This article reviews key federal Medicaid policies affecting older adults with serious, long-term mental illness: (a) the Medicaid exclusion of coverage for Institutions for Mental Diseases, (b) the Preadmission Screening and Resident Review Process, and (c) the Medicaid Home and Community Based Services waiver policy. Documenting the incentives and restrictions in these policies provides an historical context for understanding the current gaps in treatment for elders with mental illness. New federal options under the Deficit Reduction Act may provide opportunities for reducing the institutional bias for older adults with mental illness and for improving mental health services for elders under Medicaid.