Hawaii Department of Social Services and Housing, DAB No. 779 (1986)

GAB Decision 779

August 21, 1986

Hawaii Department of Social Services and Housing;

Docket Nos. 85-143; 85-216;  86-9;  86-82

Ballard, Judith A.; Settle, Norval D.  Teitz, Alexander G.

(1) The Hawaii Department of Social Services and Housing (State or
DSSH) appealed the decision of the Health Care Financing Administration
(HCFA or Agency) disallowing a total of $11,685,273 in federal financial
participation (FFP) claimed by DSSH under Title XIX (Medicaid) of the
Social Security Act (Act).  The amounts disallowed represented the
federal share of State excise taxes reimbursed by DSSH as part of the
costs incurred by providers in rendering medical services.  The
disallowances were based on HCFA's view that payments for the tax were
not actual expenditures by the State within the meaning of applicable
federal law because the State collected the tax from the providers. /1/

We conclude that federal law was ambiguous concerning whether State
income from excise taxes paid by Medicaid providers had to be deducted
from DSSH's payments to the providers in determining the amount of
expenditures eligible for FFP.  We also conclude that the State's
interpretation of applicable law was reasonable under the circumstances
of this case where:  (1) the approved State plan in effect during most
of the disallowance period clearly provided for reimbursement of the
excise tax;  (2) program regulations supported the State's
interpretation;  and (3) HCFA had paid FFP for DSSH's full payments to
providers including excise taxes for 18 years.  Thus, the Agency was
unreasonable in attempting to apply a(2) different interpretation
retroactively.  Accordingly, we are compelled to overturn most of the
disallowances. /2/

Nothing in this decision contradicts the Agency's position that
generally expenditures claimed for FFP must be "net" of any applicable
credits. Furthermore, we emphasize that nothing in this decision
precludes HCFA from promulgating a rule or issuing formal policy
guidance giving notice of HCFA's intent to prospectively and
specifically require states to apply excise taxes received from
providers as credits against Medicaid payments to those providers.

This decision is based on the written record, including comments
received in response to a draft decision issued in this case.  While we
have revised the draft decision for clarity and to respond to those
comments, our final decision is substantially the same as the draft.

Background

Hawaii has had a Statewide general excise tax in effect throughout the
State's participation in the Medicaid program. This tax is imposed on
the gross receipts of all businesses (with few exceptions not relevant
here) for the privilege of doing business in the State.  The providers
involved in this case, like all other businesses in Hawaii, paid this
excise tax on their gross receipts as an expense of operating in the
State.  Hawaii's State Medicaid plan did not specifically provide that
State taxes, per se, would be reimbursed.  However, the plan in effect
for most of the period in question did specify that providers' costs
would be reimbursed in accordance with Medicare principles of
reimbursement.  (See State Brief, p. 2) Under Medicare principles it is
clear that the State could use excise taxes as a provider cost in
calculating provider reimbursement rates.  Hawaii used the Medicare
principles from the inception of the Medicaid Program in 1966;  the
State excise tax was in effect throughout that period, and during this(
3) entire period providers in Hawaii have always been reimbursed for
excise taxes under both Medicare and Medicaid.  During both the entire
period in question here (i.e., 1979 to 1986) and the prior period not
involved in this disallowance (i.e., 1966 to 1979), Hawaii included the
amount of the tax as a provider cost item in calculating the Medicaid
reimbursement rate and claimed FFP in the amount it paid providers.
Until the first deferral notice in these cases, HCFA always paid the
State's claims for FFP for amounts paid providers for medical services
without questioning the inclusion of excise taxes in the State
reimbursement.

In December 1984, HCFA notified DSSH that a portion ($424,101) of the
amount shown on the State's Medicaid expenditure report for the quarter
ending September 30, 1984 was being deferred.  On June 17, 1985, the
State received a disallowance letter which informed the State that HCFA
had disallowed not only the $424,101 for the July through September 1984
quarter, but an additional $9,786,211 in previously allowed
expenditures, making a total disallowance of $10,210,312 for the period
from July 1, 1979 through March 31, 1985.  Thereafter, in separate
disallowance letters, HCFA notified DSSH of the disallowance of an
additional $1,474,961, bringing the total to $11,685,273 (the amount in
dispute here) for the period from July 1, 1979 through December 31,
1985.

I.  Did "federal law" mandate the disallowances here?

HCFA based the disallowances on its view that "federal law" (i.e.,
section 1903(a) of the Act and Office of Management and Budget Circular
A-87) required the disallowances.  As explained below, section 1903(a)
and the Circular simply are not that specific;  while HCFA's
interpretation is not necessarily inconsistent with them (and thus might
reasonably be imposed through a regulation or guideline), it is
unreasonable to conclude that the Act and the Circular themselves
required the disallowances.

   A. The statute did not mandate the disallowances.

The disallowance letters themselves cite only the statute as authority.
Section 1903(a)(1) of the Act provides that a state with an approved
Medicaid plan may receive:

   An amount equal to the federal medical assistance percentage . . .
of the total amount expended during such quarter as medical assistance
under the State plan. . . .  (emphasis added)

(4) After citing this provision, the disallowance letters conclude:

   Payment of a State excise tax is not an actual amount expended by the
State since the State collects the tax.  Since no actual State
expenditure has occurred, HCFA is precluded by Section 1903(a) from
reimbursing such taxes.

Throughout these cases, HCFA has persisted in arguing that the
disallowances were mandated because the statute is unambiguous on its
face in meaning that only "actual" or "net" expenditures are eligible
for FFP, and that the amounts disallowed were not actual or net
expenditures.

