State governments throughout the country increasingly have turned to managed care for their Medicaid programs, including mental health services. We used ethnographic methods and a review of legal documents and state monitoring data to examine the impact of Medicaid reform on mental health services in New Mexico, a rural state. New Mexico implemented Medicaid managed care for both physical and mental health services in 1997. The reform led to administrative burdens, payment problems, and stress and high turnover among providers. Restrictions on inpatient and residential treatment exacerbated access problems for Medicaid recipients. These facts indicate that in rural, medically underserved states, the advantages of managed care for cost control, access, and quality assurance may be diminished. Responding to the crisis in mental health services, the federal government terminated New Mexico's program but later reversed its decision after political changes at the national level. This contradictory response suggests that the federal government's oversight role warrants careful scrutiny by advocacy groups at the local and state levels.