Over the past few years, scrutiny of Medicaid “provider taxes” has intensified significantly, largely because of concerns that these funding mechanisms may artificially inflate federal spending in the Medicaid program. Under federal law, states are permitted to levy taxes on their healthcare providers, including hospitals, nursing facilities, and managed care organizations (MCOs), to generate the state share of Medicaid expenditures and draw down federal matching funds. This financing strategy has become a cornerstone of state Medicaid funding, but recent regulatory changes are poised to fundamentally reshape how states finance their programs.
The One Big Beautiful Bill Act (OBBBA), signed into law in July 2025, enacted two critical Medicaid provider tax provisions: Sections 71115 and 71117. These provisions represent the most significant changes to Medicaid provider tax policy in years. In May 2025, while Congress was actively debating OBBBA, the Centers for Medicare & Medicaid Services (CMS) issued a proposed rule that largely mirrored Section 71117. However, the proposed rule included a different transition period for affected provider taxes, creating uncertainty for states relying on this revenue source. Just two weeks ago, CMS issued the final rule, which largely reflects both OBBBA and the proposed rule, with key distinctions related to state transition periods and compliance timelines.
Background on Provider Tax Requirements
Certain existing federal requirements carefully regulate the size and scope of provider taxes to prevent states from gaming the system. A provider tax must be “uniform and broad based” to qualify for federal approval. Within the context of MCOs, this fundamental requirement means that the tax must be applied at the same rate and to all MCOs operating in the state, not just MCOs that serve the Medicaid population. This ensures fairness across the healthcare marketplace and prevents Medicaid-specific taxes that could be viewed as indirect federal financing.
However, federal regulations allow states to apply to CMS to waive the broad-based and uniform requirements under specific circumstances. States can receive approval if the tax’s net impact is generally redistributive and the tax amount is not directly correlated to Medicaid payments. To receive a waiver, states must conduct a complex statistical test to prove that the tax meets the exemption criteria. This statistical test has been the subject of controversy and stakeholder concerns for several years.
The first Trump administration recognized issues with the statistical test and issued a proposed rule in May 2019 aiming to address these concerns, but the rule was never finalized. During the Biden administration, in waiver approval letters for California and New York, CMS stated that the agency would soon propose new regulatory requirements to address mounting concerns about the test’s effectiveness in ensuring truly redistributive taxes.
The Statistical Test “Loophole” and CMS Response
Section 71117 of OBBBA and CMS’s recent final rule aim to close what CMS characterizes as a significant “loophole” in the statistical test. CMS argues that states have found ways to pass the test despite their provider taxes not being genuinely redistributive in practice. According to CMS, by circumventing the test’s intent, states can create a tax structure that burdens non-Medicaid MCOs less severely, allowing Medicaid MCOs to be “made whole” through increased Medicaid payments that effectively reimburse the tax amount.
CMS highlights in the final rule that one current tax arrangement, despite passing the statistical test, applies to Medicaid MCOs at a rate that is 117 times higher than the rate applied to non-Medicaid MCOs. This dramatic disparity demonstrates what federal regulators view as a fundamental flaw in the current system that allows states to shift costs to the federal government.
In the rule, CMS aims to eliminate this loophole by prohibiting states from taxing Medicaid services or businesses, such as Medicaid MCOs, at a higher rate than non-Medicaid services or businesses, such as commercial MCOs. CMS notes that seven states—understood to be California, Illinois, Massachusetts, Michigan, New York, Ohio, and West Virginia—currently operate under a waiver for their MCO tax and will need to “come into compliance” with the new policy. There are two additional tax waivers (one hospital tax and one nursing facility tax, for a total of nine waivers) in those seven states that also need to come into compliance.
Transition Period and Compliance Deadlines
While the May 2025 proposed rule would have required certain states to come into compliance immediately, creating potential fiscal crises, CMS issued preliminary guidance in November 2025 stating that all states would have a transition period for their waivers to come into compliance. Most of the transition periods provided in the final rule are longer than indicated in the November guidance, giving states more time to adjust their financing strategies.
