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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the Quarterly Period Ended June 30,December 31, 2002

or

For the transition period from                            to                            

Commission File No. 1-6639

MAGELLAN HEALTH SERVICES, INC.
(Exact name of registrant as specified in its charter)

(410) 953-1000
(Registrant's telephone number, including area code)

        Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý    No o

        Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes o    No ý

        The number of shares of the registrant's common stock outstanding as of JulyJanuary 31, 20022003 was 35,138,686.35,318,926.

FORM 10-Q

MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES

INDEX

MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)

The accompanying notes to Unaudited Condensed Consolidated Financial Statements
are an integral part of these statements.

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PART I—FINANCIAL INFORMATION

Item 1.—Financial Statements

MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
BALANCE SHEETS

(Unaudited)

(In thousands, except per share amounts)

(1)

Net of income tax provision of $218 and $920 for the three months ended June 30, 2001 and 2002, respectively, and $3,464 and $1,556 for the nine months ended June 30, 2001 and 2002, respectively.

(2)

Net of income tax provision (benefit) of $1,457 and $(422) for the three months ended June 30, 2001 and 2002, respectively, and $10,761 and $129 for the nine months ended June 30, 2001 and 2002, respectively.

					September 30, 2002			December 31, 2002
ASSETS
Current assets:
	Cash and cash equivalents				$	46,013		$	62,488
	Accounts receivable, less allowance for doubtful accounts of $3,056 at September 30, 2002 and $3,749 at December 31, 2002					95,124			81,228
	Restricted cash, investments and deposits					124.740			127,318
	Refundable income taxes					2,095			1,966
	Other current assets					15,758			13,131
			Total current assets			283,730			286,131
Property and equipment						86,773			85,659
Investments in unconsolidated subsidiaries						13,220			12,183
Other long-term assets						44,398			43,840
Goodwill, net						502,334			502,334
Intangible assets, net						73,625			68,770
					$	1,004,080		$	998,917
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
	Accounts payable				$	19,178		$	15,897
	Accrued liabilities					233,813			217,837
	Medical claims payable					201,763			205,331
	Debt in default and current maturities of capital lease obligations					1,039,658			1,038,934
			Total current liabilities			1,494,412			1,477,999
Long-term capital lease obligations						9,696			9,224
Deferred credits and other long-term liabilities						2,311			2,290
Minority interest						641			683
Commitments and contingencies (See Note J)
Redeemable preferred stock						67,692			69,043
Stockholders' equity:
	Preferred stock, without par value Authorized—9,793 shares at September 30, 2002 and December 31, 2002
		Issued and outstanding—none				—			—
	Common stock, par value $0.25 per share Authorized—80,000 shares Issued 37,428 shares and outstanding 35,139 shares at September 30, 2002 and December 31, 2002					9,356			9,356
	Other stockholders' equity
		Additional paid-in capital				354,097			352,718
		Accumulated deficit				(914,866	)		(903,137	)
		Warrants outstanding				25,050			25,050
		Common stock in treasury, 2,289 shares at September 30, 2002 and December 31, 2002				(44,309	)		(44,309	)
			Total stockholders' equity			(570,672	)		(560,322	)
					$	1,004,080		$	998,917

TheSee accompanying notes to Unaudited Condensed Consolidated Financial Statements
are an integral part of these statements.notes.

43

MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(In thousands, except per share amounts)

(In thousands)

TheSee accompanying notes to Unaudited Condensed Consolidated Financial Statements
are an integral part of these statements.notes.

5

MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30,

December 31, 2002

(Unaudited)

NOTE A—Summary of Significant Accounting PoliciesCompany Overview

Basis of Presentation

        The accompanying unaudited condensed consolidated financial statements of Magellan Health Services, Inc. and subsidiariesSubsidiaries ("Magellan" or the "Company") have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring adjustments considered necessary for a fair presentation, have been included.

        All references to fiscal years contained herein refer to periods of twelve consecutive months ending on September 30. Certain reclassifications have been made to fiscal 20012002 amounts to conform to fiscal 20022003 presentation.

        These unaudited condensed consolidated financial statements should be read in conjunction with the Company's audited consolidated financial statements for the fiscal year ended September 30, 20012002 and the notes thereto, which are included in the Company's Annual Report on Form 10-K/A.

Proposed Financial Restructuring

        In light of its current financial condition, the Company has undertaken an effort to restructure its debt, which totaled approximately $1.0 billion as of December 31, 2002, and to improve its liquidity. The Company believes that its operations can no longer support its existing capital structure and that it must restructure its debt to levels that are more in line with its operations. Although the Company believes it has sufficient cash on hand to meets its current operating obligations, the Company does not have sufficient cash on hand or the ability to borrow under its senior secured bank credit agreement dated February 12, 1998, as amended (the "Credit Agreement"), to pay scheduled interest and to make contingent purchase price payments, which amounts are due in February 2003. In addition, as more fully described below, certain defaults exist under the Credit Agreement that have resulted in acceleration of the obligations thereunder and certain other events of default exist that could result in acceleration of the obligations thereunder and, as a result, the Company's other indebtedness could be accelerated.

        The Company has retained Gleacher Partners, LLC ("Gleacher") as its financial advisor to assist it in its efforts to restructure its debt. The Company is currently in discussions with its lenders (the "Lenders") under the Credit Agreement and members of an ad hoc committee (the "Ad Hoc Committee") formed by the holders of its 9.375% Senior Notes due 2007 (the "Senior Notes") and the 9% Senior Subordinated Notes due 2008 (the "Subordinated Notes"). The Lenders and the Ad Hoc Committee have each retained separate financial and legal advisors to assist them in the restructuring process.

        The Company has had discussions with the Lenders, the Ad Hoc Committee and their separate financial and legal advisors and has distributed to them a draft term sheet with respect to a proposed financial restructuring. The proposed financial restructuring set forth in the draft term sheet contemplates an exchange of the Subordinated Notes for substantially all of the equity of the Company, a reinstatement of the Senior Notes with modification of certain interest payments from cash to

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additional Senior Notes, reinstatement of the obligations under the Credit Agreement with modified amortization payments, and a modification of the Company's contingent purchase price obligations to Aetna Inc. ("Aetna") and an extension of the Company's customer contract with Aetna which currently expires December 31, 2003. The draft term sheet contemplates that the proposed financial restructuring will be effected through commencement of a chapter 11 case under the U.S. Bankruptcy Code and the subsequent consummation of a plan of reorganization. In addition, the draft term sheet contemplates that the providers of behavioral health services with whom the Company contracts, as well as the Company's customers and employees, will not be adversely affected by the restructuring, all debts owing to such parties will continue to be paid in the ordinary course of business, and that the Company will continue to operate in the ordinary course of business; however, there can be no assurance in this regard. Although the Company is pursuing the proposed restructuring, none of the parties has agreed or is obligated to implement the proposed restructuring or any other restructuring.

        There can be no assurances that the Lenders, the holders of Senior Notes or Subordinated Notes or Aetna will agree to a restructuring of the Company's debt in a manner that will permit the Company to satisfy its foreseeable financial obligations. If a plan of restructuring satisfactory to the Company and its creditors cannot be effected, the Company may need to seek protection under the U.S. Bankruptcy Code.

        If the proposed restructuring is completed and implemented through a chapter 11 bankruptcy proceeding, the Company will be subject to the provisions of Statement of Position 90-7, "Financial Reporting by Entities in Reorganization under the Bankruptcy Code" ("SOP 90-7"). Under this guidance, the Company may be required to implement "fresh start" reporting, among other provisions, upon its planned emergence from bankruptcy, which would establish a new basis of accounting for the reorganized company. The potential impact of SOP 90-7 on the Company's consolidated financial statements cannot be determined at this time.

Credit Agreement Defaults

        In January 2003, the State of Tennessee's Department of Commerce and Insurance sought and received on an ex parte basis from the Chancery Court of the State of Tennessee (20th Judicial District, Davidson County), an order of seizure of Tennessee Behavioral Health, Inc. ("TBH"), one of the Company's subsidiaries (the "Tennessee Order"). As a result of the entry of the Tennessee Order, a default has occurred and is continuing under the Credit Agreement which has the effect of immediately accelerating the obligations under the Credit Agreement and giving the Lenders the right to exercise their remedies thereunder and under other agreements and documents related thereto (including guaranties and security agreements executed for the benefit of the Lenders). This acceleration also constitutes a default under the bond indentures governing the Company's Senior Notes and Subordinated Notes, which gives the holders of Senior Notes and the holders of Subordinated Notes the ability to accelerate the obligations under the Senior Notes and the Subordinated Notes, respectively, and to exercise their remedies thereunder. In February 2003, the Tennessee Order was dissolved and TBH is operating under an agreed notice of administrative supervision. Although the Tennessee Order has been dissolved, the default resulting from the entry of the order has not been waived, and therefore the obligations under the Credit Agreement remain accelerated. Furthermore, upon the expiration of certain waivers under the Credit Agreement as of January 15, 2003 (the "October Waiver" and the "January Waiver"), certain events of default exist with respect to certain financial covenants that could result in acceleration of the obligations thereunder and, as a result, acceleration of the Company's other indebtedness. In addition, defaults exist under the Credit Agreement as the Company has made investments in non-guarantor entities of the Company when such investments are prohibited during the existence of a default or event of default under the Credit Agreement. Such additional defaults could result in acceleration of the obligations of the Credit Agreement and, as a result, acceleration of the Company's other indebtedness.

