CMS Proposes Caps on Medicaid State Directed Payments and Fee for Service Supplemental Payments, Further Cutting Federal Funding of Medicaid

Key Takeaways:

• On May 22, 2026, CMS published a proposed rule (Proposed Rule), building on (and going beyond) the requirements of H.R. 1, outlining its plan to reduce both state directed payments (SDPs) and fee-for-service supplemental payments for Medicaid providers.
• SDPs – a common Medicaid financing tool that requires Medicaid managed care plans to make specific payments to certain provider types in order to advance Medicaid policy objectives (access to care, quality, parity, etc.) will largely be capped at a percentage of Medicare payments limiting a common rate structure tied to average commercial reimbursement. 
• This change impacts nearly all SDPs, not just the historical emphasis on services tied to academic medical centers.
• The Proposed Rule also targets fee-for-service supplemental payments, subjecting them to the same caps and restrictions as SDPs.
• Providers – particularly those with significant Medicaid populations – should take immediate action in response to this Proposed Rule by: (1) preparing and submitting comments before the July 21, 2026 deadline, and (2) working with your finance teams to evaluate the impact that these new payment limitations may have on your revenue streams.  

The Proposed Rule

On May 22, 2026, the Centers for Medicare & Medicaid Services (CMS) proposed to lower the limit on the total payment rate and create other requirements for SDPs in Medicaid managed care.[1]  The Proposed Rule also sets a limit for certain targeted Medicaid payments in Medicaid fee-for-service. In the Proposed Rule, CMS purports to implement Section 71116 of the Working Families Tax Cut legislation, otherwise known as H.R. 1, and proposes additional policy changes arising from the Presidential Memorandum, “Eliminating Waste, Fraud, and Abuse in Medicaid,” which was issued on July 6, 2025.[2] CMS estimates the Proposed Rule will generate an estimated $775 billion in total savings over ten years, including $510 billion in federal savings.[3] Notably, this savings projection is more than three times the initial savings projected by the Congressional Budget Office arising from the passage of H.R. 1.

The Proposed Rule, if finalized, comes at a time when states and providers are already grappling with sweeping financial and regulatory challenges associated with the implementation of H.R. 1, including new work requirements, a reduction in the “safe harbor” limit for provider taxes, and additional provider and beneficiary revalidation requirements, among others. The proposed limitations would reduce and cap Medicaid reimbursement rates for most providers, further shift the burden of funding Medicaid to state budgets, place additional financial strain on hospitals and other providers and ultimately limit access to care for Medicaid beneficiaries.

Proposed SDP Caps – H.R. 1 Implementation

The Proposed Rule implements Section 71116 of H.R. 1, which limits SDPs for inpatient hospital services, outpatient hospital services, nursing facility services, and qualified practitioner services at an academic medical center (a/k/a the Four Services). For rating periods beginning on or after July 4, 2025, the payment rate limit will be reduced from the average commercial rate to 100% of the total published Medicare payment rate for expansion states, or 110% of the total published Medicare payment rate for non-expansion states and the District of Columbia. In the absence of a total published Medicare payment rate for a specific Medicaid covered service, the payment limit would be 100% of the Medicaid state plan approved rate. The applicable payment limit will be calculated at the individual claim or service level.

Certain “grandfathered” SDPs for the Four Services may qualify for a temporary reprieve from the payment limits in the Proposed Rule. To qualify, the grandfathered SDP must have been: (1) approved by CMS by July 5, 2025; or (2) the state must have submitted a completed preprint to CMS, on or before July 4, 2025, for a rating period that includes at least one business day between October 11, 2024 and July 3, 2025, or July 5, 2025 and March 27, 2026. However, the total dollar amount for grandfathered SDPs will be phased down by 10 percentage points annually beginning with the first rating period on or after January 1, 2028, until the proposed payment rate limit is reached.

