12 1/2" finished block means just that. It will be 12" finished once the blocks are sewn together for a top. Cut this just the way the pattern says, use a scant 1/4" seam and when the block is done it should measure 12 1/2 inches.
The directions (where it says 12"finished) is refering to after it's in a quilt. Don't feel bad, I got really confused on this at first too.