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        The defaults and events of default under the Credit Agreement, as discussed above, result in the Company being unable to access additional borrowings or letters of credit under the Revolving Facility. In addition, on February 4, 2003 the Company received a letter from JPMorgan Chase Bank (in its capacity as administrative agent under the Credit Agreement) which invokes Sections 10.03 and 10.09 of the indenture relating to the Subordinated Notes. As a result, the Company will not make the scheduled interest payment on the Subordinated Notes which is due February 17, 2003.

        In the event that the Lenders exercise their rights with respect to the acceleration of obligations that has occurred or exercise their right to accelerate the obligations as a result of the other events of default, or if the bondholders exercise their right to accelerate the obligations under the Senior Notes or Subordinated Notes due to either such acceleration under the Credit Agreement, the Company may need to seek protection under the U.S. Bankruptcy Code.

Going Concern

        The Company's liquidity and defaults under debt agreements as discussed above, raise substantial doubt about the Company's ability to continue as a going concern. Although the Company has had discussions with the Lenders, the Ad Hoc Committee and their separate financial and legal advisors and has distributed to them a draft term sheet with respect to a proposed restructuring, there can be no assurance that the Company will be able to successfully complete a restructuring of its capital structure. The ability of the Company to continue as a going concern is dependent upon a number of factors including, but not limited to, completion of a restructuring on satisfactory terms, retention of customers, behavioral health providers and employees, and the Company's continued ability to provide high quality services. The unaudited condensed consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the outcome of this uncertainty.

NOTE B—Summary of Significant Accounting Policies

Segments

        The Company operates in the behavioral managed behavioral healthcare business, which it has divided into four reporting segments based on the types of services it provides and customers that it serves. The four segments of the Company are as follows: (i) Health Plan Solutions Group ("Health Plans"); (ii) Workplace Group ("Workplace"); (iii) Public Solutions Group ("Public"); and (iv) Corporate and Other. These segments are described in further detail in Note K—L—"Business Segment Information."

        On September 2, 1999, the Company's Board of Directors approved a formal plan to dispose of the businesses and interests that comprised the Company's healthcare provider and healthcare franchising business segments (the "Disposal Plan"). On October 4, 2000, the Company adopted a formal plan to dispose of the business and interest that comprised the Company's specialty managed healthcare business segment. On January 18, 2001, the Company's Board of Directors approved and the Company entered into a definitive agreement for the sale of National Mentor, Inc. ("Mentor"), which represented the business and interest that comprised the Company's human services business segment. On March 9, 2001, the Company consummated the sale of the stock of Mentor. As discussed in Note H—I—"Discontinued Operations", the results of operations of the healthcare provider, healthcare franchising, specialty managed healthcare and human services business segments have been reported in the accompanying unaudited condensed consolidated financial statements of operations as discontinued operations for all periods presented.

Use of Estimates

        The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported

8

amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Significant estimates of the Company include, among other things, accounts receivable realizability, valuation allowances for deferred tax assets, valuation of goodwill and other intangible assets, medical claims payable and legal liabilities. Actual results could differ from those estimates.

6

Managed Care Revenue

        Managed care revenue is recognized over the applicable coverage period on a per member basis for covered members. Managed care risk revenues including revenues from the Company's TRICARE contracts, earned for the three months ended June 30,December 31, 2001 and 2002 approximated $376.5$390.3 million and $383.6$392.0 million, respectively, and approximated $1,159.4 million and $1,153.0 million for the nine months ended June 30, 2001 and 2002, respectively.

        The Company has the ability to earn performance-based revenue, primarily under certain non-risk contracts. Performance-based revenue generally is based on the ability of the Company to manage care for its administrative services only ("ASO")ASO clients below specified targets. For each such contract, the Company estimates and records performance-based revenue after considering the relevant contractual terms and the data available for the performance-based revenue calculation. Pro-rata performance-based revenue is recognized on a quarterly reporting basis during the term of the contract pursuant to the rights and obligations of each party upon termination of the contracts. The Company recognized performance revenue of approximately $5.3$3.4 million and $4.3$1.0 million duringfor the three months ended June 30, 2001 and 2002, respectively, and approximately $19.0 million and $11.7 million during the nine months ended June 30,December 31, 2001 and 2002, respectively.

        The Company provides mental health and substance abuse services to the beneficiaries of TRICARE, formerly the Civilian Health and Medical Program of the Uniformed Services ("CHAMPUS"), under two separate subcontracts with health plans that contract with TRICARE. See discussion of these subcontracts in "Health Plans" above. The Company receives fixed fees for the management of the services, which are subject to certain bid-pricebid price adjustments ("BPAs"). The BPAs are calculated in accordance with contractual provisions and are based on actual healthcare utilization from historical periods as well as changes in certain factors during the contract period. The Company has information to record, on a quarterly basis, reasonable estimates of the BPAs as part of its managed care risk revenues. These estimates are based upon information available, on a quarterly basis, from both the TRICARE program and the Company's information systems. Under the contract, the Company settles the BPAs at set intervals over the term of the contracts.

        The Company recorded estimated liabilities of approximately $3.8$0.4 million and $0.9estimated receivables of $3.6 million as of September 30,December 31, 2001 and June 30,December 31, 2002, respectively, based upon the Company's interim calculations of the estimated BPAs.BPAs and certain other settlements. Such liabilitiesamounts were recorded as deductions fromadjustments to revenues. While management believes that the estimated liabilities for TRICARE adjustments are adequate,reasonable, ultimate settlement resulting from adjustments and available appeal processes may vary from the amounts provided.

  ��     Prior to fiscal 2001, the Company and its contractors under its TRICARE contracts filed joint appeals regarding incorrect data provided and contractual issues related to the initial bidding process. These contingent claims were settled in fiscal 2001, resulting in the Company recording approximately $30.3 million in additional revenues in the nine month period ended June 30, 2001.

Significant Customers

        Net revenues from two of the Company's customers each exceeded 10%10 percent of consolidated net revenues in each of the three and nine month periodsquarters ended June 30,December 31, 2001 and 2002, respectively. Net revenue from the State of Tennessee's TennCare program approximated $63.2 million and $59.6 million of consolidated net revenues for the three months ended June 30, 2001 and 2002, respectively, and $184.6 million and $174.5 million of consolidated net revenues for the nine months ended June 30, 2001 and 2002, respectively.

        Net revenue from Aetna Inc. ("Aetna") approximated $79.8$78.8 million and $55.8$54.8 million of consolidated net revenues for the three monthsquarters ended June 30, 2001 and 2002, respectively, and $238.4 million and $195.9 million of consolidated net revenues for the nine months ended June 30,December 31, 2001 and 2002, respectively. The declinesdecline in Aetna revenues wererevenue of approximately $24.0 million from fiscal 2002 to fiscal 2003 was mainly due to decreased membership as a result of Aetna intentionally reducing its membership levels during thecalendar year

7

2002 in an effort to exit less profitable businesses. Aetna has announced its expectation that its membership may be further reduced during the remainder ofthrough calendar year 2002.2003. The Company is not fully aware of which members Aetna anticipates will terminate in the future, if any, or which products such members currently receive. Therefore, the Company cannot reasonably estimate the amount by which revenue will be further reduced as a result of the membership reduction. The current Aetna contract extends through December 31, 2003.

9

        Both the Company and Premier Behavioral Systems of Tennessee, LLC ("Premier"), a joint venture in which the Company has a fifty percent interest, separately contract with the State of Tennessee to manage the behavioral healthcare benefits for the State's TennCare program. In addition, the Company contracts with Premier to provide certain services to the joint venture. The Company's direct TennCare contract (exclusive of Premier) accounted for approximately $60.0 million and $63.0 million of consolidated net revenue for the quarters ended December 31, 2001 and 2002, respectively, and such contract expires on December 31, 2003. Such revenue amounts include revenue recognized by the Company associated with services performed on behalf of Premier totaling $33.6 million and $34.6 million for the quarters ended December 31, 2001 and 2002, respectively. As discussed above, the State of Tennessee's Department of Commerce and Insurance sought and received the Tennessee Order on an ex parte basis to seize Tennessee Behavioral Health, Inc., the subsidiary of the Company that holds the direct contract with the State of Tennessee. After discussions between the parties, the Tennessee Order has been dissolved and TBH is operating under an agreed notice of supervision. Under this agreement, the State may exercise additional supervision over TBH's affairs.

