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, depending on the state, of reimbursement for 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, if finalized as proposed, 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 one such tax is on hospitals. After imposing the tax disproportionately on Medicaid plans or providers, the states reimburse them with federal 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.
What the Rule Does
The rule would prohibit higher tax rates on Medicaid than on non-Medicaid businesses even if they pass the applicable statistical test. The rule would also bar the use of vague language to disguise taxes that target Medicaid. Based on how recently the state’s tax waiver was last approved, the rule would immediately end these loophole taxes in several of the most egregious cases while giving a one-year transition period to others.
How the Scheme Works
Tax Differential: States view this burden shift as a revenue stream from the federal government.[2] States exploit this scheme 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 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 share in the responsibility for financing Medicaid. Apart from the burden on the taxpayers, when states have to 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 to Medicaid.
Financial Exposure
Current loophole taxes generate $23.6 billion in revenue. CMS estimates that closing the loophole now, before any additional states adopt this scheme, if the rule is finalized as proposed, will save the federal government over $33 billion over the next 5 years. If just two more states adopted this model each year, CMS estimates that excess federal costs could balloon more than $74 billion over 5 years.
Illegal Immigrant Coverage in California (Medi-Cal)
California has systematically expanded Medi-Cal to cover individuals regardless of immigration status[3]—now totaling over 1.6 million enrollees:
2016: Children under 19 (670,542)
2020: Young adults 19–25 (133,393)
2022: Seniors 50+ (368,674)
2024: Adults 26–49 (707,000)
The proposed rule can be viewed at the Federal Register at: https://www.federalregister.gov/public-inspection/2025-08566/medicaid-program-preserving-medicaid-funding-for-vulnerable-populations--closing-a-health
[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