The final transition periods vary significantly by provider class and the approval date of a state’s most recent MCO tax waiver:
MCO Taxes:
- States with waivers approved within two years of April 3, 2026, must comply by January 1, 2027
- States with waivers approved more than two years from April 3, 2026, must comply by the start of state fiscal year 2028
All Other Provider Classes:
- Regardless of approval date, compliance is required by the start of SFY 2029, but no later than October 1, 2028
Implications for Affected States
States are allowed to take different approaches to comply with the new policy requirements. One option is for states to reduce the tax rates on Medicaid MCOs, thereby reducing the revenue generated and reducing the federal match states can receive. States could also choose to halt their MCO tax altogether and seek alternative funding sources. Regardless of the approach taken, affected states may experience significant budget gaps that they would need to fill either by raising revenues from another source or by restricting services or benefits to reduce overall spending.
New York’s Financial Challenge
New York and California face the earliest compliance deadline of January 1, 2027, because their most recent MCO tax waivers were approved within two years of April 2026. Both states’ MCO taxes represent major sources of funding for their Medicaid programs. New York’s MCO tax is projected to net $3.7 billion in state savings in SFY 2026. The revenue contributes to the state’s healthcare stability fund and is earmarked for critical investments such as increased payment rates for hospitals and nursing homes, safety net transformation initiatives, and quality improvement pools. The state’s enacted financial plan explicitly notes that absent continued federal approval of the MCO tax, the plan does not include funding for these investments beyond SFY 2028.
California’s Dual Impact
The approximated net annual revenue for California’s MCO tax is $7.5 billion, making it one of the largest provider tax programs in the nation. In November 2024, California residents approved Proposition 35, which makes the MCO tax permanent under state law. The proposition directs the state to use the revenue to increase provider payment rates and invest in health workforce initiatives starting in 2025, and even specifies which provider types should receive payment increases over time.
CMS’s final rule will doubly impact California because the state also operates a waiver for its hospital tax. While California has until the start of SFY 2029 to bring that waiver into compliance, the hospital tax currently generates more than $5 billion in net annual revenue. The combined impact of modifying both taxes could create a budget shortfall exceeding $12 billion annually.
Interaction with OBBBA’s Hold Harmless Provision
As noted, OBBBA includes two distinct provider tax provisions. The second provision (Section 71115) is broader in scope and affects all states’ provider taxes, including those impacted by Section 71117 and the CMS final rule. Under current federal regulations, Medicaid provider taxes must be broad based and uniform but also must hold taxpayers “harmless,” which means providers cannot be guaranteed repayment of the taxes they contribute. “Hold harmless” arrangements are permissible if the taxes remain below 6% of net patient revenue.
Section 71115 of OBBBA prohibits states from increasing or enacting new Medicaid provider taxes. Starting in fiscal year 2028, states that expanded their Medicaid populations under the Affordable Care Act are required to lower the 6% hold harmless threshold by 0.5% per year, until the threshold reaches 3.5% in 2032, effectively requiring tax rate reductions below the new threshold. This reduction does not apply to provider taxes on nursing facilities or intermediate care facilities.
CMS states that the final rule does not conflict with Section 71115 because Section 71115 does not prevent modifications to existing provider taxes. However, the interaction between these two provisions creates a complex compliance landscape for states.
According to KFF analysis, the MCO taxes in California and Illinois and the hospital tax in California are currently above 3.5% of net patient revenue. Therefore, if those states opt to retain their taxes affected by the final rule beyond the transition period, they will need to eventually and gradually reduce the tax rate until they reach 3.5% in 2032.
Looking Ahead: State Policy Decisions
It remains unclear how the seven affected states will comply with these new requirements and how this will ultimately affect their Medicaid programs. Nevertheless, the states will need to fundamentally reassess how their Medicaid programs are financed and make strategic decisions about how to proceed—potentially making consequential decisions about what benefits and services to prioritize in the face of reduced federal matching funds and constrained state revenues.
