Agree with the others. What she's doing is criminal, it's fraud, and I've known someone who's had the hammer come down. Ironically when they hadn't actually done any wrong... waited until the first check came to report a check came... but evidently they were supposed to inform the office when you worked, NOT when you were paid, so they ended up paying back all assistance they'd gotten in any way over the months he couldn't find a job plus huge fines... wasn't pretty. And yet I see others doing like your friend, DH works but they claim he doesn't live there so they get free housing, free bill pay, free food, free medical, free everything... and all the while they're driving new vehicles every three years and wearing designer clothes... REALLY chaps me to see that so I steer clear just to avoid me going off on them. But also there's the chance that if the hammer comes down on them that you'll be dragged into it too... either investigated as being like them OR being asked to 'pitch in' once the cheese is cut off. Neither is worth it IMO.
I'd tell her straight out. I'm a straight arrow with no desire to be fined or jailed so I avoid folks who commit crimes and might drag me down with them. My DH and kids deserve better than that.
Of course the down side of being that honest is that if they ever do get caught, random checks are done, then you'll be the first one they blame for their (totally unjust of course) downfall. If you're the paranoid sort you might want to pick a non-legally type of reason... do you have kids? If not then maybe that could be a thing? Not comfy around them... or if you want kids but don't have any than maybe being around hers.. even listening to her brag on them is hard for you... ahhh... I donno. Something so that if the fit hits the shan they don't come after you as a snitch... that's precisely why I've never mentioned why I avoid those certain folks... don't want to be dragged into their nightmare... and as to why I don't rat them out... the kids, pure and simple. Without those funds who knows what kind of hellish existence those kids would have. I can't provide for them, and not my job to, but doesn't stop me from worrying that if I did the 'right thing' that they would suffer for it. *shrug*