        In addition, the Company derives a significant portion of its revenue from contracts with various counties in the state of Pennsylvania (the "Pennsylvania Counties"). Although these are separate contracts with individual counties, they all pertain to the Pennsylvania Medicaid program. In fiscal 2002, the Company entered into contracts with two additional Pennsylvania Counties, which increased the revenue related to this program. Revenues from the Pennsylvania Counties in the aggregate totaled $36.0 million and $56.2 million for the quarters ended December 31, 2001 and 2002, respectively.

Property and Equipment

        InProperty and equipment are stated at cost, except for assets that have been impaired, for which the first quarter of fiscal 2002,carrying amount is reduced to estimated fair value. Expenditures for renewals and improvements are capitalized to the Company approvedproperty accounts. Replacements and implemented a plan to consolidatemaintenance and repairs that do not improve or extend the Company's information systems. As a result of this plan, the Company reduced the remaining estimated useful life of certainthe respective assets are expensed as incurred. Internal-use software is capitalized internal use claims processing software to eighteen months. In addition, management also reevaluatedin accordance with American Institute of Certified Public Accountants ("AICPA") Statement of Position 98-1, "Accounting for Cost of Computer Software Developed or Obtained for Internal Use." Amortization of capital lease assets is included in depreciation expense. Depreciation is provided on a straight-line basis over the estimated useful lives of certain other computer softwarethe assets, which is generally two to ten years for buildings and hardware,improvements, three to ten years for equipment and reduced the estimated useful lives fromthree to five to three years. At the end of the second quarter of fiscal 2002, the Company appoved a plan to further accelerate the consolidation of certain information systems. As a result of this plan, the Company reduced, as of April 1, 2002, the remaining useful lives of certain other information systems to periods ranging from 12-24 months. The net book value of assets affected by these changes in useful lives at June 30, 2002 was $14.7 million.

        These changes resulted in increased depreciation of these assets on a prospective basis. The effect of these changes in useful lives was to increase depreciation expenseyears for the three and nine month periods ended June 30, 2002 by $1.8 million and $4.2 million, respectively, and to reduce net income for the three and nine month periods ended June 30, 2002 by $1.1 million and $2.5 million, respectively, or $0.03 and $0.07 per diluted share. The Company expects to incur incremental depreciation expense of $1.8 million related to these changes in useful lives in the fourth quarter of fiscal 2002.capitalized internal-use software.

Goodwill and Other Intangible Assets

        In the first quarterAs of fiscal 2002,October 1, 2001, the Company early adopted Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"). Under SFAS 142, the Company will no longer amortizeamortizes goodwill over its estimated useful life. SFAS 142 also requiresInstead, the Company is required to allocatetest the goodwill to its identifiable reporting units (as defined) and test for impairment based upon fair values at least on an annual basis.

In accordance with the early adoption of SFAS 142, the Company must performassigned the book value of goodwill to its reporting units, and performed an initial impairment test as of October 1, 2001. Accordingly, the

        The Company has completed the first phase of the goodwill impairment test and has determined that its reporting units are identical to its reporting segments. In the allocated book valuefirst quarter of its Workplace segment exceeds its fair value. Therefore,fiscal 2002, the Company plans to proceed with the second phase of the impairment test, which is the measurement of the potential loss. The Company will record anyrecorded an impairment charge of $207.8 million, before taxes ($191.6 million after taxes), to write-down the balance of goodwill related to the Workplace reporting unit to estimated fair value, based on independently appraised values. This initial impairment charge was recognized by the Company as a cumulative effect of a change in accounting principle, separate from operating results.results, in the Company's unaudited condensed consolidated statement of operations for the first quarter of fiscal 2002. The results of operations previously reported for the quarter ended

10

December 31, 2001 have been restated herein, as permitted, to reflect the cumulative effect of the adoption of SFAS 142.

Intangible Assets

        At December 31, 2002, the Company had identifiable intangible assets (primarily customer agreements and lists, provider networks and trademarks and copyrights) of approximately $68.8 million, net of accumulated amortization of $51.4 million. During the quarter ended December 31, 2002, management reevaluated the estimated useful lives of the Company's intangible assets, which resulted in reducing the remaining useful lives of certain customer agreements and lists and provider networks. Such reductions were made reflective of management's updated best estimates, given the Company's current business environment. The effect of these changes in remaining useful lives was to increase amortization expense for the current year quarter by $1.8 million and to reduce net income for the current year quarter by $1.8 million or $0.04 per diluted share. The remaining estimated useful lives at December 31, 2002, of the customer agreements and lists, provider networks, and trademarks and copyrights range from one to eighteen years.

Long-lived Assets

        Long-lived assets, including property and equipment and intangible assets to be held and used, are currently reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount should be addressed pursuant to SFAS No. 121, "Accounting for Impairment of Long-Lived Assets and for Long-Lived Assets to Disposed Of." Pursuant to this guidance, impairment is determined by comparing the carrying value of these long-lived assets to management's best estimate of the future undiscounted cash flows expected to result from the use of the assets and their eventual disposition. The cash flow projections used to make this assessment are consistent with the cash flow projections that management uses internally to assist in making key decisions, including the development of the proposed financial restructuring. In the event an impairment exists, a loss is recognized based on the amount by which the carrying value exceeds the fair value of the asset, which is generally determined by using quoted market prices or the discounted present value of expected future cash flows. The Company expects to complete its analyses and record the impactbelieves that no such impairment existed as of the change in accounting principle no later than September 30,December 31, 2002. The Company will perform its annual impairment test as of July 1, 2002, during the Company's fiscal quarter ending September 30, 2002.

        Adoptionassessment under SFAS 121 also included goodwill prior to adoption of SFAS 142 resultedon October 1, 2001. In the event that there are changes in the Company not recording approximately $7.8 million and $23.4 millionplanned use of amortization expense during the three months and nine months ended June 30, 2002, respectively. HadCompany's long-term assets or its expected future undiscounted cash flows are reduced significantly, the Company's assessment of its ability to recover the carrying value of these assets would change. In addition, in the event the proposed financial restructuring is implemented through consummation of a plan of reorganization pursuant to a bankruptcy proceeding, the Company adopted SFAS 142 effective October 1, 2000,may be required to apply fresh start reporting under which its assets and liabilities would be recorded at their then fair values. This could result in a significant write-down of the Company wouldCompany's remaining long-lived assets.

Medical Claims Payable

        Medical claims payable represent the liability for healthcare claims reported but not have recorded approximately $7.5 millionyet paid and $22.2 millionclaims incurred but not yet reported ("IBNR") related to the Company's managed healthcare businesses. The IBNR portion of amortization expense duringmedical claims payable is estimated based on past claims payment experience for member groups, enrollment data, utilization statistics, authorized healthcare services and other factors. This data is incorporated into contract specific actuarial reserve models. Although considerable variability is inherent in such estimates, management believes the three monthsliability for medical claims payable is adequate. Medical claims payable balances are continually monitored and nine months ended June 30, 2001, respectively. The following table summarizesreviewed. Changes in assumptions for care costs caused by changes in actual experience could cause these estimates to change in the near term.

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proforma effects on the three months and nine months ended June 30, 2001 had SFAS 142 been adopted October 1, 2000.

Income Taxes

        The Company's effectiveCompany files a consolidated federal income tax rate approximated 54.9% and 43.5%return for the three months ended JuneCompany and its wholly owned consolidated subsidiaries. The Company accounts for income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes". The deferred tax assets and/or liabilities are determined by multiplying the differences between the financial reporting and tax reporting bases for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. Valuation allowances on deferred tax assets are estimated based on the Company's assessment of the realizability of such amounts. The Company's financial restructuring activities and financial condition result in uncertainty as to the Company's ability to realize its net operating loss carryforwards and other deferred tax assets. Accordingly, the Company recorded significant additional valuation allowances on deferred tax assets in fiscal 2002. The Company's net deferred tax assets were fully reserved as of September 30, 20012002 and 2002, respectively, and 50.5% and 41.7% for the nine months ended June 30, 2001 and 2002, respectively. The effective rates for the current year periods exceed federal statutory rates primarily due to state income tax provision. The prior year periods are also impacted by non-deductible goodwill amortization resulting primarily from acquisitions.December 31, 2002.

NOTE B—C—Supplemental Cash Flow Information

        Below is supplemental cash flow information related to the ninethree months ended June 30,December 31, 2001 and 2002 (in thousands):

NOTE C—D—Goodwill and Other Intangible Assets, Net

Goodwill

        Goodwill represents the excess of the cost of businesses acquired over the fair value of the net identifiable assets at the date of acquisition and is not amortized in accordance with SFAS 142. See Note A—B—"Summary of Significant Accounting Policies—Goodwill and Other Intangible Assets."Goodwill". The Company's goodwill was approximately $1,033.3 million and $1,126.0$502.3 million at both September 30, 20012002 and June 30, 2002, respectively. During the first quarter of fiscal 2002, the Company reclassified certain workforce intangible assets to goodwill as part of adopting SFAS 142. The Company also identified $35.1 million associated with a portion of the contingent purchase price payments related to the acquisition of Human Affairs International ("HAI") which was previously capitalized as intangible assets and should have been capitalized as goodwill. These amounts were reclassified to goodwill during the first quarter of fiscalDecember 31, 2002. The classificationnet book value of these amounts did not have a material impact on any reporting period.goodwill was impacted by $623.7 million of impairment charges (before taxes) recorded during fiscal 2002.

