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

FORM 10-Q

(Mark One)

Commission File No. 1-6639

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

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

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

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

        The number of shares of the registrant's common stock outstanding as of April 30, 2003 was 35,318,926.

FORM 10-Q

MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES

INDEX

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PART I—FINANCIAL INFORMATION

Item 1.—Financial Statements

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

See accompanying notes.

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MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(In thousands, except per share amounts)

(1)

The results previously reported in the Company's Form 10-Q for the six months ended March 31, 2002 have been restated to reflect the cumulative effect of adoption of SFAS 142.

(2)

Net of income tax provision (benefit) of $554 and $(433) for the three months ended March 31, 2002 and 2003, respectively, and $636 and $— for the six months ended March 31, 2002 and 2003, respectively.

(3)

Net of income tax provision (benefit) of $109 and $(52) for the three months ended March 31, 2002 and 2003, respectively, and $551 and $— for the six months ended March 31, 2002 and 2003, respectively.

See accompanying notes.

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MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(In thousands)

See accompanying notes.

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MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2003

(Unaudited)

NOTE A—General

Basis of Presentation

        The accompanying unaudited condensed consolidated financial statements of Magellan Health Services, Inc., a Delaware Corporation, and its subsidiaries ("Magellan" or the "Company") have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the Securities and Exchange Commission's (the "SEC") instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring adjustments considered necessary for a fair presentation, have been included. The results of operations for the three-month and six-month periods ended March 31, 2003, are not necessarily indicative of the results to be expected for the full year.

        All references to fiscal years contained herein refer to periods of twelve consecutive months ending on September 30. Certain reclassifications have been made to fiscal 2002 amounts to conform to fiscal 2003 presentation.

        These unaudited condensed consolidated financial statements should be read in conjunction with the Company's audited consolidated financial statements for the fiscal year ended September 30, 2002 and the notes thereto, which are included in the Company's Annual Report on Form 10-K/A filed with the SEC on January 23, 2003.

Voluntary Chapter 11 Filing

        On March 11, 2003 (the "Commencement Date"), Magellan and 88 of its subsidiaries (the "Debtors") filed voluntary petitions for relief under chapter 11 of the United States Code (the "Bankruptcy Code") in the United States Bankruptcy Court for the Southern District of New York (the "Bankruptcy Court"). Magellan's chapter 11 cases have been assigned to the Honorable Prudence Carter Beatty under Case Nos. 03-40514 through 03-40602. Magellan remains in possession of its assets and properties, and continues to operate its business and manage its properties as "debtors-in-possession" pursuant to sections 1107(a) and 1108 of the Bankruptcy Code.

        On the Commencement Date, the Bankruptcy Court entered an order authorizing Magellan to pay, among other claims, the pre-petition claims of the Company's behavioral health providers and customers. Also on the Commencement Date, the Bankruptcy Court entered an order authorizing Magellan to pay certain pre-petition wages, salaries, benefits and other employee obligations, as well as to continue in place Magellan's various employee compensation programs and procedures. The Company intends to remain in possession of the management and operation of its properties and businesses and to continue to pay such pre-petition claims of behavioral health providers, customers and employees and its post-petition claims in the ordinary course of business.

        Chapter 11 is the principal business reorganization chapter of the Bankruptcy Code. Under chapter 11, a debtor is authorized to continue to operate its business in the ordinary course and to reorganize its business for the benefit of its creditors. A debtor-in-possession under chapter 11 may not engage in transactions outside the ordinary course of business without the approval of the Bankruptcy Court, after notice and an opportunity for a hearing. In addition to permitting the rehabilitation of the debtor,

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section 362 of the Bankruptcy Code generally provides for an automatic stay of substantially all judicial, administrative and other actions or proceedings against a debtor and its property, including all attempts to collect claims or enforce liens that arose prior to the commencement of the debtor's case under chapter 11. Also, the debtor may assume or reject pre-petition executory contracts and unexpired leases pursuant to section 365 of the Bankruptcy Code and other parties to executory contracts or unexpired leases being rejected may assert rejection damage claims as permitted thereunder.

        The United States Trustee has appointed an unsecured creditors committee (the "Official Committee"). The Official Committee and their legal representatives have a right to be heard on all matters that come before the Bankruptcy Court, and together with the lenders under the Company's Credit Agreement (as defined below) are the primary entities with which Magellan will negotiate the treatment of the claims of general unsecured creditors. The Official Committee comprises six members, all of whom served on an unofficial committee of note holders formed prior to the Commencement Date and with whom, among others, the Company negotiated the terms of a financial restructuring as embodied in a plan of reorganization filed with the Bankruptcy Court on the Commencement date (as amended, the "Plan"). The Company has received agreements to support the Plan from holders of 52% of the 9³/8% Senior Notes due 2007 (the "Senior Notes"), 35% of the 9% Senior Subordinated Notes due 2008 (the "Senior Subordinated Notes") and 47.5% of its senior secured debt. The Company believes that approval of the Plan maximizes the recovery to creditors and equity holders. Notwithstanding the foregoing, there can be no assurance that the Official Committee or the lenders will support Magellan's positions in the bankruptcy proceedings or that the Company will be able to obtain the votes necessary to approve the Plan, and disagreements between Magellan and the Official Committee or the lenders could protract the bankruptcy proceedings, could negatively impact Magellan's ability to operate during bankruptcy and could delay Magellan's emergence from bankruptcy.

        As part of its chapter 11 cases, the Debtors routinely file pleadings, documents and reports with the Bankruptcy Court, which may contain updated, additional or more detailed information about the Company, its assets and liabilities or financial performance. Copies of the filings for Magellan's chapter 11 cases are available, for a fee, during regular business hours at the office of the Clerk of the Bankruptcy Court or at the Bankruptcy Court's internet site at: http://www.nysb.uscourts.gov.

