Medicaid Provider Taxes

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Provider-specific taxes have been used by many states over the last two decades to help pay for
the costs of the Medicaid program. Such taxes are required to meet a number of federal laws and
regulations, some of which have been in flux recently. This report provides background
information on provider-specific taxes and describes recent legislative and administrative action
on the tax programs, including a moratorium, in place until April 1, 2009, on the implementation
of certain provisions of a recent administrative ruling. This moratorium would be further
extended to July 1, 2009, via the American Recovery and Reinvestment Bill of 2009 that was
approved by the House Energy and Commerce Committee on January 22, 2009.

Medicaid Provider Tax Legislation.................................................................................................1
Regulations ...................................................................................................................................... 2
Hold Harmless...........................................................................................................................3
Safe Harbor.........................................................................................................................3
New Regulation.........................................................................................................................3
Revising the hold harmless threshold.................................................................................4
Permissible classes of services............................................................................................4
Clarify standards for hold harmless tests............................................................................4
Opposition to the Rule..............................................................................................................5
Author Contact Information............................................................................................................6

tates have the authority to establish taxes to fund various activities. Sometimes states
establish taxes to fund specific purposes. Other times, taxes may be credited to the states’
general treasury to be used for any state purpose. One type of tax that is commonly relied S

on by many states to fund a portion of their share of Medicaid program costs is a tax on health
care providers. These taxes, called provider taxes, are required to comport with certain federal
laws established by Congress in 1991 and modified in 2005 and 2006.
The 1991 law set rules for provider taxes and for two other Medicaid funding mechanisms to
minimize state practices that were viewed as ways for states to circumvent their state/federal
shared responsibility for funding the Medicaid program. Subsequent changes to federal law and to
the administrative procedures governing the use of provider taxes have represented a continuing
struggle between ensuring the shared financing responsibility for Medicaid while balancing ¹
states’ rights and need to raise funds for state programs and Medicaid providers. New rules
issued in February of 2008 conform the administrative regulations to the legislative changes made
by Congress in 2005 and 2006, as well as make other changes to the procedures for approving
provider taxes. The rule changes become effective in April of 2008.

In 1991, Congress passed the Medicaid Voluntary Contribution and Provider-Specific Tax
Amendments (P.L. 102-234). This bill grappled with several Medicaid funding mechanisms that
were sometimes used to circumvent the state/federal shared responsibility for funding the cost of
the Medicaid program. Under these funding methods, states collect funds (through taxes or other
means) from providers and pay the money back to those providers as Medicaid payments, while
claiming the federal matching share of those payments. States were essentially “borrowing” their
required state matching amounts from the providers. Once the state share was netted out, the
federal matching funds claimed could be used to raise provider payment rates, to fund other
portions of the Medicaid program, or for other non-Medicaid purposes. In some cases, provider
groups initiated the process by approaching the state and requesting that one of the financing
programs be implemented in exchange for improved payment rates funded by the federal
matching amounts.
At the time that the 1991 law was deliberated, many of the provider taxes on the books
specifically targeted only those providers that accepted Medicaid payments because those were
the only providers for whom it would be routine and legal to pay back the borrowed funds
through Medicaid payments. The 1991 law sought to address some of the mechanisms that
allowed these arrangements to work.
With respect to provider-specific taxes, the 1991 law
• requires provider taxes be “broad based” and uniformly applied to all providers
within specified classes of providers—in other words, states cannot limit the
provider taxes only to Medicaid providers;

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• prohibits taxes that exceed 25% of the state (or non-federal) share of Medicaid
expenditures; and
• prohibits states from a direct or indirect guarantee that providers receive their
money back (or be “held harmless”)
for the purpose of claiming federal matching payments. The specified classes of providers used to
ensure that tax programs are “broad-based” are those that provide the following:
• Inpatient hospital services.
• Outpatient hospital services.
• Nursing facility services (other than services of intermediate care facilities for the
mentally retarded).
• Services of intermediate care facilities for the mentally retarded.
• Physicians’ services.
• Home health care services.
• Outpatient prescription drugs.
• Services of Medicaid managed care organizations (including health maintenance
organizations, preferred provider organizations, and such other similar ²
organizations as the Secretary may specify by regulation).
• Other classifications of health care services as specified by the Secretary.³
Requiring that all providers within a class be taxed, as opposed to only Medicaid providers,
dampened the ability of states to establish such taxes. The reason is that Medicaid providers could
easily be held harmless by inflating Medicaid payments. Other providers could not be repaid so
simply, and therefore would be more likely to oppose the imposition of such taxes.
Recent changes to law include a provision in the Deficit Reduction Act of 2005 (DRA, P.L. 109-
171), which altered one of the specified classes of providers. The “Medicaid managed care
organizations” class was changed to all “managed care organizations.” The Tax Relief and Health
Care Act of 2006 (TRHCA, P.L. 109-432) included a provision changing the rules exempting
taxes from scrutiny of their hold harmless provisions. Those rule changes are described more
fully below.

