Medicaid Financing: The Basics

Medicaid represents $1 out of every $6 spent on health care in the U.S. and is the major source of financing for states to provide health coverage and long-term services and supports for low-income residents. Medicaid is administered by states within broad federal rules and jointly funded by states and the federal government through a federal matching program with no cap. Since March 2020, the COVID-19 pandemic and its economic impact have had significant implications for Medicaid spending and enrollment. Early in the pandemic, federal legislation prohibited states from disenrolling people from Medicaid in exchange for enhanced federal matching funds. These changes resulted in significant increases in Medicaid enrollment and total Medicaid spending. The Consolidated Appropriations Act, signed into law at the end of 2022, phases down the enhanced federal matching funds as states unwind the Medicaid continuous enrollment provision starting April 1, 2023. Those changes will continue to impact Medicaid spending and enrollment trends. This brief examines the following key questions about Medicaid financing:

• How much does Medicaid cost and how are funds spent?
• How does Medicaid financing work?
• How does Medicaid relate to federal and state budgets?
• How has the pandemic impacted Medicaid spending?
• What are key issues to watch?

How much does Medicaid cost and how are funds spent?

Medicaid spending (not including administrative costs) totaled $728 billion in federal fiscal year (FFY) 2021 (Figure 1). Medicaid spending is shared by the federal government and states and includes spending for eligible enrollees for qualified services. Of the $728 billion in total Medicaid spending in FFY 2021, states paid 31% and the federal government paid 69%. The share of costs paid by the federal government was higher in that year than it has been historically due to enhanced federal funding tied to the COVID-19 pandemic.

In FFY 2021, capitated payments to Medicaid managed care organizations (MCOs) accounted for more than half of Medicaid spending (Figure 2). Managed care and health plans accounted for the largest share (56%) of Medicaid spending, with capitated payments to comprehensive MCOs accounting for 52% of Medicaid spending in FFY 2021 and other Medicaid managed care (e.g., primary care case management (PCCM) arrangements or payments to specialty plans) accounting for another 4%. Smaller shares of total Medicaid spending in FFY 2021 were for fee-for-service acute care (20%), fee-for-service long-term services and supports (19%), Medicaid spending for Medicare premiums on behalf of enrollees who also have Medicare (3%), and disproportionate share hospital (DSH) payments (2%).

Enrollees eligible based on disability or age (65+) comprise 21% of all enrollees but account for over half of total spending due to higher per person costs (Figure 3). Children account for 40% of enrollees but only 17% of spending. Adult enrollees (those made eligible under the Affordable Care Act’s expansion, as well as low-income parents) account for 39% of all enrollees and 27% of spending. Spending per enrollee for individuals eligible based on disability, the eligibility group with the highest per enrollee costs, is seven times greater than the spending for children, the group with the lowest per enrollee costs. Enrollees eligible based on disability or age (65+) are more likely to use long-term services and supports, thus contributing to higher spending.

Total spending per full-benefit enrollee ranged from a low of $4,873 in Nevada to $10,573 in North Dakota in 2019 (Figure 4). Variation in spending across the states reflects considerable flexibility for states to design and administer their own programs – including what benefits are covered and how much providers are paid — and variation in the health and population characteristics of state residents. Within each state, there is also substantial variation in the average costs for each eligibility group and within each eligibility group, per enrollee costs may vary significantly, particularly for individuals eligible based on disability.

How does Medicaid financing work?

Medicaid financing is shared by states and the federal government with a guarantee to states for federal matching payments with no pre-set limit. The percentage of costs paid by the federal government varies for specific services and types of enrollees and depending on whether the costs are for medical care or program administration.

The federal share of spending for services used by people eligible through traditional Medicaid, which includes individuals who are eligible as children, low-income parents, because of disability, or because of age (65+), is determined by a formula set in statute. The formula is designed so that the federal government pays a larger share of program costs in states with lower average per capita income. The resulting “federal medical assistance percentage” or “FMAP” varies by state and ranged from 50 percent to 78 percent for FFY 2023 (Figure 5).

To participate in Medicaid and receive federal matching dollars, states must meet core federal requirements. States must provide certain mandatory benefits (e.g., hospital, physician, and nursing home services) to core populations (e.g., low-income pregnant women and children) without waiting lists or enrollment caps. States may also receive federal matching funds to cover “optional” services (e.g., adult dental care and home and community based services ) or “optional” groups (e.g. children and pregnant people with income above the limits established for core populations). States also have discretion to determine how to purchase covered services (e.g., through fee-for-service or capitated managed care arrangements) and to establish provider payment methods and rates.