        Confirmation and consummation of a plan of reorganization are the principal objectives of a chapter 11 reorganization case. The Company filed a Plan of Reorganization on March 11, 2003 containing the terms of the proposed financial restructuring plan with the Bankruptcy Court. Subsequently, on March 26, 2003, it filed with the Bankruptcy Court its First Amended Plan of Reorganization and the related Disclosure Statement (the "Disclosure Statement"). Copies of the Plan and the Disclosure Statement have been filed with the Securities and Exchange Commission in a Form 8-K dated March 26, 2003.

        Under the Plan, holders of the Company's $625.0 million of Senior Subordinated Notes will receive, in satisfaction of their claims, which include all accrued and unpaid interest, approximately 97.5% of the common stock of the reorganized entity less the amount of common stock distributed to holders of general unsecured claims (see below). Holders of the Company's $250.0 million of Senior Notes will exchange their Senior Notes and all accrued and unpaid interest thereon for new senior subordinated unsecured notes (the "New Notes") in an amount equal to the face amount of the Senior Notes plus accrued and unpaid interest thereon. As a result of the chapter 11 filing, no cash interest payments will be made regarding either the Senior Subordinated Notes or the Senior Notes during the course of the bankruptcy proceedings. The New Notes will contain terms substantially similar to the Senior Notes, including maturity on November 15, 2007 and interest at 9³/8% per annum. Holders of general unsecured claims (other than Senior Notes claims and Senior Subordinated Notes claims) will receive, in satisfaction of their claims, common stock and New Notes as set forth in the Plan. The existing Series A redeemable preferred stock of the Company will be cancelled and the holders thereof

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will receive approximately 2.0% of the common stock of the reorganized entity, as well as warrants to purchase a like number of shares of common stock. The existing common stock of the Company will also be cancelled and the holders thereof will receive approximately 0.5% of the common stock of the reorganized entity, as well as warrants to purchase a like number of shares of common stock.

        Also pursuant to the Plan, the Company's senior secured bank credit agreement dated February 12, 1998, as amended (the "Credit Agreement"), consisting of term loans of approximately $115.8 million and a revolver under which there are outstanding borrowings of $45.0 million and outstanding letters of credit of approximately $75.3 million, will be converted to secured term loans (and letter of credit commitments with respect to outstanding letters of credit and renewals thereof) having maturities of November 30, 2005 (the "New Facilities"). The New Facilities will bear interest at a rate equal to the prime rate plus 3.25 percent and the Company will pay letter of credit fees equal to 4.25 percent per annum plus a fronting fee of 0.125 percent per annum of the face amount of letters of credit. The Company will pay the lenders a fee of one percent of the New Facilities on the effective date of the Plan. Under the New Facilities, there are amortization payments of $11.0 million per quarter during calendar 2004 and $15.0 million per quarter for the first three quarters of calendar 2005. The New Facilities will be guaranteed by substantially all of the subsidiaries of Magellan and will be secured by substantially all of the assets of Magellan and the subsidiary guarantors.

        The Plan also contemplates an equity investment in reorganized Magellan in the amount of $50.0 million pursuant to a rights offering to be made available to general unsecured creditors. The Company has obtained a commitment, subject to confirmation of the Plan and certain other customary conditions, from certain holders of its Senior Subordinated Notes to purchase any portion of the $50.0 million offering not subscribed to by other creditors. The proceeds of this equity investment will be available to the Company for general corporate purposes.

        As part of, and subject to, consummation of the Plan, Aetna Inc. ("Aetna") and Magellan have agreed to renew their contract. Under this agreement, the Company will continue to manage the behavioral health care of Aetna's members through December 31, 2005, with an option for Aetna to either purchase the business or to extend the agreement at that time. Pursuant to the Plan, upon emergence from chapter 11, the Company will pay $15.0 million of its obligation to Aetna of $60.0 million plus accrued interest, and provide Aetna with an interest-bearing note (the "Aetna Note") for the balance, which will mature on December 31, 2005. The Aetna Note will be guaranteed by substantially all of the subsidiaries of Magellan and will be secured by a second lien on substantially all of the assets of Magellan and the subsidiary guarantors. Additionally, if the contract is extended by Aetna at its option through at least December 31, 2006, one-half of the Aetna Note will be payable on December 31, 2005, and the remainder will be payable on December 31, 2006. If Aetna opts to purchase the business, the purchase price could be offset against any amounts owing under the Aetna Note. The renewal of the Aetna agreement was approved by the Bankruptcy Court on April 23, 2003.

        Although the Company has filed the Plan with the Bankruptcy Court, there can be no assurance that the Company will (i) obtain Bankruptcy Court approval of the Plan and the Disclosure Statement; (ii) obtain the approval of the Bankruptcy Court for the transactions referred to above that have not already been approved; (iii) obtain the acceptances from its creditors necessary to confirm and consummate the Plan; and/or (iv) obtain any other requisite approvals to confirm and consummate the Plan. If the Company is not successful in its financial restructuring efforts, the Company will not be able to continue as a going concern.

Credit Agreement and Note Indenture Defaults

        Certain defaults exist under the Credit Agreement and the indentures governing the Senior Notes and Senior Subordinated Notes that have resulted in acceleration of all indebtedness thereunder. However, under Section 362 of the Bankruptcy Code, the lenders under the Credit Agreement and the

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holders of the Senior Notes and Senior Subordinated Notes are prohibited from attempting to collect payment of any of such indebtedness. As a result of such defaults, the Company is unable to access additional borrowings or letters of credit under the Credit Agreement.

