New CMS Section 1115 demonstration guidance 

State Medicaid programs have historically used Section 1115 demonstrations to authorize their managed care delivery systems, cover new populations, and test new services that have the potential to improve quality of care and reduce costs. The Centers for Medicare & Medicaid Services (CMS) has always required these demonstrations to be budget neutral. While demonstration opportunities and flexibilities may have differed from administration to administration, the general approach remained relatively constant — until now.

Starting January 1, 2027, the Chief Actuary of CMS must certify that Section 1115 demonstrations are budget neutral to the federal government (i.e., “not expected to result in an increase in the amount of Federal expenditures compared to the amount that such expenditures would otherwise be in the absence of such project”).

To implement this HR 1 requirement, CMS announced a new budget neutrality framework in a State Medicaid Director Letter (SMDL) last month. A companion deck with a few additional details followed. CMS is still several months away from a formal proposed rule, estimated to be published in early 2027.

The new framework will require states to complete several new or expanded activities throughout Section 1115 demonstration planning, submission, and implementation.

1. Categorize activities. The state’s Section 1115 demonstration team should have a deep knowledge of Medicaid policy and law, including who can be covered, what services can be covered, and how coverage may be structured. States will use this knowledge to bucket all Section 1115 activities into two new categories. All other past categorizations (e.g., hypothetical expenditures) will be retired. CMS provides the likely categorization of key initiatives at the end of its State Medicaid Director Letter (SMDL).
   
   -  Medicaid Authorizable Populations and Services (MAPS) “would be associated with the coverage of populations and services the state could otherwise have implemented through the Medicaid state plan or other title XIX authority.”
   
   -  Section 1115-only activities cannot be classified as MAPS and need Section 1115 authority.
   
   
2. Estimate impacts. States will need to perform a financial impact analysis for every Section 1115‑only activity, comparing costs (i.e., direct costs, administrative costs, and indirect costs/cost effects) and savings. “The analysis could be actuarial, economic, or statistical, or another comparable rigorous approach,” and employ “modeling, simulation, estimation, or other experience and research of comparable activities already used or tested elsewhere.”
   
   The analysis should be “sufficiently thorough and well-documented to enable the [CMS] Chief Actuary to assess its conclusions, including the data, assumptions, and methodologies used in its development.” Although actuaries are not required, actuarial expertise may help states anticipate the CMS Chief Actuary’s questions and documentation needs.
   
   
3. Trim included activities, as needed. Many states have very large and long-running Section 1115 demonstrations. States will have to assess what stays, what sunsets, what gets transitioned to another authority, and what cannot be “paid for” by savings. In the SMDL, CMS encourages states “to reduce reliance on section 1115 authority where alternative Medicaid authorities are available,” such as Section 1915(b) waivers for managed care authority or home and community-based services authorities like Social Security Act Sections 1915(c), 1915(c)(11), or 1915(i) for supportive services.
   
   Additionally, administrative costs — such as systems, staff, vendors, and evaluators — will now be considered in the overall financial impact of Section 1115-only activities. This detail may push states to remove a potential Section 1115-only activity from the demonstration application altogether. Otherwise, states will have to consider how to pace and structure administrative expenditures. For example, states may assess how to maximize any current flexibilities around administrative costs in the short term and to minimize Section 1115-only administrative costs in the long term.
   
   
4. Respond to detailed CMS requests. States should plan for an extensive back-and-forth with CMS on the state’s data, assumptions, and methodologies. Per CMS, this process may include “multiple rounds of questions” and require “reclassification of activities and additional analysis from states.” Notably, CMS would “not have a fixed time frame for its review of budget neutrality.” CMS will approach reviews with a clear policy objective in mind: to “reduce federal outlays.”
   
   
5. Monitor expenditures and outcomes. States have always had to monitor and evaluate their Section 1115 demonstrations, but as with other elements, the state’s traditional approach will have to evolve. Instead of quarterly and annual reporting on Section 1115 demonstrations, states would now “be expected to monitor key indicators, program outcomes and expenditures, and manage the demonstration within CMS guardrails, to be defined.” If expenditures “substantially deviate” from a state’s projection, states must complete corrective actions. Because of the prospective determination of budget neutrality, states may implement initiatives quickly to ensure availability of savings for the next demonstration cycle and monitor the deviation between projections and actuals. 

CMS’s new budget neutrality approach has the potential to disrupt state innovations proposed and tested under Section 1115 demonstrations. It also may open opportunities in states that have not fully used Section 1115 demonstration authority in the past.

Under the new framework, only Section 1115-only activities can generate savings, and states can no longer use managed care savings to pay for initiatives. Rollover savings from past demonstrations will shrink in size — from ten years of savings to five years.

Per CMS’s companion deck, “states cannot achieve savings from simply reducing enrollment and/or benefits.” CMS will examine how a Section 1115-only activity reduces or avoids utilization or costs for other services or populations due to 1115-only activity.

In response, states may increasingly entertain smaller pilots over large transformation initiatives. States with current large-scale initiatives may focus on long-term sustainability and improvement of existing programs over pursuit of novel initiatives. For example, the state may focus on refining and improving existing initiatives initially built in past demonstration periods, such as initiatives first developed using delivery system reform incentive payment investments or health-related social needs infrastructure funding. These activities may include policy improvements, value-based payment methodologies for existing Section 1115 services, or a new service for a small, targeted population. 

CMS intends to release a proposed rule on this topic in early 2027 that will include additional detail. Even in the absence of a final rule, CMS will apply the budget neutrality framework described in the SMDL to Section 1115 demonstration approvals starting January 1, 2027, including new requests, renewals, and amendments. For any approvals issued on or after that date, but before the final rule takes effect, CMS would renegotiate budget neutrality, if necessary, to reflect changes to the methodology published in the final rule.

CMS has also signaled the intention to provide case-by-case extensions for states with Section 1115 demonstrations expiring soon, allowing additional time to implement these changes and transition to the new framework.

The new budget neutrality framework represents more than a policy change — it signals a significant shift in how Section 1115 demonstrations will be planned, evaluated, and managed.

States that begin preparing now have an opportunity to do more than comply with evolving federal expectations. By strengthening collaboration across policy, finance, actuarial services, operations, clinical programs, pharmacy, and data analytics, agencies can build demonstration strategies that are better positioned to navigate future changes while continuing to advance innovation and improve health and well-being of the people and communities they serve.