H.R. 1 and Beyond: The CMS Proposal to Cap Medicaid State-Directed Payments at Medicare Rates

President Donald Trump signed into law H.R. 1 on July 4, 2025, major budget reconciliation legislation often referred to as the "One Big Beautiful Bill Act" (Pub. L. 119-21), but which the Centers for Medicare & Medicaid Services (CMS) refers to as the "Working Families Tax Cut" (WFTC) Act. A central feature of this legislation was the enactment of major changes affecting state Medicaid programs, including new "community engagement" requirements, tighter limits on the use of provider taxes to finance a portion of state costs, and restrictions on the use of State Directed Payment (SDP) programs.

On May 20, 2026, CMS released a proposed rule addressing one of these three major issues: changes in the regulations governing SDP programs. SDPs are a type of Medicaid managed care payment arrangement authorized and regulated by CMS. Under an SDP, a state may direct managed care organizations (MCOs) to make payments to providers using specified rates, methodologies or payment structures that support state Medicaid policy objectives. SDPs may be used to establish minimum or maximum provider payment rates, implement uniform rate increases for certain classes of providers or require participation in value-based payment arrangements. This proposed rule would codify key statutory requirements established under Section 71116 of the WFTC related to the implementation of spending caps on SDPs and associated payment rate reductions, as well as "grandfather" provisions that will allow some states to transition to these new limitations over a period of years.

The proposal would also codify and build upon guidance CMS issued in September 2025 and revised in February 2026 regarding implementation of these statutory changes. Beyond implementing the WFTC, CMS proposes several additional policy changes that are not expressly required by the statute but are intended to advance broader Trump Administration goals related to aligning Medicaid payment rates more closely with Medicare rates and limiting supplemental payment arrangements. These proposals are consistent with a June 2025 presidential memorandum directing federal agencies to curb Medicaid payments that exceed Medicare rates where possible.

Importantly, this proposal represents only one component of a broader effort to implement and expand upon the Medicaid financing and programmatic reforms enacted in H.R. 1. The legislation included significant changes affecting SDPs, provider taxes and other Medicaid financing and program integrity policies. Though this proposed rule primarily addresses the SDP provisions, CMS has separately developed a proposed rule addressing Medicaid provider taxes ("Amending the Indirect Hold Harmless Threshold of Health Care-Related Taxes") and another focused on Medicaid and CHIP financing, program integrity, and access issues ("Strengthening the Integrity of Medicaid and CHIP Managed Care, Financing and Access to Care"). As of the date of this alert, both proposals remain under review at the Office of Management and Budget.

Taken together, these rulemakings reflect a broader administration effort to reshape Medicaid financing and oversight. As a result, the ultimate impact of the SDP proposal cannot be evaluated in isolation, particularly given the extent to which many SDP arrangements rely on provider taxes and intergovernmental transfers (IGTs) to finance the non-federal share of Medicaid payments.

Notably, neither H.R. 1 nor the SDP proposed rule would substantively restrict states' authority to use IGTs to finance the nonfederal share of Medicaid expenditures. However, CMS reiterates in the preamble its longstanding concern regarding financing arrangements in which the same governmental entities or providers that contribute funds through IGTs or healthcare-related taxes subsequently receive enhanced Medicaid payments funded by those contributions. Though the proposal does not impose new restrictions on IGT financing, CMS' discussion may provide insight into the agency's broader concerns regarding Medicaid financing mechanisms and foreshadow potential future policy actions in this area, particularly through the pending provider tax rulemaking.

Scope of the Proposed Regulation

In this proposed rule, CMS is taking three distinct actions:

• Implementing WFTC. CMS would codify in regulation the statutory payment limits for SDPs covering four mandated service categories effective with the first rating period on or after July 4, 2025. The agency would also codify the grandfathering framework and mandatory 10 percentage point annual phase-down beginning January 1, 2028.
• Clarifying WFTC. The statute left several key terms undefined, and CMS proposes clarifications on multiple issues, particularly in interpreting eligibility for SDPs considered grandfathered.
• Going Beyond WFTC. Based on separate authority, CMS proposes extending the Medicare-based payment limits to all services, all states and all SDPs beginning January 1, 2029. CMS also proposes parallel payment limits in fee-for-service (FFS), eliminates uniform increase SDPs and enhances compliance measures.

