Representing what could be one of the most significant overhauls of Medicaid payment policy in recent memory, the Centers for Medicare & Medicaid Services (CMS) has published its long-anticipated proposed rule, formally titled the Medicaid Managed Care State Directed Payments and Medicaid Fee-For-Service Targeted Medicaid Practitioner Payments (Proposed Rule).

If finalized, the Proposed Rule would implement section 71116 of the Working Families and Tax Cut legislation (WFTC) and, over time, extend Medicare-based payment limits as a cap on Medicaid payment rates beyond the four statutory state directed payment (SDP) service categories that were set forth in the WFTC to all SDPs and certain targeted fee-for-service (FFS) payments. This eliminates the use of Average Commercial Rates (ACR) as a means to make providers whole from chronic Medicaid underpayments and disproportionally impacts those providers for which Medicare is not an appropriate proxy payment.

Additionally, the Proposed Rule provides that states would face a series of tiered compliance deadlines running from 2025 through 2029, requiring many states to redesign, and in some cases unwind or replace longstanding payment arrangements that Medicaid providers have relied on for years since the inception of SDPs promulgated as an appropriate means to help close the Medicaid payment gap in 2016.

SDPs and supplemental payments represent tens of billions of federal and state Medicaid dollars annually. The proposed changes, if finalized, would require states to restructure longstanding payment arrangements and reduce payment levels for some programs. Given these stakes, providers should review the Proposed Rule carefully and consider submitting comments before the July 21, 2026, deadline. Early, substantive engagement in the rulemaking process is essential to establishing a record of core concerns, particularly regarding the proposed reliance on Medicare rates over ACR methodologies, the funding of the non-federal share and other issues that could adversely affect Medicaid funding in the future.

Background

Managed care is now the dominant delivery system in most state Medicaid programs. CMS’s 2024 Medicaid Managed Care Enrollment Report states that 73.7 million enrollees, or 84.8 percent of all Medicaid enrollees, received some or all of their care through a Medicaid managed care plan as of July 1, 2024. Against that backdrop, SDP programs have expanded rapidly, from 2 states in 2016 to 41 in 2024, and CMS reports that SDPs accounted for more than one-quarter of Medicaid managed care spending in FY 2025.

Subject to certain exceptions, states are generally not permitted to direct the expenditures of a Medicaid managed care organization (MCO) under the contract between the state and the plan, or to make payments to providers for services covered under that contract. SDPs are an exception to this general rule: they allow states to direct how MCOs pay providers, subject to federal approval and actuarial soundness requirements.

Over the past several years, SDP programs have grown dramatically in size and complexity, prompting increased federal scrutiny. In the preamble to the Proposed Rule, CMS cites 400 new SDP preprint submissions from 41 states received since publication of the 2024 final rule, which provided additional updates to the program.

The agency has also tied the growth in SDPs to concerns about how states finance them. In its press materials, CMS says states have often used provider taxes and intergovernmental transfers (IGTs) to fund the non-federal share of payments that are then directed back to selected providers, thereby shifting a larger share of Medicaid financing to the federal government. CMS also cites concerns in the preamble regarding fiscal integrity for the Medicaid program “when the funds to support the non-federal share of increased payments originate from the same providers that receive enhanced payments.” CMS cites the Medicaid and CHIP Payment and Access Commission (MACPAC) finding that more than half of directed payments are financed through intergovernmental transfers or provider taxes.

On February 2, 2026, CMS issued preliminary guidance on WFTC section 71116 in a Dear Colleague letter and stated that final policies would be established through notice-and-comment rulemaking. Section 71116 itself became effective by statute for Medicaid managed care rating periods beginning on or after July 4, 2025, and applies to inpatient hospital services, outpatient hospital services, nursing facility services and qualified practitioner services at an academic medical center. The Proposed Rule goes beyond that preliminary guidance by proposing to extend Medicare-based payment limits to all SDPs beginning in 2029 and otherwise supersedes the Dear Colleague letter.

