The government says the practice is legal and helps keep Medicare spending under control by differentiating between patients who may not need the same level of care.
"The impact of using observation status is to deprive Medicare beneficiaries of the Medicare … coverage to which they are entitled," the lawsuit alleges.
Democratic lawmakers have introduced legislation in bop chambers that would help patients under observation qualify for nursing home care.
The new legal challenge comes as a federal judge in Vermont last week rejected the government's request to toss a separate class action challenging the use of the "Improvement Standard." Medicare uses that standard to deny or terminate coverage to beneficiaries whose conditions are judged not to be improving.