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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal years ended December 31, 2003 and 2002,

including a restatement of previously issued consolidated financial statements

for the fiscal years ended December 31, 2001 and 2000

Commission File Number 1-10315

HealthSouth Corporation

(Exact Name of Registrant as Specified in its Charter)

Registrant’s Telephone Number, Including Area Code:    (205) 967-7116

Securities Registered Pursuant to Section 12(b) of the Act:

None

Securities Registered Pursuant to Section 12(g) of the Act:

Common Stock, $.01 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 12 months (or for such shorter period that the registrant was required to file such Reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ¨    No  x

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 the 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 Rule 12b-2 of the Act). Yes   x    No  ¨

As of May 31, 2005, there were outstanding 397,063,445 shares of common stock of the registrant, net of treasury shares. As of June 30, 2004, the aggregate market value of common stock held by nonaffiliates was approximately $2.3 billion. For purposes of the foregoing calculation only, executive officers and directors of the registrant have been deemed to be affiliates.

Documents Incorporated by Reference:    None

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CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This annual report contains historical information, as well as forward-looking statements that involve known and unknown risks and relate to future events, our future financial performance, or our projected business results. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “targets,” “potential,” or “continue” or the negative of these terms or other comparable terminology. Such forward-looking statements are necessarily estimates based upon current information and involve a number of risks and uncertainties. Actual events or results may differ materially from the results anticipated in these forward-looking statements as a result of a variety of factors. While it is impossible to identify all such factors, factors that could cause actual results to differ materially from those estimated by us include:

The cautionary statements referred to in this section also should be considered in connection with any subsequent written or oral forward-looking statements that may be issued by us or persons acting on our behalf. We undertake no duty to update these forward-looking statements, even though our situation may change in the future. Furthermore, we cannot guarantee future results, events, levels of activity, performance, or achievements.

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SPECIAL NOTE ABOUT THIS REPORT

This annual report is our first regular periodic report covering periods after September 30, 2002. Readers should be aware that several aspects of this annual report differ from other annual reports. First, this report is for the annual reporting periods ended December 31, 2003 and 2002. Second, because of the gap in our public reporting and the significant changes we have made to our business in the interim, most of the information relating to our business, current directors, current officers, and related matters is primarily for the period between December 31, 2003 and the date of this filing. Third, this report contains a restatement of our previously issued consolidated financial statements for 2001 and 2000 in addition to initial consolidated financial statements for 2003 and 2002.

PART I

General

HealthSouth is the largest provider of ambulatory surgery and rehabilitative health care services in the United States, with approximately 1,300 facilities and 40,000 full- and part-time employees. As used in this report, the terms “HealthSouth,” “we,” “us,” “our,” and the “company” refer to HealthSouth Corporation and its subsidiaries, unless otherwise stated or indicated by context. In addition, we use the term “HealthSouth Corporation” to refer to HealthSouth Corporation alone wherever a distinction between HealthSouth Corporation and its subsidiaries is required or aids in the understanding of this filing.

HealthSouth Corporation was organized as a Delaware corporation in February 1984. Our principal executive offices are located at One HealthSouth Parkway, Birmingham, Alabama 35243, and the telephone number of our principal executive offices is (205) 967-7116.

Significant Events Since Our Last Regular Periodic Report

It has been more than two years since our last annual or quarterly periodic filing. In the interim, our employees, investors, and partners have experienced profound turmoil and change. Despite these challenges, we have stabilized operations, cooperated with federal investigators, and in some cases reached settlements with government agencies. Moreover, we have identified and partially remedied deficient operational and accounting controls, made significant positive changes to our management team and board of directors, and worked to restore our credibility. In addition, we have transformed our corporate culture into one premised on integrity, transparency, honesty, accountability, and regulatory compliance. In short, we are working to put the past behind us.

Below is a summary of significant events that have occurred since the filing of our quarterly report for the period ended September 30, 2002. We encourage you to read this summary together with the discussions contained in this Item, “Risk Factors,” and in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, which highlight additional considerations about HealthSouth.

Governmental Investigations

As described more fully below, we recently settled a lawsuit brought by the United States Securities and Exchange Commission (the “SEC”) relating to our financial reporting practices prior to March 2003. Investigations by the criminal division of the United States Department of Justice (the “DOJ”) and the United States Attorney’s Office for the Northern District of Alabama are ongoing. We also were the subject of an investigation by the DOJ’s civil division regarding our participation in federal health care programs that was recently concluded, although the DOJ’s civil division continues to review certain self-disclosures made by us to

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the Office of Inspector General (the “OIG”) of the United States Department of Health and Human Services (“HHS”). As reflected in the following timeline, we became aware of these investigations beginning in late 2002 and early 2003.

Public disclosure of these investigations and the SEC’s lawsuit precipitated a number of events that had an immediate and substantial negative impact on our business, financial condition, results of operations, and cash flows. These events, which began within weeks of the SEC’s lawsuit, are summarized below:

As described more fully below, as of the filing date of this annual report:

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Still, developments relating to governmental investigations and responses to those investigations by us and by others will continue to create various risks and uncertainties that could materially and adversely affect our business, financial condition, results of operations, and cash flows.

Our Response to the Crisis

On March 19, 2003, the date the SEC announced its lawsuit against us, our board of directors placed our then-Chairman and Chief Executive Officer, Richard M. Scrushy, and our then-Chief Financial Officer, William T. Owens, on administrative leave. Their employment was subsequently terminated. Also on March 19, 2003, the board of directors elected Joel C. Gordon, a HealthSouth director since 1996, as interim Chairman of the Board, and Robert P. May, a HealthSouth director since 2002, as interim Chief Executive Officer.

On March 22, 2003, our board directed a special committee of the board of directors (the “Special Audit Review Committee”) to conduct an independent forensic investigation of accounting irregularities at HealthSouth and to consider any related matters that it concluded deserved review or comment. Our board of directors selected Jon F. Hanson, then one of only two board members who had not served as a director when the principal events under investigation occurred, to conduct the committee’s inquiry. Neither Mr. Hanson nor the committee’s legal counsel or accounting advisors had any relationships with HealthSouth, our board of directors, our employees, or others with whom we conducted business that would limit an objective inquiry regarding our financial reporting irregularities.

By early April 2003, we had taken several important steps to stabilize our business and operations, obtain vital management assistance and coordinate our legal strategy, including the following:

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We subsequently engaged:

Board, Management, and Internal Controls and Reporting Improvements

With our crisis response team in place, we immediately began the difficult tasks of identifying weaknesses in our governance, accounting, reporting, compliance, and management functions, and developing a plan for restructuring HealthSouth to remedy those weaknesses for the long term. Some of these efforts are summarized below.

Our New Board of Directors

On April 4, 2003, we created a special committee of our board of directors (the “Special Committee”). Our board of directors delegated to the Special Committee, to the fullest extent permitted by Delaware law, all authority that may be delegated to the Special Committee, and authorized the Special Committee, to the fullest extent permitted by Delaware law, to exercise all of the powers and authority of the board of directors in the management of the business and affairs of HealthSouth when the board of directors is not in session. The Special Committee currently consists of all members of the board of directors except Mr. Scrushy, who has refused our requests to resign as a director. Mr. Owens resigned from our board of directors on October 19, 2003 and was never a member of the Special Committee.

The transition of our board of directors continued with our announcement on December 2, 2003 that we had adopted a transition plan pursuant to which five long-standing members of our board of directors would voluntarily leave the board. In accordance with this plan, the following directors voluntarily resigned from the board: George H. Strong (effective December 15, 2003), Charles W. Newhall III (effective December 15, 2003), Larry D. Striplin, Jr. (effective April 2, 2004), C. Sage Givens (effective April 15, 2004), and John S. Chamberlin (effective August 19, 2004).

Of our current board of directors, seven members were added since March 2003: Steven R. Berrard (effective January 31, 2004), Edward A. Blechschmidt (effective January 31, 2004), Jay Grinney (effective May 10, 2004), Leo I. Higdon, Jr. (effective August 17, 2004), John E. Maupin, Jr. (effective August 17, 2004), Charles M. Elson (effective September 9, 2004), and Yvonne Curl (effective November 18, 2004). In addition,

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eight members of our current board of directors qualify as “independent directors” under our Corporate Governance Guidelines. Lee S. Hillman, who joined our board of directors effective September 9, 2003, voluntarily resigned from the board effective February 18, 2005. In addition, Joel C. Gordon retired from our board of directors effective May 10, 2005 pursuant to our mandatory director retirement policy. See Item 10, Directors and Executive Officers of the Registrant, for more information about our directors, including the name of each independent director.

The Special Committee has overseen the formulation and implementation of our turnaround strategy. Following the events of March 2003, the Special Committee installed a crisis response and interim management team and worked closely with that team to reduce costs, stabilize operations, and negotiate with our bondholders and other creditors. The Special Committee was also instrumental in identifying and hiring key executives, including our chief executive officer, and directing our negotiations with the various parties with which we have successfully reached settlement, including the DOJ and the SEC, which settlements are described later in this Item. The Special Committee, whose membership has changed over time along with changes to our board of directors, continues to oversee our management team and we anticipate that the business and affairs of the company will continue to be managed under the direction of the Special Committee until we are able to hold an annual meeting of our stockholders, at which point we anticipate the Special Committee will be abolished and these duties returned to our board of directors.

Our New Management Team

Since March 2003, we have recruited a new management team of highly qualified professionals, including the following new members of our executive management team:

Except for Ms. Davis and Mr. Tarr, none of the members of our executive management team has been employed by HealthSouth in the past. In addition to our executive management team, we have substantially replaced and expanded the management of our accounting and finance, internal audit, and compliance functions, and we have replaced or added key management personnel in each of our divisions.

Corporate Governance Improvements

Since March 2003, we have revised our Corporate Governance Guidelines and charters for all five of the standing committees of our board of directors (the Audit Committee, Compensation Committee, Corporate Compliance Committee, Finance Committee, and Nominating/Corporate Governance Committee). Our revised guidelines and charters meet or exceed the requirements of the Sarbanes-Oxley Act of 2002. Our revised guidelines and charters require three-quarters of the members of our board of directors to meet the criteria for independence set forth in our new Corporate Governance Guidelines. Our new Corporate Governance Guidelines

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also create a new position of non-executive chairman of the board, limit the number of terms any director may serve, and impose limitations on the number of outside directorships our directors may hold. Additionally, non-management directors meet regularly, with the chairman of the board presiding at those meetings, and all transactions with related parties must receive the prior approval of our board of directors. Our revised guidelines and charters are available at our website, www.healthsouth.com. We will provide to any person, without charge, upon request, a copy of our revised guidelines and charters. Requests for a copy may be made in writing to the following address: Corporate Compliance Office, HealthSouth Corporation, P.O. Box 380243, Birmingham, Alabama 35238.

