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

FORM 10-K

Commission File No. 1-6639

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

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

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

        Securities registered pursuant to Section 12(g) of the Act: Common Stock ($0.25 per share par value).

        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 twelve 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 /x/ No / /

        The aggregate market value of the common stock held by non-affiliates of the registrant as of the most recently completed second fiscal quarter of June 30, 2003 was approximately $1.4 million.

        The number of shares of the registrant's common stock outstanding as of July 31, 2003 was 35,318,926.

        DOCUMENTS INCORPORATED BY REFERENCE:    None.

MAGELLAN HEALTH SERVICES, INC.
TRANSITION REPORT ON FORM 10-K
For the Three Months Ended December 31, 2002

Table of Contents

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PART I

        This Form 10-K includes "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act") and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Although the Company believes that its plans, intentions and expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such plans, intentions or expectations will be achieved. Prospective investors are cautioned that any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties and that actual results may differ materially from those contemplated by such forward-looking statements. Important factors currently known to management that could cause actual results to differ materially from those in forward-looking statements are set forth under the heading "Cautionary Statements" in Item 1 and elsewhere in this Form 10-K. When used in this Form 10-K, the words "estimate", "anticipate", "expect", "believe", "should" and similar expressions are intended to be forward-looking statements.

Item 1. Business

        Magellan Health Services, Inc. ("Magellan" or the "Company"), which was incorporated in 1969 under the laws of the State of Delaware, is a national healthcare company. The Company operates in the managed behavioral healthcare business. The Company's executive offices are located at Suite 400, 6950 Columbia Gateway Drive, Columbia, Maryland 21046, and its telephone number at that location is (410) 953-1000.

        In May 2003, the Company's board of directors approved a change in the Company's fiscal year. Instead of a fiscal year ending on September 30, the Company has adopted a fiscal year that coincides with the calendar year, effective December 31, 2002. Throughout this Transition Report on Form 10-K, references to the Company's historical financial information prior to December 31, 2002 will refer to the Company's former fiscal year end of September 30. For example, fiscal years 2000, 2001 and 2002 correspond to the twelve-month periods ending September 30, 2000, 2001 and 2002, respectively. References to fiscal 2003 relate to the Company's fiscal year ending December 31, 2003.

Capital Structure Overview

        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 Bankruptcy Code (the "Bankruptcy Code") in the United States Bankruptcy Court for the Southern District of New York (the "Bankruptcy Court") (the "Chapter 11 Cases"). 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. Since the Commencement Date, the Company has remained in possession of its properties and businesses and has continued 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

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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, 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 are the primary entities with which Magellan will negotiate the treatment of the claims of general unsecured creditors. The Official Committee comprises five members, 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 July 25, 2003 (the "Plan"). Prior to the commencement date of its Chapter 11 Cases, the Company negotiated the terms of a financial restructuring which was incorporated in the original plan of reorganization filed with the Bankruptcy Court on March 11, 2003 ("Original Plan"). Prior to the commencement date of the Chapter 11 Cases, the Company entered into lock-up and voting agreements for the support of the Original Plan that the Company executed with 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. In connection with the execution of an equity commitment letter with Onex Corporation (the "Equity Investor"), as described below, which was supported by the Official Committee and the agent for the Company's senior lenders, certain modifications were made to the Original Plan as incorporated in the Plan. As a result, the counterparties may terminate such lock-up and voting agreements thereto because certain conditions have not been met. The Official Committee has stated that they support the Plan. 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 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. One creditor has informed the Company that it owns sufficient Senior Subordinated Notes to block such class of creditors' acceptance of the Plan, and has notified the Company that it intends to vote against the Plan. If the class of claims holders of Senior Subordinated Notes does not vote to accept the Plan, the Company believes that it will be able to confirm the Plan under the applicable provisions of the Bankruptcy Code. There can be no assurance, however, that the Company will be able to do so.

        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. On July 25, 2003, the Company filed with the Bankruptcy Court its Second 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 July 29, 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 88.0% of the new common stock of reorganized Magellan (the "New Common Stock"). Holders of the

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Company's $250.0 million of Senior Notes will exchange their Senior Notes and all accrued and unpaid interest thereon for new unsecured notes (the "New Notes") in an amount equal to the face amount of the Senior Notes plus cash equal to the 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 existing Senior Notes, will have a maturity of November 15, 2008 and an interest rate of 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, cash, New Common Stock equal to approximately 9.5% of reorganized Magellan, 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 will receive approximately 2.0% of the New Common Stock, as well as warrants to purchase a like number of shares of New Common Stock. The existing common stock of the Company will also be cancelled and the holders thereof will receive approximately 0.5% of the New Common Stock of the reorganized entity, as well as warrants to purchase a like number of shares of New Common Stock. The distributions of New Common Stock under the Plan will be subject to the dilutive effects of the amount of New Common Stock issued in respect of a rights offering and a direct equity investment for approximately 34.4% of the reorganized entity (see below). Pursuant to the Plan, all outstanding options and warrants to purchase existing common stock will be cancelled, and will not be replaced with options or warrants to purchase New Common Stock. The proposed distributions to the holders of existing preferred stock and common stock are conditioned on all classes of creditors accepting the Plan. The Company has been informed that one creditor who owns sufficient Senior Subordinated Notes to block such class from accepting the Plan intends to vote against the Plan. Under such circumstances, no distribution of New Common Stock will be made to holders of existing preferred stock or common stock, and such New Common Stock will be distributed to holders of general unsecured claims (other than Senior Notes claims).

        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 $73.5 million, will be either repaid in full (as discussed further below) or will be paid $50.0 million in cash and the remaining balance will be converted to secured term loans (and letter of credit commitments with respect to outstanding letters of credit and renewals thereof) having maturities through November 30, 2005 (the "New Facilities"). The New Facilities would bear interest at a rate equal to the prime rate plus 3.25 percent and the Company would 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 would pay the lenders a fee of one percent of the New Facilities on the effective date of the Plan. The New Facilities would be guaranteed by substantially all of the subsidiaries of Magellan and would be secured by substantially all of the assets of Magellan and the subsidiary guarantors. It is anticipated that the New Facilities will not be used and instead, the Credit Agreement will be refinanced as described below.

        On August 1, 2003, the Company entered into a commitment letter with Deutsche Bank (the "DB Commitment Letter') to provide an exit facility (the "Exit Facility") that would provide $100.0 million in term loans, an $80.0 million letter of credit facility and a $50.0 million revolving credit facility. The interest rate on the Exit Facility would be lower than the rates of interest on the New Facilities. Borrowings under the Exit Facility would have a term of five years. The Exit Facility would be guaranteed by substantially all of the subsidiaries of Magellan and would be secured by substantially all of the assets of Magellan and the subsidiary guarantors. The proceeds of the Exit Facility, together with cash on hand, would be used to repay the obligations under the existing Credit Agreement, to pay fees and expenses related to the Chapter 11 Cases, to make other cash payments contemplated by the Chapter 11 Cases, and for general working capital purposes. The DB Commitment Letter is subject to a number of conditions, the satisfaction or waiver of which is necessary prior to Deutsche Bank's

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obligations thereunder. There is no assurance that the Company will satisfy such conditions or have such conditions waived and therefore no assurance can be given that the Company will be able to borrow under the Exit Facility.

        The Plan provides for an option for holders of Senior Subordinated Notes and general unsecured creditors to elect to receive cash in lieu of New Common Stock that they would otherwise be entitled to receive (up to an aggregate maximum of $50 million) at a price of $22.50 per share (the "Partial Cash Out Election"). If such election is oversubscribed, those holders electing such option would be entitled to participate on a pro rata basis and would receive shares of New Common Stock for the portion of the shares of New Common Stock that is not fully cashed out. Under the Plan, this $50 million cash out election would be funded by the purchase of equity by Onex Corporation (the "Equity Investor") as set forth below. If the entire $50 million is subscribed for, approximately 13.6% of the equity of reorganized Magellan would not be issued to creditors, but would be issued to the Equity Investor as set forth below.

        The Plan also provides, in accordance with a commitment letter between the Company and the Equity Investor, for reorganized Magellan to issue shares of common stock representing approximately 34.4% of the reorganized Magellan for a purchase price of $150 million in the aggregate. The terms of such offering are as follows: (i) approximately 2.63 million shares, representing approximately 17.2% of reorganized Magellan would be offered to holders of the existing Senior Subordinated Notes and general unsecured creditors for $75 million in the aggregate (or $28.50 per share); (ii) to the extent the holders of the Senior Subordinated Notes and general unsecured creditors elect not to participate in such offering, the Equity Investor would purchase the unsubscribed equity at the same price; and (iii) approximately 2.63 million shares, representing approximately 17.2% of the reorganized Magellan would be purchased by the Equity Investor for a purchase price of $75 million in the aggregate (or $28.50 per share). In addition, up to 13.6% of reorganized Magellan would be purchased by the Equity Investor at an aggregate purchase price of $50 million (or $22.50 per share) solely to the extent necessary to fully fund the Partial Cash-Out Election.

        All purchases made by the Equity Investor would be of a separate class of common stock (the "MVS Securities"), which would be shares of multiple voting common stock of reorganized Magellan. The MVS Securities will be issued to the Equity Investor pursuant to the terms of the Plan. Each share of MVS Securities and each share of the New Common Stock will be identical in all respects, except with respect to voting and except that (a) the MVS Securities will be convertible into New Common Stock, as provided in the Amended Certificate of Incorporation and (b) the Equity Investor and its affiliates (including any entity to which MVS Securities could be transferred without conversion pursuant to the penultimate sentence of this section) shall convert shares of New Common Stock that they may acquire into the same number of shares of MVS Securities unless no MVS Securities are then outstanding. Pursuant to the terms of the Plan, the Equity Investor shall receive shares of MVS Securities on the effective date of the Plan, which MVS Securities shall be entitled to exercise 50% of the voting rights pertaining to all of reorganized Magellan's outstanding common stock (including the New Common Stock and the MVS Securities). The MVS Securities shall be convertible into the same number of shares of New Common Stock upon the transfer of the MVS Securities to any person other than the Equity Investor, Onex, Onex Partners LP, a Delaware limited partnership ("Onex Partners") or an entity controlled by Onex or Onex Partners (including a change of control of any entity other than Onex or Onex Partners owning the MVS Securities so that it is no longer controlled by Onex or Onex Partners). Onex shall be deemed to control any entity controlled by Mr. Gerald W. Schwartz so long as Mr. Schwartz controls Onex. All MVS Securities shall cease to have any special voting rights (i.e., each share of MVS Securities and New Common Stock shall have one vote per share and shall vote together on all matters submitted to stockholders, including the election of all members of the Board of Directors of reorganized Magellan, as a single class) if at any time either (i) the number of outstanding MVS Securities is less than 15.33% of the total number of MVS Securities and shares of New Common Stock issued on the Effective Date or (ii) the number of outstanding MVS Securities is

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less than 10% of the aggregate number of MVS Securities and shares of New Common Stock then outstanding.

        As part of, and subject to, consummation of the Plan, Aetna Inc. ("Aetna") and Magellan have agreed to renew their behavioral health services 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 would 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 would mature on December 31, 2005. The Aetna Note would be guaranteed by substantially all of the subsidiaries of Magellan and would 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 would be payable on December 31, 2005, and the remainder would 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 Bankruptcy Court approved the renewal of the Aetna agreement 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. The Company's current liquidity is not sufficient to satisfy the obligations under such acceleration. However, under Section 362 of the Bankruptcy Code, the lenders under the Credit Agreement and the 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 Subsequent to December 31, 2002.    Subsequent to the Commencement Date, the Company's 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 confirm a plan of reorganization under the Bankruptcy Code and obtain emergence financing; (ii) the ability of the Company to successfully achieve required cost savings to complete its restructuring; (iii) the ability of the Company to maintain adequate cash on hand; (iv) the ability of the Company to generate cash from operations; (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 consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that might result should the Company be unable to continue as a going concern.

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        The Company's financial statements subsequent to the Commencement Date reflect liabilities that are subject to compromise, which refers 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 include Senior Notes, Senior Subordinated Notes, interest accrued on the Senior Notes and Senior Subordinated Notes, contingent purchase price payable to Aetna, medical claims payable, and other unsecured pre-petition liabilities.

        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 $18.5 million of capitalized deferred financing fees associated with the Senior Notes and Senior Subordinated Notes. Subsequent to the Commencement Date, the Company has recorded as reorganization expense its 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. To the extent the estimated cost to the Company as a result of rejecting such leases is different than the liability recorded, such difference has been recorded as a component of reorganization expense, in accordance with SOP 90-7. Subsequent to the Commencement Date, the Company has recognized the net benefit from rejected leases of closed offices of approximately $3.5 million.

        Subsequent to the Commencement Date, 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 has 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 Company's financial statements subsequent to the Commencement Date, to the extent such liabilities have 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 as of the Commencement Date, 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. 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.

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History

        Prior to June 1997, the Company's primary business was the operation of psychiatric hospitals. During the first quarter of fiscal 1996, the Company acquired a 61.0% ownership interest in Green Spring Health Services, Inc. ("Green Spring"), a managed behavioral healthcare company specializing in mental health and substance abuse/dependence services. At that time, the Company intended to become a fully integrated behavioral healthcare provider by combining the managed behavioral healthcare products offered by Green Spring with the direct treatment services offered by the Company's psychiatric hospitals. During the second quarter of fiscal year 1998, the minority stockholders of Green Spring converted their 39.0% ownership interest in Green Spring into an aggregate of 2,831,516 shares of the Company's common stock and Green Spring became a wholly owned subsidiary of the Company. Subsequent to the Company's acquisition of Green Spring, based on the Company's belief that the managed behavioral healthcare industry offered growth and earnings prospects superior to those of the psychiatric hospital industry, the Company decided to sell its domestic psychiatric facilities to obtain capital for expansion of its managed behavioral healthcare business.

        In June 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 ("Crescent") for approximately $400.0 million, net of approximately $17.2 million in costs (the "Crescent Transactions"), and used approximately $200.0 million of the proceeds to reduce long-term debt, including borrowings under the then existing credit agreements. 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 50.0% ownership of CBHS; the other 50.0% of the ownership interest of CBHS was owned by COI.

        The Crescent Transactions provided the Company with approximately $200.0 million of net cash proceeds, after debt repayment. The Company used the proceeds to finance the acquisition of Allied Specialty Care Services, Inc. ("Allied") (which became part of the Company's specialty managed healthcare segment) as well as two acquisitions in managed behavioral healthcare as follows:

        On December 4, 1997, the Company consummated the purchase of Human Affairs International, Incorporated ("HAI"), from Aetna for approximately $122.1 million, which the Company funded from cash on hand. HAI managed behavioral healthcare programs primarily through employee assistance programs ("EAPs") and other managed behavioral healthcare plans. In addition, the Company agreed to make additional contingent payments of up to $60.0 million annually to Aetna through 2003 in the event certain targets were achieved with respect to the number of HAI's covered lives in specified products. The Company has made additional purchase price payments totaling $240.0 million through December 31, 2002. The final payment of $60.0 million was accrued in June 2002 and was due to be paid to Aetna in February 2003. See proposed disposition of the $60.0 million liability to Aetna as discussed in the Plan above.

        On February 12, 1998, the Company consummated the acquisition of Merit Behavioral Care Corporation ("Merit") for cash consideration of approximately $448.9 million plus the repayment of Merit's debt. Merit managed behavioral healthcare programs across all segments of the healthcare industry, including health maintenance organizations ("HMOs"), Blue Cross/Blue Shield organizations and other insurance companies, corporations and labor unions, federal, state and local governmental agencies and various state Medicaid programs. In connection with the consummation of the Merit acquisition, the Company entered into the Credit Agreement, which provided for a revolving credit facility (the "Revolving Facility") of up to $150.0 million and a term loan facility (the "Term Loan Facility") which provided for borrowings of up to $550.0 million, and the Company issued the Subordinated Notes pursuant to an indenture which governs the Subordinated Notes (the

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"Subordinated Notes Indenture"). Interest on the Subordinated Notes, which mature on February 15, 2008, is payable semi-annually on each February 15 and August 15.

        In connection with these acquisitions, the Company implemented the Managed Care Integration Plan starting in fiscal year 1998 to combine and integrate the Company's managed behavioral healthcare organizations and specialty managed care organizations. The plan included the elimination of duplicate staffing and facilities and the standardization of business practices and information technology platforms. See Note 11—"Managed Care Integration Costs and Special Charges" to the Company's audited consolidated financial statements set forth elsewhere herein.

        During fiscal 1999, the Company completed its exit from the healthcare provider and franchising businesses by selling its European psychiatric provider operations for approximately $57.0 million in April 1999 and consummating the transfer of certain assets and other interests in September 1999 pursuant to a Letter Agreement with Crescent, COI and CBHS. Under the Letter Agreement, the Company redeemed 80.0% of its common interest and all of its preferred interest in CBHS, agreed to transfer to CBHS its interests in five of its six hospital-based joint ventures ("Provider JVs") and related real estate, transferred certain assets to CBHS, agreed to pay $2.0 million to CBHS in twelve equal monthly installments beginning on the first anniversary of the closing date, transferred its healthcare franchising interest to CBHS and forgave unpaid franchise fees of approximately $115.0 million (the "CBHS Transaction"). See Note 4—"Discontinued Operations" to the Company's audited consolidated financial statements set forth elsewhere herein. The CBHS Transaction, 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 under APB 30.

        On February 16, 2000, CBHS filed a voluntary petition for relief of indebtedness under Chapter 11 of the United States Bankruptcy Code. In connection with the bankruptcy proceedings, CBHS indicated that it believed that it had certain claims against the Company regarding certain previous transactions. During fiscal 2001, the Company entered into an agreement with CBHS that provided the Company with a full release of all claims. The bankruptcy court approved the agreement in April 2001. Under the agreement, (i) the Company was released from all obligations to CBHS, (ii) the Company obtained the economic value of the five Provider JVs that were previously conveyed to CBHS and (iii) the Company agreed to pay CBHS approximately $26.0 million over a period of 270 days from the date on which the agreement was approved by the bankruptcy court. The Company paid the final installment on this obligation of $5.0 million to CBHS in January 2002. The Company, with the cooperation of its joint venture partners and CBHS, has sold the assets and operations of three Provider JVs and ceased the operations of the other two Provider JVs.

        On October 4, 2000, the Company adopted a formal plan to exit from the businesses included in the Company's specialty managed healthcare segment through the sale and/or abandonment of these businesses and related assets. The specialty managed healthcare segment included the businesses acquired in conjunction with the purchase of Vivra, Inc. ("Vivra"), which was consummated February 29, 2000 and Allied which was consummated on December 5, 1997. The purchase price for Vivra was $10.3 million. The Company paid approximately $54.5 million for Allied. The Company exited the specialty managed healthcare business via 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 contracts entered into by Allied and Vivra; however, the Company is obligated to satisfy lease agreements through 2008, for which the Company believes it has adequate reserves at December 31, 2002.

        On January 18, 2001, the Board of Directors approved, and the Company entered into a definitive agreement for, the sale of the stock of National Mentor, Inc. ("Mentor"), which represented the business and interests that comprised the Company's human services segment. The human services the Company provided through Mentor included specialty home-based healthcare services provided through

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"mentor" homes, as well as residential and day treatment services for individuals with acquired brain injuries and for individuals with developmental disabilities.

        On May 31, 2001, the Company issued $250.0 million of Senior Notes, which mature on November 15, 2007 and are general senior unsecured obligations of the Company. Interest on the Senior Notes is payable semi-annually on each May 15 and November 15. The gross proceeds of $250.0 million from the issuance and sale of the Senior Notes, together with cash on hand, were used to pay the initial purchasers' fees and other expenses related to the offering and to repay indebtedness outstanding under the Company's Term Loan Facilities as follows: $99.6 million under Tranche A Term Loans, $75.2 million under Tranche B Term Loans and $75.2 million under Tranche C Term Loans. In connection with the issuance of the Senior Notes, the Company also amended its Credit Agreement.

        As of December 31, 2002, the Company has disposed of its human services segment in its entirety, and has taken the majority of the actions necessary to complete the disposal of or shutting down of its healthcare provider and franchising segments and its specialty managed healthcare segment, but still has certain assets and liabilities of these segments on its balance sheet. These remaining assets and liabilities are described in Note 4—"Discontinued Operations" to the Company's audited consolidated financial statements set forth elsewhere herein. As of December 31, 2002, the Company has recorded reserves on its balance sheet for estimates of all future losses and expenses of disposal of these segments. However, there can be no assurance that the reserves established will prove to be adequate. In the event that any future losses or expenses exceed the amount of reserves on the balance sheet, the Company will be required to record additional losses on disposal of discontinued operations or losses from discontinued operations in the income statement.

        APB 30 requires that the results of continuing operations be reported separately from those of discontinued operations for all periods presented and that any gain or loss from disposal of a segment of a business be reported in conjunction with the related results of discontinued operations. Accordingly, the Company has restated its results of operations for fiscal 2000 for the discontinuance of the specialty managed healthcare segment, and the first quarter of fiscal 2001 and prior for the discontinuance of the human services segment. The restatements involved segregating the operating results of the discontinued segments from continuing operations and disclosing the results, net of income tax, in a separate income statement caption "Discontinued operations—Income (loss) from discontinued operations". The losses the Company incurred to exit the discontinued operations are reflected, net of income tax, in the caption "Discontinued operations—Income (loss) on disposal of discontinued operations". See Note 4—"Discontinued Operations" to the Company's audited consolidated financial statements set forth elsewhere herein.

        The Company is currently engaged in the managed behavioral healthcare business. The Company coordinates and manages the delivery of behavioral healthcare treatment services through its network of providers, which includes psychiatrists, psychologists and other behavioral healthcare professionals. The Company's managed behavioral healthcare network also includes contractual arrangements with certain third-party treatment facilities. See "Business—Provider Network", for further discussion of the Company's managed behavioral healthcare network. The treatment services provided through these provider networks include outpatient programs (such as counseling or therapy), intermediate care programs (such as intensive outpatient programs and partial hospitalization services), inpatient treatment and crisis intervention services. The Company provides these services primarily through: (i) risk-based products, whereby the Company assumes all or a portion of the responsibility for the cost of providing treatment services in exchange for a fixed per member per month fee, (ii) Administrative Services Only ("ASO") products, whereby the Company provides services such as utilization review, claims administration or provider network management, but does not assume responsibility for the cost of services, (iii) EAPs and (iv) products which combine features of some or all of its risk-based, ASO, or EAP products.

        At December 31, 2002, the Company managed the behavioral healthcare benefits of approximately 67.4 million covered lives.

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Industry

        According to an interim report from the President's New Freedom Commission on Mental Health (established on April 29, 2002 by Executive Order 13263), about 5.0% to 7.0% of adults in a given year have a "serious mental illness", defined as any diagnosable mental disorder that affects work, home or other areas of social functioning. About 5.0% to 9.0% of children have a "serious emotional disturbance" defined as any diagnosable mental disorder (in a child under 18) that severely disrupts social, academic and emotional functioning. In addition, according to the interim report, mental illness, when compared with all other diseases (such as cancer and heart disease), ranks first in terms of causing disability in the United States, Canada and Western Europe. Mental illness, including depression, bipolar disorder and schizophrenia, accounts for 25.0% of all disabilities across major industrialized countries, and in the United States alone, the economy's loss of productivity from mental illness is estimated to amount to $63.0 billion annually.

