States seeking to innovate in Medicaid may need programmatic flexibility and federal funding that goes beyond what would ordinarily be permitted. Section 1115 of the Social Security Act enables the secretary of the Department of Health and Human services to provide that flexibility and funding to test innovations in the Medicaid program, so long as those innovations meet 1115 criteria, most notably that they further the objectives of the Medicaid program. Demonstrations authorized under section 1115 are a major source of innovation in the Medicaid program for many states and are frequently used to expand eligibility, cover new benefits, or reform health care delivery systems.
The Centers for Medicare and Medicaid Services (CMS) have long required that section 1115 demonstrations be “budget neutral,” meaning that the demonstrations cost no more than would have been spent on the state’s Medicaid program without the demonstration in place. As we noted in a June 2022 article in this publication, that requirement can favor disinvestments over investments. The policies—which are not required by statute or regulation—have historically been implemented through arcane and opaque calculations that impede states’ abilities to test and sustain innovations needed to advance health equity, expand coverage, improve quality, and spur reform. In that earlier article, we outlined the challenges that budget neutrality policy presents and identified paths CMS could take to improve its policy.
Over the past several months, CMS has engaged with state Medicaid directors and leadership across the administration to tackle these issues. In demonstrations recently approved in Arizona, Arkansas, Massachusetts, and Oregon, CMS unveiled a new approach to budget neutrality, first previewed with Medicaid directors, that addresses many of the prior challenges. Although some issues remain, these changes to budget neutrality policy create significant new opportunities for all interested states to invest Medicaid funds in initiatives that advance the objectives of the Medicaid program.
Changes To Budget Neutrality Policy
CMS’s new policy still requires that states project what spending would have been without the waiver and will still use those “without waiver” baseline projections as a way to ensure that funding for the demonstration is budget neutral to the federal government. While retaining that basic framework, however, CMS announced thoughtful and major changes to how it calculates and adjusts the without-waiver baselines.
“Mid-Course” Corrections To Budget Neutrality Caps
Significantly, CMS is now allowing states to adjust their budget neutrality baseline during the demonstration period under certain circumstances. Historically, CMS rarely allowed adjustment during a demonstration, hamstringing states’ ability to increase provider rates to improve access, pay for new treatments or drugs, or respond to unexpected health crises such as a pandemic or substance use disorder epidemic. These added costs, unrelated to the demonstration and often beyond a state’s control, had to be absorbed under the budget neutrality calculations that were set before these new costs arose.
Under the new policy, states will be able to request annual adjustments to budget neutrality calculations to account for these types of spending. (CMS first provided flexibility of this type to Vermont in its June 2022 demonstration approval, but the agency formalized it as national policy in the Oregon and Massachusetts demonstrations.) The ability to make these adjustments is a fair accommodation that will considerably reduce the risk for states with respect to spending that would have occurred without the demonstration. It will also even the playing field somewhat across states: Previously, states with longstanding demonstrations that had accumulated savings could use those savings as a cushion to offset increases due to rate increases, regulatory changes, or new treatments, whereas states with new demonstrations were more exposed to those risks.
Trend Rate
When projecting spending absent the demonstration, the trend rate used is critical. Previously, CMS had applied the lesser of either the state’s historic trend in spending for the applicable population or the “President’s budget trend”—a number maintained by the federal government that reflects an approximation of national expected spending growth in Medicaid. CMS will now rely only on the national projections. As a result, states that had low growth rates in the past—perhaps due to underinvestment—will have more room under the budget neutrality calculations to make investments going forward.
Addressing Savings At Renewal
Renewals of demonstrations magnified many of the challenges with budget neutrality policy. Under policy announced in 2018 and effective in 2021, CMS began to “rebase” existing demonstrations: At renewal, CMS would use the state’s actual spending under the demonstration to serve as the new projected spending absent the demonstration rather than simply carry forward the projected without-waiver baseline. Although intended to right-size future savings calculations and reduce inequities across states that had longstanding demonstrations and those that did not, this approach accomplished those goals in a way that created a cliff for states that squeezed their ability to sustain successful innovations in future renewal periods.
Under the new policy, CMS will blend actual spending with the prior spending limits. This will avoid squeezing states’ ability to sustain innovations and will partially blunt the impact of rebasing, as will other new budget neutrality policies, although some states may still face challenges sustaining programs at future renewals.
Carrying Forward Savings From Prior Demonstrations
CMS also changed the rules on the amount of savings states can carry over from prior demonstrations. For renewals beginning in 2021, CMS allowed states to carry forward only five years of savings. Under the new policy, states can carry forward 10 years of savings. This will provide states with more flexibility to continue funding worthwhile programs and will offset some of the challenges of rebasing. This policy, however, could perpetuate some inequities across states, which is why it is critical that the mid-course correction, rebasing, and adjustments to trend rates accompany it.