General Background and Overview

Medicaid SDP programs have been allowed under CMS regulations since 2016 and have evolved and expanded since that time.¹ Essentially, SDP programs allow a state to modify contracts with Medicaid MCOs, prepaid inpatient health plans (PIHPs) or prepaid ambulatory health plans (PAHPs) to enhance provider payment rates subject to a number of rules and restrictions, including that payment rates may not exceed 100 percent of the average commercial rate (ACR) for inpatient and outpatient hospital services, nursing home services or qualified practitioner services at an academic medical center. Permissible approaches under current regulations include value-based payment (VBP) arrangements, delivery system reform or performance improvement initiatives, minimum or maximum fee schedules, and uniform dollar or percent increases. In 2024, CMS modified the SDP regulations to phase out the use of "separate payment terms" effective mid-2027. Under this change, SDP reimbursements channeled to providers through MCOs, PIHPs or PAHPs must be incorporated into the capitated rate. Many SDP programs are subject to an annual review process by CMS that involves completing and submitting a CMS form entitled "Section 438.6(c) Preprint" for review and approval.

Section 71116 of the WFTC capped the provider payment rate increases that could be provided under SDP programs for inpatient and outpatient hospital services, nursing home services or qualified practitioner services at an academic medical center at levels well below average commercial rates for rating periods beginning after the date of enactment of the new law. Specifically, the law sets the limits at no more than 110 percent of the "specified total published Medicare payment rate" in a state that did not expand its Medicaid program pursuant to the Affordable Care Act (ACA), and 100 percent of the Medicare payment rate in an ACA expansion state.²

Section 71116 also provides for SDP programs meeting certain "grandfather" requirements to obtain limited relief from the otherwise required reduction. For an SDP program that qualifies for grandfathering, the total payment amount would be kept at the grandfathered level until the rating period beginning on or after January 1, 2028, at which time "the total amount of such payment shall be reduced by 10 percentage points each year" until the total payment rate for services is equal to the 100 percent or 110 percent of the total published Medicare payment rates cap.

Determining Medicare-Comparable Rates

One question left unanswered by the statute was whether Medicare-equivalent payment rates would be calculated in the aggregate for a provider. The proposed rule indicates that this limitation will be calculated by applying the payment limit on a per-service or per-discharge basis, based on the agency's reading of the WFTC's reference to "the total payment rate for such service" as meaning the specific payment rate for a service furnished by a provider. The payment limit would therefore be calculated at the HCPCS code level or for Medicare Severity Diagnosis-Related Groups for inpatient services. This interpretation has significant practical implications because compliance would no longer be assessed solely at the aggregate SDP level. Instead, states and providers may need to demonstrate compliance on a service-by-service basis, creating substantial operational, actuarial and reporting challenges. CMS also clarifies that the "total published Medicare payment rate" is inclusive of all components in the rate, including geographic and quality adjustments, and would expect states to use CMS-published Medicare web prices and fee schedules to determine the applicable payment limit.

Although a Medicare-equivalent payment rate may be readily ascertainable in many cases, there are situations where there is no Medicare comparable rate for certain items and services covered by Medicaid. In this situation, Section 71116(a) specifies that the cap defaults to "the payment rate under a Medicaid State plan" (or under a waiver of such plan). CMS clarifies that this means 100 percent of the state plan approved rate, regardless of whether the state is an expansion or nonexpansion state, because Congress did not specify an alternative percentage for the state plan rate in nonexpansion states. CMS also considers provider payment rates reviewed and approved as part of a Section 1115 demonstration waiver or a waiver of the state plan, such as a Section 1915(c) waiver, to meet the definition of state plan-approved rates.

