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On January, 29, 2026, Centers for Medicare & Medicaid Services ("CMS") published a final rule, Medicaid Program; Preserving Medicaid Funding for Vulnerable Populations-Closing a Health Care-Related Tax Loophole (the "Final Rule") that, among other topics discussed in our prior blog post covering the proposed rule that was released on May 15, 2025 (the "Proposed Rule"), seeks to address a "tax loophole" that allows states to shift more Medicaid costs to the federal government by imposing taxes disproportionately on Medicaid providers.
As we discussed in our prior post, the federal government provides matching funds when a state imposes a tax on healthcare providers and uses the revenue to support Medicaid payments so long as the tax complies with certain statutory requirements. These statutory requirements include that health care-related taxes be broad-based, uniform, and not include "hold harmless" arrangements (i.e., where providers are effectively reimbursed for the taxes they pay). States can request a waiver from the "broad-based" and "uniform" requirements if they can show the tax is redistributive, meaning that the tax derives revenue from taxes on non-Medicaid services and uses them to finance the state's share of Medicaid payments for services. Currently, there are seven states, including California, New York, Michigan, and Massachusetts, which have relied on the existing waiver process to finance their share of Medicaid costs.
The Final Rule, which closely follows the language of the Proposed Rule, aims at tightening federal oversight by refining how CMS evaluates whether a health care-related tax is redistributive by adding more stringent requirements to ensure that taxes do not disproportionately target Medicaid providers and that the distribution of the tax burden reflects a true cross-section of the provider market.
Policy Objectives of the Final Rule
According to CMS, some states have used approved waivers and related financing structures to increase federal Medicaid matching funds without a commensurate increase in state spending, thus shifting more of the program's cost to the federal government. To ensure states do not exploit the existing "loophole," the Final Rule prohibits federal matching where states use higher tax rates and other tax structures to impose higher taxes on Medicaid than on non-Medicaid businesses.
CMS believes that, without action, more states beyond the seven that currently hold waivers would follow suit by looking to raise even higher revenues from their provider taxes. According to CMS, the loophole taxes generate $24 billion in revenue for states while closing the loophole will correspondingly save the federal government over $78 billion over the next 10 years.
Changes to the Transition Period
The Proposed Rule provided for a one-year transition period for any state tax that does not comply with the new requirements, but only if CMS has approved the associated waiver more than two years prior to the effective date of the Final Rule. This would mean that the states that received waivers more recently, including California, Michigan, Massachusetts, and New York, would not be eligible for any transition period and would consequently have only 60 days after the adoption of the Final Rule to comply with the new requirements or risk a reduction in federal Medicaid funding.
The Final Rule, however, expands upon the transition period provided for in the Proposed Rule and in the Dear Colleague letter issued by CMS as guidance after the issuance of the Proposed Rule. The Final Rule replaces that binary approach with the following compliance dates that are based on tax class and the recency of the state's waiver approval:
- Managed Care Organizations (MCO) Taxes
- Taxes on MCO services for states whose waivers were approved within two years of April 3, 2026, must come into compliance with the Final Rule by the end of State Fiscal Year 2026.
- Taxes of MCO services for states whose waivers were approved more than two years before April 3, 2026, must come into compliance with the Final Rule by the end of State Fiscal Year 2027.
- Non-MCO Taxes
- Taxes on all non-MCO services must come into compliance with the Final Rule by the end of State Fiscal Year 2027.
According to CMS, the changes to the transition timeline in the Final Rule are intended to give states an achievable path to compliance. Additionally, in response to concerns expressed by stakeholders about the lack of clarity of the new standard, CMS indicated that it expects states that have a legitimate public policy purpose for their tax program, as opposed to looking to circumvent federal rules to shift the burden of their Medicaid payments, would be able to demonstrate that legitimate purpose in their waiver request.
The Final Rule provides for a minimum transition period through December 31, 2026, which is significantly more time than the original 60 days included in the Proposed Rule. Nevertheless, for states that rely on receipt of federal funds matching on taxes for MCO services to fund Medicaid, a year is not a long time for the state to modify their existing health care-related tax structures. Consequently, states, their Medicaid agencies, and stakeholders should not delay in beginning to conduct internal reviews to determine what changes will need to be made to their tax structures to achieve compliance with the Final Rule and avoid the loss of federal matching funds.
We will continue to monitor developments and will report on updates when available.
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