The Act does not define "expended" or "expenditure," nor have we been
referred to any legislative history for an interpretation. /3/ The
everyday meaning of "expend" is "pay out." (See Webster's Third New
International Dictionary (1976)) Furthermore, Black's Law Dictionary
(5th ed.) defines "expenditure" as "spending or payment of money;  the
act of expending, disbursing, or laying out of money;  payment."
Clearly, the State did in fact pay out money, to providers of "medical
assistance," which included reimbursement for excise taxes.

While we would, nevertheless, agree with the Agency that a reasonable
interpretation of the term "expenditure" would be "net expenditure," and
that, in determining the "total amounts expended" by the State, certain
income or credits to the State should be offset or netted against
amounts paid out, this does(5) not ineluctably lead to the conclusion
that there was no "net expenditure" here.  The key issue is whether the
excise taxes paid by the providers into the State's general treasury had
to be offset against the payments by DSSH to the providers for medical
services rendered by the providers.  The statute simply does not address
this question.

Indeed, the Agency, in its briefing, did not rely solely on the statute
for the proposition that there has been no "net expenditure" when the
State reimburses a provider for an amount including an excise tax.  The
Agency argued also that the payment of the tax must be considered an
"applicable credit" within the meaning of OMB Circular A-87.  We
consider this argument at some length below.  It is, however, a far
different argument from the Agency's contention that the statute itself
unambiguously requires that FFP is available only in "net expenditures"
and that what we have here is not a "net expenditure."

If the statute were clear and unambiguous, and covered the particular
situation before us, we would of course uphold the disallowances.  But
we must reject the Agency's position that the mere use of the term
"expended" in section 1903(a) conclusively requires the result here.

   B.  The OMB Circular did not mandate the disallowances.

HCFA argued that the disallowances in this case were required by the
cost principles for state and local governments set out in Office of
Management and Budget (OMB) Circular A-87. /4/ Under A-87, costs
incurred by states must be "net of all applicable credits." (OMB
Circular A-87, Attachment A, Item C.1.g.) The Agency argued that the
excise taxes paid by the providers to the State should have been
considered credits against the State's reimbursements to the providers
for the excise taxes.  HCFA argued further that an underlying principle
of A-87 was that states were not meant to make a profit on their
programs and allowing Hawaii to receive FFP when it had no "net"
expenditure did just that.

(6) The Circular does not provide the clear and affirmative answer
needed to support HCFA's retroactive disallowance.  The Circular simply
is not definitive.  It was neither clear that these taxes had to be
considered "applicable credits" under A-87, nor that the State had to be
viewed as making a profit, prohibited under A-87.  These Circular
provisions may support a prospective rule requiring that excise taxes be
netted against Medicaid payments in claiming FFP, but the provisions are
not sufficiently clear to mandate a retroactive disallowance. /5/

The definition of "applicable credits" in A-87 gives specific examples
of what is meant by the term.  The definition refers to such things as
"purchase discounts;  rebates or allowances, . . . and adjustments of
overpayments or erroneous charges." (Attachment A, Item C.3.a.) There is
a direct link, or nexus, between the credit in those situations and the
amount to which it must be applied.  For example, if the State received
a discount or rebate on the purchase of a desk for its Medicaid program
it could not seek FFP on the full retail price.  Similarly, the State
would have to subtract from its Medicaid expenditures amounts it
recovered from a provider where it originally paid the provider in
error.

Under a reimbursement rate system, the relationship is more remote. The
rate is not simply a shorthand summary for costs which are themselves
directly claimable as Medicaid expenditures.  The State's expenditures
are payments for medical services rendered by the providers.  None of
the providers' costs, including the excise taxes, would themselves be
directly claimable as Medicaid expenditures.  It is only because
Congress has permitted a cost-related system of reimbursement to
providers that the providers' costs become significant.  The way in
which they become significant is through their use in calculating a
reimbursement rate -- i.e., they become a measure of the amount the
State will pay the provider under the State plan for rendering services.
The rate is, however, not simply an accumulation of all of a provider's
costs, but reflects application of a method of determining "allowable"
provider costs (applying principles different from A-87 cost(7)
principles) and, sometimes, subjecting those costs to limitations.
Moreover, when a prospective reimbursement system is used, the costs
used to calculate the rate are not the actual costs of providing the
medical services but are historical costs, usually adjusted for
inflation.  Many of the provider's costs might arise from payments the
provider makes to a State agency (for example, for a license fee), which
the provider would have to make irrespective of whether the provider was
rendering any services to Medicaid recipients.

Unlike the examples in the "applicable credits" provision, the right of
the State to receive funds from the provider (here, excise taxes) does
not arise out of the transaction of the State paying the provider.
Thus, the provision does not clearly inform the State that it has to
treat the excise tax as an "applicable credit" to offset Medicaid
expenditures.

With regard to "profits," A-87 merely states as a general policy for
determining allowable program costs that "(no) provision for profit or
other increment above cost is intended." (Attachment A, Item A.1) The
Agency's view that the State, in effect, obtained a "profit or increment
above cost" because it received the full tax from the provider, as well
as federal funds for a percentage of the amount of the tax, has merit
only if one considers one part of the transaction in isolation.  There
is nothing in the provision which requires an examination of offsetting
income and expenditures at this level.  From the perspective of the
entire transaction (i.e., the payment of the full rate to the provider
-- in a substantial part from State funds -- and the provider's payment
of a small percentage of that amount as an excise tax) or from the
perspective of the State's Medicaid program as a whole, the State had a
net outlay of funds, not a profit.

