Prop 35 MCO Tax: Federal Match, 2026 Funds, and H.R. 1 Risk

California’s Proposition 35 makes the state’s tax on managed care organizations permanent and directs roughly $4.7 billion a year to Medi-Cal. The Prop 35 MCO tax, approved by voters in November 2024, converts what had been a temporary levy requiring periodic legislative renewal into a locked-in funding source with strict rules on how every dollar can be spent. Medi-Cal covers more than a third of Californians, and the revenue is aimed at closing the gap between what the program pays providers and what it costs to deliver care.

How the Tax Is Structured

The tax is authorized under California Welfare and Institutions Code Section 14199.80, which directs the Department of Health Care Services (DHCS) to impose it on health plans participating in Medi-Cal and other managed care arrangements.¹ Plans owe a set dollar amount for each person enrolled each month rather than a flat percentage of revenue.

The rates are heavily tiered. For calendar year 2026, plans pay $274 per member per month on Medi-Cal enrollees in the 1,250,001 through 4,000,000 cumulative member-month range. Non-Medi-Cal enrollees in the same range are taxed at just $2.25 per member per month. The first 1.25 million cumulative member months and anything above 4 million are excluded entirely for both categories.² That lopsided structure is by design. The bulk of the tax falls on Medi-Cal enrollment, which is the spending category that triggers federal matching funds.

Why Federal Matching Is the Real Engine

The financial power of the MCO tax comes less from what California collects than from what those collections unlock. California’s Federal Medical Assistance Percentage for the period beginning October 2026 is 50 percent, meaning the federal government matches each state dollar spent on Medicaid with one federal dollar.³ When the state puts MCO tax revenue toward Medi-Cal spending, that spending draws the federal match, effectively doubling the impact of every tax dollar collected.

Federal law requires provider taxes to stay below a safe harbor threshold and to be broad-based and uniform across the taxed class of providers under 42 U.S.C. § 1396b.⁴ Because California’s tiered rates deviate from strict uniformity, the state needs a waiver from the Centers for Medicare and Medicaid Services (CMS) to claim matching funds.⁵ DHCS has secured CMS approval for the current design through 2026.²

Where the 2026 Money Goes

Proposition 35 does not leave spending decisions to the annual budget process. The measure requires MCO tax revenue to flow into specific health care categories, and DHCS publishes a detailed spending plan each year. For calendar year 2026, the total allocation is $4.656 billion:⁶

$2 billion for Medi-Cal program support, covering a portion of managed care capitation rates.
$691 million for primary care, including rate increases that target 87.5 percent of Medicare rates.
$575 million for specialty care such as cardiology and neurology, also targeting the 87.5 percent Medicare benchmark.
$355 million for emergency physician services and hospital-directed payments.
$300 million to improve patient throughput at behavioral health facilities.
$245 million for outpatient managed care rate increases.
$150 million in directed payments to designated public hospitals.
$90 million for reproductive health through the Department of Health Care Access and Information.
$150 million combined for graduate medical education and Medi-Cal workforce expansion.
$50 million for community clinic directed payments and $50 million for ground emergency medical transportation.

The 87.5 percent Medicare benchmark for primary and specialty care is the number that matters most to providers. Medi-Cal has historically paid well below Medicare, which itself pays less than commercial insurance. Bringing reimbursement closer to Medicare levels makes it financially viable for more doctors to accept Medi-Cal patients, which translates to shorter wait times and better access.

Rules That Keep the Money From Being Diverted

The strongest protection in Proposition 35 is its non-supplanting rule. Under Welfare and Institutions Code Section 14199.107, MCO tax revenue cannot replace state funding already being spent on Medi-Cal. Every dollar must go toward expanding services, raising payment rates, or supporting the health care workforce above what existed as of January 1, 2024.⁷ That directly addresses a longstanding concern: that the legislature would use MCO revenue to backfill General Fund obligations rather than expand health care spending.

That concern had history behind it. The Legislative Analyst’s Office noted the state had used prior MCO tax funds to cover existing Medi-Cal service levels, freeing up General Fund dollars for other priorities.⁸ Proposition 35 closes that door. The measure also caps administrative expenses and requires independent audits by the State Controller.

To guide spending, the measure created a 10-member stakeholder advisory committee with representatives from physician groups, hospitals, community health centers, dental providers, labor organizations, and ambulance transport providers. DHCS must consult the committee when allocating increased revenue.