        Managed behavioral healthcare companies such as the Company were formed to address the behavioral health needs of society. Managed behavioral healthcare companies focus on matching an appropriate level of specialist and treatment setting with the patient to provide care in a cost-efficient manner while improving early access to care and utilizing the most modern and effective treatments. As the growth of managed behavioral healthcare has increased, there has been a significant decrease in occupancy rates and average lengths of stay for inpatient psychiatric facilities and an increase in outpatient treatment and alternative care services.

        According to an industry trade publication entitled "Open Minds Yearbook of Managed Behavioral Health Market Share in the United States 2002-2003" published by Open Minds, Gettysburg, Pennsylvania (hereinafter referred to as "Open Minds"):

•

As of January 2002, some form of managed behavioral healthcare plan covered approximately 227.1 million beneficiaries.



•

The number of covered beneficiaries has grown from approximately 86.3 million beneficiaries in 1993 to approximately 227.1 million as of January 2002, representing a cumulative increase of 163.0% in the total number of program enrollees during that time.



•

In terms of program enrollment, the largest growth area of the managed behavioral healthcare industry over the past year has been in utilization review/case management programs. Total industry enrollment in this area has increased from 33.3 million members in 2001 to 42.9 million members in 2002, an increase of over 28.0%. Conversely, enrollment in risk-based network programs has decreased over the same period, from 63.7 million members in 2001 to 58.6 members in 2002, a decrease of 8.0%.

        Open Minds divides the managed behavioral healthcare industry as of January 2002 into the following categories of care, based on services provided, extent of care management and level of risk assumption:

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        The following is a summary of each of these categories of care as defined by Open Minds:

        Risk-Based Network Products.    Under risk-based network products, the managed behavioral healthcare company assumes all or a portion of the responsibility for the cost of providing a full or specified range of behavioral healthcare treatment services (excluding at present the cost of medication). Most of these programs have payment arrangements in which the managed care company agrees to arrange for services in exchange for a fixed fee per member per month (that varies depending on the profile of the beneficiary population) or otherwise shares the responsibility for arranging for all or some portion of the treatment services at a specific cost per employee. Under these products, the managed behavioral healthcare company not only reviews and monitors a course of treatment, but also arranges and pays for the provision of patient care. Therefore, the managed behavioral healthcare company must contract with, credential and manage a network of specialized providers and facilities that covers the complete continuum of care. The managed behavioral healthcare company must also see that the appropriate level of care is delivered in the appropriate setting. This product generally provides higher revenue for the managed behavioral healthcare company, due to the fact that it bears the financial responsibility for the cost of delivering care. The Company's risk-based products are risk-based network products as defined by Open Minds.

        Employee Assistance Programs.    An EAP is a worksite-based program designed to assist in the early identification and resolution of productivity problems associated with behavioral conditions or other personal concerns of employees and their dependants. Under an EAP, staff or network providers or other affiliated clinicians provide assessment and referral services to employee beneficiaries and their dependants. These services consist of evaluating a beneficiary's needs and, if indicated, providing limited counseling and/or identifying an appropriate provider, treatment facility or other resource for more intensive treatment services. The EAP industry developed largely out of employers' efforts to combat alcoholism and substance abuse problems afflicting workers. Many businesses have implemented alcoholism and drug abuse treatment programs in the workplace, and in some cases have expanded those services to cover a wider spectrum of personal problems experienced by workers and their families, such as depression and anxiety disorders. As a result, EAP products now typically include consultation services, evaluation and referral services and employee education and outreach services. The Company believes that federal and state "drug-free workplace" measures and Federal Occupational Safety and Health Act requirements, taken together with the growing public perception of increased violence in the workplace, have prompted many companies to implement EAPs. Although EAPs originated as a support tool to assist managers in dealing with troubled employees, payors increasingly regard EAPs as an important component in the continuum of behavioral healthcare services. The Company categorizes its products within this segment of the managed behavioral healthcare industry (as defined by Open Minds) as risk-based products.

        Integrated EAP/Managed Behavioral Healthcare Products.    EAPs are utilized in a preventive role and in facilitating early intervention and brief treatment of behavioral healthcare problems before more extensive treatment is required. Consequently, EAPs often are marketed and sold in tandem with managed behavioral healthcare programs through "integrated" product offerings. Integrated products offer employers comprehensive management and treatment of all aspects of behavioral healthcare. The Company categorizes its products within this segment of the managed behavioral healthcare industry (as defined by Open Minds) as risk-based products.

        Utilization Review/Care Management Products.    Under utilization review/care management products, a managed behavioral healthcare company manages and often arranges for treatment, but does not maintain a network of providers or assume any of the responsibility for the cost of providing treatment services. The Company categorizes its products within this segment of the managed behavioral healthcare industry (as it is defined by Open Minds) as ASO products.

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        Non-Risk-Based Network Products.    Under non-risk-based network products, the managed behavioral healthcare company provides a full array of managed care services, including selecting, credentialing and managing a network of providers (such as psychiatrists, psychologists, social workers and hospitals), and performs utilization review, claims administration and care management functions. The third-party payor remains responsible for the cost of providing the treatment services rendered. The Company categorizes its products within this segment of the managed behavioral healthcare industry (as it is defined by Open Minds) as ASO products.

Company Overview

        The Company is currently engaged in the managed behavioral healthcare business. Within the managed behavioral healthcare business, the Company operates in the following four segments, based on the services it provides and/or the customers that it serves: (i) Workplace Group ("Workplace"); (ii) Health Plan Solutions Group ("Health Plans"); (iii) Public Solutions Group ("Public") and (iv) Corporate and Other. Workplace provides, primarily to employers, EAP assessment and referral services and integrated products that combine EAP with risk-based or ASO managed behavioral healthcare services. Health Plans provides risk-based and ASO products to health plan beneficiaries primarily through contracts with managed care companies, health insurance companies and other health plans. Public provides risk-based and ASO products to Medicaid beneficiaries through contracts with State or local government agencies. Corporate and Other mainly provides administrative support to the other segments.

        According to enrollment data reported in Open Minds, the Company is the nation's largest provider of managed behavioral healthcare services. As of December 31, 2002, the Company had approximately 67.4 million covered lives under managed behavioral healthcare contracts and managed behavioral healthcare programs for approximately 2,100 customers. Through its current network comprising in excess of 46,000 providers (including treatment facilities), the Company manages behavioral healthcare programs for HMOs, Blue Cross/Blue Shield organizations and other insurance companies, corporations, federal, state and local governmental agencies, labor unions and various state Medicaid programs. The Company has the largest and most comprehensive behavioral healthcare provider network in the United States.

        The Company's professional care managers coordinate and manage the delivery of behavioral healthcare treatment services through the Company's network of providers, which includes psychiatrists, psychologists, licensed clinical social workers, marriage and family therapists and licensed clinical professional counselors. The treatment services provided by the Company's behavioral provider network include outpatient programs (such as counseling and therapy), intermediate care programs (such as sub-acute emergency care, intensive outpatient programs and partial hospitalization services), inpatient treatment services and alternative care services (such as residential treatment, home and community-based programs and rehabilitative and support services). The Company manages delivery of these services through: (i) risk-based products; (ii) EAPs; (iii) ASO products and (iv) products that combine features of some or all of these products. Under risk-based products, the Company arranges for the provision of a full range of behavioral healthcare services for beneficiaries of its customers' healthcare benefit plans through fee arrangements under which the Company assumes all or a portion of the responsibility for the cost of providing such services in exchange for a fixed per member per month fee. Under EAPs, the Company arranges for assessment services to employees and dependents of its customers, and if required, referral services to the appropriate behavioral healthcare service provider. Under ASO products, the Company provides services such as utilization review, claims administration and provider network management. The Company does not assume the responsibility for the cost of providing behavioral healthcare services pursuant to its ASO products.

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Business Strategy

        Voluntary Chapter 11 Filing.    As more fully discussed under "Business—Capital Structure Overview" above and under "Management's Discussion and Analysis of Financial Condition and Results of Operations—Outlook—Liquidity and Capital Resources" below, on March 11, 2003 the Debtors filed voluntary petitions for relief under chapter 11 of the Bankruptcy Code. If successfully consummated, the Company's proposed plan of reorganization contemplates improving Magellan's liquidity and capital structure. However, there can be no assurance that the Company will be able to consummate the Plan.

        Continued Focus on Improving Operating Efficiency and Margins.    The Company believes that it can reduce administrative costs and improve customer service by implementing best practices across the organization and by standardizing and consolidating processes as appropriate. To that end, management of the Company approved and implemented business improvement initiatives, primarily in one of its operating segments, during the first quarter of fiscal 2002. In June of 2002, these business improvement initiatives were extended to the Company as a whole, and formally termed Accelerated Business Improvement ("ABI"). Under ABI, the Company, along with the aid of an outside consultant hired by the Company, has critically analyzed its operations and administrative functions. Based on these analyses, an action plan to reduce operating inefficiencies was developed and implemented in fiscal 2002. The Company has incurred approximately $14.2 million and $4.3 million in fiscal 2002 and during the three months ended December 31, 2002, respectively, related to ABI and pre-ABI business improvement initiatives. The Company continued implementing initiatives under ABI through March 31, 2003, and incurred approximately $1.7 million related to such initiatives during such three-month period.

        As of April 1, 2003, the Company started exploring additional business and performance improvement initiatives, such as further consolidating service centers, creating more efficiency in corporate overhead, consolidating systems, improving call center technology and instituting other operational and business efficiencies. These initiatives are being formulated into a performance improvement plan ("PIP") that the Company started implementing during the fiscal quarter ended June 30, 2003. The Company expects to incur $7.0 million to $15.0 million of costs related to PIP activities during the nine-month period ended December 31, 2003. The Company expects to fund these costs with internally generated funds. However, there can be no assurance that the Company will be able to successfully fund or implement these initiatives or realize the anticipated savings.

        Leverage the Company's Market Position to Grow Revenue and Increase Earnings.    The Company believes it is positioned to grow membership and revenues over the long term as a result of its economies of scale, and proven behavioral health expertise. Such growth is contingent upon (among other things) the Company's successful emergence from chapter 11. Furthermore, as the industry leader, the Company believes it is also positioned to benefit from proposed changes in federal and state parity legislation, which proposes to reduce and in some cases eliminate the difference in coverage limits for mental health coverage as compared to medical health coverage. The Company's membership has decreased during fiscal 2002, and through June 30, 2003. There can be no assurance that the Company will be able to reverse the recent membership decreases in future periods.

        New Product Development.    The Company is exploring opportunities to expand its business including the enhancement of existing products within current business lines and the possible development of new products outside of its current business line.

Managed Behavioral Healthcare Products and Services

        General.    The following table sets forth the approximate number of covered lives as of September 30, 2001 and 2002 and December 31, 2001 and 2002 and revenue for fiscal years ending

15

September 30, 2001 and 2002 and for the three months ended December 31, 2001 and 2002 for the types of managed behavioral healthcare programs offered by the Company:

(1)

Includes Risk-Based Products, EAPs and Integrated Products.

        The number of covered lives fluctuates based on several factors, including the number of contracts entered into by the Company and changes in the number of employees, subscribers or enrollees of the Company's customers covered by such contracts.

        Risk-Based Products.    Under the Company's risk-based products, the Company typically arranges for the provision of a full range of outpatient, intermediate and inpatient treatment services to beneficiaries of its customers' healthcare benefit plans, primarily through arrangements in which the Company assumes all of the responsibility for the cost of providing such services in exchange for a per member per month fee. The Company's experience with risk-based contracts covering a large number of lives has given it a broad base of data from which to analyze utilization rates.

        Employee Assistance Programs.    The Company's EAP products typically provide assessment and referral services to employees and dependents of the Company's customers in an effort to assist in the early identification and resolution of productivity problems associated with the employees who are impaired by behavioral conditions or other personal concerns. For many EAP customers, the Company also provides limited outpatient therapy (typically limited to eight or fewer sessions) to patients requiring such services. For these services, the Company typically is paid a fixed fee per employee per month; however, the Company is usually not responsible for the cost of providing care beyond these services. If further services are necessary beyond limited outpatient therapy, the Company will refer the beneficiary to an appropriate provider or treatment facility.

        Integrated Products.    Under its integrated products, the Company typically establishes an EAP to function as the "front end" of a managed care program that provides a full range of services, including more intensive treatment services not covered by the EAP. The Company typically manages the EAP and accepts the responsibility for managing the provision of any additional treatment required upon referral out of the EAP, thus integrating the two products and using both the Company's care

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management and clinical care techniques to manage the provision of care. The Company's management of the behavioral healthcare treatment can be risk-based, for which the Company is responsible for the cost of such treatment, or ASO.

        ASO Products.    Under its ASO products, the Company provides services ranging from utilization review and claims administration to the arrangement for and management of a full range of patient treatment services, but does not assume any of the responsibility for the cost of providing treatment services. Services can include member assistance, management reporting and claims processing in addition to utilization review and care management. The Company is paid a fee per member per month for such services.

Segments

        General.    The following table sets forth the approximate number of covered lives as of September 30, 2001 and 2002 and December 31, 2001 and 2002 and revenue for fiscal years ended September 30, 2001 and 2002 and for the three months ended December 31, 2001 and 2002 in each of the Company's behavioral customer segments described below:

        See Note 15—"Business Segment Information" to the Company's audited consolidated financial statements set forth elsewhere herein for financial information regarding business segments of the Company.

        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 companies such as the Company. In the Health Plans segment, the Company's members are the

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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. See "Cautionary Statements—Dependence on Government Spending for Managed Healthcare; Possible Impact of Healthcare Reform" and "—Regulation".

Customer Contracts

        The Company's contracts with customers typically have terms of one to three years, and in certain cases contain renewal provisions (at the customer's option) for successive terms of between one and two years (unless terminated earlier). Substantially all of these contracts may be immediately terminated with cause and many are terminable without cause by the customer or the Company either upon the giving of requisite notice and the passage of a specified period of time (typically between 60 and 180 days) or upon the occurrence of other specified events. In addition, the Company's contracts with federal, state and local governmental agencies, under both direct contract and subcontract arrangements with HMOs, generally are conditioned on legislative appropriations. These contracts, notwithstanding terms to the contrary, generally can be terminated or modified by the customer if such appropriations are not made. The Company's contracts generally provide for payment of a per member per month fee to the Company. See "Cautionary Statements—Risk-Related Products" and "—Reliance on Customer Contracts".

Provider Network

        The Company's managed behavioral healthcare and EAP treatment services are provided by a network of third-party providers. The number and type of providers in a particular area depend upon customer preference, site, geographic concentration and demographic make-up of the beneficiary population in that area. Network providers include a variety of specialized behavioral healthcare personnel, such as psychiatrists, psychologists, licensed clinical social workers, substance abuse counselors and other professionals.

        As of December 31, 2002, the Company had contractual arrangements covering in excess of 46,000 individual third-party network providers (including treatment facilities). The Company's network providers are independent contractors located throughout the local areas in which the Company's customers' beneficiary populations reside. Network providers work out of their own offices, although the Company's personnel are available to assist them with consultation and other needs. Network providers include both individual practitioners, as well as individuals who are members of group practices or other licensed centers or programs. Network providers typically execute standard contracts with the Company for which the Company on a fee-for-service basis typically pays them. In some cases, network providers are paid on a "case rate" basis, whereby the provider is paid a set rate for an entire course of treatment, or through other risk sharing arrangements.

        The Company's managed behavioral healthcare network also includes contractual arrangements with third-party treatment facilities, including inpatient psychiatric and substance abuse hospitals, intensive outpatient facilities, partial hospitalization facilities, community health centers and other community-based facilities, rehabilitative and support facilities and other intermediate care and alternative care facilities or programs. This variety of facilities enables the Company to offer patients a full continuum of care and to refer patients to the most appropriate facility or program within that continuum. Typically, the Company contracts with facilities on a per diem or fee-for-service basis and, in some cases, on a "case rate" or capitated basis. The contracts between the Company and inpatient

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and other facilities typically are for one-year terms and, in some cases, are automatically renewable at the Company's option. Facility contracts are usually terminable by the Company or the facility upon 30 to 120 days' notice.

Joint Ventures

        Prior to October 29, 2002, the Company was a 50.0% partner with Value Options, Inc. in the Choice Behavioral Health Partnership ("Choice"), a managed behavioral healthcare company. Choice derives all of its revenues from a subcontract with a health plan under which it provides managed behavioral healthcare services to TRICARE beneficiaries. TRICARE was formerly known as the Civilian Health and Medical Program of the Uniformed Services (CHAMPUS). The subcontract expires on June 30, 2003. The Company accounted for its investment in Choice using the equity method of accounting with the Company's share of net income or loss of Choice recognized in the statement of operations. The Company's investment in Choice at September 30, 2001 and 2002 and at December 31, 2002 was approximately $(0.1) million, $1.6 million and $0.2 million, respectively. The Company's equity in income of Choice for fiscal years 2000, 2001 and 2002 was approximately $12.1 million, $36.4 million and $11.2 million, respectively. The Company's equity in earnings of Choice for the three months ended December 31, 2001 and 2002 was approximately $3.0 million and $0.8 million, respectively. During the second quarter of fiscal 2001, Choice recognized revenues related to the settlement of certain contract appeals under its subcontract with respect to TRICARE. The Company received $14.1 million, $38.0 million and $9.6 million in partnership distributions from Choice in fiscal years 2000, 2001 and 2002, respectively. The Company received $2.1 million and $2.3 million in partnership distributions from Choice during the three months ended December 31, 2001 and 2002, respectively. Effective October 29, 2002, the Company withdrew from equity ownership in the Choice partnership on the following terms: (i) the Company is to receive or pay, as the case may be, 50.0% of all bid price adjustments, change order and certain other pricing adjustments finalized subsequent to October 31, 2002 but relating to the period prior to November 1, 2002; (ii) the Company is to continue to share in 50.0% of all profits or losses from Choice for the period from November 1, 2002 through June 30, 2003 and (iii) if Choice's subcontract is extended beyond June 30, 2003, the Company is to be paid $150,000 per month for the extension period up to a maximum of twelve months. The Company will have no residual interest in the operations of Choice beyond these terms. See "Management's Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations", and Note 3—"Acquisitions and Joint Ventures" to the audited consolidated financial statements set forth elsewhere herein.

        The Company currently owns a 50.0% interest in Premier Behavioral Systems of Tennessee, LLC ("Premier"), which was formed to manage behavioral healthcare benefits for a certain portion of the State of Tennessee's TennCare program. 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 the Company's wholly owned subsidiary Tennessee Behavioral Health, Inc. ("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 the Company 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 required the consent of Magellan's joint venture partner in Premier. The joint venture partner agreed to give such consent provided that Magellan made a capital contribution of approximately $0.9 million into Premier (and Premier made a non-pro rata distribution of a like amount to the joint venture partner). Such capital contribution and distribution transactions were completed in May 2003. It is uncertain as to what will happen to the Premier and/or TBH membership after December 31, 2003; however, the State of Tennessee has indicated that it plans to

19

issue a request for proposals ("RFP") relating to the TennCare program. The State has also indicated that if the Company has not emerged from bankruptcy prior to the due date for the RFP, the Company will be precluded from participating in the selection process. The Company accounts for its investment in Premier using the equity method of accounting. The Company's investment in Premier at September 30, 2001 and 2002 and at December 31, 2002 was $5.6 million, $3.1 million and $3.2 million, respectively. The Company's equity in loss of Premier for fiscal years 2000, 2001 and 2002 was $(4.0) million, $(2.5) million and $(2.5) million, respectively. The Company's equity in (loss) earnings of Premier for the three months ended December 31, 2001 and 2002 was $(0.7) million and $0.1 million, respectively. The Company has not received a partnership distribution from nor has it made any further investments in Premier during fiscal years 2000, 2001 and 2002 or during the three months ended December 31, 2002. See Note 3—"Acquisitions and Joint Ventures" to the audited consolidated financial statements set forth elsewhere herein.

        The Company currently owns a 36.3% interest in Royal Health Care, LLC ("Royal"). Royal is a managed services organization that receives management fees for the provision of administrative, marketing, management and support services to five managed care organizations. Royal does not provide any services to the Company. The Company accounts for its investment in Royal using the equity method. The Company's investment in Royal at September 30, 2001 and 2002 and at December 31, 2002 was $5.3 million, $8.5 million and $8.8 million, respectively. The Company's equity in income of Royal for fiscal years 2000, 2001 and 2002 was $1.9 million, $2.6 million and $4.3 million, respectively. The Company's equity in earnings of Royal for the three months ended December 31, 2001 and 2002 was $0.8 million and $1.2 million, respectively. The Company received $0.2 million, $0.4 million and $1.1 million in partnership distributions from Royal in fiscal years 2000, 2001 and 2002, respectively. For the three months ended December 31, 2001 and 2002, the Company received partnership distributions from Royal of $0.7 million and $0.9 million, respectively. See Note 3—"Acquisitions and Joint Ventures" to the audited consolidated financial statements set forth elsewhere herein.

Competition

        The Company's business is highly competitive. The Company competes with large insurance companies, HMOs, PPOs, third-party administrators ("TPAs"), independent practitioner associations ("IPAs"), multi-disciplinary medical groups and other managed care companies. Many of the Company's competitors are significantly larger and have greater financial, marketing and other resources than the Company, and some of the Company's competitors provide a broader range of services. The Company may also encounter substantial competition in the future from new market entrants. Many of the Company's customers that are managed care companies may, in the future, seek to provide managed behavioral healthcare services directly to their subscribers, rather than by contracting with the Company for such services. Because of competition, the Company does not expect to be able to rely solely on price increases to achieve revenue growth and expects to continue experiencing downward pressure on direct operating margins. Also, the Company's current liquidity issues and financial restructuring needs may adversely affect the Company's ability to successfully compete in certain circumstances.

        The Company believes it benefits from the competitive strengths described below:

        Industry Leadership.    The Company is the largest provider of managed behavioral healthcare services in the United States, according to enrollment data reported in Open Minds, with 30.3% market share of total enrollment in 2002. The Company believes, based on data reported in Open Minds, that it also has the number one market position in each of the major managed behavioral healthcare product markets in which it competes. See "Cautionary Statements—Highly Competitive Industry" and "—Reliance on Customer Contracts", for a discussion of the risks associated with the highly competitive nature of the managed behavioral healthcare industry and the Company's reliance on contracts with payors of behavioral healthcare benefits, respectively.

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        Broad Product Offering and Nationwide Provider Network.    The Company offers managed behavioral care products that can be designed to meet specific customer needs, including risk-based and partial risk-based products, integrated EAPs, stand-alone EAPs and ASO products. As of December 31, 2002, the Company's provider network encompasses in excess of 46,000 providers (including treatment facilities) in all 50 states and Puerto Rico. See "Cautionary Statements—Risk-Related Products", for a discussion of the risks associated with risk-based products, which are the Company's primary source of revenue.

