A coalition of health care providers has filed a lawsuit against California Governor Gavin Newsom and the state legislature, claiming that a recent overhaul of the state's Medicaid insurer tax violates a voter-approved initiative and could result in either higher health insurance premiums for consumers or a multibillion-dollar budget shortfall for the state.

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The dispute centers on whether California's new tax structure for managed care organizations (MCOs) complies with both federal law and Proposition 35, a ballot measure passed by voters in November of last year. The case highlights the complex interplay between state initiatives, federal Medicaid rules, and the financial strategies California uses to fund its Medi-Cal program.

Background: Medicaid Insurer Tax and Federal Scrutiny

For years, California has relied on a special tax on Medicaid insurers to draw down additional federal matching funds. Under the previous system, the state taxed Medicaid insurers at a much higher rateβ€”$274 per enrollee per monthβ€”compared to just $2.25 for non-Medicaid enrollees. This structure allowed California to maximize federal reimbursements, but it drew repeated warnings from federal officials, who argued that the tax arrangement did not comply with the intent of federal Medicaid law.

In response to these concerns, Congress closed the loophole in 2023, and the Centers for Medicare & Medicaid Services (CMS) issued a final rule in 2024 requiring states to equalize tax rates for Medicaid and non-Medicaid insurers by January 1, 2025. If California fails to comply, it risks losing federal approval for its Medicaid funding mechanism, which could create a significant gap in the state budget. See the official waiver request.

The New Tax Law and Proposition 35

In June 2024, the California legislature passed, and Governor Newsom signed, a law raising the tax on non-Medicaid enrollees to $8.85 per month. This move was intended to bring the state into compliance with the new federal requirement for equalized tax rates. However, if insurers pass this cost on to consumers, a family of four could see their health insurance premiums rise by more than $300 per year.

The new law also allows the state to use tax funds for cashflow loans to the General Fund. This provision is controversial because Proposition 35, the voter-approved initiative, explicitly bans such transfers and caps the tax on non-Medicaid enrollees at $2.50 per month. Proposition 35 was designed to maximize federal Medicaid matching funds while restricting how the insurer tax could be used. It requires that tax revenue fund higher Medicaid reimbursements for health care providers and prohibits diversion of those funds to the General Fund. The measure also mandates a supermajority legislative vote for any changes to the tax structure, a threshold the June bill did not meet.

Health care groups that supported Proposition 35 have asked the California Supreme Court to intervene, arguing that the new law undermines both the initiative and the state constitution. Their complaint asserts that the legislature and governor could have restructured the tax to comply with both state and federal requirements, but doing so would have reduced the estimated $2 billion in annual revenue generated by the current law.

Governor Newsom's administration has indicated it will first seek federal approval for a tax structure that complies with Proposition 35 but not the new federal requirements. If federal officials reject that plan, the state will then seek approval for the legislature's version, which increases the tax on non-Medicaid enrollees to meet federal demands.

Chris Jacobs, CEO of Juniper Research Group, criticized the state's approach, saying, "Because Newsom decided to lead from behind, Californians now face the Scylla of higher health insurance premiums or the Charybdis of yet another state budget shortfall."

Federal Oversight and Fiscal Impact

Both the Biden and Trump administrations have previously warned California that its insurer tax structure violated the spirit of federal Medicaid law. With Congress closing the loophole and CMS issuing a final rule, California must now act quickly to bring its tax system into compliance. Failure to do so by the January 1 deadline could result in the loss of federal approval for its Medicaid funding mechanism, creating a significant budget gap.

The Legislative Analyst's Office (LAO) has noted that California's reliance on the insurer tax creates fiscal risks, especially if federal officials reject the state's approach or if the courts rule in favor of the health care providers challenging the law. The LAO has also pointed out that the uncertainty surrounding the tax structure could complicate budget planning and potentially lead to service cuts if federal funds are lost. See the LAO analysis.

Governor Newsom and legislative leaders have not publicly responded to the lawsuit or addressed the specific criticisms raised by health care groups. Supporters of the new law argue that it is necessary to maintain Medicaid funding levels and avoid cuts to health care services for low-income Californians.

The California Supreme Court has not yet indicated whether it will take up the case before the January 1 deadline for compliance with federal law. The outcome of the legal challenge, as well as the response from federal officials, will determine whether California can maintain its current level of Medicaid funding without increasing costs for consumers or facing a budget shortfall.