North Carolina began the expansion of Medicaid coverage on December 1, 2023. In June 2023, the state requested approval from the Centers for Medicare and Medicaid Services (CMS) for using state-directed Medicaid payments (SDPs) to pay hospitals at the level of average commercial rates for serving Medicaid patients. In September 2023, CMS approved the request, with federal matching funds picking up 72 percent of the $2.6 billion SDPs, which were distributed to hospitals at the end of 2023. North Carolina financed the state share of hospital SDPs with a tax on hospital revenues and intergovernmental transfers from state-owned hospitals. According to documents submitted by North Carolina to CMS, the $2.6 billion brings gross Medicaid payments to more than twice what Medicare would pay hospitals for similar services.
When Medicaid provider rates are allowed to be set as high as commercial levels, providers, particularly hospitals, are incentivized to raise their commercial prices to maximize the federal matching funds they receive, raising federal fiscal red flags and fueling vertical consolidation. In this Forefront article, we describe what we learned from publicly available documents such as the CMS approval letter, analyze SDPs and other issues in financing Medicaid expansion, and discuss policy recommendations. The objective is to use North Carolina as a case study to highlight issues in CMS’s Medicaid financing arrangements that require public attention and policy reforms.
Types Of Medicaid Payments To Hospitals In North Carolina
North Carolina hospitals are eligible for at least three types of Medicaid payments: (1) a base payment for inpatient and outpatient services, (2) SDPs for inpatient and outpatient services, and (3) disproportionate share (DSH) payments. The first two types are made through managed care organizations (MCOs).
Base Hospital Medicaid Payments: At Medicare Rates
North Carolina Medicaid managed care organizations (MCOs) pay all contracted hospitals base Medicaid inpatient rates, set at 100 percent of Medicare rates. They also pay hospital outpatient rates according to a formula based on costs. No evidence suggests that Medicare-level inpatient rates and cost-based outpatient rates are insufficient to attract North Carolina hospitals to participate in Medicaid managed care networks.
SDPs Bring Total Payments Above 200 Percent Of The Medicare Rates
SDPs are funneled through MCOs and paid as lump sums to hospitals based on utilization. Hospitals are divided into two categories for distribution of SDPs: state-owned academic medical centers (AMCs) and all other acute care hospitals. North Carolina estimates that SDPs will bring inpatient rates to 226 percent of Medicare rates for the former and 187 percent for the latter; and outpatient rates to 208 percent of Medicare rates for the former and 222 percent for the latter. It’s worth noting that North Carolina hospital SDPs are conditioned neither on measures of need nor on attaining quality or quality-improvement thresholds.
Averaging between inpatient and outpatient services, Medicaid SDPs together with base rates already set at Medicare levels result in hospital reimbursements exceeding 200 percent of Medicare rates. These are well above the 153 percent of Medicare rates that the median North Carolina hospital needs to break even, according to a tool created by the National Academy of State Health Policy. In short, CMS approved SDPs for North Carolina hospitals that more than double Medicare rates, leaving them with considerable profit margins.
Where did the SDPs money come from? The state levies a provider tax on all acute-care hospitals; state-owned hospitals also contribute intergovernmental transfers). For every $1 of tax revenue or intergovernmental transfers paid by hospitals, the state receives approximately $2.62 in federal matching funds. Therefore, the state can return the $1 paid by hospitals back to hospitals and still have $2.62 federal dollars to spend in almost unlimited ways, including raising Medicaid hospital rates to commercial levels.
Medicaid Disproportionate Share (DSH) Payments
Federal Medicaid law mandates that states make DSH payments to hospitals that serve a disproportionate share of low-income and uninsured patients, but states are permitted to spread DSH payments more broadly. In FY 2023 the total federal DSH allotment was approximately $16 billion. North Carolina’s 2023 DSH allotment was roughly $425 million. The state legislature acknowledged that the state would not be able to spend its full federal DSH allotment due to the size of its growing SDPs.
Federal rules prohibit DSH payments that exceed hospital uncompensated care costs for Medicaid and uninsured individuals. With SDPs, many North Carolina hospitals will make a significant profit on Medicaid and no longer qualify for DSH payments. North Carolina nonprofit hospitals, which claimed $800 million in unreimbursed Medicaid costs in 2022 as part of their community benefit, should be expected to report no such costs starting from 2023 thanks to overly generous SDPs.
SDPs Require Reform
SDPs Raise Federal Fiscal Red Flags And Lack Transparency
CMS has approved tens of billions for provider-tax-financed SDPs in similar requests from other states. These SDPs discourage state fiscal discipline and drive up federal Medicaid spending in an uncapped fashion, raising serious federal fiscal red flags. In contrast, previous federal policy capped aggregate SDPs to what Medicare would pay for similar services. The Government Accountability Office (GAO) has issued at least three reports calling for reforms from CMS.