Additionally, in a limited number of situations, Medicare pays for services on a cost-based basis rather than a specific amount derived under a regulatory payment system. Examples of this would include reimbursement for freestanding children's hospital services and certain cancer hospitals. In the proposed rule, CMS indicates that it considered several alternatives to these cost-based Medicare reimbursement approaches but ultimately decided to utilize them subject to future guidance that will address how they will be applied in a Medicaid context.

The applicable Medicare-equivalent payment limits can be summarized as follows:

Considerations Related to Grandfather Status

Section 71116(b) provides that certain SDP programs may be temporarily grandfathered, with a mandatory phase-down beginning with the first rating period starting on or after January 1, 2028. Beginning in 2028, states must reduce the grandfathered total dollar amount of their SDP programs by at least 10 percentage points annually until the applicable Medicare payment limit is reached (i.e., 100 percent or 110 percent of Medicare rates depending on expansion status).

Calendar-Based Submission/Approval Deadlines

The statute provides several alternative calendar deadlines that an SDP program that requires CMS approval via the submission of a preprint must meet to qualify for grandfather status:

• a payment described for which "written prior approval (or a good faith effort to receive such approval, as determined by the Secretary) was made before May 1, 2025"
• the "payment described is for a rural hospital [as defined] for which prior approval (or a good faith effort to receive such approval, as determined by the Secretary) was made by the date of enactment" (i.e., July 4, 2025), or
• a payment described "for which a completed preprint was submitted to the Secretary prior to the date of enactment" (i.e., July 4, 2025)

The term "completed preprint" is not defined in legislation or existing regulation. CMS proposes this term to mean an SDP program preprint with all relevant sections filled out and all information provided only in the fillable sections of the preprint and the published addendum tables, consistent with guidance in the CMS Center for Medicaid & CHIP Services Informational Bulletin of November 7, 2023. This definition essentially eliminates preprints that were submitted shortly before the applicable deadline and did not contain required information.

The term "good faith effort" is also not defined in the statute or existing regulation. Rather than provide a separate meaning to the term (e.g., honesty of intention), the proposed regulation instead simply equates it to a completed preprint. CMS does not believe that technical assistance calls or informal consultation would rise to the level of a "good faith effort" because these activities do not provide sufficiently detailed information to initiate SDP review.

Rating Period Window

A preprint that is approved or submitted in conformance with the foregoing deadlines, must also meet an additional requirement that it is for an SDP program "rating period occurring within 180 days of the date of enactment" (i.e. July 4, 2025). Rating periods are the calendar year period for which the SDP program will apply. Different states use different start and end dates for their annual rating periods that usually conform to either the calendar year (CY), federal fiscal year (FY) or state FY. The proposed rule interprets "180 days" to mean 180 business days, rather than calendar days. Under this interpretation, the grandfathering provision would apply to eligible SDPs in rating periods that include any business days between October 11, 2024, through July 3, 2025, or between July 5, 2025, and March 27, 2026. The use of business days is significant for SDPs that met the submission/approval requirement but had a rating period occurring in CY 2024 or alternatively not starting at the beginning of January 2026. CMS estimates that interpreting "180 days" as calendar days would cause at least eight additional SDPs to be ineligible for grandfathering.

Amount of Annual Reduction to the SDP Program Total Amount

One piece of data that must be included in item 4 of an SDP preprint is documentation by the state of the total dollar amount of the SDP program. As mentioned previously, for rating periods commencing after January 1, 2028, a grandfathered SDP program will see its total amount reduced by "10 percentage points each year". This language appears susceptible to two different interpretations: 1) that the total amount of the SDP program is reduced by 10 percentage points of the corresponding percentage of the Medicare rate, or 2) that the reduction is 10 percent of the dollar amount. The proposed rule adopts the latter view: "total amount" means the dollar amount documented in item 4 of the approved preprint. These annual reductions are further interpreted to mean a fixed annual reduction equal to 10 percentage points of the original grandfathered total dollar amount, rather than a compounding reduction that would produce a declining dollar amount cut year over year.

