On July 27, 2026, the U.S. District Court for the Northern District of Texas in Covenant Medical Center v. Kennedy (“Covenant”) once again vacated a 2023 Centers for Medicare & Medicaid Services (“CMS”) regulation that excluded inpatient days covered by an uncompensated care funding pool when counting Medicaid Days in the Disproportionate Share Hospital (“DSH”) payment calculation. The regulation at issue, found at 42 C.F.R. § 412.106(b)(4)(iii) and known as the “Exclusion Rule,” was previously vacated by the same court in Baylor All Saints Medical Center v. Becerra (“Baylor”), but reinstated after the Fifth Circuit reversed on jurisdictional grounds. Although Covenant presented the same legal challenge, it cleared the hurdle raised in Baylor, which requires that a claim be presented through the proper agency channels before it can be appealed to a federal district court.
Medicare DSH, Medicaid Fraction and § 1115 Waiver Days
The DSH statute provides an add-on payment for hospitals serving “a significantly disproportionate number of low-income patients.” 42 U.S.C. § 1395ww(d)(5)(F)(vi). The disproportionate patient percentage used to calculate the payment is the sum of two fractions: the Medicare Fraction, which identifies low-income Medicare beneficiaries on the basis of their participation in the Supplemental Security Income program, and the Medicaid Fraction, which identifies non-Medicare beneficiaries whose inpatient stays are covered by a state Medicaid program.
Specifically, the Medicaid Fraction’s numerator captures inpatient days for “patients who […] were eligible for medical assistance under a State plan approved under Medicaid,” including “patient days of patients not so eligible but who are regarded as such because they receive benefits under a demonstration project approved under title XI,” i.e., a project that received a waiver under § 1115—hence the term: § 1115 Waiver Days.
In the FFY 2024 IPPS Final Rule, 88 Fed. Reg. 58640 (Aug. 28, 2023), CMS promulgated the Exclusion Rule to exclude from the Medicaid Fraction certain § 1115 Waiver Days that were reimbursed through uncompensated-care funding pools. Practically, the Exclusion Rule affects hospitals in certain non-Medicaid expansion states with funding-pool waivers, such as Texas, Tennessee, Florida and others.
How Covenant Cured Baylor’s Jurisdictional Defect
In Baylor, Judge Pittman vacated the Exclusion Rule on the merits, holding that it impermissibly conflicted with both the Medicaid Fraction statute and binding Fifth Circuit precedent in Forrest General Hospital v. Azar (“Forrest General”). However, the Fifth Circuit reversed on jurisdictional grounds, holding that the plaintiff-hospitals failed to satisfy the nonwaivable presentment requirement of 42 U.S.C. § 405(g). Because the hospitals filed suit before the agency incorporated the Exclusion Rule into their submitted cost reports and issued a Notice of Program Reimbursement, there was no final determination reviewable through the Medicare channeling scheme outlined in § 1395oo.
Covenant was filed January 21, 2026, after the Fifth Circuit mandate issued, appealing from the final determination involving Covenant’s settled cost report. The administrative record thus established the agency-level presentment the Fifth Circuit found absent in Baylor.
Exclusion Rule Conflicts with the Statute and Forrest General
Closely following its earlier analysis in Baylor, the court held that the Exclusion Rule contradicts the plain text of § 1395ww(d)(5)(F)(vi)(II) as construed in Forrest General. Once the U.S. Department of Health and Human Services Secretary approves a § 1115 demonstration project, the resulting patient days must be counted in the Medicaid Fraction’s numerator. Meaning, the Secretary cannot, by subsequent rulemaking, retroactively withdraw the approval’s payment consequences. As the court noted in Baylor and repeated in Covenant, “[t]he Secretary may exercise discretion, and the Secretary did exercise discretion when he authorized it [the state plan]”—“No take-backs.”
Practical Takeaways
- Vacatur applies nationwide; therefore, as with the earlier Baylor vacatur, days associated with approved § 1115 programs are eligible for inclusion in the Medicaid Fraction of the DSH computation.
- Hospitals should re-evaluate cost report protest positions and opportunities to appeal recent settlements, as well as opportunities to amend open cost reports submitted in compliance with the vacated rule.
- Hospitals in states with uncompensated care pools should ensure that their 340B personnel are aware that Covenant may help them establish or maintain eligibility for the 340B Drug Discount Program.
If you have any questions on this recent development or would like assistance on a related matter, please contact:
- Heather Mogden at hmogden@hallrender.com or (414) 721-0457;
- Liz Elias at eelias@hallrender.com or (317) 977-1468;
- Sue Andersen at sandersen@hallrender.com or (301) 785-3996;
- Sarah Crosby at scrosby@hallrender.com or (317) 429-3663;
- Joseph Krause at jkrause@hallrender.com or (414) 721-0906;
- James Junger at jjunger@hallrender.com or (414) 721-0922;
- Todd Nova at tnova@hallrender.com or (414) 721-0464; or
- Your primary Hall Render contact.
Special thanks to Summer Associate Nick Baker for his contributions to this article.
Hall Render blog posts and articles are intended for informational purposes only. For ethical reasons, Hall Render attorneys cannot—outside of an attorney-client relationship—answer specific questions that would be legal advice.