Key changes to managed care SDPs (42 CFR § 438.6)
Replacing the ACR benchmark with Medicare-based limits

One structural change in the Proposed Rule is the replacement of the ACR as the primary payment ceiling for SDPs. To implement WFTC section 71116, CMS proposes replacing the current ACR-based limit for specified SDPs with a Medicare-based limit, or a Medicaid state plan/waiver rate when no Medicare rate exists.

The agency proposes defining the new “payment limit” as: (1) 100 percent of the total published Medicare payment rate for Medicaid expansion states, (2) 110 percent of the total published Medicare payment rate for non-expansion states or (3) 100 percent of the state plan-approved rate when there is no total published Medicare payment rate for the applicable service. CMS also proposes that the payment limit would be applied on a per-service or per-discharge basis rather than as an aggregate upper payment limit (UPL)-style test.

CMS justifies this shift on the grounds of transparency and auditability, noting that Medicare rates are publicly developed and updated, whereas ACR data are proprietary and can be difficult to verify and audit. This is a material departure from the prior framework under which hospital and nursing facility SDPs could reach the ACR. For states and providers that built programs around ACR-based headroom, the Proposed Rule would narrow available payment capacity significantly and necessitate a fresh modeling exercise for existing arrangements.

Using Medicare-based limits as the primary mechanism to set funding limits across the board raises significant concerns for providers whose Medicare benchmarks are not straightforward to operationalize. CMS specifically discusses providers reimbursed under cost-based Medicare methodologies, including freestanding children’s hospitals, and requests comment on how to determine the applicable payment limit in those circumstances. The preamble lays out several alternatives which CMS considered and requests that stakeholders provide any additional considerations or mechanisms for determining compliance with the applicable payment limit for providers paid outside of the published Medicare fee schedules or Medicare Prospective Payment System (PPS). This is a particularly acute concern for children’s hospitals, which often rely on Medicaid as a dominant share of the payer mix and a significant source of operating revenue.

Immediate applicability for the four WFTC service categories

The statutory mandate in WFTC section 71116 applies to four specific service categories: inpatient hospital, outpatient hospital, nursing facility and qualified practitioners at an academic medical center. WFTC section 71116(a) makes the new Medicare-based limit applicable to services furnished during rating periods beginning on or after July 4, 2025, unless a temporary grandfathering provision applies. For states with SDPs in these four categories, the threshold question is whether those programs qualify for grandfathering. For those that do not, the critical compliance trigger is the first rating period beginning July 4, 2025.

Notably, the Proposed Rule does not stop at the four WFTC service categories. In a broad exercise of regulatory discretion that goes beyond the statutory mandate, CMS proposes to extend the same Medicare-based payment limitations to all SDPs for all services, effective for the first rating period beginning on or after January 1, 2029. That expansion extends to service categories Congress did not specifically address, including behavioral health, dental and long-term services and supports, among others. States and providers with SDPs in these categories should begin assessing the potential impact now.

Grandfathering and structured phase-down

CMS proposes that certain SDPs may qualify for temporary grandfathering if they satisfy the applicable rating-period and preprint-status criteria, including rules tied to prior written approval, completed preprints and special treatment for certain rural-hospital arrangements. SDPs that meet these criteria would be permitted to temporarily delay full compliance with the new Medicare-based payment limit. That delay, however, is not open-ended. The amount of the grandfathered payment is capped based on the total dollar amount reflected in the qualifying preprint, and a mandatory phase-down of that amount begins with the first rating period on or after January 1, 2028.

CMS also proposes an early documentation requirement designed to monitor the phase-down process in real time. Beginning with the first rating period on or after January 1, 2027, states must submit actuary-certified comparisons of their total payment rates against the most recent Medicare rate, or against the state plan-approved rate where no Medicare rate exists. These submissions serve as a baseline tracking mechanism, allowing CMS to assess whether and by how much a state’s directed payments continue to exceed the new payment limit. This obligation is not tied to a fixed end date it continues annually until the state’s directed payments have been reduced to a level that meets the applicable payment limit, meaning states that complete the phase-down more quickly will exit the requirement sooner, while states whose payments remain above the limit will continue to owe the documentation until compliance is achieved.

