Each state administers its Medicaid program in accordance with its own Medicaid plan, which determines the groups of individuals to be covered, services to be provided, methodologies for providers to be reimbursed, and the administrative requirements that states must meet. To receive federal matching dollars for services provided to Medicaid beneficiaries, each state must submit a Medicaid plan for review and approval by HHS. States must meet certain federal requirements, but have flexibility beyond these federal parameters. For example, states must cover certain “mandatory” populations and benefits, but they have the option of covering “optional” categories of individuals and benefits. Coverage of optional populations and benefits varies across the states. States may also choose from different delivery systems, such as fee-for-service or managed care. States pay health care providers for covered services provided to Medicaid beneficiaries based on provider claims for services rendered. States generally make two types of supplemental payments to certain providers—payments separate from and in addition to those made to providers using regular Medicaid payment rates. Under federal law, states are required to make Disproportionate Share Hospital (DSH) payments to hospitals that serve a disproportionate share of low-income and Medicaid patients, in addition to regular Medicaid payments. Hospitals are subject to an annual limit on DSH payments, defined as the hospitals’ uncompensated care costs for Medicaid and uninsured patients minus Medicaid payments, and payments made on behalf of uninsured patients. States also make other supplemental payments, which are often referred to as non-DSH supplemental payments or “Upper Payment Limit (UPL) payments” to providers such as hospitals and nursing homes. These payments are based on the difference between Medicaid payments for services using regular Medicaid payment rates and the UPL, which is the ceiling on federal reimbursement. In general, the use of managed care to deliver Medicaid services precludes states from making UPL payments to providers because states are prohibited from making such payments for services provided under a managed care contract. Generally, the authority provided to the Secretary of Health and Human Services by section 1115 of the Social Security Act allows states to expand Medicaid coverage through demonstration projects to “expansion” populations that would not otherwise be eligible under traditional Medicaid programs. These demonstrations provide a way for states to innovate outside of many of Medicaid’s otherwise applicable requirements. For example, states may test ways to obtain savings or efficiencies in how they deliver services in order to cover expansion populations. Under a demonstration, states may also alter their Medicaid benefit package for categories of covered populations. Without this authority, states generally would be required to provide covered benefits in the same amount, duration, and scope to all beneficiaries covered under the state plan. States may have more than one comprehensive demonstration. For example, New Jersey had one demonstration targeted at expanding coverage to uninsured childless adults, and a separate demonstration targeted at expanding coverage to uninsured parents of Medicaid-eligible children. Both these demonstrations are comprehensive because they provide a broad range of services to these populations. States may also administer a large portion of their Medicaid program under a demonstration. For example, in Vermont, nearly all of the state’s Medicaid expenditures in fiscal year 2011 were for costs associated with a demonstration. Generally, to extend Medicaid to any previously uncovered populations or receive federal Medicaid matching funds for otherwise unallowable costs under the terms of a section 1115 demonstration, states must establish that the demonstration is budget neutral. To do so, states must show that their plans for changing their Medicaid program will generate savings to Medicaid, or they must get approval for redirecting existing Medicaid funding to cover the expected costs of the demonstration. For example: States have expanded the population eligible for Medicaid coverage by implementing managed care. In these demonstrations, states established budget neutrality by showing they would achieve savings from enrollment in managed care that could be used to cover new populations under the demonstration. States also have been approved by HHS to redirect certain categories of federal Medicaid funding for new purposes under the demonstration. Specifically, states have received approval to use all or a portion of their DSH allotments to cover previously ineligible individuals and costs under their demonstrations. States also have expanded coverage to previously ineligible populations, but in order to maintain budget neutrality, have provided the expansion population with a reduced benefit package—such as not covering inpatient hospital care—as compared to the typical benefits provided to Medicaid beneficiaries. Other strategies have included imposing higher cost-sharing on services or capping enrollment for expansion populations. States submit applications for section 1115 demonstrations to HHS. If HHS approves the demonstration, it is typically approved for a 5-year period. States that want to renew an existing demonstration have the option of requesting an extension or submitting an application for a new demonstration. States that submit an application for a new demonstration instead of an extension would need to terminate the existing demonstration, and would be required to notify beneficiaries of potential changes in coverage. A federal review team examines applications for both new demonstrations and extensions. The