        In December 1997, the Company purchased HAI from Aetna for approximately $122.1 million, excluding transaction costs. In addition, the Company incurred the obligation to make contingent purchase price payments to Aetna which may total up to $60.0 million annually over the five-year period subsequent to closing. The Company paid $60.0 million to Aetna for each of the first four years

9

subsequent to closing, including $60$60.0 million paid in each of fiscal years 2001 and 2002, and has accrued the final payment in June 2002. This payment is due in February of 2003. As part of the Company's restructuring plan discussed in Note A—"Company Overview", the Company is seeking modification of its remaining contingent purchase price obligation to Aetna.

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Other Intangible Assets, Net

        Intangible assets acquired were identified at the time of acquisition and were valued based upon independent appraisals at that time. The following is a summary of acquired intangibles the estimated useful life and the net book value at June 30,December 31, 2002 (in thousands):

        Amortization expense for the three months and nine monthsquarter ended June 30,December 31, 2002 was $2.4 million and $7.2 million, respectively.

        Deferred financing costs, which were previously classified as intangible assets, have been reclassified by the Company into other long term assets at September 30, 2001 and June 30, 2002.$4.9 million.

NOTE D—E—Long-Term Debt and Capital Lease Obligations

        Information with regard to the Company's long-term debt and capital lease obligations at September 30, 20012002 and June 30,December 31, 2002 is as follows (in thousands):

        In addition, at February 7, 2003, the Company had outstanding $75.3 million of letters of credit and $14.1 million of surety bonds.

        See Note A—"Company Overview" for discussion regarding the existence of defaults under the Credit Agreement that have resulted in the acceleration of the obligations thereunder. All of the Company's long-term debt from the Credit Agreement, Senior Notes and Subordinated Notes has been classified as a current liability in the accompanying unaudited condensed consolidated balance sheets due to such acceleration under the Credit Agreement and acceleration rights under the Indentures for the Senior Notes and Subordinated Notes.

        The Credit Agreement, as amended, provides for a Term Loan Facility in an original aggregate principal amount of $550.0$550 million, consisting of an approximately $183.3 million Tranche A Term Loan (the "Tranche A Term Loan"), an approximately $183.3 million Tranche B Term Loan (the "Tranche B Term Loan") and an approximately $183.4 million Tranche C Term Loan (the "Tranche C Term Loan"), and a Revolving Facility providing for revolving loans to the Company and the "Subsidiary Borrowers" (as defined therein) and the issuance of letters of credit for the account of the Company and its subsidiariesthe Subsidiary Borrowers in an aggregate principal amount (including the aggregate stated amount of letters of credit) of $150.0 million. LettersAs more fully described above, certain defaults and events of

13

default exist under the Credit Agreement which result in the Company being unable to access additional borrowings or letters of credit outstanding were $51.2 million at June 30, 2002. The Revolving Facility matures on February 12, 2004. Subsequent to June 30, 2002, the Company borrowed $30.0 million under the Revolving Facility, leaving a total outstanding balance for the Revolving Facility of $45.0 million as of August 13, 2002.Facility.

10

        The Credit Agreement, imposes restrictions on the Company's ability to make capital expenditures, and the Credit Agreement, the Subordinated Notes Indenture and the Senior Notes Indenture limit the Company's ability to incur additional indebtedness. These restrictions, together with the highly leveraged financial conditionas amended, contains a number of the Company, may adversely affect the Company's ability to finance its future operations or capital needs or engage in other business activitiescovenants that, may be in its interest. The covenants contained in the Credit Agreement also, among other things, restrict the ability of the Company and its subsidiaries to dispose of assets, repayincur additional indebtedness, incur or guarantee obligations, prepay other indebtedness or amend other debt instruments (including the indentureindentures for the 9.0% Senior Subordinated Notes due fiscal 2008 (the "Subordinated Notes") and the indenture for the SeniorSubordinated Notes), pay dividends, create liens on assets, enter into sale and leaseback transactions, make investments, make loans or advances, redeem or repurchase common stock, make acquisitions, engage in mergers or consolidations, change the business conducted by the Company and its subsidiaries and make acquisitions.

        Thecapital expenditures. In addition, the Credit Agreement also requires the Company to comply with specified financial ratios and tests (as defined therein), including a minimum interest coverage ratio, aratios, maximum leverage ratio,ratios, and a maximum senior debt ratio. The breach of any such covenants, ratios or tests could result in a defaultratios.

        Through September 30, 2002, the interest rates per annum applicable to the loans under the Credit Agreement, which then could result inas amended, were fluctuating rates of interest measured by reference to either at the Company's election, (a) an adjusted London inter-bank offer rate ("LIBOR") plus a defaultborrowing margin or (b) an alternate base rate ("ABR") (equal to the higher of the JP Morgan Chase Bank's published prime rate or the Federal Funds effective rate plus¹/2 of 1 percent) plus a borrowing margin. During the term of the October Waiver and the January Waiver, the borrowing margins applicable to loans under the Senior Notes IndentureRevolving Facility were 2.5 percent for ABR loans and 3.5 percent for LIBOR loans, and the borrowing margins applicable to the Tranche B Term Loan and the Tranche C Term Loan were 3.25 percent and 3.5 percent, respectively, for ABR loans and 4.25 percent and 4.5 percent, respectively, for LIBOR loans. The January Waiver amended the Credit Agreement such that the LIBOR interest rate option is no longer available to the Company for any loans which are incurred or the Subordinated Notes Indenture, which defaults would permit the lendersroll over after January 1, 2003. The Company's interest expense under the Credit Agreement and in certain circumstanceswill increase because interest on such loans will now be based on the holdersABR rate plus the applicable borrowing margin rather than the LIBOR rate plus the applicable borrowing margin which have historically been lower. Subsequent to the expiration of the Senior Notes or Subordinated Notes,January Waiver, the borrowing margins applicable to declare all amounts outstandingABR loans under those agreements to be immediately duethe Revolving Facility were 2.0 percent and payable, together with accruedunder the Tranche B Term Loan and unpaid interest. Management estimates that the Company will not be in compliance with one or moreTranche C Term Loan were 2.75 percent and 3.00 percent, respectively. In addition, as a result of its financial covenants, as amended, as of September 30, 2002 and beyond. Management is evaluating certain alternatives to alleviate this issue, including further amendments tothe Company's defaults under the Credit Agreement or refinancing amounts outstandingin January 2003, as discussed in Note A—"Company Overview", the Company must pay an additional 2.00 percent in default interest above the rates otherwise applicable to each of the loans under the Term Loan Facility and the Revolving Facility.

        The obligations of the Company and the Subsidiary Borrowers under the Credit Agreement. There can be no assurance that management will be ableAgreement are unconditionally and irrevocably guaranteed by, subject to successfully implement such alternatives. Ifcertain exceptions, each wholly owned subsidiary of the Company is unable to implement such alternatives at sufficient financing levels,Company. In addition, the Company would not haveRevolving Facility, the liquidity necessary to repay any debt that was so accelerated,Term Loan Facility and the Company's abilityguarantees are secured by security interests in and pledges of or liens on substantially all the material tangible and intangible assets of the guarantors, subject to obtain liquidity required for its operations would be uncertain. The Company's auditors have informed management that if the Company is unable to sufficiently remediate its anticipated non-compliance with debt covenants, the auditors expect to issue a going concern modification within the auditor's report on the September 30, 2002 financial statements.certain exceptions.

        In fiscal 2001, the Company issued $250.0 million of 9.375% Senior Notes which mature on November 15, 2007 and are general senior unsecured obligations of the Company. Interest on the Senior Notes is payable semi-annually on each May 15 and November 15, commencing on November 15, 2001. The gross proceeds of $250.0 million from the issuance and sale of the Senior Notes were used to repay indebtedness outstanding under the Company's Term Loan Facilities as follows: $99.6 million under Tranche A Term Loans, $75.2 million under Tranche B Term Loans, and $75.2 million under Tranche C Term Loans. The Company incurred $9.9 million of issuance costs associated with the issuance and sale of the Senior Notes. These costs were capitalized and the unamortized balance of these costs is included in other long-term assets in the accompanying unaudited condensed consolidated balance sheets.

        The Senior Notes were issued as unregistered securities and were required to be exchanged for securities registered with the Securities and Exchange Commission by January 25, 2002. The Company has not registered and/or exchanged the Senior Notes by the required datesdate and therefore is subject to penalty interest.