        Broad Base of Customer Relationships.    The Company's customers include: (i) Blue Cross/Blue Shield organizations; (ii) national HMOs and other large insurers, such as Aetna and Humana; (iii) large corporations; (iv) state and local governmental agencies and (v) certain agencies of the federal government. See "Cautionary Statements—Reliance on Customer Contracts", for a discussion of the risks associated with the Company's reliance on certain contracts with payors of behavioral healthcare benefits.

Insurance

        The Company maintains a program of insurance coverage for a broad range of risks in its business. 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 $0.25 million per claim and $1.0 million annual aggregate self-insured retention for general and professional liability, and also subject to a $0.5 million 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 the one-year period from June 17, 2002 to June 16, 2003. These policies were also written on a "claims-made" basis, and were 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 $0.25 million per claim un-aggregated self-insured retention for general and professional liability. The Company renewed its general, professional and managed care liability insurance policies with unaffiliated insurers for a one-year period from June 17, 2003 to June 16, 2004. The policies are also written on a "claims-made" basis, subject to a $1.25 million per claim ($10.0 million per class action claim) un-aggregated self-insured retention for managed care liability, and a $0.25 million 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, excluding portions of claims reported after the expiration date of the policies if they are not renewed, or if policy limits are exceeded.

Regulation

        General.    The managed behavioral healthcare industry and the provision of behavioral healthcare services are subject to extensive and evolving state and federal regulation. The Company is subject to certain state laws and regulations, including those governing: (i) the licensing of insurance companies, HMOs, PPOs, TPAs and companies engaged in utilization review and (ii) the licensing of healthcare professionals, including restrictions on business corporations from providing, controlling or exercising excessive influence over behavioral healthcare services through the direct employment of psychiatrists or, in a few states, psychologists and other behavioral healthcare professionals. Other subjects of these regulations include accreditation, government healthcare program participation requirements and reimbursement for patient services. These laws and regulations vary considerably among states and the Company may be subject to different types of laws and regulations depending on the specific regulatory approach adopted by each state to regulate the managed care business and the provision of behavioral healthcare treatment services. In addition, the Company is subject to certain federal laws as a result of the role it assumes in connection with managing its customers' employee benefit plans. The regulatory

21

scheme generally applicable to the Company's managed behavioral healthcare operations is described in this section. The subjects of these regulations include Medicare and Medicaid fraud and abuse.

        The Company believes its operations are structured to comply with applicable laws and regulations in all material respects and that it has received all licenses and approvals that are material to the operation of the business. However, regulation of the managed healthcare industry is evolving, with new legislative enactments and regulatory initiatives at the state and federal levels being implemented on a regular basis. Consequently, it is possible that a court or regulatory agency may take a position under existing or future laws or regulations, or as a result of a change in the interpretation thereof, that such laws or regulations apply to the Company in a different manner than the Company believes such laws or regulations apply. Moreover, any such position may require significant alterations to the Company's business operations in order to comply with such laws or regulations, or interpretations thereof. Expansion of the Company's business to cover additional geographic areas, to serve different types of customers, to provide new services or to commence new operations could also subject the Company to additional license requirements and/or regulation.

        Licenses.    Certain regulatory agencies having jurisdiction over the Company possess discretionary powers when issuing or renewing licenses or granting approval of proposed actions such as mergers, a change in ownership, transfer or assignment of licenses and certain intra-corporate transactions. One or multiple agencies may require as a condition of such license or approval that the Company cease or modify certain of its operations or modify the way it operates in order to comply with applicable regulatory requirements or policies. In addition, the time necessary to obtain a license or approval varies from state to state, and difficulties in obtaining a necessary license or approval may result in delays in the Company's plans to expand operations in a particular state and, in some cases, lost business opportunities. In recent years, in response to governmental agency inquiries or discussions with regulators, the Company has determined to seek licensing as a single service HMO, TPA or utilization review agent in one or more jurisdictions. Compliance activities, mandated changes in the Company's operations, delays in the expansion of the Company's business or lost business opportunities as a result of regulatory requirements or policies could have a material adverse effect on the Company.

        Insurance, HMO and PPO Activities.    To the extent that the Company operates or is deemed to operate in one or more states as an insurance company, HMO, preferred provider organization ("PPO") or similar entity, it may be required to comply with certain laws and regulations that, among other things, may require the Company to maintain certain types of assets and minimum levels of deposits, capital, surplus, reserves or net worth. In many states, entities that assume risk under contracts with licensed insurance companies or HMOs have not been considered by state regulators to be conducting an insurance or HMO business. As a result, the Company has not sought licenses as either an insurer or HMO in certain states. The National Association of Insurance Commissioners (the "NAIC") has undertaken a comprehensive review of the regulatory status of entities arranging for the provision of healthcare services through a network of providers that, like the Company, may assume risk for the cost and quality of healthcare services, but that are not currently licensed as an HMO or similar entity. As a result of this review, the NAIC developed a "health organizations risk-based capital" formula, designed specifically for managed care organizations, that establishes a minimum amount of capital necessary for a managed care organization to support its overall operations, allowing consideration for the organization's size and risk profile. The NAIC also adopted a model regulation in the area of health plan standards, which could be adopted by individual states in whole or in part, and could result in the Company being required to meet additional or new standards in connection with its existing operations. Certain states, for example, have adopted regulations based on the NAIC initiative, and as a result, the Company has been subject to certain minimum capital requirements in those states. Certain other states, such as Maryland, Texas, New York and New Jersey, have also adopted their own regulatory initiatives that subject entities such as the Company's subsidiaries to regulation under state insurance laws. This includes, but is not limited to, requiring adherence to specific financial solvency standards. State insurance laws and regulations may limit the Company's ability to pay dividends, make

22

certain investments and repay certain indebtedness. Being licensed as an insurance company, HMO or similar entity could also subject the Company to regulations governing reporting and disclosure, mandated benefits, rate setting and other traditional insurance regulatory requirements. PPO regulations to which the Company may be subject may require the Company to register with a state authority and provide information concerning its operations, particularly relating to provider and payor contracting. The imposition of such requirements could increase the Company's cost of doing business and could delay the Company's conduct or expansion of its business in some areas. The licensing process under state insurance laws can be lengthy and, unless the applicable state regulatory agency allows the Company to continue to operate while the licensing process is ongoing, the Company could experience a material adverse effect on its operating results and financial condition while its license application is pending. In addition, failure to obtain and maintain required licenses typically also constitutes an event of default under the Company's contracts with its customers. The loss of business from one or more of the Company's major customers as a result of such an event of default or otherwise could have a material adverse effect on the Company.

        Regulators may impose operational restrictions on entities granted licenses to operate as insurance companies or HMOs. For example, the California Department of Corporations imposed certain restrictions on the Company in connection with the issuance of an approval of the Company's acquisitions of HAI and Merit, including restrictions on the ability of the California subsidiaries of HAI and Merit to fund the Company's operations in other states and on the Company's ability to make certain operational changes with respect to the subsidiaries of HAI and Merit in California.

        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. In particular, the State of California has taken certain actions to increase its supervision of one of the Company's subsidiaries in California, and TBH, Premier and one of the Company's subsidiaries in Iowa are each operating under an agreed notice of administrative supervision, under which the State of Tennessee and the State of Iowa may exercise additional supervision over the affairs of such entities.

        Utilization Review and Third-Party Administrator Activities.    Numerous states in which the Company does business have adopted, or are expected to adopt, regulations governing entities engaging in utilization review and TPA activities. Utilization review regulations typically impose requirements with respect to the qualifications of personnel reviewing proposed treatment, timeliness and notice of the review of proposed treatment and other matters. TPA regulations typically impose requirements regarding claims processing and payments and the handling of customer funds. Utilization review and TPA regulations may increase the Company's cost of doing business in the event that compliance requires the Company to retain additional personnel to meet the regulatory requirements and to take other required actions and make necessary filings. Although compliance with utilization review regulations has not had a material adverse effect on the Company, there can be no assurance that specific regulations adopted in the future would not have such a result, particularly since the nature, scope and specific requirements of such provisions vary considerably among states that have adopted regulations of this type.

        There is a trend among states to require licensing or certification of entities performing utilization review or TPA activities. However, certain federal courts have held that such licensing requirements are preempted by the Employment Retirement Income Security Act of 1974 ("ERISA"). ERISA preempts state laws that mandate employee benefit structures or their administration, as well as those that provide alternative enforcement mechanisms. The Company believes that its TPA activities performed for its self-insured employee benefit plan customers are exempt from otherwise applicable state licensing or registration requirements based upon federal preemption under ERISA and have relied on this general principle in determining not to seek licenses for certain of the Company's activities in

23

many states. Existing case law is not uniform on the applicability of ERISA preemption with respect to state regulation of utilization review or TPA activities. There can be no assurance that additional licenses will not be required with respect to utilization review or TPA activities in certain states.

        Licensing of Healthcare Professionals.    The provision of behavioral healthcare treatment services by psychiatrists, psychologists and other providers is subject to state regulation with respect to the licensing of healthcare professionals. The Company believes that the healthcare professionals who provide behavioral healthcare treatment on behalf of or under contracts with the Company and the case managers and other personnel of the health services business are in compliance with the applicable state licensing requirements and current interpretations thereof. However, there can be no assurance that changes in such state licensing requirements or interpretations thereof will not adversely affect the Company's existing operations or limit expansion. With respect to the Company's crisis intervention program, additional licensing of clinicians who provide telephonic assessment or stabilization services to individuals who are calling from out-of-state may be required if such assessment or stabilization services are deemed by regulatory agencies to be treatment provided in the state of such individual's residence. The Company believes that any such additional licenses could be obtained. However, there can be no assurance that such licensing requirements will not adversely affect the Company's existing operations or limit expansion.

        Prohibition on Fee Splitting and Corporate Practice of Professions.    The laws of some states limit the ability of a business corporation to directly provide, control or exercise excessive influence over behavioral healthcare services through the direct employment of psychiatrists, psychologists, or other behavioral healthcare professionals, who are providing direct clinical services. In addition, the laws of some states prohibit psychiatrists, psychologists, or other healthcare professionals from splitting fees with other persons or entities. These laws and their interpretations vary from state to state and enforcement by the courts and regulatory authorities may vary from state to state and may change over time. The Company believes that its operations as currently conducted are in material compliance with the applicable laws. However, there can be no assurance that the Company's existing operations and its contractual arrangements with psychiatrists, psychologists and other healthcare professionals will not be successfully challenged under state laws prohibiting fee splitting or the practice of a profession by an unlicensed entity, or that the enforceability of such contractual arrangements will not be limited. The Company believes that it could, if necessary, restructure its operations to comply with changes in the interpretation or enforcement of such laws and regulations, and that such restructuring would not have a material adverse effect on its operations.

        Direct Contracting with Licensed Insurers.    Regulators in several states in which the Company does business have adopted policies that require HMOs or, in some instances, insurance companies, to contract directly with licensed healthcare providers, entities or provider groups, such as IPAs, for the provision of treatment services, rather than with unlicensed intermediary companies. In such states, the Company's customary model of contracting directly with its customers may need to be modified so that, for example, the IPAs (rather than the Company) contract directly with the HMO or insurance company, as appropriate, for the provision of treatment services. The Company intends to work with a number of these HMO customers to restructure existing contractual arrangements, upon contract renewal or in renegotiations, so that the entity, which contracts with the HMO directly, is an IPA. The Company does not expect this method of contracting to have a material adverse effect on its operations.

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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, regulations 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 released this year, 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 administrative safeguards to enhance physical, personnel and information systems security. The

25

Company has completed its review of the final regulation and is in the process of conducting an extensive gap analysis and addressing the remaining compliance issues. The Company expects that it will be fully compliant with the security regulation 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 final regulations on security and 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 which identified and assessed the potential impact of the regulations and reviewed current policies and drafted new policies to comply with the new requirements. The Company incurred approximately $3.8 million in operating costs and $2.5 million in capital expenditures related to HIPAA in fiscal year 2002. The Company incurred approximately $0.7 million in operating costs and $0.7 million in capital expenditures related to HIPAA during the three months ended December 31, 2002. Management estimates that the Company will incur approximately $3.5 million to $4.5 million in operating costs and approximately $2.5 million to $3.5 million in capital expenditures related to these efforts during its fiscal year ended December 31, 2003.

        Other Significant Privacy Regulation.    The privacy regulation under HIPAA generally does not preempt state law except under the following limited circumstances: (i) the privacy rights afforded under state law are contrary to those provided by HIPAA so that compliance with both standards is not possible and (ii) HIPAA's privacy protections are more stringent than the state law in question. Because many states have privacy laws that either provide more stringent privacy protections than those imposed by HIPAA or laws that can be followed in addition to HIPAA, the Company must address privacy issues under HIPAA and state law as well. While the Company has always been required to follow state privacy laws, the Company now has had to review these state laws against HIPAA to determine whether it must comply with standards established by both HIPAA and state law. In addition, HIPAA has created an increased awareness of the issues surrounding privacy, which may generate more state regulatory scrutiny in this area.

        Regulation of Customers.    Regulations imposed upon the Company's customers include, among other things, benefits mandated by statute, exclusions from coverages prohibited by statute, procedures governing the payment and processing of claims, record keeping and reporting requirements, requirements for and payment rates applicable to coverage of Medicaid and Medicare beneficiaries, provider contracting and enrollee rights and confidentiality requirements. Although the Company believes that such regulations do not at present materially impair its operations, there can be no assurance that such indirect regulation will not have a material adverse effect on the Company in the future.

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        ERISA.    Certain of the Company's services are subject to the provisions of ERISA. ERISA governs certain aspects of the relationship between employer-sponsored healthcare benefit plans and certain providers of services to such plans through a series of complex laws and regulations that are subject to periodic interpretation by the IRS and the U.S. Department of Labor. In some circumstances, and under certain customer contracts, the Company may be expressly named as a "fiduciary" under ERISA, or be deemed to have assumed duties that make it an ERISA fiduciary, and thus be required to carry out its operations in a manner that complies with ERISA requirements in all material respects. Although the Company believes that it is in material compliance with the applicable ERISA requirements and that such compliance does not currently have a material adverse effect on its operations, there can be no assurance that continuing ERISA compliance efforts or any future changes to the applicable ERISA requirements will not have a material adverse effect on the Company.

        Other Proposed Legislation.    In the last five years, legislation has periodically been introduced at the state and federal levels providing for new healthcare regulatory programs and materially revising existing healthcare regulatory programs. Legislation of this type, if enacted, could materially adversely affect the Company's business, financial condition or results of operations. Such legislation could include both federal and state bills affecting the Medicaid programs which may be pending in, or recently passed by, state legislatures and which are not yet available for review and analysis. Such legislation could also include proposals for national health insurance and other forms of federal regulation of health insurance and healthcare delivery. It is not possible at this time to predict whether any such legislation will be adopted at the federal or state level, or the nature, scope or applicability to the Company's business of any such legislation, or when any particular legislation might be implemented. No assurance can be given that any such federal or state legislation will not have a material adverse effect on the Company.

        Other Regulation of Healthcare Providers.    The Company's business is affected indirectly by regulations imposed upon healthcare providers. Regulations imposed upon healthcare providers include provisions relating to the conduct of, and ethical considerations involved in, the practice of psychiatry, psychology, social work and related behavioral healthcare professions, accreditation, government healthcare program participation requirements, reimbursements for patient services, Medicare and Medicaid fraud and abuse and, in certain cases, the common law duty to warn others of danger or to prevent patient self-injury.

Cautionary Statements

        This Form 10-K includes "forward-looking statements" within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. Although the Company believes that its plans, intentions and expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such plans, intentions or expectations will be achieved. Prospective investors are cautioned that any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties and that actual results may differ materially from those contemplated by such forward-looking statements. Important factors currently known to management that could cause actual results to differ materially from those in forward-looking statements are set forth below and elsewhere in this Form 10-K. When used in this Form 10-K, the words "estimate", "anticipate", "expect", "believe", "should" and similar expressions are intended to be forward-looking statements.

        Voluntary Chapter 11 Filing.    As discussed above in "Business—Capital Structure Overview," on March 11, 2003, Magellan and 88 of its subsidiaries filed voluntary petitions for relief under chapter 11 of the Bankruptcy Code in order to, among other things, restructure the Company's debt, which totaled approximately $1.0 billion as of December 31, 2002, and to improve the Company's liquidity. 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;

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(ii) obtain the approval of the Bankruptcy Court for the transactions referred to above (see "Business—Capital Structure Overview") 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 and could face liquidation. If a liquidation or protracted reorganization were to occur, there is a substantial risk that the value of the Company would be substantially eroded to the detriment of all stakeholders.

        Based on current and anticipated levels of operations and assuming consummation of the Plan, management believes that the Company will continue as a "going concern'. Accordingly, the Company's consolidated financial statements included herein have been prepared assuming the Company will continue as a "going concern'. Because of the Company's recurring losses from operations, the current stockholder's equity deficiency and the filing of the Chapter 11 Cases and the circumstances leading to the filing thereof, there is substantial doubt about the Company's ability to continue as a "going concern'. 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 obtain emergence financing if it is able to confirm its Plan under the Bankruptcy Code; and (v) 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. If the "going concern' basis was not appropriate for the Company's consolidated financial statements, then significant adjustments would be necessary in the carrying value and classification of the Company's assets and liabilities.

        The amounts reported in the consolidated financial statements included elsewhere in this transition report on Form 10-K do not reflect all of the adjustments to the carrying value of assets or the amount and classification of liabilities that ultimately may be necessary as the result of the adoption of the Plan. Adjustments necessitated by the Plan could materially change the amounts reported in the consolidated financial statements included herein.

        Restrictions on the Company's Activities.    Magellan and 88 of its subsidiaries (the "Debtors") are operating its business and managing its properties as debtors-in-possession subject to the provisions of the Bankruptcy Code. Pursuant to the provisions of the Bankruptcy Code, the Debtors are not permitted to pay any claims or obligations that arose prior to the "Commencement Date" (pre-petition claims) unless specifically authorized by the Bankruptcy Court. Similarly, claimants may not enforce any claims against any of the Debtors that arose prior to the Commencement Date unless specifically authorized by the Bankruptcy Court. In addition, as a debtor-in-possession, each of the Debtors has the right, subject to the Bankruptcy Court's approval, to assume or reject any executory contracts and un-expired leases in existence at the Commencement Date. Parties having claims as a result of any such rejection may file claims with the Bankruptcy Court, which will be dealt with as part of the Chapter 11 Cases. Pursuant to the terms of the Bankruptcy Code, the Debtors may only operate their business in the ordinary course. Therefore any transactions outside the ordinary course (e.g., asset sales and purchases, compromise or settlement of claims, incurrence of indebtedness, payment of any pre-petition indebtedness, and creation of liens) would require Bankruptcy Court approval prior to the Company's ability to enter into any such transactions. An official committee of unsecured creditors of the Debtors (the "Official Committee") has been appointed in the Debtors' chapter 11 case. In accordance with the provisions of the Bankruptcy Code, the Official Committee, as well as any other party in interest, has the right to be heard on matters that come before the Bankruptcy Court in the Debtors' chapter 11 case. The restrictions imposed by the Bankruptcy Code (to the extent relief is not granted by the Bankruptcy Court) may adversely affect the Company's ability to finance its future operations or capital needs or engage in other business activities that may be in its interest. Furthermore, as a result of the

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restrictions described above, the ability of the Company to respond to changing business and economic conditions may be significantly restricted, and the Company may be prevented from engaging in transactions that might otherwise be considered beneficial.

        In addition, as part of the Debtors' Plan, as filed with the Bankruptcy Court, the Debtors contemplate entering into an indenture governing the terms of the New Notes of the reorganized Magellan (the "New Notes Indenture") on the effective date of the Plan, as well as a new senior secured credit agreement with respect to either the New Facilities or the Exit Facility (the "New Credit Agreement") also on the effective date of the Plan. The anticipated terms of the New Credit Agreement and the New Notes Indenture are summarized in the Plan and the Disclosure Statement. In general, the New Credit Agreement and the New Note Indenture will contain a number of covenants that limit management's discretion in the operations of the Company and its subsidiaries by restricting the Company's ability to:

•

incur additional indebtedness or issue preferred or redeemable stock;



•

pay dividends and make other distributions;



•

repurchase equity interests;



•

prepay subordinated debt;



•

make restricted payments;



•

enter into sale and leaseback transactions;



•

create liens;



•

sell and otherwise dispose of assets;



•

merge or consolidate; and



•

enter into certain transactions with affiliates.

        These restrictions may adversely affect the Company's ability, after the effective date of the Plan, to finance its future operations or capital needs or engage in other business activities that may be in its interest. In addition, it is anticipated that the New Credit Agreement, as amended, will include other and more restrictive covenants and will prohibit the Company from prepaying certain of its other indebtedness.

        Disruption of Operations Due to the Filing of the Chapter 11 Cases.    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. While the Company has not experienced any significant disruption in its relationships with its behavioral health providers and customers, the Company may have difficulty maintaining existing or creating new relationships with providers and customers as a result of the Chapter 11 Cases. In addition, the filing of the Chapter 11 Cases may adversely affect the Company's ability to retain existing customers, attract new customers and maintain contracts that are critical to Company's operations.

        The filing of the Chapter 11 Cases and the publicity attendant thereto might also adversely affect the businesses of our non-debtor subsidiaries. Because our business is closely related to the businesses of all of our subsidiaries, any downturn in the business of our subsidiaries could also affect our prospects. It remains uncertain whether the commencement of the Chapter 11 Cases will adversely affect the businesses of any of our subsidiaries. Furthermore, our non-debtor subsidiaries do not have the benefit of the automatic stay provided by the Bankruptcy Code.

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        Attracting and Retaining Key Personnel.    The Company believes that its future success will be dependent upon its ability to attract and retain skilled managers and other personnel. Since the Commencement Date, the Company has been able to retain many of its key employees. However, no assurance can be given that the Company will be able to continue to retain and to attract such personnel in the future.

        Implementing the Company's Restructuring Involves Substantial Risks.    There are substantial risks in implementing the Company's restructuring strategy. These risks include:

•

the restructuring entails significant business process changes throughout the organization, which may be disruptive;



•

the possibility of adverse regulatory, legislative and other governmental developments during the course of the restructuring;



•

uncertainty surrounding the Company's restructuring increases the risk that the Company will lose customers;



•

potential difficulties in recruiting and retaining quality management to execute the new operational strategy; and



•

the potential lack of capital to invest in improving the Company's business to support a larger and more efficient enterprise.

        One or more of these factors, individually or combined, could affect adversely the Company's ability to conduct its operations.

        Risk to Pre-Petition Equity Holders and Creditors.    The Plan, if any, ultimately confirmed, will likely affect the value of various pre-petition liabilities, common stock and/or other equity securities. Until the Plan is confirmed by the Bankruptcy Court, the recoveries of pre-petition claim holders are subject to change. Accordingly, no assurance can be given as to what values, if any, will be ascribed in the bankruptcy proceedings to each of these constituencies.

