LAO 2004-05 Budget Analysis: General Government

Analysis of the 2004-05 Budget Bill

Legislative Analyst's Office
February 2004

Quality Improvement Fees

Additional Federal Funds and State Savings Possible Through Provider Fee Mechanism

The Governor's budget plan offers a modified proposal for a "quality improvement assessment fee" on Medi-Cal managed care health plans to enable the state to draw down additional federal funds for support of the program. We recommend approval of the Governor's proposal to impose such a fee for Medi-Cal managed care health plans. In addition, we recommend that the Legislature explore the option of extending such a fee to mental health managed care.


Unique Fee Mechanism Generates Additional Federal Funds. Federal Medicaid law permits states to impose fees on certain health care service providers and in turn repay the providers through increased reimbursements. Because the costs of Medicaid reimbursements to health care providers are split between states and the federal government, this arrangement provides a mechanism by which states can draw down additional federal funds for the support of their Medicaid programs. These funds can then be used to offset state costs.

The Governor's 2004-05 budget plan proposes to impose such a charge, which it terms a quality improvement assessment fee, for Medi-Cal managed care health plans. (A similar proposal for Medi-Cal managed care was enacted as part of the 2003-04 Budget Act, but the Department of Health Services (DHS), has indicated that technical problems will prevent its implementation this year.) The administration estimates that the current proposal will result in net state savings of $75 million in 2004-05 while also providing additional reimbursements to health plans. (The fees are also commonly called "quality improvement" or "quality assurance" fees.) We will discuss the Governor's fee proposal later in this analysis.

Under federal law, the fees must be imposed on all members of that class of providers. For example, a fee on hospitals must apply to all public and private hospitals, and not just psychiatric hospitals. Such a fee mechanism was adopted and is already being successfully implemented by DHS in regard to Intermediate Care Facilities for the Developmentally Disabled (ICF/DDs) in order to generate an estimated $17.5 million in savings for the state. More than a dozen other states have also imposed such fees for various types of medical providers in keeping with the provisions of federal law.

Federal Laws Limit Use of Fees. Federal Medicaid law recognizes a state's authority to levy such assessments on a broad range of Medicaid providers. These providers are: (1) inpatient hospital services; (2) outpatient hospital services; (3) nursing facility services; (4) services of ICF/DDs; (5) physicians' services; (6) home health care services; (7) outpatient prescription drugs; (8) services of a Medicaid managed care organization; and (9) other services as established by federal regulation. The policy of federal authorities has been to limit such fees to 6 percent of provider payments.

Federal statute identifies a number of conditions that must be met by a state in order to qualify such a provider fee for federal reimbursement under the Medicaid Program. For example, under federal rules, all providers that deliver the same class of services must be assessed the fee. The fee must be "broad-based," meaning that it is applied to all Medi-Cal and non-Medi-Cal payments going to the same provider. Also, all providers must be assessed the fee uniformly—a 2 percent fee cannot be assessed to some providers while a 6 percent fee is assessed to others.

Finally, federal law does not allow the state to guarantee to the providers subject to a quality improvement fee that they will be compensated with a rate increase sufficient to "hold them harmless" from any net increase in costs. In effect, the imposition of the fee and the authorization of any increases in reimbursements to providers must be handled as separate actions.

How Does the Fee Mechanism Work? Figure 1 provides a simplified explanation of how such fees can be structured to draw down additional federal funds, reduce state costs, and provide additional resources to medical providers to improve the quality of health care.

In our example, a state imposes a 6 percent quality improvement fee on the gross revenues of certain health care providers who currently are reimbursed at a rate of $100 per day (Step 1). As a result, the state collects about $6 in revenues for each $100 of revenues received from the providers subject to the fee. These fee revenues would be deposited in the state's General Fund. Continuing with our example, the state, in turn, agrees to increase its Medicaid reimbursements to $106 per day. Under this scenario, a Medicaid provider would receive a new, higher reimbursement rate for its services that equals the cost of the fee (Step 2).

The state benefits from this transaction because the federal government shares in the cost of the Medicaid program. The split between California and the federal government in 2004-05 for Medi-Cal Program costs is expected to be 50-50. Thus, in our example, the state would pay only half the additional cost of the reimbursements for providers ($3 per day of health care services) and the federal government would pay the other half of these costs (also $3 per day). This leaves the state with $3 of the $6 that it collected originally.