What “Permanent” Actually Changed

Before Proposition 35, the MCO tax had no guaranteed future. The legislature first authorized it in 2009 and renewed it several times, each with a sunset date. The most recent version, approved in 2023, was set to expire at the end of 2026.⁹ Providers could not plan around funding they were not sure would continue, and the legislature treated each renewal as a bargaining chip.

Proposition 35 eliminates the sunset. Beginning in 2027, the tax is permanent and no longer requires periodic legislative reauthorization.⁹ Changing the tax structure or spending rules requires a three-fourths supermajority in both chambers of the legislature, and any amendment must be “consistent with, and furthers the purpose of” the chapter.⁷ The other route is another ballot initiative. Both are high bars, which is the point. Health plans continue to file payments on the schedule DHCS maintains.¹⁰

The Federal Risk From H.R. 1

Proposition 35 locked the tax in at the state level, but the federal government controls whether the revenue qualifies for matching funds. That distinction became urgent in 2025 when Congress passed H.R. 1, which imposed new restrictions on provider taxes nationwide.

Under the new federal law, the safe harbor threshold for provider taxes in expansion states like California will drop from 6 percent of net patient revenue to 3.5 percent by federal fiscal year 2032. The phase-down runs 5.5 percent for FY 2028, 5 percent for FY 2029, 4.5 percent for FY 2030, 4 percent for FY 2031, and 3.5 percent from FY 2032 onward.⁴ Any tax that exceeds those caps loses eligibility for federal matching, which would gut the financial logic of the MCO tax.

There is a grandfathering provision. A state’s existing tax can remain in place if, as of July 4, 2025, the state had enacted and was actively collecting the tax and the Secretary of Health and Human Services determines the tax was within the hold harmless threshold on that date.⁴ California was collecting the tax on that date, so it should qualify, but the determination rests with HHS.

The Legislative Analyst’s Office flagged this as a serious risk. If California cannot secure an extension or favorable grandfathering determination, DHCS would need to restructure the tax to comply with the lower caps. Because Proposition 35 requires a three-fourths supermajority for changes, the LAO warned that a restructured tax “could be significantly smaller than the current version, effectively eliminating budgeted state savings.”¹¹ The feature that protects the tax from state-level interference could make it harder to adapt to new federal rules.

Does It Affect Private Insurance Premiums?

The tax falls on health plans, not directly on individual consumers or employers. But plans set premiums to cover their costs, and the tax is a cost. For plans whose enrollment is predominantly Medi-Cal, the economics work out: the tax generates federal matching revenue that flows back to pay for care. The system is essentially circular.

The picture differs for commercial, non-Medi-Cal enrollment. Plans also pay the per-member tax on those enrollees at the much lower $2.25 monthly rate for 2026, but that revenue goes to Medi-Cal, not back to the commercial side. In other states with similar taxes, insurers have begun passing the cost through to employers as premium surcharges. Whether California carriers absorb or pass along the commercial-side tax varies by market and is worth watching as 2026 rates are set.

Self-funded employer health plans, where the employer bears the financial risk rather than buying insurance, are generally not subject to the MCO tax. Federal law preempts most state-level regulation of these plans, so a significant share of the commercially insured population falls outside the tax base entirely.

1
California Legislative Information. California Welfare and Institutions Code 14199.80
2
Department of Health Care Services. Certification of Federal Approval for Modified Managed Care Organization Tax 2023-2026
3
Federal Register. Federal Financial Participation in State Assistance Expenditures – Federal Matching Shares
4
Office of the Law Revision Counsel. 42 USC 1396b – Payment to States
5
Centers for Medicare & Medicaid Services. Preserving Medicaid Funding for Vulnerable Populations – Closing a Health Care-Related Tax Loophole Proposed Rule
6
Department of Health Care Services. Proposition 35 Spending Plan 2025 and 2026
7
California Secretary of State. Proposition 35 Text of Proposed Laws
8
Legislative Analyst’s Office. The 2025-26 Budget: MCO Tax and Proposition 35
9
Legislative Analyst’s Office. Proposition 35 – Provides Permanent Funding for Medi-Cal Health Care Services
10
Department of Health Care Services. Managed Care Organization Tax
11
Legislative Analyst’s Office. Overview of Major Impacts of H.R. 1