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Placing Medicare Beneficiaries Into "Observation Status" Recent Second Circuit Decision Casts Doubt on Lawfulness of CMS Procedures
Friday, March 27, 2015

The trend toward placing more Medicare beneficiaries into observation status in the hospital has come under increasing attack by patient advocates. Such patients are considered outpatients reimbursed by Medicare Part B rather than inpatients covered by Medicare Part A, even though they may receive care in the hospital for many days and nights. Classification as observation status can have significant negative financial consequences for the beneficiary, as is discussed more fully below, particularly because Part A unlike Part B provides no post-acute benefit for skilled nursing facility care.

The Secretary of the Department of Health and Human Services (the secretary, and the department, respectively), through the Centers for Medicare & Medicaid Services (CMS) in the Medicare Benefit Policy Manual, has defined an inpatient as “a person who has been admitted to a hospital for bed occupancy for purposes of receiving inpatient hospital services.” In 2013, CMS created the two-midnight rule, which provides that treatment is generally appropriate for inpatient admission and payment under Medicare Part A “when the physician expects the patient to require a stay that crosses at least two midnights.” Consequently, if a patient fails to stay in the hospital for two nights, hospitals must list the patient as having observation status and must bill Medicare for outpatient services. Many have cited the two-midnight rule, as well as hospitals’ attempts to avoid preventable readmissions and their associated penalties, as largely contributing to the current trend toward increased observation stays.

Patients who are placed into observation status may spend several days and nights in a hospital without ever being formally admitted. These patients are treated as outpatients by CMS, and their care is covered by Medicare Part B. A Medicare beneficiary receiving hospital outpatient treatment under Part B owes a co-payment for each service received, as opposed to a one-time deductible for the first 60 days in the hospital under Part A, and more importantly has no right to Medicare reimbursement for post-hospitalization care at a skilled nursing facility.

Although the Medicare statute and regulations do not define observation services, the Medicare Benefit Policy Manual contains the following definition:

Observation care is a well-defined set of specific, clinically appropriate services, which include ongoing short term treatment, assessment, and reassessment before a decision can be made regarding whether patients will require further treatment as hospital inpatients or if they are able to be discharged from the hospital. Observation services are commonly ordered for patients who present to the emergency department and who then require a significant period of treatment or monitoring in order to make a decision concerning their admission or discharge.

The Medicare Manual further provides that the decision to discharge a patient from the hospital can usually be made in less than 24 hours, and in a majority of cases in less than 48 hours. Only in rare and exceptional cases should outpatient observation services require more than 48 hours.

Since 2004, CMS has permitted the use of Condition Code 44 – Inpatient Admission Changed to Outpatient when the physician orders inpatient services, but upon internal utilization review performed before the claim was first submitted to Medicare, the hospital determines that the services did not meet its inpatient criteria. Utilization review requirements are established by the applicable Medicare conditions of participation found at 42 C.F.R. §§ 482.30 and 485.641. To address in part the increasing use of hospital observation services and to soften the blow imposed by this new code, 42 C.F.R. § 414.5 was adopted to permit a new rebilling option, effective October 1, 2013. This regulation permitted a hospital, after the patient’s discharge, to retroactively change its decision about a patient’s inpatient status that was not reasonable and necessary, and to bill Medicare for certain provided services under Part B rather than Part A, as long as the hospital outpatient services were medically necessary.

Moreover, CMS’s preamble to the 2014 Hospital Inpatient Prospective Payment Systems Final Rule appears to indicate that such a beneficiary who is made an outpatient retroactively may still be eligible for the post-acute nursing stay under Part A if the hospital stay as an outpatient was medically necessary. CMS stated that “[m]edical necessity will generally be presumed to exist, [and] [t]he intermediary will rule the stay unnecessary only when hospitalization for three days represents a substantial departure from normal medical practice.” In other words, if a hospital changes a beneficiary’s status to outpatient after the patient’s discharge from the hospital and submits a Part B claim for the patient, and the outpatient services are determined to be medically necessary, then the patient would still be considered a hospital inpatient for the purpose of qualifying for the post-acute skilled nursing facility benefit.