States have generally chosen to use part of their financial gain—$3 in our example—from such transactions to invest in improvements in the quality of health care provided under their Medicaid programs. In our example (Step 3), the state does so by increasing rates for providers subject to the fee by the equivalent of $2 per day, bringing their total reimbursement rate to $108. The state uses $1 of its $3 revenue gain, plus a $1 match in federal Medicaid funds—to pay the $2 rate increase. This leaves the state with a net revenue gain of $2.

To sum up our example, (1) additional federal funding is drawn down that was not previously available, (2) the state experiences a net financial gain by receiving new quality improvement fee revenues that exceed the state cost of the rate increases it authorizes for Medicaid providers, and (3) the providers experience a net financial gain due to rate increases that exceed their new fees.

As noted earlier, our explanation of how the fee mechanism works in this analysis has been slightly simplified. Our example slightly understates the potential gain to a state and slightly overstates the gain to providers.

Implementation Procedures. The DHS must complete a number of complex steps before such fees can be imposed. These procedures include the review and, if necessary, modification of a state's federally-approved Medicaid plan to ensure that it allows a quality improvement fee to be assessed. In some cases, state law changes may be necessary. The DHS must also draft and publish new regulations, policies, and procedures to collect a new provider fee, including procedures to address any fee payment disputes, and, in some cases, coordinate these arrangements with affected state departments.

Fees Can Create "Winners" and "Losers." In our example above, we showed how a Medicaid provider could be held harmless, or actually receive a rate increase, through the simultaneous imposition of a quality improvement fee and rate increases. Notably, the fee now being imposed in California for operators of ICF/DDs almost entirely affects providers who are already participating in the state's Medi-Cal Program. Operators of ICF/DDs will pay a 6 percent quality assurance fee but receive an 8.8 percent rate increase.

However, quality improvement fees can also be imposed in a way that affects medical providers who are not participating in the Medi-Cal Program. Because federal law requires that such a fee apply to all providers within a defined class of providers, any providers within that class that do not provide services to Medi-Cal beneficiaries would not benefit from an increase in funding allocations that was made possible with the state's receipt of new fee revenues. The imposition of charges on providers who will not receive any offsetting benefit would probably constitute a tax increase under state law. Thus, this approach raises important tax policy issues.

When such a fee is imposed across a class of medical service providers, any non-Medicaid providers, in effect, indirectly share part of the burden of caring for Medicaid beneficiaries through their fee payments. While some would contend that it is only fair that the burden of providing health care for the poor be shared in this way, other providers are likely to object to such an arrangement. Ultimately, it is a policy call for the Legislature whether such a tax is an appropriate source of revenue to help support the Medi-Cal Program, or whether more general sources of revenue, such as the income or sales tax, are a more appropriate basis for providing financial support of health care for the poor.

The imposition of fees in such circumstances could be advantageous to the state in at least one other respect: Such fees could provide a greater incentive for providers who are not doing so to accept Medi-Cal beneficiaries. Overall access to services for beneficiaries could improve as a result.

The Governor's Managed Care Fee Proposal

As noted earlier, the 2003-04 Budget Act included a proposal to implement a quality improvement fee on Medi-Cal managed care plans beginning January 2004. The fee was expected to result in net financial gain to the state of $37.5 million in 2003-04 and $75 million in 2004-05.

The Governor's 2004-05 budget plan proposes to delay the implementation of the fee (now called a "quality improvement assessment fee") until July 2004. The delay relates to as-yet unresolved technical issues affecting how the fee would be imposed on managed care health plans.

As noted earlier, federal law requires that quality improvement fees be "broad-based," and applied to all members of a class of providers, including both those participating in Medi-Cal and those who are not. Some large managed care plans provide services to both Medi-Cal and to commercial beneficiaries within the same business entity. At the time the Legislature adopted the fee proposal last year, DHS believed it would be possible to assess the fee only on the Medi-Cal part of their business. However, we are advised that federal authorities indicated in subsequent discussions with DHS that any fees would have to be imposed on their entire line of business in order to receive federal approval.

