SECURITIES AND EXCHANGE COMMISSION

FORM 10-K

(Mark One)

Commission file number 0-20488

PSYCHIATRIC SOLUTIONS, INC.

113 Seaboard Lane, Suite C-100
Franklin, TN 37067
(Address of Principal Executive Offices, Including Zip Code)

(615) 312-5700
(Registrant’s Telephone Number, Including Area Code)

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:

     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 [X] No [   ]

     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [   ]

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

     As of March 17, 2004, 11,994,722 shares of the registrant’s common stock were outstanding. As of June 30, 2003, the aggregate market value of the shares of common stock of the registrant held by non-affiliates of the registrant was approximately $44 million. For purposes of calculating such aggregate market value, shares owned by directors, executive officers and 5% beneficial owners of the registrant have been excluded.

DOCUMENTS INCORPORATED BY REFERENCE

     Portions of the registrant’s definitive proxy statement for its 2004 annual meeting of stockholders to be held on May 4, 2004 are incorporated by reference into Part III of this Form 10-K.

INDEX

PART I

            All references in this Annual Report on Form 10-K to “Psychiatric Solutions,” “the Company,” “we,” “us” or “our” mean, unless the context otherwise requires, Psychiatric Solutions, Inc. and its consolidated subsidiaries.

Item 1. Business

Overview

            We are a leading provider of inpatient behavioral health care services in the United States. Through our inpatient division, we operate 26 owned or leased inpatient behavioral health care facilities with approximately 3,200 beds in 15 states. In addition, through our inpatient management contract division, we manage 43 inpatient behavioral health care units for third parties and 11 inpatient behavioral health care facilities for government agencies. We believe that our singular focus on the provision of inpatient behavioral health care services allows us to operate more efficiently and provide higher quality care than our competitors. We primarily operate in underserved markets with limited competition and favorable demographic trends. We generated revenue of $293.7 million and $113.9 million for the years ended December 31, 2003 and 2002, respectively.

            Our inpatient behavioral health care facilities accounted for approximately 76.1% of our revenue for the year ended December 31, 2003. These facilities offer a wide range of inpatient behavioral health care services. We offer these services through a combination of inpatient behavioral facilities and residential treatment centers. Our inpatient behavioral facilities provide the most intensive level of care, including 24-hour skilled nursing observation and care, daily interventions and oversight by a psychiatrist and intensive, highly coordinated treatment by a physician-led team of mental health professionals. Our residential treatment centers, or RTCs, offer longer term treatment programs primarily for children and adolescents with long-standing acute behavioral health problems. Our RTCs provide physician-led, multi-disciplinary treatments that address the overall medical, psychiatric, social and academic needs of the patient.

            Our inpatient management contract division accounted for approximately 23.9% of our revenue for the year ended December 31, 2003. This portion of our business involves the development, organization and management of behavioral health care programs within medical surgical hospitals and the management of inpatient behavioral health care facilities for government agencies. We provide our customers with a variety of management options, including (1) clinical and management infrastructure, (2) personnel recruitment, staff orientation and supervision, (3) corporate consultation and (4) performance improvement plans. Our broad range of services can be customized into individual programs that meet specific facility and community requirements. We are dedicated to providing quality programs with integrity, innovation and flexibility.

            The Company was incorporated in the State of Delaware in 1988. Our principal executive offices are located at 113 Seaboard Lane, Suite C-100, Franklin, Tennessee 37067. Our telephone number is (615) 312-5700.

Significant Recent Transactions

            On March 1, 2004, we acquired two inpatient psychiatric facilities from Brentwood Behavioral Health (“Brentwood”) for approximately $28 million cash with an earn-out of up to $5 million contingent upon Brentwood’s future financial results. The facilities, which have an aggregate of 311 licensed beds, are located in Shreveport, Louisiana and Jackson, Mississippi.

            On January 6, 2004, we entered into a revolving credit facility with Bank of America, N.A. of up to $50 million. We will incur a $6.4 million loss from refinancing long-term debt in the first quarter of 2004, which includes the payment of a termination fee to CapitalSource Finance LLC, our former senior lender.

            On December 24, 2003, we closed on the sale of 6,900,000 shares of our common stock at $16.00 per share. Of these shares, 900,000 were sold through the full exercise of the underwriters’ over-allotment option. We sold 3,271,538 shares for approximately $48.9 million after underwriting discounts and other issuance costs. Certain

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existing stockholders sold 3,628,462 shares in the offering. We did not receive any proceeds from the sale of common stock by the selling stockholders.

            On November 1, 2003, we acquired the 109-bed Alliance Health Center located in Meridian, Mississippi. Alliance Health Center is a licensed acute care hospital that provides psychiatric care for children, adolescents and adults. In addition, a 60-bed residential treatment center is under construction and is scheduled to open during the second quarter of 2004.

            On June 30, 2003, we consummated the acquisition of Ramsay Youth Services, Inc. (“Ramsay”), a public company that traded on the Nasdaq SmallCap Market under the symbol “RYOU,” for approximately $81.3 million, consisting of $56.2 million in cash, or $5.00 per share, $22.3 million in net assumed debt that was repaid in connection with the acquisition and $2.8 million in fees and expenses. Through the acquisition, we acquired 11 owned or leased inpatient behavioral health care facilities, which had an aggregate of 1,292 beds, and assumed 10 contracts to manage inpatient behavioral health care facilities for government agencies.

            Also, on June 30, 2003, we issued $150 million in 10 5/8% senior subordinated notes, which are fully and unconditionally guaranteed on a senior subordinated basis by substantially all of our existing operating subsidiaries. Interest on the senior subordinated notes accrues at the rate of 10.625% per annum and is payable semi-annually in arrears on June 15 and December 15, commencing on December 15, 2003. The senior subordinated notes will mature on June 15, 2013.

            In April 2003, we consummated the acquisition of six inpatient behavioral health care facilities from The Brown Schools, Inc. (“The Brown Schools”) for $63.0 million in cash. The six inpatient facilities, which have an aggregate of 895 licensed beds, are located in Austin, San Antonio and San Marcos, Texas; Charlottesville, Virginia; Colorado Springs, Colorado; and Tulsa, Oklahoma.

            On August 5, 2002, PMR Acquisition Corporation, a newly formed, wholly-owned subsidiary of PMR Corporation (“PMR”), merged with and into Psychiatric Solutions, Inc., whose name, subsequent to the merger, was changed to Psychiatric Solutions Hospitals, Inc. (“PSH”). The surviving corporation in the merger was PSH, which became a wholly-owned subsidiary of PMR, a publicly traded company. In connection with the merger, PMR changed its name to Psychiatric Solutions, Inc. and, effective August 6, 2002, the shares of Psychiatric Solutions, Inc., formerly known as PMR Corporation, were approved for listing on the Nasdaq National Market under the ticker symbol “PSYS.”

Our Industry

            An estimated 22% of the U.S. adult population and 10% of U.S. children and adolescents suffer from a diagnosable mental disorder in a given year. Based on the 2002 U.S. census, these figures translate to approximately 50 million Americans. In addition, four of the ten leading causes of disability in the United States are mental disorders.

            The behavioral health care industry is extremely fragmented with only a few large national providers. During the 1990s, the behavioral health care industry experienced a significant contraction following a long period of growth. Between 1990 and 1999, nearly 300 inpatient behavioral health care facilities, accounting for over 40% of available beds, were closed. The reduction was largely driven by third party payors who decreased reimbursement, implemented more stringent admission criteria and decreased the authorized length of stay. We believe this reduced capacity has resulted in an underserved patient population.

            Reduced capacity, coupled with mental health parity legislation providing for greater access to mental health services, has resulted in favorable industry fundamentals. Behavioral health care providers have enjoyed significant improvement in reimbursement rates, increased admissions and stabilized lengths of stay. According to the National Association of Psychiatric Health Systems, payments for the inpatient care of behavioral health and addictive disorders have increased nationwide. Inpatient admissions increased from an average of approximately 2,350 in 2001 to an average of approximately 2,500 in 2002, while the average occupancy rates stabilized at approximately 74% for both 2001 and 2002 after being approximately 69% in 2000. Following a rapid decrease

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during the early 1990s, inpatient average length of stay stabilized between 9 and 10 days from 1997 to 2002. In 2002, the inpatient average length of stay was 10.3 days. The average RTC net revenue per day in 2002 was $288 for hospital-based units and $273 for freestanding RTC facilities. The average number of admissions for hospital-based units was 171 for 2002. The average number of admissions for freestanding RTC facilities was 213 for 2002. The average occupancy rate for hospital-based units increased from 73.0% in 2001 to 74.9% in 2002, with an average length of stay of 165.5 days in 2002. The average occupancy rate for freestanding RTC facilities was 82.6% in 2002, with an average length of stay of 187.3 days in 2002. These favorable trends have resulted in high demand for inpatient behavioral health care services.

Our Strategy

            We intend to continue to successfully grow our business and increase our profitability by improving the performance of our existing inpatient facilities and through strategic acquisitions. The following are the principal elements of our strategy:

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Same-Facility Growth — We increased our revenue by approximately 9% for the year ended December 31, 2003 as compared to our revenue for the year ended December 31, 2002 through same-facility growth. Same-facility growth refers to the comparison of the five inpatient facilities owned during 2002 with the comparable period in 2003. We owned four inpatient facilities throughout 2002 and acquired a fifth inpatient facility on July 1, 2002. We expect to continue to increase our same-facility growth by increasing our admissions and maximizing reimbursement. We plan to accomplish these goals by:

•		building relationships that enhance our presence in local and regional markets;
•		developing formal marketing initiatives and expanding referral networks;
•		continuing to provide the highest quality service; and
•		expanding our services and developing new services to take advantage of increased demand in select markets where we operate.

•		Strong and Sustainable Market Position — Our inpatient facilities have an established presence in each of our markets, and we believe that the majority of our owned and leased inpatient facilities have the leading market share in their respective service areas. Our relationships and referral networks would be difficult, time-consuming and expensive for new competitors to replicate. In addition, many of the states in which we operate require a certificate of need to open an inpatient behavioral health care facility, which may be difficult to obtain and may further preclude new market participants.
•		Growth Through Strategic Acquisitions — Our industry is highly fragmented and we plan to selectively pursue the acquisition of additional inpatient behavioral health care facilities. There are approximately 500 acute and residential treatment facilities in the U.S. and the top three providers operate less than 17% of these facilities. We believe there are a number of acquisition candidates available at attractive valuations, and we have a number of potential acquisitions that are in various stages of development and negotiation. We believe our focus on inpatient behavioral health care provides us with a strategic advantage when assessing a potential acquisition.
•		Ability to Identify and Integrate Acquisitions — We have successfully integrated the five inpatient facilities we acquired in 2001 and 2002 as well as the inpatient facilities we acquired in 2003 in connection with our acquisition of Ramsay, an operator of 11 owned or leased inpatient behavioral health care facilities, and six inpatient facilities from The Brown Schools. We attribute part of our success in integrating these inpatient facilities to our rigorous due diligence review prior to completing the

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		acquisitions as well as our ability to retain key employees at the acquired facilities. We employ a disciplined acquisition strategy that is based on defined criteria including quality of service, return on invested capital and strategic benefits. We also have a comprehensive post-acquisition strategic plan to facilitate the integration of acquired inpatient facilities that includes improving facility operations, recruiting psychiatrists and expanding the breadth of services offered by the facilities.
•		Diversified Payor Mix and Revenue Base — As we have grown our business, we have focused on diversifying our sources of revenue. For the year ended December 31, 2003, we received 32.3% of our revenue from Medicaid, 21.9% from multiple commercial payors, 14.2% from various state and local government payors, 19.4% from various third parties and 12.2% from Medicare. As we receive Medicaid payments from more than 35 states, we are not significantly affected by changes in reimbursement policies in any one state. The majority of our Medicaid payments relate to the care of children and adolescents. Management believes that children and adolescents are a patient class that is less susceptible to reductions in reimbursement rates. For the year ended December 31, 2003, no single inpatient facility represented more than 11% of our revenue.
•		Experienced Management Team — Our senior management team has an average of 20 years of experience in the health care industry. Joey A. Jacobs, our Chairman, President and Chief Executive Officer, has over 28 years experience in various capacities in the health care industry. Jack R. Salberg, our Chief Operating Officer, has more than 32 years of operational experience in both profit and non-profit health care sectors. Our senior management operates as a cohesive, complementary group and has extensive operating knowledge of our industry and understanding of the regulatory environment in which we operate. Our senior managers employ conservative fiscal policies and have a successful track record in both operating our core business and integrating acquired assets.
•		Operating Efficiencies — Our management team has extensive experience in the operation of multi-facility health care services companies. We intend to focus on improving our profitability by optimizing staffing ratios, controlling contract labor costs and reducing supply costs through group purchasing. We believe that our focus on efficient operations increases our profitability and will attract qualified behavioral health care professionals and patients.
•		Consistent Free Cash Flow and Minimal Capital Requirements — We generate consistent free cash flow due to the profitable operation of our business, our low capital expenditure requirements and through the active management of our working capital. As the behavioral health care business does not require the procurement and replacement of expensive medical equipment, our capital expenditure requirements are less than that of other facility-based health care providers. Historically, our capital expenditures have amounted to less than 2% of our revenue. Our accounts receivable management is less complex than acute care providers because there are fewer billing codes for inpatient behavioral health care facilities.
•		Singular Focus on Inpatient Behavioral Health Care — We focus exclusively on the provision of inpatient behavioral health care services. We believe this allows us to operate more efficiently and provide higher quality care than our competitors. In addition, we believe our focus and reputation have helped us to develop important relationships and extensive referral networks within our markets and to attract and retain qualified behavioral health care professionals.

Services by Segment

            We operate two reportable segments: (1) our owned and leased facilities segment operates inpatient behavioral health care facilities and (2) our management contract segment manages inpatient behavioral health care units and facilities for third parties and government agencies. For financial information regarding our operating

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segments, see Note 14 to our Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K.

Inpatient Behavioral Health Care Facilities Division

            Our inpatient division operates 26 owned or leased inpatient behavioral health care facilities. These facilities offer a wide range of inpatient behavioral health care services for children, adolescents and adults. Our inpatient facilities work closely with mental health professionals, including licensed professional counselors, therapists and social workers; psychiatrists; non-psychiatric physicians; emergency rooms; law enforcement and community agencies that interact with individuals who may need treatment for mental illness or substance abuse. Many of our inpatient facilities have mobile assessment teams who travel to prospective clients in order to assess their condition and determine if they meet criteria for inpatient care. Those clients not meeting criteria for inpatient care may qualify for outpatient care or a less intensive level of care also provided by the facility. During the year ended December 31, 2003, our inpatient behavioral health care facilities division produced approximately 76% of our revenue.

            Through the diversity of programming and levels of care available, the patient can receive a seamless treatment experience from acute care to residential long-term care to group home living to outpatient treatment. This seamless care system provides the continuity of care needed to step the patient down and allow the patient to develop and use successful coping skills and treatment interventions to sustain long-term treatment success. Treatment modalities include comprehensive assessment, multidisciplinary treatment planning including the patient and family, group, individual and family therapy services, medical and dental services, educational services, recreational services and discharge planning services. Specialized interventions such as skills training include basic daily living skills, social skills, work/school adaptation skills and symptom management skills. Collateral consultations are provided to significant others such as family members, teachers, employers and other professionals when needed to help the patient successfully reintegrate back into his/her world. Services offered at our inpatient facilities include:

•		acute psychiatric care;	•		detoxification;
•		partial hospitalization;	•		developmentally delayed disorders ;
•		chemical dependency;	•		therapeutic foster care;
•		intensive outpatient;	•		neurological disorders;
•		acute eating disorders;	•		rapid adoption services;
•		reactive attachment disorder;	•		day treatment;
•		dual diagnosis;	•		independent living skills;
•		rehabilitation care;	•		attention deficit/hyperactivity disorders; and
•		day treatment;	•		vocational training.