Medicaid also provides “disproportionate share hospital” (DSH) payments to hospitals that serve a large number of Medicaid and low-income uninsured patients to offset uncompensated care costs. DSH payments totaled $17 billion in FFY 2021. Federal DSH spending is capped for each state and facility but within those limits, states have considerable discretion in determining the amount of DSH payments to each DSH hospital. States are required to provide matching funds based on a states’ traditional FMAP in order to draw down federal DSH allotments. The ACA, called for a reduction in federal DSH allotments starting in FFY 2014 based on the assumption of reduced rates of uninsurance, but the cuts have been delayed several times and are currently set to take effect in FFY 2024.

There are special match rates for the Affordable Care Act (ACA) expansion group, administration, and other services. While the standard FMAP applies to the vast majority of Medicaid spending, there are a few exceptions that provide higher match rates for specific services or populations, such as family planning and most notably people covered under the ACA Medicaid expansion. States that have implemented the expansion currently receive a 90% FMAP for adults covered through the ACA Medicaid expansion. States that had not adopted the expansion as of 2021 when the American Rescue Plan Act was enacted are eligible for a 5 percentage point increase in the state’s traditional FMAP for two years if they implement the expansion. Administrative costs incurred by states are usually matched by the federal government at a 50 percent rate, but some functions such as eligibility and enrollment systems receive higher match rates. Medicaid administrative costs are 5% or less of total Medicaid spending.

Unlike in the 50 states and D.C., annual federal funding for Medicaid in the U.S. territories is subject to a statutory cap and fixed matching rate. Once a territory exhausts its capped federal funds, it no longer receives federal financial support for its Medicaid program during that fiscal year. Over time, Congress has provided increases in federal funds for the territories broadly and in response to specific emergency events. Various pieces of legislation during the pandemic significantly increased the allotments for each of the territories (seven to nine times above the statutory levels) and also raised the FMAP rates from the statutory level of 55% to 76% for Puerto Rico and 83% for the other territories. The Consolidated Appropriations Act, passed in December 2022, provided additional federal funding and extended the 76% FMAP for Puerto Rico for five additional years and the 83% match rate for other territories permanently.

How does Medicaid relate to federal and state budgets?

Social Security, Medicare, and Medicaid are the three main entitlement programs and accounted for 44% of all federal outlays in FFY 2023 (Figure 6). Of these three programs, Medicaid is smallest in terms of federal outlays, though it covers a larger number of people than Medicare or Social Security. Overall, federal spending on domestic and global health programs and services accounted for 29% of net federal outlays in FFY 2023, including spending on Medicare (13%), Medicaid and CHIP (10%), and other health spending (6%).

Medicaid is a spending item and at the same time the largest source of federal revenues for state budgets. As a result of the federal matching structure, Medicaid has a unique role in state budgets as both an expenditure item and a source of federal revenue for states. According to data from the National Association of State Budget Officers (NASBO), in state fiscal year (SFY) 2021, Medicaid accounted for 27% of total state spending for all items in the budget (Figure 7). Medicaid accounted for only 15% of expenditures from state funds (including state general funds and other state funds), a distant second to K-12 education (25%). On the other hand, Medicaid accounted for 45% of all expenditures from federal funds in SFY 2021. While Medicaid remains the largest single source of federal funds for states, the share declined from 58% in SFY 2019, before the pandemic, due to large increases in other federal spending from unemployment compensation and other federal COVID-19 aid.

States can use provider taxes and IGTs (intergovernmental transfers) to help finance the state share of Medicaid. States have some flexibility to use funding from local governments or revenue collected from provider taxes and fees to help finance the state share of Medicaid within certain limits and rules. Provider taxes are an integral source of Medicaid financing, comprising approximately 17% of the nonfederal share of total Medicaid payments in SFY 2018 according to the Government Accountability Office (GAO). All states (except Alaska) have at least one provider tax in place and many states have more than three (Figure 8). The most common provider taxes are on nursing facilities (46 states) and hospitals (44 states). As of July 1, 2022, 32 states including DC also reported at least one provider tax that is above 5.5% of net patient revenues, which is close to the maximum federal safe harbor or allowable threshold of 6%. Federal action to lower that threshold or eliminate provider taxes, as has been proposed in the past, would therefore have financial implications for many states.

In the past, states have implemented an array of strategies to control Medicaid spending. To address long-term strategies of cost control and coordinated care, many states have moved to implement a range of payment and delivery system reforms (such as alternative payment models or value-based payments) either using managed care organizations or other models (although evidence is mixed about whether these models reduce costs). In addition, states have implemented an array of strategies to control the costs of prescription drugs, and most states refine these policies each year. On a per-enrollee basis, Medicaid spending has experienced slower cumulative growth since 2008 compared to Medicare and private insurance although there has been some variation particularly in more recent years on a year to year basis (Figure 9).  In addition, private insurance typically pays higher prices for health care than Medicare and Medicaid. Overall Medicaid provider payment rates in fee-for-services tend to be lower than other payers, and these lower payment rates have contributed to the program’s relatively low costs.

