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My husband is telling me Medicare will not pay for her to go to a local rehab/assist. living facility because even though she will have been there for 4 nights she was not admitted as an inpt., only observation. This is so wrong. Do we have any recourse to get this changed so she can have a place to go to and receive the help she needs?

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You can appeal the decision, but there are financial incentives for hospitals to do it this way, and the appeal will take forever. Write your congressman!!
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Your husband is correct. One of the Medicare cuts is to nolonger admit if the patient only needs observation. If your MIL has medicaid you might be able to send her to a SNF for respite.
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