            Acute inpatient hospitalization is the most intensive level of care offered and typically involves 24-hour skilled nursing observation and care, daily interventions and oversight by a psychiatrist, and intensive, highly coordinated treatment by a physician-led team of mental health professionals. Every patient admitted to acute care is assessed by a medical doctor within 24 hours of admission. Patients with non-complex medical conditions are monitored during their stay by the physician and nursing staff at the inpatient facility. Patients with more complex medical needs are referred to more appropriate facilities for diagnosis and stabilization prior to treatment. Patients admitted to our acute care facilities also receive comprehensive nursing and psychological assessments within 24 to 72 hours

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of admission. Oversight and management of patients’ medication is performed by licensed psychiatrists on staff at the facility, and individual, family, and group therapy is performed by licensed counselors as appropriate to the patients’ assessed needs. Education regarding their illness is also provided by trained medical health professionals.

            Detoxification for adult patients with a diagnosis of substance abuse is provided at some inpatient facilities. Substance abuse therapy and education is provided to these patients during their stay and referrals to appropriate aftercare services are made for the patient upon discharge, usually to an intensive outpatient program provided by the inpatient facility.

            Our RTCs provide longer term treatment programs for children and adolescents with long-standing behavioral health problems. Twenty four hour observation and care is provided in our RTCs, along with individualized therapy that usually consists of one-on-one sessions with a licensed counselor, as well as process and rehabilitation group therapy. Another key component of the treatment of children and adolescents in our inpatient facilities is family therapy. Participation of the child’s or adolescent’s immediate family is strongly encouraged in order to heighten the chance of success once the resident is discharged. Medications for residents are managed by licensed, often board-certified, psychiatrists while they remain at the inpatient facility. Our RTCs also provide academic programs by certified teachers to children and adolescent residents. These programs are individualized for each resident based on analysis by the teacher upon admission. Upon discharge of the resident, an academic reports are forwarded to the resident’s school. Specialized programs for children and adolescents in our RTCs include programs for sexually reactive children, sex offenders, reactive attachment disorders and clients who are developmentally delayed with a behavioral component. Our RTCs often receive out-of-state referrals to their programs due to the lack of specialized programs for these disorders within the referral’s own state.

            Other major diagnoses treated at our inpatient behavioral health care facilities include bipolar disorder, major depression, schizophrenia, attention deficit/hyperactivity disorder, impulse disorder and oppositional and conduct disorders.

            Our inpatient facilities’ programs have been adapted to the requests of various sources to provide services to patients with multiple issues and specialized needs. Our success rate with these difficult to treat cases has expanded our network of referrals. The services provided at each inpatient facility are continually assessed and monitored through an ongoing quality improvement program. This purpose of this program is to strive for the highest quality of care possible to individuals with behavioral health issues, and includes regular site visits to each inpatient facility in order to assess their compliance with legal and regulatory standards, as well as adherence to our compliance program. Standardized performance measures based on a national outcomes measurement data base comparing our inpatient facilities performance with national norms are also reported, reviewed and corrective steps are taken when necessary.

Inpatient Management Contract Division

            Our inpatient management contract division develops, organizes and manages behavioral health care programs within general third party medical/surgical hospitals and manages inpatient behavioral health care facilities for government agencies. We manage 43 inpatient behavioral health units for third parties in 15 states, including a contract to provide mental health case management services to approximately 4,400 children and adults with serious mental illness in the Nashville, Tennessee area, and 11 inpatient behavioral health care facilities for government agencies. For the year ended December 31, 2003, our inpatient management contract division produced approximately 24% of our revenue.

            Our broad range of services can be customized into individual programs that meet specific inpatient facility and community requirements. Our inpatient management contract division is dedicated to providing high quality programs with integrity, innovation and sufficient flexibility to develop customized individual programs. We provide our customer with a variety of management options, including clinical and management infrastructure, personnel recruitment, staff orientation and supervision, corporate consultation and performance improvement plans. Under the contracts, the hospital is the actual provider of the mental health services and utilizes its own facilities, support services, and generally its own nursing staff in connection with the operation of its programs.

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            In general the contracts have an initial term of two to five years and are extended for successive one-year periods unless terminated by either party. The contracts contain termination provisions that allow either party to terminate upon certain material events, including the failure to cure a breach or default under the contract, bankruptcy and the failure to maintain required licensure. While turnover of contracts is expected, we expect the number of contracts to remain relatively stable. Substantially all of the management contracts contain non-compete and confidentiality provisions. In addition, the management contracts typically prohibit the client hospital from soliciting our employees during the term of the contract and for a specified period thereafter.

            In addition, we manage 11 inpatient behavioral health care facilities for government agencies located in Florida, Georgia and Puerto Rico. In general, our contracts to manage these inpatient facilities have an initial term of one to five years. Most of these contracts may be extended for up to three successive one-year periods at the discretion of the government agency. Payment under the contracts is contingent on the annual appropriation of funds by the respective state legislature. Most contracts allow us to terminate the agreement without cause upon 90 days notice and the government agency may terminate without cause upon 30 days notice or upon the occurrence of certain material events, including our failure to meet certain performance standards for a specified period of time, bankruptcy or default under the contract.

            Our management contract revenue is sensitive to regulatory and economic changes in the States of Tennessee and Florida. Our contract to provide case management services in and around Nashville, Tennessee comprised 8% of our consolidated revenue for the year ended December 31, 2003 and our contracts to manage nine inpatient facilities for the Florida Department of Juvenile Justice comprised 6% of our consolidated revenue for the year ended December 31, 2003. The loss of these contracts would have a material adverse effect on our management contract segment.

Seasonality of Services

            Our inpatient behavioral health care facilities division typically experiences lower patient volumes and revenue during the end of the second quarter, the beginning of the third quarter, the end of the fourth quarter and the beginning of the first quarter. Because a high proportion of patients served by our inpatient behavioral health care facilities division are children and adolescents, this seasonality corresponds to periods that school is out of session. We believe that, for a variety of reasons, children and adolescent patients are less likely to be admitted during the summer months and the year-end holidays.

Marketing

            Our local and regional marketing is led by clinical and business development representatives at each of our inpatient facilities. These individuals manage relationships among a variety of referral sources in their respective communities. Our national marketing efforts are focused on increasing the census at our RTCs from various state referral sources by developing relationships and identifying contracting opportunities in their respective territories. Our customer service is managed through our call center. Both families and agencies seeking placement for children receive quick, confidential service through the call center which further promotes our facilities.

Competition

            The inpatient behavioral health care facility industry and the inpatient behavioral health care unit management industry are highly fragmented. The industry is subject to continual changes in the method in which services are provided and the types of companies providing such services. We compete with several national competitors and many regional and local competitors, some of which have greater resources than us. In addition,

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some of our competitors are owned by governmental agencies and supported by tax revenue, and others are owned by nonprofit corporations and may be supported to a large extent by endowments and charitable contributions. Such support is not available to our facilities.

            In addition, our owned, leased and managed inpatient behavioral health care facilities and managed inpatient behavioral health care units compete for patients with other providers of mental health care services, including other inpatient behavioral health care facilities, medical/surgical hospitals, independent psychiatrists and psychologists. We also compete with hospitals, nursing homes, clinics, physicians’ offices and contract nursing companies for the services of registered nurses. We believe we differentiate ourselves from our competition through our singular focus on the provision of behavioral health care services, our reputation for the quality of our services, recruitment of first rate medical staff and accessibility to our facilities. In addition, we believe that the active development of our referral network and participation in selected managed care provider panels enable us to successfully compete for patients in need of our services.

Reimbursement

            Our inpatient owned and leased facilities receive payment for services from the federal government primarily under the Medicare program, state governments under their respective Medicaid programs, private insurers, including managed care plans, and directly from patients. Most of our inpatient behavioral health facilities are certified as providers of Medicare and Medicaid services by the appropriate governmental authorities. The requirements for certification are subject to change, and, in order to remain qualified for such programs, it may be necessary for us to make changes from time to time in our inpatient facilities, equipment, personnel and services. If an inpatient facility loses certification, it will be unable to receive payment for patients under the Medicare or Medicaid programs. Although we intend to continue participating in such programs, there can be no assurance that we will continue to qualify for participation.

Medicare

            Medicare provides hospital and medical insurance benefits to persons age 65 and over, some disabled persons and persons with end-stage renal disease. Freestanding psychiatric hospitals and certified psychiatric units of acute care hospitals are currently exempt from the inpatient services prospective payment system (“PPS”) applicable to general acute care hospitals and are reimbursed on a reasonable cost basis, subject to a per discharge ceiling, calculated based on an annual allowable rate of increase over the facility’s base year amount under the Medicare law and regulations. Capital-related costs are exempt from this limitation. Medicare makes interim payments to the provider based on an estimate of the provider’s cost, and then makes a final settlement based on an annual cost report filed by the provider.

            Consistent with reimbursement trends for other segments of the health care services industry, the Centers for Medicare and Medicaid Services (“CMS”) proposed on November 19, 2003 a new Medicare PPS for inpatient behavioral health care facilities including both freestanding psychiatric hospitals and certified psychiatric units in general acute care hospitals. CMS is proposing a per diem PPS. The proposed base per diem amount will cover nearly all labor and non-labor costs of furnishing covered inpatient behavioral health care services — including routine, ancillary and capital costs. The proposed per diem will not, however, include the costs of bad debts and certain other costs that are paid separately.

            CMS is proposing that the base per diem be adjusted for specific facility characteristics that increase the cost of patient care. CMS is proposing that payment rates for individual inpatient facilities be adjusted to reflect geographic differences in wages and that rural providers receive an increased payment adjustment, as would teaching facilities. CMS is proposing that the base rate be adjusted by factors that influence the cost of an individual patient’s care, such as each patient’s diagnosis related group (“DRG”), certain other medical and psychiatric comorbidities (i.e., other coexisting conditions that may complicate treatment), and age. Because the cost of inpatient behavioral care tends to be greatest at admission and a few days thereafter, CMS is proposing to adjust the per diem rate for each day up to and including the eighth day to reflect the number of days the patient has been in the facility. Medicare will pay this per diem amount, as adjusted, regardless of whether it is more or less than a hospital’s actual costs. CMS currently plans to begin implementing the new PPS for behavioral health care facilities on April 1, 2004, although CMS may delay implementation beyond such date. CMS has also proposed a three-year

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transition period that will be a blend of decreasing cost-based payments and increasing PPS payments, with full PPS rates becoming effective in the fourth year. We are uncertain when a final rule and effective date will be released. Please see http://www.cms.hhs.gov/providers/ipfpps for additional information.

            With respect to revenue derived from behavioral health care unit management services, we bill our fees to the provider as a purchased management, administrative and consultative support service. Substantially all of the patients admitted to these programs are eligible for Medicare coverage. As a result, the providers rely upon payment from Medicare for the services. Many of the patients are also eligible for Medicaid payments. To the extent that a hospital deems revenue for a program we manage to be inadequate, it may seek to terminate its contract with us or not renew the contract. Similarly, we may not necessarily solicit new unit management contracts if prospective customers do not believe that such programs will generate sufficient revenue.

            Although Medicare currently uses a cost-based reimbursement formula for inpatient behavioral health care facility services, Medicare will not pay these full amounts to a facility. It will deduct from that rate an amount for patient “coinsurance,” or the amount that the patient is expected to pay. Many patients are unable to pay the coinsurance amount. Even if these patients are also covered by Medicaid, some states’ Medicaid programs will not pay the Medicare coinsurance amount. As a result, the Medicare coinsurance amount will go uncollected by the provider except to the extent that the provider is partially reimbursed that amount as a Medicare “bad debt.” To the extent that neither a Medicare patient nor any secondary payor for that patient pays the Medicare coinsurance amount after a reasonable collection effort or the patient’s indigence is documented, the provider is entitled to be paid 70% of this “bad debt” by Medicare. However, there are instances when Medicare denies reimbursement for all or part of claimed bad debts for coinsurance on Medicare patients on grounds that the provider did not engage in a reasonable collection effort or that the provider failed to maintain adequate documentation of its collection effort or of the patient’s indigence.

Medicaid

            Medicaid, a joint federal-state program that is administered by the respective states, provides hospital benefits to qualifying individuals who are unable to afford care. We cannot predict the extent or scope of changes that may occur in the ways in which state Medicaid programs contract for and deliver services to Medicaid recipients. All Medicaid funding is generally conditioned upon financial appropriations to state Medicaid agencies by the state legislatures and there are political pressures on such legislatures in terms of controlling and reducing such appropriations.

            Some states may adopt substantial health care reform measures that could modify the manner in which all health services are delivered and reimbursed, especially with respect to Medicaid recipients and other individuals funded by public resources. Many states have enacted or are considering enacting measures designed to reduce their Medicaid expenditures. As we receive Medicaid payments from more than 35 states, we are not significantly affected by changes in reimbursement policies in any one state. Most states have applied for and been granted federal waivers from current Medicaid regulations to allow them to serve some or all of their Medicaid participants through managed care providers. The majority of our Medicaid payments relate to the care of children and adolescents. We believe that children and adolescents are a patient class that is less susceptible to reductions in reimbursement rates. The reduction in other public resources could have an impact on the delivery of services to Medicaid recipients. Any significant changes in Medicaid funding, the structure of a particular state’s Medicaid program, the contracting process or reimbursement levels could have a material adverse impact on our financial condition and results of operations.

Managed Care and Commercial Insurance Carriers

            In addition to government programs, our inpatient facilities are reimbursed for certain behavioral health care services by private payors including health maintenance organizations (“HMOs”), preferred provider organizations (“PPOs”), commercial insurance companies, employers and individual private payors. To attract additional volume, our inpatient facilities offer discounts from established charges to certain large group purchasers

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of health care services. Generally, patients covered by HMOs, PPOs and other private insurers will be responsible for certain co-payments and deductibles, which are paid by the patient.

            The Mental Health Parity Act of 1996 (“MHPA”) is a federal law that requires annual or lifetime limits for mental health benefits be no lower than the dollar limits for medical/surgical benefits offered by a group health plan. MHPA applies to group health plans or health insurance coverage offered in connection with a group health plan that offers both mental health and medical/surgical benefits. However it does not require plans to offer mental health benefits. MHPA was scheduled to “sunset” on December 31, 2003, but the Mental Health Reauthorization Act of 2003 extended the sunset date of MHPA to December 31, 2004. Bills have also been introduced in Congress that could potentially apply this concept on a more far-reaching scale. Approximately 34 states have also enacted some form of mental health parity laws. Some of these laws apply only to select groups such as those with severe mental illness or specific diagnosis.