While states have to pay for a share of Medicaid, research shows that the influx of federal dollars from Medicaid spending has positive effects for state economies. Medicaid spending flows through a state’s economy and can generate impacts greater than the original spending alone. The infusion of federal dollars into the state’s economy results in a multiplier effect, directly affecting not only the providers who received Medicaid payments for the services they provide to beneficiaries, but also indirectly affecting other businesses and industries as well. The literature shows that states expanding Medicaid under the ACA have realized budget savings, revenue gains, and overall economic growth. Recent studies have confirmed prior research and shown positive effects of Medicaid expansion on the finances of hospitals and other providers.

How has the pandemic impacted Medicaid spending?

Medicaid enrollment and spending typically increase during recessions. Medicaid spending is driven by multiple factors, including the number and mix of enrollees, their use of health care and long-term services and supports, the prices of Medicaid services, and state policy choices about benefits, provider payment rates, and other program factors. During economic downturns, enrollment in Medicaid grows, increasing state Medicaid costs while state tax revenues are declining. Due to the federal match, as spending increases during economic downturns, so does federal funding. During the pandemic-induced recession and the two economic downturns prior to the pandemic, Congress enacted legislation that temporarily increased the federal share of Medicaid spending to provide increased support for states to help fund Medicaid. High enrollment growth rates, tied first to the Great Recession, then ACA implementation, and later the pandemic, were the primary drivers of total Medicaid spending growth over the last decade (Figure 10).

Since March 2020, the COVID-19 pandemic and its economic impact have had significant implications for Medicaid spending and enrollment. At the start of the pandemic, Congress enacted the Families First Coronavirus Response Act (FFCRA), which included a requirement that Medicaid programs keep people continuously enrolled during the COVID-19 public health emergency in exchange for a 6.2 percentage point increase in the FMAP for states. These provisions have driven Medicaid enrollment to record highs and contributed to declines in the uninsured rate.

Medicaid enrollment and total Medicaid spending increased following the start of the COVID-19 pandemic. A recent KFF analysis estimates Medicaid/CHIP enrollment reached nearly 95 million by March 2023, with enrollment growth since February 2020 accounting for one in four enrollees. In KFF’s annual budget survey, total Medicaid spending growth (including both federal and state funds) has increased since the pandemic began, and state Medicaid programs identified enrollment growth as the primary driver expenditure growth. Due to the FFCRA enhanced FMAP, state Medicaid spending declined in SFY 2020 and SFY 2021 and increased at a slower rate than total spending in SFY 2022. In addition, KFF estimates found that the fiscal relief from the enhanced FMAP met or exceeded the state costs of the additional enrollment through FFY 2022 in every state.

While state economic conditions recovered quickly following the onset of the pandemic compared to past recessions, recent economic turmoil casts uncertainty on states’ longer-term fiscal outlooks. Improving state economic conditions as well as federal fiscal relief mitigated the need for the widespread state spending cuts that occurred in prior recessions. Many states experienced surpluses in SFY 2021 and SFY 2022, enabling them to make additional investments and build up state rainy-day funds. While the vast majority of states in KFF’s annual budget survey reported they did not anticipate state revenue shortfalls or Medicaid budget cuts at that time, about half of the states did note uncertainty in their state’s longer term fiscal outlook due to economic factors such as rising inflation and costs of medical care, workforce challenges, and the possibility of another recession.

What are Key Issues to Watch?

The end of the Medicaid continuous enrollment provision and enhanced FMAP will have significant implications for Medicaid enrollment and spending. In the Consolidated Appropriations Act, signed into law at the end of 2022, Congress set an end to the Medicaid continuous enrollment provision on March 31, 2023 and phased down the enhanced FMAP through December 2023. While the number of Medicaid enrollees who may be disenrolled during the unwinding period is highly uncertain, studies estimate that between 5% and 17% of current enrollees might be disenrolled. State Medicaid agencies anticipate slowing or declining enrollment growth during the unwinding of the continuous enrollment provision will result in a lower total spending growth rate, and the expiration of the enhanced FMAP is expected to shift the state and federal spending shares. These changes occur as states are beginning to contend with new challenges due to rising inflation, workforce shortages, and a slowing economy, and how these issues will impact future state budgeting is uncertain. Medicaid plays a significant role in state budgets as both a spending and revenue source and has played a key role in the COVID-19 response and recovery across states.

There is great uncertainty as to how Medicaid enrollment and spending will change during the next few years. The majority of Democrats and Republicans hold favorable views of Medicaid and the number of states adopting the Medicaid expansion continues to increase. At the same time, there are emerging proposals to significantly reduce the federal government’s spending on Medicaid. Such proposals are unlikely to pass in the Senate, but they suggest that proposals to limit federal spending for Medicaid could be debated again in Congress.