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Penalty interest is calculated at the rate of $0.192 per week per $1,000 principal amount of the Senior Notes, which approximates $48,000 per week, until such time as the Senior Notes are exchanged. During the nine months ended June 30, 2002, theThe Company incurred approximately $1.3$1.9 million in penalty interest in fiscal 2002, with $27 thousand of which $0.9penalty interest being incurred during the first quarter of fiscal 2002. The Company incurred $0.6 million hasof penalty interest during the quarter ended December 31, 2002. The Senior Notes have not been paidexchanged for registered securities as of June 30, 2002.the date of filing of this Form 10-Q. In addition, defaults exist under the indentures for the Senior Notes and the Subordinated Notes, as discussed in Note A—"Company Overview", and as a result the Company must pay an additional 1.00 percent in default interest above the rates otherwise applicable to the Senior Notes and the Subordinated Notes.

NOTE E—F—Accrued Liabilities

        Accrued liabilities consist of the following (in thousands):

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NOTE F—G—Income per Common Share

        The following tables reconcile income (numerator) and shares (denominator) used in the Company's computations of income from continuing operations per common share (in thousands):

        Conversion of the redeemable preferred stock (see Note L—M—"Redeemable Preferred Stock") was presumed outstanding for the ninethree months ended June 30, 2001. ConversionDecember 31, 2001 and 2002. Additionally,

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redemption of the redeemable preferred stockTPG series "A" option (see Note M—"Redeemable Preferred Stock") was not presumed for the three months ended June 30,December 31, 2001 and 2002, and for the nine months ended June 30, 2002, due to the anti-dilutive effect. In addition, accrued dividendsThe Option expired, without being exercised, on redeemable preferred stock, which were payable in cash or common stock as of June 30, 2001, were payable only in cash at June 30,August 19, 2002. Certain stock options and warrants which were outstanding during the three months and nine months ended June 30,December 31, 2001 and 2002, were not included in the computation of diluted earnings per share because of their anti-dilutive effect.

NOTE G—H—Investments in Unconsolidated Subsidiaries

        Choice Behavioral Health Partnership.    ThePrior to October 29, 2002, the Company iswas a 50%50 percent partner in Choice Behavioral Health Partnership ("Choice"), a general partnership, with Value Options, Inc. Choice is a managed behavioral healthcare company which derives all of its revenues from a subcontract with a health plan that contracts with TRICARE. The original term of the contract was for the 12 month option period ended June 30, 1997, with an additional option period available for contract extensions at the discretion of TRICARE. The fifth option period extended through June 30, 2001; however, during 2000 Choice received notification that two additional option periods were added to the contract, extending it to

12

expires on June 30, 2003. Choice's future results may be unfavorably affected if it is unable to extend the contract beyond June 30, 2003 and/or maintain adequate reimbursement rates. The Company accountsaccounted for its investment in Choice using the equity method.

        A summary As of unaudited financial information forSeptember 30, 2002, the Company's investment in Choice was $1.6 million. The Company's equity in earnings of Choice for the quarters ended December 31, 2001 and 2002 was $3.0 million and $0.8 million, respectively. The Company received $2.1 million and $2.3 million in partnership distributions from Choice for the three months ended December 31, 2001 and 2002, respectively. The remaining undistributed income from Choice is $0.2 million as follows (in thousands):of December 31, 2002, which is expected to be collected by June 2003.

        Choice's subcontract with respect to TRICARE has similar provisions as the Company's TRICARE arrangements and Choice's accounting policies for its TRICARE subcontract are the same as those described for the Company (See Note A—B—"Summary of Significant Accounting Policies"). During the second quarter of fiscal 2001, Choice and its contractor agreed to a settlement of a joint appeal regarding incorrect data provided and contractual issues related to the initial bidding process, resulting in Choice receiving approximately $50.0 million. As a result, net revenue for Choice for the nine months ended June 30, 2001 includes $45.9 million related to the settlement of this contingent claim and the Company's equity in earnings of Choice benefited by 50% of such settlement revenue. Approximately $2.8$1.4 million of the $50.0 million settlement is recorded as deferred revenue at June 30,December 31, 2002 and will be fully recognized by June 2003, based on the terms of the settlement.

        Effective October 29, 2002, the Company withdrew from the Choice partnership on the following terms: (i) the Company is to receive or pay, as the case may be, fifty percent of all bid price adjustments, change order and other pricing adjustments finalized subsequent to October 31, 2002 but relating to the period prior to November 1, 2002; (ii) the Company is to continue to share in fifty percent of all profits or losses from Choice for the period from November 1, 2002 through June 30, 2003; and (iii) if Choice's subcontract is extended beyond June 30, 2003, the Company is to be paid $150.0 thousand per month for the extension period up to a maximum of twelve months. During the quarter ended December 31, 2002, the Company recognized revenue of $3.3 million related to amounts earned under this agreement subsequent to the withdraw date.

        Premier Behavioral Systems, LLC.    The Company owns a 50% interest in Premier Behavioral Systems, LLC ("Premier").    Premier was formed to manage behavioral healthcare benefits for the State of Tennessee's TennCare program. The Company accounts for its investment in Premier using the equity method. The Company's investment in Premier at September 30, 20012002 and June 30,December 31, 2002 was $5.6$3.1 million and $1.8$3.2 million, respectively. The Company's equity in earnings (loss)losses of Premier for the three months ended June 30,December 31, 2001 was $0.7 million and its equity in income for the three months ended December 31, 2002 was $0.1 million and $(4.2) million, respectively, and for the nine months ended June 30, 2001 and 2002 was $(1.7) million and $(3.8) million, respectively.million. The Company hasdid not receivedreceive a partnership distribution from Premier in any period presented.for the quarters ended December 31, 2001 and 2002. In May 2002, the Company signed a new contract with the State of Tennessee under which the Company willwas to provide all services under the TennCare program through a direct contract. The newSuch TennCare contract covers the period from July 1, 2002 through December 31, 2003. Accordingly, Premier was to cease providing services upon the expiration of its contract on June 30, 2002,2002; however, the State of Tennessee

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has delayed exercised its option to delay the transfer of Premier's TennCare membership to the Company pendingfor up to six months. In December 2002, Premier signed a contract amendment to extend the State's clarification of certain matters regarding the membership transfer. The Company believes thatPremier contract through February 28, 2003 with four potential one-month extensions through June 30, 2003. It is uncertain as to what will happen to the Premier membership will shift toafter this contract amendment expires;

16

however, the Company during either the first or second quarter of fiscal 2003, at which time the Premier contract will terminate. The State of Tennessee requireshas expressed its desire to have more than one managed behavioral health organization involved with the TennCare program. The Company's direct contract with the State of Tennessee executed in May 2002 is otherwise not materially affected by the changes with the Premier to exist for 24 months after contract termination during which time the final run-out of claims and other liabilities will occur.contract.

        Royal Health Care, LLC.    The Company owns a 37.1%37.1 percent interest in Royal Health Care, LLC ("Royal"). Royal is a managed services organization that receives management fees for the provision of administrative, marketing, management and support services to five managed care organizations. Royal does not provide any services to the Company. The Company accounts for its investment in Royal using the equity method. The Company's investment in Royal at September 30, 20012002 and June 30,December 31, 2002 was $5.3$8.5 million and $7.2$8.8 million, respectively. The Company's equity in earnings of Royal for the three monthsquarters ended June 30,December 31, 2001 and 2002 was $0.7$0.8 million and $1.6 million, respectively, and for the nine months ended June 30, 2001 and 2002 was $2.0 million and $3.0$1.2 million, respectively. The Company received $0.0$0.7 million and $0.4$0.9 million in partnership distributions from Royal for the three months ended June 30,December 31, 2001 and 2002, respectively. The Company received $0.4 million and $1.1 million in partnership distributions from Royal for the nine months ended June 30, 2001 and 2002, respectively. The Company's equity in income from Royal for the three months and nine months ended June 30, 2002 includes a favorable $0.7 million retroactive adjustment associated with a change in the operating agreement for Royal.

NOTE H—I—Discontinued Operations

Healthcare Provider and Franchising Segments

        During fiscal 1997, the Company sold substantially all of its domestic acute-care psychiatric hospitals and residential treatment facilities (collectively, the "Psychiatric Hospital Facilities") to Crescent Real Estate Equities ("Crescent") for $417.2 million in cash and certain other consideration (the "Crescent Transactions"). Simultaneously with the sale of the Psychiatric Hospital Facilities, the Company and Crescent Operating, Inc. ("COI"), an affiliate of Crescent, formed Charter Behavioral Health Systems, LLC ("CBHS") to conduct the operations of the Psychiatric Hospital Facilities and certain other facilities transferred to CBHS by the Company. The Company retained a 50%50 percent ownership of CBHS; the other 50%50 percent ownership interest of CBHS was owned by COI.

        On September 10, 1999, the Company consummated the transfer oftransferred certain assets and other interests and forgave certain receivables pursuant to a Letter Agreement dated August 10, 1999an agreement with Crescent, COI and CBHS that effected the Company's exit from its healthcare provider and healthcare franchising businesses (the "CBHS Transactions"). As part of this transaction, the Company agreed to provide CBHS with the net economic value of five hospital-based joint ventures ("Provider JVs") and agreed to transfer to CBHS its interests in the Provider JVs and related real estate as soon as practicable. In addition, the Company became obligated to pay $2.0 million to CBHS in 12 equal monthly installments beginning on the first anniversary of the closing date (the "CBHS Note").