Furthermore, A-87 itself contains language which reasonably could have
led the State to believe that excise taxes were allowable costs.
Attachment B at Item B.25 contains a provision specifically stating:

   In general, taxes or payments in lieu of taxes which the grantee
agency is legally required to pay are allowable.

The Agency argued that this provision did not mean excise taxes were
allowable costs here since it was the providers, not the grantee agency
(DSSH), that had to pay the tax.  While technically we might agree with
the Agency, the important point is that the provision created further
ambiguity regarding whether taxes had to be considered an "applicable
credit" under A-87.  While the State was not obligated to pay the tax
directly, it was obligated under its State plan to pay a rate calculated
by including the tax.

(8) Moreover, the record reveals that even certain Agency officials,
when faced with this provision, were confused.  On August 18, 1981 the
Regional Administrator, Division of Financial Operations, HCFA, stated
in a letter to the Director, California Department of Health Services,
that FFP was available for State reimbursement of a California sales
tax.  (See California Appeal File, Exhibit L, California Department of
Health Services, Board Docket Nos. 85-156, et al.) On December 8, 1981,
the Regional Administrator asked the Regional Attorney, Region IX, for
advice regarding FFP for sales tax.  The Administrator's letter
specifically cited in full the A-87 provision (then 45 CFR Part 74,
Subpart Q, Appendix C, Part II, Section B (25)) and noted that it was
the provision "governing sales tax." The Regional Attorney responded
that FFP was available. /6/ (See California, supra, Exhibit J)

II.  Was the State's interpretation reasonable under the circumstances
of this case?

In addition to the ambiguity and mixed message in A-87, there are other
factors which set a context in which the State reasonably determined
that it did not have to treat the excise taxes as an "applicable credit"
offsetting its payments to the providers for medical services.  We
discuss these factors below.

   A.  The State plan as support for the State's interpretation.

HCFA did not dispute that Hawaii's approved State plan applicable during
most of the disallowance period provided for reimbursement of Medicaid
providers in accordance with Medicare principles of reimbursement.  HCFA
did not dispute that under Medicare principles the excise taxes in
question were costs which could properly be(9) considered in calculating
Medicare reimbursement rates. /7/ HCFA argued, instead, that it was not
reasonable to apply Medicare rules in a Medicaid context.  HCFA
explained that Medicare was designed as an insurance program (the
federal government assumed the entire cost of medical services), whereas
Medicaid was designed as a matching program (the state and federal
governments shared the cost of medical services).

In response, the State argued in effect that the Agency should be bound
by the State plan provision which it approved.  The State pointed out
that the State Medicaid plan applicable during most of the disallowance
period stated that a cost incurred by a provider was reimbursable if
that cost was reimbursable under Medicare, and since providers' costs
for excise taxes were reimbursable under Medicare they were also
reimbursable under Medicaid.

We conclude that under the circumstances of this case, the State plan
supports the State's argument.  While Hawaii is wrong to suggest that
approval of a state plan provision means so much that a state can ignore
clearly applicable rules and regulations, we cannot agree that approval
of a state plan provision means so little that the Agency can
unilaterally and retroactively disavow that to which it has clearly
agreed.

Agency approval of the State plan here cannot reasonably be construed as
anything other than approval of the use of Medicare principles of
reimbursement for Medicaid;  thus, it was approval of the use of excise
taxes paid by providers in the State's calculation of the reimbursement
rate to be paid to providers.  This approval does not mean that the
State can ignore other applicable provisions if they clearly require
that excise taxes paid by the providers be netted against amounts
reimbursed under the rate.  Stated differently, the fact that the tax
paid by(10) the provider may be an allowable cost in its rate does not
automatically mean the State is entitled to FFP on the tax portion of
the reimbursement to the provider.

Since it was not clear that the use of Medicare principles for purposes
of Medicaid reimbursement contravened A-87 (or any other HCFA issuance),
we conclude that the Agency cannot now attempt to give retroactive
effect to its newly developed position.  Under the circumstances here,
HCFA cannot unilaterally disavow the plan provision to which it agreed.

HCFA attempted to shift the burden to the State by arguing that the
State's blanket adoption of Medicare principles (rather than
specifically stating its intent with regard to excise taxes) was the
reason for approval, and that, at the time of approval of the State
plan, HCFA did not fully realize the impact of the Medicare principles.
Nevertheless, as the administering agency, HCFA must be held responsible
for knowing what it approves.  Moreover, we note that HCFA administered
both the Medicare and Medicaid programs and was responsible for
developing the Medicare reimbursement principles.

Finally, we note that the Agency did not deny that it had provided FFP
for rates calculated using an excise tax for 18 years.  While the Agency
claimed that it was unaware during that period that it was providing FFP
for taxes, the Agency should have known that taxes were included in
calculating the rates since the Medicare cost principles were being
used.  In these circumstances, a reasonable implication of such a
practice for such a long period is that at least some responsible Agency
officials knew that FFP was being paid and thought that FFP was
available under federal law.

   B.  The program income regulations as support for the State's
interpretation.

The State argued that 45 CFR 74.41 specifically provided that taxes need
not be considered in determining the net amount of a state's
expenditure.  The State argued that 45 CFR 74.41 and 74.42 governed what
program income had to be recognized in determining the net amount of a
state's expenditure for purposes of FFP.  The State argued that while
"program income" was to be deducted, taxes were excluded from "program
income," except when "earmarked" for use in the program.  The state
concluded that since no part of the excise tax was specifically
earmarked for use in Medicaid, the taxes should be included in the net
amount of Hawaii's expenditure for purpose of FFP.

