The Evolution of Medicaid Waivers and Directed Payments to Hospitals

Since its creation in 1965, Medicaid has served as a lifeline for low-income individuals, families, and the disabled, offering health coverage in partnership with state governments.

Over time, states have sought greater flexibility in administering their Medicaid programs, leading to the development of Medicaid waivers. Among the most influential outcomes of these waivers in recent decades has been the rise of directed payments to hospitals: financial tools designed to stabilize hospital finances, support access to care, and promote value-based purchasing.

Origins of Medicaid Waivers

The Medicaid program was initially structured with a rigid set of federal requirements. However, as states faced diverse and evolving healthcare needs, Congress authorized waiver authority to permit experimentation outside the traditional federal framework. The most relevant exceptions to hospital payments are:

• Section 1115 Waivers: Created under Section 1115 of the Social Security Act, these waivers allow states to test new approaches that promote Medicaid’s objectives. They provide broad flexibility, including managed care expansion and supplemental hospital payments.

• Section 1915(b) and 1915(c) Waivers: These allow for managed care delivery systems and home- and community-based services, respectively. While important for long-term care, they are less central to hospital reimbursement.

The use of 1115 waivers gained momentum in the 1990s and 2000s, with states designing delivery system reforms and seeking to stabilize safety-net hospitals through supplemental payments.

The Rise of Medicaid Directed Payments

The introduction of Medicaid Managed Care Organizations (MCOs) created complications for financing hospital services. In traditional fee-for-service (FFS) Medicaid, states could directly pay hospitals supplemental funds through programs like Disproportionate Share Hospital (DSH) payments and Upper Payment Limits (UPLs). But under managed care, the state paid capitation to the MCOs, and those entities – not the state – paid the providers.

To address this issue, the Centers for Medicare & Medicaid Services (CMS) established a regulatory framework in 2016 for state-directed payments (SDPs) under 42 CFR §438.6(c). These allowed states to direct how MCOs pay certain providers, as long as they met Centers for Medicare & Medicaid Services (CMS) rules regarding actuarial soundness, transparency, and network adequacy.

Purpose and Structure of Directed Payments

Directed payments help states advance payment reform goals, support financially distressed hospitals, and address access challenges in underserved areas.

They must be:

• Based on utilization;
• Tied to value-based purchasing or quality metrics (in many cases); and
• Pre-approved by CMS annually through rate certifications.

Examples include increased payments to public hospitals, minimum fee schedules for essential services, and incentive-based payments tied to quality benchmarks.

States often fund these payments with non-federal share sources, such as provider taxes, Intergovernmental Transfers (IGTs), and Certified Public Expenditures (CPEs). This financial interdependence between providers and the Medicaid program adds complexity and scrutiny.

Impact and Controversy

As I have written about previously, SDP payments have continued to skyrocket. The Government Accountability Office (GAO) raised concerns over:

• Inconsistent documentation;
• Limited oversight on whether payments achieved intended goals; and
• Payments not always being linked to quality or access improvements.

CMS has since increased its review of directed payment proposals, requiring more rigorous justification and validation of methodologies.

Future Outlook

As healthcare systems shift toward value-based care, directed payments are likely to continue evolving. States will need to demonstrate clear connections between payment strategies and improved outcomes. Moreover, CMS may impose tighter guardrails to prevent abuse and ensure transparency.

The impending expiration of some 1115 waivers (e.g., Florida’s waiver in 2030) also prompts states to reevaluate how they use LIP funding, supplemental payments, and SDPs within broader Medicaid reforms.