Indiana Family and Social Services Administration spokesman Marcus Barlow said state officials decided to change the policy after discussions with the U.S. Food and Nutrition Service.
Advocates and legal experts said the 10-year-old policy was a clear violation of federal law that says food stamps can't be counted against other benefits.
The policy was the target of a lawsuit filed this month on behalf of a 26-year-old autistic Indianapolis man, and has been the subject of an investigation and two stories by The Associated Press.
Barlow said the lawsuit and media attention "brought it to our attention, definitely."
Since 1964, federal law has barred states from counting food stamps as income or using them to reduce any other public benefits. Legal experts said the law was clear.
But since 2000, Indiana's food stamp policy has affected people with developmental disabilities who need financial help to live independently and who receive additional assistance to buy groceries.
Under that system, when the federal government raised food stamp amounts, Indiana officials reduced state grocery allowances so a person's total food benefits did not exceed $200 a month.
Barlow said Wednesday that food stamp benefits will no longer be counted in that formula, though the $200 monthly cap will remain in place for the state grocery allowance. He said the change would be reflected in benefits paid in August.
Division of Developmentally Disabled and Rehabilitative Services Director Julia Holloway decided to change the policy Monday after agency lawyers determined the state policy was ambiguous, he said.
"They just looked at it further and we talked with our federal partners and there was some ambiguity there, and we decided to cut out the ambiguity and changed the policy," Barlow said.
The decision was roundly welcomed.
"They did the right thing, then," said state Sen. Sue Errington, D-Muncie, who serves on an interim Medicaid oversight committee. "If there's anybody who needed all they were entitled to, it's the developmentally disabled."
Ken Falk, legal director of the American Civil Liberties Union of Indiana, which filed the suit on behalf of the autistic man, Michael Dick, said Dick's lawyers needed to talk with state attorneys before deciding on their next legal step.
"If we're able to resolve it without going any further that would be a good thing," Falk said.
Michael Dick's father said he was glad to see the case moving forward.
"At least we're making progress with this whole thing," said Steven Dick, an attorney.
Barlow did not know whether the state would pay any retroactive benefits to Dick or anyone else who receives food stamps and the state grocery allowance.
"That's still being worked out," he said.
The lawsuit, filed July 9 in Marion County Superior Court, seeks class action status for people enrolled in Indiana's Developmental Disabilities Medicaid Waiver Program and estimates thousands of people could be affected. The website of the state's social services agency says about 6,700 people were enrolled in that program as of May.
But Barlow said only about 440 people in that program also receive the state aid at the heart of the lawsuit.
Gov. Mitch Daniels had said "it's worth having a look" at the state's food stamp practice in light of the lawsuit filed by the autistic man and his father.