Federal vs. State Tensions in Medicaid Financing: A New Chapter in Oversight

A Rule About Taxes, Or About Power?

At first glance, the CMS proposed rule titled “Preserving Medicaid Funding for Vulnerable Populations—Closing a Health Care-Related Tax Loophole” appears to be a highly technical adjustment to how provider taxes are structured and assessed. But as any seasoned compliance officer knows, Medicaid is never just about mechanics—it’s also about governance.

The rule’s intent is to close a long-exploited loophole that lets states collect provider taxes in ways that disproportionately target Medicaid services, yet still technically pass federal requirements. What’s emerging, however, is a broader narrative: a growing tension between CMS’s enforcement authority and states’ desire to maintain flexibility in Medicaid financing.

This isn’t just about dollars—it’s about who gets to decide how they’re used.

CMS’s Position: Guarding the Federal Match

At its core, the rule reasserts CMS’s role as the gatekeeper of federal Medicaid funds. It sends a strong message that the federal share of Medicaid should not be inflated by technical workarounds or selective tax structures.

Specifically, the rule:

• Eliminates waiver approvals for provider taxes that impose higher rates on Medicaid services, regardless of statistical test outcomes.

  
  

• Increases CMS discretion in determining whether a provider tax is “generally redistributive.”

  
  

• Requires more detailed justifications for waiver requests.

From CMS’s viewpoint, these changes are about upholding the intent of Medicaid law—not just the letter. Provider taxes must be broad-based, fair, and truly redistributive—not manipulated to backdoor federal revenue.

The State Viewpoint: Flexibility Eroding

States, however, are raising red flags. The provider tax loophole has been a cornerstone of how states finance Medicaid—especially for programs that go beyond the federally mandated minimum. These include:

• Medicaid expansion populations.

• Enhanced payments for safety-net providers.

• State-only programs for noncitizens and other excluded groups.

For states, the message in this rule is clear—and unwelcome: Washington is narrowing the lanes for fiscal innovation, and that could mean hard decisions about coverage and benefits ahead.

Where the Friction Shows

1. Waiver Discretion vs. Formula

   Previously, passing the B1/B2 statistical test was a relatively objective exercise. Under the new rule, even states that pass the test can be denied waivers if CMS deems the tax rates too disparate. This introduces subjectivity, which states worry will lead to inconsistent enforcement.

   
   

2. Policy Spillover

   By penalizing certain tax structures, CMS may indirectly force states to restructure or eliminate unrelated state-funded programs that depend on the same financial mechanisms. States argue that CMS is stepping outside its lane, influencing programs that federal law doesn’t even govern.

   
   

3. Chilling Effect on Program Design

   The rule could deter states from experimenting with new funding models or pursuing waiver innovations out of fear that CMS will later disallow them, even if they comply with published standards.

A Strategic Moment for Compliance Professionals

This rule is about more than audits and waivers—it’s a shift in federal-state dynamics. Compliance leaders should see this as an opportunity to:

• Proactively assess your state’s provider tax models—are they exposed under the new standards?

  
  

• Engage early with state Medicaid leadership—offer risk assessments and modeling support.

  
  

• Track CMS enforcement tone—will this become a one-off recalibration or part of a broader shift in Medicaid oversight?

Conclusion

CMS’s proposed rule reflects a growing assertion of federal oversight in Medicaid—a move to ensure that program rules are not only followed but honored in spirit. But for states, it may feel like a move toward centralization and a retreat from the creative, flexible Medicaid model that has defined the program for decades.

The challenge for all of us in compliance? Navigating this evolving power dynamic without losing sight of the people who depend on these programs every day.

Do you have questions about this blog? Please contact jessicazeff@simplycomplianceconsulting.com.