Annual Cost Reports

            All facilities participating in the Medicare program and some Medicaid programs, whether paid on a reasonable cost basis or under a PPS, are required to meet certain financial reporting requirements. Federal regulations require submission of annual cost reports identifying medical costs and expenses associated with the services provided by each facility to Medicare beneficiaries and Medicaid recipients. Annual cost reports required under the Medicare and some Medicaid programs are subject to routine governmental audits, which may result in adjustments to the amounts ultimately determined to be due to us under these reimbursement programs. These audits often require several years to reach the final determination of amounts earned under the programs. Nonetheless, once the Medicare fiscal intermediaries have issued a final Notice of Program Reimbursement (“NPR”) after audit, any disallowances of claimed costs are due and payable within 30 days of receipt of the NPR. Providers have rights to appeal, and it is common to contest issues raised in audits of prior years’ cost reports.

Regulation and Other Factors

Licensure, Certification and Accreditation

            Health care facilities are required to comply with extensive regulation at the federal, state and local levels. Under these laws and regulations, health care facilities must meet requirements for licensure and qualify to participate in government programs, including the Medicare and Medicaid programs. These requirements relate to the adequacy of medical care, equipment, personnel, operating policies and procedures, fire prevention, maintenance of adequate records, hospital use, rate-setting, and compliance with building codes and environmental protection laws. There are also extensive regulations governing a facility’s participation in government programs. Facilities are subject to periodic inspection by governmental and other authorities to assure continued compliance with the various standards necessary for licensing and accreditation.

            All of the inpatient facilities owned and operated by us are properly licensed under applicable state laws. Most of the inpatient facilities owned and operated by us are certified under Medicare and Medicaid programs and most are accredited by the Joint Commission on Accreditation or Healthcare Organizations (“JCAHO”), the effect of which is to permit the inpatient facilities to participate in the Medicare and Medicaid programs. Should any of our inpatient facilities lose its accreditation by JCAHO, or otherwise lose its certification under the Medicare and/or Medicaid program, that inpatient facility would be unable to receive reimbursement from the Medicare and Medicaid programs. If a provider contracting with us were excluded from any federal health care programs, no services furnished by that provider would be covered by any federal health care program. If we were excluded from federal health care programs, our owned and leased inpatient facilities would not be eligible for reimbursement by any federal health care program. In addition, providers would as a practical matter cease contracting for our inpatient behavioral health care unit management services because they could not be reimbursed for any management fee amounts they paid to us.

            We believe that the inpatient facilities we own and operate are in substantial compliance with current applicable federal, state, local and independent review body regulations and standards. The requirements for

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licensure, certification and accreditation are subject to change and, in order to remain qualified, it may be necessary for us to effect changes in our inpatient facilities, equipment, personnel and services. Additionally, certain of the personnel working at inpatient facilities owned and operated by us are subject to state laws and regulations governing their particular area of professional practice. We assist our client hospitals in obtaining required approvals for new programs. Some approval processes may lengthen the time required for programs to begin operations.

Fraud and Abuse Laws

            Participation in the Medicare and/or Medicaid programs is heavily regulated by federal law and regulation. If a hospital fails to substantially comply with the numerous federal laws governing that facility’s activities, the hospital’s participation in the Medicare and/or Medicaid programs may be terminated and/or civil or criminal penalties may be imposed. For example, a hospital may lose its ability to participate in the Medicare and/or Medicaid program if it pays money to induce the referral of patients or purchase of items or services where such items or services are reimbursable under a federal or state health care program.

            The anti-kickback provision of the Social Security Act prohibits the payment, receipt, offer or solicitation of money with the intent of generating referrals or orders for services or items covered by a federal or state health care program (the “Anti-kickback Statute”). Violations of the Anti-kickback Statute may be punished by criminal or civil penalties, exclusion from federal and state health care programs, imprisonment and damages up to three times the total dollar amount involved. The Anti-kickback Statute has been interpreted broadly by federal regulators and certain courts to prohibit the intentional payment of anything of value if even one purpose of the payment is to influence the referral of Medicare or Medicaid business. Therefore, many commonplace commercial arrangements between hospitals and physicians could be considered by the government to violate the Anti-kickback Statute.

            The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) broadened the scope of the fraud and abuse laws by adding several criminal statutes that are not related to receipt of payments from a federal health care program. HIPAA created civil penalties for proscribed conduct, including upcoding and billing for medically unnecessary goods or services. HIPAA established new enforcement mechanisms to combat fraud and abuse. These new mechanisms include a bounty system, where a portion of the payments recovered is returned to the government agencies, as well as a whistleblower program. HIPAA also expanded the categories of persons that may be excluded from participation in federal and state health care programs.

            The Office of Inspector General (“OIG”) of the Department of Health and Human Services (“HHS”) is responsible for identifying fraud and abuse activities in government programs. In order to fulfill its duties, the OIG performs audits, investigations and inspections. In addition, it provides guidance to health care providers by identifying types of activities that could violate the Anti-kickback Statute. We have a variety of financial relationships with physicians who refer patients to our owned and leased facilities, as well as at behavioral health programs and facilities we manage. We also have contracts with physicians providing for a variety of financial relationships including employment contracts, independent contractor agreements, professional service agreements and medical director agreements.

            The OIG is authorized to publish regulations outlining activities and business relationships that would be deemed not to violate the Anti-kickback Statute. These regulations are known as “safe harbor” regulations. The safe harbor regulations do not make conduct illegal, but instead delineate standards that, if complied with, protect conduct that might otherwise be deemed in violation of the Anti-kickback Statute. We use our best efforts to structure each of our arrangements, especially each of our business relationships with physicians, to fit as closely as possible within an applicable safe harbor. However, not all of our business arrangements fit wholly within safe harbors, so we cannot guarantee that these arrangements will not be scrutinized by government authorities or, if scrutinized, that they will be determined to be in compliance with the Anti-kickback Statute or other applicable laws. The failure of a particular activity to comply with the safe harbor regulations does not mean that the activity violates the Anti-kickback Statute. If we do violate the Anti-kickback Statute, we would be subject to criminal and civil penalties and/or possible exclusion from participating in Medicare, Medicaid or other governmental health care programs.

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            The OIG also issues advisory opinions to outside parties regarding the interpretation and applicability of the Anti-kickback Statute and other OIG health care fraud and abuse sanctions. An OIG advisory opinion only applies to the people or entities which requested it. However, advisory opinions are published and made available to the public (see http://oig.hhs.gov/fraud/advisoryopinions.html), and they provide guidance on those practices the OIG believes may (or may not) violate federal law. On April 3, 2003, the OIG issued Advisory opinion No. 03-8 regarding an arrangement whereby a company would develop and manage distinct part inpatient rehabilitation units located within general acute care hospitals in exchange for a management fee calculated on a per patient per day basis. The OIG found that the proposed arrangement could potentially generate prohibited remuneration under the Anti-kickback Statute and that the OIG could potentially impose administrative sanctions on the management company. The OIG noted that any definitive conclusion regarding the existence of an anti-kickback violation would require a determination of the parties’ intent, which is beyond the scope of the advisory opinion process.

            The OIG’s analysis noted that the proposed arrangement did not qualify for the safe harbor for personal services and management contracts because the aggregate compensation paid by the hospital to the management company was not set in advance. The OIG noted that “per patient,” “per click,” “per order,” and similar payment arrangements with parties in a position, either directly or indirectly, to refer or recommend an item or service payable by a federal health care program are disfavored under the Anti-kickback Statute. The principal concern is that such arrangements promote overutilization and unnecessarily lengthy stays. Other items of concern to the OIG included that the unit was under the medical direction of a physician in a position to generate referrals to the unit, the management company performed community outreach including marketing, and the fee arrangement could be deemed a success fee. While the proposed arrangement had certain features that would appear to reduce the risk, the OIG could not conclude that the residual risk was sufficiently low to grant protection prospectively.

            We provide services to medical/surgical facilities through behavioral health care management contracts and are compensated, in part, on a per discharge basis. We have not requested an advisory opinion from the OIG with respect to our inpatient management contracts. We believe that we are in compliance with the Anti-kickback Statute, despite the fact that our inpatient management contracts do not qualify for the safe harbor for personal services and management contracts because the aggregate compensation paid by our client hospitals is not set in advance. There can be no assurances that our contracts will not be reviewed and challenged by the OIG or other regulatory authorities empowered to do so.

            The Social Security Act also includes a provision commonly known as the “Stark Law.” This law prohibits physicians from referring Medicare and Medicaid patients for the furnishing of any “designated health services” to health care entities in which they or any of their immediate family members have ownership or other financial interest. These types of referrals are commonly known as “self referrals.” Sanctions for violating the Stark Law include civil monetary penalties, assessments equal to twice the dollar value of each service rendered for an impermissible referral and exclusion from the Medicare and Medicaid programs. There are ownership and compensation arrangement exceptions for many customary financial arrangements between physicians and facilities, including employment contracts, leases and recruitment agreements. The federal government released regulations interpreting some, but not all, of the provisions included in the Stark Law in January 2001, and the government has said it intends to release the second phase of the final Stark Law regulations in the future. We have structured our financial arrangements with physicians to comply with the statutory exceptions included in the Stark Law and subsequent regulations. However, the future Stark Law regulations may interpret provisions of this law in a manner different from the manner in which we have interpreted them. We cannot predict the effect such future regulations will have on us.

            Many states in which we operate also have adopted, or are considering adopting, laws similar to the Anti-kickback Statute and/or the Stark Law. Some of these state laws apply even if the government is not the payor. These statutes typically provide criminal and civil penalties as remedies. While there is little precedent for the interpretation or enforcement of these state laws, we have attempted to structure our financial relationships with physicians and others in light of these laws. However, if a state determines that we have violated such a law, we would be subject to criminal and civil penalties.

Emergency Medical Treatment and Active Labor Act

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            The Emergency Medical Treatment and Active Labor Act (“EMTALA”) is a federal law that requires any health care facility that participates in the Medicare program to conduct an appropriate medical screening examination of every person who presents to the hospital’s emergency department for treatment and, if the patient is suffering from an emergency medical condition, to either stabilize that condition or make an appropriate transfer of the patient to a facility that can handle the condition. The obligation to screen and stabilize emergency medical conditions exists regardless of a patient’s ability to pay for treatment. There are severe penalties under EMTALA if a hospital fails to screen or appropriately stabilize or transfer a patient or if the hospital delays appropriate treatment in order to first inquire about the patient’s ability to pay. Penalties for violations of EMTALA include civil monetary penalties and exclusion from participation in the Medicare program. In addition, an injured patient, the patient’s family or a medical facility that suffers a financial loss as a direct result of another hospital’s violation of the law can bring a civil suit against the hospital.

            On September 9, 2003, CMS published a final rule, which became effective November 10, 2003, clarifying a hospital’s duties under EMTALA. In the final rule, CMS clarified when a patient is considered to be on a hospital’s property for purposes of treating the person pursuant to EMTALA. CMS’ rules did not specify “on-call” physician requirements for an emergency department, but provided a subjective standard stating that “on-call” hospital schedules should meet the hospital’s and community’s needs. CMS also did not directly address whether EMTALA applies to direct admissions, individuals who come to a hospital pursuant to a physician’s orders for a routine procedure, individuals who present themselves at a hospital’s psychiatric department or delivery/labor department and whether screening requirements apply to patients transferred from other facilities. Although we believe that our inpatient behavioral health care facilities comply with EMTALA, we cannot predict if CMS will implement new requirements in the future and whether we will comply with any new requirements.

The Federal False Claims Act

            The federal False Claims Act prohibits providers from knowingly submitting false claims for payment to the federal government. This law has been used not only by the federal government, but also by individuals who bring an action on behalf of the government under the law’s “qui tam” or “whistleblower” provisions. When a private party brings a qui tam action under the federal False Claims Act, the defendant will generally not be aware of the lawsuit until the government makes a determination whether it will intervene and take a lead in the litigation.

            Civil liability under the federal False Claims Act can be up to three times the actual damages sustained by the government plus civil penalties for each separate false claim. There are many potential bases for liability under the federal False Claims Act, including claims submitted pursuant to a referral found to violate the Anti-kickback Statute. Although liability under the federal False Claims Act arises when an entity knowingly submits a false claim for reimbursement to the federal government, the federal False Claims Act defines the term “knowingly” broadly. Although simple negligence will not give rise to liability under the federal False Claims Act, submitting a claim with reckless disregard to its truth or falsity can constitute “knowingly” submitting a false claim. From time to time, companies in the health care industry, including us, may be subject to actions under the federal False Claims Act.

HIPAA Transaction, Privacy and Security Requirements

            There are currently numerous laws at the state and federal levels addressing patient privacy concerns. Federal regulations issued pursuant to HIPAA contain, among other measures, provisions that require many organizations, including our inpatient facilities, to implement very significant and potentially expensive new computer systems, employee training programs and business procedures. The federal regulations are intended to encourage electronic commerce in the health care industry.

            On August 17, 2000, HHS finalized regulations requiring our inpatient facilities to use standard data formats and code sets established by the rule when electronically transmitting information in connection with several transactions, including health claims and equivalent encounter information, health care payment and remittance advice and health claim status. On February 20, 2003, HHS issued final modifications to these regulations. Compliance with these regulations was required on October 16, 2003. We have implemented or upgraded computer systems, as appropriate, at our inpatient facilities and at our corporate headquarters to comply with the new transaction and code set regulations and have tested these systems with several of our payers.

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            HIPAA requires HHS to issue regulations establishing standard unique health identifiers for individuals, employers, health plans and health care providers to be used in connection with standard electronic transactions. On May 31, 2002, HHS issued a final rule that calls for using the Employer Identification Number (the taxpayer identifying number for employers that is assigned by the Internal Revenue Service) as the standard unique health identifier for employers. Most health care organizations, including our inpatient facilities, must comply with this final rule by July 30, 2004. Health plans, health care clearinghouses and providers would use this identifier, among other uses, in connection with the standard electronic transactions standards.

            On January 23, 2004, HHS published a final rule that adopted the National Provider Identifier (“NPI”) as the standard unique health identifier for health care providers. When the NPI is implemented, health care providers, including our inpatient facilities, will use only the NPI to identify themselves in connection with electronic transactions. Legacy numbers, such as Medicaid numbers, CHAMPUS numbers, and Blue Cross-Blue Shield numbers, will not be permitted. Health care providers will no longer have to keep track of multiple numbers to identify themselves in the standard electronic transactions with one or more health plans. The NPI will be a 10-digit all numeric number that will be assigned to eligible health care providers, including our inpatient facilities, by the National Provider System (“NPS”), an independent government contractor. Under the final rule, all health care providers may begin applying for NPIs on May 23, 2005 with the NPS. All health care providers, including our inpatient facilities, must obtain and start using NPIs in connection with the standard electronic transactions no later than May 23, 2007.

            HHS has not yet issued proposed rules that establish the standard for unique health identifiers for health plans or individuals. Once these regulations are issued in final form, we expect to have about two years to become fully compliant.

            On February 20, 2003, HHS finalized a rule that establishes, in part, standards to protect the confidentiality, availability and integrity of health information by health plans, health care clearinghouses and health care providers that receive, store, maintain or transmit health and related financial information in electronic form, regardless of format. These security standards require our inpatient facilities to establish and maintain reasonable and appropriate administrative, technical and physical safeguards to ensure the integrity, confidentiality and the availability of electronic health and related financial information. The security standards were designed to protect electronic information against reasonably anticipated threats or hazards to the security or integrity of the information and to protect the information against unauthorized use or disclosure. Although the security standards do not reference or advocate a specific technology, and covered health care providers, plans and clearinghouses have the flexibility to choose their own technical solutions, we expect that the security standards will require our inpatient facilities to implement significant new systems, business procedures and training programs. Our inpatient facilities must comply with these security regulations by April 21, 2005.

