BACKGROUND: In several states, payers penalize hospitals when an inpatient readmission follows an inpatient stay. Observation stays are typically excluded from readmission calculations. Previous studies suggest inconsistent use of observation designations across hospitals. We sought to describe variation in observation stays and examine the impact of inclusion of observation stays on readmission metrics. METHODS: We conducted a retrospective cohort study of hospitalizations at 50 hospitals contributing to the Pediatric Health Information System database from January 1, 2018, to December 31, 2018. We examined prevalence of observation use across hospitals and described changes to inpatient readmission rates with higher observation use. We described 30-day inpatient-only readmission rates and ranked hospitals against peer institutions. Finally, we included observation encounters into the calculation of readmission rates and evaluated hospitals’ change in readmission ranking. RESULTS: Most hospitals (n = 44; 88%) used observation status, with high variation in use across hospitals (0%–53%). Readmission rate after index inpatient stay (6.8%) was higher than readmission after an index observation stay (4.4%), and higher observation use by hospital was associated with higher inpatient-only readmission rates. When compared with peers, hospital readmission rank changed with observation inclusion (60% moving at least 1 quintile). CONCLUSIONS: The use of observation status is variable among children’s hospitals. Hospitals that more liberally apply observation status perform worse on the current inpatient-to-inpatient readmission metric, and inclusion of observation stays in the calculation of readmission rates significantly affected hospital performance compared with peer institutions. Consideration should be given to include all admission types for readmission rate calculation.