The Mansfield-based Center for Medicare Advocacy filed a class action lawsuit Thursday challenging the practice of placing hospital patients on “observation status,” an alternative to admitting them as inpatients that can leave Medicare patients with hefty bills for hospital and nursing home care.

The lawsuit, filed against U.S. Department of Health and Human Services Secretary Kathleen Sebelius, has seven named plaintiffs, including five from Connecticut, some of whom faced hundreds of dollars in hospital bills and thousands of dollars in nursing home bills because they were placed on observation status despite having spent several days in the hospital.

Medicare patients on observation status are not considered inpatients, making them ineligible for Medicare hospitalization coverage and subject to coinsurance and nursing home costs.

“That status is denying thousands of beneficiaries of their Medicare coverage rights, even though they are inpatients in hospitals,” Judith Stein, executive director of the Center for Medicare Advocacy, said during a conference call with reporters Thursday.

The named plaintiff, retired Connecticut physician Richard Bagnall, spent three days at UConn’s John Dempsey Hospital in 2009 after being found to be in atrial fibrillation. Although he signed a notice indicating that he was a hospital inpatient and was later moved to a hospital floor, according to the lawsuit, Bagnall was on observation status.

Had Bagnall been admitted as an inpatient, Medicare’s hospitalization coverage, known as Part A, would have covered his hospital stay and the care he received at a nursing facility after leaving the hospital.

But because he was on observation status, Bagnall’s care fell under Medicare Part B, a voluntary, supplemental part of the program, which requires patients to pay about 20 percent of the cost of care. Bagnall later received a notice that he was responsible for about $500 for the hospital stay.

And he had to pay even more for nursing home care. Medicare’s hospitalization benefit covers nursing home care for patients recovering from a hospital stay, if they have spent at least three consecutive days as inpatients in a hospital. But because Bagnall was not considered to have been an inpatient, he was left to pay the $5,685 bill.

While observation status can have significant consequences for patients, hospitals have financial incentives to use it, and have increasingly been using it in place of admitting patients, according to the lawsuit.

Hospitals are subject to reviews of their inpatient admissions by government contractors, and if a patient’s admission is considered improper, the hospital must refund the Medicare Part A payment. Observation status allows them to avoid potential penalties.

In addition, the lawsuit noted, the federal health reform law penalizes hospitals for patients who are readmitted within 30 days of discharge, but if the patient was considered on observation status the first time, the hospital won’t face sanctions if the patient returns.

The lawsuit notes that neither the federal Medicare statute nor the associated regulations mentions observation status. Medicare manuals do reference it, and describe it as existing for specific services such as short-term treatment, assessment and reassessment that occur while a decision is being made about whether the patient will need further treatment as an inpatient or can be discharged.

“In practice, however, observation status is applied in an ad hoc fashion to Medicare beneficiaries who for all practical purposes are hospital inpatients,” the lawsuit said.

The lawsuit cited statistics from the Medicare Payment Advisory Commission, which advises Congress on Medicare policy, that from 2006 to 2008, the number of observation status claims increased by 22.4 percent, and the claims for stays of 48 hours or longer increased by 70.3 percent.

The lawsuit noted that patients can be admitted as inpatients, then have their status changed to observation, as happened to Lawrence Barrows, who spent seven days at Dempsey Hospital in 2009. At one point, he was formally admitted to the hospital, according to the lawsuit, but two days before he was discharged, his status was changed to observation, with no notice issued. Barrows later got a notice that he was responsible for $400 in coinsurance for the hospital stay.

Barrows received care after discharge at a nursing home, but it was not covered by Medicare because he was not considered to have spent three days as an inpatient, and his family received a bill for about $30,400. Barrows died later that year and his widow, Lee, who represents him in the lawsuit, negotiated a lower bill and has been paying it off in installments.

“Changes must be made,” Lee Barrows said during the conference call Thursday.

Another patient named in the lawsuit, Mildred Savage, spent five days at William W. Backus Hospital in Norwich before going to a nursing facility. Because she was considered on observation status, she received a notice from Medicare saying she was responsible for about $400 for the cost of the stay. After her initial discharge, Savage returned to the hospital for two days, during which she was considered an inpatient, then went to a nursing home. But because she did not satisfy the three-day rule, Savage did not qualify for Medicare coverage for the second nursing home stay, and had to pay the cost–$17,388–out of pocket.

Savage died last month and is represented in the action by her son.

The lawsuit asks the court to prohibit the health and human services secretary from allowing Medicare beneficiaries to be placed on observation status. It also asks that patients placed on observation status be given written notification about it and the consequences for Medicare coverage, to establish a procedure for administrative review of decisions to put people on observation status, and to review all coverage decisions for named plaintiffs and class members involving Part B coverage related to being on observation status.

Terry Berthelot, an attorney for the Center for Medicare Advocacy, said hospitals are not required to give patients notice when they are on observation status. The federal Centers for Medicare and Medicaid Services asks that hospitals give notice when they change a patient to observation status retroactively, but Berthelot said there is no enforcement mechanism to ensure they do.

Rep. Joe Courtney, D-2^nd District, said during the conference call that families of patients on observation status get a “completely unexpected, stunning bit of information, that hteir loved one is now in a position where they either are going to have to take them home, where it’s not safe, or find $10,000, $15,000 cash to put down a deposit in a long-term care facility.”

Courtney, who introduced legislation to count time spent on observation status toward a patient’s three-day requirement for nursing facility coverage, said the increasing use of observation status is being driven by the audits hospitals are subject to, which drives them to be more conservative in how they designate patients.

Stein said that Courtney’s bill and a similar introduced by Sen. John Kerry, D-Mass., have bipartisan support but that there has been no action to pass them. She said the center decided it could not wait since many people are being harmed by the use of observation status.

She said the lawsuit targets Sebelius, rather than hospitals, because the HHS secretary has the authority to set Medicare criteria and tell hospitals that the observation status they’re using is not appropriate.

Gill Deford, lead counsel in the lawsuit and the center’s director of litigation, said that the federal Centers for Medicare & Medicaid Services creates incentives and disincentives for hospitals to take certain actions.

“Right now there are a lot of incentives for hospitals to put people in observation status and keep them there,” he said.

A spokesman for the Centers for Medicare & Medicaid Services, which is part of HHS, said he could not comment on pending litigation.