Medicaid and CHIP: A Tale of Two Funding Structures

As Medicaid spending soars, policymakers should draw lessons from CHIP

Key points

• Although Medicaid and the Children’s Health Insurance Program (CHIP) are both designed to provide a health care safety net for low-income individuals, their funding structures are distinct.

• Federal Medicaid funding is an open-ended entitlement to states; there is no upper limit on the amount of federal Medicaid money a state can receive.

• By contrast, CHIP has a fixed nationwide limit on federal spending.

• These differences have profound effects on state policymakers’ incentives and the fiscal sustainability of these programs.

In discussions of US health policy, Medicaid and the Children’s Health Insurance Program (CHIP) are often discussed as a single entity. For example, a recent Census Bureau report combines Medicaid and CHIP in its statistics on health coverage. To be sure, the two programs have much in common. Both are designed to provide a health care safety net to those in need, are jointly funded by the federal government and the states, and are administered by the states within broad federal guidelines. Despite these similarities, a closer look reveals important differences – and lessons.

In 2020, Medicaid spent $661 billion and enrolled about 68 million people. According to official projections, Medicaid spending is expected to exceed $1 trillion in 2028; that year, the program will account for more than one in six health care dollars spent in the U.S. Along with Social Security and Medicare, Medicaid is rapidly devouring federal and state budgets, nudging the U.S. toward a fiscal crisis.

Spending on CHIP is a rounding error in comparison. In 2020, federal and state spending on CHIP fell just short of $20 billion. CHIP enrollment hovered around 6.7 million people – about one-tenth the level of Medicaid enrollment. Passed in 1997, CHIP was created partly in response to research showing that health care access in childhood could have profound effects on adult health, labor market behavior, and educational attainment. Many states’ Medicaid eligibility rules for children were viewed as too restrictive, so CHIP was designed to cover children whose families earned too much to qualify for Medicaid. Each state can set its own CHIP eligibility threshold, but it usually falls between 138% and 300% of the federal poverty guidelines.

Differences between Medicaid and CHIP are partly attributable to each program’s specific missions, eligibility rules, and benefits packages. For example, much of Medicaid spending goes to support long-term care for the elderly and people with disabilities – a rapidly-growing population. By contrast, CHIP is aimed primarily at children, most of whom are in good health.

But perhaps nothing is more responsible for the vast divergence in the size and breadth of Medicaid and CHIP than how each program is funded – and the incentives those funding structures create for state and federal policymakers.

In Medicaid, financing is split between the states and the federal government as dictated by the Federal Medical Assistance Percentage (FMAP), a formula that determines what proportion of total Medicaid spending is covered by the federal government. The FMAP is calculated based on average personal income for each state relative to the national average. Poorer states receive higher FMAPs. By law, the FMAP cannot be less than 50%, while some states receive FMAPs as high as 80% or more – meaning that for every $1 that states spend on Medicaid, the federal government contributes an additional amount, ranging from $1 to about $3. Federal Medicaid funding is an open-ended entitlement to states; as long as states are willing to commit some of their own money, there is no limit to what the federal government will match.

This open-ended design has some advantages. It allows Medicaid to function as an automatic stabilizer, ramping up spending in economic downturns without the need for congressional action (and avoiding the inevitable delays that come with the legislative process). It also gives states access to resources to respond quickly to health crises or natural disasters. From February 2020 to July 2022, for example, Medicaid enrollment surged by nearly 13 million people (18%).

But Medicaid’s open-ended design is also at the root of its fiscal challenges. By offering uncapped matching funds at such a generous rate, the federal government encourages states to spend more on Medicaid – and to be less vigilant about how the money is spent. That includes expanding coverage to new groups (such as able-bodied, childless adults) or offering a broader range of benefits (like dental services, speech therapy, and optical care). John Hood, writing in National Affairs in 2010, eloquently described these perverse incentives:

[State and local policymakers] reap all the political benefits of more generous coverage or looser eligibility rules, but pay only a fraction of the financial cost of such largesse, since the federal government picks up most of the tab. And during downturns and times of lean budgets, state lawmakers will bear the entire political burden if they allow steep eligibility cuts — but will reap only a portion of the fiscal benefits, since most of the cost savings will accrue to the federal government. State and local officials are thus more inclined to spend lavishly on Medicaid than on programs funded entirely by the state.

From state legislators’ perspectives, Medicaid spending – which pours resources into politically-influential state healthcare industries – is an exceptional bargain. While states come out ahead, the country as a whole is worse off: funds are spent inefficiently and the federal government’s fiscal imbalance deepens.

By contrast, CHIP is a capped program, and each state is provided an annual allotment of CHIP spending. Like Medicaid, states must contribute some of their own funds to draw down federal money. But unlike Medicaid, there is a limit to the federal government’s munificence.

Congress decides how much total federal spending to allocate to CHIP in any given year. Then, state allotments are calculated through a series of complicated formulas based on past allotments, past spending, and an inflation factor that captures growth in per capita national health expenditures and each state’s child population. Up to the cap, CHIP creates even worse incentives than Medicaid, because its FMAP rates are generally higher than for Medicaid. Once the cap is reached, however, states shoulder the entire costs of further spending – and act accordingly. In late 2017, as Congress’ failure to reauthorize CHIP led to dwindling federal funds, many states were expected to allow CHIP coverage to lapse for millions of beneficiaries. In short, state policymakers were unwilling to maintain CHIP without federal support.

CHIP’s design is rooted in the lessons learned about the negative consequences of Medicaid’s open-ended funding structure. Legislators drafting the language to create CHIP in the mid-1990s understood that Medicaid was on an unsustainable fiscal trajectory. From 1988-92, Medicaid’s total (state and federal costs) had more than doubled, from about 2.5% of the federal budget to more than 5%.

As intended, CHIP’s capped structure has helped constrain the program’s growth. While nominal Medicaid expenditures increased by 225% over the last two decades, nominal CHIP expenditures grew only 78%.

Incentives matter, and efforts to reform America’s entitlement programs should learn the lessons of Medicaid and CHIP.