Internal Control Improvements

As discussed in Item 9A, Controls and Procedures, our new management team and advisors have determined that our financial systems and internal controls historically have been ineffective. Given the state of our internal controls, we hired a large group of accounting professionals and consultants to assist us with a substantive reconstruction of our historical accounting records so that we could prepare restated financial statements for 2001 and 2000 and initial financial statements for 2003 and 2002. In addition, we have engaged in, and are continuing to engage in, substantial efforts to improve our internal control over financial reporting and disclosure controls and procedures related to substantially all areas of our financial statements and disclosures. These efforts include the following:

We are also upgrading our information systems. For example, we plan to complete an upgrade of our inpatient division’s patient accounting system and computing infrastructure by October 2006. We have already completed the upgrade of our surgery centers division’s patient accounting system. We are nearing completion of the modernization of the clinical computing infrastructure in our outpatient division. In addition, we have installed a new Radiology Information System and Picture Archiving and Communication System in seven of our diagnostic facilities in Alabama, and we are currently reviewing opportunities for these systems in our other diagnostic centers. We plan to use these new technologies to automate the interface of our patient accounting systems to our general ledger, to create tangible operating efficiencies, and to improve accounts receivable collection.

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Corporate Compliance Improvements

Since March 2003, we have adopted a revised compliance program, including revised Standards of Business Conduct, to reinforce our dedication to compliance with all laws and regulations and good corporate governance. We have incorporated elements of the Standards of Business Conduct into a formal compliance training program which is required to be completed by all employees. We require each HealthSouth employee to sign a written acknowledgment that the employee has completed the program and agrees to be bound by the Standards of Business Conduct.

In addition to revising our compliance program, we have instituted several important compliance-related organizational changes. First, we engaged an independent third party to receive calls made to our compliance hotline. By outsourcing this function, the Corporate Compliance Committee seeks to create an environment that encourages the reporting of inappropriate or suspicious conduct without the fear of reprisal. Additionally, we hired John Markus as our Executive Vice President and Chief Compliance Officer. Mr. Markus is an attorney with more than 13 years of experience in corporate compliance. We are committing substantial financial resources to our corporate compliance department on a yearly basis, including the creation of a dedicated regulatory compliance audit staff. We have also established a compliance steering committee that includes all members of our executive management team and have appointed compliance officers for each of our operating divisions.

Results of Forensic Audit Review and Restatement and Reclassification of Previously Issued Consolidated Financial Statements

As mentioned above, the Special Audit Review Committee, through its legal counsel, retained PricewaterhouseCoopers LLP to assist in a forensic review of our historical accounting and financial reporting. Furthermore, we engaged Grant Thornton LLP, Callaway Partners, LLC, KPMG LLP, and American Appraisal Associates to assist in reconstructing our financial records.

In the course of reviewing our historical accounting and financial reporting and reconstructing our financial records:

The Special Audit Review Committee completed its review in May 2004 and provided a copy of the report of its findings to us on May 28, 2004. We furnished the report to the SEC in a Form 8-K on June 1, 2004. In June 2005, we completed the reconstruction of our accounting records for periods from January 1, 2000 to December 31, 2003. PricewaterhouseCoopers LLP has completed its audits of our 2003 and 2002 consolidated financial statements, as well as the reaudits of our 2002 and 2001 consolidated financial statements, and its report accompanies this annual report.

In our restated consolidated financial statements for 2001 and 2000, we restate our earnings, write down property and equipment, goodwill, and other intangible assets, and make other adjustments from our previously

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issued consolidated financial statements. These adjustments include a cumulative net reduction to shareholders’ equity of $3.9 billion as of December 31, 2001, a reduction in previously reported net income of $393.6 million for 2001 and $642.7 million for 2000. Adjustments to our January 1, 2000 previously reported retained earnings balance approximated $3.0 billion. In addition, we reduced net goodwill and other intangible assets recognized in our previously issued consolidated financial statements from $2.7 billion to $1.4 billion as of December 31, 2001. We also adjusted the net carrying values of property and equipment recognized in our previously issued consolidated financial statements from $2.8 billion to $1.8 billion as of December 31, 2001. The following chart summarizes the net impact of the restatement adjustments on our previously reported revenues, net income, and net income per share:

For more information regarding the restatement of our 2001 and 2000 consolidated financial statements, see Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, and Note 2, Restatement and Reclassification of Previously Issued Consolidated Financial Statements, to our accompanying consolidated financial statements.

Financial Restructuring

The response of our lenders and other creditors to the governmental investigations regarding our financial reporting and related activities forced us to take immediate steps to increase our liquidity, including implementing severe cost reductions and entering into protracted negotiations with our lenders and other creditors to expand our credit options.

Cost Reductions

During 2003 and 2004, we aggressively pursued cost reduction activities in non-patient care areas, including the elimination of non-clinical corporate positions, the completion of several non-core asset sales that resulted in total sale proceeds of $271 million, the completion of lease buyouts that resulted in annual savings in lease obligations, and the tightening of spending controls, including a reduction in non-critical capital expenditures. See this Item, “Our Business—Operational Agenda” for a description of our continuing efforts to reduce overhead.

Consent Solicitations for Publicly Traded Debt

On March 16, 2004, we announced that we were soliciting consents seeking approval of proposed amendments to, and waivers under, the indentures governing all of our public debt. We solicited these consents to resolve issues relating to our inability to provide current financial statements, to increase our ability to incur indebtedness under certain circumstances, and to obtain waivers of all alleged and potential defaults under the respective indentures governing our public debt.

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On June 24, 2004, we announced that we had closed our consent solicitations and executed seven supplemental indentures, bringing us into compliance on all of our $2.6 billion in public debt. Accordingly, we have classified this debt as long-term at December 31, 2003. We paid $80 million in consent fees for all of our debt issues covered by the consent solicitations.

For more information regarding our consent solicitations, see Item 4, Submission of Matters to a Vote of Security Holders, and Note 10, Long-term Debt, to our accompanying consolidated financial statements.

Amended and Restated Credit Agreement

On March 23, 2003, our line of credit was frozen under the $1.25 billion credit agreement with JPMorgan Chase Bank, which serves as administrative agent, Wachovia Bank, N.A., UBS Warburg LLC, Deutsche Bank AG, and Bank of America, N.A. On March 27, 2003, we received notice that we were in default under this agreement. We commenced negotiations with our lenders to resolve the default. On March 21, 2005, we amended and restated our credit agreement, thereby curing any defaults of the credit agreement that existed prior to such amendment and restatement. Our amended and restated credit agreement consists of a $315 million term loan, a $250 million revolving line of credit, and $150 million in letter of credit facilities. It is secured by substantially all of HealthSouth Corporation’s assets and the stock of HealthSouth Corporation’s first-tier subsidiaries. For additional information about our amended and restated credit agreement, see Note 10, Long-term Debt, to our accompanying consolidated financial statements.

Senior Subordinated Credit Agreement

As a result of the default under our $1.25 billion credit agreement, our lenders instituted a payment blockage that prohibited us from making an approximately $350 million payment of principal and interest due to holders of our 3.25% Convertible Subordinated Debentures due April 1, 2003. On January 16, 2004, we repaid these bonds ($344 million in the aggregate) from the net proceeds of a $355 million loan arranged by Credit Suisse First Boston. This loan has an interest rate of 10.375% per annum, payable quarterly, with a 7-year maturity, callable after the third year with a premium. We also issued a warrant to the lender to purchase 10 million shares of our common stock. The warrant has a term of 10 years from the date of issuance and an exercise price of $6.50 per share. For additional information about our senior subordinated credit agreement, see Note 10, Long-term Debt, to our accompanying consolidated financial statements.

Term Loan Agreement

On June 15, 2005, we entered into a $200 million term loan agreement with a consortium of financial institutions, JPMorgan Chase Bank, N.A., as Administrative Agent (“JPMorgan”), and Citicorp North America, Inc., as Syndication Agent. Pursuant to the term loan agreement, we obtained a new senior unsecured term facility consisting of term loans in an aggregate principal amount of $200 million. The term loans initially bear interest at a rate of LIBOR (adjusted for statutory reserve requirements) plus 5% per year (the “Initial Rate”). Thereafter, they will bear interest, at our option, at a rate of (1) the Initial Rate or (2) 4% per year plus the higher of (x) JPMorgan’s prime rate and (y) the Federal Funds Rate plus 0.5%. The term loans mature in full on June 15, 2010.

The proceeds of the term loans, together with cash on hand, were used to repay our $245 million 6.875% Senior Notes due June 15, 2005 and to pay fees and expenses related to the term loans. For additional information about our term loan agreement, see Note 10, Long-term Debt, to our accompanying consolidated financial statements.

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Status of Long-Term Indebtedness and Liquidity

Our long-term debt as of December 31, 2003 is summarized in the following table.

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Our long-term debt as of December 31, 2004 is summarized in the following chart.

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As of May 31, 2005, the maturity schedule for (1) the indebtedness set forth in the table above under the caption “Bonds Payable” and (2) the indebtedness related to our amended and restated credit agreement (assuming the maturity for the amended and restated credit agreement is extended to 2010), is as follows:

If all noteholders were to exercise their options to require us to repurchase their notes in 2007 and 2009, the maturity schedule would be as follows:

As of December 31, 2004, we had approximately $346 million in available cash and cash equivalents. We also had approximately $244 million in “restricted cash,” which is cash we cannot use because of various obligations we have under lending agreements, partnership agreements, and other arrangements primarily related to our captive insurance company. As of December 31, 2003, we had $472.8 million in available cash and cash equivalents and $174.9 million in restricted cash. For more information about our liquidity, please see Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, “Liquidity and Capital Resources,” Note 1, Summary of Significant Accounting Policies, Note 3, Liquidity, and Note 10, Long-term Debt, to our accompanying consolidated financial statements.

Medicare Program Settlement

The Civil DOJ Settlement

On January 23, 2002, the United States intervened in four lawsuits filed against us under the federal civil False Claims Act. These so-called “qui tam” (i.e., whistleblower) lawsuits were transferred to the Western District of Texas and were consolidated under the caption United States ex rel. Devage v. HealthSouth Corp., et al., No. 98-CA-0372 (DWS) (W.D. Tex. San Antonio).

On April 10, 2003, the United States informed us that it was expanding its investigation to review whether fraudulent accounting practices affected our previously submitted Medicare cost reports.

On December 30, 2004, we entered into a global settlement agreement (the “Settlement Agreement”) with the United States. This settlement was comprised of (1) the claims consolidated in the Devage case, which related to claims for reimbursement for outpatient physical therapy services rendered to Medicare, the TRICARE Management Activity (“TRICARE”), or United States Department of Labor (“DOL”) beneficiaries, (2) the submission of claims to Medicare for costs relating to our allegedly improper accounting practices, (3) the submission of other unallowable costs included in our Medicare Home Office Cost

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Statements and in our individual provider cost reports, and (4) certain other conduct (collectively, the “Covered Conduct”). The parties to this global settlement include us and the United States acting through the DOJ’s civil division, the OIG, the DOL through the Employment Standards Administration’s Office of Workers’ Compensation Programs, Division of Federal Employees’ Compensation (“OWCP-DFEC”), TRICARE, and certain other individuals and entities which had filed civil suits against us and/or our affiliates (those other individuals and entities, the “Relators”).

Pursuant to the Settlement Agreement, we agreed to make cash payments to the United States in the aggregate amount of $325 million, plus accrued interest from November 4, 2004 at an annual rate of 4.125%. The United States agreed, in turn, to pay the Relators the portion of the Settlement Amount due to the Relators pursuant to the terms of the Settlement Agreement. We made an initial payment of $75 million (plus interest) to the United States on January 3, 2005, with the remaining balance of $250 million (plus interest) to be paid in quarterly installments over three years. We made our first quarterly payment of approximately $22.3 million (including interest) on March 31, 2005.

