Hundreds of thousands of Americans with serious mental illness sleep in jails, shelters and prisons on any given night. Fewer than 40,000 are in state psychiatric hospitals. This is largely due to a federal policy, the Institutions for Mental Disease Exclusion, which created a financial incentive for states to kick the mentally ill out of hospitals. The White House’s new budget proposes easing the exclusion. It’s the most important thing federal government could do to improve care for the seriously mentally ill.

The IMD Exclusion,...