            On December 28, 2000, HHS published a final rule establishing standards for the privacy of individually identifiable health information. The final rule establishing the privacy standards became effective on April 14, 2001, with compliance required by April 14, 2003. On August 14, 2002, HHS published final revisions to the privacy rule. The final revisions did not alter the compliance date of April 14, 2003 for the majority of the requirements in the privacy regulations. These privacy standards apply to all health plans, all health care clearinghouses and health care providers that transmit health information in an electronic form in connection with the standard transactions. Our inpatient facilities are covered entities under the final rule. The privacy standards apply to individually identifiable information held or disclosed by a covered entity in any form, whether communicated electronically, on paper or orally. These standards impose extensive new administrative requirements on our inpatient facilities. They require our compliance with rules governing the use and disclosure of this health information. They create new rights for patients in their health information, such as the right to amend their health information, and they require our inpatient facilities to impose these rules, by contract, on any business associate to whom they disclose such information in order to perform functions on their behalf. In addition, our inpatient facilities will continue to remain subject to any state laws that are more restrictive than the privacy regulations issued under HIPAA. These state laws vary by state and could impose additional penalties.

            A violation of these regulations could result in civil money penalties of $100 per incident, up to a maximum of $25,000 per person per year per standard. HIPAA also provides for criminal penalties of up to $50,000

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and one year in prison for knowingly and improperly obtaining or disclosing protected health information, up to $100,000 and five years in prison for obtaining protected health information under false pretenses, and up to $250,000 and ten years in prison for obtaining or disclosing protected health information with the intent to sell, transfer or use such information for commercial advantage, personal gain or malicious harm. Since there is no history of enforcement efforts by the federal government at this time, it is not possible to ascertain the likelihood of enforcement efforts in connection with the HIPAA regulations or the potential for fines and penalties which may result from the violation of the regulations.

            Compliance with these regulations has and will continue to require significant commitment and action by us and our inpatient facilities. We have appointed members of our management team to direct our compliance with these standards. Implementation of these regulations has and will continue to require our inpatient facilities and us to engage in extensive preparation and make significant expenditures. At this time we have appointed a privacy officer at each inpatient facility, prepared privacy policies, trained our workforce on these policies and entered into business associate agreements with the appropriate vendors. Because some of the regulations are proposed regulations, we cannot predict the total financial impact of the regulations on our operations.

     Certificates of Need (“CON”)

            The construction of new health care facilities, the acquisition or expansion of existing facilities, the transfer or change of ownership and the addition of new beds, services or equipment may be subject to state laws that require prior approval by state regulatory agencies. These CON laws generally require that a state agency determine the public need for construction or acquisition of facilities or the addition of new services. Failure to obtain necessary state approval can result in the inability to expand facilities, add services, complete an acquisition or change ownership. Violations of these state laws may result in the imposition of civil sanctions or revocation of a facility’s license.

     Corporate Practice of Medicine and Fee Splitting

            Some states have laws that prohibit unlicensed persons or business entities, including corporations or business organizations that own hospitals, from employing physicians. Some states also have adopted laws that prohibit direct and indirect payments or fee-splitting arrangements between physicians and unlicensed persons or business entities. Possible sanctions for violation of these restrictions include loss of a physician’s license, civil and criminal penalties and rescission of business arrangements. These laws vary from state to state, are often vague and have seldom been interpreted by the courts or regulatory agencies. Although we attempt to structure our arrangements with health care providers to comply with the relevant state laws and the few available regulatory interpretations, there can be no assurance that government officials charged with responsibility for enforcing these laws will not assert that we, or certain transactions in which we are involved, are in violation of such laws, or that such laws ultimately will be interpreted by the courts in a manner consistent with our interpretation.

     Health Care Industry Investigations

            Significant media and public attention has focused in recent years on the hospital industry. Because the law in this area is complex and constantly evolving, ongoing or future governmental investigations or litigation may result in interpretations that are inconsistent with industry practices, including our practices. It is possible that governmental entities could initiate investigations or litigation in the future at inpatient facilities owned or managed by us and that such matters could result in significant penalties as well as adverse publicity. It is also possible that our executives and other management personnel could be included in governmental investigations or litigation or named as defendants in private litigation.

     Insurance

            As is typical in the health care industry, we are subject to claims and legal actions by patients in the ordinary course of business. To cover these claims, we maintain professional malpractice liability insurance and general liability insurance in amounts we believe to be sufficient for our operations, although it is possible that some

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claims may exceed the scope of the coverage in effect. At various times in the past, the cost of malpractice insurance and other liability insurance has risen significantly. Therefore, there can be no assurance that such insurance will continue to be available at reasonable prices which would allow us to maintain adequate levels of coverage.

     Conversion Legislation

            Many states have adopted legislation regarding the sale or other disposition of hospitals operated by not-for-profit entities. In other states that do not have such legislation, the attorneys general have demonstrated an interest in these transactions under their general obligations to protect charitable assets. These legislative and administrative efforts primarily focus on the appropriate valuation of the assets divested and the use of the proceeds of the sale by the not-for-profit seller. These reviews and, in some instances, approval processes can add additional time to the closing of a not-for-profit hospital acquisition. Future actions by state legislators or attorneys general may seriously delay or even prevent our ability to acquire certain hospitals.

     Regulatory Compliance Program

            We are committed to ethical business practices and to operating in accordance with all applicable laws and regulations. Our Compliance Program was established to ensure that all employees have a solid framework for business, legal, ethical, and employment practices. Our Compliance Program establishes mechanisms to aid in the identification and correction of any actual or perceived violations of any of our policies or procedures or any other applicable rules and regulations. We have an appointed Chief Compliance Officer as well as compliance coordinators at each inpatient facility. The Chief Compliance Officer heads our Compliance Committee which consists of senior management personnel and a member of our board of directors. Employee training is a key component of the Compliance Program. All employees receive training during orientation and annually thereafter.

Insurance

            Due to our acquisition of Ramsay, we have two distinct insurance programs that cover our inpatient facilities. For our inpatient facilities that were not acquired from Ramsay, we have obtained professional and general liability insurance for claims in excess of $3 million with an insured limit of $10 million. In December 2003, we increased this insured limit to $20 million. For the inpatient facilities acquired from Ramsay, we have obtained professional and general liability insurance for claims in excess of $500,000 with an insured limit of $25 million. These policies include umbrella coverage of $20 million and $25 million, respectively. The self-insured reserves for professional and general liability risks are calculated based on historical claims, demographic factors, industry trends, severity factors, and other actuarial assumptions calculated by an independent third party. The self-insured reserve is discounted to its present value using a 5% discount rate. This estimated accrual for professional and general liabilities could be significantly affected should current and future occurrences differ from historical claim trends and expectations. We have established a captive insurance company to manage this additional self-insured retention for our inpatient facilities not acquired from Ramsay. We plan to merge these plans in the near future. While claims are monitored closely when estimating professional and general liability accruals, the complexity of the claims and wide range of potential outcomes often hampers timely adjustments to the assumptions used in these estimates. We believe that our insurance coverage conforms to industry standards. There are no assurances, however, that our insurance will cover all claims (e.g., claims for punitive damages) or that claims in excess of our insurance coverage will not arise. A successful lawsuit against us that is not covered by, or is in excess of, our insurance coverage may have a material adverse effect on our business, financial condition and results of operations.

Employees

            As of December 31, 2003, we employed approximately 6,780 employees, of whom approximately 4,810 are full-time employees. Approximately 4,940 employees staff our owned and leased inpatient behavioral health care facilities, approximately 1,780 employees staff our inpatient management contracts and approximately 60 are in corporate management including finance, accounting, development, utilization review, training and education, information systems, member services, and human resources. None of our employees is subject to a collective bargaining agreement and we believe that our employee relations are good.

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Available Information

            We make available free of charge through our website, which you can find at www.psysolutions.com, our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to these reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission.

Item 2. Properties.

     At December 31, 2003, our inpatient behavioral health care facilities division operated 24 owned or leased inpatient behavioral health care facilities with approximately 3,100 licensed beds in 14 states. The following table sets forth the name, location, number of licensed beds and the acquisition date for each of our owned and leased inpatient behavioral health care facilities.

            In addition, our principal executive offices are located in approximately 7,745 square feet of leased space in Franklin, Tennessee. We do not anticipate that we will experience any difficulty in renewing our lease upon its

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expiration in December 2006, or obtaining different space on comparable terms if such lease is not renewed. We believe our executive offices and our hospital property and equipment are generally well maintained, in good operating condition and adequate for our present needs.

Item 3. Legal Proceedings.

            We are subject to various claims and legal actions that arise in the ordinary course of our business. In the opinion of management, Psychiatric Solutions is not currently a party to any proceeding that would have a material adverse effect on its financial condition or results of operations.

Item 4. Submission of Matters to a Vote of Security Holders.

            None.

PART II

Item 5. Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

            Our common stock has traded on the Nasdaq National Market under the symbol “PSYS” since August 6, 2002. Prior to August 6, 2002, our common stock was traded on the Nasdaq National Market under the symbol “PMRP.”

            The table below sets forth, for the calendar quarters indicated, the high and low sales prices per share as reported on the Nasdaq National Market for our common stock and, prior to August 6, 2002, for PMR Corporation’s common stock. The stock prices have been adjusted to reflect a 1-for-3 reverse stock split effected on August 5, 2002.

            At the close of business on March 17, 2004, there were approximately 105 holders of record of our common stock.

            On May 6, 2002, PMR’s board of directors declared a special cash dividend of $5.10 per share of common stock payable on May 24, 2002 to the stockholders of record as of the close of business on May 17, 2002. The total amount of the dividend was approximately $12.3 million. We currently intend to retain future earnings for use in the expansion and operation of our business. Our Credit Agreement with Bank of America, N.A. prohibits us from paying dividends on our common stock. Also, the Indenture governing our 10 5/8% senior subordinated notes provides certain financial conditions that must be met in order for us to pay dividends. Subject to the terms of applicable contracts, the

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payment of any future cash dividends will be determined by our Board of Directors in light of conditions then existing, including our earnings, financial condition and capital requirements, restrictions in financing agreements, business opportunities and conditions, and other factors.

            On April 1, 2003, we sold 2,272,727 shares of our series A convertible preferred stock for $12.5 million to Oak Investment Partners X, Limited Partnership, Oak X Affiliates Fund, Limited Partnership, Salix Ventures II, L.P., Salix Affiliates II, L.P. and The 1818 Mezzanine Fund II, L.P. These investors purchased an additional 2,272,727 shares of our series A convertible preferred stock for $12.5 million on June 19, 2003. Our shares of series A convertible preferred stock were not registered under the Securities Act of 1933, as amended. We issued these shares in reliance upon the exception from registration provided in Section 4(2) of the Securities Act and the rules and regulations promulgated thereunder. Each of these sales was made solely to accredited investors without the use of an underwriter. The holders of the series A convertible preferred stock have the right, at any time, at such holder’s option, to convert any or all outstanding shares (and fractional shares) of series A convertible preferred stock, in whole or in part, into shares of our common stock. In addition, the series A convertible preferred stock will automatically be converted into shares of our common stock if at any time after October 1, 2004, our common stock price on the Nasdaq National Market (computed on a volume-weighted average basis) exceeds $15.00 per share (as adjusted) for thirty consecutive trading days. Each share of series A convertible preferred stock is convertible into one share of our common stock. Holders of our series A convertible preferred stock are entitled to receive pay-in-kind dividends, compounded quarterly, equal to 5% per share of the original share price through March 31, 2005. Thereafter, pay-in-kind dividends will compound quarterly at 7% per share of the original share price.

Item 6. Selected Financial Data.

            The selected financial data presented below for the years ended December 31, 2003, 2002 and 2001, and at December 31, 2003 and December 31, 2002, are derived from our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K. The selected financial data for the years ended December 31, 2000 and 1999, and at December 31, 2001, 2000 and 1999, are derived from our audited consolidated financial statements not included herein. The selected financial data presented below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and with our consolidated financial statements and notes thereto included elsewhere in this Annual Report on Form 10-K.

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(2)     Refer to the notes to the consolidated financial statements regarding our adoption of Statement of Financial Accounting Standards No. 145, Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections (“SFAS 145”). As a result of our adoption of SFAS 145, we have reclassified certain losses on refinancing of long-term debt previously reported as an extraordinary item to a component of income from continuing operations.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

     The following discussion and analysis should be read in conjunction with the selected financial data and the accompanying consolidated financial statements and related notes thereto included in this Annual Report on Form 10-K.

Overview

     Psychiatric Solutions completed a number of significant transactions in 2003. Through acquisitions, we increased our inpatient facility operations nearly fivefold to 24 inpatient facilities and 3,128 licensed beds at December 31, 2003 from five inpatient facilities and 699 licensed beds at December 31, 2002. We also raised capital through offerings of our common stock, series A convertible preferred stock and debt securities, as well as borrowings from our credit facility. As a result, we ended 2003 with nearly $45 million in cash, $67 million in working capital and $150 million in fixed assets, all significant increases from our 2002 levels. We believe these developments position us as a leading provider of inpatient behavioral health care services in the United States. We also believe that our singular focus on the provision of behavioral health care services allows us to operate more efficiently and provide higher quality care than our competitors. Our business is characterized by diversified sources of revenue, stable cash flows and low capital expenditure requirements.

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     Our business strategy is to acquire inpatient behavioral health care facilities and improve operating results within new and existing inpatient facilities and our other inpatient behavioral health care operations. We completed our first significant acquisition in 2000 when we acquired Sunrise Behavioral Health, Ltd. and its inpatient behavioral health care management contracts. We continued implementing our acquisition strategy in 2001 with the acquisition of four inpatient behavioral health care facilities. In 2002, we acquired one inpatient behavioral health care facility and merged with PMR, a public company and operator of inpatient behavioral health care management contracts. 2003 marked our largest acquisitions to date with the purchase of six inpatient behavioral health care facilities from The Brown Schools and the acquisition of Ramsay, an operator of 11 owned or leased inpatient behavioral health care facilities and ten contracts to manage inpatient behavioral health care facilities for certain state governmental agencies.

     We strive to improve the operating results of new and existing inpatient behavioral health care operations by providing the highest quality service, expanding referral networks and marketing initiatives and meeting increased demand for our services by expanding our services and developing new services. We also improve operating results by optimizing staffing ratios, controlling contract labor costs and reducing supply costs through group purchasing. During 2003, we increased our revenue from owned and leased inpatient facilities by approximately 9% as compared to our 2002 revenue from owned and leased inpatient facilities through same-facility growth. Same-facility growth also produced gains in owned and leased inpatient facility admissions and patient days of approximately 4% and 7%, respectively, in 2003 as compared to 2002. Same-facility growth refers to the comparison of the five inpatient facilities owned during 2002 with the comparable period in 2003. We owned four inpatient facilities throughout 2002 and acquired a fifth inpatient facility on July 1, 2002.

Recent Acquisitions

     On March 1, 2004, we acquired two inpatient psychiatric facilities from Brentwood Behavioral Health for $28 million cash with an earn-out of up to $5 million contingent upon future financial results. The facilities, which have an aggregate of 311 licensed beds, are located in Shreveport, Louisiana and Jackson, Mississippi.

     On November 1, 2003, we acquired the 109-bed Alliance Health Center located in Meridian, Mississippi. Alliance Health Center is a licensed acute care hospital that provides psychiatric care for children, adolescents and adults. In addition, a 60-bed residential treatment center is under construction and is scheduled to open during the second quarter of 2004.

