diff --git a/lua/neotest/lib/file/init.lua b/lua/neotest/lib/file/init.lua
index 274d7d00..507b0aa3 100644
--- a/lua/neotest/lib/file/init.lua
+++ b/lua/neotest/lib/file/init.lua
@@ -129,11 +129,33 @@ function M.parse_dir_from_files(root, files)
     paths[elem.path] = elem
   end
   local sorted_paths = { { path = "", type = "dir" } }
+
+  ---We use a custom string compare because it allows us to keep children under their directories
+  ---For example with default string compare "x", "x/y", "x.z" would be sorted to "x", "x.z", "x/y" which then breaks
+  ---paths_to_positions function because it assumes children are directly after their parents.
+  ---@param x string
+  ---@param y string
+  local function path_compare(x, y)
+    local target = string.byte("/")
+    for i = 1, math.min(#x, #y) do
+      local xe, ye = x:byte(i), y:byte(i)
+      if xe ~= ye then
+        if xe == target then
+          return true
+        elseif ye == target then
+          return false
+        end
+        return xe < ye
+      end
+    end
+    return #x < #y
+  end
+
   for _, elem in pairs(paths) do
     table.insert(sorted_paths, elem)
   end
   table.sort(sorted_paths, function(a, b)
-    return a.path < b.path
+    return path_compare(a.path, b.path)
   end)
   return Tree.from_list(parse_tree(paths_to_positions(sorted_paths)), function(pos)
     return pos.id
diff --git a/tests/unit/lib/files/init_spec.lua b/tests/unit/lib/files/init_spec.lua
new file mode 100644
index 00000000..b5e3b803
--- /dev/null
+++ b/tests/unit/lib/files/init_spec.lua
@@ -0,0 +1,120 @@
+local files = require("neotest.lib").files
+A = function(...)
+  print(vim.inspect(...))
+end
+
+describe("files library", function()
+  describe("parsing directory tree from files", function()
+    it("places files under the root", function()
+      local root = "/root"
+      local result = files.parse_dir_from_files(root, { "/root/test_a", "/root/test_b" })
+      assert.same(result:to_list(), {
+        {
+          id = "/root",
+          name = "root",
+          path = "/root",
+          type = "dir",
+        },
+        {
+          {
+            id = "/root/test_a",
+            name = "test_a",
+            path = "/root/test_a",
+            type = "file",
+          },
+        },
+        {
+          {
+            id = "/root/test_b",
+            name = "test_b",
+            path = "/root/test_b",
+            type = "file",
+          },
+        },
+      })
+    end)
+
+    it("places files under the parent directory", function()
+      local root = "/root"
+      local result = files.parse_dir_from_files(root, { "/root/dir/test_a", "/root/test_b" })
+      assert.same(result:to_list(), {
+        {
+          id = "/root",
+          name = "root",
+          path = "/root",
+          type = "dir",
+        },
+        {
+          {
+            id = "/root/dir",
+            name = "dir",
+            path = "/root/dir",
+            type = "dir",
+          },
+          {
+            {
+              id = "/root/dir/test_a",
+              name = "test_a",
+              path = "/root/dir/test_a",
+              type = "file",
+            },
+          },
+        },
+        {
+          {
+            id = "/root/test_b",
+            name = "test_b",
+            path = "/root/test_b",
+            type = "file",
+          },
+        },
+      })
+    end)
+
+    it("parses directory and file with same name", function()
+      local root = "/root"
+      local result =
+        files.parse_dir_from_files(root, { "/root/dir.py", "/root/dir/test_a", "/root/test_b" })
+      assert.same(result:to_list(), {
+        {
+          id = "/root",
+          name = "root",
+          path = "/root",
+          type = "dir",
+        },
+        {
+          {
+            id = "/root/dir",
+            name = "dir",
+            path = "/root/dir",
+            type = "dir",
+          },
+          {
+            {
+              id = "/root/dir/test_a",
+              name = "test_a",
+              path = "/root/dir/test_a",
+              type = "file",
+            },
+          },
+        },
+        {
+          {
+            id = "/root/dir.py",
+            name = "dir.py",
+            path = "/root/dir.py",
+            type = "file",
+          },
+        },
+        {
+          {
+            id = "/root/test_b",
+            name = "test_b",
+            path = "/root/test_b",
+            type = "file",
+          },
+        },
+      })
+    end)
+  end)
+end)