Accounting Impact of Chapter 11 Filing

        The accompanying interim consolidated condensed financial statements have been prepared in accordance with AICPA Statement of Position No. (SOP) 90-7, "Financial Reporting by Entities in Reorganization under the Bankruptcy Code" ("SOP 90-7") and on a going concern basis, which contemplates continuity of operations, realization of assets and liquidation of liabilities in the ordinary course of business. The ability of the Company, both during and after the chapter 11 cases, to continue as a going concern is dependent upon, among other things, (i) the ability of the Company to successfully achieve required cost savings to complete its restructuring; (ii) the ability of the Company to maintain adequate cash on hand; (iii) the ability of the Company to generate cash from operations; (iv) the ability of the Company to confirm a plan of reorganization under the Bankruptcy Code and obtain emergence financing; (v) the ability of the Company to maintain its customer base; and (vi) the Company's ability to achieve profitability. There can be no assurance that the Company will be able to successfully achieve these objectives in order to continue as a going concern. The accompanying unaudited condensed consolidated financial statements do not include any adjustments that might result should the Company be unable to continue as a going concern.

        Liabilities subject to compromise in the accompanying condensed consolidated balance sheets refer to certain of the liabilities of the Debtors incurred prior to the Commencement Date that are owed to unrelated parties. In accordance with SOP 90-7, liabilities subject to compromise are recorded at the estimated amount that is expected to be allowed as pre-petition claims in the chapter 11 proceedings and are subject to future adjustments. Adjustments may result from negotiations, actions of the Bankruptcy Court, further developments with respect to disputed claims, rejection of executory contracts and unexpired leases, proofs of claim, implementation of the Plan, or other events. Liabilities subject to compromise consisted of the following as of March 31, 2003 (in thousands):

        In order to record its debt instruments at the amount of claim expected to be allowed by the Bankruptcy Court in accordance with SOP 90-7, as of the Commencement Date, Magellan wrote off as reorganization expense its deferred financing fees associated with the Senior Notes and Senior Subordinated Notes. Reorganization expense also includes professional fees and other expenses directly associated with the bankruptcy process. As part of its financial restructuring plan, the Company has rejected certain leases for closed offices. The estimated cost to the Company as a result of rejecting such leases is different than the liability recorded. In accordance with SOP 90-7, such difference has been recorded as a component of reorganization expense. Furthermore, in accordance with SOP 90-7,

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reorganization expense includes the estimated interest income that the Company earned attributable to additional unrestricted cash balances that have accumulated as a result of the chapter 11 proceeding.

        The following table summarizes reorganization expense for the periods indicated (in thousands):

        Magellan is required to accrue interest expense during the chapter 11 proceedings only to the extent that it is probable that such interest will be paid pursuant to the proceedings. Based on the structure of the Plan, Magellan recognized interest expense subsequent to the Commencement Date with respect to the loans and letters of credit under its Credit Agreement, and its capital lease obligations.

        Magellan obtained approval from the Bankruptcy Court to pay or otherwise honor certain of its pre-petition obligations, including, claims of the Company's behavioral health providers, customers, and employee wages, salaries, benefits and certain other employee obligations. The Company has been paying, and intends to continue to pay, such pre-petition claims in the ordinary course of business. However, in accordance with SOP 90-7, these pre-petition liabilities of the Debtors are classified as "current liabilities subject to compromise" in the accompanying condensed consolidated balance sheet at March 31, 2003 to the extent such liabilities had not been paid at that time.

        In accordance with SOP 90-7, Magellan is required to record its preferred stock at the amount expected to be allowed as a claim by the Bankruptcy Court. Accordingly, the Company recorded a net $2.7 million adjustment, which is mainly composed of the write-off of unamortized issuance costs related to its preferred stock. Such amount is reflected in "Preferred stock reorganization items, net" in the accompanying condensed consolidated statements of operations. In addition, the Company stopped accruing preferred stock dividends subsequent to the Commencement Date.

        Based on the current terms of the Plan, the Company believes it would qualify for and be required to implement the "Fresh Start" accounting provisions of SOP 90-7 upon emergence from bankruptcy, which would establish a "fair value" basis for the carrying value of the assets and liabilities of reorganized Magellan. The application of "Fresh Start" accounting on the Company's consolidated financial statements may result in material changes in the amounts and classifications of the Company's non-current assets (including property and equipment and intangible assets), however the potential impact cannot be determined at this time.

NOTE B—Summary of Significant Accounting Policies

Use of Estimates

        The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period.

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Significant estimates of the Company include, among other things, accounts receivable realizability, valuation allowances for deferred tax assets, valuation of goodwill and other intangible assets, medical claims payable and legal liabilities. Actual results could differ from those estimates.

Managed Care Revenue

        Managed care revenue is recognized over the applicable coverage period on a per member basis for covered members. Managed care risk revenues earned for the three months ended March 31, 2002 and 2003 approximated $379.1 million and $352.0 million, respectively, and approximated $769.4 million and $740.7 million for the six months ended March 31, 2002 and 2003, respectively.

        The Company has the ability to earn performance-based revenue, primarily under certain non-risk contracts. Performance-based revenue generally is based on the ability of the Company to manage care for its ASO clients below specified targets. For each such contract, the Company estimates and records performance-based revenue after considering the relevant contractual terms and the data available for the performance-based revenue calculation. Pro-rata performance-based revenue is recognized on a quarterly reporting basis during the term of the contract pursuant to the rights and obligations of each party upon termination of the contracts. The Company recognized performance revenue of approximately $4.0 million and $2.1 million, for the three months ended March 31, 2002 and 2003, respectively, and approximately $7.4 million and $3.1 million during the six months ended March 31, 2002 and 2003, respectively.

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

        The Company recorded estimated receivables of approximately $1.0 million and $0.2 million as of September 30, 2002 and March 31, 2003, respectively, based upon the Company's interim calculations of the estimated BPAs and certain other settlements. Such amounts were recorded as adjustments to revenues. While management believes that the estimated TRICARE adjustments are reasonable, ultimate settlement resulting from adjustments and available appeal processes may vary from the amounts provided.

Significant Customers

        Net revenues from two of the Company's customers each exceeded ten percent of consolidated net revenues in each of the three-month and six-month periods ended March 31, 2002 and 2003, respectively.

