Answer: You should assign observation codes with a place of service of 22 (Outpatient Hospital), not 23 (Emergency Room - Hospital).
Reason: The patient's status - not his physical location - determines the POS. Even though the patient is physically in an ER, when the FP registers him to observation status he is considered a hospital outpatient. The physician can perform observation anywhere: in a room, a clinic or a hallway.
Watch out: Double-check your observation code. You should use 99235 (Observation or inpatient hospital care, for the evaluation and management of a patient including admission and discharge on the same date ...) if the FP admits and discharges the patient on the same date. But if the 12-hour observation occurs on different dates, you should instead report the admission with 99218-99220 (Initial observation care, per day, for the evaluation and management of a patient ...) and the discharge with 99217 (Observation care discharge day management ...).
Medicare alert: Carriers may want you to use 99218-99220 for same-day observation admits and discharges. "If the patient is discharged on the same date as admission to observation, pay only the initial observation care code because that code represents a full day of care," states the Medicare Claims Processing Manual, Chapter 12, section 30.6.8.B. Therefore if an FP provides 12 hours of observation care on the same date, Medicare would seem to expect to see only a code in the 99218-99220 range, not 99234-99236.
The Medicare Fee Schedule, however, does designate 99234-99236 as active codes.