The Mode C Altitude being displayed on ATC's radar can be used for separation purposes if it is within 300 feet of the pilot's reported altitude as the OPs question points out.
Important, however, is the understanding that the actual maximum altimeter error allowed during FAR Part 43 testing and checking (with respect to the Mode C readout versus the actual altitude the altimeter is displaying) is 125 feet.
(REF: See the excerpt from FAR Part 43, Appendix E, (C) below)
(c) Automatic Pressure Altitude Reporting Equipment and ATC Transponder System Integration Test. The test must be conducted by an appropriately rated person under the conditions specified in paragraph (a). Measure the automatic pressure altitude at the output of the installed ATC transponder when interrogated on Mode C at a sufficient number of test points to ensure that the altitude reporting equipment, altimeters, and ATC transponders perform their intended functions as installed in the aircraft. The difference between the automatic reporting output and the altitude displayed at the altimeter shall not exceed 125 feet.
Also, as noted in the Aeronautical Information Manual (among other guidance), when the pilot sets his altimeter to the airfield elevation (at the correct location on an airport), if the altitude (displayed on the altimeter) is +/- 75 feet or greater than the actual airfield elevation, the error should be referred to a repair station.
(REF: AIM, para. 7-2-3)
If the difference from the known field elevation and the altitude read from the altimeter is plus or minus 75 feet or greater, the accuracy of the altimeter is questionable and the problem should be referred to an appropriately rated repair station for evaluation and possible correction.
So, the FAR Part 43 periodic inspection/test is successful only if the Mode C reported altitude (during the bench test) is +/- 125 feet. And, most importantly, if the crew is following the published guidance, the maximum actual error between what the altimeter is displaying (to the crew) and the actual altitude of the aircraft will be +/- 75 feet.
As a result, not considering any other potential errors (e.g., cold temperature, instrument failure, etc.), two aircraft that are supposed to be separated by 1000 feet would likely never be actually separated by less than 850 feet, assuming the aircraft are at their assigned altitude and using the same altimeter setting, (if both aircraft altimeter's were off by 75 feet). The fact that on ATC radar the Mode C readout being displayed might show that as little as 400 feet of vertical separation (technically possible, but extraordinarily implausible) is really irrelevant in light of the fact that the altimeter the pilot is relying on is displaying an altitude that has a max instrument error of only +/- 75 feet.