The Settlement Agreement provides for our release by the United States from any civil or administrative monetary claim the United States had or may have had relating to Covered Conduct that occurred on or before December 31, 2002 (with the exception of Covered Conduct for certain outlier payments, for which the release date is extended to September 30, 2003). The Settlement Agreement also provides for our release by the Relators from all claims based upon any transaction or incident occurring prior to December 30, 2004, including all claims that have been or could have been asserted in each Relator’s civil action, and from any civil monetary claim the United States had or may have had for the Covered Conduct that is pled in each Relator’s civil action.

The Settlement Agreement also provides for the release of HealthSouth by the OIG and OWCP-DFEC, and the agreement by the OIG and OWCP-DFEC to refrain from instituting, directing, or maintaining any administrative action seeking exclusion from Medicare, Medicaid, the FECA Program, the TRICARE Program and other federal health care programs, as applicable, for the Covered Conduct. The DOJ’s civil division continues to review certain self-disclosures made by us to the OIG.

The Administrative Settlement Agreement

In connection with the Settlement Agreement, we entered into a separate settlement agreement (the “Administrative Settlement Agreement”) with the Centers for Medicare & Medicaid Services (“CMS”) acting on behalf of HHS, to resolve issues associated with various Medicare cost reporting practices.

Subject to certain exceptions and the terms and conditions of the Administrative Settlement Agreement, the Administrative Settlement Agreement provides for the release of HealthSouth by CMS from any obligations related to any cost statements or cost reports that had or could have been submitted to CMS or its fiscal intermediaries by HealthSouth for cost reporting periods ended on or before December 31, 2003. The Administrative Settlement Agreement provides that all covered cost reports be closed and considered final and settled.

Financial Consequences of the Civil DOJ Settlement and the Administrative Settlement Agreement

As described in Note 21, Medicare Program Settlement, to our accompanying consolidated financial statements, the total known cost of settlement is $347.7 million, which is comprised of the $325 million cash settlement to be paid to the United States, $19.7 million representing uncollectible amounts due arising from cost reports submitted for the fiscal years ended December 31, 2003 and prior, as well as unallowable costs in the covered cost reports, and $3 million in associated legal fees.

The December 2004 Corporate Integrity Agreement

On December 30, 2004, we entered into a new corporate integrity agreement (“CIA”) with the OIG. This new CIA has an effective date of January 1, 2005 and a term of five years from that effective date. It incorporates

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a number of compliance program changes already implemented by us and requires, among other things, that not later than 90 days after the effective date we:

On April 28, 2005, we submitted an implementation report to the OIG stating that we had, within the 90-day time frame, materially complied with the initial requirements of this new CIA.

The CIA also requires that we engage an Independent Review Organization (“IRO”) to assist us in assessing and evaluating: (1) our billing, coding, and cost reporting practices with respect to our inpatient rehabilitation facilities (“IRFs”), (2) our billing and coding practices for outpatient items and services furnished by outpatient departments of our inpatient facilities and through other HealthSouth outpatient rehabilitation facilities; and (3) certain other obligations pursuant to the CIA and the Settlement Agreement. We have engaged PricewaterhouseCoopers LLP to serve as our IRO.

Failure to meet our obligations under our CIA could result in stipulated financial penalties. Failure to comply with material terms, however, could lead to exclusion from further participation in federal health care programs, including Medicare and Medicaid, which currently account for a substantial portion of our revenues.

SEC Settlement

On June 6, 2005, the SEC approved a settlement (the “SEC Settlement”) with us relating to the actions filed by the SEC on March 19, 2003 captioned SEC v. HealthSouth Corporation and Richard M. Scrushy, No. CV-03-J-0615-S (N.D. Ala.) (the “SEC Litigation”).

That lawsuit alleges that HealthSouth and our former Chairman and Chief Executive Officer, Richard M. Scrushy, violated and/or aided and abetted violations of the antifraud, reporting, books-and-records, and internal controls provisions of the federal securities laws. On April 3, 2003, the SEC filed an amended complaint adding additional charges against Mr. Scrushy. On May 7, 2003, the SEC Litigation was stayed pending the resolution of any criminal charges against Mr. Scrushy or notification that Mr. Scrushy would not be criminally charged.

Under the terms of the SEC Settlement, we have agreed, without admitting or denying the SEC’s allegations, to be enjoined from future violations of certain provisions of the securities laws. We have also agreed to:

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The SEC Settlement also provides that we must treat the amounts ordered to be paid as civil penalties as penalties paid to the government for all purposes, including all tax purposes, and that we will not be able to be reimbursed or indemnified for such payments through insurance or any other source, or use such payments to set off or reduce any award of compensatory damages to plaintiffs in related securities litigation pending against us.

In connection with the SEC Settlement, we consented to the entry of a final judgment in the SEC Litigation (which judgment was entered by the United States District Court for the Northern District of Alabama, Southern Division) to implement the terms of the SEC Settlement. However, Mr. Scrushy remains a defendant in the SEC Litigation.

For additional information about the SEC Settlement, see Note 22, SEC Settlement, to our accompanying consolidated financial statements.

Our Business

We have spent two years responding to the various legal, financial, and operational challenges summarized above. We are now in the first year of a multi-year turnaround plan. We are primarily focused on continuing to evaluate our business, the broader health care market, and the specific geographic markets we serve, with the goal of repositioning HealthSouth as a leading provider of post-acute care and select ambulatory services. To this end, we are planning to expand the post-acute care services provided at or complementary to our inpatient facilities, such as long-term acute care, skilled nursing, and home health services. In addition, we plan to reposition the focus of our outpatient facilities (surgery, outpatient rehabilitation, and diagnostic) into key markets, and look for expansion and growth opportunities in those markets. We also have received inquiries from parties interested in acquiring our diagnostic division. As we continue to develop our strategic plan, we will evaluate the role of each division, including the diagnostic division, in that plan. Even if consistent with our strategic plan, an important consideration in our decision to divest any material asset from our portfolio would be whether the transaction would help to deleverage the company.

Industry Trends

As a provider of rehabilitative health care, ambulatory surgery, and diagnostic services, our revenues and growth are affected by trends in health care spending. According to estimates published by CMS’s Office of the Actuary, the health care sector is growing faster than the overall economy. In 2004, the total U.S. gross domestic

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product is estimated to be $11.7 trillion. Total national health care spending comprised $1.8 trillion, or 15.4% of that figure. While the United States Department of Commerce reports that the overall economy is estimated to have grown at an average rate of 5.2% per year since 1990, health care spending has increased by an average of 7% per year over that same time period. CMS estimates that by 2014 total national health care expenditures will have increased to $3.6 trillion, which will represent 18.7% of the projected U.S. gross domestic product.

Demographic factors contribute to long-term growth projections in health care spending. According to the U.S. Census Bureau’s 2004 interim projections, there were approximately 35 million Americans aged 65 or older. The number of Americans aged 65 or older is expected to increase to approximately 40 million by 2010 and approximately 54 million by 2020. By 2030, the number of Americans aged 65 or older is expected to reach approximately 70 million, or 20% of the U.S. population.

We believe that the aging of the U.S. population and the continuing growth in health care spending will increase demand for the types of services we provide. First, many of the health conditions associated with aging—such as strokes and heart attacks, neurological disorders, and diseases and injuries to the muscles, bones, and joints—will increase the demand for ambulatory surgery and rehabilitative services. Second, pressure from payors to provide efficient, high-quality health care services is forcing many procedures traditionally performed in acute care facilities out of the acute care environment.

Operating Divisions

We believe that demographics, regulation, payor pressures to reduce cost, technological advancements, and increased quality requirements will continue to fuel demand for the services we provide. We believe we can take advantage of these health care trends in the markets we currently occupy as well as leverage our size and expertise to expand our services and increase our influence in key markets.

We currently provide various patient care services through four primary operating divisions and certain other services through a fifth operating division, which together correspond to our five reporting segments. Although we have no current plans to change our operating divisions, we are continually evaluating and looking to optimize our operational structure and the mix of services we provide, which may lead to future changes in our operating divisions. Our consolidated net operating revenues were $3.96 billion for the fiscal year ended December 31, 2003 and $3.96 billion for the fiscal year ended December 31, 2002. We had a diversified payor mix across all our reporting segments, with Medicare representing the highest percentage of revenues.

For additional information regarding our business segments and related information, see Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, “Segment Results of Operations,” and Note 24, Segment Reporting, to our accompanying consolidated financial statements.

Inpatient

We are the nation’s largest provider of inpatient rehabilitation services. Our inpatient division operates IRFs and long-term acute care hospitals (“LTCHs”) and provides treatment on both an inpatient and outpatient basis. Our inpatient facilities are located in 28 states, with a concentration of facilities in Texas, Pennsylvania, Florida, Tennessee, and Alabama. We also have facilities in Puerto Rico and Australia.

As of December 31, 2004, our inpatient division operated 94 freestanding IRFs (65 of which are wholly owned and 29 of which are jointly owned), 1 wholly owned acute care hospital where we ceased providing acute care services in favor of inpatient rehabilitation services, and 3 satellite facilities with inpatient beds. As of December 31, 2004, we operated 9 LTCHs (8 of which are wholly owned and 1 of which is jointly owned), 7 of which are freestanding and 2 of which are hospital-within-hospital facilities. We also operated 2 satellite facilities with LTCH beds. One of our LTCHs was not certified as an LTCH by CMS until April 2005, although it received patients in 2004 and was reimbursed by Medicare as an acute care hospital. Our inpatient division also

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provides outpatient services through 152 facilities (128 of which are wholly owned and 24 of which are jointly owned) located within our IRFs or in satellite facilities near our IRFs. In addition to HealthSouth facilities, our inpatient division operates 13 inpatient facilities, 11 outpatient facilities, and 2 gamma knives through management contracts.

Our IRFs provide services to patients who require intensive inpatient rehabilitative care. Inpatient rehabilitation patients typically experience significant physical disabilities due to various conditions, such as head injury, spinal cord injury, stroke, certain orthopedic problems, and neuromuscular disease. Our IRFs provide the medical, nursing, therapy, and ancillary services required to comply with local, state, and federal regulations, as well as accreditation standards of the Joint Commission on Accreditation of Healthcare Organizations (the “JCAHO”) and, for some facilities, the Commission on Accreditation of Rehabilitation Facilities. The outpatient services offered by our inpatient division generally differ from those offered by our outpatient division (described below) based on patient diagnosis.

Although the market for inpatient rehabilitation services is highly competitive, it is also highly fragmented. This fragmentation creates potential consolidation opportunities for us. In addition, because of our size, we believe we differentiate ourselves from our competitors in the following ways:

Our inpatient division’s payor mix is weighted toward government-funded sources, including Medicare. For the year ended December 31, 2003, Medicare represented 70.6% of the inpatient division’s net operating revenue, which totaled $2 billion. For the year ended December 31, 2002, Medicare represented 64% of the inpatient division’s net operating revenue, which totaled $1.9 billion.

On May 7, 2004, CMS issued a final rule, effective July 1, 2004, that stipulates revised classification criteria that a facility is required to meet to be considered an IRF by Medicare. This is known as the “75% Rule.” The 75% Rule is discussed in more detail in this Item, “Sources of Revenue.” The 75% Rule, as revised, generally provides that to be considered an IRF, and to receive reimbursement for services under the IRF prospective payment system methodology, 75% of a facility’s total patient population must require intensive rehabilitation services associated with treatment of at least one of 13 designated medical conditions. As a practical matter, this means that to maintain our current level of revenue from our IRFs we will need to reduce the number of non-qualifying patients treated at our IRFs and replace them with qualifying patients, establish other sources of revenues at our IRFs, or both. The revised 75% Rule will be phased in over a period that began on July 1, 2004 and will end (i.e., full compliance will be required) for cost reporting periods beginning on or after July 1, 2007.

