Medicaid is one of the largest programs in federal and state budgets. In fiscal year 2005, Medicaid expenditures totaled an estimated $317 billion. States pay qualified health providers for a broad range of covered services provided to eligible beneficiaries. The federal government reimburses states for a share of these expenditures. The federal matching share of each state’s Medicaid expenditures for services is determined by a formula defined under federal law and can range from 50 to 83 percent. Each state administers its Medicaid program in accordance with a state Medicaid plan that must be approved by HHS. Traditional Medicaid programs represent an open-ended entitlement, meaning the state will enroll all eligible individuals who apply for Medicaid, and both the state and federal government will pay their shares of expenditures for individuals covered under a state’s approved Medicaid plan. States have considerable flexibility in designing their Medicaid programs, but under federal Medicaid law, states generally must meet certain requirements for what benefits are provided and who is eligible for the program. Medicaid demonstrations provide a way for states to innovate outside of many of Medicaid’s usual requirements. Under section 1115 of the Social Security Act, the Secretary has authority to waive certain federal Medicaid requirements and authorize otherwise unallowable expenditures for “experimental, pilot, or demonstration projects” that are likely to promote Medicaid objectives. States have used the flexibility granted through section 1115 to implement major changes to existing state Medicaid programs. For example, some states used Medicaid section 1115 demonstrations in the 1980s and 1990s to introduce mandatory managed care for their Medicaid beneficiaries. Since the early 1980s, HHS has required that states show that their proposed section 1115 demonstrations will be budget neutral to the federal government—that is, federal expenditures under a state’s demonstration will not be greater than if the state had continued its existing Medicaid program. HHS requires states to show that proposed demonstrations are budget neutral by preparing 5-year projections of spending (1) under the current Medicaid program and (2) under the proposed demonstration. HHS policy states that for a demonstration to be considered budget neutral, the federal share of projected Medicaid expenditures under the demonstration can be no greater than the federal share of projected Medicaid expenditures based on continuing the existing Medicaid program. Because HHS bases spending limits for proposed demonstrations on the projected cost of continuing an existing Medicaid program, a state has an incentive to maximize its projected costs. HHS policy states that the federal share of spending on demonstrations will be limited by spending limits calculated from two components: Spending base. States select a recently completed fiscal year that establishes base levels of funding for services and programs affected by the proposed demonstration—a state’s “spending base.” States also identify beneficiary groups for inclusion in the proposed demonstration. These beneficiary groups can, at the Secretary’s discretion, include individuals enrolled in other demonstrations a state may be operating and beneficiaries from the State Children’s Health Insurance Program (SCHIP), which provides health coverage to children in families whose incomes, while low, are above Medicaid’s eligibility requirements. Growth rates. States should submit to HHS 5 years of historical data for per person costs and beneficiary enrollment in their existing Medicaid programs, including quantified explanations for anomalies in their historical trends. HHS policy says that spending limits should be based on growth rates that are the lower of state-specific history or estimates of nationwide growth for the beneficiary groups included in the demonstration (referred to in this report as benchmark growth rates). HHS’s guidance is specific to per person cost growth rates and does not explicitly address the application of enrollment growth rates; however, HHS refers to state historical and nationwide enrollment growth rates in considering the spending limits. Nationwide estimates of cost and beneficiary enrollment growth are developed by CMS actuaries to assist OMB in preparing the President’s Budget. To project the costs of continuing a state’s existing Medicaid program, HHS policy calls for applying the benchmark growth rates to the state’s spending base over a 5-year period to establish total projected costs absent the demonstration. HHS sets spending limits for proposed demonstrations based in part on these total projected costs (see fig. 1). HHS allows states to use higher-than-benchmark growth rates if they can establish that historical or nationwide data do not accurately depict anticipated growth in the state Medicaid program. HHS considers spending limits to be a product of negotiations that are informed by HHS’s policy to consider the state’s historical experience and projections of growth in the President’s Budget. In addition, HHS’s policy indicates that states, in providing HHS with state-specific historical growth rates, must quantify any anomalies in the trends. Recently approved section 1115 Medicaid demonstrations in Florida and Vermont significantly change the operation of the two states’ Medicaid programs. Both demonstrations expand the use of managed care by requiring most Medicaid beneficiaries to enroll in managed care plans: Florida through state contracts with multiple managed care plans to provide services and Vermont by creating a single managed care organization operated by an office within the state Medicaid agency. Florida: Approved by HHS in