First, you can refuse the test if they don't have a court order. Second, yes they are observed tests, generally, and if you try to cheat the test they will be far more convinced that you have a problem, because if you know how to cheat it, then you're more likely to have more experience with drugs. Whether or not you use drugs only enables them to remove your children if there is a threat of imminent harm to your children. If I were you, I would politely decline to take the test.
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This sounds like they were conducting a home study of some kind. As pointed out by another attorney, you can refuse a test, but just like with the sobriety test, you risk denial of benefits or simply an inconclusive determination of fitness. You should consult with an attorney in person with more details.