(11) The Agency responded that 45 CFR 74.41 and 74.42 did not apply here
because the rationale behind the disallowances was not that the receipt
of taxes constituted "program income," but rather that it constituted an
"applicable credit" under A-87.  The Agency argued further, that, even
if the Board concluded that 45 CFR 74.41 and 74.42 were applicable, the
taxes should not be excluded since the taxes were specifically earmarked
for use in the Medicaid program by the State plan.

We conclude that, while the program income regulations may not have been
part of the narrow basis on which the Agency fashioned its
disallowances, they are related to the general issue of how a government
grantee should treat a receipt of funds in the operation of a grant
program;  they serve as further evidence that the law was not as clear
as the Agency would have us believe.

The program income regulations directly address the question of whether
there must be an offset for taxes in calculating a state's net
expenditures under a program such as Medicaid.  Section 74.42(c) sets
out the general rule that "program income" should be excluded from "net"
expenditures.  The regulation states:

   . . . the maximum percentage of Federal participation is applied to
the net amount determined by deducting the (program) income from total
allowable costs. . . .

Section 74.41(c)(1) sets out the specific exclusion of taxes from
program income (thus allowing taxes to be included in net expenditures).
That provision states:

   (c) The following shall not be considered program income:

   (1) Revenues raised by a government recipient under its governing
powers, such as taxes, special assessments, levies, and fines.
(However, the receipt and expenditure of such revenues shall be recorded
as a part of grant or subgrant project transactions when such revenues
are specifically earmarked for the project in accordance with the terms
of the grant or subgrant.)

While the Agency argued that the more general applicable credit
provision is the basis for the disallowance, its rationale is weakened
by the very presence of what we consider to be the more specific program
income provision.

Moreover, we find no merit in the Agency's alternative argument that the
existence of the Medicaid plan meant that the taxes were(12) earmarked
for the Medicaid program.  The Medicaid plan here did not "earmark" the
taxes for the Medicaid program.  The Agency did not dispute the State's
assertion that the taxes went into the general treasury.

The State argued that 45 CFR 74.41 bars prospective as well as
retrospective application of HCFA's present interpretation. Appellant's
Supplemental Brief, April 23, 1986, p. 5.  The State's argument implied
that the only way for the Agency to change policy was by issuing a new
regulation.

We do not agree with this conclusion.  First, 45 CFR 74.41 does not bar
the Agency's action any more than OMB Circular A-87 mandated it.  The
Board does not conclude that the program income regulation dictates a
decision for the State;  the program income regulation is simply one
factor supporting the State's interpretation.  The Agency, of course, is
free to adopt another reasonable interpretation;  it merely cannot
impose that interpretation retroactively under the circumstances here.
Moreover, a formally adopted regulation is not necessarily the only
mechanism available for announcing a new interpretation.

III.  Additional arguments.

The parties made several additional arguments which, while not
dispositive, must be addressed.  We discuss them below primarily because
the parties devoted significant briefing to them.

   A.  Sham taxes.

Strictly speaking, we are concerned only with the tax at issue in these
disallowances, and, more particularly, with HCFA's retroactive
implementation.  However, we have considered HCFA's concern that
allowing FFP for expenditures on rates calculated using excise taxes
would encourage states to create sham taxes.  We believe HCFA's fear is
an insufficient basis to justify a result other than that which we are
compelled to reach based on all the considerations discussed in sections
I and II above.

The Agency could issue an action transmittal or promulgate a regulation
stating that reimbursement by a state of any taxes paid by a provider to
any state or local governmental unit would not be eligible for FFP,
rather than crafting after-the-fact legal arguments to support a newly
announced interpretation of a federal statute.  Moreover, the Agency's
argument assumes Machiavellian machinations on the part of states which
appear unlikely and certainly are not present in this case.  The record
reveals that the State here simply followed the provisions of its
approved State(13) plan and the applicable Medicaid regulations.  The
reality of the situation appears to be that, given the complex nature of
the interplay between the State plan and Medicaid regulations, neither
the State nor the Agency fully appreciated until recently that there
might be a problem.  Furthermore, the tax here clearly was not devised
as a sham, insofar as it was already in effect at the time Medicaid was
adopted in Hawaii.

   B.  The donated funds analogy.

The parties cited certain Board decisions dealing with donated funds to
support their conflicting claims about whether FFP was available where
there was no net outlay of State funds.  The donated funds analogy is a
bit far-fetched;  but in any event, we conclude below that while the
decisions are not directly relevant, on the whole they tend to support
the result we reach here.

The State argued that certain Board decisions dealing with donated funds
established that there can be FFP for a payment to a provider even
though there is an offsetting contribution to the State by the provider,
and thus no net outlay of State funds.  The State cited New Mexico Human
Services Department, Decision No. 382, January 31, 1983, and Michigan
Department of Social Services, Decision No. 352, September 30, 1982, to
support its position.  In effect, the Agency argued that this was true
only for an unconditional donation of funds, and that the State taxes
here were more like conditional restricted donations for which FFP was
not available under past Board decisions.  The Agency cited Texas
Department of Human Resources, Decision No. 381, January 31, 1983, as
support for its position.  HCFA argued that this case involved a
conditional donation since there was a written document, the Medicaid
plan, which provided that excise taxes were to be reimbursed to the
provider.  Further, HCFA argued that New Mexico did not support the
State's position.  HCFA did not address Michigan.