     On June 30, 2003, we consummated the acquisition of Ramsay, a public company that traded on the Nasdaq SmallCap Market under the symbol “RYOU,” for approximately $81.3 million, consisting of $56.2 million in cash, or $5.00 per share, $22.3 million in net assumed debt that was repaid in connection with the acquisition and $2.8 million in fees and expenses. We financed the acquisition of Ramsay with proceeds from the issuance of $150 million in 10 5/8% senior subordinated notes and an issuance of $12.5 million of our series A convertible preferred stock. The 11 owned or leased inpatient behavioral health care facilities we acquired from Ramsay, which have an aggregate of 1,292 beds, are located primarily in the Southeastern region of the United States with locations also in Michigan, Missouri and Utah. In the acquisition, we also assumed 10 contracts to manage inpatient behavioral health care facilities for government agencies in Florida, Georgia and Puerto Rico.

     In April 2003, we consummated the acquisition of six inpatient behavioral health care facilities from The Brown Schools for $63.0 million in cash. The six inpatient facilities, which have an aggregate of 895 licensed beds, are located in Austin, San Antonio and San Marcos, Texas; Charlottesville, Virginia; Colorado Springs, Colorado; and Tulsa, Oklahoma. The Brown Schools offer a full continuum of care for troubled adolescents and adults. We financed the acquisition of The Brown Schools with proceeds from the private placement of $12.5 million of our series A convertible preferred stock and an increase in funding under our credit facility.

     Acquiring inpatient behavioral health care facilities is a key part of our business strategy. Because we have grown through acquisitions accounted for as purchases, it is difficult to make meaningful comparisons between our financial statements for the fiscal periods presented.

Sources of Revenue

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Patient Service Revenue

     Patient service revenue is generated by our inpatient facilities as a result of services provided to patients within the inpatient behavioral health care facility setting. Patient service revenue is reported on an accrual basis in the period in which services are rendered, at established rates, regardless of whether collection in full is expected. Patient service revenue includes amounts estimated by management to be reimbursable by Medicare and Medicaid under provisions of cost or prospective reimbursement formulas in effect. Amounts received are generally less than the established billing rates of the inpatient facilities and the differences are reported as deductions from patient service revenue at the time the service is rendered. For the year ended December 31, 2003, patient service revenue comprised approximately 76.1% of our total revenue.

Management Contract Revenue

     Management contract revenue is earned by our inpatient management contract division. The inpatient management contract division receives contractually determined management fees from hospitals and clinics for providing psychiatric unit management and development services as well as management fees for managing inpatient behavioral health care facilities for government agencies. For the year ended December 31, 2003, management contract revenue comprised approximately 23.9% of our total revenue.

Results of Operations

     The following table illustrates our consolidated results of operations for the years ended December 31, 2003, 2002 and 2001 (dollars in thousands).

Year Ended December 31, 2003 Compared To Year Ended December 31, 2002

     Revenue. Revenue from operations was $293.7 million for the year ended December 31, 2003 compared to $113.9 million for the year ended December 31, 2002, an increase of $179.8 million or 157.9%. Revenue from owned and leased inpatient facilities accounted for $223.3 million of the 2003 results compared to $81.9 million of the 2002 results, an increase of $141.4 million or 172.5%. The increase in revenues from owned and leased inpatient facilities relates primarily to revenues of $14.9 million during the first six months of 2003 for Riveredge Hospital acquired in July 2002, $57.3 million during 2003 for The Brown Schools acquired in April 2003 and $59.6 million for the owned and leased inpatient facilities acquired from Ramsay on June 30, 2003. The remainder of the increase

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in revenues from owned and leased inpatient facilities is primarily attributable to growth in admissions and patient days of 4.1% and 7.0%, respectively, on a same-facility basis. Revenue from inpatient management contracts accounted for $70.3 million of the 2003 results compared to $32.0 million of the 2002 results, an increase of $38.3 million or 119.7%. The increase in revenues from inpatient management contracts relates to revenues of $13.6 million from inpatient management contracts acquired from PMR in August 2002 and $22.6 million for Ramsay’s inpatient management contracts acquired in June 2003. The remainder of the increase in revenues from inpatient management contracts relates to growth of approximately $3.4 million in our contract to provide case management services in and around Nashville, Tennessee. This growth was offset by a reduction in the number of inpatient unit management contracts from 48 at December 31, 2002 to 42 at December 31, 2003, impacting revenues by approximately $1.2 million.

     Salaries, wage, and employee benefits. Salaries, wages and employee benefits expense was $153.5 million in 2003, or 52.3% of revenue for the year ended December 31, 2003, compared to $62.3 million in 2002, or 54.7% of revenue for the year ended December 31, 2002. Salaries, wages and employee benefits expense from owned and leased inpatient facilities was $122.5 million in 2003, or 54.9% of 2003 revenue from owned and leased inpatient facilities, compared to $47.0 million in 2002, or 57.4% of 2002 revenue from owned and leased inpatient facilities. Same-facility salaries, wages and employee benefits expense from owned and leased inpatient facilities was $48.2 million in 2003, or 53.9% of 2003 same-facility revenue from owned and leased inpatient facilities. This decrease in salaries, wages and employee benefits expense as a percentage of revenue from owned and leased inpatient facilities relates to efforts within our owned and leased inpatient facilities to maintain staffing levels on higher volumes. Salaries, wages and employee benefits expense from inpatient management contracts was $27.5 million in 2003, or 39.1% of 2003 revenue from inpatient management contracts, compared to $13.2 million in 2002, or 41.2% of 2002 revenue from inpatient management contracts. Same-facility salaries, wages and employee benefits expense from inpatient management contracts was $12.0 million in 2003, or 35.2% of 2003 same-facility revenue from inpatient management contracts. This decrease in same-facility salaries, wages and employee benefits expense as a percentage of same-facility revenue from inpatient management contracts relates to our acquisition from PMR of a contract to provide case management services in and around Nashville, Tennessee. We incur very little salaries, wages and employee benefits to provide these services because almost all costs to provide these services are recorded in other operating expenses because the actual services provided are subcontracted. Salaries, wages and employee benefits expense for our corporate office was $2.8 million for 2003 compared to $2.1 million for 2002 as the result of the addition of staff necessary to manage the inpatient facilities and inpatient management contracts acquired during 2002 and 2003.

     Professional fees. Professional fees were $33.3 million in 2003, or 11.3% of revenue for the year ended December 31, 2003, compared to $14.4 million in 2002, or 12.6% of revenue for the year ended December 31, 2002. Professional fees from owned and leased inpatient facilities were $26.3 million in 2003, or 11.8% of 2003 revenue from owned and leased inpatient facilities, compared to $10.3 million in 2002, or 12.6% of 2002 revenue from owned and leased inpatient facilities. Same-facility professional fees from owned and leased inpatient facilities were $10.8 million in 2003, or 12.1% of 2003 same-facility revenue from owned and leased inpatient facilities. This decrease in professional fees from same-facility owned and leased inpatient facilities as a percentage of revenue from same-facility owned and leased inpatient facilities was the result of efforts within our owned and leased inpatient facilities to reduce our reliance on contract labor. Professional fees from inpatient management contracts were $5.2 million in 2003, or 7.3% of 2003 revenue from inpatient management contracts, compared to $3.5 million in 2002, or 11.1% of 2002 revenue from inpatient management contracts. Same-facility professional fees from inpatient management contracts were $3.6 million in 2003, or 10.6% of 2003 same-facility revenue from inpatient management contracts. Professional fees for our corporate office were approximately $1.5 million in 2003 compared to approximately $500,000 in 2002. The increase in professional fees in our corporate office relates to accounting, legal and other services required to meet the needs of a public company and achieving our acquisition strategy.

     Supplies. Supplies expense was $17.1 million in 2003, or 5.8% of revenue for the year ended December 31, 2003, compared to $5.3 million in 2002, or 4.7% of revenue for the year ended December 31, 2002. Supplies expense from owned and leased inpatient facilities was $15.3 million in 2003, or 6.8% of 2003 revenue from owned and leased inpatient facilities, compared to $5.3 million in 2002, or 6.5% of 2002 revenue from owned and leased inpatient facilities. Same-facility supplies expense from owned and leased inpatient facilities was $5.9 million in 2003, or 6.6% of 2003 same-facility revenue from owned and leased inpatient facilities. Supplies expense from inpatient management contracts was $1.7 million in 2003, or 2.5% of 2003 revenue from inpatient management

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contracts, compared to $40,000 in 2002, or less than 1% of 2002 revenue from inpatient management contracts. Supplies expense at owned and leased inpatient facilities has historically comprised the majority of our supplies expense as a whole; however, our inpatient management contracts segment began to utilize supplies to a larger extent due to the assumption of ten inpatient management contracts from Ramsay. Supplies expense for our corporate office consists of office supplies and are negligible to supplies expense overall.

     Provision for bad debts. The provision for bad debts was $6.3 million in 2003, or 2.2% of revenue for the year ended December 31, 2003, compared to $3.7 million in 2002, or 3.2% of revenue for the year ended December 31, 2002. The provision for bad debts at owned and leased inpatient facilities was $6.7 million in 2003, or 3.0% of 2003 revenue from owned and leased inpatient facilities, compared to approximately $3.5 million in 2002, or 4.3% of 2002 revenue from owned and leased inpatient facilities. This reduction in provision for bad debts from owned and leased inpatient facilities as a percentage of owned and leased inpatient facility revenue was driven by the acquisition of inpatient facilities from The Brown Schools and Ramsay, which have fewer self-pay accounts. Historically, the provision for bad debts from inpatient management contracts has amounted to less than 1% of revenue from inpatient management contracts.

     Other operating expenses. Other operating expenses were approximately $48.7 million in 2003, or 16.6% of revenue for the year ended December 31, 2003, compared to $16.0 million in 2002, or 14.1% of revenue for the year ended December 31, 2002. Other operating expenses for owned and leased inpatient facilities were $21.7 million in 2003, or 9.7% of 2003 revenue from owned and leased inpatient facilities, compared to $6.6 million in 2002, or 8.1% of 2002 revenue from owned and leased inpatient facilities. Same-facility other operating expenses from owned and leased inpatient facilities were $7.9 million in 2003, or 8.8% of 2003 same-facility revenue from owned and leased inpatient facilities. This increase in other operating expenses for same-facility owned and leased inpatient facilities as a percentage of same-facility revenue from owned and leased inpatient facilities revenue relates primarily to increased insurance costs in 2003. Other operating expenses for inpatient management contracts were $24.9 million in 2003, or 35.5% of 2003 revenue from inpatient management contracts, compared to $7.9 million in 2002, or 24.8% of 2002 inpatient management contract revenue. Same-facility other operating expenses from inpatient management contracts was $11.1 million in 2003, or 32.5% of 2003 same-facility revenue from inpatient management contracts. This increase in other operating expenses for same-facility inpatient management contracts as a percentage of same-facility revenue from inpatient management contracts is attributable to growth in the contract to provide case management services in and around Nashville, Tennessee where actual services provided are subcontracted. Other operating expenses at our corporate office increased to $1.4 million in 2003 from approximately $1.3 million in 2002.

     Depreciation and amortization. Depreciation and amortization expense was $5.8 million for the year ended December 31, 2003 compared to $1.8 million for the year ended December 31, 2002, an increase of approximately $4.0 million or 222.2%. This increase in depreciation and amortization expense is the result of the acquisitions of Riveredge Hospital in July 2002, PMR in August 2002, The Brown Schools in April 2003 and Ramsay in June 2003.

     Interest expense. Interest expense was $14.8 million for the year ended December 31, 2003 compared to $5.6 million for the year ended December 31, 2002, an increase of $9.2 million or 164.3%. The increase in interest expense is primarily attributable to the increase in our long-term debt from approximately $43.8 million at December 31, 2002 to approximately $175.0 million at December 31, 2003 due to our 10 5/8% senior subordinated note offering, the expansion of our senior credit facility and the refinancing of our term loans from CapitalSource Finance LLC (“CapSource”) with mortgage loans insured by the U.S. Department of Housing and Urban Development (“HUD”). The proceeds from the 10 5/8% senior subordinated notes and the expanded credit facility were used to finance acquisitions in 2003.

     Other expenses. Other expenses totaled $5.3 million for the year ended December 31, 2003 compared to approximately $180,000 for the year ended December 31, 2002. Other expenses in 2003 consisted of $4.9 million in loss on the refinancing of our long-term debt, $960,000 in expense recorded to recognize the change in fair value of stock purchase “put” warrants (for additional information on these warrants, see “Liquidity and Capital Resources” below) and the release of $545,000 in reserves related to our stockholder notes. Other expenses in 2002 consisted of approximately $90,000 in loss on the refinancing of our long-term debt and approximately $90,000 to increase the reserve related to our stockholder notes.

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Year Ended December 31, 2002 Compared To Year Ended December 31, 2001

     Revenue. Revenue from continuing operations was $113.9 million for the year ended December 31, 2002 compared to $44.0 million for the year ended December 31, 2001, an increase of $69.9 million or 158.9%. Revenue from owned and leased inpatient facilities accounted for $81.9 million of the 2002 results compared to $16.0 million of the 2001 results, an increase of $65.9 million or 411.9%. The increase in revenues from owned and leased inpatient facilities relates primarily to revenues of $11.0 million and $15.0 million during the first eight months of 2002 for Cypress Creek Hospital and West Oaks Hospital, respectively, acquired in September 2001, $14.4 million during the first ten months of 2002 for Texas NeuroRehab Hospital acquired in November 2001, $10.8 million during the first eleven months of 2002 for Holly Hill Hospital acquired in December 2001 and $13.2 million during 2003 for Riveredge Hospital acquired in July 2002. Revenue from inpatient management contracts accounted for $32.0 million of the 2002 results compared to $28.0 million of the 2001 results, an increase of $4.0 million or 14.3%. The increase in revenues from our inpatient management contracts relates to the additional inpatient management contracts assumed in the merger with PMR.

     Salaries, wage, and employee benefits. Salaries, wages and employee benefits expense was $62.3 million in 2002, or 54.7% of revenue for the year ended December 31, 2002, compared to $26.2 million in 2001, or 59.6% of revenue for the year ended December 31, 2001. Salaries, wages and employee benefits expense from owned and leased inpatient facilities was $47.0 million in 2002, or 57.4% of 2002 revenue from owned and leased inpatient facilities, compared to $9.5 million in 2001, or 59.2% of 2001 revenue from owned and leased inpatient facilities. Same-facility salaries, wages and employee benefits expense from owned and leased inpatient facilities was $10.6 million in 2002, or 60.5% of same-facility revenue from owned and leased inpatient facilities. Salaries, wages and employee benefits expense from inpatient management contracts was $13.2 million in 2002, or 41.3% of 2002 revenue from inpatient management contracts, compared to $15.5 million in 2001, or 55.3% of 2001 revenue from inpatient management contracts. Same-facility salaries, wages and employee benefits expense from inpatient management contracts was $12.9 million in 2002, or 52.7% of same-facility 2002 revenue from inpatient management contracts. Salaries, wages and employee benefits expense for our corporate office was $2.1 million for 2002 compared to $1.2 million for 2001 as the result of the addition of staff necessary to manage the inpatient facilities acquired during the latter part of 2001 and July 2002.

