Further Education Funding Council inspectors found the provision was mainly socially orientated and therefore was not eligible for funding by the FEFC, which purely finances educational programmes.
They also discovered that a small number of students were in the secure wing of High Royds hospital as part of a prison term or were sectioned under the Mental Health Act. Legally, FEFC funding cannot be claimed for anyone detained under a court order.
The college has been told it must make fundamental changes to its programmes in order to qualify for FEFC cash in future. It will have to ensure its courses, which included life skills such as cookery, have measurable educational content and meet the individual learning needs of students.
Principal Chris Pratt admitted the special needs provision, which transferred to Airedale from Leeds City Council in 1993 when colleges left local authority control, had not met educational criteria, though he denied managers had been aware of the lapse.
He said: "We were not totally aware of the relationship between the quality of the provision and funding, but now it has been pointed out to us we are doing something about it." The college acted immediately to seek advice from consultants, appointed a new special needs manager and was already starting to make improvement, he said.
The Airedale and Wharfedale case highlights a dilemma facing providers of special needs courses. Some believe explicitly educational programmes, leading to recognised qualifications, are not always the most appropriate for students. However, local authorities - who fund non-vocational adult education - frequently have too little cash to meet demand.
Leeds City Council had no scope to increase its budget, said Mr Pratt. The college would either have to change its courses to meet FEFC funding criteria or not run them. The college will shut down its hospital provision until the New Year.