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This paper examines the impact of the Hospital Readmissions Reduction Program (HRRP) on hospitals’ admission decisions. HRRP provides incentives for hospitals to reduce readmissions by imposing penalties to hospitals that exhibited higher than average 30-day risk-adjusted readmission rates. Indeed, after HRRP was introduced in 2012, readmission rates have fallen by 1.2% on average across monitored conditions. In this paper, we show that part of this reduction may be due to hospitals admitting more patients for observation as opposed to inpatient admission. Under this classification, patients receive hospital-level care but do not count towards admissions for HRRP purposes. To show that this is the case, we combine four hospital-level datasets. We exploit variation in hospitals’ financial exposure to HRRP due to: i) readmission performance relative to national average; and ii) financial constraints. We find that hospitals exposed to HRRP penalties increased observation bed usage by 16.9% more compared to non-penalized hospitals, and by as much as 40.6% if they were also financially constrained. A back-of-the-envelope calculation suggests that if just 10% of the change in observation admissions was done to avoid readmissions, the observed reduction in readmissions following HRRP would be 21% smaller than reported. Furthermore, if hospitals are indeed using observation admissions to avoid readmissions then one would expect that post-HRRP readmissions of patients originally discharged from the same hospital would have decreased at a higher rate compared to readmissions to hospitals other than the discharging hospital. Using a detailed patient-level dataset, we confirm that this is indeed the case.