Today, CMS published a long-anticipated final rule titled “Medicaid Program; Preserving Medicaid Funding for Vulnerable Populations – Closing a Health Care-Related Tax Loophole“ (Final Rule). The Final Rule, effective April 3, 2026, closes the so-called “statistical loopholes” in the P1/P2 and B1/B2 statistical tests used to permit waivers of broad-based or uniformity requirements in Medicaid health care-related tax regulations. The Final Rule also takes specific aim at state health care-related tax structures imposed on managed care organizations (MCOs). Per CMS, the loophole has allowed certain states to have waivers in place that pass the statistical tests but are not generally redistributive and therefore not statutorily approvable by CMS.
During the comment period of the proposed rule, Congress enacted section 71117 of the Working Families Tax Cuts legislation, more commonly known as the “One Big Beautiful Bill Act” (Pub. L. 119-21, July 4, 2025), which codified similar requirements in statute. On November 14, 2025, CMS also published a letter providing “preliminary guidance” (November 2025 Guidance).
Background: The “Loophole” in Plain Terms
One way that states may finance the non-federal share of Medicaid expenditures is through the imposition of “health care related taxes” — i.e., taxes imposed on a class of health care items services (e.g., inpatient hospital services, MCO services) or providers of those services (e.g., hospitals, MCOs). Section 1903(w) of the Social Security Act (SSA) allows a state to apply revenues from health care related taxes towards its share of Medicaid expenditures only if the taxes are “broad-based” (applied to all providers within the assessed class); “uniform” (applied at the same tax rate within an assessed class); and do not hold assessed providers harmless. That said, the SSA permits CMS to waive the broad based and/or uniformity requirements (and thus allow a state to impose a tax that is not broad-based or uniform) if the state can demonstrate the tax is “generally redistributive.”
To evaluate state waiver requests for health-care related taxes, CMS developed two statistical tests to verify that the tax does not shift a disproportionate burden onto Medicaid compared to a standard broad-based and uniform tax. The P1/P2 test applies when a state wants to exclude certain providers from the tax (a waiver of the broad-based requirement). The B1/B2 test applies when a state wants to impose varying tax rates (a waiver of the uniformity requirement).
According to CMS, the B1/B2 test contained an unintended statistical “loophole” that enabled some states to manipulate their health-care related taxes. These taxes technically passed the B1/B2 statistical test but were not actually generally redistributive because much of the higher tax burden was imposed on Medicaid. CMS estimates that this “loophole” enabled approximately $24 billion in total tax collections in 2024 alone, spanning nine taxes across seven states. The Final Rule attempts to close this loophole and is projected to yield over $78 billion in federal Medicaid savings over ten years from 2027 through 2036.
What the Final Rule Does
New Definitions. CMS provides new definitions in 42 C.F.R. § 433.52 for“Medicaid taxable unit” and “non-Medicaid taxable unit” to provide clarity on what constitutes a unit subject to taxation attributable to the Medicaid program. CMS also promulgated a new definition for “Tax rate group,” which, together with the changes to 42 C.F.R. § 433.68(e)(3) outlined below, establishes a single term to refer to various types of permissible tax groupings.
Additional “Generally Redistributive” Requirements. To show that health-care related taxes are generally redistributive, the Final Rule adds a new requirement in 42 C.F.R. § 433.68(e)(3) for states to demonstrate that they are not imposing a higher tax rate on any taxpayer or tax rate group based on Medicaid taxable units than the rate imposed on groups defined by non-Medicaid taxable units. As an illustrative example, CMS states in the regulation that a tax on MCOs would violate the new regulations if Medicaid member months are taxed at $200 per member month while non-Medicaid member months are taxed at only $20 per member month.
Proxy Provision. As part of the new requirement in 42 C.F.R. § 433.68(e)(3), CMS has added specific language to the regulation to prevent states from circumventing the new requirements regarding whether a tax is generally redistributive. Specifically, states may not use proxy terminology provider group designations that do not explicitly reference “Medicaid” but which are designed to achieve the same effect as the practices prohibited in the new regulation. This proxy provision is controversial because of fears that CMS will not be objective in determining what is and is not a Medicaid proxy. Indeed, while CMS acknowledges that states may still design tax rate groups for “legitimate public policy goals,” so long as the purpose is not to direct higher tax burdens to Medicaid, the Final Rule provides that “there may not be a singular factor that will be dispositive of the existence of a proxy for Medicaid.” Rather, “a combination of factors taken as a whole [is] likely to guide” CMS’s determination of compliance.
Extended Transition Periods. The most significant new information in the Final Rule involves the transition periods for states with non-compliant taxes set forth in 42 C.F.R.§ 433.68(e)(3)(4)(A)-(C). The proposed rule proposed either no transition or a one-year transition, while the November 2025 Guidance outlined two transition periods. The Final Rule contains three different transition periods—two for “health care-related taxes on services of MCOs,” and one for “all other taxes on permissible classes.” In establishing the additional transition periods, CMS expressly recognized that MCO loophole taxes impose the greatest burden on the Medicaid program and thus warrant shorter transition periods, while non-MCO taxes should receive additional time.
Under the Final Rule, the three transition periods are as follows:
- Health-care related taxes on MCO services that are generally not redistributive and were approved by CMS between April 3, 2024 and April 3, 2026 have a transition period ending on December 31, 2026, making the compliance date January 1, 2027.
- Health-care related taxes on MCO services that are generally not redistributive and were approved by CMS before April 3, 2024 (more than 2 years before April 3, 2026) have a transition period ending the day before the first state fiscal year (FY) beginning at least one year after April 3, 2026, making the compliance date State FY 2028 (varies by state).
- Health-care related taxes on all services other than MCO services that are generally not redistributive have a transition period of the final day of the state FY that ends in calendar year 2028, but no later than September 30, 2028.
States have two pathways to comply before the transition period ends:
- Submit a compliant waiver: States may submit a waiver for a new tax that is genuinely redistributive and satisfies the statistical tests plus the new requirements at 42 C.F.R. § 433.68(e)(3).
- Restructure the tax without a new waiver: States may eliminate the need for a waiver altogether by complying with the rules regarding those taxes that are considered to be broad-based or uniform.
CMS does not state whether and how the standards in the Final Rule apply to pending tax waiver requests.
Key Takeaways
State Medicaid agencies, state budget offices, and state legislatures relying on health care-related taxes to fund their Medicaid programs should take immediate stock of their current tax structures as the compliance deadlines arrive quickly. In the Final Rule, CMS committed to provide states with technical assistance to redesign a compliant health-related tax structure and emphasized that federal financial participation remains available for certain administrative costs associated with compliance efforts. States should also note that penalties may apply to revenues collected after the applicable compliance deadline.