This interpretation, together with the interpretation that each Medicaid item or service must ultimately be reduced to a specified percentage of Medicare rates, raises interesting questions regarding how those two thresholds will interact. CMS does not exhaustively address this issue but provides an example where a grandfathered total dollar amount for rating period covering CY 2025 is $1 billion, which would be required to be reduced by 10 percentage points beginning in CY 2028. It also accompanies this with an illustrative example of how the corresponding total published Medicare payment rate for a hypothetical provider class under the SDP program would be reduced.

* This is the grandfathered total dollar amount.

There are also significant compliance-related implications with the proposed rule. One helpful clarification is that grandfathered SDP programs that are utilizing separate payment terms may continue to do so notwithstanding the otherwise applicable phase out of this option in July of 2027. However, it also appears that a Medicare-equivalent rate will need to be calculated on a provider-specific basis, and ensuring that Medicaid payments do not exceed the applicable limit could be a complex undertaking.

Going Beyond WFTC: SDPs in Medicaid Managed Care

As mentioned previously, SDP programs are entirely a creature of regulation. H.R. 1 is the first statute to mention them. In the proposed rule, CMS is making changes to the rules that go beyond implementing the WFTC changes. CMS relies on its statutory authority to police risk-based capitation contracts and their actuarial soundness,³ as well as the broad requirement that state Medicaid programs "ensure payments are consistent with efficiency, economy, and quality, and are sufficient to enlist enough providers so that care is available to enrollees to the same extent as it is to the general population in the same geographic area"⁴ as the basis for these modifications. Additionally, as noted earlier, CMS indicates that it is acting to implement the June 2025 presidential memorandum directing that Medicaid payment rates do not exceed Medicare rates where possible.

Expansion of Medicare Payment Limits

CMS proposes expanding the Medicare-based payment limits to all services, in all states and territories, for all SDPs beginning with the first rating period on or after January 1, 2029. Without a uniform limit across all services, the agency is concerned that states could engage in cost shifting by increasing SDP payments for services not addressed in the WFTC legislation to offset revenue losses from the four capped services. The 2029 start date is intended to give states sufficient time to redesign SDPs, work with interested parties and legislative bodies, and engage in technical consultation with CMS.

VBP SDPs

As previously mentioned, one permissible form of SDP provider reimbursement is the use of VBPs. This can include arrangements that are structured as prospective payments to providers (e.g., per member per month payment) for an attributed population or defined set of services. Because VBP models create a greater risk of unintentionally exceeding the per-service payment limit, CMS proposes to require states implementing VBP SDPs to provide a detailed validation methodology to ensure payments do not exceed the applicable limit. For example, a state using a population-based payment SDP would be required to reconcile prospective population-based payments against actual utilization during the rating period to verify compliance. CMS seeks comments on ideas to operationalize alternative value-based arrangements in Medicaid to achieve CMS' priorities of holding providers accountable for health outcomes and reducing wasteful spending.

Changes to Permissible SDP Types

CMS proposes to eliminate uniform increase SDPs beginning with the first rating period on or after January 1, 2029, citing concerns that states are using them to ensure predetermined aggregate payments to specific providers rather than advancing access and quality. As noted previously, a limited exception would allow uniform increase SDPs governed by separate payment terms for grandfathered SDPs during the temporary grandfathering period. Minimum and maximum fee schedule SDPs would be restructured and limited to the new payment limits.  The proposed rule would revamp the description of minimum fee schedules and provide guardrail language to clarify that they cannot exceed the applicable Medicare-equivalent maximum on a per-service basis. Maximum fee schedules would also still be allowed but subject to a proviso that they not exceed the applicable Medicare-equivalent rate and not interfere with the ability of an MCO, PIHP or PAHP to reasonably manage risk and retain discretion to accomplish the goals of their contract with the state.