Federal regulations further define the rules with which Medicaid provider taxes must comply. ⁴
Most regulations have been in place since not long after the 1991 law was enacted. Following
the passage of TRHCA and DRA, the Center for Medicare and Medicaid services issued a new

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rule implementing several changes to comport with those laws, as well as making a number of
other changes.
Regulations established in 1992 and 1993 describe three tests that are applied to a state’s tax to
determine whether taxpayers are held harmless: a positive correlation test, a Medicaid payment
test, and a guarantee test. Taxes that fail any of those tests are determined to have a hold harmless ⁵
provision in violation of the law.
• A positive correlation test is used to determine whether a state or other unit of
government imposing the tax provides directly or indirectly for a non-Medicaid
payment to the taxpayers in an amount that is positively correlated to either the
tax amount or the difference between their Medicaid payment and the tax
amount.
• The Medicaid payment test is violated if all or any portion of the Medicaid
payment to the taxpayer varies based only on the amount of the total tax
payments.
• The guarantee test is violated if the state or other unit of government imposing
the tax provides directly or indirectly for any payment, offset, or waiver that
guarantees to hold taxpayers harmless for all or a portion of the tax.
The administrative rules, however, waive the application of those hold harmless tests when the
tax is applied at a rate that produces revenues that are less than or equal to between 5.5% and 6%
of the revenue received by the taxpayer. This threshold has been referred to as a “safe harbor.”
TRHCA changed the threshold under which tax programs could avoid being tested for violations
of the hold harmless rule. The rule in effect before THRCA allowed for taxes on providers of 6%
or less of their revenue to forego scrutiny of hold harmless provisions. THRCA changed the
threshold so that for fiscal years beginning on or after January 1, 2008, through September 30,
2011, taxes at or below 5.5% of revenues could forego such scrutiny. After that period, the
threshold would revert to 6% of revenues.
On February 22, 2008, HHS published a final rule: “Medicaid Program: Health Care Related ⁶
Taxes” in the Federal Register. The rule describes a number of changes to the Centers for
Medicare and Medicaid’s (CMS’s) policies for reviewing health care-related taxes. Two of the
changes implement provisions enacted in TRHCA and DRA, as described above. There are a
number other changes proposed as well.

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The rule would make the following changes: (1) revise the threshold for determining if a tax
program is required to undergo a test to determine whether a provider is being “held harmless”
for the tax payment and clarify use of the term “revenues”; (2) clarify standards for determining
the existence of a hold harmless arrangement; (3) codify one class of health care services
permissible for establishing health care provider taxes; and (4) remove obsolete language. In
addition, a few other notable changes are made, all of which are described in more detail below.
In order to conform CMS regulations to the statutory changes made by THRCA, the new rule
changes the threshold under which tax programs could avoid scrutiny of hold harmless provisions
from 6% of a taxpayer’s revenue to 5.5% for fiscal years beginning on or after January 1, 2008,
through September 30, 2011. In addition, the regulation further specifies that the revenues against
which the 5.5% threshold should be applied are “net operating revenues.” The former regulation
had not specified the type of revenues against which to apply the threshold test.
As described above, DRA broadened one permissible class of services from the services of
“Medicaid managed care organizations” to those of all managed care organizations. The
regulation makes changes to conform with the DRA change. It further specifies that all services of
MCOs, regardless of payer source, will be considered a permissible class of health care items or
services for the purpose of the taxes. This is to reduce incentives for MCOs to reorganize to
separate their business lines, thereby isolating Medicaid business, for the purpose of imposing
Medicaid taxes only on the subsidiary of the MCO. The preamble of the proposed regulation ⁷
notes that this practice was found to be occurring.
Several clarifications are made in the application of three tests to determine if a tax includes a
prohibited hold harmless.
• Positive Correlation Test—One clarification involves the determination of
whether a tax includes a direct or indirect non-Medicaid payment to the tax
payers that is positively correlated to the tax amount or to the difference between
the Medicaid payment and the tax amount. In the past, the use of the term
“positively correlated” raised disagreements about allowable taxes. Tax programs
disallowed by CMS were subsequently reinstated by an appeals board because
the positive correlation test was not applied in a strict statistical manner. This
regulation would allow a finding of a hold harmless for payments and taxes that
are correlated even when there is not a strict correlation in a mathematical sense.
This change would ensure that CMS is able to apply the positive correlation test
in the broadest manner possible, allowing that a positive correlation can exist
even if the correlation varies over time, the correlation changes, or if the payment
to the taxpayer is conditional on the payment of the tax. The preamble of the
proposed rule argues for the need for flexibility and subjectivity in the review of

