How Medicaid Matching Funds Work—And What Happens When They’re Cut

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More than a million Californians could lose Medi-Cal coverage over the next decade because of federal budget changes signed into law in July 2025.

What makes this crisis different from a simple cut is the way the federal government finances Medicaid. The system operates through matching funds: for every dollar a state spends, the federal government contributes its share based on a formula. When Washington reduces its contribution, states don’t lose money. They lose leverage. And the mathematics of that leverage create a trap that even wealthy states can’t escape.

How Federal Matching Rates Work

Poorer states get higher federal matching rates. Wealthier states get lower rates.

California, as a relatively wealthy state, gets the minimum for traditional populations: 50 percent federal matching.

Expansion adults—those with incomes between 100 and 138 percent of the federal poverty line—get covered at a 90 percent federal match. The state funds only 10 percent. Each state dollar invested in expansion attracts nine federal dollars.

Why 90 Percent Matching Changes Everything

At the state’s base 50 percent matching rate, it contributes a dollar for every federal dollar spent on traditional Medicaid. If the state wants to expand services to an additional 100,000 people, it must fund half that expansion itself.

But expansion adults get a 90 percent federal match. This explains why California and other states adopted the Medicaid expansion. The fiscal calculus was irresistible.

The Trap: Why the State Can’t Replace Federal Money

Say federal Medicaid dollars for California decrease by $10 billion due to policy changes. A typical analysis might suggest that the state could increase its appropriations by $10 billion to compensate. But that analysis is wrong.

Federal funds aren’t a fixed pool that states can supplement at will. They’re a share of total program costs. If California’s share is 50 percent, and the federal government reduces its contribution by $10 billion, the state was previously contributing $10 billion in state funds for that same service category—total program spending of $20 billion.

To maintain the same level of service after losing $10 billion in federal dollars, California must increase its appropriation by $10 billion, creating a total increased program cost of $20 billion, on which the federal government provides 50 percent.

California must increase appropriations by $20 billion to offset a $10 billion federal reduction.

This is the multiplier effect of the matching fund system working in reverse. It’s why federal cuts create disproportionate fiscal pressure that even wealthy states struggle to absorb.

If the enhanced federal share dropped from 90 percent to 80 percent, California’s cost per expansion enrollee would double. A person costing $10,000 annually in Medicaid services requires $1,000 in state contribution at the 90 percent match. At 80 percent, that same person requires $2,000 in state contribution.

California would need to increase its spending by 100 percent to maintain services for the same population, even though the federal match only decreased by 11 percent.

What H.R. 1 Does

A federal budget law signed in July 2025—H.R. 1—doesn’t cut money. It restructures the entire financing mechanism in ways that create problems that pile up on top of each other in state budgets.

Federal budget analysts estimate the law will reduce federal Medicaid spending by $911 billion over ten years.

Provider Tax Restrictions

For decades, states have used a financing mechanism: they impose taxes on healthcare providers—particularly managed care organizations and hospitals—then use that tax revenue as the state’s contribution to Medicaid. That contribution triggers federal matching at the standard rate.

A final rule effective January 29, 2026, substantially restricts this practice by requiring states to tax Medicaid and non-Medicaid healthcare at more uniform rates.

California’s MCO tax generates more than $12 billion annually in gross revenue, with less than $8 billion in net revenue available to California. That revenue is now disappearing. The state must either backfill it through general fund appropriations or reduce provider payments.

State-Directed Payment Caps

States can require managed care plans to send extra payments to specific providers—typically public hospitals, safety-net providers, and rural hospitals. The payments serve genuine policy purposes: ensuring adequate access in underserved areas and supporting public hospital finances.

The law limits these extra payments and mandates reductions over time.

For providers that depended on those supplemental payments to cover costs exceeding Medicare rates, each reduction means either accepting lower margins, reducing services, or closing facilities.

Public hospitals relied on MCO tax revenue directed toward supplemental payments. With provider taxes eliminated and payments capped and phased down, public hospital revenue faces reduction from multiple directions simultaneously.

Work Requirements and Administrative Burden

The legislation requires states to implement mandatory work requirements for Medicaid expansion adults. States must verify that people are meeting these requirements and handle disputes.

Federal budget analysts estimate these work requirements will reduce Medicaid spending by $344 billion over ten years, primarily through lost services rather than administrative savings. The administrative machinery required to implement and enforce these requirements consumes significant resources before any losses occur.

States must hire additional eligibility workers, develop or modify verification systems, and conduct more communications with beneficiaries. States must fund half the increased administrative burden from their own resources.

If states make too many mistakes administering work requirements, the federal government cuts their funding. A perverse incentive to spend aggressively on administrative controls even if the state would prefer to redirect resources elsewhere.

The legislation also changed eligibility redeterminations for expansion adults to twice per year, increasing the frequency of renewals. More frequent redeterminations predictably increase churning—people losing and regaining services due to administrative friction rather than income changes.

