42 CFR 438.6: State Directed Payments and the 2024 Final Rule

42 CFR 438.6 is the federal regulation that controls how states structure payments to Medicaid managed care organizations. Titled “Special contract provisions related to payment,” it governs state directed payments, incentive and withhold arrangements, and the phase-out of legacy pass-through payments.¹ Every payment arrangement it permits must be written into a managed care contract and certified by an actuary as financially sound.

How the Regulation Is Organized

The rule is built in four subsections. Section (a) defines the terms used throughout, including “average commercial rate,” “pass-through payment,” “incentive arrangement,” and “minimum fee schedule.”¹ Section (b) covers risk-sharing mechanisms like incentive bonuses and withholds. Section (c) governs state directed payments, the most complex and heavily regulated category. Section (d) sets out the wind-down schedule for pass-through payments.

Running through all of them is the actuarial soundness requirement at 42 CFR 438.4. A capitation rate paid to a managed care organization must be projected to cover all reasonable and appropriate costs required under the contract, developed using generally accepted actuarial principles, and certified by an actuary.² That principle is the guardrail on every mechanism the regulation allows.

State Directed Payments Under 438.6(c)

The default rule is that a state cannot direct a managed care organization’s spending. Section 438.6(c) carves out narrow exceptions that let a state tell its plans how to reimburse certain providers.¹ States use these exceptions to channel supplemental funding to safety-net hospitals, raise Medicaid rates closer to Medicare levels, and support delivery system reforms.

The Five Permitted Categories

Value-based purchasing models such as pay-for-performance, bundled payments, or other arrangements that reward outcomes over volume.
Delivery system reform initiatives, whether multi-payer or Medicaid-specific.
Minimum fee schedules that require plans to pay providers at least a specified rate. The floor can be based on state plan rates, Medicare rates (up to 100 percent of the published Medicare rate from no more than three years prior), or another rate the state proposes.
Uniform dollar or percentage increases that add a flat amount or bump to what plans pay a class of providers for a particular service.
Maximum fee schedules that cap what plans pay for a service, as long as the plan retains enough flexibility to manage risk and meet its contract goals.

Each category must be tied to a specific service and applied equally across a class of providers delivering that service.¹ A state cannot use a directed payment to funnel money to one favored hospital while excluding its competitors.

Prior Approval and the Preprint

Most directed payments need written CMS approval before a state can implement them. Approval runs through a standardized document called the 438.6(c) preprint, submitted to a dedicated CMS email address.³ The preprint requires the state to describe the arrangement, explain how it advances the state’s quality strategy, and provide assurances on financing and provider participation. CMS will not approve the related managed care contract until the rate certification accounts for all directed payments.

Two categories skip the preprint. States do not need prior CMS approval for a minimum fee schedule set at their own state plan rates.³ The 2024 managed care final rule added a second exemption for minimum fee schedules set at exactly 100 percent of the total published Medicare rate.⁴ Every other arrangement requires a completed preprint before the payment’s start date.

Standards Each Directed Payment Must Meet

A directed payment that needs prior approval must be based on the actual delivery of services, distributed equally and on the same performance terms across the provider class, and tied to at least one goal in the state’s quality strategy. The state must also submit an evaluation plan showing how it will measure whether the payment achieved that goal.⁴

A few restrictions catch states off guard. A directed payment cannot condition provider participation on the provider agreeing to make intergovernmental transfer payments, a rule aimed at preventing states from effectively requiring providers to kick back their non-federal share. Directed payments do not renew automatically; a state must reapply for approval. And the state cannot set the exact dollar amount or frequency of spending and then recoup unspent funds from the managed care plan.³ Together these rules preserve some plan discretion and keep directed payments from operating as disguised pass-throughs.

The Average Commercial Rate Ceiling

The 2024 final rule formalized the average commercial rate as the upper payment limit for directed payment spending on hospital services, professional services at academic medical centers, and nursing facility services. The “average commercial rate” is the average rate paid by the highest-claiming commercial payers for specific services, measured by claims volume.¹ For other service categories there is no hard regulatory cap, though CMS has signaled it uses the average commercial rate as a benchmark when reviewing those arrangements.⁵

A state that wants to raise Medicaid reimbursement to 150 percent of Medicare for hospital services must show that the resulting total payment stays at or below average commercial rates. States must also report the total dollars each managed care plan spent on directed payments within one year after the end of the rating period.⁴

Incentive Arrangements

Incentive arrangements under 438.6(b)(2) let a state pay a managed care plan bonus amounts for hitting performance targets such as improved immunization rates or reduced avoidable readmissions. The hard ceiling is 105 percent: total payments under an incentive arrangement cannot exceed 105 percent of the approved capitation rate for the enrollees or services covered. Anything above that is automatically considered not actuarially sound.¹ The cap keeps the base rate and potential bonus within a reasonable band and blocks states from setting a low base rate paired with an oversized promised bonus. Actuaries must certify that both the base rate and the full incentive amount fall within actuarially sound boundaries.