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In January 2005, CMS suspended enforcement of the revised 75% Rule in response to a provision of the Consolidated Appropriations Act of 2005, enacted as Public Law 108-447, that directed CMS not to change the status of certain IRFs for their failure to comply with the revised 75% Rule until the Secretary of HHS made a determination based on the recently issued report by the Government Accountability Office (the “GAO”). On June 21, 2005, CMS issued a notice announcing that it will proceed with implementing the revised 75% Rule as set forth in its previously issued final rule. The notice states that CMS has determined it has already been taking the steps that the GAO recommended to improve how facilities are classified as an IRF and that the revised classification criteria for IRFs contained in the revised 75% Rule are not inconsistent with the recommendations in the GAO report. Accordingly, the June 21 notice lifts the suspension of enforcement of the revised 75% Rule.

Anticipating that CMS would implement the revised 75% Rule as previously adopted, our inpatient division has been reducing certain types of non-qualifying admissions in order to achieve compliance with the rule. As discussed in greater detail in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, we project this reduction in census, unless mitigated, will have a materially adverse impact on our inpatient division’s revenues. To reduce the potential negative impact on our inpatient division’s revenues, we are considering the following mitigation strategies:

In addition to the specific mitigation strategies discussed above, we are participating with the rest of the industry to help educate various governmental agencies and policy makers about the efficacy of inpatient rehabilitative care in an attempt to broaden the 13 designated medical conditions under the revised 75% Rule. Because we receive a significant percentage of our revenues from our inpatient division, and because our inpatient division receives a significant percentage of its revenues from Medicare, our inability to achieve compliance with and mitigate the revised 75% Rule could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

Surgery Centers

We operate the largest network of ambulatory surgery centers (“ASCs”) in the United States. As of December 31, 2004, our surgery centers division provided ambulatory surgery services through 177 freestanding ASCs and 3 surgical hospitals in 36 states, with a concentration of centers in California, Texas, Florida, North Carolina, and Pennsylvania.

Our ASCs provide the facilities and medical support staff necessary for physicians to perform non-emergency surgical procedures. Our typical ASC is a freestanding facility with two to six fully equipped

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operating and procedure rooms and ancillary areas for reception, preparation, recovery, and administration. Each of our ASCs is licensed by the state and certified as a provider under federal programs, including specifically Medicare and Medicaid. Our ASCs are available for use only by licensed physicians, oral surgeons, and podiatrists. To ensure consistent quality of care, each of our ASCs has a medical advisory committee of three to ten physicians that implements quality control procedures and reviews the professional credentials of physicians applying for medical staff privileges at the center. In addition, all but a few unique specialty centers are certified by the JCAHO.

Like most other ASCs, the majority of our centers are owned in partnership with surgeons and other physicians who perform procedures at the centers. As a result of increased competition in the ASC market and other factors, physicians are demanding increased equity participation in ASCs. Consequently, we expect an increasing level of physician equity participation in our ASCs, and thus our percentage ownership of centers within our ASC portfolio will decline over time. Currently, our ownership interest in centers within our ASC portfolio varies from 20% to 100%. Our average ownership is over 50%.

A critical component of this division’s performance depends upon our ability to periodically provide physicians who use our ASCs with the opportunity to purchase ownership interests in our ASCs. This so-called “resyndication” of ownership interests is important because it enables us to increase the ownership participation of physicians who use our ASCs as well as attract new physicians to our ASCs. Our ability to resyndicate ASC ownership interests has been limited to date because, until recently, we have not been able to produce reliable financial statements. We have completed resyndications for 19 ASCs since July 2004 when we began the resyndication process, and we anticipate we will complete another 15 to 20 resyndications in the remaining months of 2005. We have assembled a dedicated team of accountants, attorneys, and other specialists to expedite this effort.

Our surgery centers division has a diversified payor mix with managed care and other discount plans representing the highest percentage. For the year ended December 31, 2003, managed care and other discount plans represented 51.6% of the division’s net operating revenue, which totaled $920.1 million. For the year ended December 31, 2002, managed care and other discount plans represented 52.7% of the division’s net operating revenue, which totaled $926.4 million.

The ASC market continues to grow, due in part to improved anesthesia, new instrumentation, financial incentives for physicians, payor pressure to reduce costs, and other factors. Because the market is highly fragmented, however, it is highly competitive. We plan to combat this competition (1) by increasing our concentration in specific markets, (2) by leveraging the size of our network to realize improved operating efficiencies, increased marketing opportunities, and better payor contracting, and (3) using technology such as standardized e-coding to improve division performance.

Outpatient

We are the largest operator of outpatient rehabilitation facilities in the United States. As of December 31, 2004, our outpatient division provided outpatient therapy through 765 HealthSouth facilities (706 of which are wholly owned and 59 of which are jointly owned) and 39 facilities managed under contract by us. These facilities are located in 44 states, with a concentration of centers in Florida, Texas, New Jersey, New York, and Missouri.

Our outpatient rehabilitation facilities are staffed by physical therapists, occupational therapists, and other clinicians and support personnel, depending on the services provided at a particular location, and are open at hours designed to accommodate the needs of the patient population being served and the local demand for services. Our centers offer a range of rehabilitative health care services, including physical therapy and occupational therapy, with a particular focus on orthopedic, sports-related, work-related, hand and spine injuries, and various neurological/neuromuscular conditions.

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Our outpatient division has a diversified payor mix with managed care and other discount plans representing the highest percentage. For the year ended December 31, 2003, managed care and other discount plans represented 45.3% of the division’s net operating revenue, which totaled $587.0 million. For the year ended December 31, 2002, managed care and other discount plans represented 43.5% of the division’s net operating revenue, which totaled $663.6 million.

Diagnostic

We are the second largest operator of freestanding diagnostic imaging centers in the United States. As of December 31, 2004, our diagnostic division operated 96 diagnostic centers (80 of which are wholly owned and 16 of which are jointly owned) in 26 states and the District of Columbia, with a concentration of centers in Texas, Washington, D.C., Alabama, Georgia, and Florida. Our diagnostic centers provide outpatient diagnostic imaging services, including MRI services, CT services, X-ray services, ultrasound services, mammography services, nuclear medicine services, and fluoroscopy. We do not provide all services at all sites, although approximately 75% of our diagnostic centers are multi-modality centers offering multiple types of service.

Our diagnostic centers provide outpatient diagnostic procedures performed by experienced radiological technologists. After the diagnostic procedure is completed, the images are reviewed by radiologists who have contracted with us. Those radiologists prepare an interpretation which is then delivered to the referring physician.

Our diagnostic division has a diversified payor mix with managed care and other discount plans representing the highest percentage. For the year ended December 31, 2003, managed care and other discount plans represented 63.4% of the division’s net operating revenue, which totaled $279.6 million. For the year ended December 31, 2002, managed care and other discount plans represented 56.9% of the division’s net operating revenue, which totaled $305.9 million.

Although the market for diagnostic services is highly competitive, we are expanding our focus on referring physicians outside of the orthopedic specialty to broaden our base of referrals. We also have received inquiries from parties interested in acquiring our diagnostic division. As we continue to develop our strategic plan, we will evaluate the role of each division, including the diagnostic division, in that plan. Even if consistent with our strategic plan, an important consideration in our decision to divest any material asset from our portfolio would be whether the transaction would help to deleverage the company.

Corporate and Other

This division is managed directly from our corporate office. It comprises all revenue producing activities that do not fall within one of the four operating divisions discussed above, including our medical centers, other patient care services, and certain non-patient care services.

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For the year ended December 31, 2003, the division’s net operating revenue totaled $228.3 million. For the year ended December 31, 2002, the division’s net operating revenue totaled $215.9 million.

Operational Agenda

We have established a multi-year operational agenda that is divided into the following focus areas:

Revenue. Our current strategy is to grow our revenues by expanding the post-acute care services provided at or complementary to our inpatient facilities, such as long-term acute care, skilled nursing, and home health services. We also plan to reposition the focus of our outpatient facilities (surgery, outpatient rehabilitation, and diagnostic) into key markets, and look for expansion and growth opportunities in those markets. In addition, we hope to mitigate the impact of the 75% Rule using a combination of the four mitigation strategies discussed in this Item, “Our Business – Inpatient.” We are also considering ways to increase revenues through improved managed care contract modeling and consolidated sales and marketing efforts.

Cost. We have substantially reduced unnecessary overhead expense and closed or sold under-performing facilities. We will continue to work to reduce costs by reorganizing and flattening each operating division, implementing standardized labor management metrics and performance expectations, and streamlining our supply chain. In addition, we are closely monitoring our business and will, when necessary, close or sell additional under-performing facilities.

Infrastructure. We have invested significant resources to evaluate and improve our financial, reporting, and compliance infrastructure, and will continue to invest heavily in our infrastructure throughout this turnaround period. Although our infrastructure needs improvement in many areas, we are specifically focused on implementing required internal controls (e.g., compliance with Section 404 of the Sarbanes-Oxley Act of 2002), enhancing our financial infrastructure (e.g., improving financial and operational reporting and establishing a formal capital expenditure process, formal budget process, and revised levels of authority), enhancing our management reporting capabilities (e.g., standardizing our monthly reporting and analysis, standardizing our financial projections and implementing a faster month-end close), developing regulatory compliance programs, enhancing our information systems (e.g. upgrading our patient accounting systems), and implementing an information technology strategic plan.

Quality. We are working to develop strong quality assurance programs within our facilities and divisions. We plan to supplement these programs by establishing a robust company-wide quality agenda that will include standardized division-specific quality metrics and improved clinical information through the use of technology.

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People. We have replaced our executive management team and a number of other management personnel, and we plan to continue investing heavily in recruiting new employees to HealthSouth. We are also looking at ways to increase retention and employee development, as well as overall employee relations, and we have developed a human resources strategic plan. Our goal is to build a culture of integrity, transparency, diversity, and excellence, while simplifying and flattening our organizational structure.

Competition

Inpatient

Our IRFs and LTCHs compete primarily with rehabilitation units and skilled nursing units within acute care hospitals in the markets we serve. In addition, we face competition from large privately and publicly held companies such as Rehabcare Group, Inc., Select Medical Corporation, and Kindred Healthcare, Inc.

Some of these competitors may have greater patient referral support and financial and personnel resources in particular markets than we do. We believe we compete successfully within the marketplace based upon our size, reputation for quality, competitive prices, and positive rehabilitation outcomes.

Surgery Centers

We face competition from other providers of ambulatory surgical care in developing ASC joint ventures, acquiring existing centers, attracting patients, and negotiating managed care contracts in each of our markets. There are several publicly held companies, divisions or subsidiaries of publicly held companies, and several private companies that operate ASCs. Further, many physician groups develop ASCs without a corporate partner, utilizing consultants who typically perform these services for a fee and who may not require an equity interest in the ongoing operations of the center.

We believe that we compete effectively in this market because of our size, experience, and reputation for providing quality care. Our limited access to capital makes it more difficult for us to develop or acquire new ASCs, however, which puts us at a competitive disadvantage in certain markets.