        Net revenue from Aetna approximated $61.4 million and $49.9 million for the three months ended March 31, 2002 and 2003, respectively, and $140.2 million and $104.7 million for the six months ended March 31, 2002 and 2003, respectively. The decline in Aetna revenue of approximately $35.5 million in the six months ended March 31, 2003 compared to the six months ended March 31, 2002 was mainly due to decreased membership as a result of Aetna intentionally reducing its membership levels during calendar 2002 and during the first calendar quarter of 2003 in an effort to exit less profitable businesses. The current Aetna contract extends through December 31, 2005. See Note A—"General" for discussion of the contract extension with Aetna.

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        Both the Company, through its wholly-owned subsidiary Tennessee Behavioral Health, Inc. ("TBH"), and Premier Behavioral Systems of Tennessee, LLC ("Premier"), a joint venture in which the Company has a fifty percent interest, separately contract with the State of Tennessee to manage the behavioral healthcare benefits for the State's TennCare program. In addition, the Company contracts with Premier to provide certain services to the joint venture. The Company recognized approximately $54.9 million and $49.7 million of consolidated net revenue for the three months ended March 31, 2002 and 2003, respectively, and $114.9 million and $112.7 million for the six months ended March 31, 2002 and 2003, respectively in connection with the TennCare program. In addition to revenue under TBH's contract with the State of Tennessee, such revenue amounts include revenue recognized by the Company associated with services performed on behalf of Premier totaling $31.1 million and $23.6 million for the three months ended March 31, 2002 and 2003, respectively, and $64.7 million and $58.2 million for the six months ended March 31, 2002 and 2003, respectively. TBH and Premier are each operating under an agreed notice of administrative supervision. Under such agreements, the State may exercise additional supervision over the affairs of such entities.

        In May 2002, the Company signed a contract with the State of Tennessee under which the Company was to provide all services under the TennCare program through a direct contract with TBH. Such TennCare contract covers the period from July 1, 2002 through December 31, 2003. Accordingly, Premier was to cease providing services upon the expiration of its contract on June 30, 2002; however, the State of Tennessee exercised its option to delay the transfer of Premier's TennCare membership to TBH for up to six months. In December 2002, Premier signed a contract amendment under which the Premier contract was extended through June 30, 2003. On May 9, 2003, Premier and the State of Tennessee executed an extension of the Premier agreement through December 31, 2003, which agreement requires the consent of Magellan's joint venture partner in Premier. The joint venture partner has agreed to give such consent provided that Magellan makes a capital contribution of approximately $0.9 million into Premier (and Premier makes a non-pro rata distribution of a like amount to the joint venture partner). Such a capital contribution requires Bankruptcy Court approval. The Company is seeking such approval. It is uncertain as to what will happen to the Premier membership after the stated expiration of the contract, however, the State of Tennessee has expressed its desire to have more than one managed behavioral health organization involved with the TennCare program. TBH's contract with the State of Tennessee executed in May 2002 is otherwise not materially affected by the changes with the Premier contract.

        The Company has a significant concentration of business related to two separate subcontracts with health plans that contract with TRICARE. The Company recognized net revenues from the first TRICARE contract of $7.7 million and $7.6 million in the quarters ended March 31, 2002 and 2003, respectively. During the six months ended March 31, 2002 and 2003 the Company derived approximately $16.0 million and $16.5 million, respectively, of net revenue from this contract. This contract extends through April 30, 2003. The Company was informed by the health plan that it will not renew this contract beyond that date. The Company recognized net revenues from the second TRICARE contract of $12.0 million and $10.5 million in the quarters ended March 31, 2002 and 2003, respectively. During the six months ended March 31, 2002 and 2003 the Company derived approximately $24.7 million and $24.5 million, respectively, of net revenue from this contract. This contract extends through March 31, 2004. The health plan has not included the Company as a subcontractor in its bid to the government for a contract beyond such date.

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

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$43.2 million and $56.3 million for the quarters ended March 31, 2002 and 2003, respectively, and $79.2 million and $112.5 million for the six months ended March 31, 2002 and 2003, respectively.

Goodwill

        As of October 1, 2001, the Company early adopted Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"). Under SFAS 142, the Company no longer amortizes goodwill over its estimated useful life. Instead, the Company is required to test the goodwill for impairment based upon fair values at least on an annual basis. In accordance with the early adoption of SFAS 142, the Company assigned the book value of goodwill to its reporting units, and performed an initial impairment test as of October 1, 2001.

        The Company has determined that its reporting units are identical to its reporting segments. In the first quarter of fiscal 2002, the Company recorded an impairment charge of $207.8 million, before taxes ($191.6 million after taxes), to write-down the balance of goodwill related to the Workplace reporting unit to estimated fair value, based on independently appraised values. This initial impairment charge was recognized by the Company as a cumulative effect of a change in accounting principle, separate from operating results, in the Company's unaudited condensed consolidated statement of operations for the first quarter of fiscal 2002. The results of operations previously reported for the six months ended March 31, 2002 have been restated herein, as permitted, to reflect the cumulative effect of the adoption of SFAS 142.

Intangible Assets

        At March 31, 2003, the Company had identifiable intangible assets (primarily customer agreements and lists, provider networks and trademarks and copyrights) of approximately $63.9 million, net of accumulated amortization of $56.5 million. During the quarter ended December 31, 2002, management reevaluated the estimated useful lives of the Company's intangible assets, which resulted in reducing the remaining useful lives of certain customer agreements and lists and provider networks. Such reductions reflected management's updated best estimates, given the Company's current business environment. The effect of these changes in remaining useful lives was to increase amortization expense for the three-month and six-month periods ended March 31, 2003 by $1.7 million and $3.5 million, respectively. Net income for such periods has been reduced by the same amounts, or $0.05 and $0.10 per diluted share for the three and six-month periods ended March 31, 2003, respectively. The remaining estimated useful lives at March 31, 2003 of the customer agreements and lists, provider networks, and trademarks and copyrights range from one to eighteen years.