        Risk-Related Products.    The Company's revenues come primarily from arrangements under which it assumes all or a portion of the responsibility for the cost of providing a full or specified range of behavioral healthcare treatment services (excluding at present the cost of pharmaceuticals or other medication) to a specified beneficiary population in exchange, generally, for a fixed per member per month fee. The Company refers to such arrangements as "risk-related contracts" or "risk-related products". Revenues from such arrangements accounted for approximately 87.7%, 87.8% and 87.7% of the Company's net revenue in fiscal years 2000, 2001 and 2002, respectively. For the three months ended December 31, 2001 and 2002, risk-related products accounted for approximately 87.7% and 87.2%, respectively, of the Company's net revenue. In order for such contracts to be profitable, the Company must accurately estimate the rate of service utilization by beneficiaries enrolled in programs managed by the Company and control the unit cost of such services. The most significant factor affecting the profitability of risk-related contracts is the ability to control direct service costs in relation to contract pricing. If the aggregate cost of behavioral healthcare treatment services provided to a given beneficiary population in a given period exceeds the aggregate of the per member per month fees received by the Company with respect to the beneficiary population in such period, the Company will incur a loss with respect to such beneficiary population during such period. The Company's assumptions as to service utilization rates and costs may not accurately and adequately reflect actual utilization rates and costs. Increases in behavioral healthcare costs or higher-than-anticipated utilization rates, significant aspects of which are outside the Company's control, may cause expenses associated with such contracts to exceed revenue from such contracts.

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        In addition, adjustments may be required to the estimates, particularly those regarding cost of care, made in reporting historical financial results. See Note 2—"Summary of Significant Accounting Policies" to the audited consolidated financial statements set forth elsewhere herein. Medical claims payable, in the Company's financial statements, includes reserves for incurred but not reported ("IBNR") claims, which are estimated by the Company. The Company determines the amount of such reserves based on past claims payment experience for member groups, including the average interval between the date services are rendered and the date claims are paid and between the date services are rendered and the date the claims are received, enrollment data, utilization statistics, adjudication decisions, authorized healthcare services and other factors. This data is incorporated into contract specific reserve models. The estimates for submitted claims and IBNR claims are made on an accrual basis and adjusted in future periods as required. However, changes in assumptions for medical costs caused by changes in actual experience (such as changes in the delivery system, changes in utilization patterns, unforeseen fluctuations in claims backlogs and others) may ultimately prove these estimates inaccurate. During fiscal 2001, the Company recorded an adjustment (and corresponding income statement charge) of $15.0 million to its estimate of claims incurred in prior years based on the results of the reduction in claims inventory and other claims processing improvements. During fiscal 2002, the Company experienced net unfavorable prior fiscal year medical claims development of $6.4 million (unfavorable $8.6 million for Health Plans partially offset by favorable $2.2 million for Public). During the three months ended December 31, 2002, the Company experienced net favorable prior fiscal year medical claims development of $3.7 million (composed of Health Plans $1.3 million, Workplace $0.8 million and Public $1.6 million). As of December 31, 2002, the Company believes that its medical claims payable balance of $205.3 million is adequate in order to satisfy ultimate claim liabilities incurred through December 31, 2002. Any adjustments to such estimates could adversely affect the Company's results of operations in future periods.

        If the Company's membership in risk-based business grows, its exposure to potential losses from risk-related products will also be increased. Furthermore, certain of these contracts and certain state regulations limit the profits that the Company may earn on risk-related business and may require refunds if the loss experience is more favorable than that originally anticipated. Although experience varies on a contract-by-contract basis, historically, the Company's risk-related contracts have been profitable in the aggregate. However, the degree of profitability varies significantly from contract to contract. For example, the Company's Medicaid contracts with governmental entities generally tend to have direct profit margins that are lower than its other contracts. The most significant factor affecting the profitability of risk-related contracts is the ability to control direct service costs in relation to contract pricing.

        Certain of the contracts of the Company and certain state regulations may also require the Company or certain of its subsidiaries to reserve a specified amount of cash as financial assurance that it can meet its obligations under such contracts. As of December 31, 2002, the Company had restricted cash and investments of approximately $127.3 million pursuant to such contracts and regulations. Such amounts are not available to the Company for general corporate purposes. Furthermore, certain state regulations restrict the ability of subsidiaries that offer risk-related products to pay dividends to the Company. Additional state regulations could be promulgated which would increase the amount of restricted cash or other security the Company would be required to maintain. In addition, the Company's customers may require additional restricted cash or other security with respect to the Company's obligations under its contracts, including unpaid medical claims.

        Integration of Operations.    Since 1998, the Company has consolidated its managed behavioral healthcare businesses by eliminating duplicate staffing and facilities, most recently through the implementation of ABI and PIP (see "Business—Business Strategy" above). The Company is also focusing on reduction in computer system platforms, best practices analysis, standardization of provider contracting and utilization of the Internet to reduce the administrative burden on providers, customers

31

and beneficiaries, as well as further consolidation of regional service centers and other administrative positions. The Company believes that it can reduce administrative costs and improve customer service through these measures. The Company expects to fund these costs with internally generated funds. However, there can be no assurance that the Company will be able to successfully implement these initiatives or realize the anticipated savings.

        In addition, if the Company experiences significant disruptions in its computer systems and related claims payment problems during the integration process, these developments would adversely affect the Company's relationships with many of its contracted providers and customers, and its business and results of operations.

        Reliance on Customer Contracts.    Substantially all of the Company's net revenue is derived from contracts with payors of behavioral healthcare benefits. The Company's managed behavioral healthcare contracts typically have terms of one to three years, and in certain cases contain renewal provisions (at the customer's option) providing for successive terms of between one and two years (unless terminated earlier). Substantially all of these contracts are immediately terminable with cause and many, including some of the Company's most significant contracts, are terminable without cause by the customer upon the provision of requisite notice and the passage of a specified period of time (typically between 60 and 180 days), or upon the occurrence of certain other specified events. The Company's ten largest customers accounted for approximately 57.6% of the Company's net revenue for fiscal year 2002, and approximately 58.2 percent of the Company's net revenue during the three months ended December 31, 2002. Loss of all of these contracts or customers would, and loss of any one of these contracts or customers could, have a material adverse effect on the Company. One of these contracts is a subcontract with a health plan under which the Company provides mental health and substance abuse services to the beneficiaries of TRICARE. The Company recognized net revenues from this contract of $33.0 million, $61.5 million and $48.0 million in the fiscal years ended September 30, 2000, 2001 and 2002, respectively. The Company recognized net revenues from this contract of $12.7 million and $14.0 million during the three months ended December 31, 2001 and 2002, respectively. 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, price competition in bidding for contracts can significantly affect the financial terms of any new or renegotiated contract.

        The Company's two largest customer contracts are with Aetna and the State of Tennessee's TennCare program. The Company's managed behavioral contracts with Aetna, including NYLCare Health Plans and Prudential HealthCare, which were acquired by Aetna in July 1998 and August 1999, respectively, accounted for approximately $283.7 million, $315.6 million and $250.3 million of consolidated net revenue in fiscal years 2000, 2001 and 2002, respectively. The Company recognized net revenues from Aetna of $78.8 million and $54.8 million during the three months ended December 31, 2001 and 2002, respectively. The decrease in Aetna revenue of approximately $65.3 million in fiscal 2002 compared to fiscal 2001, and of approximately $24.0 million for the three months ended December 31, 2002 as compared to the three months ended December 31, 2001, was mainly due to decreased membership as a result of Aetna intentionally reducing its membership levels in an effort to exit less profitable businesses. The Company recognized net revenue from Aetna of $49.9 million during the three months ended March 31, 2003, which represents a decrease of $4.9 million from the revenue recognized during the three months ended December 31, 2002. Such decrease was mainly due to a further reduction in membership.

        As described above in "Business—Capital Structure Overview," as part of, and subject to, consummation of the Plan, Aetna and Magellan have agreed to renew their contract, under which the Company will continue to manage the behavioral health care of Aetna's members through December 31, 2005.

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        Both the Company through TBH, and Premier, a joint venture in which the Company has a 50.0% interest, separately contract with the State of Tennessee to manage the behavioral healthcare benefits for the State's TennCare program. In addition, the Company contracts with Premier to provide certain services to the joint venture. The Company's direct TennCare contract (exclusive of Premier) accounted for approximately $226.9 million, $248.9 million and $237.5 million of consolidated net revenue in fiscal years 2000, 2001 and 2002, respectively. The Company's direct TennCare contract accounted for approximately $60.0 million and $63.0 million of consolidated net revenue for the three months ended December 31, 2001 and 2002, respectively. Such direct TennCare contract expires on December 31, 2003. Such revenue amounts include revenue recognized by the Company associated with services performed on behalf of Premier totaling $96.0 million, $102.0 million and $134.9 million for fiscal years 2000, 2001 and 2002, respectively, and $33.6 million and $34.6 million for the three months ended December 31, 2001 and 2002, 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 required the consent of Magellan's joint venture partner in Premier. The joint venture partner agreed to give such consent provided that Magellan made a capital contribution of approximately $0.9 million into Premier (and Premier made a non-pro rata distribution of a like amount to the joint venture partner). Such capital contribution and distribution transactions were completed in May 2003. It is uncertain as to what will happen to the Premier and/or TBH membership after December 31, 2003, however, the State of Tennessee has indicated that it plans to issue a request for proposals ("RFP") relating to the TennCare program. The State has also indicated that if the Company has not emerged from bankruptcy prior to the due date for the RFP, the Company will be precluded from participating in the selection process.

        The Aetna and TennCare contracts may not be extended or successfully renegotiated or the terms of any new contracts may not be comparable to those of existing contracts.

        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 $90.8 million, $121.1 million and $181.9 million in fiscal 2000, 2001 and 2002, respectively. Revenues from the Pennsylvania Counties were $36.0 million and $56.2 million for the three months ended December 31, 2001 and 2002, respectively.

        Fluctuation in Operating Results.    The Company's quarterly operating results have varied in the past and may fluctuate significantly in the future due to a combination of factors, including:

•

changes in utilization levels by enrolled members of its risk-based contracts, including seasonal utilization patterns;



•

performance-based contractual adjustments to revenue, reflecting utilization results or other performance measures;

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•

changes in estimates for contractual adjustments under commercial contracts and TRICARE contracts;



•

retrospective membership adjustments;



•

the timing of implementation of new contracts and enrollment changes;



•

pricing adjustments upon contract renewals, and price competition in general;



•

contract terminations;



•

shift in membership between risk and non-risk products; and



•

changes in estimates regarding medical costs and incurred but not yet reported medical claims.

        These factors may affect the Company's quarterly and annual revenues, expenses and results of operations in the future. Accordingly, reliance should not be placed on quarter-to-quarter or year-to-year comparisons of the Company's results of operations as an indication of future performance. It is possible that in future periods the Company's results of operations may be below the expectations of the public market, analysts and investors.

        Dependence On Government Spending For Managed Healthcare; Possible Impact of Healthcare Reform.    A significant portion of the Company's revenue is derived, directly or indirectly, from federal, state and local governmental agencies, including state Medicaid programs. Reimbursement rates vary from state to state, are subject to periodic negotiation and may limit the Company's ability to maintain or increase rates. The Company is unable to predict the impact on its operations of future regulations or legislation affecting Medicaid or Medicare programs, or the healthcare industry in general, and future regulations or legislation may have a material adverse effect on the Company. Moreover, any reduction in government spending for such programs could also have a material adverse effect. In addition, the Company's contracts with federal, state and local governmental agencies, under both direct contract and subcontract arrangements, generally are conditioned upon financial appropriations by one or more governmental agencies, especially with respect to state Medicaid programs. These contracts generally can be terminated or modified by the customer if such appropriations are not made. Finally, some of the Company's contracts with federal, state and local governmental agencies, under both direct contract and subcontract arrangements, require the Company to perform additional services if federal, state or local laws or regulations imposed after the contract is signed so require, in exchange for additional compensation to be negotiated by the parties in good faith. Government and other third-party payors are generally seeking to impose lower reimbursement rates and to renegotiate reduced contract rates with service providers in a trend toward cost control. See "Business—Industry" and "—Business Strategy".

        The U.S. Congress is considering legislation which, among other things, would place limits on healthcare plans and methods of operations, limit employers' and healthcare plans' ability to define medical necessity and permit employers and healthcare plans to be sued in state courts for coverage determinations. It is uncertain whether the Company could recoup, through higher revenues or other measures, the increased costs of federally mandated benefits or other increased costs caused by such legislation or similar legislation. In addition, if any federal parity legislation is adopted and the difference in coverage limits for mental health coverage and medical health coverage is reduced or eliminated, any increase in revenue the Company derives following such legislation may not be sufficient to cover the increase in costs that would result from a greater utilization of mental healthcare services. The Company cannot predict the effect of this legislation, nor other legislation that may be adopted by Congress, and such legislation may have an adverse effect on the Company.

        Regulation.    The managed behavioral healthcare industry and the provision of behavioral healthcare services are subject to extensive and evolving state and federal regulation. The Company is

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subject to certain state laws and regulations and federal laws as a result of the role the Company assumes in connection with managing its customers' employee benefit plans.

        The regulatory issues that may affect operations include:

•

whether the Company's current licenses will be negatively impacted by the Company's financial condition, see further discussion at "Business—Regulation—Insurance, HMO and PPO Activities";



•

whether the Company needs to obtain additional licenses from state authorities to conduct its business, including utilization review and TPA activities;



•

whether the Company complies with various limits imposed by state authorities to prevent corporations from controlling or excessively influencing behavioral healthcare services through the direct employment of psychiatrists, psychologists or other professionals, and to prohibit such persons from splitting fees with other persons or entities;



•

whether the Company is able to comply with laws that impose financial terms and requirements upon insurance companies, PPOs, HMOs, TPAs, managed behavioral healthcare organizations and entities that assume risk under contracts with licensed insurance companies or HMOs;



•

whether the Company complies with laws that impose upon insurance companies, PPOs, HMOs and other types of third-party payors an obligation to contract with any healthcare provider willing to meet the terms of the payor's contracts with similar providers;



•

maintaining confidentiality of patient information; and



•

becoming compliant with HIPAA within the imposed deadlines. See "Business—Regulation—HIPAA".

        The imposition of additional license requirements and other regulatory requirements may, among other things, increase the Company's equity requirements, increase the cost of doing business or force changes in the Company's operations significantly to comply with these requirements.

        Risks Related To Realization of Goodwill and Intangible Assets.    The Company's total assets at December 31, 2002 reflect goodwill of approximately $502.3 million, representing 50.3% of the Company's total assets. 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 consolidated statement of operations for fiscal 2002. The Company proceeded with its annual impairment test, which is the comparison of the adjusted recorded goodwill balance at September 1, 2002 to the fair value of the goodwill. During the fourth quarter of fiscal 2002, the Company recorded an impairment charge of $415.9 million to write-down the balance of goodwill related to the Health Plans, Workplace and Public reporting units to estimated fair value, based on independently appraised values. This write-down occurred due to changes in the Company's financial performance and its business outlook from the beginning of the year through September 1,

35

2002, which decreased the estimated fair value of the Company's reporting units. The annual impairment charge is presented in the Company's fiscal 2002 consolidated statement of operations as "Goodwill impairment charges", a component of income from continuing operations. See Note 2—"Summary of Significant Accounting Policies" to the audited consolidated financial statements set forth elsewhere herein for further discussion of the impact of the adoption of SFAS 142.

        In addition to goodwill, at December 31, 2002, the Company had identifiable intangible assets (primarily customer lists, contracts, provider networks and treatment protocols) of approximately $68.8 million, net of accumulated amortization of $51.4 million. During the three months ended December 31, 2002, management reevaluated the estimated useful lives of the Company's intangible assets, which resulted in the Company changing the remaining useful lives of certain customer agreements and lists and provider networks. As a result of such reevaluation, the Company's intangible assets are now being amortized over their estimated remaining useful lives which range from approximately one to eighteen years. The amortization periods used by the Company may differ from those used by other entities. In addition, the Company may be required to shorten the amortization period for intangible assets in future periods based on changes in the Company's business. The Company may not ever realize the value of such assets.

        The Company evaluates, on a regular basis, whether events and circumstances have occurred that indicate that all or a portion of the carrying value of intangible assets may no longer be recoverable, in which case a charge to earnings for impairment losses could become necessary. When events or changes in circumstances are present that indicate the carrying amount of intangible assets may not be recoverable, the Company assesses the recoverability of intangible assets other than goodwill by determining whether the carrying value of such intangible assets will be recovered through the future cash flows expected from the use of the asset and its eventual disposition. In fiscal year 2000, the Company recorded impairment losses on goodwill, intangible assets and other long-lived assets of $15.8 million for continuing operations related to the Company's Group Practice Affiliates subsidiary and $75.2 million for discontinued operations related to the Company's specialty managed healthcare segment.

        Any event or change in circumstances which leads to a future determination requiring additional write-offs of a significant portion of unamortized intangible assets or goodwill would adversely affect the Company's results of operations.

        Claims for Professional Liability.    The management and administration of the delivery of managed behavioral healthcare services, and the direct provision of behavioral healthcare treatment services, entail significant risks of liability. From time to time, the Company is subject to various actions and claims of professional liability for alleged negligence in performing utilization review activities, as well as for the acts or omissions of the Company's employees, network providers or other parties. In the normal course of business, the Company receives reports relating to suicides and other serious incidents involving patients enrolled in the Company's programs. Such incidents occasionally give rise to malpractice, professional negligence and other related actions and claims against the Company or its network providers. As the number of lives covered by the Company grows and the number of providers under contract increases, actions and claims against the Company (and, in turn, possible legal liability) predicated on malpractice, professional negligence or other related legal theories can be expected to increase. The Company is also subject to actions and claims for the costs of services for which payment was denied. Many of these actions and claims seek substantial damages and require the Company to incur significant fees and costs related to its defense. Pending or future actions or claims for professional liability (including any judgments, settlements or costs associated therewith) may have a material adverse effect on the Company.

        Professional Liability and Other 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

36

carries professional liability insurance, subject to certain deductibles and self-insured retentions. Such insurance may not be sufficient to cover any judgments, settlements or costs relating to present or future claims, suits or complaints. Upon expiration of the Company's insurance policies, sufficient insurance may not be available on favorable terms, if at all. To the extent the Company's customers are entitled to indemnification under their contracts with the Company relating to liabilities they incur arising from the operation of the Company's programs, such indemnification may not be covered under the Company's insurance policies. To the extent that certain actions and claims seek punitive and compensatory damages arising from alleged intentional misconduct by the Company, such damages, if awarded, may not be covered, in whole or in part, by the Company's insurance policies. The Company also has certain potential liabilities relating to the self-insurance program the Company maintained with respect to its provider business prior to the Crescent Transactions. If the Company is unable to secure adequate insurance in the future, or if the insurance the Company carries is not sufficient to cover any judgments, settlements or costs relating to any present or future actions or claims, such judgments, settlements or costs may have a material adverse effect on the Company. In addition, the Company obtains surety bonds from insurance companies to meet requirements under the laws and regulations of states in which the Company operates. As of January 3, 2003, the Company has approximately $14.1 million of surety bonds outstanding. The surety bond carriers have collateral in the form of letters of credit in the amount of $13.2 million. If the Company is unable to obtain adequate surety bonds or make alternative arrangements to satisfy the requirements for such bonds, it may no longer be able to operate in those states, which would have a material adverse effect on the Company.

        Class Action Suits and Other Legal Proceedings.    Certain managed healthcare companies, including the Company, have been targeted as defendants in national class action lawsuits regarding their business practices. The national class action claims against the Company allege misrepresentations with respect to, and failure to disclose, the Company's claims practices, the extent of the benefits coverage and other matters that cause the value of the benefits to be less than the value represented to the members. Management believes that these national class action lawsuits are part of a trend targeting the healthcare industry, particularly managed care companies. The Company is a party to certain other class action lawsuits involving its business practices. The Company is also subject to other lawsuits and legal proceedings in conducting its business. See Item 3—"Legal Proceedings" elsewhere herein. Such lawsuits may have a material adverse effect on the Company.

        Government Investigations.    From time to time, the Company receives notifications from and engages in discussions with various government agencies concerning the Company's respective managed care businesses and operations. As a result of these contacts with regulators, the Company may, as appropriate, implement changes to its operations, revise its filings with such agencies and/or seek additional licenses to conduct its business. In addition, the Company continues to be subject to governmental investigations and inquiries, civil suits and other claims and assessments with respect to the provider business. See Item 3—"Legal Proceedings" elsewhere herein. The Company's inability to cooperate with these government investigations and inquiries and comply with the various requirements imposed on the Company as a result of these proceedings may have a material adverse effect on the Company's business.

        Catastrophic Events.    Catastrophic events may negatively impact the Company by causing: (i) increases in the use of behavioral healthcare services; (ii) increases in premiums for professional liability and other insurance; (iii) limitations on the available amount of insurance coverage or surety bonds as described above in "—Professional Liability and Other Insurance" and/or (iv) uncertainty in financial markets resulting in the inability to obtain financing on acceptable terms or at all, in connection with the proposed financial restructuring or for debt repayments, acquisitions, capital expenditures or working capital. Catastrophic events include floods, fires, earthquakes, hurricanes, acts of war and/or terrorist attacks, such as the events of September 11, 2001.

37

        Arthur Andersen LLP.    Arthur Andersen LLP, the Company's former independent public accountants that audited the Company's financial statements for the fiscal years ended September 30, 2000 and 2001, was found guilty by a jury on June 15, 2002 of federal obstruction of justice in connection with the government's investigation of Enron Corp. Arthur Andersen ceased practicing before the Commission effective August 31, 2002. It is possible that events arising out of the indictment may adversely affect the ability of Arthur Andersen to satisfy any claims arising from its provision of auditing and other services to the Company, including claims that may arise out of Arthur Andersen's audit of the Company's financial statements. The Commission has said that it will continue accepting financial statements audited or reviewed by Arthur Andersen provided that the Company complies with the applicable rules and orders issued by the Commission in March 2002 for such purpose.

        In the future, should the Company seek to access the public capital markets, the Commission's current rules require the inclusion or incorporation by reference of three years of audited financial statements in any prospectus. These rules would require the Company to present audited financial statements for one or more fiscal years audited by Arthur Andersen until the Company's audited financial statements for the fiscal year ending December 31, 2004 become available in the first quarter of the Company's fiscal year 2005. The Commission recently adopted rules exempting certain issuers filing Securities Act registration statements containing financial statements audited by Arthur Andersen from having to comply with rules that would also require such issuers to present manually signed reissued accountants' reports and written consents issued by Arthur Andersen. Although the Company believes that it currently meets the requirements for such exemptions, if the Commission ceases accepting financial statements audited by Arthur Andersen pursuant to such exemptions, it is possible that the Company's financial statements for the years ended September 30, 2000 and September 30, 2001 audited by Arthur Andersen might not satisfy the Commission's requirements. If this occurs, the Company would not be able to access the public capital markets unless Ernst & Young LLP, the Company's current independent accounting firm, or another independent accounting firm is able to audit the financial statements originally audited by Arthur Andersen. Any delay or inability to access the public capital markets caused by those circumstances could have a material adverse effect on the Company.

