Statement by
Thomas Scully
Centers for Medicaid and Medicare Services
Department of Health and Human Services

Hearing: Challenges facing the Medicaid Program in the 21st Century
before the
House Energy and Commerce Committee Subcommittee on Health

October 08, 2003

Chairman Bilirakis, Ranking Member Brown, distinguished Committee members, thank you for inviting me to discuss the challenges facing the Medicaid program in the 21st Century, and for allowing Dennis Smith, the Federal Medicaid director, to appear with me today. The Medicaid program faces many challenges. With more than 40 million Americans lacking health insurance, CMS has been pursuing a wide range of initiatives to expand insurance coverage, including working aggressively to improve the Medicaid waiver process. Through waivers and State plan amendments (SPAs), Medicaid eligibility expanded by more than 2.27 million people between January 2001 and September 2003. In addition, we are focused on outreach so that potentially eligible individuals know about the Medicaid program, and as in the Medicare program, we are working to ensure that Medicaid beneficiaries receive quality care. While all of these areas present challenges to the Medicaid program, today I am here to focus on Medicaid finances, perhaps the most immediately pressing challenge to the program.

Medicaid spending continues to rise each year - and this is no small concern. When I first went to work at OMB in 1989 during the first Bush Administration, total Federal and State Medicaid spending was $61.2 billion. By the time I departed in 1993, total Medicaid spending had grown to approximately $132 billion. Today, total Medicaid spending for 2004 is projected to be $304 billion - that's nearly a tripling in spending over 10 years and five-fold increase since 1989. Moreover, Medicaid - not Medicare - is now the largest government health program in the United States. In FY 2002, total Federal-State Medicaid outlays ($259 billion) exceeded Medicare outlays ($257 billion) for the first time. This trend is continuing, with Medicaid outlays exceeding Medicare by about $4 billion in FY 2003 ($281 billion versus $277 billion), and estimated to exceed it by approximately $26 billion in FY 2004 ($304 billion versus $289 billion). In addition, in May, Congress approved a temporary infusion of additional Federal funds as part of the Jobs and Growth Tax Relief Reconciliation Act of 2003. Under the new law, States will get a temporary increase in the percentage rate for Federal Medicaid matching funds (FMAP) for five calendar quarters, beginning April 1, 2003, and ending June 30, 2004. Thus, total Federal spending for Medicaid over the next ten years is estimated at $2.6 trillion. Combined Federal and State spending on Medicaid in this period is estimated at $4.5 trillion.

While some of this growth is due to expanded coverage and eligibility - positive growth for the program because so many more uninsured Americans are getting health care services - much of the increase in Medicaid spending over the past 10 years can be attributed to the ever-increasing costs of providing long-term care. The Medicaid program primarily serves three groups of beneficiaries. Women and children comprise about 73 percent of enrollees but utilize just 27 percent of the Medicaid funding. The elderly and people with disabilities are the other two major groups that comprise just 27 percent of the Medicaid population, though the cost of their care consumes about 70 percent of Medicaid spending. In fact, almost 70 percent of nursing home beds are now Medicaid-financed, and State and Federal governments pay roughly 60 percent of all long-term care costs nationally.

Since Medicaid expenditures are a large and growing proportion of most State budgets, the Medicaid program is an area to which States turn to reduce costs. To reduce costs, States are feeling pressure to drop optional Medicaid benefits or to reduce optional populations. States also find other creative revenue enhancing mechanisms, including utilizing a variety of legal and regulatory loopholes to enhance the Federal funds they receive to provide health care for their citizens. Intergovernmental transfers (IGTs) are a prime example of such loopholes. While it is completely legal for States to share costs with counties and other local government bodies to recoup Medicaid expenditures, IGTs are only supposed to provide the statutorily determined match rate for a State. However, States often find ways to use IGTs to avoid paying the statutory match rate and effectively shift a larger portion of Medicaid costs to the Federal government. The Federal government should only match real expenditures for the Medicaid population at the real matching rates, but in recent years, IGTs have been used to draw billions in Federal funds with no true State or local spending.