Grey Area Payments Prohibited

Medicaid generally prohibits states from interfering in the process by which MCOs, PIHPs and PAHPs negotiate and administer payments to providers. SDP programs are one of a handful of exceptions to this general rule. CMS included a section in the proposed rule discussing what it refers to as "grey area payments" under state Medicaid programs, including vague contractual requirements for provider payments not subject to approval as an SDP or pass-through payment. CMS indicates that these types of arrangements are largely impermissible. To clarify longstanding requirements, CMS proposes to specify that SDPs must be based only on the utilization and delivery of services furnished by a provider and that states cannot condition provider participation in an SDP on paying any portion of the SDP to an entity other than the furnishing provider.

Concerns about Provider Classes

CMS raises significant concerns about how states define provider classes under SDPs, as it has observed that, in some instances, states define provider classes so narrowly that a single provider constitutes the entire class and that single provider is the source of the provider tax or intergovernmental transfer (IGT) that constitutes the nonfederal share of the payment. The agency notes that at least two states have submitted more than a dozen individual SDP preprints, each with a single provider class and only one eligible provider. CMS is not proposing to define "provider class" in this rule but is soliciting comments on whether and how to define the term, including options such as aligning provider classes with state plan provider groupings or requiring that class criteria be directly tied to the goals and objectives of the managed care quality strategy.

Compliance, Monitoring and Guidance

To operationalize the new payment limits, CMS proposes enhanced compliance and monitoring requirements. States would be required to submit to CMS a list of all providers eligible for an SDP along with their National Provider Identifiers, the applicable Medicare or state plan rate serving as the basis for the payment limit for each covered service, and a detailed description of how the state will ensure that per-service payments do not exceed the limit. CMS reminds states that payments in excess of the applicable payment limit would trigger existing overpayment obligations. CMS plans to issue guidance, as needed, on topics including federal requirements and standards for SDPs, documentation required to demonstrate compliance with the payment limit, and considerations for state monitoring, oversight and evaluation of SDPs.

Going Beyond WFTC: Targeted Medicaid Payment Limits in FFS

Payment Limits

Based on its existing statutory, CMS proposes a new practitioner- or provider-specific limit on total Medicaid FFS payments when those payments are targeted. The agency considers payments to be targeted when they are directed to a subset of participating practitioners or providers rather than available to all providers furnishing the same service. This differs from existing aggregate upper payment limits (UPLs) in that it applies at the individual practitioner or provider level.

The FFS targeted payment limits mirror the managed care SDP limits and would be 100 percent of applicable Medicare FFS payment rates for expansion states and 110 percent for nonexpansion states. The limit applies to the total Medicaid payment (base plus supplemental) to prevent states from reclassifying payments to avoid the limit.

Exceptions

The limit does not apply when payments are uniform for all participating practitioners or providers statewide or within a defined geographic region, or when payments are already subject to other regulatory UPLs. CMS seeks comments on whether additional guidance would be helpful for states seeking to preserve or increase the supply of providers in rural areas. Exceptions would also apply where there is no reasonable Medicare-equivalent payment rate or where payments are reconciled to a provider's actual incurred costs.

VBP Arrangements as FFS Targeted Payments

Unlike VBP SDPs in managed care, VBP arrangements in FFS Medicaid that are open to all Medicaid participating practitioners or providers of a given covered service would be exempt from the targeted payment limit. However, if a state designs a VBP methodology that limits participation to a select group of practitioners or providers, such as those with the means and ability to fund the non-federal share, those payments would be considered targeted and subject to the Medicare rate cap.

Transition Period

States with existing targeted FFS payments that exceed the proposed limits must submit a State Plan Amendment (SPA) to bring payments into compliance, with an effective date no later than the start of the first state FY beginning on or after January 1, 2029.

