The House-passed health care bill—known as the American Health Care Act (AHCA)— includes the most far-reaching changes in Medicaid financing since the program was enacted in 1965. The legislation would roll back the Affordable Care Act’s (ACA) substantial federal support for expanding program eligibility, and it would impose an upper limit on per-enrollee federal Medicaid spending in future years.

The Congressional Budget Office (CBO) estimates that the AHCA would reduce federal expenditures on Medicaid by $834 billion over the next decade. Medicaid enrollment would fall by 14 million people in 2026. CBO predicts that the number of uninsured would increase by 23 million people in 2026 compared to current law, due largely to the reduction in Medicaid enrollment.

Federal payments for Medicaid amounted to $344 billion in 2015, or almost two-thirds of the total cost of the program. Those payments are made through matching grants that pay a substantial percentage of each state’s payment for medical services. That system discourages state efforts to make Medicaid more efficient because the state only keeps a small portion of every dollar saved.

By limiting federal payments on a per-enrollee basis, the AHCA payment reform aims to restore the incentive for spending discipline at the state level while ensuring that states are protected if Medicaid rolls increase. The legislation would also cut the additional funding to the 31 states plus the District of Columbia that expanded Medicaid eligibility under the ACA.

While there are some advocates for these changes, there is considerable unease, even among Republicans, over the AHCA’s proposal to pull back entirely on the federal government’s support for an expanded program. Governors and senators from expansion states have been most vocal in their concerns that federal support for Medicaid under the bill could fall short of what is needed to provide reasonable coverage for poor and modest income families. Those from non-expansion states fear that they could be receive less federal funding because they did not expand and thus cover fewer people.

A situation in which half of the country live in states with much expanded federal support for insurance and the other half do not is politically untenable. As an inducement for states to expand Medicaid eligibility, the ACA offered federal payments that covered 100 percent of the cost for newly eligible beneficiaries starting in 2014, declining to 90 percent in 2020 and subsequent years. That compares with federal payments for previously eligible enrollees that vary from 50 to about 75 percent of the cost of services. Under the ACA, states receive higher subsidies to cover people who are less poor, turning the logic of Medicaid financing upside down.

Moreover, many states now have preferential relationships with the federal government based on waiver programs that other, non-waiver states do not enjoy. Such waivers can permit states to expand Medicaid eligibility to individuals who would not otherwise be able to enroll in the program. Although the Supreme Court affirmed that states have the right to set eligibility standards for their Medicaid programs, it is difficult to justify the patchwork result as sound federal policy.

A compromise is possible and necessary for health reform legislation to pass the Senate. Republican and Democratic policymakers should develop a plan that accepts important principles from both parties.

Republicans must accept that Medicaid should be available to all citizens below some income level, and the program’s financial incentives should be calibrated accordingly. Democrats must accept that the current system of federal matching payments for financing Medicaid undermines political accountability and fiscal responsibility. A compromise plan would combine a middle-ground expansion of the program with financing reforms that lower costs over the longer term without imposing undue risks to beneficiaries or the states.

The Problem with FMAP

Medicaid is financed jointly by the federal government and the states through a system of matching grants tied to state per capita income. The federal payment is a percentage of the program’s cost (known as the federal medical assistance percentage, or FMAP) rather than a fixed dollar amount. Consequently, this system discourages sensible cost-cutting in the program and has led to higher costs for the federal government.

Most federal funding provided to the states under Medicaid is determined by the FMAP, a standard state-specific formula based on the ratio of per capita income in a state to the national average. A state whose per capita income equals the national average receives a federal payment equal to 55 percent of the cost of medical services. States with lower per capita incomes get higher FMAPs.

Medicaid law puts a floor on the standard FMAP at 50 percent to protect high-income states who would otherwise receive smaller federal payments according to the formula. States with above-average per capita incomes—including California, Massachusetts, and New York—would have lower FMAPs without the floor. One study found that Connecticut’s FMAP in 2004 would have dropped to 13 percent if not for the floor.

The ACA provides an enhanced match rate for states that expand Medicaid eligibility to individuals (primarily adult males) with incomes up to 138 percent of the federal poverty level (FPL). From 2014 through 2016, the federal government paid 100 percent of the costs for newly eligible Medicaid enrollees. In 2017, the FMAP for this expansion population was reduced to 95 percent, declining to 90 percent by 2020 and subsequently.