     Professional fees. Professional fees were $14.4 million in 2002, or 12.6% of revenue for the year ended December 31, 2002, compared to $7.0 million in 2001, or 16.0% of revenue for the year ended December 31, 2001. Professional fees from owned and leased inpatient facilities were $10.3 million in 2002, or 12.5% of 2002 revenue from owned and leased inpatient facilities, compared to $2.6 million in 2001, or 16.1% of 2001 revenue from owned and leased inpatient facilities. Same-facility professional fees from owned and leased inpatient facilities were $2.2 million in 2002, or 12.6% of same-facility revenue from owned and leased inpatient facilities. Professional fees from inpatient management contracts were $3.5 million in 2002, or 11.1% of 2002 revenue from inpatient management contracts, compared to $4.1 million in 2001, or 14.7% of 2001 revenue from inpatient management contracts. Same-facility professional fees from inpatient management contracts were $3.5 million in 2002, or 14.2% of same-facility 2002 revenue from inpatient management contracts. Professional fees for our corporate office were approximately $500,000 in 2002 compared to approximately $300,000 in 2001. The increase in professional fees at our corporate office relates to accounting, legal, and other services required as a public company.

     Supplies. Supplies expense was $5.3 million in 2002, or 4.7% of revenue for the year ended December 31, 2002, compared to $1.2 million in 2001, or 2.8% of revenue for the year ended December 31, 2001. Supplies expense at owned and leased inpatient facilities comprise almost the entire amount of our consolidated supplies expense. Supplies necessary at our owned and leased inpatient facilities include medical, pharmaceutical and office supplies. The increase in supplies expense as a percentage of revenue is due to our acquisition of four inpatient facilities in the last four months of 2001 and Riveredge Hospital in July 2002. Supplies expense for inpatient management contracts and our corporate office consists of office supplies and is negligible to our supplies expense overall.

     Provision for bad debts. The provision for bad debts was $3.7 million in 2002, or 3.2% of revenue for the year ended December 31, 2002, compared to $662,000 in 2001, or 1.5% of revenue for the year ended December 31, 2001. The provision for bad debts at owned and leased inpatient facilities was $3.5 million in 2002, or 4.3% of 2002 revenue from owned and leased inpatient facilities, compared to approximately $400,000 in 2001, or 2.4% of 2001

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revenue from owned and leased inpatient facilities. This increase in provision for bad debts at owned and leased inpatient facilities as a percentage of owned and leased inpatient facility revenue relates to changes in our payer mix and the impact of our acquisitions.

     Other operating expenses. Other operating expenses were approximately $16.0 million in 2002, or 14.1% of revenue for the year ended December 31, 2002, compared to $3.0 million in 2001, or 6.9% of revenue for the year ended December 31, 2001. Other operating expenses for owned and leased inpatient facilities were $6.6 million in 2002, or 8.0% of 2002 revenue from owned and leased inpatient facilities, compared to $1.1 million in 2001, or 6.9% of 2001 revenue from owned and leased inpatient facilities. Same-facility other operating expenses from owned and leased inpatient facilities were $1.3 million in 2002, or 7.3% of same-facility revenue from owned and leased inpatient facilities. This increase in same-facility other operating expenses for owned and leased inpatient facilities as a percentage of same-facility revenue from owned and leased inpatient facilities relates primarily to increased insurance costs in 2002. Other operating expenses for inpatient management contracts were $7.9 million in 2002, or 24.9% of 2002 revenue from inpatient management contacts, compared to $1.6 million in 2001, or 5.6% of 2001 revenue from inpatient management contracts. Same-facility other operating expenses from inpatient management contracts were $1.3 million in 2002, or 5.3% of same-facility 2002 revenue from inpatient management contracts. This overall increase in other operating expenses for inpatient management contracts as a percentage of revenue from inpatient management contracts is attributable to our assumption from PMR of a contract to provide case management services in and around Nashville, Tennessee where actual services provided are subcontracted and all related expenses are recorded in other operating expenses. Other operating expenses at our corporate office increased to $1.3 million in 2002 from approximately $400,000 in 2001 primarily due to increased insurance costs in 2002.

     Depreciation and amortization. Depreciation and amortization expense was $1.8 million for the year ended December 31, 2002 compared to $945,000 for the year ended December 31, 2001, an increase of approximately $800,000 or 87.3%. This increase in depreciation and amortization expense is the result of full year operations in 2002 for the inpatient facilities acquired in the last four months of 2001 as well as our acquisition of Riveredge Hospital in July 2002.

     Interest expense. Interest expense was $5.6 million for the year ended December 31, 2002 compared to $2.7 million for the year ended December 31, 2001, an increase of $2.9 million or 107.4%. The increase in interest expense is due to borrowings under our senior credit facility as well as subordinated debt obtained to fund acquisitions in 2001 and 2002.

Liquidity and Capital Resources

     As of December 31, 2003, we had working capital of $66.9 million, including cash and cash equivalents of $44.8 million, compared to working capital of $2.4 million at December 31, 2002. We did not maintain a balance under our revolving line of credit at December 31, 2003 whereas we had a balance of $5.4 million on our revolving line of credit at December 31, 2002. The increase in working capital is primarily due to cash raised in our public equity offering of approximately $48.9 million as well as cash provided by operating activities of $15.5 million during the year ended December 31, 2003.

     Cash provided by operating activities was $15.5 million for the year ended December 31, 2003 compared to $8.9 million for the year ended December 31, 2002. The increase in cash flows from operating activities was primarily due to the cash generated from our acquisitions of the operations of Ramsay and the six inpatient facilities from The Brown Schools in 2003 and by the full year operations of PMR and Riveredge Hospital, which we acquired in 2002.

     Cash used in investing activities was $105.3 million for the year ended December 31, 2003 compared to cash provided by investing activities of $4.2 million for the year ended December 31, 2002. Cash used in investing activities for the year ended December 31, 2003 was primarily the result of $100.4 million cash paid for acquisitions, net of cash acquired. Cash used in the acquisition of The Brown Schools was approximately $13.4 million, of which $12.5 million came from our private placement of series A convertible preferred stock. The

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balance of The Brown Schools purchase of approximately $51.2 million was financed from our former credit facility with CapSource. Cash used in the acquisition of Ramsay, including the subsequent purchase for $3.6 million of real estate at our Macon facility, was $84.4 million, net of cash acquired of approximately $4 million. Cash used in the acquisition of Alliance Health Center was approximately $1.4 million, which paid for certain transaction costs. The $12.5 million purchase price for Alliance Health Center was financed from our former credit facility with CapSource. Cash used for other acquisitions, including Calvary Center, was approximately $1.2 million. In January 2004, we paid the balance of the purchase price for the Calvary Center of approximately $3.3 million after certain state licensure matters were resolved. The remainder of cash used in investing activities for the year ended December 31, 2003 included capital expenditures of approximately $5.8 million and purchases of investments of approximately $1.0 million offset by changes in other long-term assets of approximately $1.8 million. Capital expenditures are generally not for the expansion of capacity within our inpatient facilities and historically approximate 2% of our net revenues. During 2003, our capital expenditures included typical non-expansion capital expenditures, as well as expenditures to upgrade computer systems at some of our newly acquired facilities and certain expansion projects. These expansion projects included the construction of a 60-bed RTC at Alliance Health Center. Cash provided by investing activities for the year ended December 31, 2002 was the result of cash acquired of approximately $6.0 million in our acquisition of PMR offset by cash used in capital purchases of $1.5 million and other assets of $612,000.

     Cash provided by financing activities was $132.3 million for the year ended December 31, 2003. During 2003, we received cash from borrowings of approximately $62.0 million, net of refinancings and not including proceeds from borrowings that were paid directly to the sellers of our acquisitions. Also during 2003, we received $48.9 million and $24.5 million, net of issuance costs, from the secondary offering of our common stock and from our issuance of series A convertible preferred stock, respectively. These sources of cash from financing activities were offset by cash payments during 2003 of $2.0 million and $1.4 million for capitalized loan costs on new debt and early termination fees on debt that we refinanced, respectively. Finally, we received approximately $300,000 in cash from the exercise of stock options and warrants during 2003. Cash used in financing activities of $12.0 million for the year ended December 31, 2002 consisted primarily of payments on long-term debt, not including proceeds from borrowings that were paid directly to the sellers of our acquisitions.

     On January 26, 2004, we entered into an interest rate swap agreement to manage our exposure to fluctuations in interest rates. The swap agreement effectively converts $20 million of fixed-rate long-term debt to a LIBOR indexed variable rate instrument plus an agreed upon interest rate spread.

     On January 6, 2004, we entered into a revolving credit facility with Bank of America, N.A. of up to $50 million. The revolving credit facility has a three-year term and is secured by all real property owned by us or our subsidiaries that has a value in excess of $2.5 million, the stock of all of our operating subsidiaries and substantially all of the personal property owned by us or our subsidiaries.

     On November 5, 2003, we borrowed approximately $12.1 million under a mortgage loan agreement insured by HUD, secured by real estate located at Riveredge Hospital near Chicago, Illinois. Interest accrues on the HUD loan at 5.65% and principal and interest are payable in 420 monthly installments through December 2038. We used the proceeds from the loan to repay approximately $11.2 million of our term debt under our former amended and restated senior secured credit facility, pay certain financing costs, and fund required escrow amounts for future improvements to the property.

     On August 28, 2003, we borrowed approximately $6.8 million under a mortgage loan agreement insured by HUD, secured by real estate located at West Oaks Hospital in Houston, Texas. Interest accrues on the HUD loan at 5.85% and principal and interest are payable in 420 monthly installments through September 2038. We used the proceeds from the loan to repay approximately $5.8 million of our term debt under our former amended and restated senior secured credit facility, pay certain financing costs, and fund required escrow amounts for future improvements to the property.

     On June 30, 2003, we issued $150 million in 10 5/8% senior subordinated notes, which are fully and unconditionally guaranteed on a senior subordinated basis by substantially all of our existing operating subsidiaries. Proceeds from the issuance of the senior subordinated notes and the private placement of $12.5 million in series A convertible preferred stock were used to finance the acquisition of Ramsay and pay down substantially all of our long-term debt. Interest on the senior subordinated notes accrues at the rate of 10.625% per annum and is payable semi-annually in arrears on June 15 and December 15, commencing on December 15, 2003. The senior subordinated notes will mature on June 15, 2013.

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     In connection with the closing of the sale of our 10 5/8% senior subordinated notes, we amended and restated our former senior credit facility with CapSource to increase our senior secured revolving line of credit to $50.0 million from $28.0 million and to refinance $36.0 million in term loans with the proceeds from the sale of our 10 5/8% senior subordinated notes. Our former credit facility was secured by substantially all of our assets and the stock of our existing operating subsidiaries. The term loans accrued interest at the Citibank, N.A. prime rate plus 4.5% subject to a floor of 8.75% and were due in November 2003. We refinanced the remaining $11.2 million in term loans with a mortgage loan insured by HUD on November 5, 2003. The revolving line of credit accrued interest at the Citibank, N.A. prime rate plus 2% subject to a floor of 6.25% and was due in June 2006. We were required to pay interest on a minimum balance of $17.5 million under our revolving line of credit. At December 31, 2003, the interest rate under the revolving line of credit was 6.25%. As of December 31, 2003, we had $50.0 million available under the revolving line of credit. We were required to pay on a monthly basis an unused fee in the amount of 0.5% per annum on the unused portion of the amended and restated credit facility. Such fees were approximately $110,000 for the year ended December 31, 2003.

     On April 1, 2003, concurrent with the acquisition of The Brown Schools, we received $12.5 million from the private placement of 2,272,727 shares of our series A convertible preferred stock with affiliates of Oak Investment Partners and Salix Ventures and The 1818 Mezzanine Fund II, L.P. (the “1818 Fund”). These investors purchased an additional 2,272,727 shares of our series A convertible preferred stock for $12.5 million on June 19, 2003. The proceeds were used to acquire The Brown Schools and Ramsay. Each share of series A convertible preferred stock is convertible into one share of our common stock. Holders of our series A convertible preferred stock are entitled to receive pay-in-kind dividends, compounded quarterly, equal to 5% per share of the original share price through March 31, 2005. Thereafter, pay-in-kind dividends will compound quarterly at 7% per share of the original share price. The impact of the series A convertible preferred stock on diluted earnings per share is calculated using the if-converted method.

     On April 1, 2003, our former senior credit facility with CapSource was expanded to approximately $81.0 million with the increase of our revolving line of credit to $28.0 million from $17.5 million and a new $36.0 million term loan in addition to our then-existing $17.0 million term loan. We borrowed approximately $52.2 million during April 2003, including the $36.0 million term loan and $16.2 million under the revolving line of credit, to partially fund our acquisition of six inpatient facilities from The Brown Schools. The revolving line of credit and new $36.0 million term loan were repaid on June 30, 2003 with proceeds from the issuance of our 10 5/8% senior subordinated notes.

     On June 28, 2002, we entered into a Securities Purchase Agreement with the 1818 Fund where the 1818 Fund agreed to purchase up to $20 million of senior subordinated notes with detachable nominal warrants. At closing on June 28, 2002, a total of $10 million of the senior subordinated notes were issued. In connection with the issuance of the senior subordinated notes to the 1818 Fund, we issued detachable stock purchase warrants for the purchase of 372,412 shares of our common stock at an exercise price of $.01 per share. Also, we provided the 1818 Fund with the ability to require us to repurchase its warrants or the common stock acquired upon exercise of its warrants at fair market value for cash. On May 16, 2003, the 1818 Fund exercised its stock purchase warrant to purchase 372,412 shares of our common stock. Deducting the exercise price of $0.01 per share based on the closing price of our common stock on May 15, 2003, the 1818 Fund received 372,039 shares of our common stock from the exercise of its warrant. In connection with the exercise of the warrants, the 1818 Fund provided us with a written consent to waive its ability to require that we repurchase the warrants for cash effective April 1, 2003. On June 30, 2003, we repaid principal of $10 million, accrued interest and a prepayment penalty of 3% to the 1818 Fund with proceeds from the issuance of our 10 5/8% senior subordinated notes, and we no longer have the ability to borrow under the Securities Purchase Agreement with the 1818 Fund. The 1818 Fund’s right to require us to repurchase the 372,039 shares of our common stock that it received upon the exercise of its stock purchase warrant terminated upon the 1818 Fund’s sale of its shares in our secondary equity offering that we closed in December 2003.

     In connection with our acquisition of Sunrise Behavioral Health, Ltd. in May 2000, we issued subordinated convertible notes in the amount of $3.6 million. The principal amount of these convertible notes and the interest thereon was converted into 537,908 shares of our common stock in April and May 2003 based on a conversion price of $8.53 per share. In addition, we also issued two promissory notes totaling $4.5 million in connection with our acquisitions of three facilities in 2001. At December 31, 2003, one note with a current principal balance of $1.0 million remained outstanding. This note accrues interest at 9% per annum and is due June 30, 2005. Among other

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customary covenants, the note contains cross-default covenants triggered by a default of any other indebtedness of at least $1.0 million. We were in compliance with these covenants as of December 31, 2003.

     As part of the determination of our provision for income taxes, we are required to estimate and record reserves for certain tax positions that, though we believe are fully supportable, are subject to audit by taxing authorities. We have accrued for certain tax contingencies for which the ultimate determination by the taxing authorities is uncertain. If the taxing authorities were to propose and sustain assessments on the contingencies, we would incur approximately $4 million in additional tax payments in future years. We believe we have adequately provided for this tax contingency.

     We believe that our working capital on hand, cash flows from operations and funds available under our revolving line of credit will be sufficient to fund our operating needs, planned capital expenditures and debt service requirements for the next 12 months.