As Federal and State Medicaid spending continues to grow rapidly, it is increasingly important for CMS to ensure that taxpayer dollars are serving their intended statutory purpose of improving health care quality and access for Medicaid beneficiaries. There are many opportunities for improving the fiscal integrity and management of the Medicaid program. I would like to discuss some of the problems we have seen, and some strategies that might refocus the program away from financing gamesmanship and back to delivering health care to America's vulnerable populations.


Medicaid is a partnership between the Federal government and the States. While the Federal government provides financial support to the States and is responsible for overseeing the Medicaid program, each State essentially designs and runs its own program. States have great flexibility in administering their programs, and the Federal government pays States a portion of their costs by matching certain spending levels, with statutory matching rates currently ranging between 50 and 77 percent. This creates a natural tension in which States strive to maximize Federal matching dollars. The Federal government has a responsibility to ensure that funds are matched appropriately. However, through various financing and funding mechanisms, including the use of donations and taxes, the Disproportionate Share Hospital (DSH) program, and Upper Payment Limits (UPL), many States manage to inappropriately draw down more Federal Medicaid dollars with fewer State dollars, resulting in an effective FMAP that is higher than the statutorily determined matching rates, creating inequities among States. CMS has begun to close these loopholes and ensure that States receive appropriate matching rates, but it is a long, complicated and politically unpleasant battle.

To prevent inappropriate funding mechanisms now, and in the future, it is important that we understand the various types of loopholes that States have exploited in the past and continue to exploit today. We must remain vigilant in closing and avoiding all of these loopholes. President Bush, Secretary Thompson, and I take this very seriously. We want to continue to work with you to correct current inappropriate State funding mechanisms to ensure the fiscal integrity of the Medicaid program and to ensure that Federal dollars are used to pay for Medicaid covered services for Medicaid-eligible individuals.


As I mentioned, over the last two decades States have developed innovative ways of enhancing Federal matching dollars. In 1985 the Centers for Medicare & Medicaid Services (CMS), formerly the Health Care Financing Administration (HCFA), changed the regulations governing the way the Federal government provides matching funds to States when they received private donations to help cover administrative costs. This rule change was merely intended to reduce record keeping and provide States more flexibility for accepting philanthropic donations.

Additionally, regulations at the time allowed States to impose special taxes on specific provider groups. These regulations led States to impose taxes and receive donations from providers that led to new ways to finance States' share of Medicaid expenditures. In 1986, Congress was concerned that States were not reimbursing Disproportionate Share Hospitals (DSH) for their uncompensated care costs. Legislation was passed that eliminated any limit on DSH payments. The combination of new revenue sources from donations and taxes and the ability to pay unlimited reimbursement to Disproportionate Share Hospitals (DSH) led to a significant increase in the Medicaid expenditures claimed by States. Once these exploding loopholes began to be limited, States pursued the Upper Payment Limit (UPL) loophole more aggressively. These scenarios, which I will describe in greater detail, provided opportunities for States to creatively draw additional Federal matching funds.

Provider Donations and Provider-Specific Taxes

An early maximization strategy States employed to enhance Federal Medicaid matching funds without using additional State resources was the use of provider donations and taxes. Typically, a State would either arrange for providers to "donate" funds to the Medicaid program, or it would establish special "taxes" on certain provider groups. Once these funds were collected from the affected providers, they were then repaid to those providers through increased Federal Medicaid payments, largely in the form of DSH payments. Since States had a great deal of flexibility in how they made DSH payments, they were able to raise DSH rates to compensate providers for the costs associated with the donations or taxes. As the DSH payments were raised, the effective level of Federal matching funds increased correspondingly. In the end, the providers were repaid their donations or taxes, and the State was left with the Federal matching funds to either return to the provider or to keep for whatever use it decided. The only party that incurred any new cost was the Federal government. It was a no risk, no cost, free money mechanism for dozens of States.