Employees of the Registrant

        At December 31, 2002, the Company had approximately 5,400 full-time and part-time employees. The Company believes it has satisfactory relations with its employees.

Available Information

        The Company makes its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 available on the Company's Internet website at http://www.magellanhealth.com as soon as practicable after the Company has electronically filed such material with, or furnished it to, the SEC. The information on the Company's website is not part of or incorporated by reference in this transition report on Form 10-K.

Item 2. Properties

        The Company's principal executive offices are located in Columbia, Maryland; the lease for the Company's headquarters expires in 2005. Additionally, the Company currently leases 61 offices in 29 states and Puerto Rico with terms expiring between 2003 and 2013. The Company believes that its current facilities are suitable for and adequate to support the level of its present operations.

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Item 3. Legal Proceedings

        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".

        The management and administration of the delivery of managed behavioral healthcare services, and the direct provision of behavioral healthcare treatment services, entail significant risks of liability. From time to time, the Company is subject to various actions and claims arising from the acts or omissions of its employees, network providers or other parties. In the normal course of business, the Company receives reports relating to suicides and other serious incidents involving patients enrolled in its programs. Such incidents occasionally give rise to malpractice, professional negligence and other related actions and claims against the Company or its network providers. See also "Cautionary Statements—Claims for Professional Liability". Many of these actions and claims received by the Company seek substantial damages and therefore require the defendant to incur significant fees and costs related to their defense. To date, claims and actions against the Company alleging professional negligence have not resulted in material liabilities and the Company does not believe that any such pending action against it will have a material adverse effect on the Company. However, there can be no assurance that pending or future actions or claims for professional liability (including any judgments, settlements or costs associated therewith) will not have a material adverse effect on the Company.

        To the extent the Company's customers are entitled to indemnification under their contracts with the Company relating to liabilities they incur arising from the operation of the Company's programs, such indemnification may not be covered under the Company's insurance policies. In addition, to the extent that certain actions and claims seek punitive and compensatory damages arising from alleged intentional misconduct by the Company, such damages, if awarded, may not be covered, in whole or in part, by the Company's insurance policies.

        From time to time, the Company receives notifications from and engages in discussions with various governmental agencies concerning its respective managed care businesses and operations. As a result of these contacts with regulators, the Company in many instances implements changes to its operations, revises its filings with such agencies and/or seeks additional licenses to conduct its business. In recent years, in response to governmental agency inquiries or discussions with regulators, the Company has determined to seek licensure as a single service health maintenance organization, third-party administrator or utilization review agent in one or more jurisdictions.

        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 ("OIG") and the United States Department of Justice

39

("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 the Psychiatric Hospital 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 (as defined) 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. As of December 31, 2002, the Company could not reasonably estimate the potential liability, if any, associated with the Department of Justice inquiries. Accordingly, no reserve was recorded related to this matter as of December 31, 2002. Subsequent to the Commencement Date, the Company began settlement negotiations with the Department of Justice concerning its inquiries. The Company believes that it will reach a settlement with the Department of Justice, which will include a release from all claims related to its inquiries, prior to the conclusion of the Chapter 11 Cases.

        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. The State of California has taken certain actions to increase its supervision of one of the Company's subsidiaries in California. In addition, TBH, Premier and one of the Company's subsidiaries in Iowa are each operating under an agreed notice of administrative supervision. Under such agreements, the State of Tennessee and the State of Iowa may exercise additional supervision over the affairs of such entities.

        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 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-K). 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 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. As part of the Company's bankruptcy proceedings, Wachovia has filed a proof of claim against the Company for approximately the aforementioned amounts. The Company believes that Wachovia's claims constitute pre-petition general unsecured claims and, to the extent

40

allowed by the Bankruptcy Court, would be resolved as Other General Unsecured Claims under the Plan in the Chapter 11 Cases. See "Business—Capital Structure Overview".

        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 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 Class Actions have been stayed as a consequence of the commencement of the Company's Chapter 11 Cases. The Company believes that the claims in the Class Actions constitute pre-petition general unsecured claims and, to the extent allowed by the Bankruptcy Court, would be resolved as Other General Unsecured Claims under the Plan in the Chapter 11 Cases. See "Business—Capital Structure Overview". The plaintiffs did not file a timely proof of claim with the Bankruptcy Court and therefore the Company believes that there will be no allowed claim with respect thereto in the Chapter 11 Cases.

        The Company is also subject to or party to other class action suits, litigation and claims relating to its operations and business practices. Litigation asserting claims against the Company for pre-petition obligations (the "Pre-petition Litigation") has been stayed as a consequence of the commencement of the Chapter 11 Cases. The Company believes that the Pre-petition Litigation claims constitute pre-petition general unsecured claims and, to the extent allowed by the Bankruptcy Court, would be resolved as Other General Unsecured Claims under the Plan in the Chapter 11 Cases. See "Business—Capital Structure Overview".

        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.

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

        None.

41

PART II

Item 5. Market Price for Registrant's Common Equity and Related Stockholder Matters

        The Company has one class of common stock, $0.25 par value per share, which is currently listed for trading on the Over-the-Counter Bulletin Board (ticker symbol "MGLH"). On October 9, 2002, the common stock of the Company was de-listed from the New York Stock Exchange, where it previously traded under the ticker symbol "MGL". As of July 31, 2003, there were 8.940 holders of record of the Company's common stock. The following table sets forth the high and low sales prices of the Company's common stock from October 1, 2000 through December 31, 2002:

        The Company did not declare any cash dividends during fiscal 2001 or 2002 or during the three months ended December 31, 2002. The Company is prohibited from paying dividends on its common stock under the terms of the Credit Agreement, except in very limited circumstances. See "Management's Discussion and Analysis of Financial Condition and Results of Operations—Outlook—Liquidity and Capital Resources—Restrictive Covenants in the Company's Debt Instruments".

Item 6. Selected Financial Data

        In May 2003, the Company's board of directors approved a change in the Company's fiscal year. Instead of a fiscal year ending on September 30, the Company has adopted a fiscal year that coincides with the calendar year, effective December 31, 2002. The following table sets forth selected historical consolidated financial information of the Company for each of the five fiscal years in the period ended September 30, 2002 and the three-month transition period ended December 31, 2002. The table also presents unaudited comparable data for the three months ended December 31, 2001.

        Net loss for fiscal 2002 includes the effect of the adoption of SFAS 142. Adoption of SFAS 142 resulted in the Company recognizing an impairment loss of $207.8 million, before taxes ($191.6 million after taxes), in the first quarter of fiscal 2002, recorded as a cumulative effect of a change in accounting principle, separate from operating results. Adoption of SFAS 142 also resulted in the Company recording goodwill impairment charges of $415.9 million in the fourth quarter of fiscal 2002. Partially offsetting the combined unfavorable impact of these charges is the fact that the Company did not record approximately $31.1 million of goodwill amortization during fiscal 2002 in accordance with SFAS 142. See Note 2—"Summary of Significant Accounting Policies—Goodwill" to the audited consolidated financial statements set forth elsewhere herein for further discussion of the impact to the Company of the adoption of SFAS 142 in fiscal 2002. In addition, the Company's capital restructuring

42

activities and financial condition result in uncertainty as to the Company's ability to realize its net operating loss carryforwards and other deferred tax assets. Accordingly, as of September 30, 2002, the Company has recorded an increase to its valuation allowance of $200.5 million, resulting in a total valuation allowance covering all of its net deferred tax assets. See Note 9—"Income Taxes" to the audited consolidated financial statements set forth elsewhere herein. The operating results for fiscal 2001 were positively impacted by settlements of certain contract appeals related to subcontracts with respect to TRICARE. For fiscal 2001, net revenue and equity in earnings of unconsolidated subsidiaries included $30.3 million and $22.6 million, respectively, related to such settlements. For fiscal 2001, income from continuing operations and net income each included approximately $31.7 million related to the positive impact of these settlements. Additionally, in the fourth quarter of fiscal 2002, the Company adopted SFAS 145, which led to the reclassification of losses due to early extinguishment of debt in fiscal 2001 from extraordinary losses to losses from operations.

        On September 2, 1999, the Company's Board of Directors approved a formal plan to dispose of the Company's businesses and interests included in the Company's healthcare provider and healthcare franchising segments and on September 10, 1999, the Company consummated such disposal. On October 4, 2000, the Company adopted a formal plan to dispose of the business included in the Company's specialty managed healthcare segment. On January 18, 2001, the Company adopted a formal plan to dispose of the business representing the Company's human services segment, and on March 9, 2001, the Company consummated such disposal. Accordingly, the statement of operations data has been restated to reflect the healthcare provider, healthcare franchising, specialty managed healthcare and human services business segments as discontinued operations. Selected consolidated financial information for the three years in the period ended September 30, 2002 and for the three months ended December 31, 2002, and as of September 30, 2001 and 2002 and December 31, 2002 presented below, have been derived from, and should be read in conjunction with, the Company's audited consolidated financial statements and the notes thereto included elsewhere herein. Selected consolidated financial information for the years ended September 30, 1998 and 1999 and as of September 30, 1998, 1999 and 2000 has been derived from the Company's audited consolidated financial statements not included in this Form 10-K. The selected consolidated financial information as of and for the three months ended December 31, 2001 is unaudited. The selected financial data set forth below also should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" appearing elsewhere herein.

43

MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES

(1)

Amounts are unaudited.

(2)

Net of income taxes.

44

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

        This Form 10-K includes "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act") and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Although the Company believes that its plans, intentions and expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such plans, intentions or expectations will be achieved. Prospective investors are cautioned that any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties and that actual results may differ materially from those contemplated by such forward-looking statements. Important factors currently known to management that could cause actual results to differ materially from those in forward-looking statements are set forth under the heading "Cautionary Statements" in Item 1 and elsewhere in this Form 10-K. When used in this Form 10-K, the words "estimate", "anticipate", "expect", "believe", "should" and similar expressions are intended to be forward-looking statements.

Voluntary Chapter 11 Filing

        As more fully discussed under "Business—Capital Structure Overview" above and under "Outlook—Liquidity and Capital Resources" below, on March 11, 2003, Magellan and 88 of its subsidiaries filed voluntary petitions for relief under chapter 11 of the Bankruptcy Code in order to, among other things, restructure the Company's debt, which totaled approximately $1.0 billion as of December 31, 2002, and to improve the Company's liquidity. 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 (see "Business—Capital Structure Overview") 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.

Fiscal Year Change

        In May 2003, the Company's board of directors approved a change in the Company's fiscal year. Instead of a fiscal year ending on September 30, the Company has adopted a fiscal year that coincides with the calendar year, effective December 31, 2002. Throughout this Transition Report on Form 10-K, references to the Company's historical financial information prior to December 31, 2002 will refer to the Company's former fiscal year end of September 30. For example, fiscal 2000, 2001 and 2002 correspond to the twelve-month periods ending September 30, 2000, 2001 and 2002, respectively. References to fiscal 2003 relate to the Company's fiscal year ending December 31, 2003.

Business Overview

        Over the past few years, the Company has exited non-core businesses and focused on its core managed behavioral healthcare business, primarily by taking the following actions:

•

On September 10, 1999, the Company transferred assets and other interests and forgave certain receivables in a series of transactions that effected the Company's exit from its healthcare provider and healthcare franchising business. These transactions, together with the formal plan of disposal authorized by the Company's Board of Directors on September 2, 1999, represented the disposal of the Company's healthcare provider and healthcare franchising business segments.



•

On October 4, 2000, the Company adopted a formal plan to dispose of the businesses included in the Company's specialty managed healthcare segment through the sale and/or abandonment of these businesses and related assets. The specialty managed healthcare segment includes the

45

businesses acquired in conjunction with the purchase of Vivra, Inc. ("Vivra") which was consummated February 29, 2000 and Allied Specialty Care Services, Inc. ("Allied") which was consummated on December 5, 1997. The initial purchase price for Vivra was $10.3 million. The Company paid approximately $54.5 million for Allied.

•

On January 18, 2001, the Company's Board of Directors approved and the Company entered into a definitive agreement for the sale of the stock of National Mentor, Inc. ("Mentor"), which represented the business and interests that comprise the Company's human services segment. On March 9, 2001, the Company consummated the sale of Mentor. The sale of Mentor represented the disposal of the Company's human services segment.

        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. The operating results of the discontinued segments have been disclosed, net of income tax, in a separate income statement caption "Discontinued operations—Income (loss) from discontinued operations". The losses the Company incurred to exit the discontinued operations are reflected, net of income tax, in the caption "Discontinued operations—Loss on disposal of discontinued operations". The assets, liabilities and cash flows related to discontinued operations have not been segregated from continuing operations.

        The Company currently is engaged in the managed behavioral healthcare business. The Company coordinates and manages the delivery of behavioral healthcare treatment services through its network of providers, which includes psychiatrists, psychologists and other behavioral health professionals. The Company's managed behavioral healthcare network also includes contractual arrangements with certain third-party treatment facilities. See "Business—Provider Network", for further discussion of the Company's managed behavioral healthcare network. The treatment services provided through these provider networks include outpatient programs (such as counseling or therapy), intermediate care programs (such as intensive outpatient programs and partial hospitalization services), inpatient treatment and crisis intervention services. The Company provides these services primarily through: (i) risk-based products, where the Company assumes all or a portion of the responsibility for the cost of providing treatment services in exchange for a fixed per member per month fee, (ii) Administrative Services Only ("ASO") products, where the Company provides services such as utilization review, claims administration and/or provider network management, (iii) Employee Assistance Programs ("EAP") and (iv) products which combine features of some or all of the Company's risk-based, ASO or EAP products. At December 31, 2002, the Company managed the behavioral healthcare benefits of approximately 67.4 million individuals.

        Within the managed behavioral healthcare business, the Company operates in the following four segments, based on the services it provides and/or the customers that it serves: (i) Health Plan Solutions Group ("Health Plans"); (ii) Workplace Group ("Workplace"); (iii) Public Solutions Group ("Public") and (iv) Corporate and Other.

        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 companies 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. During fiscal years 2000, 2001 and 2002, the Company derived approximately $283.7 million, $315.6 million and $250.3 million, respectively, of net revenue from its contracts with Aetna, Inc. ("Aetna"). The Company recognized net revenues from Aetna of $78.8 million and $54.8 million during the three months ended

46

December 31, 2001 and 2002, respectively. The decline in Aetna revenue of approximately $65.3 million in fiscal 2002 compared to fiscal 2001, and of approximately $24.0 million for the three months ended December 31, 2002 as compared to the three months ended December 31, 2001, was mainly due to decreased membership as a result of Aetna intentionally reducing its membership levels in an effort to exit less profitable businesses. The Company recognized net revenue from Aetna of $49.9 million during the three months ended March 31, 2003, which represents a further decrease of $4.9 million from the revenue recognized during the three months ended December 31, 2002. Such decrease was mainly due to a further reduction in membership.

        As described in "Business—Capital Structure Overview," as part of, and subject to, consummation of the Plan, Aetna and Magellan have agreed to renew their contract, under which the Company will continue to manage the behavioral health care of Aetna's members through December 31, 2005.

        The Company provides mental health and substance abuse services to the beneficiaries of TRICARE, formerly the Civilian Health and Medical Program of the Uniformed Services (CHAMPUS), under two separate subcontracts with health plans that contract with TRICARE. The Company recognized net revenues from the first TRICARE contract of $19.4 million, $39.3 million and $31.2 million in the fiscal years ended September 30, 2000, 2001 and 2002, respectively. The Company recognized net revenues from the first contract of $8.3 million and $8.9 million during the three months ended December 31, 2001 and 2002, respectively. 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 $33.0 million, $61.5 million and $48.0 million in the fiscal years ended September 30, 2000, 2001 and 2002, respectively. The Company recognized net revenues from the second contract of $12.7 million and $14.0 million during the three months ended December 31, 2001 and 2002, respectively. 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.

        Choice Behavioral Health Partnership ("Choice"), in which the Company previously had a 50.0% interest, also is a subcontractor with respect to TRICARE. All of Choice's revenues are derived from its subcontract with respect to TRICARE. Such subcontract expires June 30, 2003. Effective October 29, 2002, the Company withdrew from equity ownership in the Choice partnership on the following terms: (i) the Company is to receive or pay, as the case may be, 50.0% of all bid price adjustments, change order and other pricing adjustments finalized subsequent to October 31, 2002 but relating to the period prior to November 1, 2002; (ii) the Company is to continue to share in 50.0% of all profits or losses from Choice for the period from November 1, 2002 through June 30, 2003 and (iii) if Choice's subcontract is extended beyond June 30, 2003, the Company is to be paid $150,000 per month for the extension period up to a maximum of twelve months. The Company will have no residual interest in the operations of Choice beyond these terms. See Note 3—"Acquisitions and Joint Ventures" to the audited consolidated financial statements set forth elsewhere herein.

        The Company and Choice receive fixed fees for the management of the services, which are subject to certain bid-price adjustments (BPAs). The BPAs are calculated in accordance with contractual provisions and actual healthcare utilization from the data collection period, as defined. The BPAs are recorded when measurable, based upon information available from both the TRICARE program and the Company's information systems.

        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 or ASO contracts. The Company provides managed behavioral healthcare services to the

47

State of Tennessee's TennCare program, both through a direct contract with the Company's wholly owned subsidiary Tennessee Behavioral Health, Inc. ("TBH") and through Premier Behavioral Systems of Tennessee, LLC ("Premier"), a joint venture in which the Company owns a 50.0% interest. In addition, the Company contracts with Premier to provide certain services to the joint venture. The Company's direct TennCare contract (exclusive of Premier) accounted for approximately $226.9 million, $248.9 million and $237.5 million of consolidated net revenue in fiscal years 2000, 2001 and 2002, respectively. The Company's direct TennCare contract accounted for approximately $60.0 million and $63.0 million of consolidated net revenue for the three months ended December 31, 2001 and 2002, respectively. Such revenue amounts include revenue recognized by the Company associated with services performed on behalf of Premier totaling $96.0 million, $102.0 million and $134.9 million for fiscal years 2000, 2001 and 2002, respectively, and $33.6 million and $34.6 million for the three months ended December 31, 2001 and 2002, 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 required the consent of Magellan's joint venture partner in Premier. The joint venture partner agreed to give such consent provided that Magellan made a capital contribution of approximately $0.9 million into Premier (and Premier made a non-pro rata distribution of a like amount to the joint venture partner). Such capital contribution and distribution transactions were completed in May 2003. It is uncertain as to what will happen to the Premier and/or TBH membership after December 31, 2003; however, the State of Tennessee has indicated that it plans to issue a request for proposals ("RFP") relating to the TennCare program. The State has also indicated that if the Company has not emerged from bankruptcy prior to the due date for the RFP, the Company will be precluded from participating in the selection process.

        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 $90.8 million, $121.1 million and $181.9 million in fiscal 2000, 2001 and 2002, respectively. Revenues from the Pennsylvania Counties were $36.0 million and $56.2 million for the three months ended December 31, 2001 and 2002, respectively.

        Public risk contracts generally have higher per member premiums, cost and (to some degree) more volatility than both Health Plans and Workplace, due to the nature of populations, benefits provided and other matters. See "Cautionary Statements—Dependence on Government Spending for Managed Healthcare; Possible Impact of Healthcare Reform" and "—Regulation".

        Corporate and Other.    This segment of the Company is comprised primarily of 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.

48

Critical Accounting Policies and 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. 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 fiscal years ended September 30, 2000, 2001 and 2002 approximated $1,439.6 million, $1,540.7 million and $1,537.9 million, respectively. Managed care risk revenues for the three months ended December 31, 2001 and 2002 were approximately $390.3 million and $388.7 million, 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 an interim basis pursuant to the rights and obligations of each party upon termination of the contracts. The Company recognized performance revenue of approximately $7.8 million, $22.7 million and $13.0 million in the fiscal years ended September 30, 2000, 2001 and 2002, respectively. For the three months ended December 31, 2001 and 2002, the Company recognized performance-based revenue of approximately $3.4 million and $1.0 million, 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 "Health Plans" above. 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, for reasonable estimates of the BPAs as part of its managed care risk revenues. These estimates are based upon information available, on a quarterly basis, from both the TRICARE program and the Company's information systems. Under the contract, the Company settles the BPAs at set intervals over the term of the contracts.

        The Company recorded estimated liabilities of approximately $3.8 million as of September 30, 2001 and estimated receivables of $1.0 million and $3.6 million as of September 30, 2002 and December 31, 2002, respectively, based upon the Company's interim calculations of the estimated BPAs. Such amounts were recorded as adjustments to revenues. While management believes that the estimated TRICARE adjustments are adequate, ultimate settlement resulting from adjustments and available appeal processes may vary from the amounts provided.

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

        Goodwill.    The Company's total assets at December 31, 2002 reflect goodwill of approximately $502.3 million, representing 50.3% of the Company's total assets. 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

49

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 consolidated statement of operations for fiscal 2002. The Company proceeded with the annual impairment test, which is the comparison of the adjusted recorded goodwill balance at September 1, 2002 to the estimated fair value of the goodwill. During the fourth quarter of fiscal 2002, the Company recorded an impairment charge of $415.9 million to write-down the balance of goodwill related to the Health Plans, Workplace and Public reporting units to estimated fair value, based on independently appraised values. This write-down occurred due to changes in the Company's financial performance and its business outlook from the beginning of the year through September 1, 2002, which decreased the estimated fair value of the Company's reporting units. The annual impairment charge is presented in the Company's 2002 consolidated statement of operations as "Goodwill impairment charges", a component of income from continuing operations. See Note 2—"Summary of Significant Accounting Policies" to the audited consolidated financial statements set forth elsewhere herein for further discussion of the impact of the adoption of SFAS 142.

        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") which superseded SFAS No. 121, "Accounting for Impairment of Long-Lived Assets and for Long-Lived Assets to Disposed Of" ("SFAS 121"). 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 December 31, 2002. The Company's previous assessment under SFAS 121 also included goodwill prior to adoption of SFAS 142 on October 1, 2001. In the event that there are changes in the planned use of the Company's long-term assets or its expected future undiscounted cash flows are reduced significantly, the Company's assessment of its ability to recover the carrying value of these assets would change. In addition, 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.

        Deferred Taxes.    The Company files a consolidated federal income tax return for the Company and its wholly owned consolidated subsidiaries. The Company accounts for income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes". The deferred tax assets and/or liabilities are determined by multiplying the differences between the financial reporting and tax reporting bases for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. The effect of a change in tax rates on deferred taxes is recognized in income in the period that includes the enactment date. Valuation allowances on deferred tax assets are estimated based on the Company's assessment of the realizability of such amounts. At December 31, 2002, the Company had estimated tax net operating loss ("NOL") carryforwards of approximately $711.0 million available to reduce future federal taxable income. These NOL carryforwards expire in 2006 through 2021 and are

50

subject to examination by the Internal Revenue Service. The Company's financial restructuring activities and financial condition result in uncertainty as to the Company's ability to realize its net operating loss carryforwards and other deferred tax assets. Accordingly, as of September 30, 2002, the Company recorded an increase to its valuation allowance of $200.5 million, resulting in a total valuation allowance covering all of the Company's net deferred tax assets. The Company's net deferred tax assets were fully reserved as of September 30, 2002 and December 31, 2002. Net deferred tax assets were approximately $81.6 million at September 30, 2001.