Litigation Asserts Possible New Rights of Patients in Observation Status

In the case of Barrows v. Burwell (formerly Bagnell v. Sebelius), plaintiffs filed an action in the U.S. District Court for the District of Connecticut on November 3, 2011, against the secretary on behalf of a proposed class of Medicare beneficiaries who were placed into observation status by hospitals rather than being admitted as inpatients. Unlike inpatients covered by Medicare Part A, patients placed in observation status often receive hospital care similar to that of inpatients but are covered by Medicare Part B, which generates co-payment charges for each service received and does not cover post-hospital treatment at a skilled nursing facility. Plaintiffs alleged that patients’ placement into observation status caused each to pay thousands, and sometimes tens of thousands, of dollars more for medical care than they would have if they had been admitted as inpatients. Beneficiaries covered by Medicare Part B would receive a Medicare Summary Notice (MSN) often weeks or months after being discharged by the hospital. While in the hospital, they might not have even known that they were not admitted as inpatients, were covered under Part B rather than Part A, and would face the resulting financial consequences.

As a result, the plaintiffs in this litigation sought a permanent injunction on multiple grounds that would (a) prohibit the secretary from allowing Medicare beneficiaries to be placed on observation status and deprive them of Part A coverage; (b) require the secretary to ensure that the beneficiary receives expedited written notification of the fact that he or she has been placed into observation status, the consequences of such placement for Medicare coverage, and the beneficiary’s right to obtain expedited review of that action; and (c) establish a procedure for administrative review of a decision to place a beneficiary on observation status.

After the district court dismissed the entire case on the secretary’s motion, the plaintiffs appealed the dismissal of two of their nine claims, claiming that the secretary’s failure to provide an expedited system of notice and administrative review violated the Medicare Act and federal due process clause. In its decision on January 22, 2015, the United States Court of Appeals for the Second Circuit affirmed the dismissal of the plaintiffs’ Medicare Act claims but vacated the district court’s dismissal of their due process claims.

The court of appeals held that the district court had erred in accepting the secretary’s argument that the plaintiffs lacked a property interest in being treated as inpatients. The secretary had maintained that a hospital’s decision to admit a patient is a complex medical judgment left to the treating physician’s discretion. The appeals court noted that the plaintiffs had properly pleaded that there were in fact significant constraints upon physician discretion in this situation. The plaintiffs had alleged that instead of a discretionary judgment left to the treating physician, a hospital’s decision to admit a patient is in practice guided by fixed and objective criteria set forth in commercial screening guides issued by CMS. The appeals court also noted the plaintiffs’ argument that CMS exerts further pressure on hospitals through its billing policies and its retroactive Recovery Audit Contractor reviews to incentivize, as a cost-saving or compliance measure, placing Medicare beneficiaries into observation status for longer periods, and the plaintiffs’ allegations must be taken as true on a motion to dismiss. The court concluded that the plaintiffs at this early stage of the litigation had sufficiently asserted that the admission decision was not left to the discretion or judgment of treating physicians, and the plaintiffs might ultimately be able to prove a sufficient property interest to state a due process claim.

In unusually specific instructions to the district court, the appeals court remanded the case to the lower court for limited discovery on the sole issue of whether the plaintiffs had a property interest in being admitted to hospitals as inpatients, based on a factual determination as to whether the decision to admit these patients was a complex medical judgment left to the discretion of the treating physicians, or whether in practice the decision was made by applying fixed criteria set by the federal government. If the evidence in discovery establishes that the plaintiffs have such a property interest, then the district court is directed to analyze whether the complaint would be properly dismissed on the state action and due process prongs of due process analysis. Any further appeal of a final judgment in this case by the district court must be assigned to the same court of appeals panel of judges.


Although the 2013 regulations may limit the problems for Medicare beneficiaries whose inpatient status is changed to outpatient while in the hospital, the “observation status” phenomenon will remain a problem for many other such patients requiring post-acute skilled nursing care. The Barrows v. Burwell litigation could potentially have enormous consequences for Medicare beneficiaries, hospitals, and skilled nursing facilities.

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