Outpatient

Our outpatient rehabilitation facilities compete directly or indirectly with the physical and occupational therapy departments of hospitals, physician-owned therapy clinics, other private therapy clinics, and chiropractors. We also face competition from large privately held and publicly held physical therapy companies such as U.S. Physical Therapy, Inc. and Benchmark Medical, Inc., as well as mid-sized regional companies. It is particularly difficult to compete with physician-owned therapy clinics because physicians have traditionally been our customers, rather than our competitors. Consequently, in addition to competing with those physicians who offer physical therapy services as in-office ancillary services, we lose them as a referral source.

Some of these competitors may have greater patient referral support and financial and personnel resources in particular markets than we do. We believe we compete successfully within the marketplace based upon our reputation for quality, competitive prices, positive rehabilitation outcomes, and innovative programs.

Diagnostic

The market for diagnostic services is highly fragmented and highly competitive. Many physicians and physician groups have opened diagnostic facilities as an in-office ancillary service. Our diagnostic centers also compete with local hospitals, other multi-center imaging companies, and local independent diagnostic centers.

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Other Competition

In some states where we operate, the construction or expansion of facilities, the acquisition of existing facilities, or the introduction of new beds or services may be subject to review by and prior approval of state regulatory agencies under a “Certificate of Need” program. Certificate of Need laws often require the reviewing agency to determine the public need for additional or expanded health care facilities and services. Certificate of Need programs generally require approvals for capital expenditures involving IRFs, LTCHs, acute care hospitals, and ASCs if such capital expenditures exceed certain thresholds. We potentially face competition any time we initiate a Certificate of Need project or seek to acquire an existing facility or Certificate of Need. This competition may arise either from competing national or regional companies or from local hospitals or other providers which file competing applications or oppose the proposed Certificate of Need project. The necessity for these approvals serves as a barrier to entry and has the potential to limit competition by creating a franchise to provide services to a given area. We have generally been successful in obtaining Certificates of Need or similar approvals when required, although there can be no assurance that we will achieve similar success in the future.

We rely significantly on our ability to attract, develop, and retain physicians, therapists, and other clinical personnel for our facilities. We compete for these professionals with other health care companies, hospitals, and potential clients and partners. In addition, changes in health care regulations have enabled physicians to open facilities in direct competition with us, which has increased the choices for such professionals and therefore made it more difficult and/or expensive for us to hire the necessary personnel for our facilities.

Sources of Revenues

We receive payment for patient care services from the federal government (primarily under the Medicare program), state governments (under their respective Medicaid or similar programs), managed care plans, private insurers, and directly from patients. In addition, we receive payment for non-patient care activities from various sources. The following table identifies the sources and relative mix of our revenues for the periods stated:

Medicare is a federal program that provides certain hospital and medical insurance benefits to persons aged 65 and over, some disabled persons, and persons with end-stage renal disease. Medicaid is a jointly administered federal and state program that provides hospital and medical benefits to qualifying individuals who are unable to afford health care.

Our facilities generally offer discounts from established charges to certain group purchasers of health care services, including Blue Cross and Blue Shield (“BCBS”), other private insurance companies, employers, HMOs, PPOs, and other managed care plans. These discount programs, which are often negotiated for multi-year terms, limit our ability to increase revenues in response to increasing costs.

Patients are generally not responsible for the difference between established gross charges and amounts reimbursed for such services under Medicare, Medicaid, BCBS plans, HMOs, or PPOs, but are responsible to the extent of any exclusions, deductibles, copayments, or coinsurance features of their coverage. The amount of such

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exclusions, deductibles, copayments, and coinsurance has been increasing each year. Collection of amounts due from individuals is typically more difficult than from governmental or third-party payors.

Medicare Reimbursement

Medicare, through statutes and regulations, establishes reimbursement methodologies for various types of health care facilities and services. These methodologies have historically been subject to periodic revisions that can have a substantial impact on existing health care providers. In accordance with authorization from Congress, CMS makes annual upward or downward adjustments to Medicare payment rates in most areas. Frequently, these adjustments can result in decreases in actual dollars per procedure or a freeze on reimbursement despite increases in costs.

We expect that Congress and CMS will address reimbursement rates for a variety of care settings over the next several years. Any downward adjustment to rates for the types of facilities that we operate could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

A basic summary of current Medicare reimbursement in our service areas follows:

Acute Care. As a result of the Social Security Act Amendments of 1983, Congress adopted a prospective payment system (“PPS”) to cover the routine and ancillary operating and capital costs of most Medicare inpatient acute care hospital services. Under this system, the Secretary of HHS has established fixed payment amounts per discharge based on diagnosis-related groups (“DRGs”). With limited exceptions, reimbursement received for inpatient acute care hospital services is limited to the DRG payment rate, regardless of the number of services provided to the patient or the length of the patient’s hospital stay. Under Medicare’s acute care PPS, a hospital may retain the difference, if any, between its DRG payment rate and its operating costs incurred in furnishing inpatient services, and is at risk for any operating costs that exceed its DRG payment rate. We currently operate several hospitals that are reimbursed under Medicare’s acute care PPS. Only one of these hospitals receives significant acute care PPS payments relating to Medicare inpatient services, however. These hospitals can qualify for additional payments available for “outlier” cases that incorporate certain higher cost factors. CMS instituted a change to the cost outlier threshold and reimbursement methodology for acute care facilities effective October 1, 2003. Generally, this change has resulted in lower overall reimbursement to acute care facilities.

Inpatient Rehabilitation and the 75% Rule. Historically, freestanding and hospital-based IRFs received cost-based reimbursement from Medicare under an exemption from the acute care PPS. The Balanced Budget Act of 1997 and its implementing regulations replaced the traditional IRF cost-based methodology, however, with a PPS system that recognizes 21 “Rehabilitation Impairment Categories.” This new IRF-PPS became effective on January 1, 2002.

To qualify as an IRF under Medicare, a facility must show that 75% of the facility’s patient population requires “intensive rehabilitation services” that fall into a specified list of conditions. When originally promulgated in 1984, that list included ten conditions:

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On May 7, 2004, CMS issued a final rule revising the 75% Rule that, among other things, modified and expanded the specified list of conditions from 10 to 13. Importantly, CMS replaced the “polyarthritis” condition with three new conditions, and added a separate category for knee or hip joint replacement, which has the effect of significantly limiting the types of patients that qualify as requiring “intensive rehabilitation services.” In anticipation of the considerable difficulty many IRFs will have satisfying the revised 75% Rule, CMS established a phase-in period for compliance, as follows:

Any IRF that fails to meet the requirements of the 75% Rule is subject to reclassification as an acute care hospital. The effect of such reclassification would be to revert Medicare prospective IRF payment rates to lower acute care payment rates. Our inpatient division has begun to reduce or refocus admissions at most locations in an attempt to achieve compliance with the current phase-in schedule for the revised 75% Rule. We estimate that the revised 75% Rule will have a material adverse impact on out inpatient division’s revenues. For additional information about the estimated impact of the revised 75% Rule, see Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations. As discussed in this Item, “Our Business—Inpatient,” we have begun to implement a strategy to mitigate the impact of the revised 75% Rule on our revenues.

In January 2005, CMS suspended enforcement of the revised 75% Rule in response to a provision of the Consolidated Appropriations Act of 2005, enacted as Public Law 108-447, that directed CMS not to change the status of certain IRFs for their failure to comply with the revised 75% Rule until the Secretary of HHS made a determination based on the recently issued report by the Government Accountability Office (the “GAO”). On June 21, 2005, CMS issued a notice announcing that it will proceed with implementing the revised 75% Rule as set forth in its previously issued final rule. The notice states that CMS has determined it has already been taking the steps that the GAO recommended to improve how facilities are classified as an IRF and that the revised classification criteria for IRFs contained in the revised 75% Rule are not inconsistent with the recommendations in the GAO report. Accordingly, the June 21 notice lifts the suspension of enforcement of the revised 75% Rule.

Because we receive a significant percentage of our revenues from our inpatient division, and because our inpatient division receives a significant percentage of its revenues from Medicare, our inability to achieve compliance with and mitigate the revised 75% Rule could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

Although the revised 75% Rule presents our biggest operating risk, other coverage policies can affect our operations. For example, Medicare providers like us can be negatively affected by the adoption of coverage policies, either at the national or local level, that determine whether an item or service is covered and under what clinical circumstances it is considered to be reasonable, necessary, and appropriate. In the absence of a national coverage determination, local Medicare fiscal intermediaries and carriers may specify more restrictive criteria than otherwise would apply nationally. For instance, Cahaba Government Benefit Administrators, the fiscal

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intermediary for Alabama, has issued a local coverage determination setting forth very detailed criteria it proposes to use in determining the medical appropriateness of services provided by IRFs. We cannot predict whether other Medicare contractors will adopt additional local coverage determinations or other policies or how these will affect us.

On May 25, 2005, CMS published a proposed rule that updates the IRF-PPS for federal fiscal year 2006. The proposed rule (1) increases the market basket payments by 3.1% utilizing a new methodology, (2) incorporates downward adjustments for reimbursement (resulting in an overall decrease of approximately 1.9%) in response to coding changes, (3) reduces the outlier payment threshold for cases with unusually high costs, (4) implements refinements to the Case-Mix Groups, comorbidity tiers, and relative weights, (5) implements new and revised payment adjustments that will be implemented on a budget neutral basis, (6) adopts the new geographic labor market area definitions based on the definitions created by the Office of Management and Budget known as Core-Based Statistical Areas, and (7) incorporates several other modifications to Medicare reimbursement for IRFs. After a notice and comment period, CMS is expected to publish a final rule in the next several months. CMS predicted in its announcement of the proposed rule that overall payments to IRFs nationwide would increase by 2.9% if the proposed rule were implemented. However, the final rule could result in a reduction in our reimbursement from Medicare for care provided in our IRFs.

Long Term Acute Care Hospitals. Long Term Acute Care Hospitals (“LTCHs”) provide diagnostic and medical treatment to patients with chronic diseases or complex medical conditions. In order for a facility to qualify as an LTCH, patients discharged from the facility in any given cost reporting year must have an average length-of-stay in excess of 25 days. Currently LTCHs are exempt from acute care PPS and receive Medicare reimbursement on the basis of reasonable costs subject to certain limits. However, this cost-based reimbursement is transitioning to a PPS system over a 5-year period which began for twelve-month periods beginning on or after October 1, 2002. Providers were given the option to transition into the full LTCH-PPS by receiving 100% of the federal payment rate at any time through the transition period. We have elected to receive the full federal payment rate for all of our LTCHs. Under the new LTCH-PPS system, Medicare will classify patients into distinct diagnostic groups (“LTC-DRGs”) based upon specific clinical characteristics and expected resource needs. The LTCH-PPS also provides for an adjustment for differences in area wages as well as a cost of living adjustment for LTCHs located in Alaska or Hawaii.

On May 4, 2005, CMS published a proposed rule relating to acute care PPS that will, if finalized, impact LTCH relative weights and LTC-DRG assignments for the period October 1, 2005 through September 30, 2006. On May 6, 2005, CMS published a final rule regarding LTCH-PPS rate updates and policy changes effective for discharges on or after July 1, 2005. The final rule increases LTCH-PPS standard payment rates by 3.4% and adopts revised labor market area definitions based on the Core-Based Statistical Areas designated by the Office of Management and Budget using 2000 census data. The final rule also lowers the eligibility threshold for hospitals to qualify for outlier payments. Although the final rule, which is effective July 1, 2005, will increase Medicare payment rates, the proposed rule, if adopted in its current form and made effective beginning October 1, 2005, will reduce total Medicare payments to us as a result of the impact of the relative weight calculations on our LTCH reimbursement. If the May 4, 2005 proposed rule is adopted in its current form, we estimate it will cause a reduction in inpatient division revenues of approximately $2.3 million for the period affected.