Impact on Providers and Clinicians

This proposed rule, in conjunction with a yet-to-be-released rule addressing provider taxes, represents the most significant restructuring of Medicaid provider payments in decades. CMS projects that under the SDP proposed rule total Medicaid spending would fall by $782.6 billion over 10 years. Hospitals would be disproportionately affected by this reduction. The proposed rule indicates that "[t]he majority of these projected reductions would be for hospitals, with some reductions for AMCs and nursing facilities, and smaller reductions for other provider types, including physicians." CMS estimates SDPs funded through IGTs or provider taxes to supplement Medicaid reimbursement account for over 80 percent of SDPs that exceed Medicare rates.

The proposed rule would also cut Medicaid payments to other healthcare providers. Academic medical centers (AMCs) would be negatively impacted by both the SDP payment limits and the FFS targeted payment limits that would cap physician supplemental payments that currently average 207 percent of Medicare rates. Nursing facilities would also be subject to the new Medicare-based caps under WFTC, but CMS does not have sufficient data to project their specific economic impacts. Physicians, clinicians and emergency medical transportation providers would be negatively affected by the targeted FFS payment cap. CMS notes that states claimed approximately $2.63 billion in FFS supplemental payments to physicians, clinicians and ground emergency medical transportation for FY 2024. Emergency medical transportation providers, including air ambulances, would be subject to payment limits benchmarked to the Medicare Ambulance Fee Schedule.

Discussion

The proposed rule is open for public comment until July 21, 2026. CMS has solicited comments on a number of issues raised in the rule, including several that are noted in this alert and various alternative approaches that were considered but not adopted. Some aspects of the proposed rule that may merit consideration include:

• negative impact on access to care if SDPs that support service lines and charity care are substantially reduced
• limited guardrails for safety-net and rural hospitals that have disproportionately high Medicaid volumes
• burdensome VBP arrangement validation requirements will disincentivize those contracts in Medicaid
• underestimated financial impact due to limitations in available data
• limited time to prepare for aggressive reduction in grandfathered SDPs, as well as the payment cap on targeted FFS payments

Many states submitted new or substantially revised SDP program proposals with higher total payment amounts prior to the statutory deadlines and some are still awaiting CMS determination as to whether their preprints will be grandfathered. For these jurisdictions, the final determination of what constitutes a good faith effort or a completed preprint could be dispositive. For states that did not attempt to substantially change the contours of their SDP programs in anticipation of Trump Administration-driven limitations on the program, this is generally less of a concern. Regardless, grandfathered status will be important for all states with SDP programs as it provides a window before these programs begin to see reductions.

In the longer term, the migration to Medicare-based payment rate caps will be highly disruptive. For many providers it will represent a significant reduction in Medicaid payments which may have unknown impacts on the availability of services. From an administrative perspective, the compliance challenges would appear to be considerable. Numerous issues not thoroughly addressed in the proposed rule will require future deliberation and determination through future rulemaking or guidance.

Additionally, as noted above, the impact of the SDP program proposed rule will need to be assessed in tandem with the proposed limitations on provider taxes. Given that many SDP programs are financed through such taxes, adverse changes to these revenue sources could undermine the meaningfulness of the payments allowed under SDPs.

Finally, it should be noted that there is still time before the various changes in the proposed rule take effect. During that window, Congress may consider changing or delaying provisions of H.R. 1 or reversing CMS' views on various issues.

If you have any questions, please reach out to the authors or another member of Holland & Knight's Healthcare Team.

Notes

¹ The current regulations can be found at 42 CFR 438.6.

² Section 71116 defines "total published Medicare payment rate" by reference to the regulatory definition that currently indicates that it means "amounts calculated as payment for specific services that have been developed under Title XVIII Part A and Part B" of the Social Security Act.

³ Social Security Act Section 1902(a)(4) and 1903(m)(2)(A)(iii).

⁴ Social Security Act Section 1902(a)(30)(A).

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