diff --git a/codeflash/verification/verifier.py b/codeflash/verification/verifier.py
index c5e6a4726..c43bf500d 100644
--- a/codeflash/verification/verifier.py
+++ b/codeflash/verification/verifier.py
@@ -34,7 +34,9 @@ def generate_tests(
     # TODO: Sometimes this recreates the original Class definition. This overrides and messes up the original
     #  class import. Remove the recreation of the class definition
     start_time = time.perf_counter()
-    test_module_path = Path(module_name_from_file_path(test_path, test_cfg.tests_project_rootdir))
+    # Use traverse_up=True to handle co-located __tests__ directories that may be outside
+    # the configured tests_root (e.g., src/gateway/__tests__/ when tests_root is test/)
+    test_module_path = Path(module_name_from_file_path(test_path, test_cfg.tests_project_rootdir, traverse_up=True))
 
     # Detect module system via language support (non-None for JS/TS, None for Python)
     lang_support = current_language_support()
diff --git a/tests/test_module_name_from_file_path.py b/tests/test_module_name_from_file_path.py
new file mode 100644
index 000000000..1c1759a8c
--- /dev/null
+++ b/tests/test_module_name_from_file_path.py
@@ -0,0 +1,85 @@
+"""Tests for module_name_from_file_path with co-located test directories."""
+
+import pytest
+from pathlib import Path
+from codeflash.code_utils.code_utils import module_name_from_file_path
+
+
+class TestModuleNameFromFilePath:
+    """Test module name resolution for various directory structures."""
+
+    def test_file_inside_project_root(self, tmp_path: Path) -> None:
+        """Test normal case where file is inside project root."""
+        project_root = tmp_path / "project"
+        project_root.mkdir()
+
+        test_file = project_root / "test" / "test_foo.py"
+        test_file.parent.mkdir()
+        test_file.touch()
+
+        result = module_name_from_file_path(test_file, project_root)
+        assert result == "test.test_foo"
+
+    def test_file_outside_project_root_without_traverse_up(self, tmp_path: Path) -> None:
+        """Test that file outside project root raises ValueError by default."""
+        project_root = tmp_path / "project" / "test"
+        project_root.mkdir(parents=True)
+
+        # File is in a sibling directory, not under project_root
+        test_file = tmp_path / "project" / "src" / "__tests__" / "test_foo.py"
+        test_file.parent.mkdir(parents=True)
+        test_file.touch()
+
+        with pytest.raises(ValueError, match="is not within the project root"):
+            module_name_from_file_path(test_file, project_root)
+
+    def test_file_outside_project_root_with_traverse_up(self, tmp_path: Path) -> None:
+        """Test that traverse_up=True handles files outside project root."""
+        project_root = tmp_path / "project" / "test"
+        project_root.mkdir(parents=True)
+
+        # File is in a sibling directory, not under project_root
+        test_file = tmp_path / "project" / "src" / "__tests__" / "codeflash-generated" / "test_foo.py"
+        test_file.parent.mkdir(parents=True)
+        test_file.touch()
+
+        # With traverse_up=True, it should find a common ancestor
+        result = module_name_from_file_path(test_file, project_root, traverse_up=True)
+
+        # Should return a relative path from some ancestor directory
+        assert "test_foo" in result
+        assert not result.startswith(".")
+
+    def test_colocated_test_directory_structure(self, tmp_path: Path) -> None:
+        """Test real-world scenario with co-located __tests__ directory.
+
+        This reproduces the bug from trace 7b97ddba-6ecd-42fd-b572-d40658746836:
+        - Source: /workspace/target/src/gateway/server/ws-connection/connect-policy.ts
+        - Tests root: /workspace/target/test
+        - Generated test: /workspace/target/src/gateway/server/__tests__/codeflash-generated/test_xxx.test.ts
+
+        Without traverse_up=True, this should fail.
+        """
+        project_root = tmp_path / "target"
+        project_root.mkdir()
+
+        tests_root = project_root / "test"
+        tests_root.mkdir()
+
+        # Source file location
+        source_file = project_root / "src" / "gateway" / "server" / "ws-connection" / "connect-policy.ts"
+        source_file.parent.mkdir(parents=True)
+        source_file.touch()
+
+        # Generated test in co-located __tests__ directory
+        test_file = project_root / "src" / "gateway" / "server" / "__tests__" / "codeflash-generated" / "test_resolveControlUiAuthPolicy.test.ts"
+        test_file.parent.mkdir(parents=True)
+        test_file.touch()
+
+        # This should fail WITHOUT traverse_up
+        with pytest.raises(ValueError, match="is not within the project root"):
+            module_name_from_file_path(test_file, tests_root)
+
+        # This should succeed WITH traverse_up
+        result = module_name_from_file_path(test_file, tests_root, traverse_up=True)
+        assert "test_resolveControlUiAuthPolicy" in result