Effective July 1, 2004, CMS expanded its interrupted stay policy to include a discharge and readmission to the LTCH within three days, regardless of where the patient is transferred upon discharge. Accordingly, if a patient is readmitted to an LTCH within three days of discharge, Medicare will pay only one LTC-DRG. This expanded, but did not replace, the prior interrupted stay policy which provides that if an LTCH patient is discharged to an acute care hospital, an IRF, or a skilled nursing facility and then is readmitted to the LTCH within a fixed period of time, the entire hospitalization, both before and after the interruption, will be considered one episode of care and thus generate one LTC-DRG payment.

Effective October 1, 2004, CMS promulgated regulations altering the separateness and control requirements pertaining to LTCHs which are located within a hospital. Such hospitals within hospitals (“HIHs”) must meet

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more stringent requirements as to their independence from the host hospital and further must follow additional HIH requirements based upon the percentage of admittances from the host hospital. These HIH policies are to be phased in over a four-year period which began on October 1, 2004. See this Item, “Regulation—Hospital Within Hospital Rules.” We expect Congress and CMS to conduct a further review of LTCH payment policy. Any changes in program rules or reimbursement levels could adversely affect our LTCH operations.

Ambulatory Surgery Centers. ASC services are reimbursed by Medicare based on prospectively determined rates. These rates are not based on DRG’s like acute care hospital services. Rather, they are based upon the classifications of procedures into different payment groups which are based on surgical procedure complexity. Surgical procedures approved by CMS for ASC reimbursement are classified into nine payment groups for facility reimbursement purposes. All approved surgical procedures within the same payment group are reimbursed at a single rate, adjusted by the location of the facility and applicable wage index.

On April 29, 2005, CMS posted an interim final rule updating the list of approved surgical procedures. The interim final rule, which becomes effective July 5, 2005, deletes five approved procedures and adds 65 new procedures to the list of approved surgical procedures. Other significant changes in ASC reimbursement are presently being contemplated.

The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (“MMA”) froze Medicare payment rates for ASCs beginning in April 2004 through 2009 and directed HHS to implement a new payment system by 2008. For 2004, ASCs were subject to a 1% Medicare rate reduction, which dropped payment levels to roughly the 2002 rates. The MMA also required HHS to take into account a GAO study of ASCs to be completed by December 31, 2004 (although the GAO missed that deadline and has not provided a revised completion date). That study will examine the costs of providing the same service in the centers versus hospital outpatient departments, the accuracy of ASC payment levels and whether the outpatient prospective payment system would be a good basis for a new ASC payment system. Both the Medicare Payment Advisory Commission (“Med PAC”) and the OIG are recommending greater parity of payments for services performed in hospital outpatient departments (“HOPDs”) and those performed in ASCs. Such parity would likely result in lower payments for certain procedures that receive higher reimbursement in ASCs than in a HOPD, but could result in higher reimbursement for those services currently priced lower in ASCs than in HOPDs. Although Congressional action is required before ASC payment levels could actually be adjusted, further reductions in ASC Medicare reimbursement are possible. Any significant reductions in Medicare reimbursement could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

Outpatient Rehabilitation. Our outpatient rehabilitation facilities are certified by Medicare and reimbursed by Medicare on an adjusted fee schedule basis. Under this basis, facilities receive a fixed fee per reimbursable procedure performed. This fee is adjusted by the geographical area in which the facility is located. The Balanced Budget Act of 1997 changed the reimbursement methodology for Medicare Part B therapy services from cost based to fee screen payments. It also established two types of annual per-beneficiary limitations on outpatient therapy services: (1) a $1,500 cap for all outpatient therapy services and speech language pathology services; and (2) a $1,500 cap for all outpatient occupational therapy services. Both of these amounts were indexed for inflation. Subsequent legislation suspended implementation of these caps through 2002. CMS began enforcing the therapy caps on September 1, 2003 (the inflation-adjusted amounts for 2003 are $1,590). The MMA suspended application of the therapy cap from the date of enactment (December 8, 2003) through calendar year 2005. This provision will not be applied retroactively to beneficiaries who exceeded their caps prior to the date of enactment. The therapy caps do not apply to therapy services provided in acute care hospital outpatient departments or outpatient departments of IRFs. At this time, we are unable to quantify the impact of this legislation on our business, financial condition, results of operations, and cash flows.

Diagnostic Facilities. Medicare allows diagnostic facilities that are independent of physician practices or hospitals to bill for approved diagnostic procedures as Independent Diagnostic Testing Facilities (“IDTFs”). Such procedures must be performed by licensed or certified nonphysician personnel under appropriate physician

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supervision or by physicians in accordance with detailed guidelines. IDTFs are reimbursed for approved tests with required physician orders on the basis of appropriate Current Procedural Terminology (“CPT”) codes under Medicare Part B. CPT reimbursement is geographically adjusted by CMS. Medicare uses the Resource-Based Relative Value Scale (“RBRVS”) fee schedule to pay for services provided in freestanding imaging centers. Each CPT code is assigned a set of relative value units (“RVUs”) that reflects the average time, effort, and practice costs (including a geographic adjustment) involved in performing a given procedure. Medicare payment amounts are based on a procedure’s total RVUs multiplied by a dollar conversion factor. Medicare makes payment determinations for diagnostic radiology procedures and imaging agents based on where the procedure is performed. More specifically, Medicare uses different payment methodologies for procedures performed in a hospital outpatient department versus an IDTF.

Hospital Outpatient Surgical Services. The Balanced Budget Act of 1997 authorized CMS to implement the Hospital Outpatient Prospective Payment System (“OPPS”) on July 1, 2000, for certain hospital outpatient services, which excludes diagnostic laboratory services, ambulance services, orthotics, prosthetics, chronic dialysis, screening mammographies, and outpatient rehabilitation services. OPPS payments are based on procedures and common procedure codes grouped by Ambulatory Payment Classifications (“APCs”). Our three surgical hospitals, which provide mostly outpatient surgical services, as well as our one Medical Center, are paid under the OPPS for outpatient surgical services.

On November 15, 2004, CMS published the 2005 OPPS final rule. The rule affects Medicare outpatient services furnished on or after January 1, 2005. The rate adjustments to the OPPS will mainly affect the Birmingham Medical Center, and our three surgical hospitals. The changes are expected to increase Medicare outpatient net revenues for these facilities.

Medicaid Reimbursement

Medicaid programs are jointly funded by the federal and state governments. As the Medicaid program is administered by the individual states under the oversight of CMS in accordance with certain regulatory and statutory guidelines, there are substantial differences in reimbursement methodology and coverage from state to state. Many states have experienced shortfalls in their Medicaid budget and are implementing significant cuts in both reimbursement rates and service coverage. Additionally, certain states control Medicaid expenditures through rationing or restricting certain services. Downward pressure on Medicaid payment rates could cause a decline in revenues.

Cost Reports

Because of our participation in the Medicare, Medicaid and TRICARE programs, we are required to meet certain financial reporting requirements. Federal and, where applicable, state regulations require the submission of annual cost reports covering the revenue, costs, and expenses associated with the services provided by our inpatient and certain surgery center hospitals to Medicare beneficiaries and Medicaid recipients.

Annual cost reports required under the Medicare and Medicaid programs are subject to routine audits, which may result in adjustments to the amounts determined to be ultimately due HealthSouth under these reimbursement programs. These audits are used for determining if any under- or over-payments were made to Medicare and to set payment levels for future years.

On December 30, 2004, we announced that HealthSouth had signed an agreement with CMS to resolve issues associated with various Medicare cost reporting practices. Subject to certain exceptions, the settlement provides for the release of HealthSouth by CMS from any obligations related to any cost statements or cost reports which had, or could have been submitted to CMS or its fiscal intermediaries by HealthSouth for cost reporting periods ended on or before December 31, 2003. The settlement provides that all covered federal cost reports be closed and considered final and settled. Open state Medicaid cost reports are still subject to potential audits as described above. See this Item, “Medicare Program Settlement.”

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Charge Structure for Uninsured Patients

During 2003 and 2004, a great deal of attention was focused on the charge structure and lack of available discounts extended to uninsured patients by health care facilities. Many health care providers have historically been reluctant to grant discounts that would produce charges to uninsured patients below the level of reimbursement provided by Medicare and Medicaid because of regulatory prohibitions on billing Medicare or Medicaid programs more than a provider’s “usual and customary charges.” Recent regulatory guidance has indicated, however, that health care providers may offer free or substantially discounted services to uninsured patients in many circumstances.

We cannot predict whether other regulatory or statutory provisions will be enacted by federal or state authorities that would prohibit or otherwise regulate relationships which we have established or may establish with other health care providers or the possibility of materially adverse effects on our business or revenues arising from such future actions. We believe, however, that we will be able to adjust our operations so as to be in compliance with any regulatory or statutory provision that may be applicable.

Managed Care and Other Discounted Plans

Most of our facilities offer discounts from established charges to certain large group purchasers of health care services, including managed care plans, BCBS, other private insurance companies, and employers. Managed care contracts typically have terms of between one and three years, although we have a number of managed care contracts that automatically renew each year unless a party elects to terminate the contract. While some of our contracts provide for annual rate increases of three to five percent, we cannot provide any assurance that we will continue to receive increases.

Regulation

The health care industry is subject to significant federal, state, and local regulation that affects our business activities by controlling the reimbursement we receive for services provided, requiring licensure or certification of our facilities, regulating the use of our properties, and controlling our growth.

Licensure and Certification

Health care facility construction and operation are subject to numerous federal, state, and local regulations relating to the adequacy of medical care, equipment, personnel, operating policies and procedures, maintenance of adequate records, fire prevention, and compliance with building codes and environmental protection laws. Our facilities are subject to periodic inspection by governmental and non-governmental certification authorities to ensure continued compliance with the various standards necessary for facility licensure. All of our inpatient facilities and substantially all of our ASCs are currently required to be licensed. Only a relatively small number of states require licensure for outpatient rehabilitation facilities. Many states do not require diagnostic facilities to be licensed.

In addition, facilities must be “certified” by CMS to participate in the Medicare program and generally must be certified by Medicaid state agencies to participate in Medicaid programs. All of our inpatient facilities participate in (or are awaiting the assignment of a provider number to participate in) the Medicare program. Approximately 94% of our outpatient therapy facilities (including outpatient rehabilitation facilities and other outpatient facilities) currently participate in, or are awaiting the assignment of a provider number to participate in, Medicare programs. Substantially all of our ASCs and diagnostic centers are certified (or are awaiting certification) under the Medicare program. Our Medicare-certified facilities undergo periodic on-site surveys in order to maintain their certification.

Failure to comply with applicable certification requirements may make our facilities ineligible for Medicare or Medicaid reimbursement. In addition, Medicare or Medicaid may seek retroactive reimbursement from

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noncompliant facilities or otherwise impose sanctions on noncompliant facilities. Non-governmental payors often have the right to terminate provider contracts if a facility loses its Medicare or Medicaid certification. We have developed operational systems to oversee compliance with the various standards and requirements of the Medicare program and have established ongoing quality assurance activities; however, given the complex nature of governmental health care regulations, there can be no assurance that Medicare, Medicaid, or other regulatory authorities will not allege instances of noncompliance.