        Medical Claims Payable.    Medical claims payable in the Company's consolidated financial statements represent the liability for healthcare claims reported but not yet paid and claims incurred but not yet reported ("IBNR") related to the Company's managed healthcare business. The IBNR portion of medical claims payable is estimated based on past claims payment experience for member groups, enrollment data, utilization statistics, authorized healthcare services and other factors. This data is incorporated into contract-specific actuarial reserve models. The estimates for submitted claims and IBNR claims are made on an accrual basis and adjusted in future periods as required. However, changes in assumptions for medical costs caused by changes in actual experience (such as changes in the delivery system, changes in utilization patterns, unforeseen fluctuations in claims backlogs, etc.) may ultimately prove these estimates inaccurate. As of December 31, 2002, the Company believes that its medical claims payable balance of $205.3 million is adequate in order to satisfy ultimate claim liabilities incurred through December 31, 2002. Medical claims payable balances are continually monitored and reviewed. Changes in assumptions for care costs caused by changes in actual experience could cause the estimates to change in the near term.

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Results of Operations

        The Company's significant accounting policies are discussed in Note 2—"Summary of Significant Accounting Policies" to the audited consolidated financial statements set forth elsewhere herein.

        The Company evaluates performance of its segments based on profit or loss from continuing operations before depreciation, amortization, interest (net), goodwill impairment charges, managed care integration costs, special charges, income taxes and minority interest ("Segment Profit"). See Note 15—"Business Segment Information" to the Company's audited consolidated financial statements set forth elsewhere herein. The following table summarizes, for the periods indicated, operating results and other financial information, by business segment (in millions):

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Three months ended December 31, 2002 ("Current Year Quarter"), compared to the three months ended December 31, 2001 ("Prior Year Quarter")

        As noted above, the Company changed its fiscal year end from September 30 to December 31, effective December 31, 2002. The following discussion of historical operating results compares the Current Year Quarter with the Prior Year Quarter.

Health Plans

        Net Revenue.    Net revenue related to the Health Plans segment decreased by 9.2% or $24.1 million to $237.1 million for the Current Year Quarter from $261.2 million for the Prior Year Quarter. The decrease in revenue is mainly due to a reduction in revenue under the Company's contract with Aetna (mainly due to decreased membership) of $23.6 million, terminated contracts of $14.4 million, lower performance revenue of $3.0 million (see below) and contract changes (mainly risk to non-risk) of $4.2 million, which decreases were partially offset by net increases in rates of $11.1 million, net increased membership from existing customers (excluding Aetna) of $4.7 million, new business of $2.4 million and other net changes.

        Performance-based revenues for the Health Plans segment were $3.6 million and $0.6 million in the Prior Year Quarter and Current Year Quarter, respectively. The decrease is primarily due to the Prior Year Quarter including performance revenue for a contract that no longer has performance revenue terms.

        Cost of Care.    Cost of care decreased by 9.8% or $14.9 million to $137.5 million for the Current Year Quarter from $152.4 million for the Prior Year Quarter. The decrease in cost of care is mainly due to decreased membership from Aetna of $15.1 million, terminated contracts of $9.0 million, net contract changes (mainly risk to non-risk) of $2.8 million, favorable prior fiscal year medical claims development during the Current Year Quarter of $1.3 million and unfavorable prior fiscal year medical claims development during the Prior Year Quarter of $4.6 million, which decreases were partially offset by estimated higher care trends of $13.2 million, net increased membership from existing customers of $3.7 million, and new business of $1.0 million. Excluding the impact of prior fiscal year medical claims development, cost of care increased as a percentage of risk revenue from 66.1% in the Prior Year Quarter to 68.7% in the Current Year Quarter, mainly due to higher care trends experienced in the Current Year Quarter, partially offset by rate and other revenue increases since the Prior Year Quarter.

        Direct Service Costs.    Direct service costs decreased by 23.7% or $10.8 million to $34.7 million for the Current Year Quarter from $45.5 million for the Prior Year Quarter. The decrease in direct service costs is due to lower costs required to support the Company's decrease in net membership, and due to cost reduction efforts undertaken by the Company including the shutdown of several regional service centers. Direct service costs decreased as a percentage of revenue from 17.4% for the Prior Year Quarter to 14.6% for the Current Year Quarter. The decrease in the percentage of direct service costs in relationship to revenue is mainly due to the aforementioned cost reduction efforts undertaken by the Company.

        Equity in Earnings of Unconsolidated Subsidiaries.    Equity in earnings of unconsolidated subsidiaries decreased 47.4% or $1.8 million to $2.0 million for the Current Year Quarter from $3.8 million for the Prior Year Quarter. The decrease in equity in earnings of unconsolidated subsidiaries mainly relates to the Company's withdrawal from the Choice partnership as of the end of October 2002.

Workplace

        Net Revenue.    Net revenue related to the Workplace segment increased by 0.9% or $0.5 million to $56.3 million for the Current Year Quarter from $55.8 million for the Prior Year Quarter. The increase

53

in revenue is mainly due to net increased membership from existing customers of $0.8 million, partially offset by other net changes.

        Cost of Care.    Cost of care remained constant at $18.4 million for the Current Year Quarter and the Prior Year Quarter. Increases in cost of care due to net increased membership from existing customers of $0.6 million, and higher care trends of $0.2 million, were entirely offset by favorable prior fiscal year medical claims development during the Current Year Quarter of $0.8 million. Excluding the impact of prior fiscal year medical claims development, cost of care increased as a percentage of risk revenue from 40.8% in the Prior Year Quarter to 43.3% in the Current Year Quarter, mainly due to higher care trends experienced in the Current Year Quarter and due to changes in business mix.

        Direct Service Costs.    Direct service costs decreased by 5.7% or $1.2 million to $19.9 million for the Current Year Quarter from $21.1 million for the Prior Year Quarter. As a percentage of revenue, direct service costs decreased from 37.8% for the Prior Year Quarter to 35.3% for the Current Year Quarter. The aforementioned changes in direct service costs are mainly due to cost reduction efforts undertaken by the Company.

Public

        Net Revenue.    Net revenue related to the Public segment increased by 19.3% or $24.7 million to $152.5 million for the Current Year Quarter from $127.8 million for the Prior Year Quarter. The increase in revenue is mainly due to net increased membership from existing customers of $17.3 million, net rate increases of $6.2 million and other net changes.

        Cost of Care.    Cost of care increased by 19.9% or $20.9 million to $125.8 million for the Current Year Quarter from $104.9 million for the Prior Year Quarter. The increase in cost of care is mainly due to net increased membership from existing customers of $14.0 million and higher care trends of approximately $8.5 million, which increases were partially offset by favorable prior fiscal year medical claims development during the Current Year Quarter of $1.6 million. Excluding the impact of prior fiscal year medical claims development, as a percentage of risk revenue, cost of care increased from 86.3% for the Prior Year Quarter to 87.4% for the Current Year Quarter mainly due to higher care trends experienced in the Current Year Quarter, partially offset by rate and other revenue increases since the Prior Year Quarter.

        Direct Service Costs.    Direct service costs increased by 7.9% or $0.8 million to $10.9 million for the Current Year Quarter from $10.1 million for the Prior Year Quarter. The increase in direct service costs is primarily due to higher costs required to support the Company's increase in net membership, partially offset by cost reduction efforts undertaken by the Company. As a percentage of revenue, direct service costs decreased from 7.9% for the Prior Year Quarter to 7.1% for the Current Year Quarter, primarily due to the Company's ability to control the rate of increase of direct service costs associated with membership growth and due to the Company's cost reduction efforts.

        Equity in Earnings (Loss) of Unconsolidated Subsidiaries.    Equity in earnings (loss) of unconsolidated subsidiaries for Public increased $0.7 million to $0.1 million for the Current Year Quarter from $(0.6) million for the Prior Year Quarter. The Public segment's investment in unconsolidated subsidiary relates to Premier. The improvement is primarily due to favorable rate changes partially offset by unfavorable care trends.

Corporate and Other

        Other Operating Expenses.    Other operating costs related to the Corporate and Other Segment increased by 3.5% or $1.5 million to $44.2 million for the Current Year Quarter from $42.7 million for the Prior Year Quarter. As a percentage of total net revenue, other operating costs increased from 9.6% for the Prior Year Quarter to 9.9% for the Current Year Quarter. These variances are mainly due

54

to approximately $3.2 million of expenses incurred in the Current Year Quarter in relation to the Company's financial restructuring efforts, partially offset by the Company's cost reduction efforts.

        Depreciation and Amortization.    Depreciation and amortization increased by 28.6% or $3.2 million to $14.4 million for the Current Year Quarter from $11.2 million for the Prior Year Quarter. The increase is partially due to $1.8 million of additional amortization expense related to an adjustment of the remaining useful lives of certain intangible assets as of October 1, 2002. The remaining increase is primarily due to higher depreciation expense associated with fixed asset addition activity.

        Interest, Net.    Net interest expense increased by 8.5% or $1.9 million to $24.3 million for the Current Year Quarter from $22.4 million for the Prior Year Quarter. The increase in net interest expense is partially due to the inclusion in the Current Year Quarter of $0.6 million in penalty interest due to the non-registration of the Senior Notes, as discussed in Note E—"Long-Term Debt and Capital Lease Obligations" to the unaudited condensed consolidated financial statements set forth elsewhere herein. The remaining increase in net interest expense is mainly due to higher borrowing levels on the Company's revolving line of credit, higher amortization of deferred financing costs and lower invested cash and investment balances during the Current Year Quarter.

        Other Items.    The Company recorded special charges of $4.5 million and $3.9 million in the Prior Year Quarter and the Current Year Quarter, respectively. The special charges related to restructuring plans that have resulted in the elimination of certain positions and the closure of certain offices. These charges primarily consist of employee severance and termination benefits, lease termination costs and consulting fees. See Note 11—"Managed Care Integration Plan and Special Charges" to the audited consolidated financial statements set forth elsewhere herein for further discussion.

        Income Taxes.    The Company's effective income tax rate decreased to 22.4% for the Current Year Quarter from 41.0% for the Prior Year Quarter. The Current Year Quarter effective rate is less than federal statutory rates primarily due to the realization of certain previously reserved deferred tax assets. The Prior Year Quarter effective rate exceeds federal statutory rates primarily due to state income tax provision.

        Discontinued Operations.    The following table summarizes, for the periods indicated, income from discontinued operations, net of tax (in thousands):

        Income from the healthcare provider and franchising segments for the Current Year Quarter is a result of changes in estimates of certain accrued liabilities of $0.9 million (pre-tax), as well as the result of the positive settlement of outstanding Medicare and Medicaid cost reports of $0.7 million (pre-tax), offset by the cost of collections, legal fees and other costs of exiting the business. Income from the healthcare provider and franchising segments for the Prior Year Quarter is a result of the positive settlement of outstanding Medicare and Medicaid cost reports of $1.9 million (pre-tax), offset by the cost of collections, lease termination payments, legal fees and other costs of exiting the business. See Note 4—"Discontinued Operations" to the Company's audited consolidated financial statements set

55

forth elsewhere herein. The following table summarizes, for the periods indicated, the gain on disposal of discontinued operations, net of tax (in thousands):

        The Current Year Quarter gain on disposal related to the human services segment relates to a favorable adjustment of self insurance reserves on a pre-tax basis of approximately $0.2 million. During the Prior Year Quarter, the Company and its joint venture partner sold the operations and assets of the remaining provider joint venture ("Provider JV") for $7.6 million, less selling costs of $0.1 million. This resulted in the Company receiving $3.5 million in cash and recording a pre-tax gain in the healthcare provider and franchising segments of approximately $1.3 million.

Fiscal 2002 compared to fiscal 2001

Health Plans

        Net Revenue.    Net revenue related to the Health Plans segment decreased by 6.4% or $66.5 million to $977.4 million in fiscal 2002 from $1,043.9 million in fiscal 2001. During fiscal 2001, the Company settled certain contract appeals related to two subcontracts with respect to TRICARE that resulted in additional revenues of $30.3 million. The decrease in revenue is mainly due to TRICARE settlements of $30.3 million, the decrease in revenue under the Company's contract with Aetna (mainly due to decreased membership) of $65.2 million, terminated contracts in fiscal 2001 and fiscal 2002 of $38.7 million, contract changes (mainly risk to non-risk) of $16.1 million, decreased performance-based revenue of $7.6 million (see below) and the effect of the fiscal 2001 sale of Group Practice Affiliates, Inc. ("GPA"), a staff model physician practice, of $2.2 million, which decreases were partially offset by net increases in rates of $41.4 million, net increased membership from existing customers (excluding Aetna) of $38.4 million, new business of $11.0 million and other net changes.

        The Company earns performance-based fees as part of certain of its health plan contracts. Performance-based revenues are recorded when earned and estimable. Performance-based revenues for the Health Plans segment were $19.9 million and $12.3 million in fiscal 2001 and 2002, respectively. The decrease is primarily due to the inclusion in fiscal 2001 of positive changes in estimates regarding fiscal 2000 amounts and other positive contractual developments in fiscal 2001 under certain arrangements for which no contract periods had been settled in fiscal 2000.

        Cost of Care.    Cost of care decreased by 4.0% or $25.1 million to $596.8 million in fiscal 2002 from $621.9 million in fiscal 2001. The decrease in cost of care is primarily due to decreased membership from Aetna of $46.6 million, terminated contracts in fiscal 2001 and fiscal 2002 of $24.1 million, net contract changes (mainly risk to non-risk) of $16.1 million and unfavorable prior fiscal year medical claims development during fiscal 2001 of $15.0 million, which decreases were partially offset by higher care trends over the prior year of $31.6 million, net increased membership from existing customers (excluding Aetna) of $22.7 million, unfavorable prior fiscal year medical claims development during fiscal 2002 of $8.6 million (which entirely relates to fiscal 2001), new business of $5.2 million and other net changes. Cost of care increased as a percentage of risk revenue to 71.8% in fiscal 2002 from 69.4% in fiscal 2001, mainly due to higher care trends experienced in fiscal 2002 and the inclusion of revenue from the TRICARE settlement in fiscal 2001, partially offset by rate and other revenue increases in fiscal 2002.

        Direct Service Costs.    Direct service costs decreased by 2.3% or $4.0 million to $169.7 million in fiscal 2002 from $173.7 million in fiscal 2001. As a percentage of revenue, direct service costs increased

56

to 17.4% for fiscal 2002 from 16.6% for fiscal 2001. The decrease in direct service costs is primarily due to the sale of GPA and cost reduction efforts undertaken by the Company including the shutdown of several regional service centers. The increase in the percentage of direct service costs in relationship to revenue is mainly due to the inclusion of revenue from the TRICARE settlement in fiscal 2001, partially offset by rate and other revenue increases in fiscal 2002.

        Equity in Earnings of Unconsolidated Subsidiaries.    Equity in earnings of unconsolidated subsidiaries decreased by 60.4% or $23.6 million to $15.5 million in fiscal 2002 from $39.1 million in fiscal 2001. During fiscal 2001, the Company recorded $22.6 million of earnings in connection with the settlement of certain appeals related to the Choice partnership's subcontract with respect to TRICARE. These settlements increased the Company's fiscal 2001 income from continuing operations and net income by approximately $13.5 million. The decrease in equity in earnings is primarily due to the fiscal 2001 TRICARE settlement, lower revenue from Choice due to decreased rates in the current option year and higher care trends for Choice of approximately $1.7 million, partially offset by a favorable $0.7 million retroactive adjustment recorded in fiscal 2002 associated with a change in the operating agreement for Royal.

Workplace

        Net Revenue.    Net revenue related to the Workplace segment increased by 0.1% or $0.3 million to $228.7 million in fiscal 2002 from $228.4 million in fiscal 2001. The increase in revenue is mainly due to net increased membership from existing customers of $10.5 million and new business of $4.1 million, partially offset by terminated contracts in fiscal 2001 and fiscal 2002 of $10.4 million, the effect of the fiscal 2001 sale of the Company's Canadian operations, which contributed $3.3 million of revenue in fiscal 2001 and other net changes.

        Cost of Care.    Cost of care increased by 9.7% or $6.7 million to $76.0 million in fiscal 2002 from $69.3 million in fiscal 2001. The increase in cost of care is mainly due to higher care trends of $7.6 million, net increased membership from existing customers of $3.4 million and new business of $0.3 million, partially offset by terminated contracts of $4.0 million and the sale of the Company's Canadian operations of $0.6 million. As a percentage of risk revenue, cost of care increased to 41.3% for fiscal 2002 from 38.7% for fiscal 2001, mainly due to higher care trends experienced in fiscal 2002.

        Direct Service Costs.    Direct service costs increased by 7.3% or $5.8 million to $85.6 million in fiscal 2002 from $79.8 million in fiscal 2001. As a percentage of revenue, direct service costs increased to 37.4% for fiscal 2002 from 34.9% for fiscal 2001. The aforementioned changes are mainly due to a change in the mix of business to include more ASO and cost-plus contracts in fiscal 2002.

Public

        Net Revenue.    Net revenue related to the Public segment increased by 13.2% or $63.8 million to $547.0 million in fiscal 2002 from $483.2 million in fiscal 2001. The increase in revenue is mainly due to new business of $44.1 million and net rate increases of $28.5 million, partially offset by net decreased membership from existing customers of $7.6 million and terminated contracts of $1.2 million.

        Cost of Care.    Cost of care increased by 11.5% or $46.6 million to $452.9 million in fiscal 2002 from $406.3 million in fiscal 2001. As a percentage of risk revenue, cost of care decreased to 86.7% for fiscal 2002 from 87.3% for fiscal 2001. The increase in cost of care is mainly due to new business of $35.0 million and higher care trends of $25.6 million, partially offset by net decreased membership from existing customers of $9.4 million, favorable prior fiscal year medical claims development during fiscal 2002 of $2.2 million (which entirely relates to fiscal 2001), terminated contracts of $0.2 million and other net changes.

        Direct Service Costs.    Direct service costs increased by 7.9% or $3.0 million to $40.9 million in fiscal 2002 from $37.9 million in fiscal 2001. The increase in direct service costs is primarily due to

57

costs associated with new business. As a percentage of revenue, direct service costs decreased from 7.8% for fiscal 2001 to 7.5% for fiscal 2002. This change is primarily due to favorable rate changes, which increased revenue but had no effect on direct service costs.

        Equity in Loss of Unconsolidated Subsidiaries.    Equity in loss of unconsolidated subsidiaries was $(2.5) million for both fiscal 2002 and 2001. The Public segment's investment in unconsolidated subsidiary relates to Premier, in which the Company maintains a 50.0% interest. Results for fiscal 2002 as compared to fiscal 2001 reflect higher care trends which were entirely offset by rate increases and the inclusion in fiscal 2001 of an expense of $3.1 million for certain legal actions.

Corporate and Other

        Other Operating Expenses.    Other operating costs related to the Corporate and Other Segment decreased by 2.9% or $4.8 million to $163.4 million in fiscal 2002 from $168.2 million in fiscal 2001. As a percentage of total revenue, other operating costs decreased to 9.3% for fiscal 2002 from 9.6% for fiscal 2001. The decrease in other operating expenses is mainly due to lower headcount in various corporate departments of $0.4 million, reduction in discretionary employee benefit costs of $1.3 million, changes in estimates for certain employee benefit related costs recorded in the prior fiscal year of $0.4 million and certain self insurance and legal reserves of approximately $4.0 million, partially offset by fees incurred in conjunction with migration of operating systems of $1.3 million.

        Depreciation and Amortization.    Depreciation and amortization decreased by 30.3% or $20.7 million to $47.6 million in fiscal 2002 from $68.3 million in fiscal 2001. The decrease is primarily attributable to the implementation of SFAS 142 in fiscal 2002. Had the Company adopted SFAS 142 effective October 1, 2000, the Company would not have recorded approximately $30.2 million of amortization expense related to continuing operations during fiscal 2001. Partially offsetting this decrease is $5.7 million of increased depreciation expense related to revisions to the estimated useful lives of certain assets and increased depreciation expense associated with fixed asset additions in fiscal 2002. See Note 2—"Summary of Significant Accounting Policies" to the audited consolidated financial statements set forth elsewhere herein for further discussion of the impact of the adoption of SFAS 142 and the accelerated depreciation caused by the revision in estimated useful lives of certain fixed assets.

        Interest, Net.    Net interest expense decreased by 8.1% or $8.1 million to $92.2 million for fiscal 2002 from $100.3 million in fiscal 2001. Fiscal year 2001 interest expense includes approximately $6.6 million to write-off deferred loan costs related to the issuance of the Senior Notes. The charge of $6.6 million was previously reported as an extraordinary loss on early extinguishment of debt, net of the tax benefit of $2.6 million. The fiscal 2001 write-off of the deferred loan costs was reclassified to interest expense due to the adoption of SFAS No. 145, "Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13 and Technical Corrections" ("SFAS 145") in the fourth quarter of fiscal 2002. See further discussion of this reclassification in Note 6—"Long-Term Debt and Capital Lease Obligations" to the audited consolidated financial statements set forth elsewhere herein. Fiscal year 2001 also benefited from $2.1 million of interest income received in conjunction with a retroactive pricing adjustment related to a customer contract. In fiscal 2002, the Company incurred approximately $1.9 million in penalty interest due to non-registration of the Senior Notes, as discussed in Note 6—"Long-Term Debt and Capital Lease Obligations" to the audited consolidated financial statements set forth elsewhere herein. Excluding the items above, net interest expense decreased by approximately $5.5 million from fiscal 2001. The decrease is primarily the result of lower average outstanding debt and lower average interest rates in fiscal 2002 versus fiscal 2001. The lower average outstanding debt is due to scheduled payments of principal on the Term Loans under the Credit Agreement as well as unscheduled payments under the Credit Agreement with the proceeds from the sale of the Company's human services segment in fiscal 2001.

        Other Items.    The Company recorded special charges of $3.3 million in fiscal 2001 related to the loss on the sale of the Company's Canadian subsidiary. The Company recorded special charges of

58

$15.7 million in fiscal 2002 related to restructuring plans that have resulted in the elimination of certain positions and the closure of certain offices. These charges primarily consist of severance, lease and consulting fees. See Note 11—"Managed Care Integration Costs and Special Charges" to the audited consolidated financial statements set forth elsewhere herein for further discussion. During fiscal 2002, the Company recorded goodwill impairment charges of $415.9 million related to its annual impairment test of goodwill in accordance with SFAS 142. This impairment charge was a result of writing down the balance of goodwill related to the Health Plans, Workplace and Public reporting units to estimated fair value, based upon independently appraised values. For further discussion, see Note 2—"Summary of Significant Accounting Policies" to the Company's audited consolidated financial statements set forth elsewhere herein.

