal match, set to take effect after the moratorium expired.³⁹ Later that year, Congress passed legislation that specifically authorized states to use these provider taxes for state matching funds within certain limits.⁴⁰ Under these statutory limits, provider taxes must be broad-based, uniform, and not guarantee—either directly or indirectly—that the taxes will be repaid through Medicaid payments.⁴¹ However, federal law also provides a “safe harbor” for states, deeming provider taxes set at or below six percent of net patient revenue as permissible.^42-43 These requirements are also often waived, as federal law requires HHS to approve waivers of the statutory limits if it determines the proposed provider tax programs are “redistributive in nature.”^44-45

Ultimately, these money laundering schemes allow states to offset their portion of Medicaid costs with this special tax revenue.⁴⁶ Despite the statutory limits banning both direct and indirect guarantees, the safe harbor and waiver provisions have allowed providers who pay these taxes to receive all of the “taxes” they pay returned to them in the form of higher Medicaid payments.^47-48

This means federal taxpayers are paying a higher share of Medicaid costs than intended.⁴⁹

The increased reliance on provider taxes and contributions from hospitals and facilities run by local governments resulted in the effective FMAP increasing by an average of more than 5.4 points in 2018, with some states able to boost their effective FMAP by nearly 12 points.^50-51 For some supplemental payment programs within Medicaid, the provider tax scheme lets states raise their effective FMAP by a whopping 32 percentage points.⁵²

The cost of this financing gimmick is almost certainly higher today, as states’ non-GF Medicaid spending has exploded by more than 70 percent since 2018.^53-55

States admit provider tax schemes are designed to shift costs to federal taxpayers

States acknowledge that these financing gimmicks are designed to shift what should otherwise be state costs back onto federal taxpayers. State officials admitted to Government Accountability Office auditors, for example, that they use this money laundering to increase Medicaid spending “without risk of the state needing to contribute” state funds.⁵⁶ They elaborated that this allowed them to increase spending “when budget constraints limited their states’ use of state general revenue funds” to finance it.⁵⁷

In California, state budget officials admit that the tax generally has been used “solely to offset General Fund spending” on Medicaid.⁵⁸ Budget analysts for Missouri’s General Assembly acknowledge that these tax schemes are “used to offset General Revenue.”⁵⁹ New York legislators have been perhaps the most brazen in admitting the purpose of the state’s money laundering scheme.⁶⁰

“The MCO tax generates $4 billion in receipts from Managed Care plans. This revenue is to be used by the State to repay the tax obligation for each plan through their capitated rates. This repayment generates an additional $4 billion in federal funding to then be used by the State as the non-federal share of investments in the Medicaid program.”

As states acknowledge, these schemes are designed not to benefit the truly needy, but to shift more costs to federal taxpayers that would otherwise be paid for out of state general funds.

Tax schemes do not benefit the truly needy

This financing arrangement is not designed to protect the truly needy, but instead allows wealthy states to get an increased share of federal funding for large and bloated Medicaid programs and spend state tax dollars on other priorities.⁶¹

This financing scheme also encourages states to make large supplemental payments to the same hospitals that are paying provider taxes as another way to access more federal funding, which raises questions about the legitimacy of these payments.⁶² The Government Accountability Office found that 39 states made supplemental Medicaid payments to hospitals that exceeded their actual costs of providing Medicaid services by more than $2.7 billion.⁶³

California’s managed care organization tax is a particularly egregious example of this scheme. Despite the statutory requirement that provider taxes be “uniform,” California requires managed care organizations to pay a tax of $187.50 per month for Medicaid enrollees and $2 per month for non-Medicaid enrollees.⁶⁴ The state collects roughly $12.7 billion per year from MCOs for Medicaid enrollees, compared to just $27 million for commercial enrollees.⁶⁵ Because the entire cost of this tax is built into the capitated rates paid to Medicaid MCOs, this effectively serves as a $7.6 billion direct tax on the federal government, at the expense of taxpayers from all 50 states.⁶⁶ The state then uses the new federal revenue gained from the tax to further fund Medicaid services, which in turn generates more federal matching funds.⁶⁷

California can also use this money laundering—which essentially operates as a tax on the federal government—to fund special projects for which federal funding is specifically prohibited. Federal law prohibits states from using federal funding to provide Medicaid coverage to illegal aliens, for example, but California operates a “state-funded” program for these ineligible aliens, which now costs an alarming $9.5 billion per year.^68-69 Because California uses the laundered money to offset general fund costs, it can then dedicate general funds to pay for “state-funded” programs for illegal aliens.⁷⁰ The MCO tax on ObamaCare expansion enrollees also shifts the entire cost of expansion to federal taxpayers.^71-79 In total, California is projected to receive $119 billion in federal Medicaid funding next year, far more than any other state.⁸⁰