     In addition, we are actively seeking acquisitions that fit our corporate growth strategy and may acquire additional inpatient psychiatric facilities. Management continually assesses our capital needs and, should the need arise, we will seek additional financing, including debt or equity, to fund potential acquisitions or for other corporate purposes. In negotiating such financing, there can be no assurance that we will be able to raise additional capital on terms satisfactory to us. Failure to obtain additional financing on reasonable terms could have a negative effect on our plans to acquire additional inpatient psychiatric facilities.

Obligations and Commitments

     The fair value of our $150 million 10 5/8% senior subordinated notes was approximately $167 million as of December 31, 2003. The carrying value of our other long-term debt, including current maturities, of $25.0 million and $43.8 million at December 31, 2003 and December 31, 2002, respectively, approximated fair value. We had no variable rate debt outstanding at December 31, 2003.

Impact of Inflation and Economic Trends

     Although inflation has not had a material impact on our results of operations, the health care industry is very labor intensive and salaries and benefits are subject to inflationary pressures as are rising supply costs which tend to escalate as vendors pass on the rising costs through price increases. Some of our freestanding owned, leased and managed inpatient behavioral health care facilities we operate are experiencing the effects of the tight labor market, including a shortage of nurses, which has caused and may continue to cause an increase in our salaries, wages and benefits expense in excess of the inflation rate. Although we cannot predict our ability to cover future cost increases, management believes that through adherence to cost containment policies, labor management and reasonable price increases, the effects of inflation on future operating margins should be manageable. Our ability to pass on increased costs associated with providing health care to Medicare and Medicaid patients is limited due to various federal, state and local laws which have been enacted that, in certain cases, limit our ability to increase prices. In addition, as a result of increasing regulatory and competitive pressures and a continuing industry wide shift of patients into managed care plans, our ability to maintain margins through price increases to non-Medicare patients is limited.

     The behavioral health care industry is typically not directly impacted by periods of recession, erosions of consumer confidence or other general economic trends as most health care services are not considered a component of discretionary spending. However, our inpatient facilities may be indirectly negatively impacted to the extent such economic conditions result in decreased reimbursements by federal or state governments or managed care payers. We are not aware of any economic trends that would prevent us from being able to remain in compliance with all of our debt covenants and to meet all required obligations and commitments in the near future.

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Critical Accounting Policies

     Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. In preparing our financial statements, we are required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses included in the financial statements. Estimates are based on historical experience and other information currently available, the results of which form the basis of such estimates. While we believe our estimation processes are reasonable, actual results could differ from our estimates. The following represent the estimates considered most critical to our operating performance and involve the most subjective and complex assumptions and assessments.

     Allowance for Doubtful Accounts

     Our ability to collect outstanding patient receivables from third party payors and receivables due under our inpatient management contracts is critical to our operating performance and cash flows.

     The primary collection risk with regard to patient receivables lies with uninsured patient accounts or patient accounts for which primary insurance has paid, but the portion owed by the patient remains outstanding. We estimate the allowance for doubtful accounts primarily based upon the age of the accounts since patient discharge date. We continually monitor our accounts receivable balances and utilize cash collection data to support our estimates of the provision for doubtful accounts. Significant changes in payor mix or business office operations could have a significant impact on our results of operations and cash flows.

     The primary collection risk with regard to receivables due under our inpatient management contracts is attributable to contractual disputes. We estimate the allowance for doubtful accounts for these receivables based primarily upon the specific identification of potential collection issues. As with our patient receivables, we continually monitor our accounts receivable balances and utilize cash collection data to support our estimates of the provision for doubtful accounts.

     Allowances for Contractual Discounts

     The Medicare and Medicaid regulations are complex and various managed care contracts may include multiple reimbursement mechanisms for different types of services provided in our inpatient facilities and cost settlement provisions requiring complex calculations and assumptions subject to interpretation. We estimate the allowance for contractual discounts on a payor-specific basis given our interpretation of the applicable regulations or contract terms. The services authorized and provided and related reimbursement are often subject to interpretation that could result in payments that differ from our estimates. Additionally, updated regulations and contract renegotiations occur frequently necessitating continual review and assessment of the estimation process by our management.

     Professional and General Liability

     We are subject to medical malpractice and other lawsuits due to the nature of the services we provide. Due to our acquisition of Ramsay, we have two distinct insurance programs that cover our inpatient facilities. For our inpatient facilities that were not acquired from Ramsay, we have obtained professional and general liability insurance for claims in excess of $3 million with an insured limit of $10 million. In December 2003, we increased this insured limit to $20 million. For the inpatient facilities acquired from Ramsay, we have obtained professional and general risks liability insurance for claims in excess of $500,000 with an insured limit of $25 million. These policies include umbrella coverage of $20 million and $25 million, respectively. The self-insured reserves for professional and general liability risks are calculated based on historical claims, demographic factors, industry trends, severity factors, and other actuarial assumptions calculated by an independent third party. The self-insured reserve is discounted to its present value using a 5% discount rate. This estimated accrual for professional and general liabilities could be significantly affected should current and future occurrences differ from historical claim trends and expectations. We have established a captive insurance company to manage this additional self-insured retention for our inpatient facilities not acquired from Ramsay. We plan to merge these plans in the new future. While claims are monitored closely when estimating professional and general liability accruals, the complexity of the claims and wide range of potential outcomes often hampers timely adjustments to the assumptions used in these estimates.

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     Income Taxes

     As part of our process for preparing our consolidated financial statements, our management is required to compute income taxes in each of the jurisdictions in which we operate. This process involves estimating the current tax benefit or expense of future deductible and taxable temporary differences. The future deductible and taxable temporary differences are recorded as deferred tax assets and liabilities which are components of our balance sheet. Management then assesses our ability to realize the deferred tax assets based on reversals of deferred tax liabilities and, if necessary, estimates of future taxable income. If management determines that some or all of a deferred tax asset will more likely than not be realized, then a valuation allowance is recorded against the deferred tax asset. Management must also assess the impact of acquisitions on the realization of deferred tax assets subject to a valuation allowance to determine if all or a portion of the valuation allowance will be offset by reversing taxable differences or future taxable income of the acquired entity. To the extent the valuation allowance can be reversed due to the estimated future taxable income of an acquired entity, then our valuation allowance is reduced accordingly as an adjustment to purchase price.

Forward-Looking Statements

     This Annual Report on Form 10-K and other materials we have filed or may file with the Securities and Exchange Commission, as well as information included in oral statements or other written statements made, or to be made, by our senior management, contain, or will contain, disclosures that are “forward-looking statements” within the meaning of the safe harbor provisions of The Private Securities Litigation Reform Act of 1995. Forward-looking statements include all statements that do not relate solely to historical or current facts and can be identified by the use of words such as “may,” “will,” “expect,” “believe,” “intend,” “plan,” “estimate,” “project,” “continue,” “should” and other comparable terms. These forward-looking statements are based on the current plans and expectations of management and are subject to a number of risks and uncertainties, including those set forth below, which could significantly affect our current plans and expectations and future financial condition and results.

     We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Stockholders and investors are cautioned not to unduly rely on such forward-looking statements when evaluating the information presented in our filings and reports.

     While it is not possible to identify all these factors, we continue to face many risks and uncertainties that could cause actual results to differ from those forward-looking statements, including:

	•		potential competition that alters or impedes our acquisition strategy by decreasing our ability to acquire additional inpatient facilities on favorable terms;
	•		our ability to improve the operations of acquired inpatient facilities;
	•		our ability to maintain favorable and continuing relationships with physicians who use our inpatient facilities;
	•		our limited operating history;
	•		our ability to receive timely additional financing on terms acceptable to us to fund our acquisition strategy and capital expenditure needs;
	•		risks inherent to the health care industry, including the impact of unforeseen changes in regulation, reimbursement rates from federal and state health care programs or managed care companies and exposure to claims and legal actions by patients and others;
	•		our ability to retain key employees who are instrumental to our successful operations;
	•		our ability to ensure confidential information is not inappropriately disclosed and that we are in compliance with federal and state health information privacy standards; and

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•

our ability to comply with federal and state governmental regulation covering healthcare-related products and services on-line, including the regulation of medical devices and the practice of medicine and pharmacology.

     In addition, future trends for pricing, margins, revenues and profitability remain difficult to predict in the industries that we serve.

Risk Factors

     If we fail to comply with extensive laws and government regulations, we could suffer penalties or be required to make significant changes to our operations.

     The health care industry is required to comply with extensive and complex laws and regulations at the federal, state and local government levels relating to, among other things:

	•		billing for services;
	•		relationships with physicians and other referral sources:
	•		adequacy of medical care;
	•		quality of medical equipment and services;
	•		qualifications of medical and support personnel;
	•		confidentiality, maintenance and security issues associated with health-related information and medical records;
	•		licensure;
	•		hospital rate or budget review;
	•		operating policies and procedures; and
	•		addition of facilities and services.

     Among these laws are the Anti-kickback Statute and the Stark Law. These laws impact the relationships that we may have with physicians and other referral sources. The OIG has enacted safe harbor regulations that outline practices that are deemed protected from prosecution under the Anti-kickback Statute. Our current financial relationships with physicians and other referral sources may not qualify for safe harbor protection under the Anti-kickback Statute. Failure to meet a safe harbor does not mean that the arrangement automatically violates the Anti-kickback Statute, but may subject the arrangement to greater scrutiny. Further, we cannot guarantee that practices that are outside of a safe harbor will not be found to violate the Anti-kickback Statute.

     In order to comply with the Stark Law, our financial relationships with physicians and their immediate family members must meet an exception. We attempt to structure our relationships to meet an exception to the Stark Law, but the regulations implementing the exceptions, some of which are still under review, are detailed and complex, and we cannot guarantee that every relationship fully complies with the Stark Law.

     If we fail to comply with the Anti-kickback Statute, the Stark Law or other applicable laws and regulations, we could be subjected to liabilities, including criminal penalties, civil penalties (including the loss of our licenses to operate one or more inpatient facilities), and exclusion of one or more of our inpatient facilities from participation in the Medicare, Medicaid and other federal and state health care programs. See “Item 1. Business — Regulation and Other Factors.”

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     Because many of these laws and regulations are relatively new, we do not always have the benefit of significant regulatory or judicial interpretation of these laws and regulations. In the future, different interpretations or enforcement of these laws and regulations could subject our current or past practices to allegations of impropriety or illegality or could require us to make changes in our inpatient facilities, equipment, personnel, services, capital expenditure programs and operating expenses. A determination that we have violated these laws, or the public announcement that we are being investigated for possible violations of these laws, could have a material adverse effect on our business, financial condition, results of operations or prospects and our business reputation could suffer significantly. In addition, we are unable to predict whether other legislation or regulations at the federal or state level will be adopted, what form such legislation or regulation will take or their impact.

We may be required to spend substantial amounts to comply with legislative and regulatory initiatives relating to privacy and security of patient health information and standards for electronic transactions.

     There are currently numerous legislative and regulatory initiatives at the federal and state levels addressing patient privacy and security concerns. In particular, federal regulations issued under HIPAA contain provisions that have required, and in the future may require, our facilities to implement costly new computer systems and to adopt business procedures designed to protect the privacy and security of each of their patients’ individually identifiable health and related financial information. Compliance with the privacy regulations was required on April 14, 2003 for most health care organizations, including our inpatient facilities. The privacy regulations have had a financial impact on the health care industry because they impose extensive new administrative requirements, restrictions on the use and disclosure of individually identifiable patient health and related financial information, provide patients with new rights with respect to their health information and require our inpatient facilities to enter into contracts extending many of the privacy regulation requirements to third parties who perform functions on our behalf involving health information.

     On February 20, 2003, HHS issued final security regulations. Compliance with these security regulations is required by April 21, 2005 for most health care organizations, including our inpatient facilities. These security regulations require our inpatient facilities to implement administrative, physical and technical safeguards to protect the integrity, confidentiality and availability of electronically received, maintained or transmitted patient individually identifiable health and related financial information. We cannot predict the total financial or other impact of these regulations on our business. Compliance with these regulations requires substantial expenditures, which could negatively impact our financial results. In addition, our management has spent, and may spend in the future, substantial time and effort on compliance measures.

     On August 17, 2000, HHS issued regulations requiring most health care organizations, including our inpatient facilities, to use standard data formats and code sets by October 16, 2003 when electronically transmitting information in connection with several types of transactions, including health claims, health care payment and remittance advice and health claim status transactions. We have implemented or upgraded computer systems, as appropriate, at our inpatient facilities and at our corporate headquarters to comply with the new transaction and code set regulations and have tested these systems with several of our payers.

     Violations of the privacy, security and transaction regulations could subject our inpatient facilities to civil penalties of up to $25,000 per calendar year for each provision contained in the privacy, security and transaction regulations that is violated and criminal penalties of up to $250,000 per violation for certain other violations. Since there is no history of enforcement efforts by the federal government at this time, it is not possible to ascertain the likelihood of enforcement efforts in connection with these regulations or the potential for fines and penalties which may result from the violation of the regulations.

Other companies within the health care industry continue to be the subject of federal and state investigations, which increases the risk that we may become subject to investigations in the future.

     Both federal and state government agencies as well as private payors have heightened and coordinated civil and criminal enforcement efforts as part of numerous ongoing investigations of health care organizations. These investigations relate to a wide variety of topics, including:

•

cost reporting and billing practices;

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	•		quality of care;
	•		financial relationships with referral sources;
	•		medical necessity of services provided; and
	•		treatment of indigent patients.

     The OIG and the U.S. Department of Justice have, from time to time, undertaken national enforcement initiatives that focus on specific billing practices or other suspected areas of abuse. Moreover, health care providers are subject to civil and criminal false claims laws, including the federal False Claims Act, which allows private parties to bring whistleblower lawsuits against private companies doing business with or receiving reimbursement under government programs. Some states have adopted similar state whistleblower and false claims provisions. Publicity associated with the substantial amounts paid by other health care providers to settle these lawsuits may encourage our current and former employees and other health care providers to bring whistleblower lawsuits. Any investigations of us or our executives or managers could result in significant liabilities or penalties as well as adverse publicity.

As a provider of health care services, we are subject to claims and legal actions by patients and others.

     Facilities acquired by us may have unknown or contingent liabilities, including liabilities related to patient care and liabilities for failure to comply with health care laws and regulations, which could result in large claims and significant defense costs. Although we generally seek indemnification covering these matters from prior owners of facilities we acquire, material liabilities for past activities of acquired facilities may exist and such prior owners may not be able to satisfy their indemnification obligations. We are also susceptible to being named in claims brought related to patient care and other matters at inpatient facilities owned by third parties and operated by us.