The CBHS Transactions, together with the formal plan of disposal authorized by the Company's Board of Directors on September 2, 1999 (the measurement date), represented the disposal of the Company's healthcare provider and healthcare franchising business segments.

        On February 16, 2000, CBHS filed a voluntary petition for relief of indebtedness under Chapter 11 of the United States Bankruptcy Code. In connection with the bankruptcy proceedings, CBHS indicated that it believed that it had certain claims against the Company regarding certain previous transactions. During fiscal 2001, the Company entered into an agreement with CBHS that provided the Company with a full release of all claims. The agreement was approved by the bankruptcy court in April 2001. Under the agreement, (i) the Company was released of all obligations to CBHS; (ii) the Company

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obtained the economic value of the five Provider JVs that was previously conveyed to CBHS; and (iii) the Company agreed to pay CBHS approximately $26 million over a 9 month period. The Company paid the final installment of $5.0 million to CBHS in January 2002. The Company has sold the assets and operations of three Provider JVs and ceased the operations of the other two Provider JVs.

Specialty Managed Healthcare Segment

        On December 5, 1997, the Company purchased the assets of Allied Health Group, Inc. and certain affiliates ("Allied"). Allied provided specialty managed care services, including risk-based products and administrative services, to a variety of insurance companies and other customers. Allied's products included, among other things, claims authorization, analysis, adjudication and payment, comprising multiple clinical specialties. The Company paid approximately $50.0 million for Allied, with cash on hand. During the quarter ended December 31, 1998, the Company and the former owners of Allied amended the Allied purchase agreement (the "Allied Amendments"). The Allied Amendments resulted in the Company paying the former owners of Allied $4.5 million additional consideration, which was recorded as goodwill. On February 29, 2000, the Company consummated the purchase of the outstanding stock of Vivra, Inc. ("Vivra"), which also provided specialty managed care services. The initial purchase price of Vivra was $10.25 million, excluding transaction costs. Allied and Vivra, as well as certain other related assets, comprised the Company's specialty managed healthcare segment. The Company accounted for the Allied and Vivra acquisitions using the purchase method of accounting.

        On October 4, 2000, the Company adopted a formal plan to dispose of the business and interest that comprised the Company's specialty managed healthcare segment. The Company exited the specialty managed healthcare business through the sale and/or abandonment of businesses and related assets, certain of which activities had already occurred in the normal course prior to October 4, 2000. The Company has exited all operating contracts entered into by Allied and Vivra;in connection with the specialty managed healthcare segment; however, the Company is obligated to satisfy lease agreements through 2008, for which the Company believes it has adequate reserves at June 30,December 31, 2002.

Human Services Segment

        On January 18, 2001, the Company's Board of Directors approved and the Company entered into a definitive agreement for the sale of National Mentor, Inc. ("Mentor"), which represented the business and interest that comprised the Company's human services segment. On March 9, 2001, the Company consummated the sale of the stock of Mentor for approximately $113.5 million, net of approximately $2.0 million in transaction costs. The Company's consideration consisted of $103.5 million in cash and $10.0 million in the form of an interest-bearing note. Additionally, the Company assumed liabilities of approximately $3.0 million. Approximately $50.2 million of the proceeds were used to retire loans under the Term Loan Facility as required by the Credit Agreement with the remainder of the cash proceeds used to reduce amounts outstanding under the Revolving Facility.

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Accounting for Discontinued Operations

        The Company has accounted for the disposal of the discontinued segments under Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" ("APB 30"). APB 30 requires that the results of continuing operations be reported separately from those of discontinued operations for all periods presented and that any gain or loss from disposal of a segment of a business be reported in conjunction with the related results of discontinued operations. Accordingly, the Company has restated its results of operations for: (a) fiscal 1999 and prior for the discontinuance ofAll activity related to the healthcare provider and healthcare franchising businesses; (b) fiscal 2000 and prior for the discontinuance ofsegments, the specialty managed healthcare segment;segment and

15

(c) the first quarter of fiscal 2001 and prior for the discontinuance of the human services segment. The restatements involved segregating the operating results of the discontinued segments from continuing operations and disclosing the results, net of income tax, in a separate income statement caption "Discontinued operations—Income (loss) from discontinued operations". The losses the Company incurred to exit thesegment are reflected as discontinued operations are reflected, net of income tax, infor the caption "Discontinued operations—Income (loss) on disposal of discontinued operations". Thethree months ended December 31, 2001 and 2002. As permitted, the assets, liabilities and cash flows related to discontinued operations have not been segregated from those related to continuing operations.

The summarized results of the discontinued operations segments are as follows (in thousands):

(1)

Amounts represent positive settlements of certain outstanding Medicare and Medicaid cost reports, net of cost of collection, legal fees and settlement of other liabilities. Net revenue for the three and nine months ending June 30, 2002 related to the healthcare provider and franchising segments includes a reduction of estimates of regulatory reserves pertaining to the former psychiatric hospital facilities of approximately $3.1 million, before taxes.
reports.

(2)

Interest expense has not been allocated to discontinued operations.

(3)

Includes provision (benefit) for income taxes, minority interest and (income) loss from disposal of discontinued operations.

(4)

Amount for the three months ended December 31, 2002 primarily represents changes in estimates of certain legal fee accruals.

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Remaining Assets and Liabilities

        Healthcare Provider and Healthcare Franchising—Segments.         The remaining assets and liabilities of the healthcare provider businessand franchising segments at June 30,December 31, 2002 include, among other things, (i) cash and cash equivalents of $0.7 million; (ii) restricted cash of $1.2 million, (ii)$2.0 million; (iii) accounts receivable of $0.6 million; (iv) investment in provider joint ventures of $2.4 million; (v) hospital-based real estate of $3.4 million, (iii)million; (vi) long-term debt of $6.4 million related to the hospital-based real estateestate; and (iv)(vii) accounts payable and accrued liabilities of $7.6$7.7 million.

        The Company is also subject to inquiries and investigations from governmental agencies and other legal contingencies related to itsthe operating and business practices of the healthcare provider segment prior to June 17, 1997. See Note I—J—"Commitments and Contingencies".

        Specialty Managed Healthcare Segment.        The remaining assets and liabilities of the specialty managed healthcare segment at June 30,December 31, 2002 include, among other things, (i) cash and security depositsreserve related to the discontinuance of $0.2 million, (ii) reserve for discontinued operations of $4.1$5.8 million and (iii)(ii) accounts payable and accrued liabilities of $0.6$0.4 million.

        The following table provides a roll-forward of reserves related to the discontinuance of the specialty managed healthcare segment:

(1)

The Company reevaluated its lease reserve balance related to the specialty managed healthcare segment as of June 30, 2002. The reserve was increased by an estimated $1.3 million to reflect changes in estimates.

Human Services Segment. As of June 30, 2002 the human services segment has remaining liabilities of $0.7 million consisting of accrued liabilities.(in thousands):

NOTE I—J—Commitments and Contingencies

Insurance

        The Company maintains a program of insurance coverage for a broad range of risks in its business. As part of this program of insurance, the Company is self-insured for a portion of its general and current professional liability risks. The reserves for self-insured general and professional liability losses forPrior to July 1999, the period prior to June 17, 1997, including loss adjustment expenses, were included in reserve for unpaid claims in the Company's consolidated balance sheet and were based on actuarial estimates that were discounted at an average rate of 6% to their present value based on the Company's historical claims experience adjusted for current industry trends. TheseCompany maintained certain reserves related primarily to the professional liability risks of the Company's healthcare provider segment prior to the Crescent Transactions. On July 2, 1999, the Company transferred its remaining medical malpractice claims portfolio (the "Loss Portfolio Transfer") to a third-party insurer for approximately $22.3 million. The Loss Portfolio Transfer was funded from assets restricted for settlement of unpaid claims. The insurance limit obtained through the Loss Portfolio Transfer for future medical malpractice claims is $26.3 million. The Company continually evaluates the adequacy of these insured limits and management believes these amounts are sufficient; however, there can be no assurance in that regard.

        The Company previously maintained general, professional and managed care liability insurance policies with unaffiliated insurers covering the two-year period from June 17, 2000 to June 16, 2002. The policies were written on a "claims-made" basis, subject to a $250,000 per claim and $1.0 million annual aggregate self-insured retention for general and professional liability, and also subject to a $500,000 per claim and $2.5 million annual aggregate self-insured retention for managed care liability. The Company renewed its general, professional and managed care liability insurance policies with unaffiliated insurers for a one-year period beginning June 17, 2002. The new policies are also written

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on a "claims-made" basis, and are subject to a $1.0 million per claim ($5.0 million per class action claim) unaggregated self-insured retention for managed care liability, and a $250,000 per claim unaggregated self-insured retention for general and professional liability. The Company also purchases excess liability coverage in an amount deemed reasonable by management for the size and profile of the organization. The Company is responsible for claims within its self-insured retentions, excluding portions of claims reported after the expiration date of the policies if they are not renewed, or if policy limits are exceeded.