The 2004-05 budget plan addresses this objection of federal authorities by proposing that all Medi-Cal managed care plans establish a separate business entity for their Medi-Cal line of business. Some plans are already structured in this way, and DHS has indicated that all plans could do so by 2004-05. At the time this analysis was prepared, DHS was continuing to discuss these implementation issues with managed care plans.

LAO Comments. Our analysis indicates that the DHS proposal would probably result in fee revenues and a net General Fund gain to the state of the magnitude indicated in the Governor's 2004-05 budget plan. Specifically, the budget plan assumes that the imposition of a 6 percent fee on managed care plans would result in about $300 million in revenues that would be deposited in the General Fund. It further assumes that these providers would receive rate increases of about 9 percent that would increase Medi-Cal Program expenditures by about $225 million. The end result would be a net financial gain to the state of about $75 million annually. These net state savings would be ongoing and would change over time in accordance with managed care plan revenues.

State Has Opportunity to Expand on Fee Strategy

Greater State Financial Gain Possible. Our analysis indicates that it may also be possible for the state to impose quality improvement fees on mental health managed care plans to achieve a net General Fund financial gain for the state of as much as $70 million annually while providing a net increase in resources available to counties for mental health care of as much as $23 million.

We would note that our estimate is presented for illustrative purposes only. The financial gains which can result from drawing down additional federal funds through quality improvement fees could be split differently between the state and providers than the figures we have presented in this analysis.

Currently, the state Department of Mental Health (DMH) contracts with county entities, identified in state law as Medicaid managed care plans, to provide specialty mental health services for certain groups of children and adults specified in state law. These contracts are a voluntary arrangement for counties. Were a county to decline to contract with the state for this purpose, DMH would contract instead with other private or public entities to provide specialty mental health services within that jurisdiction. At present, however, nearly all counties are serving as the managed care plans for their respective jurisdictions.

About $2.6 billion would be available for counties from a combination of federal, state, and county funds for specialty mental health services in 2004-05 under the Governor's budget plan. This includes services both for Medi-Cal beneficiaries and others not eligible for Medi-Cal. Our estimate assumes that a 6 percent quality improvement fee could be imposed on the total expenditures for this entire class of services provided by the counties. Our estimate also assumes that the state would use part of its fee revenue to increase the separate allocations that the state provides for mental health managed care plans by about 45 percent. This increase in state funding would be matched by an increase in matching federal funds. Thus, counties would collectively receive an additional amount of mental health managed care funds that would more than offset the quality improvement fees they would collectively pay to the state.

While our estimate assumes that mental health managed care allocations would generally be increased to offset the cost of the fee, other approaches are possible. For example, the additional funding provided by the state could be targeted to improve the mental health services provided to specific Medi-Cal populations.

One implementation issue warrants further study to determine if our approach is feasible. Based on our initial discussions of the quality improvement fee concept with DMH and DHS, it is not clear at this time whether any of the counties would have to restructure their mental health managed care operations to separate out the provision of specialty mental health services from the other health services provided within that jurisdiction. Some restructuring of such operations might be necessary to formally establish mental health managed care plans as a separate class of providers of services under federal law.

Analyst's Recommendations

In order to draw down additional federal funds to offset the cost to the state of the Medi-Cal Program, we recommend approval of the Governor's modified proposal to establish a quality improvement assessment fee for Medi-Cal managed care plans. Our analysis indicates that, while DHS was unable to implement such a fee in the current fiscal year, progress is being made in structuring the fee program so that it will obtain federal approval in time for implementation in the budget year.

Given the state's serious fiscal problems and the growing cost of the Medi-Cal Program, we further recommend the Legislature explore the option of imposing a quality improvement fees on mental health managed care plans. Specifically, we recommend that DHS and DMH report at budget hearings on the feasibility of imposing quality improvement fees for these providers, the potential revenues that could be generated from such fees, and any significant operational issues that would affect their implementation.

A similar quality improvement fee proposal for In-Home Supportive Services (IHSS) is discussed in our analysis of the IHSS program later in this chapter.

Such fees are also possible for other classes of medical services provided as part of the Medi-Cal Program.

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