     To protect ourselves from the cost of these claims, professional malpractice liability insurance and general liability insurance coverage is maintained in amounts and with deductibles common in the industry. Due to our acquisition of Ramsay, we have two distinct insurance programs that cover our inpatient facilities. For our inpatient facilities that were not acquired from Ramsay, we have obtained professional and general liability insurance for claims in excess of $3 million with an insured limit of $10 million. In December 2003, we increased this insured limit to $20 million. For the inpatient facilities acquired from Ramsay, we have obtained professional and general liability insurance for claims in excess of $50,000 with an insured limit of $25 million. These policies include umbrella coverage of $20 million and $25 million, respectively. The self-insured reserves for professional and general liability risks are calculated based on historical claims, demographic factors, industry trends, severity factors, and other actuarial assumptions calculated by an independent third party. The self-insured reserve is discounted to its present value using a 5% discount rate. This estimated accrual for professional and general liabilities could be significantly affected should current and future occurrences differ from historical claim trends and expectations. We have established a captive insurance company to manage this additional self-insured retention for our inpatient facilities not acquired from Ramsay. While claims are monitored closely when estimating professional and general liability accruals, the complexity of the claims and wide range of potential outcomes often hampers timely adjustments to the assumptions used in these estimates. There are no assurances that our insurance will cover all claims (e.g., claims for punitive damages) or that claims in excess of our insurance coverage will not arise. A successful lawsuit against us that is not covered by, or is in excess of, our insurance coverage may have a material adverse effect on our business, financial condition and results of operations. This insurance coverage may not continue to be available at a reasonable cost, especially given the significant increase in insurance premiums generally experienced in the health care industry.

If federal or state health care programs or managed care companies reduce reimbursement rates or methods of reimbursement for services provided, revenues may decline.

     A large portion of our revenue comes from the Medicare and Medicaid programs. In recent years, federal and state governments have made significant changes in these programs. These changes have, in certain instances, decreased the amount of money we receive for our services. Future federal and state legislation may further reduce

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the payments received for services provided or increase the timing of reimbursement payments to us. In addition, we are particularly sensitive to regulatory and economic changes in the State of Texas. We operated seven inpatient facilities in Texas that generated 33% of our revenue for the year ended December 31, 2003.

     Insurance and managed care companies and other third parties from whom we receive payment are increasingly attempting to control health care costs by requiring that facilities discount their fees in exchange for exclusive or preferred participation in their benefit plans. This trend may continue and may reduce the payments received by us for our services.

If competition decreases the ability to acquire additional inpatient facilities on favorable terms, we may be unable to execute our acquisition strategy.

     Competition among hospitals and other health care providers in the United States has intensified in recent years due to cost containment pressures, changing technology, changes in government regulation and reimbursement, changes in practice patterns (such as shifting from inpatient to outpatient treatments), the impact of managed care organizations and other factors. An important part of our business strategy is to acquire inpatient facilities in growing markets. Some inpatient facilities and health care providers that compete with us have greater financial resources and a larger, more experienced development staff focused on identifying and completing acquisitions. In addition, some competitors are owned by governmental agencies or not-for-profit corporations supported by endowments and charitable contributions, and can finance capital expenditures on a tax-exempt basis. Any or all of these factors may impede our business strategy.

If we fail to improve the operations of acquired inpatient facilities, we may be unable to achieve our growth strategy.

     We may be unable to maintain or increase the profitability of, or operating cash flows at, any existing hospital or other acquired inpatient facility, effectively integrate the operations of any acquisitions or otherwise achieve the intended benefit of our growth strategy.

State efforts to regulate the sale of inpatient facilities operated by not-for-profit entities could prevent us from acquiring additional inpatient facilities and executing our business strategy.

     Hospital acquisitions generally require a longer period to complete than acquisitions in many other industries and are subject to additional regulatory uncertainty. Many states have adopted legislation regarding the sale or other disposition of facilities operated by not-for-profit entities. In other states that do not have specific legislation, the attorneys general have demonstrated an interest in these transactions under their general obligations to protect charitable assets from waste. These legislative and administrative efforts focus primarily on the appropriate valuation of the assets divested and the use of the proceeds of the sale by the non-profit seller. In addition, the acquisition of facilities in certain states requires advance regulatory approval under “certificate of need” or state licensure regulatory regimes. These state-level procedures could seriously delay or even prevent us from acquiring inpatient facilities, even after significant transaction costs have been incurred.

Additional financing may be necessary to fund our acquisition program and capital expenditures, and additional financing may not be available when needed.

     Our acquisition program requires substantial capital resources. Likewise, the operation of existing inpatient facilities requires ongoing capital expenditures for renovation, expansion and the upgrade of equipment and technology.

     We may not receive additional financing on satisfactory terms. In addition, our level of indebtedness at any time may restrict our ability to borrow additional funds. If we are not able to obtain financing, then we may not be in a position to consummate acquisitions or undertake capital expenditures.

Recently acquired businesses and businesses acquired in the future will expose us to increased operating risks.

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     We acquired four inpatient facilities in 2001, one inpatient hospital in 2002 and seventeen inpatient facilities in 2003.

     This expansion exposes us to additional business and operating risk and uncertainties, including:

	•		our ability to effectively manage the expanded activities;
	•		our ability to realize our investment in the increased number of inpatient facilities;
	•		our exposure to unknown liabilities; and
	•		our ability to meet contractual obligations.

     If we are unable to manage this expansion efficiently or effectively, or are unable to attract and retain additional qualified management personnel to run the expanded operations, it could have a material adverse effect on our business, financial condition and results of operations.

We depend on our relationships with physicians who use our inpatient facilities.

     Our business depends upon the efforts and success of the physicians who provide health care services at our inpatient facilities and the strength of the relationships with these physicians.

     Our business could be adversely affected if a significant number of physicians or a group of physicians:

	•		terminate their relationship with, or reduce their use of, our inpatient facilities;
	•		fail to maintain acceptable quality of care or to otherwise adhere to professional standards;
	•		suffer damage to their reputation; or
	•		exit the market entirely.

We depend on our key management personnel.

     We are highly dependent on our senior management team, which has many years of experience addressing the broad range of concerns and issues relevant to our business. We have entered into employment agreements with Joey A. Jacobs, Chief Executive Officer, and Jack Salberg, Chief Operating Officer, which include non-competition and non-solicitation provisions. Key man life insurance policies are not maintained on any member of senior management other than Mr. Jacobs. The loss of key management or the inability to attract, retain and motivate sufficient numbers of qualified management personnel could have a material adverse effect on us.

We have a limited operating history.

     We began operations in 1997 and acquired our first inpatient facility in 2001. Because of our limited operating history, we have limited insight into trends that may emerge in our industry and that affect our business. As a result, there can be no assurance that we will achieve satisfactory operating results.

Our stock price could be volatile.

     The market price of our common stock could fluctuate significantly in response to various factors, including:

•

problems in achieving revenue enhancements and operating efficiencies;

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	•		actual and estimated earnings and cash flows;
	•		quarter-to-quarter variations in operating results;
	•		changes in market conditions in the mental health or behavioral health care industries;
	•		changes in general economic conditions;
	•		fluctuations in the securities markets in general;
	•		operating results differing from analysts’ estimates; and
	•		changes in analysts’ earnings estimates.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk.

     Our interest expense is sensitive to changes in the general level of interest rates. With respect to our interest-bearing liabilities, all of our long-term debt outstanding at December 31, 2003 is subject to a weighted average fixed interest rate of 9.95%. Since all of our long-term debt outstanding at December 31, 2003 is subject to a fixed interest rate, we did not estimate changes to our interest expense or fair value of long-term debt based on a hypothetical increase in interest rates. As discussed above, we do have a $50 million revolving credit facility that is subject to variable interest rates; however, at December 31, 2003, no balance was outstanding under the revolving line of credit. In the event we increase our amount outstanding under the revolving credit facility and interest rates change significantly, we expect management would take actions intended to further mitigate our exposure to such change. Information on quantitative and qualitative disclosure about market risk is included in Part II, Item 7 of this Annual Report on Form 10-K under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources – Contractual Obligations.”

Item 8. Financial Statements and Supplementary Data.

     Information with respect to this Item is contained in our consolidated financial statements indicated in the Index on Page F-1 of this Annual Report on Form 10-K.

Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure.

     None.

Item 9A. Controls and Procedures.

Evaluation of Disclosure Controls and Procedures

     Our chief executive officer and principal accounting officer have reviewed and evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934 (the “Exchange Act”)) as of the end of the period covered by this annual report. Based on that evaluation, the chief executive officer and principal accounting officer have concluded that our disclosure controls and procedures effectively and timely provide them with material information relating to Psychiatric Solutions and its consolidated subsidiaries required to be disclosed in the reports we file or submit under the Exchange Act.

Changes in Internal Controls Over Financial Reporting

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     During the period covered by this report, there have been no changes in our internal control over financial reporting that have materially affected or are reasonable likely to materially affect our internal control over financial reporting.

PART III

Item 10. Directors And Executive Officers of the Registrant.

Directors

     The information relating to our directors set forth in the Company’s Proxy Statement relating to the 2004 Annual Meeting of Stockholders under the caption “Election of Directors” and “Corporate Governance — Audit Committee” is incorporated herein by reference.

Executive Officers of the Registrant

     The executive officers of the Company are:

     Joey A. Jacobs, President and Chief Executive Officer. Mr. Jacobs serves as President and Chief Executive Officer and was one of our co-founders in April 1997. Prior to our founding, Mr. Jacobs served for 21 years in various capacities with Hospital Corporation of America (“HCA,” also formerly known as Columbia and Columbia/HCA), most recently as President of the Tennessee Division. Mr. Jacobs’ background at HCA also includes serving as president of HCA’s Central Group, vice president of the Western Group, assistant vice president of the Central Group and assistant vice president of the Salt Lake City Division.

     Steven T. Davidson, Chief Development Officer. Mr. Davidson has served as Chief Development Officer since August 1997 and has over 21 years of health care experience. Prior to joining us, Mr. Davidson served as the Director of Development at HCA from 1991 until 1997. Mr. Davidson also served as a Senior Audit Supervisor and Hospital Controller during his term at HCA, which began in 1983, where he supervised audits of hospitals and other corporate functions. Prior to joining HCA, Mr. Davidson was employed by Ernst & Young LLP as a Senior Auditor. Mr. Davidson is a Certified Public Accountant and a member of the American Institute of Certified Public Accountants.

     Jack Salberg, Chief Operating Officer. Mr. Salberg has served as Chief Operating Officer since May 2000 and has more than 32 years of operational experience in both for-profit and non-profit health care sectors. Prior to joining us, Mr. Salberg served as president and chief executive officer of Sunrise Behavioral Health, Ltd. from 1996 to 2000. In addition, Mr. Salberg served for ten years in various capacities with American Healthcorp, most recently as senior vice president with specific responsibilities for multi-facility contract management. Mr. Salberg also spent three years as head of Health Group, Inc.’s psychiatric division. In addition, Mr. Salberg was employed for four years with Humana Corporation as a hospital executive director and seven years with Arden Hill Hospital, an independent hospital, as its associate executive director.

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     Jack E. Polson, Chief Accounting Officer. Mr. Polson has served as Chief Accounting Officer since August 2002. Prior to being appointed Chief Accounting Officer, Mr. Polson had served as Controller since June 1997. From June 1995 until joining us, Mr. Polson served as controller for Columbia Healthcare Network, a risk-bearing physician health organization. From May 1992 until June 1995, Mr. Polson served as an internal audit supervisor for HCA.

     Brent Turner, Vice President, Treasurer and Investor Relations. Mr. Turner has served as the Vice President, Treasurer and Investor Relations since February 2003. From April 2002 until joining us, Mr. Turner served as Executive Vice President and Chief Financial Officer of Educational Services of America, a privately-held owner and operator of schools for children with learning disabilities. From November 2001 until March 2002, Mr. Turner served as Senior Vice President of Business Development for The Brown Schools, a provider of educational and therapeutic services for at-risk youth. From 1996 until January 2001, Mr. Turner was employed by Corrections Corporation of America, a private prison operator, serving as Treasurer from 1998 to 2001.

Code of Ethics

     The Company has adopted a Code of Ethics that applies to all of the Company’s directors, officers and employees. The Code of Ethics is available on our website at www.psysolutions.com. We will disclose any amendment to, other than technical, administrative or non-substantive amendments, or waiver of its code of ethics granted to a director or executive officer by filing a Form 8-K disclosing the amendment or waiver within five business days.

Section 16(a) Compliance

     The information relating to Section 16(a) beneficial ownership reporting compliance set forth in our Proxy Statement relating to the 2004 Annual Meeting of Stockholders under the caption “Security Ownership of Certain Beneficial Owners and Management” is incorporated herein by reference.

Item 11. Executive Compensation.

     The information set forth in our Proxy Statement relating to the 2004 Annual Meeting of Stockholders under the caption “Executive Compensation” is incorporated herein by reference. The Comparative Performance Graph and the Compensation Committee Report on Executive Compensation also included in the Proxy Statement are expressly not incorporated herein by reference.

Item 12. Security Ownership of Certain Beneficial Owners and Management.

     The information set forth in our Proxy Statement relating to the 2004 Annual Meeting of Stockholders under the caption “Security Ownership of Certain Beneficial Owners and Management” and “Equity Compensation Plan Information” is incorporated herein by reference.

Item 13. Certain Relationships and Related Transactions.

     The information set forth in our Proxy Statement relating to the 2004 Annual Meeting of Stockholders under the caption “Certain Relationships and Related Transactions” is incorporated herein by reference.

Item 14. Principal Accountant Fees and Services.

     The information set forth in our Proxy Statement relating to the 2004 Annual Meeting of Stockholders under the caption “Independent Auditors – Audit and Non-Audit Fees” is incorporated herein by reference.

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Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.

     (a) The following documents are filed as part of this Annual Report on Form 10-K:

1.

Consolidated Financial Statements: The consolidated financial statements of Psychiatric Solutions are included as follows:

2.

Financial Statement Schedules.

All schedules are omitted because they are not applicable or are not required, or because the required information is included in the consolidated financial statements or notes in this report.

3.

The exhibits which are filed with this report or which are incorporated herein by reference are set forth in the Exhibit Index on pages 41 through 45.

     (b) Reports on Form 8-K.

     On October 31, 2003, Psychiatric Solutions furnished a Report on Form 8-K, which reported the issuance of a press release announcing the operating results of Psychiatric Solutions for the quarter ended September 30, 2003.

     On November 6, 2003, Psychiatric Solutions filed a Report on Form 8-K, which reported the issuance of press releases announcing the registration of 6,000,000 shares of its common stock and the acquisition of the Alliance Health Center on November 3, 2003.

     On December 19, 2003, Psychiatric Solutions filed a Report on Form 8-K, which reported the issuance of a press release announcing the public offering of 6,000,000 shares of its common stock at $16 per share.

     On December 29, 2003, Psychiatric Solutions filed a Report on Form 8-K, which reported the issuance of a press release announcing it closed on the sale of 6,900,000 shares of its common stock.

     (c) Exhibit.

41

42

43

44

45

PSYCHIATRIC SOLUTIONS, INC.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

F-1

REPORT OF INDEPENDENT AUDITORS

To the Board of Directors and Stockholders of Psychiatric Solutions, Inc.

We have audited the accompanying consolidated balance sheets of Psychiatric Solutions, Inc. as of December 31, 2003 and 2002 and the related consolidated statements of income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2003. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Psychiatric Solutions, Inc. at December 31, 2003 and 2002, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States.

As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting in 2001 for goodwill and intangible assets.

ERNST & YOUNG LLP

Nashville, Tennessee
March 3, 2004

F-2

PSYCHIATRIC SOLUTIONS, INC.

See accompanying notes.

F-3

PSYCHIATRIC SOLUTIONS, INC.
CONSOLIDATED STATEMENTS OF INCOME
(In thousands except for per share amounts)

See accompanying notes.

F-4

PSYCHIATRIC SOLUTIONS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(in thousands)

See accompanying notes.

F-5

PSYCHIATRIC SOLUTIONS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

(Continued)

F-6

PSYCHIATRIC SOLUTIONS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)