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Regulatory Issues

        The healthcare industry is subject to numerous laws and regulations. The subjects of such laws and regulations include, but are not limited to, matters such as licensure, accreditation, government healthcare program participation requirements, information privacy and security, reimbursement for patient services, and Medicare and Medicaid fraud and abuse. Over the past several years, government activity has increased with respect to investigations and/or allegations concerning possible violations of fraud and abuse and false claims statutes and/or regulations by healthcare providers. Entities that are found to have violated these laws and regulations may be excluded from participating in government healthcare programs, subjected to fines or penalties or required to repay amounts received from the government for previously billed patient services. The Office of the Inspector General of the Department of Health and Human Services and the United States Department of Justice ("Department of Justice") and certain other governmental agencies are currently conducting inquiries and/or investigations regarding the compliance by the Company and certain of its subsidiaries with such laws and regulations. Certain of the inquiries relate to the operations and business practices of the Psychiatric Hospital Facilities prior to the consummation of the Crescent Transactions in June 1997. The Department of Justice has indicated that its inquiries are based on its belief that the federal government has certain civil and administrative causes of action under the Civil False Claims Act, the Civil Monetary Penalties Law, other federal statutes and the common law arising from the participation in federal health benefit programs of CBHS psychiatric facilities nationwide. The Department of Justice inquiries relate to the following matters: (i) Medicare cost reports; (ii) Medicaid cost statements; (iii) supplemental applications to CHAMPUS/TRICARE based on Medicare cost reports; (iv) medical necessity of services to patients and admissions; (v) failure to provide medically necessary treatment or admissions; and (vi) submission of claims to government payors for inpatient and outpatient psychiatric services. No amounts related to such proposed causes of action have yet been specified. The Company cannot reasonably estimate the settlement amount,potential liability, if any, associated with the Department of Justice inquiries. Accordingly, no reserve has been recorded related to this matter.

        In addition, the Company's financial condition could cause regulators of certain of the Company's subsidiaries to exercise certain discretionary rights under regulations including increasing its supervision of such entities, requiring additional restricted cash or other security or seizing or otherwise taking control of the assets and operations of such subsidiaries. During the first and second quarters of fiscal 2003, the State of California has taken certain actions to increase its supervision of one of the Company's subsidiaries in California and the State of Tennessee and Premier agreed to an arrangement under which the State may exercise additional supervision over the affairs of Premier. In addition, the State of Tennessee's Department of Commerce and Insurance sought and received the Tennessee Order on an ex parte basis to seize TBH, the subsidiary of the Company that holds the direct contract with the State of Tennessee. After discussions between the parties, the Tennessee Order was dissolved and TBH is operating under an agreed notice of administrative supervision. Under this arrangement, the State may exercise additional supervision over TBH's affairs.

HIPAA

        Confidentiality and patient privacy requirements are particularly strict in the field of behavioral healthcare service.healthcare. The Health Insurance Portability and Accountability Act of 1996 ("HIPAA") requires the Secretary of the Department of Health and Human Services ("HHS") to adopt standards relating to the transmission, privacy and security of health information by healthcare providers and healthcare plans. HIPAA calls for HHS to create regulations in several different areas to address the following areas:following: electronic transactions and code sets, privacy, security, provider IDs, employer IDs, health plan IDs and individual IDs. At present, regulation relating to electronic transactions and code sets, privacy and employer IDs have been released in final form. The Company has commissioned a dedicated HIPAA Project Management Office ("PMO") to coordinate participation from its customers, providers and

20

business partners in achieving compliance with these regulations. The Company, through the PMO, has put together a dedicated HIPAA Project Team to develop, coordinate and implement the compliance plan. Additionally, the Company has identified business area leads and work group chairpersons to support and lead compliance efforts related to their areas of responsibility and expertise.

        The Transactions and Code Sets regulation is final and was originally scheduled to become effective on October 16, 2002; however, companies may now elect a one-year deferral. The Company has filed for the extension as permitted by law. This regulation establishes standard data content and formats for the submission of electronic claims and other administrative and health transactions. This regulation only applies to electronic transactions, and healthcare providers will still be able to submit paper documents without being subject to this

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regulation. In addition, health plans must be prepared to receive these various transactions. The Company intendshas completed the development of a new electronic data interchange ("EDI") strategy, which it believes will significantly enhance its HIPAA compliance efforts. The Company has signed an agreement with an external EDI tool vendor to file forexpand the extension as permitted by law.Company's usage of EDI technology, developed a project plan and an accompanying resource requirements rationale, and identified anomalies through mapping of the HIPAA standard transactions to the Company's various clinical, claim and provider systems.

        The final regulation on privacy was published on December 28, 2000 and accepted by Congress on February 16, 2001. This regulation, which became effective on April 14, 2001 with a compliance date of April 14, 2003, requires patient consent and authorization to release healthcare information in certain situations, creates rules about how much and when information may be released and creates rights for patients to review and amend their health records.records, creates a requirement to notify members of privacy practices and also requires that entities contract with their downstream business associates using standards required by the regulation. This regulation applies to both electronic and paper transactions. A new proposed modification to this rule was published on March 27, 2002 in the federal register with a 30 day30-day comment period. This proposal seeks to change some of the areas of the privacy regulation that had an unintended adverse effect on the provision of care. The final modification to the privacy regulation will bewas published in the August 14, 2002 Federal Register. The compliance date for the privacy regulation, including these changes, remains April 14, 2003. The Company has developed and implemented various measures to address areas such as confidential communications, accounting of disclosures, right of access and amendment, identifying and contracting with business associates, creation of HIPAA compliant policies and information technology upgrades. The Company believes that it is on track to be in compliance with the privacy regulations by the compliance date.

        The draft version of the regulation on security was published on August 12, 1998. The final version of this rule was originally expected to be released shortly after the privacy regulation. It is now expected to be released sometime after September 30, 2002.February 20, 2003. This regulation creates safeguards for physical and electronic storage of, maintenance and transmission of, and access to, individual health information. Although the final security regulation has not been released, the Company has taken steps to address the requirements of the draft regulation through the implementation of technical, physical and administrative safeguards to enhance physical, personnel and information systems security. The compliance date for this regulation is expected to be April 21, 2005.

        The provider ID and employer ID regulations are similar in concept. The provider ID regulation was published in draft form on May 7, 1998 and would create a unique number for healthcare providers that will be used by all health plans. The employer ID regulation was published in draft form on June 16, 1998 and calls for using the Employer Identification Number (the taxpayer identifying number for employers that is assigned by the Internal Revenue Service) as the identifying number for employers that will be used by all health plans. The final regulation on employer IDs was published on May 31, 2002 with a compliance date of July 30, 2004. The health plan ID and individual ID regulations have not been released in draft form.

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        Management is currently assessing and acting on the wide reaching implications of these regulations to ensure the Company's compliance by the implementation dates. Management has identified HIPAA as a major initiative impacting the Company's systems, business processes and business relationships. This issue extends beyond the Company's internal operations and requires active participation and coordination with the Company's customers, providers and business partners. Management has commissioned a dedicated HIPAA project team to develop, coordinate and implement our compliance plan. With respect to the proposed regulation on security and the final regulation on privacy, Managementthe Company has hired a chiefpersonnel dedicated to physical and information security officer,issues, appointed an officer who will be responsible for privacy issues, commissioned separate security and privacy workgroups to identify and assess the potential impact of the regulations and reviewed current policies and drafted new policies to comply with the new requirements. Management believes that significant resources will be required over the next 18 to 21 months to ensure compliance with the new requirements. The Company incurred approximately $2.7$0.7 million in operating costs for each of the three months ended December 31, 2001 and $1.9 million in capital2002. Capital expenditures related to HIPAA inwere $0.7 million for the ninethree months ended June 30, 2002.December 31, 2002, with no capital expenditures incurred during the three months ended December 31, 2001. Management estimates that the Company will incur approximately $1.0$4.0 million to $2.0$5.0 million in operating expenditures and approximately $2.0$3.0 million to $3.0$4.0 million in capital expenditures during the remaining nine months of fiscal 2003 related to these efforts during the fourth quarter of fiscal 2002.HIPAA.