review team is led by CMS and includes representatives from OMB; from other agencies within HHS as applicable, such as the Substance Abuse and Mental Health Services Administration providing a review of waivers that affect mental health; and HHS Secretarial offices including the Assistant Secretary for Planning and Evaluation and the Assistant Secretary for Financial Resources. CMS’s Office of the Actuary provides nationwide data on projected Medicaid cost growth, but is not part of the federal review team. The federal review may consist of negotiations, including the exchange of questions and answers between the review team and the state. In approving applications, HHS might not approve all components of the states’ request contained in their applications. (See app. I for a discussion of applications that were submitted and reviewed between January 2007 and May 2012.) According to HHS’s policy, spending limits are based on the projected cost of continuing states’ existing Medicaid programs without a demonstration. The higher the projected costs, the more federal funding states are eligible to receive. The spending limits can be either an annual per person limit or an aggregate spending limit that remains fixed for the entire length of the demonstration, or a combination of both. HHS policy states that demonstration spending limits will be calculated from two components: Spending base. States select a recently completed year that establishes base levels of expenditures for populations included in the proposed demonstration—a state’s “spending base.” States also identify beneficiary groups for inclusion in the proposed demonstration. For example, demonstrations may include beneficiary groups, such as aged, blind and disabled, or families with children. However, the spending base must exclude certain base year expenditures, such as impermissible provider payments. Growth rates. States should submit to HHS 5 years of historical data for per person costs and beneficiary enrollment in their existing Medicaid program. HHS’s policy states that spending limits should be based on a benchmark growth rate, which is the lower of state- specific historical growth or the estimates of nationwide growth for the beneficiary groups included in the demonstration. The policy indicates that states, in providing HHS with state-specific historical growth rates, must also provide quantified explanations of any unusual changes in the trends. Nationwide projections of cost growth are developed by CMS actuaries to assist OMB in preparing the President’s budget. Growth rates for determining budget neutrality can vary for different eligibility groups. For example, the nationwide estimates of per capita cost growth in Medicaid for fiscal year 2012 were 6.0 percent for children, 3.4 percent for aged individuals, 2.6 percent for blind and disabled individuals, and 2.5 percent for adults. Figure 1 illustrates steps used to set spending limits for proposed section 1115 demonstrations. Some types of section 1115 demonstrations are not required to follow this process for determining spending limits. Specifically, for demonstrations that redirect a state’s federal DSH funding, HHS policy is to base the spending limit on the lower of the state’s DSH allotment or actual DSH expenditures prior to the demonstration. In addition, there is another group of recent section 1115 demonstrations pursuant to which federal law has defined how to calculate budget neutrality. Specifically, under the Children’s Health Insurance Program Reauthorization Act of 2009 (CHIPRA), states with existing section 1115 demonstrations covering childless adults using State Children’s Health Insurance Program (CHIP) funding were required to end these projects.apply and receive approval for new section 1115 demonstrations through which they could continue to cover childless adults using Medicaid funds. CHIPRA required that these new demonstrations be budget neutral, and required HHS to use a defined process of identifying the spending base and growth rates for demonstration spending limits. The 10 new comprehensive section 1115 demonstrations we examined focused on implementing ways of using federal funds to pay for services not typically covered under Medicaid. All 10 demonstrations were approved to implement different coverage strategies or cost sharing for certain beneficiary populations. Appendix II provides a brief summary of the key features of 10 demonstrations. Two states we reviewed—Arizona and Texas—obtained the authority under their section 1115 demonstrations to establish funding pools for purposes of making supplemental payments and to receive federal matching funds for these payments. As approved, Arizona’s section 1115 demonstration allows the state to make new types of supplemental payments to providers, and allowed the state to establish a funding pool from which these payments could be made. Arizona has operated a comprehensive section 1115 demonstration for many years, under which the majority of the Medicaid population is enrolled in managed care. Under its previous demonstration, the state made DSH payments to hospitals, but did not make UPL payments to its providers because the majority of services were provided under managed care contracts. UPL payments for services provided under managed care are generally prohibited under federal regulations. In March 2011, the state requested to terminate its existing section 1115 demonstration in order to limit coverage of certain adult populations.Subsequently, the state received approval for a new demonstration that continued the existing managed care delivery system, granted the authority for the state to make new types of supplemental payments to providers through a Safety Net Care Pool (SNCP), and expanded coverage to certain populations.