The Medicaid FMAP is the fundamental flaw in the program’s current design and the main reason it is so costly. States can initiate new spending in Medicaid—spending that often will boost economic activity in the state—and federal taxpayers pay for at least half the cost. At the same time, savings from state-initiated Medicaid-spending cuts are also shared with federal taxpayers.

For instance, in a state where the FMAP is 60 percent, the governor and state legislators face the unattractive prospect of keeping only $1.00 of every $2.50 in Medicaid savings they can identify and implement. The other $1.50 goes to the federal treasury. Put another way, governors and state legislators are reluctant to impose $2.50 in budgetary pain for a $1.00 gain to their bottom line.

In addition to discouraging states from adopting cost-saving measures, the FMAP system has encouraged states to increase federal matching payments through taxes on providers and other creative financing mechanisms. Provider taxes increase the cost of health services for all payers in a state, including Medicaid. The state recovers at least 50 percent of those costs from the federal government through the FMAP payment, and it also receives the full amount of additional tax revenue. Such mechanisms help states to cover their share of Medicaid expenses and improve their overall fiscal outlook. But on balance that shifts more Medicaid cost to the federal government.

Forging a Compromise

To reach a compromise on Medicaid, Republican and Democratic policymakers will each need to give some ground. Republicans must accept that low-income individuals who have no other access to health insurance need a safety-net program, and Medicaid is it. At the same time, Democrats must accept that the program needs substantial reform. The existing system of federal matching payments is wasteful and fiscally ruinous. It is inequitable and unsustainable to have large disparities in federal support between the expansion and non-expansion states. Moreover, federal rules make it difficult for the states to manage the program and quickly test new ideas for improving its efficiency.

A compromise should promote more nationally uniform eligibility standards for a reformed Medicaid program with more fiscal discipline and state flexibility. We recommend three major elements for such a plan.

Shift from Per-Capita Caps to Per-Capita Payments

The House-passed AHCA places an upper limit on federal payments tied to each state’s Medicaid spending in 2016. Separate per-person limits are established for five enrollee groups: elderly, blind and disabled, children, adults who were eligible before the ACA expansion, and adults made eligible by the ACA. The per-person limits, or caps, are indexed in future years based on the consumer price index (CPI) for medical services (plus 1 percentage point for the elderly and disabled).

Under this reform, adding enrollees raises the ceiling on federal payments by the per-capita amount. However, if the cost of benefits (per enrollee) increases faster than the AHCA’s medical inflation index, the state would be required to pay the amount that exceeds the federal payment limit. States would have a strong incentive to limit costs on a per person basis to avoid exposing their taxpayers to additional program obligations.

However, potential cost savings are limited because the House-passed bill builds on the existing FMAP system. States would not be willing to take actions to lower the growth of per-person costs below the growth rate of the AHCA’s price index because federal payments would decline, as they do now. This creates the same perverse incentives for states that are embedded in the current program up to the point where federal spending reaches the level of the per person limits.

It would be better to move entirely away from the matching system. Caps on federal matching payments should be replaced by actual per-person payments to the states identical to the AHCA caps. This would not increase federal spending in any significant way because, as just explained, states would have a strong incentive under the AHCA to provide enough matching funds to maximize the amount of federal Medicaid support anyway. The incentive for states to reduce unnecessary Medicaid spending would be strengthened by per-person payments because the states would retain the full amount of any savings they were able to achieve.

States would be subject to a maintenance of effort requirement that could allow some flexibility. For instance, states might be required to spend 95 percent of their historical spending on the program, indexed in future years to inflation. A similar approach was adopted for the Temporary Assistance for Needy Families (TANF) block grant. This requirement would help strike a balance between the potentially conflicting objectives of increasing state and local flexibility and maintaining the national Medicaid safety net.

Per-person payments are also preferable to the AHCA’s option that allows states to receive a block grant based on historical costs. The block grant would be adjusted for inflation but would not take enrollment changes into account as they occurred over time. Since the amount of the block grant would depend on assumptions about enrollment over a period as long as 10 years, the chance of over- or under-payment would be substantial.

Provide Strong Incentives for States to Conform to a National Eligibility Standard

CBO estimates that the AHCA would yield significant budget savings by adopting inflation adjustments that grow more slowly than projected Medicaid spending per enrollee. Additional savings are projected from rolling back enhanced federal funding for the ACA’s expansion population.