I spent a considerable amount of time on this issue while I was at the Office of Management and Budget in the first Bush Administration. I can tell you that the widespread use of these financing mechanisms contributed to extraordinary increases in Federal Medicaid expenditures in the late 1980s and early 1990s. For example, in 1989 we found that three States were drawing a combined total of $23 million from Federal funds through provider taxes and donations. This number increased to eight States drawing an additional $300 million in 1990, and by 1991 more than half of the States were drawing an incredible $12 billion.

In 1991, Congress passed the "Medicaid Voluntary Contribution and Provider-Specific Tax Amendments of 1991," the first piece of stand-alone Medicaid legislation in the program's history. This law set out strict conditions that States must meet in order to use taxes levied on health care providers as part of their State dollars eligible for Federal Medicaid matching funds. The law said the taxes must be:

  • Broad based, or applied to all members of a definable group. For example, they must apply to all hospitals, not just psychiatric hospitals;
  • Uniform, with all providers within the group being taxed at the same rate; and
  • Not part of a "hold harmless" agreement where the funds are returned to the providers either directly or indirectly.

The law also eliminated Federal Medicaid matching payments for provider donations, except in very limited circumstances. After significant consultation with the States, CMS published a final regulation implementing this law in 1993. The rule laid out a process for States to request waivers of certain provisions for tax programs that are not broad based or uniform. The "hold harmless" provision, however, cannot be waived. In an effort to improve State compliance with the law, in 1995 CMS issued detailed regulatory guidelines explaining the Donations and Tax rules.

In 1997, CMS notified States that if legislation explicitly ending the use of impermissible taxes and resolving outstanding State liabilities was not passed, CMS would have no choice but to ask the Department of Justice to pursue enforcement measures to resolve States' liabilities. Also in 1997, the Balanced Budget Act (BBA) banned States from using Federal Medicaid matching funds for purchases unrelated to health care, such as building roads and bridges. In 1998, CMS proposed legislation to allow the Secretary to work out compromises with States regarding large unallowable funds States received, rather than having to refer these cases to the Justice Department. Although this proposal never became law, due to the other restrictions I discussed, it appears that today States generally have stopped attempting to exploit this particular loophole.

Disproportionate Share Hospitals

Another financing mechanism commonly used by States has its roots in the early 1980's. In 1981, Congress recognized that some hospitals were treating a large number of uninsured patients thereby increasing their uncompensated care costs (UCC). As a result, these hospitals were taking in far less revenue per patient and experiencing difficulty remaining open. With the passage of the Omnibus Budget Reconciliation Act (OBRA) of 1981, Congress allowed States to pay more to hospitals treating a disproportionate share of uncompensated care cases as a way to encourage these hospitals to continue treating needy patients. Although this program concept clearly represented a good idea, the States were slow to embrace it.

A major change to the DSH law took effect in OBRA 1986, which prohibited the Federal government from putting any limit on payments made to hospitals that serve a disproportionate number of low-income patients with special needs. Then, in OBRA 1987, Congress created DSH payment rules and qualifications in law, specifically defining Disproportionate Share Hospitals and requiring States to pay additional funds to certain qualifying hospitals. OBRA 1993 further restricted State use of DSH revenues by limiting the amount that States could pay to specific hospitals to 100 percent of their uncompensated care costs, further limiting abusive DSH practices.

As OBRA 1993 took effect, States began looking for new ways to maximize Federal funds. One way States financed their share of Medicaid expenses was through IGTs. States have always been allowed to shift funds among the different levels of government to reduce administrative burdens. For instance, a County can transfer funds to the State, and States can use this money as their share of Medicaid expenditures. However, States provided DSH payments to public facilities that exceeded their Medicaid costs, receiving more Federal matching funds in the process, and these facilities could then refund some of the money to the State through IGTs.