Long-lived Assets

        Long-lived assets, including property and equipment and intangible assets to be held and used, are currently reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount should be addressed pursuant to SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS 144"). Pursuant to this guidance, impairment is determined by comparing the carrying value of these long-lived assets to management's best estimate of the future undiscounted cash flows expected to result from the use of the assets and their eventual disposition. The cash flow projections used to make this assessment are consistent with the cash flow projections that management uses internally to assist in making key decisions, including the development of the proposed financial restructuring. In the event an impairment exists, a loss is recognized based on the amount by which the carrying value exceeds the fair value of the asset, which is generally determined by using quoted market prices or the discounted present value of expected future cash flows. The Company believes that no such impairment existed as of March 31, 2003. In the event that there are changes in the planned use of the Company's long-term assets or its expected future undiscounted cash

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flows are reduced significantly, the Company's assessment of its ability to recover the carrying value of these assets would change. In addition, upon emergence from bankruptcy, the Company believes that it would be required to apply Fresh Start accounting, which could result in a significant change to the recorded values of the Company's long-lived assets.

Income Taxes

        The Company's effective income tax rate decreased to 8.4 percent for the six months ended March 31, 2003 from 41.2 percent for the six months ended March 31, 2002. The current year effective rate is less than federal statutory rates primarily due to the Company's financial restructuring activities and financial condition which result in uncertainty as to the Company's ability to realize net operating loss carryforwards and other deferred tax assets otherwise generated from the net operating loss in the period. The prior year effective rate exceeds federal statutory rates primarily due to state income tax provision.

Stock-Based Compensation

        At March 31, 2003, the Company had stock-based employee incentive plans, which are described more fully in Note 7 in the Company's Annual Report on Form 10-K. The following table illustrates pro forma net income and pro forma net income per share as if the fair value-based method of accounting for stock options had been applied in measuring compensation cost for stock-based awards.

        Reported and pro forma net income and net income per share amounts are set forth below (in thousands, except per share data):

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NOTE C—Supplemental Cash Flow Information

        Below is supplemental cash flow information related to the six months ended March 31, 2002 and 2003 (in thousands):

NOTE D—Income per Common Share

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

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        Conversion of the redeemable preferred stock (see Note I—"Redeemable Preferred Stock") was not presumed for the three-month periods or the six-month periods ended March 31, 2002 or March 31, 2003 due to its anti-dilutive effect. Certain stock options and warrants which were outstanding during the three-month period or the six-month period ended March 31, 2002 were not included in the computation of diluted earnings per share because of their anti-dilutive effect. Because the Company has reported a loss from continuing operations during fiscal 2003, no common stock equivalents have been included in the computation of weighted average common shares outstanding for fiscal 2003.

NOTE E—Discontinued Operations

Healthcare Provider and Franchising Segments

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

        On September 10, 1999, the Company transferred certain assets and other interests and forgave certain receivables pursuant to an agreement with Crescent, COI and CBHS that effected the Company's exit from its healthcare provider and healthcare franchising businesses (the "CBHS Transactions"). The CBHS Transactions, together with the formal plan of disposal authorized by the Company's Board of Directors on September 2, 1999 (the measurement date), represented the disposal of the Company's healthcare provider and healthcare franchising business segments.

Specialty Managed Healthcare Segment

        On October 4, 2000, the Company adopted a formal plan to dispose of the business and interest comprised by the Company's specialty managed healthcare segment. The Company exited the specialty managed healthcare business through the sale and/or abandonment of businesses and related assets, certain of which activities had already occurred in the normal course prior to October 4, 2000. The Company has exited all operating contracts entered into in connection with the specialty managed healthcare segment; however, the Company is obligated to satisfy lease agreements, for which the Company believes it has adequate reserves at March 31, 2003.

Human Services Segment

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

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Accounting for Discontinued Operations

        The Company has accounted for the disposal of the discontinued segments under Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" ("APB 30"). APB 30 requires that the results of continuing operations be reported separately from those of discontinued operations for all periods presented and that any gain or loss from disposal of a segment of a business be reported in conjunction with the related results of discontinued operations. All activity related to the healthcare provider and franchising segments, the specialty managed healthcare segment and the human services segment are reflected as discontinued operations for the six months ended March 31, 2002 and 2003. As permitted, the assets, liabilities and cash flows related to discontinued operations have not been segregated from those related to continuing operations.

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

(1)

Amounts represent positive settlements of certain outstanding Medicare and Medicaid cost reports.

(2)

Interest expense has not been allocated to discontinued operations.

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(3)

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

(4)

Amount for the six months ended March 31, 2003 primarily represents changes in estimates of certain legal fee accruals.

(5)

As part of its financial restructuring plan and chapter 11 proceedings, the Company has rejected certain leases for closed offices. The estimated cost to the Company as a result of rejecting such leases is different than the liability recorded. In accordance with SOP 90-7, such difference has been recorded as reorganization benefit.

        The remaining assets and liabilities of the healthcare provider and franchising segments at March 31, 2003 include, among other things, (i) cash and cash equivalents of $0.7 million; (ii) restricted cash of $2.0 million; (iii) accounts receivable of $0.1 million; (iv) investment in provider joint ventures of $2.4 million; (v) hospital-based real estate of $3.4 million; (vi) long-term debt of $6.4 million related to the hospital-based real estate; and (vii) accounts payable and accrued liabilities of $7.1 million (of which approximately $4.7 million is included in "current liabilities subject to compromise" in the accompanying condensed consolidated balance sheet in accordance with SOP 90-7).

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

        The remaining assets and liabilities of the specialty managed healthcare segment at March 31, 2003 include, among other things, (i) reserve related to the discontinuance of operations of $2.3 million and (ii) accounts payable and accrued liabilities of $0.6 million. These liabilities are included in "current liabilities subject to compromise" in the accompanying condensed consolidated balance sheet in accordance with SOP 90-7.