Certificates of Need

In some states where we operate, the construction or expansion of facilities, the acquisition of existing facilities, or the introduction of new beds or services may be subject to review by and prior approval of state regulatory agencies under a “Certificate of Need” program. Certificate of Need laws often require the reviewing agency to determine the public need for additional or expanded health care facilities and services. Certificate of Need programs generally require approvals for capital expenditures involving IRFs, LTCHs, acute care hospitals, and ASCs if such capital expenditures exceed certain thresholds. Most states do not require such approvals for outpatient rehabilitation, occupational health, or diagnostic facilities and services. However, any time a Certificate of Need is required, we must obtain it before acquiring, opening, or expanding a health care facility or starting a new health care program.

False Claims Act

Over the past several years, an increasing number of health care providers have been accused of violating the federal False Claims Act. That act prohibits the knowing presentation of a false claim to the United States government, and provides for penalties equal to three times the actual amount of any overpayments plus up to $11,000 per claim. In addition, the False Claims Act allows private persons, known as “relators,” to file complaints under seal and provides a period of time for the government to investigate such complaints and determine whether to intervene in them and take over the handling of all or part of such complaints. Because of the sealing provisions of the False Claims Act, it is possible for health care providers to be subject to False Claims Act suits for extended periods of time without notice of such suits or an opportunity to respond to them. Because we perform thousands of similar procedures a year for which we are reimbursed by Medicare and other federal payors and there is a relatively long statute of limitations, a billing error or cost reporting error could result in significant civil or criminal penalties under the False Claims Act or other laws. We have recently entered into a substantial settlement of claims under the False Claims Act. See this Item, “Medicare Program Settlement.” We remain a named defendant in certain unsealed suits under the False Claims Act where the United States did not intervene. See Item 3, Legal Proceedings, “Certain Regulatory Actions.”

Corporate Integrity Agreement

As described in this Item, “Medicare Program Settlement,” we entered into a new corporate integrity agreement (“CIA”) in December 2004, which is effective for five years beginning January 1, 2005. Failure to comply with our new CIA could lead to severe penalties such as exclusion from further participation in federal health care programs, including Medicare and Medicaid, which currently account for a substantial portion of our revenues. Failure to meet lesser requirements of our new CIA could result in stipulated financial penalties. See Note 21, Medicare Program Settlement, for a description of the accounting treatment of the settlement relating to this CIA. On April 28, 2005, we submitted an implementation report to the OIG stating that we had, within the 90-day time frame, materially complied with the initial requirements of this new CIA.

As part of our ongoing dialogue with the OIG, we have, over the past two years, submitted disclosures detailing various activities involving HealthSouth and certain third parties. We have summarized several transactions that are currently being reviewed by the DOJ’s civil division under Item 13, Certain Relationships and Related Transactions, “Other Transactions.”

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Relationships with Physicians and Other Providers

The Anti-Kickback Law. Various state and federal laws regulate relationships between providers of health care services, including employment or service contracts and investment relationships. Among the most important of these restrictions is a federal criminal law prohibiting (a) the offer, payment, solicitation, or receipt of remuneration by individuals or entities to induce referrals of patients for services reimbursed under the Medicare or Medicaid programs or (b) the leasing, purchasing, ordering, arranging for, or recommending the lease, purchase, or order of any item, good, facility, or service covered by such programs (the “Anti-Kickback Law”). In addition to federal criminal sanctions, including penalties of up to $50,000 for each violation plus tripled damages for improper claims, violators of the Anti-Kickback Law may be subject to exclusion from the Medicare and/or Medicaid programs. In 1991, the OIG issued regulations describing compensation arrangements that are not viewed as illegal remuneration under the Anti-Kickback Law (the “1991 Safe Harbor Rules”). The 1991 Safe Harbor Rules create certain standards (“Safe Harbors”) for identified types of compensation arrangements that, if fully complied with, assure participants in the particular arrangement that the OIG will not treat that participation as a criminal offense under the Anti-Kickback Law or as the basis for an exclusion from the Medicare and Medicaid programs or the imposition of civil sanctions.

The OIG closely scrutinizes health care joint ventures involving physicians and other referral sources for compliance with the Anti-Kickback Law. In 1989, the OIG published a Fraud Alert that outlined questionable features of “suspect” joint ventures, and has continued to rely on such Fraud Alert in later pronouncements. We currently operate some of our rehabilitation hospitals and outpatient rehabilitation facilities as general partnerships, limited partnerships or limited liability companies (collectively, “partnerships”) with third-party investors, including other institutional health care providers but also including, in a number of cases, physician investors. Some of these partners may be deemed to be in a position to make or influence referrals to our facilities. Those partnerships that are providers of services under the Medicare program, and their limited partners, are subject to the Anti-Kickback Law. A number of the relationships we have established with physicians and other health care providers do not fit within any of the Safe Harbors. The 1991 Safe Harbor Rules do not expand the scope of activities that the Anti-Kickback Law prohibits, nor do they provide that failure to fall within a Safe Harbor constitutes a violation of the Anti-Kickback Law; however, the OIG has indicated that failure to fall within a Safe Harbor may subject an arrangement to increased scrutiny. While we do not believe that our rehabilitation facility partnerships engage in activities that violate the Anti-Kickback Law, there can be no assurance that such violations may not be asserted in the future, nor can there be any assurance that our defense against any such assertion would be successful.

Most of our ASCs are owned by partnerships, which include as partners physicians who perform surgical or other procedures at such centers. HHS has promulgated four categories of safe harbors under the Anti-Kickback Law for ASCs (the “ASC Safe Harbors”). Under the ASC Safe Harbors, ownership by a referring physician in a freestanding ASC will be protected if a number of conditions are satisfied. The conditions include the following:

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Because we invest in each partnership that owns an ASC and often provide management and other services to the ASC, our arrangements with physician investors do not fit within the terms of the ASC Safe Harbors. In addition, because we do not control the medical practices of our physician investors or control where they perform surgical procedures, in some of our ASCs, the quantitative tests described above have not been met and/or will not be met in the future, and that certain other conditions of the ASC Safe Harbors have not been or will not be satisfied. We cannot assure you that all physician-investors will perform, or have performed, one-third of their procedures at the ASC or have informed or will inform their referred patients of their investment interests. Accordingly, there can be no assurance that the ownership interests in some of our ASCs will not be challenged under the Anti-Kickback Law.

Some of our diagnostic centers are also owned or operated by partnerships that include radiologists as partners. While those ownership interests are not directly covered by the Safe Harbor Rules, we do not believe that such arrangements violate the Anti-Kickback Law because radiologists are typically not in a position to make referrals to diagnostic centers. In addition, our mobile lithotripsy operations are conducted by partnerships in which urologists are limited partners. Because such urologists are in a position to, and do, perform lithotripsy procedures utilizing our lithotripsy equipment, we believe that the same analysis underlying the ASC Safe Harbor should apply to ownership interests in lithotripsy equipment held by urologists. There can be no assurance, however, that the Anti-Kickback Law will not be interpreted in a manner contrary to our beliefs with respect to diagnostic and lithotripsy services.

We have entered into management agreements to manage many of our facilities that are owned by partnerships in which physicians have invested. A number of these agreements incorporate a percentage-based management fee. Although there is a safe harbor for personal services and management contracts, this safe harbor requires, among other things, that the aggregate compensation paid to the manager over the term of the

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agreement be set in advance. Because our management fee may be based on a percentage of revenues, the fee arrangement may not meet this requirement. However, we believe that our management arrangements satisfy the other requirements of the safe harbor for personal services and management contracts and that they comply with the Anti-Kickback Law. The OIG has taken the position that percentage-based management agreements are not protected by a safe harbor, and consequently, may violate the Anti-Kickback Law. On April 15, 1998, the OIG issued Advisory Opinion 98-4 which reiterates this proposition. This opinion focused on areas the OIG considers problematic in a physician practice management context, including financial incentives to increase patient referrals, no safeguards against overutilization and incentives to increase the risk of abusive billing. The opinion reiterated that proof of intent to violate the Anti-Kickback Law is the central focus of the OIG. We have implemented programs designed to safeguard against overbilling and otherwise achieve compliance with the Anti-Kickback Law and other laws, but we cannot assure you that the OIG would find our compliance programs to be adequate.

While several federal court decisions have aggressively applied the restrictions of the Anti-Kickback Law, they provide little guidance as to the application of the Anti-Kickback Law to our partnerships, and we cannot provide any assurances that a federal or state agency charged with enforcement of the Anti-Kickback Law and similar laws might not claim that some of our partnerships have violated or are violating the Anti-Kickback Law. Such a claim could adversely affect relationships we have established with physicians or other health care providers or result in the imposition of penalties on us or on particular HealthSouth facilities. Any conviction of a partnership for violations of the Anti-Kickback Law would have severe consequences on that partnership’s ability to be a viable entity and our ability to attract physician investors to other partnerships and could result in substantial fines as well as our exclusion from Medicare and Medicaid. Moreover, even the assertion of a violation of the Anti-Kickback Law by one or more of our partnerships could have a material adverse effect upon our business, financial condition, results of operations, or cash flows.

Stark Prohibitions. The so-called “Stark II” provisions of the Omnibus Budget Reconciliation Act of 1993 amend the federal Medicare statute to prohibit the making by a physician of referrals for “designated health services” including physical therapy, occupational therapy, radiology services or radiation therapy, to an entity in which the physician has an investment interest or other financial relationship, subject to certain exceptions. Such prohibition took effect on January 1, 1995 and applies to all of our partnerships with physician partners and to our other financial relationships with physicians. Final Regulations for Phase II Stark Regulations were published in the Federal Register on March 26, 2004 and had an effective date of July 26, 2004. The final regulations substantially clarified recruitment arrangements among health care facilities, individual physicians and group practices and addressed compensation arrangements with physicians.

Ambulatory surgery is not identified as a “designated health service” under Stark II, and we do not believe the statute is intended to cover ambulatory surgery services. The Phase I Final Stark Regulations expressly clarify that the provision of designated health services in an ASC is excepted from the referral prohibition of Stark II if payment for such designated health services is included in the ambulatory surgery center payment rate. Likewise, the Stark regulations expressly provide that a referral for designated health services does not include a request by a radiologist for diagnostic radiology services if the request results from a consultation initiated by another physician and the tests or services are furnished by or under the supervision of a radiologist. As a result, we believe that radiologists may enter into joint ventures for diagnostic imaging centers without violating Stark II in most circumstances.

Our lithotripsy units frequently operate on hospital campuses, and it is possible to conclude that such services are “inpatient and outpatient hospital services”—a category of designated health services under Stark II. CMS had indicated that lithotripsy services provided at a hospital would constitute “inpatient and outpatient hospital services” and thus would be subject to Stark II. However, a federal court decision does not support this interpretation. On January 3, 2003, CMS withdrew its appeal of Judge Henry Kennedy’s decision in American Lithotripsy Society and Urology Society of America v. Thompson, made in the Federal District Court for the District of Columbia. The Court of Appeals accepted the withdrawal, and, accordingly, the District Court

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decision is final. This order permanently enjoined CMS from implementing and enforcing its Stark II regulation declaring lithotripsy a “designated health service.” If Congress passes revised legislation on this topic, CMS adopts additional regulations or is otherwise successful in re-asserting its position on lithotripsy services and Stark, we would be forced to restructure many of our relationships for lithotripsy services at substantial cost.