Elimination of uniform increase SDPs

Among the more structural changes in the Proposed Rule is CMS’s proposal to eliminate uniform-rate-increase SDPs. Beginning with rating periods on or after January 1, 2028, new uniform rate increase SDPs and renewals of non-grandfathered uniform rate increase SDPs would no longer be permitted, citing compliance and program integrity concerns. CMS proposes a limited exception allowing uniform rate increases only for grandfathered SDPs and only until the new payment limit is reached for that grandfathered SDP.

In expressing concern that states have designed uniform rate increase SDPs to vary inversely with utilization, CMS observes in the preamble that states “almost exclusively fund uniform dollar or percentage increase SDPs with IGTs or provider taxes and then design the SDP in such a way that the uniform increase changes depending on utilization during the rating period to ensure that the entire funding amount collected from the IGT or tax, plus at least a portion of the Federal matching funds, are expended via the SDP.”

Minimum and maximum fee schedules: Retained, but capped

CMS proposes to retain minimum and maximum fee schedule SDPs as permissible payment methodologies for rating periods beginning on or after January 1, 2028, provided they do not exceed the applicable payment limit. Beginning with the first rating period on or after January 1, 2028, states would no longer be required to submit preprints for minimum- or maximum-fee-schedule SDPs to obtain written prior approval, a streamlining measure intended to reduce administrative burden for those compliant structures.

Clarifying the prohibition on third-party payment redirection

Under the Proposed Rule, SDP payments must flow directly and entirely to the provider furnishing the services, with no portion of the payments contractually redirected to plans, consultants, associations or other third-party entities. CMS proposes revising 42 CFR § 438.6(c)(2)(ii)(A) to codify this requirement, clarifying that SDPs must be based solely on the utilization or delivery of services furnished by a provider and cannot be conditioned on paying any portion to another entity.

CMS uses the Proposed Rule to reinforce this prohibition, reiterating that “grey area payments” (vague contract provisions directing payments outside SDP or pass-through rules) are impermissible. CMS states that any administrative allocation to plans or third-party entities as a condition of SDP payment runs afoul of existing rules, regardless of how it is structured contractually.

For hospitals specifically, the provider impact extends further. CMS signals it will scrutinize how supplemental payments interact with Disproportionate Share Hospital (DSH) calculations, warning that SDPs paid to a hospital for inpatient and outpatient services made in accordance with 42 CFR § 438.6(c) are treated as Medicaid payment and must be offset from costs when calculating the hospital-specific DSH limit.

Key changes to FFS targeted practitioner and provider payments (New 42 CFR § 447.381)
A new per-service payment ceiling for targeted FFS payments

CMS’s proposed FFS provisions are designed to address a specific regulatory concern that, as new payment limits tighten what managed care plans can direct to providers through supplemental arrangements, states may respond by migrating those payments into the FFS system to avoid the new restrictions. CMS proposes to close that avenue by imposing a parallel payment ceiling on the FFS side, ensuring the same policy framework applies regardless of how a state structures its Medicaid payments.

The new ceiling applies to any FFS Medicaid payment, including base payments, supplemental payments and add-ons, when that payment is not available to all providers furnishing the same Medicaid-covered service. CMS defines the term “targeted” FFS payments broadly, anticipating and foreclosing efforts to recharacterize supplemental payments as add-ons or other payment components to evade the new ceiling. Where the cap applies, the total of all FFS payments for a targeted service may not exceed 100 percent of the applicable Medicare FFS rate in Medicaid expansion states, or 110 percent in non-expansion states.

Not all providers will be subject to the new ceiling. Two categories of payments are excluded outright: payments that are uniform statewide or within a defined political subdivision (such as a county, parish, borough or municipality) and described as such in the state plan, and payments already subject to an existing UPL or other statutory limit, to the extent those limits actually apply.