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

(1)

As part of its financial restructuring plan and chapter 11 proceedings, the Company has rejected certain leases for closed offices. The estimated cost to the Company as a result of rejecting such leases is different than the liability recorded. In accordance with SOP 90-7, such difference has been recorded as a component of reorganization expense (benefit).

NOTE F—Commitments and Contingencies

Insurance

        The Company maintains a program of insurance coverage for a broad range of risks in its business. As part of this program of insurance, the Company is self-insured for a portion of its general and current professional liability risks. Prior to July 1999, the Company maintained certain reserves related primarily to the professional liability risks of the Company's healthcare provider segment prior to the Crescent Transactions. On July 2, 1999, the Company transferred its remaining medical malpractice claims portfolio (the "Loss Portfolio Transfer") to a third-party insurer for approximately $22.3 million. The Loss Portfolio Transfer was funded from assets restricted for settlement of unpaid claims. The insurance limit obtained through the Loss Portfolio Transfer for future medical malpractice claims is $26.3 million. The Company continually evaluates the adequacy of this insured limit and management believes such amount is sufficient; however, there can be no assurance in that regard.

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        The Company maintained general, professional and managed care liability insurance policies with unaffiliated insurers covering the two-year period from June 17, 2000 to June 16, 2002. The policies were written on a "claims-made" basis, subject to a $250,000 per claim and $1.0 million annual aggregate self-insured retention for general and professional liability, and also subject to a $500,000 per claim and $2.5 million annual aggregate self-insured retention for managed care liability. The Company renewed its general, professional and managed care liability insurance policies with unaffiliated insurers for a one-year period beginning June 17, 2002. The new policies are also written on a "claims-made" basis, and are subject to a $1.0 million per claim ($5.0 million per class action claim) un-aggregated self-insured retention for managed care liability, and a $250,000 per claim un-aggregated self-insured retention for general and professional liability. The Company also purchases excess liability coverage in an amount deemed reasonable by management for the size and profile of the organization. The Company is responsible for claims within its self-insured retentions. In addition, the Company is responsible for claims reported after the expiration date of the policies if they are not renewed, and for portions of claims that exceed the policy limits.

Regulatory Issues

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

        In addition, the Company's financial condition could cause regulators of certain of the Company's subsidiaries to exercise certain discretionary rights under regulations including increasing its supervision of such entities, requiring additional restricted cash or other security or seizing or otherwise taking control of the assets and operations of such subsidiaries. During fiscal 2003, the State of California has taken certain actions to increase its supervision of one of the Company's subsidiaries in California. In addition, TBH and Premier are each operating under an agreed notice of administrative supervision. Under such agreements, the State of Tennessee may exercise additional supervision over the affairs of such entities.

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HIPAA

        Confidentiality and patient privacy requirements are particularly strict in the field of behavioral healthcare. The Health Insurance Portability and Accountability Act of 1996 ("HIPAA") requires the Secretary of the Department of Health and Human Services ("HHS") to adopt standards relating to the transmission, privacy and security of health information by healthcare providers and healthcare plans. HIPAA calls for HHS to create regulations in several different areas to address the following: electronic transactions and code sets, privacy, security, provider IDs, employer IDs, health plan IDs and individual IDs. At present, regulation relating to electronic transactions and code sets, privacy, employer IDs and security have been released in final form. The Company has commissioned a dedicated HIPAA Project Management Office ("PMO") to coordinate participation from its customers, providers and business partners in achieving compliance with these regulations. The Company, through the PMO, has put together a dedicated HIPAA Project Team to develop, coordinate and implement the compliance plan. Additionally, the Company has identified business area leads and work group chairpersons to support and lead compliance efforts related to their areas of responsibility and expertise.

        The Transactions and Code Sets regulation is final and was originally scheduled to become effective on October 16, 2002; however, companies may now elect a one-year deferral. The Company has filed for the extension as permitted by law. This regulation establishes standard data content and formats for the submission of electronic claims and other administrative and health transactions. This regulation only applies to electronic transactions, and healthcare providers will still be able to submit paper documents without being subject to this regulation. In addition, health plans must be prepared to receive these various transactions. The Company has completed the development of a new electronic data interchange ("EDI") strategy, which it believes will significantly enhance its HIPAA compliance efforts. The Company has signed an agreement with an external EDI tool vendor to expand the Company's usage of EDI technology, developed a project plan and an accompanying resource requirements rationale and identified anomalies through mapping of the HIPAA standard transactions to the Company's various clinical, claim and provider systems.

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

        The draft version of the regulation on security was published on August 12, 1998. The final version of this rule was published on February 20, 2003 with a compliance date of April 21, 2005. This regulation creates safeguards for physical and electronic storage of, maintenance and transmission of, and access to, individual health information. Although the final security regulation was just recently released, the Company began compliance efforts over two years ago by taking steps to address the requirements of the draft regulation through the implementation of technical, physical and

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administrative safeguards to enhance physical, personnel and information systems security. The Company is now reviewing the final rule to determine what other actions must be taken to ensure compliance with the rule by the compliance date.

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

        Management is currently assessing and acting on the wide reaching implications of these regulations to ensure the Company's compliance by the respective implementation dates. Management has identified HIPAA as a major initiative impacting the Company's systems, business processes and business relationships. This issue extends beyond the Company's internal operations and requires active participation and coordination with the Company's customers, providers and business partners. Management has commissioned a dedicated HIPAA project team to develop, coordinate and implement our compliance plan. With respect to the proposed regulation on security and the final regulation on privacy, the Company has hired personnel dedicated to physical and information security issues, appointed an officer who will be responsible for privacy issues, commissioned separate security and privacy workgroups to identify and assess the potential impact of the regulations and reviewed current policies and drafted new policies to comply with the new requirements. The Company incurred approximately $1.2 million and $0.9 million in operating costs during the three months ended March 31, 2002 and 2003, respectively, and approximately $1.9 million and $1.6 million during the six months ended March 31, 2002 and 2003, respectively. Capital expenditures related to HIPAA were approximately $0.8 million and $0.7 million for the three months ended March 31, 2002 and 2003, respectively, and approximately $0.8 million and $1.4 million for the six months ended March 31, 2002 and 2003, respectively. Management estimates that the Company will incur approximately $1.5 million to $2.5 million in operating expenditures and approximately $2.5 million to $3.5 million in capital expenditures during the remaining six months of fiscal 2003 related to HIPAA.