Why Other States Face Different Pressures

The impact varies dramatically across states based on how much federal funding they receive. States with higher federal matching rates receive federal matching for the vast majority of their Medicaid costs. When federal policy reduces their federal matching by a given amount, their responsibility increases far less dramatically than for states with lower matching rates.

Consider a federal policy that reduces total Medicaid spending by 10 percent nationwide. For states where the federal government was funding approximately 84 percent, a 10 percent federal reduction means they must choose between accepting a 10 percent reduction in services or increasing appropriations substantially to maintain services.

For California, where the federal government funds 50 percent, a 10 percent federal reduction means the state must choose between accepting a 10 percent reduction or increasing appropriations by 20 percentage points of current Medicaid spending to maintain services.

Same federal policy. Vastly different pressure.

Economic Ripple Effects

Federal Medicaid spending reductions don’t affect only the healthcare sector. Every dollar of federal Medicaid represents new money injected into California’s economy from outside the state. Healthcare providers receive this federal money and use it to pay workers, purchase supplies, and make investments. Those payments create income for healthcare workers, who spend their wages on goods and services from other businesses.

Research shows that every dollar of Medicaid spending generates $1.50 to $2.00 in total economic activity.

If California loses $5 billion in annual federal Medicaid dollars, and the multiplier effect is 1.75, the total reduction in economic activity is about $8.75 billion. This reduced economic activity translates into lower tax revenues from income taxes, sales taxes, and corporate taxes.

Healthcare is among the largest employers in most states, particularly in rural areas. Research suggests Medicaid spending creates roughly one healthcare job for every $50,000-$60,000 spent. By this metric, California’s potential $5 billion annual Medicaid reduction could eliminate between 80,000 and 100,000 healthcare jobs over time.

These job losses would occur unevenly. Rural areas and safety-net providers would experience concentrations of losses. California has already experienced significant rural hospital closures in recent years. Further Medicaid reductions accelerate this trend.

What the State Learned From Previous Federal Cuts

A 2009 federal law provided temporary extra funding during the Great Recession. During the severe 2008-2009 recession, California faced a combined shortfall of $59.5 billion. The law provided emergency relief through enhanced federal matching for Medicaid, temporarily increasing the federal government’s share from California’s baseline 50 percent to about 62% through 2010.

This temporary enhancement provided California with about $8.5 billion in federal funds. When the enhanced matching funds began phasing out in 2011 and 2012, the state faced difficult choices.

California made some cuts but spent more money to protect certain groups. The experience illustrated that even the wealthiest state by total economy operates under significant fiscal constraints that prevent it from indefinitely backfilling federal Medicaid reductions with state-only funds.

The Impossible Choice

When federal matching funds decrease, states face a structured choice between three options: increase appropriations at multiples of the federal reduction to maintain services, reduce services and accept disenrollments, or reduce provider payment rates while maintaining services.

California’s challenges—structural deficits, competing demands from education and infrastructure, legal constraints on progressive taxation—make the first option infeasible at the scale required. The second option, reducing services, is politically painful but mathematically inevitable unless the first option occurs. The third option, reducing provider payments, faces limits because further payment reductions threaten provider participation and safety-net viability.

The immediate challenge involves implementing federal requirements while managing fiscal consequences. California must decide whether to maintain current services, reduce them, or make strategic adjustments to benefits or provider payments. The governor’s budget proposal delayed major decisions, waiting for federal guidance.

Major implementation decisions can’t be deferred indefinitely. The work requirement system must be designed and tested before implementation. Provider payment policies must be set to comply with payment caps. Provider tax alternatives must be negotiated. Administrative systems for six-month redeterminations must be developed and tested.

The Federal-State Partnership Under Strain

The current fiscal crisis raises fundamental questions about the viability of the federal-state Medicaid partnership model established in 1965. Policymakers designed the system assuming the federal government would support and expand Medicaid, not restrict it.

The formula encourages the federal government and states to share costs and decisions, but it assumes both partners are committed to program viability. When federal policy restricts program access, limits financing mechanisms, and reduces matching rates, the system becomes strained.

For wealthy states with lower federal matching percentages, the incentive to maintain Medicaid becomes weaker when federal matching decreases. If California’s effective matching rate on expansion falls from 90 percent to 80 percent or lower, the fiscal calculus for investment changes fundamentally.

Eventually, if federal matching becomes low enough and federal requirements become burdensome enough, wealthy states might choose to reduce Medicaid scope or transition to state-only programs. This would represent a fundamental restructuring of the federal-state partnership.

How the federal government pays for Medicaid may matter more than what services it covers. The formula determines how much states must contribute, which determines what states can afford, which determines program scope regardless of nominal eligibility rules.

Short of federal policy changes restoring enhanced matching rates or reducing work requirement and administrative burden, California faces inevitable reductions. California cannot fix this problem by itself—the math doesn’t work.

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