The move comes on the heels of ongoing hospital industry criticism and a legal challenge.
The cut is being imposed because CMS estimated it would have to pay almost $220 million more in increased inpatient admissions under the two midnight policy.
Hospitals will also receive a 0.6% temporary increase in revenues from Medicaid in fiscal 2017 -- the same amount hospitals lost over the last three years under the two midnight rule.
Last September, a federal judge sided with the American Hospital Association and other hospitals nationwide. The ruling ordered the Department of Health and Human Services to justify the cut -- a 0.2% reduction for inpatient services reimbursements.