Legal

        On March 11, 2003, the Company and 88 of its subsidiaries filed voluntary petitions for relief under chapter 11 of the Bankruptcy Code in the Bankruptcy Court (Case Nos. 03-40514 through 03-40602). The Company continues to operate its business and manage its property as a debtor-in-possession pursuant to sections 1107 and 1108 of the Bankruptcy Code. As a result of the filing, attempts to collect, secure or enforce remedies with respect to pre-petition claims against the Company are subject to the automatic stay provisions of section 362(a) of the Bankruptcy Code. The Company's chapter 11 cases are discussed in greater detail in Note A—"General" to the Company's unaudited condensed consolidated financial statements set forth elsewhere herein and in "Management's Discussion and Analysis of Financial Condition and Results of Operations—Voluntary Chapter 11 Filing".

        On or about August 4, 2000, the Company was served with a lawsuit filed by Wachovia Bank, N.A. ("Wachovia") in the Court of Common Pleas of Richland County, South Carolina, seeking recovery under the indemnification provisions of an Engagement Letter between South Carolina National Bank (now Wachovia) and the Company and the Employee Stock Ownership Plan ("ESOP") Trust Agreement between South Carolina National Bank (now Wachovia) and the Company for losses sustained in a settlement entered into by Wachovia with the United States Department of Labor ("DOL") in connection with the ESOP's purchase of stock of the Company in 1990 while Wachovia

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served as ESOP Trustee. The participants of the ESOP were primarily employees who worked in the Company's healthcare provider and franchising segments. The Company subsequently removed the case to the United States District Court for the District of South Carolina (Case No. 3:00-CV-02664). Wachovia also alleges fraud, negligent misrepresentation and other claims, and asserts losses of $30 million from the settlement with the DOL (plus costs and interest which amount to approximately $10 million as of the date of filing of this Form 10-Q). During the second quarter of fiscal 2001, the court entered an order dismissing all of the claims asserted by Wachovia, with the exception of the contractual indemnification portion of the claim. The Company disputes Wachovia's claims and has been vigorously contesting such claims. During November 2002, the Company's Board of Directors rejected a proposed settlement of this claim that had been reached as a result of a court-ordered mediation. As a result, the Company has not recorded any reserves relating to this matter. No trial date has been set by the Court.

        On October 26, 2000, two class action complaints (the "Class Actions") were filed against Magellan Health Services, Inc. and Magellan Behavioral Health, Inc. (the "Defendants") in the United States District Court for the Eastern District of Missouri under the Racketeer Influenced and Corrupt Organizations Act ("RICO") and the Employment Retirement Income Security Act of 1974 ("ERISA"). The class representatives purport to bring the actions on behalf of a nationwide class of individuals whose behavioral health benefits have been provided, underwritten and/or arranged by the Defendants since 1996 (RICO class) and 1994 (ERISA class). The complaints allege violations of RICO and ERISA arising out of the Defendants' alleged misrepresentations with respect to and failure to disclose its claims practices, the extent of the benefits coverage and other matters that cause the value of benefits to be less than the value represented to the members. The complaints seek unspecified compensatory damages, treble damages under RICO, and an injunction barring the alleged improper practices, plus interest, costs and attorneys' fees. During the third quarter of fiscal 2001, the court transferred the Class Actions to the United States District Court for the District of Maryland (Case No. L-01-01786). These actions are similar to suits filed against a number of other health care organizations, elements of which have already been dismissed by various courts around the country, including the Maryland court where the Class Actions are now pending. While the Class Actions are in the initial stages and an outcome cannot be determined, the Company believes that the claims are without merit and intends to defend them vigorously. The Company has not recorded any reserves related to these matters.

        The Company is also subject to or party to other class action suits, litigation and claims relating to its operations and business practices.

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

Unclaimed Property

        Several states have initiated audits of the Company's filings related to unclaimed property under escheat laws. A single firm that specializes in unclaimed property audits is conducting the audits on behalf of such states. In general, state escheat statutes allow the examination of unclaimed property filings to extend back 10 years or more. The Company has recorded estimated reserves for potential unclaimed property liabilities pertaining to its continuing operations. The Company is also analyzing its potential unclaimed property exposure related to discontinued operations. However, such amounts are not considered probable and estimable at this time, and no discontinued operations reserves related to unclaimed property have been recorded at March 31, 2003.

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NOTE G—Managed Care Integration Plan and Special Charges

Integration Plan

        During fiscal 1998, management committed the Company to a plan to combine and integrate the operations of its managed behavioral care organizations and specialty managed care organizations (the "Integration Plan") that resulted in the elimination of certain duplicative functions, closure of facilities and standardized business practices and information technology platforms. As of March 31, 2003, the remaining Integration Plan liability balance represents the estimated net lease payments related to one leased office facility. The following table provides a roll-forward of remaining liabilities resulting from the Integration Plan (in thousands):

(1)

The Company has negotiated a lease buyout at an amount that was less than the remaining, recorded liability. In accordance with Emerging Issues Task Force ("EITF") Issue No. 95-3 "Recognition of Liabilities in Connection with a Purchase Business Combination" ("EITF 95-3"), the difference of approximately $0.4 million has been recorded as a reduction to goodwill, as the original liability was created by the Company's exit of an activity associated with the purchase of a company.