        Income Taxes.    The Company's financial restructuring activities and financial condition result in uncertainty as to the Company's ability to realize its net operating loss carryforwards and other deferred tax assets. Accordingly, as of September 30, 2002, the Company recorded an increase to its valuation allowance of $200.5 million, resulting in a total valuation allowance covering all of the Company's net deferred tax assets. Excluding the impact of this valuation allowance adjustment, the Company's effective income rate was approximately (12.5)% for fiscal 2002 as compared to 53.5% for fiscal 2001. The effective rate varies substantially from statutory rates due primarily to the impact of non-deductible goodwill included in the fiscal 2002 goodwill impairment charge, non-deductible goodwill amortization in fiscal 2001 and non-deductible intangible asset amortization resulting primarily from acquisitions.

        Discontinued Operations.    The following table summarizes, for the periods indicated, income (loss) from discontinued operations, net of tax (in thousands):

        Income from the healthcare provider and franchising segments includes a reduction of estimates of regulatory reserves pertaining to the former psychiatric hospitals of approximately $5.2 million, before taxes. Additionally, the Company recorded positive settlements of outstanding Medicare and Medicaid cost reports of $7.4 million in fiscal 2002, offset by the cost of collections, legal fees and other costs of exiting the business. Loss from the healthcare provider and franchising segments for fiscal 2001 is a result of the positive settlement of outstanding Medicare and Medicaid cost reports of $6.3 million and collection of certain receivables previously written off of $1.0 million, offset by the cost of collections, lease termination payments and other costs of exiting the business. See Note 4—"Discontinued Operations" to the Company's audited consolidated financial statements set forth elsewhere herein.

        Income from the specialty managed healthcare segment for fiscal 2001 represents the settlement of obligations for less than the amount previously estimated. See Note 4—"Discontinued Operations" to the Company's audited consolidated financial statements set forth elsewhere herein.

        Income from the human services segment of $1.8 million for fiscal 2001 is primarily the result of operating results prior to the sale of the segment in the second fiscal quarter of 2001. See Note 4—"Discontinued Operations" to the Company's audited consolidated financial statements set forth

59

elsewhere herein. The following table summarizes, for the periods indicated, the income (loss) on disposal of discontinued operations, net of tax (in thousands):

        In fiscal 2002, the Company and its joint venture partner sold the operations and assets of the remaining provider joint venture ("Provider JV"), resulting in the Company receiving $3.5 million in cash and recording a pre-tax gain of approximately $1.3 million. In conjunction with the Charter Behavioral Health Systems, LLC ("CBHS") settlement consummated in fiscal 2001, the Company was released from certain liabilities and therefore determined that certain liabilities recorded as a result of certain transactions with CBHS during fiscal 1999 were no longer needed. The reversal of these liabilities, net of tax, was recorded during the third quarter of fiscal 2001, resulting in a change in estimate related to the loss on disposal of the healthcare provider and franchising segments of $2.7 million. See Note 4—"Discontinued Operations" to the Company's audited consolidated financial statements set forth elsewhere herein.

        The loss on disposal of the specialty managed healthcare segment in fiscal 2002 is primarily attributable to net changes in estimates of certain future lease obligations and other reserves of approximately $2.5 million.

        Income from disposal of the human services segment in fiscal 2002 represents changes in estimates regarding previously recorded liabilities related to the disposal of the segment. The Company recorded an estimated loss on disposal of the human service segment of approximately $12.1 million during fiscal 2001. This loss is comprised of an estimated pre-tax loss of $2.8 million and tax provision of $9.3 million. The tax provision is related to the tax gain on the sale which results from a lower tax basis, primarily due to approximately $26.1 million of goodwill that has no tax basis. See Note 4—"Discontinued Operations" to the Company's audited condensed consolidated financial statements set forth elsewhere herein.

        Cumulative Effect of Change in Accounting Principle.    As of October 1, 2001, the Company early adopted SFAS 142. The initial goodwill impairment charge of $207.8 million, before taxes ($191.6 million after taxes), was recorded as a cumulative effect of a change in accounting principle during such fiscal quarter. This impairment charge was a result of writing down the balance of goodwill related to the Workplace reporting unit to estimated fair value as of October 1, 2001, based upon independently appraised values. For further discussion, see Note 2—"Summary of Significant Accounting Policies" to the Company's audited consolidated financial statements set forth elsewhere herein.

Fiscal 2001 compared to fiscal 2000

Health Plans

        Net Revenue.    Net revenue related to the Health Plans segment increased by 12.3% or $114.1 million to $1,043.9 million in fiscal 2001 from $929.8 million in fiscal 2000. During fiscal 2001, the Company sold GPA, a staff model physician practice with revenues of $21.0 million in fiscal 2000 and $2.2 million in fiscal 2001 prior to the sale. In addition, in fiscal 2001, the Company settled certain contract appeals related to two subcontracts with respect to TRICARE that resulted in additional revenues of $30.3 million. These additional revenues increased fiscal 2001 income from continuing operations and net income by approximately $18.2 million. The increase in revenue is mainly due to the TRICARE settlements of $30.3 million, new business of $18.9 million, net increased membership from existing customers of $85.1 million, net increases in rates of $24.0 million and increased performance revenue of $13.6 million (see below), partially offset by the effect of the GPA sale of $18.8 million, terminated contracts of $35.6 million and other net changes.

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        The Company earns performance-based fees as part of certain of its health plan contracts. Performance-based revenues are recorded when earned and estimable. Performance-based revenues for the Health Plans segment were $6.3 million and $19.9 million in fiscal 2000 and 2001, respectively. The increase is primarily due to positive changes in estimates regarding fiscal 2000 amounts and other positive contractual developments in fiscal 2001 under certain arrangements for which no contract periods had been settled in fiscal 2000.

        Cost of Care.    Cost of care increased by 18.4% or $96.7 million to $621.9 million in fiscal 2001 from $525.2 million in fiscal 2000. In the quarter ended March 31, 2001, the Company recorded a $15.0 million adjustment to its estimate of claims incurred in prior years based on the results of the Company's reduction in claims inventory and other claims processing improvements. The increase in cost of care is mainly due to this adjustment recorded in fiscal 2001 to the Company's estimate of claims incurred in prior years, new business of $12.3 million, net increased membership from existing customers of $59.4 million and higher utilization over the prior year of $28.6 million, partially offset by the effect of the GPA sale of $6.3 million, terminated contracts of $21.7 million and other net changes. Cost of care increased as a percentage of risk revenue to 69.4% in fiscal 2001 from 65.9% in fiscal 2000, mainly due to the aforementioned adjustment recorded in fiscal 2001 to the estimate of claims incurred in prior years, as well as higher care utilization experienced in fiscal 2001. The higher utilization of care resulted from various factors, including a shift in certain membership from more restrictive products to products with more open access and higher benefit levels.

        Direct Service Costs.    Direct service costs increased by 1.8% or $3.1 million to $173.7 million in fiscal 2001 from $170.6 million in fiscal 2000. As a percentage of revenue, direct service costs decreased to 16.6% for fiscal 2001 from 18.3% for fiscal 2000. The GPA sale is a significant transaction affecting the comparability of direct service costs between years. GPA had direct service costs of $15.0 million and $1.9 million in fiscal 2000 and 2001, respectively. The increase in direct service costs is due to increased direct service costs required to support the Company's increase in net membership, exclusive of the sale of GPA, partially offset by the sale of GPA of $13.1 million.

        Equity in Earnings of Unconsolidated Subsidiaries.    Equity in earnings of unconsolidated subsidiaries increased 183.3% or $25.3 million to $39.1 million in fiscal 2001 from $13.8 million in fiscal 2000. During fiscal 2001, the Company recorded $22.6 million in connection with the settlement of certain appeals related to the Choice partnership's subcontract with respect to TRICARE. The remaining increase is primarily attributable to increased earnings in Choice. These settlements increased the Company's fiscal 2001 income from continuing operations and net income by approximately $13.5 million.

Workplace

        Net Revenue.    Net revenue related to the Workplace segment decreased by 6.2% or $15.0 million to $228.4 million in fiscal 2001 from $243.4 million in fiscal 2000. During fiscal 2001, the Company sold its Canadian operations, which produced revenue of $18.6 million in fiscal 2000 and $3.3 million in fiscal 2001 prior to the sale. The decrease in revenue is mainly due to the sale of the Company's Canadian operations of $15.3 million and terminated contracts of $6.8 million, partially offset by new business of $4.3 million, net increased membership from existing customers of $2.7 million and other net changes.

        Cost of Care.    Cost of care decreased by 4.5% or $3.3 million to $69.3 million in fiscal 2001 from $72.6 million in fiscal 2000. The decrease in cost of care is mainly due to the sale of the Company's Canadian operations of $3.5 million and terminated contracts of $5.3 million, partially offset by new business of $0.9 million and higher utilization of $4.6 million. As a percentage of risk revenue, cost of care increased to 38.7% for fiscal 2001 from 37.7% for fiscal 2000, mainly due to higher care trends experienced in fiscal 2001.

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        Direct Service Costs.    Direct service costs decreased by 5.2% or $4.4 million to $79.8 million in fiscal 2001 from $84.2 million in fiscal 2000. The decrease in direct service costs is mainly due to the sale of the Company's Canadian operations of $10.6 million, partially offset by higher direct service costs needed to support the Company's increase in net membership, exclusive of the sale of the Company's Canadian operations. As a percentage of revenue, direct service costs remained relatively consistent at 34.9% for fiscal 2001 as compared to 34.6% for fiscal 2000.

Public

        Net Revenue.    Net revenue related to the Public segment increased by 3.3% or $15.5 million to $483.2 million in fiscal 2001 from $467.7 million in fiscal 2000. One significant transaction affecting the comparability of revenue between years is the Company's termination of a large state Medicaid contract effective October 1, 2000. This contract had revenues of $44.3 million in fiscal 2000. The increase in revenue is mainly due to new business of $21.8 million, net increased membership from existing customers of $16.5 million, net rate increases of $19.7 million and other net changes, partially offset by terminated contracts of $50.2 million (including the state Medicaid contract mentioned above).

        Cost of Care.    Cost of care increased by 3.8% or $15.0 million to $406.3 million in fiscal 2001 from $391.3 million in fiscal 2000. As a percentage of risk revenue, cost of care increased to 87.3% for fiscal 2001 from 87.0% for fiscal 2000. The increase in cost of care is mainly due to new business of $18.0 million, net increased membership from existing customers of $14.4 million, higher utilization of $18.9 million and other net changes, partially offset by terminated contracts of $41.9 million (including the state Medicaid contract mentioned above of $41.1 million).

        Direct Service Costs.    Direct service costs decreased by 14.4% or $6.4 million to $37.9 million in fiscal 2001 from $44.3 million in fiscal 2000. The decrease in direct service costs is primarily due to the termination of the state Medicaid contract discussed above of $3.4 million as well as the termination of other contracts which were mainly ASO and which had relatively high direct service cost requirements. As a percentage of revenue, direct service costs decreased to 7.8% for fiscal 2001 from 9.5% for fiscal 2000. This change is also due to the termination of the contracts previously discussed.

        Equity in Loss of Unconsolidated Subsidiaries.    Equity in loss of unconsolidated subsidiaries for Public decreased 37.5% or $1.5 million to $(2.5) million in fiscal 2001 from $(4.0) million in fiscal 2000. The Public segment's investment in unconsolidated subsidiary relates to Premier, in which the Company maintains a 50.0% interest. The change is primarily due to increases in estimates of accruals for potential losses from certain legal actions offset by increased rates in fiscal 2001.

Corporate and Other

        Other Operating Expenses.    Other operating costs related to the Corporate and Other Segment increased by 9.3% or $14.3 million to $168.2 million in fiscal 2001 from $153.9 million in fiscal 2000. As a percentage of total revenue, other operating costs increased to 9.6% for fiscal 2001 from 9.4% for fiscal 2000. The increase in other operating costs was due to increases in certain support activities which were made in order to improve the Company's service levels to its customers and the need for additional support (claims administration, network and information technology) to service the Company's increased membership base. The increase in the ratio of other operating costs to total revenue is mainly due to the increased costs associated with improving customer service levels.

        Depreciation and Amortization.    Depreciation and amortization approximated $68.3 million in both fiscal 2001 and fiscal 2000. Depreciation remained constant primarily as a result of current year capital expenditures being offset by divestitures of fixed assets related to the sale of GPA and the Company's Canadian subsidiary. During fiscal 2001, the Company recorded higher amortization expense due to the

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$60.0 million increase to goodwill resulting from contingent purchase price activity with respect to the acquisition of Human Affairs International, Incorporated ("HAI").

        Interest, Net.    Net interest expense increased 3.1% or $3.0 million to $100.3 million for fiscal 2001 from $97.3 million in fiscal 2000. The increase is primarily due to the fact that the Company incurred approximately $6.6 million in interest expense in fiscal 2001 representing the write-off of deferred loan costs related to the issuance of the Senior Notes. The charge of $6.6 million was previously reported as an extraordinary loss on early extinguishment of debt, net of the tax benefit of $2.6 million. The fiscal 2001 write-off of the deferred loan costs was reclassified to interest expense due to the adoption of SFAS 145 in the fourth quarter of fiscal 2002. See further discussion of this reclassification in Note 6—"Long-Term Debt and Capital Lease Obligations" to the audited consolidated financial statements set forth elsewhere herein. Fiscal year 2001 also benefited from $2.1 million of interest income received in conjunction with a retroactive pricing adjustment related to a customer contract. Excluding these fiscal 2001 items, net interest expense decreased by approximately $1.5 million from fiscal 2000 to fiscal 2001. The decrease in interest expense is mainly the result of lower average outstanding debt in fiscal 2001 versus fiscal 2000. The Company used the proceeds collected from the sale of the Company's human services segment and the sale of its Canadian operations to reduce debt during fiscal 2001. See Note 4—"Discontinued Operations" to the audited consolidated financial statements set forth elsewhere herein.

        Other Items.    The Company recorded special charges of $3.3 million in fiscal 2001 related to the loss on the sale of the Company's Canadian subsidiary. See Note 11—"Managed Care Integration Costs and Special Charges" to the Company's audited consolidated financial statements set forth elsewhere herein. The Company recorded special charges of $25.4 million during fiscal 2000 comprised of: (i) $4.5 million of severance and lease termination costs and $15.8 million of impairment of certain long lived assets related to the closure of offices in connection with the exiting from the psychiatric practice management business; (ii) $7.0 million of severance and lease termination costs related to the restructuring of the corporate function and certain behavioral managed healthcare sites and (iii) a $1.9 million gain on the sale of the corporate aircraft.

        Income Taxes.    The Company's effective income tax rate increased to 53.5% for fiscal 2001 from 50.8% for fiscal 2000. The effective rate exceeds statutory rates due primarily to non-deductible goodwill amortization resulting primarily from acquisitions. The fiscal 2000 period benefited by reductions in reserve estimates of approximately $9.1 million related to settlements with the Internal Revenue Service.

        Discontinued Operations.    The following table summarizes, for the periods indicated, income (loss) from discontinued operations, net of tax (in thousands):

        Loss from the healthcare provider and franchising segments for fiscal 2001 is a result of lease termination payments and other costs of exiting the business, partially offset by the positive settlement of outstanding Medicare and Medicaid cost reports of $6.3 million and collection of certain receivables previously written off of $1.0 million, less the cost of collections. See Note 4—"Discontinued Operations" to the Company's audited consolidated financial statements set forth elsewhere herein.

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        Income from the specialty managed healthcare segment for fiscal 2001 represents the settlement of obligations for less than the amount previously estimated. During fiscal 2000, the Company recorded a $58.2 million impairment of long-lived assets which adversely affected the segment's profitability. See Note 4—"Discontinued Operations" to the Company's audited consolidated financial statements set forth elsewhere herein.

        Income from the human services segment was $1.8 million for fiscal 2001 compared to $8.5 million in fiscal 2000. The decrease is primarily a result of the sale of the segment in the second fiscal quarter of 2001. See Note 4—"Discontinued Operations" to the Company's audited consolidated financial statements set forth elsewhere herein. The following table summarizes, for the periods indicated, the income (loss) on disposal of discontinued operations, net of tax (in thousands):

        In conjunction with the CBHS settlement consummated in fiscal 2001, the Company was released from certain liabilities and therefore determined that certain liabilities recorded as a result of the CBHS Transactions during fiscal 1999 were no longer needed. The reversal of these liabilities, net of tax, was recorded during the third quarter of fiscal 2001, resulting in a change in estimate related to the loss on disposal of the healthcare provider and franchising segments of $2.7 million. See Note 4—"Discontinued Operations" to the Company's audited consolidated financial statements set forth elsewhere herein.

        The Company recorded a loss on disposal of discontinued operations related to the specialty managed healthcare segment of approximately $17.7 million, net of tax benefit of $9.2 million, at the end of fiscal 2000. This loss represents the additional cost incurred as a result of the plan adopted on October 4, 2000 to fully exit the specialty managed healthcare segment. The pre-tax loss is comprised of a $17.1 million impairment of the remaining long-lived assets and $9.8 million in lease terminations and other exit costs as defined by APB 30. See Note 4—"Discontinued Operations" to the Company's audited consolidated financial statements set forth elsewhere herein.

        The Company recorded an estimated loss on disposal of the human service segment of approximately $12.1 million during fiscal 2001. This loss is comprised of an estimated pre-tax loss of $2.8 million and tax provision of $9.3 million. The tax provision is related to the tax gain on the sale which results from a lower tax basis, primarily due to approximately $26.1 million of goodwill that has no tax basis. See Note 4—"Discontinued Operations" to the Company's audited consolidated financial statements set forth elsewhere herein.

Outlook—Results of Operations

        The Company's Segment Profit is subject to significant fluctuations on a quarterly basis. These fluctuations may result from: (i) changes in utilization levels by enrolled members of the Company's risk-based contracts, including seasonal utilization patterns; (ii) performance-based contractual adjustments to revenue, reflecting utilization results or other performance measures; (iii) contractual adjustments and settlements; (iv) retrospective membership adjustments; (v) timing of implementation of new contracts, enrollment changes and contract terminations; (vi) pricing adjustments upon contract renewals (and price competition in general) and (vii) changes in estimates regarding medical costs and incurred but not yet reported medical claims.

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        The Company's business is subject to rising care costs in certain portions of its business. Future results of operations will be heavily dependent on management's ability to obtain customer rate increases that are consistent with care cost increases and/or to reduce operating expenses.

        Based upon the Company's financial condition and due to the status of its financial restructuring activities, the Company anticipates a reduction in the fiscal year ending December 31, 2003 revenue from lost customer contracts at a higher rate than it has experienced in prior fiscal years. Such anticipated losses include one of the TRICARE contracts as previously discussed. In addition, it is possible that the Company's customers that are managed care companies may, in the future, seek to provide managed behavioral healthcare services directly to their subscribers, rather than by contracting with the Company for such services. Furthermore, the Company's financial condition is expected to result in limited opportunities for the Company to sell new business until such time as its financial restructuring and chapter 11 activities would be completed.

        Interest Rate Risk.    The Company had $160.8 million of total debt outstanding under the Credit Agreement at December 31, 2002. As of June 2003, the Company's interest rates for the loans under the Credit Agreement are based on the prime rate plus a borrowing margin of 2.50 percent for Revolving Loans, 3.25 percent for the Tranche B Loans and 3.50 percent for Tranche C Loans. The prime rate was 4.75 percent on December 31, 2001 and 4.25 percent on December 31, 2002. Based on the December 31, 2002 borrowing levels under the Credit Agreement, a 0.25 percent increase in interest rates would cost the Company approximately $0.4 million per year in additional interest expense. The Company's earnings could be adversely affected by increases in interest rates.

        Migration of Operating Systems.    An area of focus for the Company has been reducing the number of the Company's information systems, especially relating to claims and clinical activities. As discussed in operating restructuring activities below, the Company continues to pursue consolidation of its current information systems in order to obtain efficiencies.

        In the first quarter of fiscal 2002, the Company approved and implemented a plan to consolidate the Company's information systems. As a result of this plan, the Company reduced the remaining estimated useful life of certain capitalized internal use claims processing software to eighteen months. In addition, management also reevaluated the estimated useful lives of certain other computer software and hardware, and reduced the estimated useful lives from five to three years. At the end of the second quarter of fiscal 2002, the Company approved a plan to further accelerate the consolidation of certain information systems. As a result of this plan, the Company reduced, as of April 1, 2002, the remaining useful lives of certain other information systems to periods ranging from twelve to twenty-four months. The net book value of assets affected by the change in useful lives at December 31, 2002 was approximately $7.5 million.

        These changes resulted in increased depreciation of these assets on a prospective basis. The effect of these changes in useful lives was to increase depreciation expense for the fiscal year ended September 30, 2002 and the three months ended December 31, 2002 by $5.7 million and $1.0 million, respectively. These changes reduced net income for fiscal 2002 and for the three months ended December 31, 2002 by $3.4 million ($0.10 per diluted share) and $0.7 million ($0.02 per diluted share), respectively.

        Operating Restructuring Activities.    The Company continues to conduct certain operating restructuring activities which impact results 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 $4.5 million being recorded during the three months ended December 31, 2001. The fiscal 2002 special charges consisted of (i) $6.3 million to terminate 277

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employees, the majority of which were field operational personnel in the Health Plans segment and (ii) $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, and all terminations were completed by September 30, 2002. The majority of the employee termination costs were paid in full by March 31, 2003. The special charges of $1.9 million represent costs to downsize and close 14 leased facilities. These closure and exit costs include payments required under lease contracts (less any applicable existing and/or estimated sublease income) after the properties were abandoned, write-offs of leasehold improvements related to the facilities and other related expenses. The leased facilities terminate at various dates through fiscal 2006. At December 31, 2002, outstanding liabilities of $1.3 million related to the 2002 Restructuring Plan are included in "accrued liabilities" in the accompanying audited consolidated balance sheets.

        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 $2.9 million to terminate 228 employees, the majority of which were field operational personnel, and $1.0 million to downsize and close excess facilities and other associated activities. During the three months ended December 31, 2002, the Company recognized additional special charges related to the ABI initiative of $2.0 million to terminate 172 employees that comprised both field operational and corporate personnel, and $0.5 million to downsize and close excess facilities, and other associated activities. The employee termination costs include severance and related termination benefits, including payroll taxes. The other special charges of $0.5 million 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 and/or estimated sublease income) after the properties were abandoned, write-offs of leasehold improvements related to the facilities and other related expenses. The leased facilities have lease termination dates ranging from fiscal 2004 through fiscal 2008. At December 31, 2002, outstanding liabilities of $3.1 million related to ABI are included in "accrued liabilities" in the accompanying audited consolidated balance sheets.

        Implementation of ABI also resulted in additional costs of $1.8 million during the three months ended December 31, 2002 for outside consultants, office relocation and other associated activities.