Withhold Arrangements

Withholds under 438.6(b)(3) work in the opposite direction. Instead of offering a bonus on top of the capitation rate, the state holds back a portion of the payment and returns it only if the plan meets agreed-upon metrics. If the plan misses its targets, the state keeps the withheld amount.

Two protections apply. The capitation rate minus whatever portion of the withhold is not reasonably achievable must still be actuarially sound on its own, so a plan that falls short of its targets still has enough to cover its enrollees’ care. And the total withhold amount must be reasonable given the plan’s financial operating needs, the size of its covered population, and its capital reserves.¹ The data, assumptions, and methodology used to determine the achievable portion of the withhold must be documented and submitted as part of the rate certification.

Pass-Through Payments and Their Phase-Out

Pass-through payments are supplemental amounts a state requires managed care plans to add to their contracted provider rates, but that are not tied to a specific service delivered to a specific enrollee and do not fit any directed payment category.¹ For years, these payments propped up safety-net hospitals and nursing facilities without any link to service quality or volume. CMS treats them as incompatible with the managed care model and set a phase-out schedule under 438.6(d).

Physicians and nursing facilities: pass-through payments could continue through rating periods beginning before July 1, 2022. For contracts starting on or after that date, states can no longer require these payments.¹
Hospitals: hospital pass-through payments follow a 10-year glide path that started with rating periods beginning on or after July 1, 2017. The allowable amount drops by 10 percentage points of the base amount each year. For contracts beginning on or after July 1, 2027, states cannot require any hospital pass-through payments.¹

As of 2026, the physician and nursing facility pass-through authority has already expired. Hospital pass-through payments are in their final year, with the allowable amount at 10 percent of the original base. States that relied on legacy pass-throughs have largely transitioned to state directed payments under 438.6(c) as the replacement vehicle.

2024 Final Rule and Recent Changes

The 2024 Medicaid managed care final rule made several changes to 438.6. It formalized the average commercial rate ceiling, exempted 100-percent-of-Medicare minimum fee schedules from prior approval, and strengthened evaluation requirements for directed payments. Starting September 10, 2025, CMS will not consider a preprint complete unless it includes minimum evaluation elements showing how the state will measure quality or outcome improvements.⁶

CMS also began publishing all approved state directed payment preprints submitted on or after February 1, 2023. Separately, Section 71116 of Public Law 119-21 directed CMS to revise the payment limit rules for directed payments covering inpatient and outpatient hospital services, nursing facility services, and qualified practitioner services at academic medical centers.⁶ The full impact of that statutory change is still being implemented through rulemaking.

How Actuarial Certification Ties It All Together

Every mechanism under 438.6 loops back to actuarial soundness at 42 CFR 438.4. Whether a state is using incentives, withholds, directed payments, or the remaining pass-throughs, the final capitation rate for each plan must account for all of them.¹ Each directed payment must be reflected in the base data, as a trend adjustment, or as a separate rate adjustment, and the actuary must certify the result.

Capitation rates must also be specific to each rate cell, so the rate for one population group cannot subsidize another.² And rate assumptions cannot vary across populations based on the federal matching rate in a way that increases federal costs. The actuarial certification is the checkpoint where CMS verifies that the entire structure, including everything permitted under 438.6, produces rates that are adequate, appropriate, and not designed to game the federal funding formula.

1
eCFR. 42 CFR 438.6 – Special Contract Provisions Related to Payment
2
eCFR. 42 CFR 438.4 – Actuarially Sound Capitation Rates
3
Medicaid. State Directed Payment 42 CFR 438.6(c) Proposal Preprint
4
Federal Register. Medicaid and CHIP Managed Care Access, Finance, and Quality Final Rule
5
MACPAC. Directed Payments in Medicaid Managed Care
6
Medicaid. State Directed Payments