Our review of publicly available documents found almost no detail about how average commercial rates are calculated or trended. The CMS approval letter and “pre-print” form for $2.6 billion SDPs was for the North Carolina budget year ending June 30, 2023, before the State’s Medicaid expansion even began on December 1, 2023.
North Carolina plans to request a 10 percent increase in SDPs for 2024. In order to do so, the State must demonstrate that average commercial hospital prices have risen 10 percent, Medicaid inpatient and outpatient utilization combined has increased 10 percent, or some combination of the two factors. Unfortunately, CMS does not disclose the state calculations and data sources for average commercial rates when it approves state requests for federal matching funds for SDPs. The GAO noted that it, too, was unable to access key information contained in CMS approval documents.
SDPs Inflate Commercial Rates
CMS’s approval for North Carolina to use SDPs to pay hospitals’ Medicaid services at commercial rates incentivizes hospitals to inflate their commercial rates to drive higher revenues not only from commercial payers but also from Medicaid. Higher commercial rates also appeal to the state because it can levy a higher provider tax from hospitals (all paid back to hospitals through SDPs) and receive greater federal matching funds. Taken together, hospitals and the state both depend on higher hospital commercial prices and high hospital service utilization to increase revenues.
North Carolina hospitals have the market power to raise commercial prices. Seven North Carolina hospital markets tracked by the Health Care Cost Institute (HCCI) are considered highly concentrated or very highly concentrated, and most of them have grown more concentrated and obtained higher commercial prices. For example, commercial prices increased 14 percent in the Charlotte metropolitan market and 12 percent in the Asheville market between 2017 and 2021. Inpatient price increases exceeded the national median in both markets between over the same period.
Higher hospital commercial prices have been shown to result in higher profits and higher administrative costs, but relatively smaller increases in services, including charity care, that directly benefit patients and local communities.
SDPs Fuel Vertical Consolidation
By elevating Medicaid payments to hospitals while leaving rates for other providers at much lower levels, CMS tilts the competitive playing field to hospitals, promoting hospital-centric consolidation and eliminating competing care alternatives for patients and payers. For example, innovations in telehealth, enhanced primary care, expansion of ambulatory surgery, and hospital-at-home care models offer lower-cost alternatives to hospital services, but only if they are available in the market. Flush with capital from SDPs, North Carolina hospitals can buy these competitors and terminate the services or raise their prices (i.e., by adding facility fees).
Moreover, hospitals are allowed to use SDPs to subsidize and bolster physician practices they own, gaining a competitive advantage over other physician practices. In contrast, the MCOs under contract to the North Carolina Medicaid program do not have flexibility to use hospital SDPs to raise rates for independent physicians. If MCOs take steps to lower avoidable hospital utilization, they may be vulnerable to hospital litigation or refusals by hospitals to contract as in-network providers.
Proposed SDPs Reforms
CMS has not yet finalized a rule proposed in April 2023 contemplating changes to rein in escalating costs and provide clear rationale for Medicaid SDPs. As of publication of this article, the door to the U.S. Treasury remains wide open for states to receive federal matching funds to pay hospitals up to average commercial rates. As we await a final rule from CMS, we urge the agency to use its authority to eliminate any direct or indirect tying of Medicaid rates and SDPs to commercial rates. We further urge CMS to release details about state-specific SDPs arrangements, including hospital payment source information and calculation. Such transparency is indispensable to establish a policy rationale and maintain public trust and confidence.
Policy Suggestions On Site-Neutral Payment And DSH Allotment
Federal policymakers are currently discussing the importance of Medicare “site neutral” payments to promote efficiency and fair competition. Medicaid payment should also promote site neutrality. By paying hospitals Medicaid rates above 200 percent of Medicare levels, CMS and North Carolina are distorting an already tilted market further in favor of hospital-delivered care—even when the same care could be provided at lower cost in alternative providers.
When Congress enacted the Affordable Care Act (ACA) in 2010, it reduced Medicaid DSH allotments to states because coverage expansions in Medicaid and ACA marketplace insurance plans were expected to reduce hospital uncompensated care costs associated with the uninsured (and indeed they have). However, Congress has repeatedly postponed these cuts despite a strong policy case for revisiting the rationale for and distribution of these payments.
More than 30 percent of DSH payments nationally were allocated to hospitals that provided less than the state median share of uncompensated care. MACPAC has consistently recommended that DSH allotments be aligned with hospital uncompensated care costs. Considering the growth and size of SDPs, Congress should prioritize the revision of DSH allotment policy.
Authors’ Note
All authors are supported by Arnold Ventures. Bai is also supported by PatientRightAdvocate.org.
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