        The Company continued the ABI initiative during the three months ended March 31, 2003, which resulted in the recognition of special charges of $1.7 million which mainly related to the termination of an additional 73 employees that represented both field operational and corporate personnel. The employee termination costs include severance and related termination benefits, including payroll taxes. All terminations and termination benefits related to the ABI initiative were communicated to the affected employees on or prior to March 31, 2003, with all of the terminations completed by May 1, 2003. All employee termination costs are expected to be paid in full by September 30, 2004.

        As of April 1, 2003, the Company started exploring additional business and performance improvement initiatives, such as further consolidating service centers, creating more efficiency in corporate overhead, consolidating systems, improving call center technology and instituting other operational and business efficiencies. These initiatives are being formulated into a performance improvement plan ("PIP") that the Company started implementing during the fiscal quarter ended June 30, 2003. The Company expects to incur $7.0 million to $15.0 million of costs related to PIP activities during the nine-month period ended December 31, 2003. The Company expects to fund these costs with internally generated funds. However, there can be no assurance that the Company will be able to successfully fund or implement these initiatives or realize the anticipated savings.

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        As part of its financial restructuring plan and chapter 11 proceedings, the Company anticipates rejecting certain leases for closed offices. As leases for closed offices are rejected, the net liability arising from such rejections will be compared to the net liability already recorded by the Company, and the difference will be recorded as a component of "reorganization expense" in the Company's statement of operations, in accordance with SOP 90-7.

        Additionally, in fiscal 2002, the Company reevaluated severance and lease reserves related to a restructuring activity initiated in the fourth quarter fiscal 2000 (the "2000 Restructuring Plan"). The analysis resulted in revised estimates of such costs, based on current information, and the recording of an additional $1.4 million in severance and lease costs.

        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, regulations 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

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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 released this year, 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 administrative safeguards to enhance physical, personnel and information systems security. The Company has completed its review of the final regulation and is in the process of conducting an extensive gap analysis and addressing the remaining compliance issues. The Company expects that it will be fully compliant with the security regulation 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 final regulations on security and 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 which identified and assessed the potential impact of the regulations and reviewed current policies and drafted new policies to comply with the new requirements. The Company incurred approximately $3.8 million in operating costs and $2.5 million in capital expenditures related to HIPAA in fiscal year 2002. The Company incurred approximately $0.7 million in operating costs and $0.7 million in capital expenditures related to HIPAA during the three months ended December 31, 2002. Management estimates that the Company will incur approximately $3.5 million to $4.5 million in operating costs and approximately $2.5 million to $3.5 million in capital expenditures related to these efforts during its fiscal year ended December 31, 2003.

Historical Liquidity and Capital Resources

Three months ended December 31, 2002 ("Current Year Quarter"), compared to the three months ended December 31, 2001 ("Prior Year Quarter")

        As noted above, the Company changed its fiscal year end from September 30 to December 31, effective December 31, 2002. The following discussion of historical liquidity and capital resources compares the Current Year Quarter with the Prior Year Quarter.

        Operating Activities.    The Company's net cash provided by operating activities was $24.1 million and $28.0 million for the three months ended December 31, 2001 and 2002, respectively. The increase in operating cash flows from the Prior Year Quarter to the Current Year Quarter is primarily due to the Company's improved operating results. The Company reported segment profit of $52.9 million and $56.6 million for the three months ended December 31, 2001 and 2002, respectively.

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        Investing Activities.    The Company utilized $6.0 million and $8.4 million in funds during the three months ended December 31, 2001 and 2002, respectively, for capital expenditures. Capital expenditures increased 40.0 percent or $2.4 million from the Prior Year Quarter to the Current Year Quarter. This increase is largely attributable to capital expenditures incurred in the Current Year Quarter related to the new operating facility located in Maryland Heights, Missouri. Other capital expenditures relate to management information systems and related equipment.

        During the Prior Year Quarter, the Company sold its remaining provider joint venture receiving $3.5 million in proceeds that resulted in an after-tax gain from discontinued operations of approximately $0.8 million.

        Financing Activities.    During the three months ended December 31, 2002, the Company repaid $0.4 million of indebtedness outstanding under the Term Loan Facility (as defined herein), made payments on capital lease obligations of $0.8 million and incurred approximately $1.9 million to obtain waivers of financial covenants under its Credit Agreement.

        During the three months ended December 31, 2001, the Company repaid $0.4 million of indebtedness outstanding under the Term Loan Facility, made payments on capital lease obligations of $0.6 million and incurred additional fees of approximately $1.3 million primarily related to an amendment to the Credit Agreement.

Fiscal 2000-2002

        Operating Activities.    The Company's net cash provided by operating activities was $106.9 million, $85.7 million and $66.7 million for fiscal 2000, 2001 and 2002, respectively. The decrease in operating cash flows from fiscal 2001 to fiscal 2002 is primarily due to the fact that fiscal 2001 benefited from approximately $30.0 million of settlements of contract appeals with respect to TRICARE in fiscal 2001 and $25.0 million in distributions from Choice related to its settlements of contract appeals in fiscal 2001 with respect to TRICARE, partially offset by the payment of approximately $44.0 million related to discontinued operations obligations during fiscal 2001. Operating cash flows for fiscal 2002 were negatively impacted by $5.4 million of cash outflows related to discontinued operations. The decrease in operating cash flows from fiscal 2000 to fiscal 2001 was primarily due to the payment of approximately $44.0 million related to discontinued operations obligations during fiscal 2001 and collection of $28.0 million in cost report settlements during fiscal 2000 compared to $6.0 million in fiscal 2001, offset by the TRICARE settlements as discussed above.

        Investing Activities.    The Company utilized $36.9 million, $34.7 million and $27.6 million in funds during fiscal 2000, 2001 and 2002, respectively, for capital expenditures. Capital expenditures decreased 20.5%, or $7.1 million, from fiscal 2001 to fiscal 2002. The majority of the Company's capital expenditures relate to management information systems and related equipment. These expenditures have decreased from fiscal 2001 to fiscal 2002 primarily as the result of the Company's focus on cost reduction through the ABI restructuring initiative. Also contributing to this decrease are capital leases of $3.8 million entered into by the Company during fiscal 2002 that would have otherwise required a capital expenditure. Included in fiscal 2000 capital expenditures was $3.7 million related to Mentor, which business was sold in the second quarter of fiscal 2001.

        The Company used $68.6 million, $87.7 million and $63.7 million in funds during fiscal 2000, 2001 and 2002, respectively, net of cash acquired, for acquisitions and investments in businesses. Included in each year is a contingent purchase price payment of $60.0 million to Aetna related to the acquisition of HAI and an earn-out payment of $3.7 million with respect to the acquisition in 1998 of Inroads, a managed behavioral healthcare company, by Merit Behavioral Care Corporation ("Merit") (which was later acquired by the Company). In fiscal 2001, the Company also paid the remaining contingent purchase price of $24.0 million to the shareholders of CMG Health, Inc. ("CMG"), a managed behavioral healthcare company acquired by Merit in September 1997.

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        The Company received proceeds from the sale of assets, net of transaction costs and cash conveyed, of $3.3 million, $110.6 million and $3.5 million in fiscal 2000, 2001 and 2002, respectively. The sales proceeds were generated primarily from: (i) the sale of the corporate aircraft in fiscal 2000, (ii) the sale in fiscal 2001 of Mentor, two of the three remaining Provider JVs of the discontinued healthcare provider segment, assets of the psychiatric practice management business and the Company's Canadian operations and (iii) the sale of the remaining Provider JV in fiscal 2002.

        Financing Activities.    The Company borrowed approximately $59.6 million, $356.6 million and $105.0 million during fiscal 2000, 2001 and 2002, respectively. The borrowings in fiscal 2000 and 2002 were primarily draws under the revolving credit facility (the "Revolving Facility") for short-term capital needs. The borrowings in fiscal 2001 represent draws under the Revolving Facility for short-term capital needs and the issuance of $250.0 million of 9.375% Senior Notes due 2007 (the "Senior Notes"), less issuance costs.

        The Company made repayments of approximately $110.3 million, $458.2 million and $65.9 million on debt and capital lease obligations during fiscal 2000, 2001 and 2002, respectively. Fiscal 2000 repayments included scheduled term loan facility ("Term Loan Facility") principal payments, as well as Revolving Facility and Term Loan Facility repayments made with the proceeds from the issuance of Series A Redeemable Preferred Stock to the Texas Pacific Group ("TPG") (see below). Fiscal 2001 repayments included scheduled Term Loan Facility repayments, scheduled capital lease payments, Term Loan Facility and Revolving Facility repayments made with the proceeds from the sale of Mentor and Term Loan Facility repayments made with proceeds from issuance of the Senior Notes and the sale of the Company's Canadian operations. Fiscal 2002 repayments included scheduled Term Loan Facility repayments, Term Loan repayments with cash received from asset sales during the year, scheduled capital lease payments and Revolving Facility repayments primarily with cash generated from operations.

        In fiscal 2001, the Company issued the Senior Notes which mature on November 15, 2007 and are general senior unsecured obligations of the Company. Interest on the Senior Notes is payable semi-annually on each May 15 and November 15, commencing on November 15, 2001. The gross proceeds of $250.0 million from the issuance and sale of the Senior Notes were used to repay indebtedness outstanding under the Company's Term Loan Facilities. In fiscal 2001, the Company reported a net extraordinary loss from the early extinguishment of debt of approximately $4.0 million, net of income tax benefit, to write-off unamortized deferred financing costs related to repayment of indebtedness outstanding under the Company's Term Loan Facilities. In accordance with SFAS 145, which the Company early adopted in the fourth quarter of fiscal 2002, the Company has reclassified the prior year loss from early extinguishment of debt from an extraordinary loss to interest, net and provision for income taxes in the fiscal 2001 consolidated statement of operations. See Note 6—"Long-Term Debt and Capital Lease Obligations" to the Company's audited consolidated financial statements set forth elsewhere herein.

        The Company completed the sale of 59,063 shares of Series A Redeemable Preferred Stock to TPG during the first quarter of fiscal 2000, for a total price of approximately $54.8 million, net of issuance costs. Approximately 50.0% of the net proceeds were used to reduce debt outstanding under the Term Loan Facility with the remaining 50.0% being used for general corporate purposes. See Note 8—"Redeemable Preferred Stock" to the Company's audited consolidated financial statements set forth elsewhere herein.

Outlook—Liquidity and Capital Resources

        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 Bankruptcy Code (the "Bankruptcy Code") in the United States Bankruptcy Court for the

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Southern District of New York (the "Bankruptcy Court") (the "Chapter 11 Cases"). 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. Since the Commencement Date, the Company has remained in possession of its properties and businesses and has continued 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, 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 are the primary entities with which Magellan will negotiate the treatment of the claims of general unsecured creditors. The Official Committee comprises five members, 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 July 25, 2003 (the "Plan"). Prior to the commencement date of its Chapter 11 Cases, the Company negotiated the terms of a financial restructuring which was incorporated in the original plan of reorganization filed with the Bankruptcy Court on March 11, 2003 ("Original Plan"). Prior to the commencement date of the Chapter 11 Cases, the Company entered into lock-up and voting agreements for the support of the Original Plan that the Company executed with 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. In connection with the execution of an equity commitment letter with Onex Corporation (the "Equity Investor"), as described below, which was supported by the Official Committee and the agent for the Company's senior lenders, certain modifications were made to the Original Plan as incorporated in the Plan. As a result, the counterparties may terminate such lock-up and voting agreements thereto because certain conditions have not been met. The Official Committee has stated that they support the Plan. 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 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. One creditor has informed the Company that it owns sufficient Senior Subordinated Notes to block such class of creditors' acceptance of the Plan, and has notified the Company that it intends to vote against the Plan.

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If the class of claims holders of Senior Subordinated Notes does not vote to accept the Plan, the Company believes that it will be able to confirm the Plan under the applicable provisions of the Bankruptcy Code. There can be no assurance, however, that the Company will be able to do so.

        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. On July 25, 2003, the Company filed with the Bankruptcy Court its Second 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 July 29, 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 88.0%. 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 unsecured notes (the "New Notes") in an amount equal to the face amount of the Senior Notes plus cash equal to the 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 existing Senior Notes, will have a maturity of November 15, 2008 and an interest rate of 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, cash, New Common Stock equal to approximately 9.5% of reorganized Magellan, 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 will receive approximately 2.0% of the New Common Stock, as well as warrants to purchase a like number of shares of New Common Stock. The existing common stock of the Company will also be cancelled and the holders thereof will receive approximately 0.5% of the New Common Stock of the reorganized entity, as well as warrants to purchase a like number of shares of New Common Stock. The distributions of New Common Stock under the Plan will be subject to the dilutive effects of the amount of New Common Stock issued in respect of a rights offering and a direct equity investment for approximately 34.4% of the reorganized entity (see below). Pursuant to the Plan, all outstanding options and warrants to purchase existing common stock will be cancelled, and will not be replaced with options or warrants to purchase New Common Stock. The proposed distributions to the holders of existing preferred stock and common stock are conditioned on all classes of creditors accepting the Plan. The Company has been informed that one creditor who owns sufficient Senior Subordinated Notes to block such class from accepting the Plan intends to vote against the Plan. Under such circumstances, no distribution of New Common Stock will be made to holders of existing preferred stock or common stock, and such New Common Stock will be distributed to holders of general unsecured claims (other than Senior Notes claims).

        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 $73.5 million, will be either repaid in full (as discussed further below) or will be paid $50.0 million in cash and the remaining balance will be converted to secured term loans (and letter of credit commitments with respect to outstanding letters of credit and renewals thereof) having maturities through 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 would pay letter of credit fees equal to 4.25 percent per annum plus a fronting fee of 0.125 percent per

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annum of the face amount of letters of credit. The Company would pay the lenders a fee of one percent of the New Facilities on the effective date of the Plan. The New Facilities would be guaranteed by substantially all of the subsidiaries of Magellan and would be secured by substantially all of the assets of Magellan and the subsidiary guarantors. It is anticipated that the New Facilities will not be used and instead, the Credit Agreement will be refinanced as described below.

        On August 1, 2003, the Company entered into a commitment letter with Deutsche Bank (the "DB Commitment Letter') to provide an exit facility (the "Exit Facility") that would provide $100.0 million in term loans, an $80.0 million letter of credit facility and a $50.0 million revolving credit facility. The interest rate on the Exit Facility would be lower than the rates of interest on the New Facilities. Borrowings under the Exit Facility would have a term of five years. The Exit Facility would be guaranteed by substantially all of the subsidiaries of Magellan and would be secured by substantially all of the assets of Magellan and the subsidiary guarantors. The proceeds of the Exit Facility, together with cash on hand, would be used to repay the obligations under the existing Credit Agreement, to pay fees and expenses related to the Chapter 11 Cases, to make other cash payments contemplated by the Chapter 11 Cases, and for general working capital purposes. The DB Commitment Letter is subject to a number of conditions, the satisfaction or waiver of which is necessary prior to Deutsche Bank's obligations thereunder. There is no assurance that the Company will satisfy such conditions or have such conditions waived and therefore no assurance can be given that the Company will be able to borrow under the Exit Facility.

        The Plan provides for an option for holders of Senior Subordinated Notes and general unsecured creditors to elect to receive cash in lieu of New Common Stock that they would otherwise be entitled to receive (up to an aggregate maximum of $50 million) at a price of $22.50 per share (the "Partial Cash Out Election"). If such election is oversubscribed, those holders electing such option would be entitled to participate on a pro rata basis and would receive shares of New Common Stock for the portion of the shares of New Common Stock that is not fully cashed out. Under the Plan, this $50 million cash out election would be funded by the purchase of equity by Onex Corporation (the "Equity Investor") as set forth below. If the entire $50 million is subscribed for, approximately 13.6% of the equity of reorganized Magellan would not be issued to creditors, but would be issued to the Equity Investor as set forth below.

        The Plan also provides, in accordance with a commitment letter between the Company and the Equity Investor, for reorganized Magellan to issue shares of common stock representing approximately 34.4% of the reorganized Magellan for a purchase price of $150 million in the aggregate. The terms of such offering are as follows: (i) approximately 2.63 million shares, representing approximately 17.2% of reorganized Magellan would be offered to holders of the existing Senior Subordinated Notes and general unsecured creditors for $75 million in the aggregate (or $28.50 per share); (ii) to the extent the holders of the Senior Subordinated Notes and general unsecured creditors elect not to participate in such offering, the Equity Investor would purchase the unsubscribed equity at the same price; and (iii) approximately 2.63 million shares, representing approximately 17.2% of the reorganized Magellan would be purchased by the Equity Investor for a purchase price of $75 million in the aggregate (or $28.50 per share). In addition, up to 13.6% of reorganized Magellan would be purchased by the Equity Investor at an aggregate purchase price of $50 million (or $22.50 per share) solely to the extent necessary to fully fund the Partial Cash-Out Election.

        All purchases made by the Equity Investor would be of a separate class of common stock (the "MVS Securities"), which would be shares of multiple voting common stock of reorganized Magellan. The MVS Securities will be issued to the Equity Investor pursuant to the terms of the Plan. Each share of MVS Securities and each share of the New Common Stock will be identical in all respects, except with respect to voting and except that (a) the MVS Securities will be convertible into New Common Stock, as provided in the Amended Certificate of Incorporation and (b) the Equity Investor and its affiliates (including any entity to which MVS Securities could be transferred without conversion

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pursuant to the penultimate sentence of this section) shall convert shares of New Common Stock that they may acquire into the same number of shares of MVS Securities unless no MVS Securities are then outstanding. Pursuant to the terms of the Plan, the Equity Investor shall receive shares of MVS Securities on the effective date of the Plan, which MVS Securities shall be entitled to exercise 50% of the voting rights pertaining to all of reorganized Magellan's outstanding common stock (including the New Common Stock and the MVS Securities). The MVS Securities shall be convertible into the same number of shares of New Common Stock upon the transfer of the MVS Securities to any person other than the Equity Investor, Onex, Onex Partners LP, a Delaware limited partnership ("Onex Partners") or an entity controlled by Onex or Onex Partners (including a change of control of any entity other than Onex or Onex Partners owning the MVS Securities so that it is no longer controlled by Onex or Onex Partners). Onex shall be deemed to control any entity controlled by Mr. Gerald W. Schwartz so long as Mr. Schwartz controls Onex. All MVS Securities shall cease to have any special voting rights (i.e., each share of MVS Securities and New Common Stock shall have one vote per share and shall vote together on all matters submitted to stockholders, including the election of all members of the Board of Directors of reorganized Magellan, as a single class) if at any time either (i) the number of outstanding MVS Securities is less than 15.33% of the total number of MVS Securities and shares of New Common Stock issued on the Effective Date or (ii) the number of outstanding MVS Securities is less than 10% of the aggregate number of MVS Securities and shares of New Common Stock then outstanding.

        As part of, and subject to, consummation of the Plan, Aetna Inc. ("Aetna") and Magellan have agreed to renew their behavioral health services 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 would 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 would mature on December 31, 2005. The Aetna Note would be guaranteed by substantially all of the subsidiaries of Magellan and would 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 would be payable on December 31, 2005, and the remainder would 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 Bankruptcy Court approved the renewal of the Aetna agreement 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. The Company's current liquidity is not sufficient to satisfy the obligations under such acceleration. However, under Section 362 of the Bankruptcy Code, the lenders under the Credit Agreement and the holders of the Senior Notes and Senior Subordinated Notes are prohibited from attempting to collect payment of such indebtedness.

        Credit Agreement and Liquidity.    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 confirm a plan of reorganization under the Bankruptcy Code and obtain emergence

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financing; (ii) the ability of the Company to successfully achieve required cost savings to complete its restructuring; (iii) the ability of the Company to maintain adequate cash on hand; (iv) the ability of the Company to generate cash from operations; (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 Company's consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that might result should the Company be unable to continue as a going concern.

        The Company had a working capital deficit of approximately $1.2 billion as of December 31, 2002. The December 31, 2002 working capital deficit includes approximately $1.0 billion of long-term debt, which has been classified as a current liability due to certain of the Company's debt agreement defaults. As of December 31, 2002, the Company had unrestricted cash of approximately $62.5 million. As a result of certain defaults existing under the Credit Agreement, the Company is unable to access additional borrowings or letters of credit under the Credit Agreement.

        During the fiscal year ended December 31, 2003, the Company estimates it will have non-operating cash outflows related to (among other things) capital expenditures of approximately $33.0 million to $43.0 million (the majority of the Company's capital expenditures relate to management information systems and related equipment, including improvements to its computer systems in conjunction with the Company's on-going integration plan and efforts to comply with HIPAA), the final installment of approximately $1.4 million on its earn-out with respect to the 1998 purchase of Inroads (a managed behavioral healthcare company), liabilities with respect to its discontinued operations and costs associated with the financial restructuring activities. During the pendency of the Company's chapter 11 process, from which the Company plans to emerge by September 30, 2003, the Company will not pay cash interest on the Senior Notes or the Senior Subordinated Notes or pay certain other liabilities subject to compromise. The Company believes that its cash on hand and its operating cash flows will be sufficient to satisfy its non-operating cash requirements for the remainder of the fiscal year ended December 31, 2003, however there can be no assurance in this regard.

        The Company's letter of credit requirements may increase as a result of (i) customers seeking security for the medical claims payable to providers for services rendered to members covered under the customers' risk-based contracts with the Company, (ii) potential new regulations which would require the Company to post security for its risk-based business and (iii) the need to replace or collateralize surety bonds with letters of credit due to the current conditions of the surety bond market. As of June 30, 2003, the Company had outstanding letters of credit and surety bonds totaling $73.5 million and $14.1 million, respectively. The surety bond carriers have collateral in the form of letters of credit in the amount of $13.2 million (which are included in the total letters of credit of $73.5 million). If the Company is unable to obtain adequate surety bonds or make alternative arrangements to satisfy the requirements for such bonds, it may no longer be able to operate in certain states, which would have a material adverse effect on the Company. The beneficiaries of letters of credit generally require such letters of credit to have a one-year term, and to renew annually. Because the Company is unable to issue or increase letters of credit under the Credit Agreement, Magellan could lose customers, which would have a material adverse effect on the Company.

        Debt Service Obligations and Future Commitments.    The Company is highly leveraged with indebtedness and other future commitments that are substantial in relation to its stockholders' deficit and in relation to its earnings. Notwithstanding the classification of all long-term debt as current due to certain defaults under the Credit Agreement and the indentures governing the Senior Notes and the Subordinated Notes, the Company will not pay principal on the Credit Agreement, cash interest on the Senior Notes or the Senior Subordinated Notes or certain other liabilities subject to compromise, including the final contingent purchase price payment of $60 million to Aetna during the course of the bankruptcy proceedings. Under the Company's proposed Plan of Reorganization, the Company would

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emerge with a revised capital structure as described above. See "Outlook—Liquidity and Capital Resources—Voluntary Chapter 11 Filing".

        Notwithstanding the classification of all long-term debt as current as discussed above, or the pendency during the chapter 11 proceedings of the payment of the aforementioned debt, related interest and Aetna liabilities, the following table sets forth the future financial commitments of the Company as of December 31, 2002 (in thousands):