In New Mexico there was a specific statutory provision which stated that
funds involved could be considered as State funds for purposes of FFP as
long as they were donated without restriction to the State.  In Michigan
the Board concluded that the Agency simply failed to prove its case and
implied that in another context it might interpret "expenditure"
differently.  The Board's conclusions in both cases were sufficiently
narrow so that they do not control when applied generally by the State
here.  However, the treatment of unrestricted donations adds yet another
reason why the State may have thought that unrestricted tax payments did
not have to be offset against Medicaid reimbursements before claiming
FFP.(14) In Texas the State Medicaid agency (DHR), in order to meet a
deadline, sent its employees to certain hospitals to assist in
determining the Medicaid eligibility of patients.  The hospitals agreed
to pay part of the workers' salaries.  DHR and the hospitals entered
into written agreements specifying, among other things, how much the
hospitals would pay DHR for the workers. DHR paid the workers out of its
general funds, which contained the payments from the hospitals.  The
Board concluded that the payments from the hospitals were applicable
credits against DHR's expenditures under 45 CFR Part 74, Subpart Q,
Appendix C (now A-87;  see n. 4).  The Board's analysis turned on the
fact that the agreements were "quid pro quo" agreements (work in
exchange for pay). /8/ The Agency argued that the excise taxes paid by
the providers here were analogous to these "conditional" agreements and
therefore, should be considered applicable credits under OMB A-87.

We cannot agree.  Texas did not involve the calculation of FFP for State
expenditures in accordance with an approved Medicaid reimbursement rate.
This case does. Moreover, we do not agree that the providers' payments
of excise taxes were equivalent to conditional donations.  The Medicaid
and Medicare plan provisions stating that the excise taxes were
reimbursable provider costs are not analogous to the written agreements
in Texas.  The excise taxes were not in any way a quid pro quo.  The
taxes were not paid in exchange for the Medicaid reimbursement.

   C.  Resolution of State budget Officers.

The State of Hawaii formally submitted into the record a resolution of
the National Association of State Budget Officers.  The State argued
that the resolution supported its position that the HCFA policy was new,
disruptive of established government relationships, and should not be
applied either retroactively or prospectively.  HCFA submitted into the
record the Secretary's response to the resolution.  The Secretary stated
that the tax issue was before the Board and that the HCFA policy in no
way affected the State's authority to formulate its own tax policy.  We
have noted the resolution and find it to be unpersuasive in most of the
respects for which it was offered by the State.

(15) The resolution itself was simply a declaration which:  (1) urged
Congress and the Administration to take legislative or administrative
action to prevent the Department from withholding FFP for state
expenditures for taxes;  and (2) argued that the Department's action in
withholding FFP for taxes diminished the states' power to tax.

The State did not explain how this declaration supported the State's
arguments and the resolution itself contained no basis for the
assertions made.  The document did indicate that many people apparently
considered the position taken in the HCFA disallowances new, but that
does not change our analysis.  Further, we do not see how the Agency's
interpretation of 1903(a) (1) of the Act can be said in any way to
diminish the State's power to tax.  In any event, that question is not
before us.  Our decision concerns whether FFP was available, not whether
the State could tax.

IV.  Notice.

In this section, we discuss why we conclude that the Agency has not
provided sufficient notice to the State of an interpretation of section
1903(a) (1) which would mandate disallowing costs of the type claimed
here.  This conclusion is based not only on the nature of the Agency
documents which informed the State of the proposed Agency action, but
also on what we perceive as a lack of any consistent and fully-developed
policy specifying when taxes must be netted against Medicaid
expenditures for services.

   A.  The documents.

In the cover letter to the draft decision the Board noted that if the
Board's initial conclusions were adopted as the final decision, then FFP
would be available to the State until such time as the State had actual
notice of the Agency's present interpretation.  The Board noted that
actual notice was required before a party could be adversely affected by
a change in Agency policy. /9/ (See Alabama Department of Pension and
Security, Decision No. 128,(16) October 31, 1980;  Oregon Department of
Human Resources, Decision No. 129, October 31, 1980; Utah Department of
Social Services, Decision No. 130, October 31, 1980; New Mexico Human
Services Department, Decision No. 382, January 31, 1983; and see 5
U.S.C. 552(a) (1) (D) and (E)) The Board asked the parties to brief the
question of which, if any, of the following Agency actions should be
considered to be actual notice:

   (1) receipt of the first deferral letter, dated December 20, 1984;

   (2) receipt of the first disallowance letter, dated June 12, 1985;

   (3) receipt of the notification dated August 6, 1985, that the
proposed Hawaii State Plan Amendment (85-7) would not be approved unless
the excise tax provision was excluded.

   1.  Arguments.

The Agency argued that the earliest actual notice was the receipt of the
deferral letter.  The Agency argued simply that the deferral letter
informed the State of the policy underlying the disallowances.

(17) The State argued that the earliest action that could be considered
actual notice would be the final decision of the Board.  The State
argued that it was unaware of any instance in which deferral letters are
used to announce new policy.  The State argued that deferrals merely
point out that the Agency has a question about a cost and frequently the
questions are resolved in the State's favor without a disallowance ever
being taken.  The State noted that the deferral letter in this case
stated that the questioned claims were "for sales tax." The State argued
that words such as these could not serve as actual notice of such a
fundamental change in policy as the Agency proposed here.  Further, the
State indicated that it interpreted the first deferral letter to be a
misunderstanding as to the nature of the tax since the tax was, in fact,
an excise rather than a sales tax.

The Agency did not address the question of whether the first
disallowance letter or the letter refusing to approve the State plan
amendment should be considered actual notice.  The State argued against
either action being considered actual notice.