Proposed SDP Caps – Beyond H.R. 1

The Proposed Rule does not stop with the Four Services targeted by H.R. 1. CMS proposes to go further than Section 71116 by extending the new payment rate limit to all SDPs (except grandfathered SDPs) in all states – for example, professional services at a non-academic medical center – for rating periods beginning on or after January 1, 2029. No applicable phase down period would apply to impacted SDPs. Thus, states that have historically relied on SDPs that utilized average commercial rates (typically higher than Medicare rates) for certain services, will pay providers less as a result of these proposed changes.

Finally, the Proposed Rule would eliminate SDP arrangements that allow set rate increases for rating periods beginning on or after January 1, 2028, with an exception for grandfathered programs.

CMS Targets Fee-For-Service Supplemental Payments

Although not statutorily required or changed by H.R. 1, CMS is also targeting supplemental payments, a key Medicaid funding tool providers rely on to bridge the gap between Medicaid reimbursement levels and the actual cost of care in a fee-for-service reimbursement. The Proposed Rule would establish a Medicaid practitioner or provider-specific limit for the total Medicaid fee-for-service payment authorized under a State plan or waiver when all or a portion of the payment is targeted to a subset of practitioners or providers furnishing certain Medicaid-covered services. The limit for targeted Medicaid payments is equal to 100% of the total published Medicare payment rate for expansion states and 110% of the total published Medicare payment rate for non-expansion states – the same as the proposed limits for SDPs.

The proposed limit for targeted Medicaid payments would not apply, however, if: (1) a State’s Medicaid fee-for-service payment methodology is uniform for all Medicaid practitioners or providers furnishing certain services within the State or within a geographic region of the State; or (2) the Medicaid practitioners or providers total Medicaid fee-for-service payment is already subject to a payment limit (i.e., an inpatient hospital services upper payment limit). This adjustment would cripple some states’ legal provider tax framework where such taxes and supplemental payments are limited to certain provider types under other federal laws.

Under the Proposed Rule, states with an approved state plan that exceed these payment limits will be required to submit a new State Plan Amendment (SPA) to remove or update the payments to comply no later than the first State fiscal year that begins on or after January 1, 2029. The new limits would apply to all new payment proposals after the final rule’s effective date. Failure to comply with the new targeted Medicaid payment limit could result in disallowance or other reduction of federal Medicaid funds. Any proposed SPAs that exceed the payment limit may be subject to disapproval.

CMS Voices Concern Regarding Intergovernmental Transfers

Neither H.R. 1 nor the Proposed Rule substantively limit a State’s right to utilize intergovernmental transfers (IGTs) as a tool to generate the non-Federal share to finance their Medicaid programs.[4] However, CMS has taken steps recently to address what it views as impermissible arrangements relating to Medicaid financing sources. In the commentary to the Proposed Rule, CMS took the opportunity to reiterate the Federal government’s concern that States are utilizing IGTs and health-care related taxes to collect money to fund the non-Federal share for SDPs from the same entities that receive enhanced payments because of their IGT or provider tax contributions. CMS argues the enhanced provider payments are not necessarily aligned with Medicaid utilization or quality health outcomes, which raises additional fiscal integrity concerns. CMS indicated the need for greater scrutiny on the sources States use to generate the non-Federal share and how those Medicaid funds are ultimately redistributed. Any policy changes impacting the utilization of IGTs as a Medicaid financing mechanism may significantly impact a State’s ability to raise the non-Federal share of expenditures and should be monitored closely.

Providers Need to Start Preparing Now

There is little doubt the Proposed Rule would place significant restrictions on a state’s ability to draw down federal Medicaid funding and pay providers, which will result in reduced Medicaid payments. Providers, including hospitals and health care systems, must prepare for the impending budget crisis and find novel ways to support key service lines as they work to maintain access to care for entire communities, not just Medicaid beneficiaries.

Transactions that include Medicaid reimbursement should be evaluated for financial viability as both Medicaid enrollment and Medicaid reimbursement are likely to decrease in the coming years under the current proposals.

Public comments on the Proposed Rule are due by July 21, 2026. For more information about the potential impacts of the Proposed Rule or Medicaid compliance in general, please contact one of the authors or your regular Polsinelli attorney.