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tax arrangements and notes that it is impossible to anticipate all hold harmless
plans that could be created.
• The Medicaid Payment Test—Under the Medicaid payment test, a hold harmless
arrangement exists if all or any portion of a Medicaid payment varies based only
on the amount of the tax payment. The new rule adds a clarification to allow for a
finding that a Medicaid payment varies based on the tax payment when a
payment is conditional on the tax payment. The preamble of the proposed rule
states that because Medicaid payments are required, by statute, to be based on
efficiency, economy, and quality of care, payments conditioned solely on the
payment of a tax are considered to be in violation of that law.
• The Guarantee Test—Under the existing regulation, tax arrangements that
include a direct or indirect guarantee that holds taxpayers harmless for any
portion of their tax costs are considered to be in violation of the hold harmless
prohibition. The new rule further specifies that the hold harmless rule is violated
if a tax arrangement includes a direct or indirect guarantee of a direct or indirect
payment of any portion of their tax costs.
The new rule includes a number of other changes, as well:
• It removes all references to transition periods that expired in the early 1990s.
• It standardizes the terminology used for referring to the tax amount and the
payment amount across all of the hold harmless tests. The purpose of this change
seems to be twofold—to reduce confusion raised by using slightly different terms
in different places for the same thing, and to utilize terms that are sufficiently
broad to allow for the maximum amount of flexibility for the agency in applying
the hold harmless tests.
• It makes parallel changes to the provisions implementing the hold harmless
prohibition for bona fide provider donations.
HHS estimates that the imposition of the rule would reduce federal Medicaid outlays by $0.4
billion over the five-year period beginning in 2008. The Congressional Budget Office estimates
the impact to be a reduction in federal outlays of $0.6 billion over the same period. States,
however, in responding to a survey conducted by the staff of the House Committee on Oversight
and Government Reform, estimate their loss of federal Medicaid funds to be over $5 billion for ⁸
the period, an amount more than 10 times the HHS estimates.
Opposition to the rule was expressed in a letter from the American Public Human Services
Association and the National Association of State Medicaid Directors to the Acting Administrator ⁹
of CMS. The letter raised concerns that the rule reduces consistency and clarity, that its changes
exceed the Secretary’s authority, and that it would impede a state’s ability to condition Medicaid

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reimbursements on payment of required taxes. Other concerns about specific provisions were
raised, as well.
Based on their survey of state Medicaid Directors, the majority staff of the House Committee on
Oversight and Government Reform conclude that the fiscal and programmatic impacts of CMS’s
recent regulatory changes—including the provider tax regulation—are far more extensive than
has been understood and warn against making such changes without fully understanding the
impact on Medicaid programs and beneficiaries. Their results echo the objections of governors
and hospital associations expressing the concern that the Administration’s recent rule changes
would have a significant impact on Medicaid financing that could potentially harm access to
Medicaid services for Medicaid beneficiaries.
Finally, Congress has taken action as well. As part of H.R. 2642, The Supplemental
Appropriations Act of 2008 (the War Supplemental), signed into law on June 30, 2008, a
moratorium is placed on much of the final regulation until April 1, 2009. That law halts the
implementation of all provisions of the rule, except for those enacted as part of TRHCA and DRA
(described above). This moratorium would be further extended to July 1, 2009, via the American
Recovery and Reinvestment Bill of 2009 that was approved by the House Energy and Commerce
Committee on January 22, 2009.
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