Use Of “Hypothetical” Treatment Of Certain Expenditures
Another way to open the door to testing new reforms, particularly those that are focused on improving care for historically underserved populations, is to allow new initiatives some room—and time—to be tested. CMS’s reliance on “hypothetical” treatment of certain expenditures furthers this goal. For certain expenditures that CMS considers to be “Medicaid-like” but would not qualify for federal matching funds absent a demonstration, CMS will more consistently treat those expenditures as if they could be covered absent the demonstration. As a result, states do not need to offset those expenditures with savings, although they also cannot accrue budget neutrality savings from these investments.
In the recent slate of demonstration renewals, CMS relied on this approach for several initiatives, including continuous enrollment, an expansion of benefits and coverage for youth with special health care needs, and spending on health-related social needs. Use of “hypotheticals” promotes innovation in the Medicaid program by enabling states to test bold new initiatives without fear of them failing to generate short-term savings. Consider, for example, Oregon’s pathbreaking policy of providing continuous enrollment for children up to age six. Such a policy could generate significant Medicaid savings as a result of more stable coverage and care during this critical period of developmental growth, although not likely in the five-year time demonstration period.
Like several of the other changes in budget neutrality policy, this change reduces inequities across states, in this case by enabling states without savings from prior demonstrations to test promising, new initiatives. Finally, it provides a more sustainable funding path for new initiatives by insulating them from the negative impact of dwindling savings due to rebasing, while balancing federal spending interests by not allowing budget neutrality savings to accrue from these initiatives.
Remaining Challenges With Budget Neutrality Policy
With these changes, CMS—working alongside its federal partners—has significantly strengthened budget neutrality policy, but some challenges remain.
Treatment Of New Adults
CMS declined to change its policy on the budget neutrality treatment of the adult group created by the Affordable Care Act (ACA) (referred to as the new adult group), which covers childless adults up to 138 percent of the federal poverty level and parents with incomes above pre-ACA Medicaid eligibility levels up to 138 percent of poverty. As coverage for the new adult group was about to begin in 2014, CMS decided that in the context of a demonstration impacting the new adult group, expenditures affecting that group should be treated as hypothetical for the purposes of budget neutrality. Much was unknown at the time about the cost of coverage for this new group, so the intent was to insulate states from the uncertainty of spending for this new population. However, hypothetical status means that states cannot accrue savings on initiatives affecting people in the new adult group, reducing the total savings available for a state to sustain its initiatives.
CMS also is rebasing the budget neutrality baseline for the new adult group, which increases the risk to the states without allowing the opportunity for savings. As CMS continues to refine budget neutrality policy, it should consider revisiting its policy around the treatment of the new adult group.
Hypothetical Expenditures As Entitlements
When it revised budget neutrality policy, CMS also created a new challenge. It announced that health-related social needs expenditures would be treated as hypothetical expenditures but that they would be subject to a limit on expenditures that states could not exceed, even if they had budget neutrality savings. Ordinarily, if a state exceeds a limit on a hypothetical, the state may use savings under its budget neutrality cap to cover the overages; only once the state exhausts those savings is it ineligible for federal funds.
For states, such as Oregon, seeking to treat health-related social needs services as a new entitlement for eligible individuals, this spending limit presents challenges. As this policy is implemented, CMS could evaluate the impact and make changes as needed.
Cross-Program Savings
Finally, the new policy did not address savings on individuals dually eligible for Medicaid and Medicare or any other savings that cross federal programs. Spending on Medicaid services, such as long-term care, can save on Medicare acute care spending, yet budget neutrality policy fails to account for those savings to the Medicare program. This complex issue is ripe for new thinking.
Summing Up
Together, the suite of changes to budget neutrality policy adopted by CMS constitutes a significant advance in the agency’s approach to section 1115 demonstrations. Under the new policy, states will have more flexibility to test and sustain programs aimed at increasing coverage, improving access, and reducing health disparities. States without longstanding demonstrations will be better able to innovate alongside their peers, and all states will be better positioned to address changing circumstances in their Medicaid programs during a demonstration period. Although some issues remain, CMS has largely succeeded in balancing the need for fiscal integrity in the Medicaid program with the desire to afford states the ability to create and sustain innovations that advance the core goals of the Medicaid program.
Authors’ Note
Manatt Health and the State Health and Value Strategies, a program of the Robert Wood Johnson Foundation, regularly collaborate and work together on projects.