First, the State argued that the disallowance letter could not be
considered actual notice.  The State's premise was that the Agency was,
in effect, attempting to impose a policy of general applicability;  the
State argued that the appropriate mechanism for such an action was
through a regulation or action transmittal, not a disallowance letter.
Disallowance letters, the State noted, issue from the Regional level and
inform states about the allowability of specific costs;  they are not
central office pronouncements of new policy.  The State argued that
disallowances might well be unauthorized departures from policy by a
region or interim actions that have not been fully reviewed by central
office.  The State argued that it did not change State policy upon
receipt of the disallowance because it thought FFP was available under
the law.  The State pointed out that changing reimbursement
methodologies at the State level was a major undertaking, involving
administrative rulemaking (notice and hearing) and clearance at various
State levels including the Governor's office.  Furthermore, the State
noted the major adverse effects on a wide range of businesses and
professions.  The State argued that if, after review of the
disallowances, the Board rejected the policy underlying the
disallowances, the State would be unable to restore the relevant State
plan provisions retroactively;  the effect would be to forego FFP for
its rightful claims.

The State presented essentially the same argument why the letter
refusing to approve the State plan provision could not be considered
actual notice.  The State argued that the disapproval letter "linked"
the reason for the disapproval with(18) the disallowances.  The State
argued that it believed that if the disallowances were reversed the
disapproval action would also be reversed.

The State concluded that the only action that could be considered notice
in this matter would be the decision of the Board.  The State argued
that the Board's decision would represent final determination on the
matter by the Department.  The State argued that the Agency issued the
disallowances here specifically for the purpose of obtaining a
definitive ruling on the policy issue from this Board.  The argument
implied that it would be unfair to impose the policy prior to that
definitive ruling.

   2.  Analysis.

We agree that the deferral letter cannot be considered actual notice of
the Agency's policy.  We find it significant that HCFA did not correctly
identify the tax, thus leaving open the possibility that the deferral
reflected a misunderstanding, not a new policy.  But even if the letter
had correctly identified the tax, we do not believe that a deferral
letter is the appropriate vehicle for announcing policy.  The deferral
regulations at 45 CFR 201.15, cited in the letter to Hawaii, state that
deferral action means "the process of suspending payment . .  . pending
the receipt and analysis of further information relating to the
allowability of the claim. . . ." Thus, it is clear that the deferral
was not a final HCFA decision and could not be considered actual notice
of a policy since HCFA might well reverse its position after further
review.

For the same reason, we conclude that neither the first nor subsequent
disallowance letters constituted actual notice of the Agency policy.
The disallowance letters were not final decisions of the Department.
Each disallowance letter itself states that the decision "shall be the
final decision of the Department unless . . . you deliver or mail . . .
a written notice of appeal to the . . . Board. . . ." (underlining
added).  Thus, the disallowances here could not be considered notice
since the possibility existed that they would be reversed.

Moreover, neither the deferral nor the disallowances were part of the
Agency's general system of providing policy guidance.  The Agency
traditionally has provided policy guidance through such issuances as
action transmittals and regulations.  To conclude here that a deferral
or a disallowance letter should be considered notice of the changed
policy would result in an unprecedented departure from Agency practice.
The deferral and disallowances were Agency assertions that this
particular grantee misspent(19) money in the past.  They were not
documents having prospective effect. /10/

While this distinction may appear technical, it is an important one. As
the State pointed out, a disallowance might possibly represent an
unauthorized departure from national policy by a regional office or an
interim action that has not been fully considered by central office. In
this case, for the State to change its reimbursement system based on a
disallowance letter would involve a complex cumbersome process which
might well have to be reversed later.

We are here dealing with one series of disallowances for one state only,
but a national issue.  It appears that many states may be similarly
situated.  A federal department's policy in such an instance ought
reasonably to be articulated nationally, and the fact that the "policy"
here was not so announced -- particularly when it could so easily have
been, through an action transmittal -- undermines the argument that
Hawaii has had notice sufficient to cause it -- and only it -- to
undergo substantial administrative disruption. /11/

(20) We also conclude that the Agency's letter of August 6, 1985
(notifying the State that its plan amendment would not be approved with
the excise tax provision) was not actual notice.  We reach this
conclusion because the letter clearly was not a final Agency statement
and not part of the Agency's system of providing policy guidance.  In
fact, the August 6 letter specifically stated that it was not a final
decision.  The letter requested additional information and noted that
processing of the proposed amendments would be suspended pending a
review of the information. /12/

   B.  Agency policy unclear.

Further support for our decision is the fact that it is not clear from
the record what policy the Agency intended to adopt.  The Agency's
statements and actions before the Board regarding the basis for this
disallowance are inconsistent in several respects.  The State payments
initially disallowed by the Agency included reimbursements to providers
calculated under a retrospective rate system that included gross excise
taxes in calculating the reimbursement rate.  Initially the Agency
argued as a basis for the disallowance that when the State recovered
excise taxes from the providers and reinbursed the taxes to the provider
under the rate methodology of the State plan, there was a circular
movement of funds and no "net" expenditure by the State.  (Respondent's
Brief, November 15, 1985, p. 6) We will refer to this for convenience as
the "circular rate" theory of the disallowance.

Nevertheless, the Agency's theory in fact appears broader than the
circular rate theory.  The disallowances were calculated by taking a
percentage of the State's overall expenditures for medical services,
including some not paid under a rate.  There is no evidence here that
all expenditures for medical assistance were paid under a rate, and many
normally are not.  For example, the Medicare regulations indicate that
certain services such as(21) physician's services may be paid based on
"reasonable charges" rather than under a rate calculated using the
provider's costs (see 42 CFR 405.501 and 405.502), and the State plan
provided for using the Medicare principles for Medicaid.