Legal

        On or about August 4, 2000, the Company was served with a lawsuit filed by Wachovia Bank, N.A. ("Wachovia") in the Court of Common Pleas of Richland County, South Carolina, seeking recovery under the indemnification provisions of an Engagement Letter between South Carolina National Bank (now Wachovia) and the Company and the Employee Stock Ownership Plan ("ESOP") Trust Agreement between South Carolina National Bank (now Wachovia) and the Company for losses sustained in a settlement entered into by Wachovia with the United States Department of Labor

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("DOL") in connection with the ESOP's purchase of stock of the Company in 1990 while Wachovia served as ESOP Trustee. The participants of the ESOP were primarily employees who worked in the Company's healthcare provider and franchising segments. The Company subsequently removed the case to the United States District Court for the District of South Carolina (Case No. 3:00-CV-02664). Wachovia also alleges fraud, negligent misrepresentation and other claims, and asserts losses of $30 million from the settlement with the DOL (plus costs and interest which amount to approximately $8$10 million as of the date of filing of this Form 10-Q). During the second quarter of fiscal 2001, the court entered an order dismissing all of the claims asserted by Wachovia, with the exception of the contractual indemnification portion of the claim. The Company disputes Wachovia's claims and has been vigorously contesting such claims. This matter is scheduled to go to trial in October 2002. AsDuring November 2002, the Company's Board of Directors rejected a result of court-ordered mediation, management is consideringproposed settlement of this claim at substantially less than the amountthat had been reached as a result of claimed losses, contingent upon the approval of our board of directors and the exclusion of the potential settlement from the financial covenants under the Company's current or refinanced debt instruments. This latter condition is not largely within the Company's control and neither of these conditions has been satisfied.a court-ordered mediation. As a result, the Company has not recorded any reserves relating to this matter. No trial date has been set by the Court.

        On October 26, 2000, two class action complaints (the "Class Actions") were filed against Magellan Health Services, Inc. and Magellan Behavioral Health, Inc. (the "Defendants") in the United States District Court for the Eastern District of Missouri under the Racketeer Influenced and Corrupt Organizations Act ("RICO") and the Employment Retirement Income Security Act of 1974 ("ERISA"). The class representatives purport to bring the actions on behalf of a nationwide class of individuals whose behavioral health benefits have been provided, underwritten and/or arranged by the Defendants since 1996 (RICO class) and 1994 (ERISA class). The complaints allege violations of RICO and ERISA arising out of the Defendants' alleged misrepresentations with respect to and failure to disclose its claims practices, the extent of the benefits coverage and other matters that cause the value of benefits to be less than the amount of premiums paid.value represented to the members. The complaints seek unspecified compensatory damages, treble damages under RICO, and an injunction barring the alleged improper practices, plus interest, costs and attorneys' fees. During the third quarter of fiscal 2001, the court

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transferred the Class Actions to the United States District Court for the District of Maryland.Maryland (Case No. L-01-01786). These actions are similar to suits filed against a number of other health care organizations, elements of which have already been dismissed by various courts around the country, including the Maryland court where the Class Actions are now pending. While the Class Actions are in the initial stages and an outcome cannot be determined, the Company believes that the claims are without merit and intends to defend them vigorously. The Company has not recorded any reserves related to this matter.these matters.

        The Company is also subject to or party to other class action suits, litigation and claims relating to its operations and business practices. The Company's managed care litigation matters include a class action lawsuit, which alleges that a provider at a Company facility violated privacy rights of certain patients.

        In the opinion of management, the Company has recorded reserves that are adequate to cover litigation, claims or assessments that have been or may be asserted against the Company, and for which the outcome is probable and reasonably estimable. Management believes that the resolution of such litigation and claims will not have a material adverse effect on the Company's financial position or results of operations; however, there can be no assurance in this regard. One or more significant adverse outcomes with regard to such litigation and claims could impair

Unclaimed Property

        Several states have initiated audits of the Company's abilityfilings related to comply with certain financial covenantsunclaimed property under escheat laws. A single firm that specializes in unclaimed property audits is conducting the audits on behalf of such states. In general, state escheat statutes allow the examination of unclaimed property filings to extend back 10 years or more. The Company has recorded estimated reserves for potential unclaimed property liabilities pertaining to its Credit Agreement.continuing operations. The Company is also analyzing its potential unclaimed property exposure related to discontinued operations. However, such amounts are not considered probable and estimable at this time, and no discontinued operations reserves related to unclaimed property have been recorded at December 31, 2002.

NOTE J—K—Managed Care Integration Plan and Special Charges

        In June 2002,Integration Plan

        During fiscal 1998, management committed the Company implementedto a new business improvement initiative, named Accelerated Business Improvement ("ABI"). ABI was institutedplan to expandcombine and integrate the initiativesoperations of the 2002 Restructuring Plan (as defined below) to the Company as a whole,its managed behavioral care organizations and is focused on reducing operational and administrative costs, while maintaining or improving service to customers. ABIspecialty managed care organizations (the "Integration Plan") that resulted in the recognitionelimination of special chargescertain duplicative functions, closure of approximately $0.5 million duringfacilities and standardized business practices and information technology platforms. As of December 31, 2002, the three-month period

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ended June 30, 2002 to terminate 30 employees,remaining Integration Plan liability balance represents the majority of which were field operational personnel. The employee termination costs of $0.5 million include severance and related termination benefits, including payroll taxes. All terminations and termination benefits were communicated to the affected employees in the third quarter of fiscal 2002, and six terminations were completed by June 30, 2002. The majority of the employee termination costs currently accrued will be paid in full by June 30, 2003. At June 30, 2002, outstanding liabilities of $0.5 millionestimated net lease payments related to ABI are included in "Accrued liabilities" in the accompanying Balance Sheets.one leased office facility. The following table provides a roll-forward of remaining liabilities resulting from the Integration Plan (in thousands):

Special Charges

        During fiscal 2000 the Company incurred special charges incurred inrelated to the implementationclosure of this plan:certain provider offices and restructuring of the corporate function and certain managed behavioral healthcare office

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sites. The following table provides a roll-forward of remaining liabilities resulting from these special charges (in thousands):

        As of December 31, 2001, management committed the companyCompany to a restructuring plan to eliminate certain duplicative functions and facilities (the "2002 Restructuring Plan") primarily related to the Health Plans segment. The Company's 2002 Restructuring Plan resulted in the recognition of special charges of approximately $8.2 million during fiscal 2002, with special charges of $4.5 million being recorded during the nine-month periodthree months ended June 30, 2002.December 31, 2001. The special charges for fiscal 2002 consisted of (a) $6.3 million to terminate 277 employees, the majority of which were field operational personnel in the Health Plans segment, and (b) $1.9 million to downsize and close excess facilities, and other associated activities. The employee termination costs include severance and related termination benefits, including payroll taxes. All terminations and termination benefits were communicated to the affected employees in fiscal 2002, with the majority of $6.3the terminations completed by September 30, 2002. The majority of the employee termination costs will be paid in full by March 31, 2003. The special charges of $1.9 million represent costs to downsize and close 14 leased facilities. These closure and exit costs include payments required under lease contracts (less any applicable existing and/or estimated sublease income) after the properties were abandoned, write-offs of leasehold improvements related to the facilities and other related expenses. The leased facilities terminate at various dates through fiscal 2006. At December 31, 2002, outstanding liabilities of $1.3 million related to the 2002 Restructuring Plan are included in "accrued liabilities" in the accompanying consolidated balance sheets. The following table provides a roll-forward of remaining liabilities resulting from these special charges (in thousands):

(1)

Upon reevaluation of reserves related to the restructuring plan, the Company reduced the severance and lease reserves, with the reduction in lease reserves attributable to lease buyouts obtained on office space previously leased by the Company.

        In June 2002, the Company implemented a new business improvement initiative, named Accelerated Business Improvement ("ABI"). ABI was instituted to expand the initiatives of the 2002 Restructuring Plan to the Company as a whole, and is focused on reducing operational and administrative costs, while maintaining or improving service to customers. During fiscal 2002, ABI resulted in recognition of (a) $2.9 million to terminate 228 employees, the majority of which were field operational personnel, and (b) $1.0 million to downsize and close excess facilities, and other associated activities. At September 30, 2002 outstanding liabilities related to ABI totaled $3.4 million.

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        During the three months ended December 31, 2002, the Company continued the ABI initiative, which resulted in the recognition of special charges of (a) $2.0 million to terminate 171 employees that comprised both field operational and corporate personnel, and (b) $0.5 million to downsize and close excess facilities, and other associated activities. The employee termination costs of $2.0 million include severance and related termination benefits, including payroll taxes. All terminations and termination benefits were communicated to the affected employees in the first three quartersquarter of fiscal 2002, and all2003, with 71 of the terminations were completed by June 30,December 31, 2002. The majority of the employee termination costs accrued during the first quarter of fiscal 2003 will be paid in full by March 31,June 30, 2003. The other special charges of $1.9 millionprimarily represent costs to downsize and close excess facilities were incurred in connection with the closure of approximately 12two leased facilities. These closure and exit costs include payments required under lease contracts (less any applicable existing and/or estimated sublease income) after the properties were abandoned, write-offs of leasehold improvements related to the facilities and other related expenses. The leased facilities have lease termination dates ranging from fiscal 20022005 through fiscal 2006.2008. At June 30,December 31, 2002, outstanding liabilities of $3.4$3.1 million related to the 2002 Restructuring PlanABI are included in "Accrued"accrued liabilities" in the accompanying Balance Sheets.unaudited condensed consolidated balance sheets. The following table provides a roll-forward of liabilities resulting from thesethe special charges:charges incurred in the implementation of this plan (in thousands):