A compromise reform plan would not fully eliminate the enhanced payments made to states that expanded Medicaid under the ACA. Savings from shifting to indexed per-capita payments and from reducing the ACA’s enhanced matching payments could be used to provide additional support to all states that increase their income eligibility levels to conform to a national standard.

For instance, the federal government could provide bonus funding to all states that provide eligibility for Medicaid enrollment to all non-disabled adults living in households with incomes up to a legislated standard, such as 100 percent of the federal poverty level (FPL). This bonus funding would be allocated based on a number of factors, such as the state’s per-capita income, the number of persons made eligible for Medicaid using this standard, and the overall size of the state’s Medicaid program. States that did not conform to the national eligibility standard would not be eligible for bonus payments, and their share of the bonus pool would be redistributed to states that did conform to the standard.

States would be free to expand Medicaid eligibility for non-disabled adults above the national standard, but federal support for that expansion would be reduced. States that expanded the program under the terms of the ACA would be given time to transition to a lower level of federal support for enrollment above 100 percent of FPL. Per-capita payments for those states could include an amount that reflects the ACA’s enhanced federal match. During the transition, those additional per-capita amounts would be gradually reduced.

For example, the additional amount that would be paid for the ACA’s expansion population could be reduced by 10 percentage points per year. That reduction could continue until the federal payment for enrolling the expansion population above 100 percent of FPL had been reduced to 20 percent of the total cost per person of the state’s expansion population. Under this approach, states choosing to maintain an income eligibility standard for the ACA expansion population above 100 percent of FPL would pay for a much greater share of the total cost.

Non-expansion states also would be allowed to provide coverage above 100 percent of FPL, and to receive federal support for 20 percent of the cost.

This approach to financing coverage for non-disabled adults would provide a strong incentive for every state to expand Medicaid eligibility to the federal poverty line. States would be free to go above that, but with less generous federal support.

Give States Greater Flexibility

Converting federal financial support for Medicaid into fixed per-person payments to the states would provide greater financial certainty to the federal government. In return, the federal government should give states greater freedom to manage the program without undue interference.

The current system requires states to seek waivers from federal rules for many routine program changes. Greater flexibility would reduce the administrative burden that results. But other types of changes would continue to require federal oversight. For instance, states could not impose tighter income and asset eligibility standards for populations that are guaranteed coverage under pre-ACA law without federal permission, and the scope of benefits required by current law could not be altered absent federal approval to protect against arbitrary cost-saving measures.

Beyond eligibility and benefits, there are many other ways states can attempt to improve program efficiency. For instance, some states, led by Indiana, have adopted programs that incorporate the use of personally controlled savings accounts. Other states are using Medicaid funds to purchase private coverage on the ACA’s insurance exchanges. Still other states are experimenting with various approaches to cost sharing that require some payment from program participants to foster more personal responsibility in the use of services. Some state policymakers have expressed interest in using incentives to encourage Medicaid participants to work and improve their earnings and thus perhaps become eligible for job-based insurance.

A compromise on Medicaid should give states wide freedom to pursue these, and other program innovations that do not involve reducing eligibility or benefits, without the need for prior federal approval.

Summing Up

Medicaid is in need of reform, for fiscal and programmatic reasons. The current federal matching system for financing program costs discourages cost-cutting by the states because most of the savings goes to the federal government. At the same time, Medicaid is falling short as the nation’s safety-net insurance program. A top objective of the Affordable Care Act was expansion of the program to all persons living in households below 138 percent of the federal poverty line. But only half of the population now lives in states that expanded their programs under the terms of the ACA. The result is an untenable and inequitable distribution of federal support for insurance coverage, and inadequate options for many poor households living in non-expansion states.

Republicans rightly see this year as an opportunity to pursue significant changes in Medicaid. But they also must recognize that there is no realistic alternative to Medicaid for the nation’s poorest households. If the party offered a reasonable replacement for the ACA’s eligibility rules, it might be possible to draw some bipartisan support for the party’s goal of shifting from federal matching payments to the states to fixed federal contributions per Medicaid beneficiary, coupled with greater state flexibility to manage costs. The result would be a stronger, more sustainable, and more equitable Medicaid program.