While the Agency did not articulate a basis for the disallowance of
costs not calculated under a rate, clearly a broader theory than the
circular rate theory must have beeb used.  The broader theory would seem
to be based solely on the circular movement of funds:  any time the
State paid a provider for its costs of providing medical services
(regardless of whether excise tax was used as a cost item in calculating
a rate), the State received back (through the excise tax on the
provider's gross receipts) a percentage of the amount paid out.  We
refer to this as the "rebate" theory of the disallowance (in effect, the
State received a rebate on its payments to providers).

Adding more confusion to what theory the Agency used for its
disallowance is the December 18, 1984 memorandum from a "high level"
Agency official.  (Respondent's Appeal File, Tab A) The Agency counsel
cited the memorandum for purposes of establishing that FFP was never
available for excise tax.  (Respondent's Brief, November 15, 1985, p.
20) The memorandum was an internal Agency document directed to the
Regional Administrator for Financial Operations, Region X.  Its purpose
was to provide "policy guidance" regarding the availability of FFP for
Hawaii's excise tax and California's sales tax.  The memorandum stated:

   The definition of medical assistance does not include sales or excise
taxes as an "add-on" to the care and services furnished.  Reimbursement
to the State for medical assistance furnished Medicaid recipients plus
the taxes asserted by the State on providers of medical assistance would
result in providing excess FFP above that defined as medical assistance.
. . .

   We recommend that you immediately disallow all the claims for sales
and excise taxes added on to either medical assistance or administrative
services. . . . (emphasis added)

The term "add-on" creates additional doubt that the Agency had a clear
theory of the disallowance here.  "Medical assistance" includes the
amount a State pays to providers in accordance with a rate established
under an approved State plan.  (Sections 1905(a) and 1902(a) of the Act)
Where, under the approved plan, the tax is one of the costs to be used
in the base for calculating the rate, it makes no sense to call the tax
an "add-on" to "medical(22) assistance" if the tax is a component part
of the rate from which "medical assistance" is determined.  The "add-on"
language makes it seem that Agency policy would prohibit FFP for a
State's payment of tax to itself, but not for a provider's payment of
tax to the State.  For example, where a State buys a desk for use in its
Medicaid program, and as part of the purchase pays a sales tax to itself
and later attempts to claim the sales tax as part of its "medicaid
services," there is indeed an "add-on." However, when the tax is used as
a cost item in the base for calculating a rate under an approved rate
methodology, the tax is not an "add-on" but arguably a component of
"medical assistance." Thus, it is not at all clear that the policy
espoused in the memorandum even applies to the facts of Hawaii although
the Agency may have relied on it, at least for the later disallowances.

We cannot be sure which of the three approaches discussed above the
Agency intended to adopt.  Each approach has its own practical
ramifications:  under the "circular rate" theory an excise tax would be
disallowed only if reimbursed under a rate;  under the "rebate" theory,
an excise tax would be disallowed whether in a rate or not;  under the
"add-on" theory, the tax would be disallowed only if paid by the State.
Also, each policy has broad ramifications affecting the State's
relationship with its providers and its program operations.

We conclude that the State cannot be said to have been given notice of
any specific Agency policy.  Moreover, it is not for the Board to choose
among the various possible interpretations.  Stating policy is the
Agency's function and such sweeping policy implications as those in this
case should be addressed through explicit and considered policy
guidance.

Conclusion

Based on the foregoing, we reverse the disallowances except as qualified
by the footnote below. /13/