Intergovernmental Transfer Financing (DSH) County Provider and State Profit Example [D]

To end this practice, the Balanced Budget Act of 1997 mandated State-specific caps on the total level of Federal matching payments to State DSH hospitals.

Upper Payment Limits

As Congress mandated limits on DSH payments and restricted States' ability to use donations and taxes, States began exploring other creative ways to enhance their Federal Medicaid funding, such as maximizing their "Upper Payment Limit" calculations. In 1987 Congress had established Upper Payment Limits for State owned or operated inpatient facilities, in an effort to remove the inherent incentive for States to overpay themselves. However, under the revised rules, States still were allowed to exceed these UPLs for certain publicly owned providers. By calculating the maximum amount that Medicare would have paid to each Medicaid facility - the Upper Payment Limit - States were able to obtain extra Federal matching funds. Under this scenario, States could calculate the upper limit for both public and private hospitals and nursing homes in the aggregate, rather than separating public from private. This gave them the flexibility to pay public hospitals and nursing homes more than private facilities. As a result, public hospitals could then return money to the State. The State, in turn, could use these funds to obtain more Federal matching dollars. The State could then return a portion of its share of the money to the public facilities, and keep the Federal share for its own use.


Intergovernmental Transfer Financing IGT from Physician Group Example [D]


Intergovernmental Transfer Financing Bank Loan to
County-owned Provider Example [D]

The Agency saw the first indications that States were using Upper Payment Limits in publicly owned providers to raise revenues in the early 1990s, although the dollar amounts and the number of States were limited. At that time, aggressive consultants began advising States to use Upper Payment Limits as a way to increase Federal Medicaid revenues flowing to the States. In 1999, at CMS' request, the Health and Human Services Office of the Inspector General performed audits in six States that confirmed the abusive nature of these payment arrangements. To close this loophole, CMS published three regulations establishing Federal upper payment limits (UPL) that limited the ability of States to increase their share of the Federal payments under Medicaid without actually spending State funds. Generally, the new UPL rules prevent States from paying each type of hospital and nursing home in Medicaid more than 100 percent of what Medicare would pay for similar services.

The final regulation, which took effect May 15, 2002, included provisions for a gradual phase out of excess Federal funds drawn down by States using these funding schemes. There are three phase-down periods: two, five and eight years, and States are assigned to each depending upon the length of time they had operated the funding schemes. The longer a State relied on the excess funds, the longer they have to phase out the use of those funds.

In early 2002, CMS notified 24 States determined by CMS to be qualified for a transition period under the upper payment limit (UPL) regulations. CMS provided the States with its preliminary determination regarding the length of each State's transition period and requested that each State submit the necessary UPL calculations to support its preliminary findings. CMS is presently evaluating the UPL calculations provided by each of the 24 States and the associated Medicaid spending, both of which are necessary to make final UPL calculations. The first transition period of the two-year phase out ended on September 30, 2002.


CMS has a strong interest in strengthening financial oversight and ensuring payment accuracy and fiscal integrity. Federal matching funds must be a match for real State expenditures, not a match of phantom dollars. At the Federal level, our primary role is to exercise proper oversight and review of State financial practices and to provide guidance and support for States' efforts to ensure program and fiscal integrity. While we have made substantial progress in helping States identify and reduce improper payments, we are now turning our attention to strengthening Medicaid Federal financial management activities.

We have taken some initial steps to improve our financial management processes, but we know that more work can and must be done. As part of the President's FY 2003 Budget, we have dedicated $10 million from the Health Care Fraud and Abuse Control (HCFAC) account to develop a comprehensive Medicaid program integrity plan. The FY 2004 Budget proposes to allocate $20 million from HCFAC for this initiative. We are increasing attention to, and emphasizing the importance of Medicaid financial management at all levels of our Agency and across all of our regions. This effort involves improving Federal oversight capabilities of State Medicaid financial practices, and focusing attention on program areas of greatest risk, so that our resources are targeted appropriately. The following are examples of improvements and progress we have made as part of our Medicaid financial management and program integrity redesign.