Special Charges

        During fiscal 2000 the Company incurred special charges related to the closure of certain provider offices and restructuring of the corporate function and certain managed behavioral healthcare office sites. At March 31, 2003, outstanding liabilities of approximately $1.2 million related to such activities are included in "current liabilities subject to compromise" in the accompanying condensed consolidated balance sheet, in accordance with SOP 90-7.

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

(1)

As part of its financial restructuring plan and chapter 11 proceedings, the Company has rejected certain leases for closed offices. The estimated cost to the Company as a result of rejecting such leases is different than the liability recorded. In accordance with SOP 90-7, such difference has been recorded as a component of "reorganization expense" in the accompanying condensed consolidated statements of operations.

        As of December 31, 2001, management committed the Company to a restructuring plan to eliminate certain duplicative functions and facilities (the "2002 Restructuring Plan") primarily related to the Health Plans segment. The Company's 2002 Restructuring Plan resulted in the recognition of special charges of approximately $8.2 million during fiscal 2002, with special charges of $7.9 million being recorded during the six months ended March 31, 2002. The special charges for fiscal 2002 consisted of (a) $6.3 million to terminate 277 employees, the majority of which were field operational

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personnel in the Health Plans segment, and (b) $1.9 million to downsize and close excess facilities, and other associated activities. The employee termination costs included severance and related termination benefits, including payroll taxes. All terminations and termination benefits were communicated to the affected employees in fiscal 2002, with the majority of the terminations completed by September 30, 2002. The remaining employee termination costs are expected to be paid in full by April 30, 2004. The special charges of $1.9 million represent costs to downsize and close 14 leased facilities. These closure and exit costs include payments required under lease contracts (less any applicable existing and/or estimated sublease income) after the properties were abandoned, write-offs of leasehold improvements related to the facilities and other related expenses. At March 31, 2003, outstanding liabilities of approximately $0.8 million related to the 2002 Restructuring Plan are included in "current liabilities subject to compromise" in the accompanying condensed consolidated balance sheet, in accordance with SOP 90-7.

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

(1)

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

(2)

As part of its financial restructuring plan and chapter 11 proceedings, the Company has rejected certain leases for closed offices. The estimated cost to the Company as a result of rejecting such leases is different than the liability recorded. In accordance with SOP 90-7, such difference has been recorded as a component of "reorganization expense" in the accompanying condensed consolidated statements of operations.

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

        During the six months ended March 31, 2003, the Company continued the ABI initiative, which resulted in the recognition of special charges of (a) $3.7 million to terminate an additional 245 employees that represented both field operational and corporate personnel, and (b) $0.5 million to downsize and close additional excess facilities and other associated activities. The employee termination costs of $3.7 million include severance and related termination benefits, including payroll taxes. All terminations and termination benefits were communicated to the affected employees during the six months ended March 31, 2003, with all of the terminations completed by May 1, 2003. All employee termination costs accrued and unpaid as of March 31, 2003 are expected to be paid in full by September 30, 2004. The other special charges primarily represent costs to downsize and close three leased facilities. These closure and exit costs include payments required under lease contracts (less any applicable existing or estimated sublease income) after the properties were abandoned, write-offs of leasehold improvements related to the facilities and other related expenses. At March 31, 2003,

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outstanding liabilities of approximately $2.4 million related to ABI are included in "current liabilities subject to compromise" in the accompanying unaudited condensed consolidated balance sheet, in accordance with SOP 90-7.

        The following table provides a roll-forward of liabilities resulting from the special charges incurred in the implementation of this plan (in thousands):

(1)

As part of its financial restructuring plan and chapter 11 proceedings, the Company has rejected certain leases for closed offices. The estimated cost to the Company as a result of rejecting such leases is different than the liability recorded. In accordance with SOP 90-7, such difference has been recorded as a component of "reorganization expense" in the accompanying condensed consolidated statements of operations.

        Implementation of ABI resulted in additional incremental costs that were expensed as incurred. Special charges for the six months ended March 31, 2003 includes $1.8 million for the cost of outside consultants, costs for relocating closed office contents and other associated activities.

NOTE H—Business Segment Information

        The Company operates solely in the managed behavioral healthcare business. The Company provides managed behavioral healthcare services to health plans, insurance companies, corporations, labor unions and various governmental agencies. Within the managed behavioral healthcare business, the Company is further divided into the following four segments, based on the services it provides and/or the customers that it serves, as described below.

Health Plans

        The Company provides managed behavioral healthcare services primarily to beneficiaries of managed care companies, health insurers and other health plans. Health Plans' contracts encompass both risk-based and ASO contracts. Although certain large health plans provide their own managed behavioral healthcare services, many health plans "carve out" behavioral healthcare from their general healthcare services and subcontract such services to managed behavioral healthcare organizations such as the Company. In the Health Plans segment, the Company's members are the beneficiaries of the health plan (the employees and dependents of the customer of the health plan), for which the behavioral healthcare services have been carved out to the Company.

        Workplace.    The Company's Workplace segment mainly provides EAP services and integrated products primarily to employers, including corporations and governmental agencies. In addition, the Workplace segment provides ASO products to certain health plan customers, including Aetna.

        Public.    The Company provides managed behavioral healthcare services to Medicaid recipients through direct contracts with state and local governmental agencies. Public's contracts encompass both risk-based and ASO contracts.

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        Corporate and Other.    This segment of the Company primarily comprises operational support functions such as claims administration, network services, sales and marketing, and information technology as well as corporate support functions such as executive, finance and legal. Discontinued operations activity is not included in the Corporate and Other segment operating results.

        The accounting policies of these segments are the same as those described in the summary of significant accounting policies included in the Company's Annual Report on Form 10-K/A. The Company evaluates performance of its segments based on profit or loss from continuing operations before depreciation, amortization, interest (net), goodwill impairment charges, special charges, income taxes and minority interest ("Segment Profit"). Intersegment sales and transfers are not significant.

        The following tables summarize, for the periods indicated, operating results and other financial information, by business segment (in thousands):