In the final days of the Biden presidency, HHS approved a similar MCO tax scheme in New York.⁸¹ Despite the federal requirement that these taxes be uniform, New York imposes a tax on MCOs of up to $126 per member per month for Medicaid enrollees, up to $13 per member per month for Basic Health Plan (BHP) enrollees, and up to $2 per member per month for commercial enrollees.⁸² The state collects roughly $2.7 billion per year from MCOs for Medicaid enrollees, another $100 million for BHP enrollees—an optional program states may offer to individuals who do not qualify for Medicaid—and just $76 million for commercial enrollees.⁸³

As in California, federal taxpayers bear the brunt of these taxes, creating a financial windfall for New York.⁸⁴ The state then uses the laundered money—gained from indirectly taxing the federal government—as the state share for Medicaid, generating even more federal matching funds. Like California, New York can then spend these funds on costs for which federal funding is expressly prohibited, such as its program for illegal aliens.⁸⁵ New York already receives $3,046 per resident in federal Medicaid funding, more than any other state.⁸⁶

These tax arrangements do not benefit the truly needy—those the Medicaid program was designed to help. They merely cycle money between providers and the state to pump as much federal revenue into the state as possible, at the expense of all federal taxpayers.

Congress should put a stop to provider tax schemes to save billions

For years, provider tax schemes have been under scrutiny due to their impact on federal Medicaid spending.⁸⁷ Presidents George W. Bush, Barack Obama, and Donald Trump all proposed cracking down on the abuse.⁸⁸ Congress briefly reduced the safe harbor for these provider tax schemes, but the temporary restrictions expired in 2011.⁸⁹

States’ efforts to deliberately create taxes that “generate” federal revenue have allowed the problem to fester. Congress must stop states from using these provider tax financing gimmicks that shift state costs on to federal taxpayers.

Option 1: Congress can prohibit provider tax revenue from being used for the state share of Medicaid

Provider taxes are abused to some degree in nearly every state.^90-91 Federal law provides a safe harbor for states adopting these taxes, deeming them permissible when the tax collected is six percent of net patient revenue or less.^92-93 But this safe harbor has allowed the money laundering scheme to grow exponentially over time. Congress could prohibit provider tax revenue from counting toward state Medicaid spending altogether. This would save $612 billion over the 2025-2034 budget window.⁹⁴

Option 2: Congress can reduce the provider tax safe harbor by one point per year until it is eliminated

This approach would phase in the elimination of provider taxes more gradually by reducing the allowable percentage of providers’ revenue that can be collected as a provider tax from six percent to zero over the course of six years. This would generate $462 billion in savings over 10 years.⁹⁵

Option 3: Congress could freeze the provider tax scam and gradually lower the safe harbor

Congress could explore a third option that would stop the provider tax abuse from growing in the short-term and gradually address it over the long term. For example, Congress could limit the amount of provider tax revenues states can use as state matching funds to the amount collected in 2024. This would stop states from creating new provider taxes or raising rates on existing taxes. This would grandfather existing taxes, but prevent the revenues states could use from those taxes from growing over time. In order to solve the issue long term, Congress could then gradually phase down the safe harbor over time. One option would be to begin phasing down the safe harbor in fiscal year 2028, such as by half of a percentage point per year, letting the safe harbor reach zero by 2039. This approach would allow states to continue using provider taxes already in place at the levels collected last year while preparing for a very gradual phase-out beginning in 2028. This option would save more than $280 billion.⁹⁶

The Bottom Line: Congress should put an end to Medicaid money laundering by stopping provider tax schemes that inflate federal Medicaid spending.

The Medicaid program was designed to provide a safety net for the truly needy. The financing of Medicaid is supposed to be a state-federal partnership that prioritizes federal funding for lower-income states that have a smaller tax base. However, states are using provider tax schemes and other gimmicks to artificially inflate their claimed “state share” of Medicaid costs in order to shift billions of dollars onto federal taxpayers. This is effectively money laundering, as providers receive what they pay in taxes back through federal Medicaid funding, and states use the remaining revenue for their other budget priorities at the expense of federal taxpayers. To stop wasteful spending and ensure resources are preserved for the truly needy, Congress should put a stop to provider tax schemes. 

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