October 2005 and launched in July 2006, Florida’s demonstration is designed to give Medicaid beneficiaries different options for health care plans and benefits through increased use of managed care plans to provide Medicaid coverage to beneficiaries, in a competitive environment. In the initial phase of the demonstration, certain Medicaid beneficiaries in two counties are required to enroll in state-approved managed care plans. Managed care plans compete for Medicaid beneficiaries by offering different coverage options, including customized benefits and cost sharing, subject to certain limitations. Unlike many other previous Medicaid managed care systems, managed care plans in Florida have the authority to design benefit packages subject to approval by the state. Initially implemented in a two-county area, the managed care components of the demonstration are planned for statewide implementation by June 2010. Another key component of Florida’s demonstration was the establishment of a pool of funds to finance supplemental payments—payments above the state’s usual payment rate— to certain types of Florida health care providers. Known as the low-income pool, this component of the demonstration was designed in part to continue funding for a supplemental payment program for hospitals that the state had in place prior to the demonstration. Payments from the $5 billion low-income pool ($1 billion annually) are authorized for selected Medicaid providers statewide to help offset the cost of providing care to Medicaid beneficiaries and underinsured and uninsured individuals. Vermont: Approved by HHS in September 2005 and launched the following month, Vermont’s demonstration is designed to contain costs and, by potentially delivering services to Medicaid beneficiaries for less and reinvesting excess revenue, to allow the state to serve more of its uninsured population. Under the demonstration, Vermont created a single, state-operated managed care organization to cover virtually all of the state’s Medicaid population. HHS approved a managed care arrangement whereby the state Medicaid agency contracts with one of its own components (the Office of Vermont Health Access) to operate as a managed care organization. The Office of Vermont Health Access receives monthly actuarially certified lump-sum payments from the state Medicaid agency, which in turn receives the federal share of these lump- sum payments. The monthly payment is intended to cover the medical costs and administrative expenses of serving enrolled beneficiaries. Vermont also received authority to retain “savings,” that is, any excess revenue generated by the state managed care organization, and apply them to programs that meet certain agreed-upon health objectives, such as increasing health insurance coverage. On several occasions since the mid-1990s, we have reported concerns that HHS had approved Medicaid demonstrations that were not budget neutral to the federal government. In 1995 we reported that HHS applied new, more flexible budget neutrality guidance allowing three states to consider “new methodologies” for determining budget neutrality of proposed demonstrations. Based in part on these new methodologies, HHS had approved spending limits for these demonstrations that were not budget neutral and could increase federal Medicaid expenditures. In 2002, we reported that HHS approved spending limits for demonstrations that were not budget neutral to the federal government by allowing two states to include inappropriate or impermissible costs in their spending projections. We recommended that HHS ensure that valid methods are used to demonstrate budget neutrality by developing and implementing consistent criteria for reviewing and approving states’ budget neutrality analyses. HHS disagreed with the recommendation, stating that its methods were valid. In 2004, we reported that HHS approved spending limits for section 1115 demonstrations in four states that were not budget neutral to the federal government. These states projected the costs of their Medicaid programs at rates of growth exceeding state-specific and nationwide benchmarks for Medicaid cost and enrollment growth without documenting the rationale for the higher growth rates. We recommended that HHS (1) clarify criteria for reviewing and approving spending limits of states’ proposed demonstrations and (2) reconsider the spending limits of recently approved demonstrations. We also recommended that HHS document and make public the basis for any section 1115 demonstration approvals, including the basis for cost and enrollment growth rates used to set spending limits, and ensure that states comply with reporting and evaluation requirements. HHS concurred with our recommendations to make public the basis for its approvals, but did not concur with our recommendations on clarifying approval criteria and reconsidering recently approved demonstrations using these criteria. Our past work also includes reports addressing concerns with aspects of HHS’s oversight of certain state supplemental payment arrangements that threatened the fiscal integrity of Medicaid’s federal-state partnership. States, with HHS approval, can make supplemental Medicaid payments— payments above the state’s usual Medicaid payment rates for certain services, such as nursing home care—and they often do so for appropriate reasons. For example, states may make supplemental Medicaid payments to certain safety net providers that serve a large share of high-cost Medicaid beneficiaries. However, our work since the early 1990s examining some of these arrangements found that many states were, in essence, finding ways through the arrangements to inappropriately increase the federal share of Medicaid spending at little or no cost to the state.