Section 1902(a)(2) of the Social Security Act (the Act) requires states to share the responsibility of financing the Medicaid program with the federal government, by providing at least 40 percent of the non-federal share of expenditures under the state plan. There are several ways states can finance the non-Federal share, including health care-related taxes under section 1903(w) of the Act. States have historically looked for ways to shift this responsibility more toward the federal government, and both Congress and CMS have sought to address these cases.[1]
On May 12, 2025, the Centers for Medicare & Medicaid Services (CMS) issued a proposed rule that would end states’ ability to exploit a health care-related tax loophole currently used by seven states to generate billions in federal Medicaid payments—without contributing their fair share or expanding care for Medicaid enrollees. These states impose higher taxes primarily on Medicaid business of managed care organizations (MCOs), although there are similarly situated current Medicaid loophole taxes on other providers, such as hospitals and nursing facilities. After imposing the tax disproportionately on Medicaid plans or providers, the states effectively reimburse these entities entirely with federal matching funds, while avoiding any state financial cost. This, in turn, allows the states to use the surplus for other purposes—including the expansion of healthcare coverage for illegal immigrants. This effectively means federal money is financing these other interests, instead of enhancing the state Medicaid program.
On July 4, 2025, President Trump signed the Working Families Tax Cuts legislation (Public Law 119-21) and adopted the policies of the proposed rule in section 71117. The legislation also authorized the Secretary to grant transition periods of up to 3 years. On November 14, 2025, CMS issues a Dear Colleague letter outlining the minimum transition periods available under section 71117(c). This final rule, displayed on [date], codifies the proposed provisions adopted by Congress and expands upon the transition periods granted in the Dear Colleague letter.
What the Rule Does
The rule prohibits higher tax rates on Medicaid than on non-Medicaid businesses to ensure states don’t exploit an inadvertent mathematical loophole in the applicable statistical test. The rule also bars the use of vague language or complex designs to disguise taxes that target Medicaid. Based on how recently the state’s tax waiver was last approved and the permissible class, the rule provides States at least until the end of calendar year 2026, and in some cases the full 3 years authorized by Congress.
How the Loophole Works
Tax Differential: Some states view this burden shift as a revenue stream from the federal government.[2] Some states exploit this loophole by greatly increasing taxes on Medicaid business, but through tax structures that are designed to still pass the statistical test in Medicaid regulations at 42 CFR 433.68(e)(2). For example, in California MCO tax rates are set at $274 per member, per month (PMPM) for Medicaid while comparable commercial member months are taxed at $1.75 PMPM.
States may use these taxes to:
- Trigger federal Medicaid match payments,
- Repay taxpayers the tax amount, and
- Pocket excess funds, which may or may not then go toward Medicaid uses.
These schemes technically pass the current statistical test for permissibility due to an inadvertent loophole but violate the spirit of the law that states must share in the responsibility for financing Medicaid. Apart from the burden on the taxpayers, when states must contribute, they have an incentive to monitor and operate their programs competently to ensure the best value for the dollars that they spend. It further violates the requirement under section 1903(w)(3)(E) of the Act that non-uniform taxes (taxes that do not have the same rate for all payers) be generally redistributive or generally move money from non-Medicaid payers to pay for Medicaid expenditures.
Financial Exposure
Current loophole taxes generate $24 billion in revenue for states. CMS estimates that closing the loophole will save the federal government over $78 billion over the next 10 years.
[1] For example, the Medicaid Voluntary Contribution and Provider Specific Tax Amendments of 1991 (Pub. L. 102-234, enacted December 12, 1991) amended section 1903 of the Act to prevent States from shifting a disproportionate amount of tax burden to entities with a high percentage of Medicaid business, thus shifting the State responsibility for financing of the program to the Federal government.
[2] See for example the California Legislative Analyst’s Office report about California’s MCO tax: https://lao.ca.gov/Publications/Report/4992