Creating National Reimbursement Teams

In an effort to improve national consistency in the issuance and application of Medicaid reimbursement policy, we have put together a team of Central and Regional Office staff, the National Institutional Reimbursement Team (NIRT), who are responsible for reviewing all institutional reimbursement State plan amendments, providing technical assistance to the States, and developing Medicaid institutional reimbursement regulations and policy. For example, the team is currently using a standard set of questions that must be answered by States before a State plan amendment will be approved and will help ensure that the payment methodology is clear. Questions include issues such as, "Do providers retain all of the Medicaid payments including the Federal and State share (including normal per diem, DRG, DSH, supplemental, and enhanced payments) or is any portion of the payments returned to the State, local governmental entity, or any other intermediary organization?" As a result of this effort, we will better know what we are paying for and how we are paying for it. The team's work will help ensure consistency in the application and review of our Medicaid policies. We also have established a Non-Institutional Provider Team (NIPT), which functions similarly to the NIRT, but for non-institutional providers, namely physicians. The NIRT and the NIPT have been working together on UPL transitions for those States with both inpatient and outpatient UPL phase-outs.

Upfront Reviews of State Funding Sources and Expenditures

We will be redirecting and adding resources this year with the goal of changing the emphasis of the Financial Management (FM) review of State Medicaid/SCHIP programs from an after-the-fact review to an upfront and proactive review. Our new emphasis would be primarily to review the non-Federal share amounts and related expenditures prior to the beginning of the fiscal year so that any problems or issues can be resolved before any claims are submitted. This process would provide an approval of the State's operating plan for the upcoming year, with the goal of eliminating the need for CMS to intervene and disallow Federal Medicaid funding after it has already been spent by the State and to identify any unallowable funding schemes or expenditures before they actually happen. Now is the best time to start this effort - while States are currently developing budget plans for next year. That way, we can examine spending before States are locked into a budget, and avoid disallowances that disrupt the State budget cycle.

Making Federal Matching Payments Only When State Plan Amendments Are Approved

In the past, States have been allowed to draw down Federal matching payments for State plan amendments that were submitted, but not yet approved. This allowed States to assume a financial risk if their plan amendment was subsequently disapproved. Since Federal matching payments were readily available while their State plan amendments were being considered, States had little incentive to ensure their plan amendments were approved. In fact, some State plan amendments were pending for years while the States continued to draw down Federal matching payments. In January 2001, we issued a State Medicaid Director letter informing the States that we would no longer make Federal matching payments until State plan amendments were approved, thus removing the previous incentive for States to keep plan amendments pending. For our part, we have changed our policy so that we will either approve or disapprove plan amendments within 90 days.

Partnership with State and Federal Oversight Agencies

Another key element of our new financial management strategy is to strengthen our working relationships and our exchanges of information with several State entities. Every State has one or more audit entities responsible for ensuring that State expenditures, including those in the Medicaid and State Children's Health Insurance Programs, are properly made and documented. Furthermore, every Medicaid Agency has a surveillance and utilization review staff to pinpoint and pursue questionable provider claims and Agency payments. Finally, as you know, virtually all States operate a Medicaid Fraud Control Unit, typically housed in the Attorney General's office, to pursue instances of suspected Medicaid fraud. By better cultivating our relationships with State agencies that perform these types of functions, we believe we can continue to enhance our oversight of the Medicaid program nationwide. In addition, over the last several years, at the Federal level, we have developed a close collaboration with the Department of Health and Human Services' Office of the Inspector General. We intend to continue this relationship.


CMS has several efforts underway to improve Medicaid's financial oversight and management. For example, both the General Accounting Office and this Committee's Oversight and Investigation Subcommittee have begun investigations into potential waste, fraud, and abuse in Medicaid State plans. Additionally, the Medicare reform legislation currently in conference, also addresses Medicaid with the inclusion of a provision that would require a State, as a condition of receiving DSH payments, to submit an annual report that:

  • Identifies each DSH hospital that received a payment adjustment under this section for the preceding fiscal year and the amount of the payment adjustment made to such hospital for the preceding year;

  • Includes such other information as the Secretary determines necessary to ensure the appropriateness of the payment adjustments made under this section for the preceding fiscal year.