CMS also proposes two case-by-case exceptions. A provider may be exempt if there is no reasonable Medicare equivalent rate for the service it furnishes, or if its payments are reconciled to actual incurred costs. For cost-reconciled payments, states must be able to demonstrate compliance with the economy, efficiency and quality of care requirements of section 1902(a)(30)(A) upon CMS request.

For providers whose payments fall within the new ceiling, the practical consequences are significant. Any combined FFS payments that currently exceed the applicable Medicare benchmark must be reduced unless an exception applies. States must submit a state plan amendment to revise or eliminate non-compliant targeted FFS payments, effective no later than the start of the first state fiscal year beginning on or after January 1, 2029.

That deadline, however, should not be read as an invitation to delay. CMS has written the “targeted” definition specifically to foreclose payment restructuring as a workaround, meaning providers cannot rely on changes to payment labeling or structure at the state level to preserve existing payment levels. Providers should engage with their state Medicaid agencies now to assess whether their current FFS payments exceed the applicable Medicare benchmark and, if so, understand the scope of any required reductions before the compliance deadline.

Key timelines and effective dates

The following is a consolidated timeline of the key dates in the Proposed Rule:

Date
Requirement

July 4, 2025 (operative)

Medicare/state plan-based payment limit applies to the four WFTC SDP service categories for services furnished during rating periods beginning on or after this date, subject to grandfathering for eligible SDPs

July 9, 2026

States must submit SDP preprints prospectively, prior to the SDP start date, as a condition of written prior approval

July 21, 2026

Public comment period closes

January 1, 2027

Grandfathered SDP annual reporting begins–states must submit actuary-certified total payment rate comparisons against the applicable Medicare or state plan rate

January 1, 2028

Grandfathered SDP phase-down begins, with a minimum 10 percentage point annual reduction of the grandfathered total dollar amount continuing until the payment limit is met

New and non-grandfathered uniform increase SDPs are no longer permitted, with a limited exception for grandfathered SDPs transitioning to the payment limit

Minimum and maximum fee schedule SDPs no longer require preprint submission for written prior approval, provided the fee schedule does not exceed the payment limit

January 1, 2029

Medicare-based payment limit extends to all SDPs for all services in all states, DC and territories

First state fiscal year beginning on or after January 1, 2029

States with noncompliant targeted FFS payments must have a state plan amendment effective by the start of the applicable state fiscal year

Conclusion

One of the most consequential Medicaid payment regulatory actions in recent years, the Proposed Rule fundamentally alters the state directed payment benchmarks available for both managed care SDPs and FFS targeted payments, phases out uniform increase SDPs, imposes new prospective preprint submission requirements and purports to close potential avenues for regulatory arbitrage through FFS reforms. The shift from ACR to Medicare-based limits will reduce Medicaid funding and payment options for many states, particularly those that have structured SDPs financed through provider taxes and IGTs to further leverage a state’s ability to access federal matching funds for Medicaid and is likely to require substantial redesign of Medicaid payment arrangements in many states. Since Medicaid reimbursement has long underpaid providers, states must now find ways to properly fund provider care or risk losing continued access to care.

Beyond the financial impact on large academic medical centers and safety-net institutions, the reliance on Medicare rates as a universal payment benchmark raises particular concerns for children’s hospitals and other providers paid under cost-based Medicare methodologies, for which no equivalent payment framework exists. Provider organizations have already framed the proposal as raising important questions about statutory scope and implementation, and the comment period is the principal opportunity to address those concerns on the administrative record. CMS has specifically invited comment on the scope of the FFS practitioner and provider limit, the definition of “targeted” payments, the treatment of cost-based methodologies, the grandfathering criteria and the phase-down schedule.

We anticipate that CMS will soon publish additional proposed rules addressing other WFTC provisions, such as provider taxes and the waiver of uniform taxes.

The Norton Rose Fulbright team continues to monitor evolving federal and state requirements related to Medicaid payment mechanisms and will provide updates as the rulemaking process advances. If you have questions about how the Proposed Rule may affect your organization, please contact your Norton Rose Fulbright relationship lawyer or any member of our healthcare practice team.