        /1/ We use "DSSH," "Hawaii," and "State," interchangeably when
referring to the appellant in this decision.  Nevertheless, it is useful
in picturing what happened in this case to note that, while DSSH paid
the providers for medical services, the providers did not pay excise
taxes back to DSSH.  Rather, the providers paid excise taxes to the
State Department of Taxation and the tax money went into the State's
general treasury.         /2/ There may be a separate basis for
disallowing a certain portion of the claimed costs.  Long-term care
providers were paid for some part of the disallowance period under a
prospective payment system, with rates not computed under Medicare
principles, but with a Medicare upper cap. We discuss below in footnote
13 why we do not decide the part of this dispute pertaining to these
providers for this period.         /3/ The State argued that certain
past Board decisions concluded that an "expenditure" is the amount the
State pays the provider under a rate. (Appellant's Brief, p. 7, citing
Missouri Department of Social Services, Decision No. 630, March 18,
1985;  Illinois Department of Public Aid, Decision No. 467, September
30, 1983;  and New York State Department of Social Services, Decision
No. 521, March 6, 1984.) This is true, but simply does not resolve the
question of whether that expenditure has to be reduced to the extent the
State receives part of it back in the form of taxes. The point of those
decisions was that A-87 principles do not apply directly to a provider's
costs (even where the provider is a state facility) because the
expenditure which is reimbursable under Medicaid is the payment of the
rate to the provider for services rendered, not the provider's costs for
supplies, salaries, etc., which are merely used in calculating the rate,
when permitted by the methodology and cost principles adopted in a state
plan.         /4/ OMB Circular A-87, issued January 28, 1981 (46 Fed.
Reg. 9548), was previously designated as FMC 74-4.  The cost principles
set out in OMB A-87 had initially been contained in 45 CFR Part 74,
Appendix C, which has since been removed (45 Fed. Reg. 34274).  Part 74
now incorporates OMB A-87 by reference.  See 45 CFR 74.171.         /5/
As we discuss in section IV below, the Agency itself has not been
consistent in how it has read the "applicable credits" provision,
particularly with respect to whether all State taxes paid by a provider
must be offset against Medicaid payments or whether this treatment is
required only when the tax is included in the rate calculation or added
on to the rate by the State.  /6/ We note that the record also contains
        a memorandum written by another Agency official (classified by
the Agency as a "high level" official) which states that FFP was never
available for such taxes under Medicaid.  The memorandum was written on
December 18, 1984, only two days before the first deferral in these
cases.  The memorandum does not diminish the fact that other officials
(even if lower or mid-level) earlier had a different view of the law.
Again, the point is that the law was not clear.         /7/ The HCFA
Medicare Provider Reimbursement Manual (HIM-15) provides at section
2122.1 that "the general rule is that taxes assesses against the
provider in accordance with the levying enactments of the several states
. . . and for which the provider is liable for payment, are allowable
costs." The only exception to the rule is for taxes measured by or based
on net income, which are essentially taxes on profit.  See, e.g., Humana
of Kentucky v. Harris, CCH Medicare/Medicaid Guide section 31,610.  The
Hawaii tax is not a net income tax;  it is payable by providers even if
they operate at a loss.         /8/ Texas was remanded to the Department
by the United States District Court for the Western District of Texas by
Order dated August 2, 1985. The remand does not affect our analysis here
since we distinguish Texas.  Moreover, the Board's amended decision on
remand was not based on the "applicable credit" provision.  (See Texas
Department of Human Services, Remand of Decision No. 381, June 18,
1986.)         /9/ The Agency argued in earlier briefing that there was
no change in policy since the Agency never had a formal written policy
on the issue. The Agency argued that FFP for State expenditures for such
taxes was paid "inadvertently" and that its present position on excise
taxes was an initial interpretation of the Act.  (Agency Response Brief,
p. 21) The fact that the Agency allowed the State to include the tax in
its rate calculation without question for 18 years seriously undermines
the argument, however. The Agency, in effect, admitted that actual
notice was required when it asserted that its pronouncement on excise
taxes constituted an interpretative rule.  (Agency Reply Brief, pp.
18-19) Section 552(a) (1) (D) of 5 U.S.C. (the Administrative Procedure
Act) specifically identifies "statements of general policy or
interpretations of general applicability," as well as substantive rule
changes, as among the Agency actions requiring publication in the
Federal Register or actual notice before a party can be adversely
affected.  Thus, notice was required here whether the new interpretation
was an initial interpretation (as the Agency argued) or a changed
interpretation (as the State argued).  Even if the Agency policy were
considered an "interpretative rule," exempted from notice and comment
rulemaking procedures under 5 U.S.C. 553(b) (A), actual notice would be
required before the State could be adversely affected.  See section
552(a) (1).         /10/ This does not mean that the Agency need be
hamstrung by the Board in its rightful function of interpreting statutes
or regulations.  In this case, for example, HCFA could have gone forward
at the time of issuing of the first disallowance letter with a
simultaneous action transmittal setting forth its policy.  /11/ The
        record in the related California cases, originally joined with
this case but later severed, contains an internal memorandum of February
1983 from an attorney in the Office of the General Counsel pertaining to
a Georgia sales tax on pharmaceutical products furnished Medicaid
patients.  (See California Department of Health Services, Docket No.
85-156, Appellant's Exhibit E) After giving an opinion that FFP was not
available for this sales tax, the writer went on to say that while the
"new policy" of not paying for sales taxes arguably constituted an
interpretive rule (not subject to the notice and comment provisions of 5
U.S.C. 553(b) (A)), given the uncertain state of the law, notice and
comment was the appropriate action.  The opinion continued:  "Further,
since Section 552 of the APA takes the position that effective notice be
accomplished either by publication in the federal register or by actual
notice, we believe that actual notice of this new policy be given to all
jurisdictions that participated in the Medicaid program." HCFA was
advised to "proceed along both avenues, addressing the problem in the
short term by actual notice, and, in the long run, by publication." (p.
5) /12/ We emphasize that the Board is not deciding that all
disallowances and other actions short of rules or action transmittals
(and the like) are insufficient notice under the Administrative
Procedure Act.  This is a matter which we find neither fully developed
in the record nor necessary to reach here.  We have determined only that
in the peculiar circumstances of this case, the disallowances were
insufficient legally to bind Hawaii.         /13/ A State is entitled to
FFP only for expenditures made in accordance with its approved State
plan. (Arkansas Department of Human Services, Decision No. 357, November
15, 1982, p.  9;  section 1903(a) of the Act) In this case, State plan
amendment 85-1, approved by the Agency, deleted the provision proposed
by the State to include gross excise tax as a cost in the base used to
calculate the provider reimbursement rate for long-term care facilities
under a prospective payment system.  Thus, it appears that from the
effective date of that provision, FFP attributable to gross excise taxes
reimbursed to long-term care providers would be unallowable as not in
accordance with the State plan.  Although the plan amendment shows an
"effective date" of February 1, 1985, it is not clear from the record
what date actually should be considered the "effective date." The record
indicates that a restraining order issued on January 25, 1985
(incorrectly noted in Appellant's letter as 198 6) by the Federal
District Court for the District of Hawaii postponed implementation of
the reimbursement methodology adopted under plan amendment 85-1.
(Appellant's letter, June 30, 1986, p. 2;  Respondent's letter, June 30,
1986, p. 1) Furthermore, the record also indicated that a settlement
agreement between the parties which precipitated dismissal of the
restraining order on June 4, 1985 apparently further postponed
implementation of the methodology contained in plan amendment 85-1.
(Appellant's letter, June 30, 1986, p. 2) It is not clear from the
record what was stated in either the restraining order or the settlement
agreement.  It is also not clear whether the agreement was incorporated
into a court order dismissing the restraining order, so as to have the
effect of the court order. We therefore do not decide whether to uphold
or reverse the disallowance pertaining to long-term care providers under
the prospective payment system of plan amendment 85-1.  We leave it to
the parties to resolve this question.  If they are unable to do so, they
may return to us on this one issue.