These are all temporary solutions, and Medicaid financing needs fundamental structural reforms that will return the program to a Federal and state partnership. The Administration has demonstrated its commitment to increasing states' flexibility in administering their Medicaid programs. The HIFA, Independence Plus and Pharmacy Plus waiver initiatives have given states significantly more flexibility to expand eligibility and to tailor their programs to meet the needs of their beneficiaries.

However, reform of the financing structure of Medicaid is needed if we are serious about reducing waste, fraud and abuse. Because state governments are facing budget pressures, they will seek creative Medicaid financing strategies. The financial incentives in the program exacerbate this problem. Under the current Federal-state matching mechanism, if a state cuts one dollar of its own spending, then the state forfeits between one and two dollars in federal funds. Under current law, states may eliminate coverage of optional populations and drop optional benefits. They are doing so. In the past year, over two-thirds of states have reduced services or eligibility and most states are currently considering other benefit or eligibility cutbacks. This puts the health coverage of thousands of Americans at risk because when states can no longer afford to pay their share of the costs, they may lose the Federal funding as well.

We want to give states another option so that they can manage their health care budgets, while preventing further service and benefit cuts and while actually expanding coverage for low income Americans. Our proposal builds on the success of the State Children's Health Insurance Program (SCHIP) and the Health Insurance Flexibility and Accountability (HIFA) demonstrations in increasing coverage while providing flexibility and reducing the administrative burden on states.

Under this proposal, states would have the option of electing to continue the current Medicaid program or to choose an alternative global financing option. States electing this alternative would have to continue providing current mandatory services for mandatory populations. For optional populations and optional services, the increased flexibility of these allotments would allow each State to innovatively tailor its provision of health benefit packages for its low-income residents. For example, states could provide premium assistance to help families buy employer-based insurance. States could create innovative service delivery models for special needs populations including persons with HIV/AIDS, the mentally ill, and persons with chronic conditions without having to apply for a waiver. Another important part of the new plan would permit States to encourage the use of home and community-based care without needing a waiver, thereby preventing or delaying institutional care. The Administration has been engaged in discussions with the governors aimed at creating a proposal that both accomplishes the desirable goal of reform and addresses some of the major concerns in Medicaid.

An additional avenue for addressing Medicaid funding challenges is to encourage consumers to buy long-term care insurance. For example, the President has proposed to expand the four State programs on Long Term Care Partnerships, as well as two important tax relief measures for care givers and those who purchase long term care insurance.


Through complex, creative financing schemes States have artificially maximized Federal Medicaid matching funds. This practice is simply unacceptable. The Medicaid program must be a Federal-State partnership, not an exercise in financing gamesmanship. We must continue to ensure that beneficiaries receive the high quality care they deserve, and that we are appropriately matching State Medicaid funds. The last two decades have demonstrated that States can be extremely resourceful in creating innovative funding mechanisms that do not comply with the intent of the Medicaid program, which requires States to certify that they have the appropriate funding to pay their matching Medicaid share. We all need to work harder to ensure States are able to help pay for high quality health care for their residents through appropriate means, but we need to be vigilant in order to prevent further loopholes before they become set in law or regulation. We appreciate your support in these efforts and the opportunity to discuss this important topic with you today. We are happy to answer your questions.


Medicaid Estimated Total Expenditures by Federal Fiscal Year [D]


Medicaid Estimated Expenditures (in $ Billions) for Selected Expenditure Categories: Elderly and Nursing Home Spending Combined [D]


Distribution of Persons Served Through Medicaid and Payments by Basis of Eligibility, Fiscal Year 2000 [D]

Last Revised: November 6, 2003