While we do not believe that our financial relationships with physicians violate the Stark II statute or the associated regulations, no assurances can be given that a federal or state agency charged with enforcement of the Stark II statute and regulations or similar state laws might not assert a contrary position or that new federal or state laws governing physician relationships, or new interpretations of existing laws governing such relationships, might not adversely affect relationships we have established with physicians or result in the imposition of penalties on us or on particular HealthSouth facilities. Even the assertion of a violation could have a material adverse effect upon our business, financial condition, or results of operations. In addition, a number of states have passed or are considering statutes which prohibit or limit physician referrals of patients to facilities in which they have an investment interest. Any actual or perceived violation of these state statutes could have a material adverse effect on business, financial condition, results of operations, and cash flows.

HIPAA

The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) broadened the scope of certain fraud and abuse laws by adding several criminal provisions for health care fraud offenses that apply to all health benefit programs. HIPAA also added a prohibition against incentives intended to influence decisions by Medicare beneficiaries as to the provider from which they will receive services. In addition, HIPAA created new enforcement mechanisms to combat fraud and abuse, including the Medicare Integrity Program, and an incentive program under which individuals can receive up to $1,000 for providing information on Medicare fraud and abuse that leads to the recovery of at least $100 of Medicare funds. Federal enforcement officials now have the ability to exclude from Medicare and Medicaid any investors, officers, and managing employees associated with business entities that have committed health care fraud, even if the officer or managing employee had no knowledge of the fraud.

HIPAA also contains certain administrative simplification provisions that require the use of uniform electronic data transmission standards for certain health care claims and payment transactions submitted or received electronically. HHS has issued regulations implementing the HIPAA administrative simplification provisions and compliance with these regulations became mandatory for our facilities on October 16, 2003. HHS has agreed to accept noncompliant Medicare claims, for an unspecified time, to assist providers that are not yet able to process compliant transactions. However, this extension may be terminated by HHS and is not binding on private payors. We believe that the cost of compliance with these regulations has not had and is not expected to have a material adverse effect on our business, financial condition, results of operations, and cash flows.

HIPAA also requires HHS to adopt standards to protect the privacy and security of individually identifiable health-related information. HHS released regulations containing privacy standards in December 2000 and published revisions to the regulations in August 2002. Compliance with these regulations became mandatory on April 14, 2003. The privacy regulations regulate the use and disclosure of individually identifiable health-related information, whether communicated electronically, on paper, or orally. The regulations also provide patients with significant new rights related to understanding and controlling how their health information is used or disclosed. HHS released security regulations on February 20, 2003. The security regulations became mandatory on April 20, 2005 and require health care providers to implement administrative, physical, and technical practices to protect the security of individually identifiable health information that is maintained or transmitted electronically. The privacy regulations and security regulations could impose significant costs on our facilities in order to comply with these standards.

Penalties for violations of HIPAA include civil and criminal monetary penalties. In addition, there are numerous legislative and regulatory initiatives at the federal and state levels addressing patient privacy concerns.

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Facilities will continue to remain subject to any federal or state privacy-related laws that are more restrictive than the privacy regulations issued under HIPAA. These statutes vary and could impose additional penalties.

EMTALA

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

Hospital Within Hospital Rules

Effective October 1, 2004, CMS enacted final regulations that provide if a long term acute care “hospital within hospital” has Medicare admissions from its host hospital that exceed 25% (or an adjusted percentage for certain rural or Metropolitan Statistical Area dominant hospitals) of its Medicare discharges for its cost-reporting period, the LTCH will receive an adjusted payment for its Medicare patients of the lesser of (a) the otherwise full payment under the LTCH-PPS or (b) the full payment that Medicare would pay under the acute care PPS. In determining whether an LTCH meets the 25% criterion, patients transferred from the host hospital that have already qualified for outlier payments at the acute host facility would not count as part of the host hospital’s allowable percentage. Cases admitted from the host hospital before the LTCH crosses the 25% threshold will be paid under the LTCH-PPS. Under the final regulation, this “25% Rule” is set to phase in over a four year period which began on October 1, 2004.

Additionally, other excluded hospitals or units of a host hospital, such as inpatient rehabilitation facilities and/or units, must meet certain HIH requirements in order to maintain their excluded status and not be subject to Medicare’s acute care PPS.

The majority of our IRFs and LTCHs are freestanding facilities. As such, many of HealthSouth’s facilities are not subject to these rules. HealthSouth’s “hospital within hospital” LTCH or inpatient competitors or their referral sources could refer a certain number of patients to free-standing facilities for LTCH or inpatient rehabilitation services, and HealthSouth facilities may benefit from increased referrals.

Risk Management and Insurance

We insure a substantial portion of our professional, general liability, and workers’ compensation risks through a self-insured retention program implemented through HCS, Ltd., which is our wholly-owned offshore captive insurance subsidiary. HCS provides our first layer of insurance coverage for professional and general liability risks (up to $6 million per claim and $60 million in the aggregate per year) and workers’ compensation claims (between $250,000 and $1 million per claim, depending upon the state). We maintain professional and general liability insurance with unrelated commercial carriers for losses in excess of amounts insured by HCS. HealthSouth and HCS maintained reserves for professional, general liability, and workers’ compensation risks that totaled $208.1 million, net of insurance recoverables, at December 31, 2003. Management considers such reserves, which are based on actuarially determined estimates, to be adequate for those liability risks. However, there can be no assurance that the ultimate liability will not exceed management’s estimates.

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We also maintain directors and officers, property, and other typical insurance coverages with unrelated commercial carriers. See Item 3, “Insurance Coverage Litigation,” for a description of various lawsuits that have been filed to contest coverage under certain directors and officers insurance policies.

Employees

As of December 31, 2004, we employed approximately 40,000 individuals, of whom approximately 28,000 were full-time employees. We are subject to various state and federal laws that regulate wages, hours, benefits, and other terms and conditions relating to employment. Except for approximately 65 employees at one IRF (about 15% of that facility’s workforce), none of our employees are represented by a labor union. We are not aware of any current activities to organize our employees at other facilities. We believe our relationship with our employees is satisfactory. Like most health care providers, we have experienced labor costs rising faster than the general inflation rate. In some markets, nurse and other medical support personnel availability has become a significant operating issue to health care providers. To address this challenge, we are implementing initiatives to improve retention, recruiting, compensation programs, and productivity. The shortage of nurses and other medical support personnel, including physical therapists, may require us to increase utilization of more expensive temporary personnel.

Available Information

Our website address is www.healthsouth.com. We make available through our website the following documents, free of charge: our annual reports (Form 10-K), our quarterly reports (Form 10-Q), our current reports (Form 8-K), and any amendments we file with respect to any such reports promptly after we electronically file such material with, or furnish it to, the SEC. Please note, however, that with the exception of current reports and this annual report, we have not filed periodic reports with the SEC for periods after September 30, 2002, and we have previously cautioned that the financial information contained in previously filed reports should not be relied upon. In addition to the information that is available on our website, you may read and copy any materials we file with or furnish to the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Room 1580, Washington, D.C. 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also maintains a website, www.sec.gov, which includes reports, proxy, and information statements, and other information regarding us and other issuers that file electronically at the SEC.

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RISK FACTORS

Our business, operations, and financial condition are subject to various risks. Some of these risks are described below, and you should take such risks into account in evaluating HealthSouth or any investment decision involving HealthSouth. This section does not describe all risks that may be applicable to our company, our industry, or our business, and it is intended only as a summary of certain material risk factors. More detailed information concerning the risk factors described below is contained in other sections of this annual report.

Risks Related to Pending Governmental Investigations and Litigation

Any adverse outcome of continuing investigations being conducted by the DOJ and other governmental agencies could have a material adverse effect on us.

While we are fully cooperating with the DOJ and other governmental authorities in their investigations, we cannot predict the outcome of those investigations. Such investigations could have a material adverse effect on us, the trading prices of our securities, and our ability to raise additional capital. If we are convicted of a crime, certain contracts and licenses that are material to our operations could be revoked which would materially and adversely affect our business, financial condition, results of operations, and cash flows.

Several lawsuits have been filed against us involving our accounting practices and other related matters and the outcome of these lawsuits may have a material adverse effect on our business, financial condition, results of operations, and cash flows.

A number of class action, derivative, and individual lawsuits have been filed against us, as well as certain of our past and present officers and directors, relating to, among other things, allegations of numerous violations of securities laws. We cannot predict the outcome of these lawsuits. Substantial damages or other monetary remedies assessed against us could have a material adverse effect on our business, financial condition, results of operations, and cash flows. See Item 3, Legal Proceedings, for a discussion of these lawsuits.

Although we have entered into a recent settlement with various government agencies and other parties regarding our participation in federal health care programs, we remain a defendant in litigation relating to our participation in federal health care programs, and the outcome of these lawsuits may have a material adverse effect on our business, financial condition, results of operations, and cash flows.

Qui tam actions brought under the False Claims Act are sealed by the court at the time of filing. The only parties privy to the information contained in the complaint are the relator, the federal government, and the court. Therefore, it is possible that additional qui tam actions have been filed against us that we are unaware of or which we have been ordered by the court not to discuss until the court lifts the seal from the case. Thus, it is possible that we are subject to liability exposure under the False Claims Act based on qui tam actions other than those discussed in this report.

CMS has been granted authority to suspend payments, in whole or in part, to Medicare providers if CMS possesses reliable information that an overpayment, fraud, or willful misrepresentation exists. If CMS suspects that payments are being or have been made as the result of fraud or misrepresentation, CMS may suspend payment at any time without providing us with prior notice. The initial suspension period is limited to 180 days. However, the payment suspension period can be extended almost indefinitely if the matter is under investigation by the OIG or the DOJ. Therefore, we are unable to predict if or when we may be subject to a suspension of payments by the Medicare and/or Medicaid programs, the possible length of the suspension period or the potential cash flow impact of a payment suspension. Any such suspension would adversely impact our business, financial condition, results of operations, and cash flows.

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If the OIG determines we have violated federal laws governing kickbacks and self-referrals, it could impose substantial civil money penalties on us and could seek to exclude our provider entities from participation in the federal health care programs which would severely impact our financial condition and ability to continue operations.

If the OIG determines that we have violated the Anti-Kickback Law, the OIG may commence administrative proceedings to impose penalties under the Civil Monetary Penalties Law of up to three times the amount of damages and $11,000 per claim for each false or fraudulent claim allegedly submitted by us. If the OIG determines that we have violated the federal Stark statute’s general prohibition on physician self-referrals (42 U.S.C. § 1395nn), it may impose a civil money penalty of up to $15,000 per service billed in violation of the statute.

The OIG has been granted the authority to exclude persons or entities from participation in the federal health care programs for a variety of reasons, including: (1) committing an act in violation of the Anti-Kickback Law, (2) submitting a false or fraudulent claim, (3) submitting a claim for services rendered in violation of the physician self-referral statute, or (4) violating any other provision of the Civil Monetary Penalties Law. Thus, if the OIG believes that we have submitted false or fraudulent claims, paid or received kickbacks, submitted claims in violation of the physician self-referral law, or committed any other act in violation of the Civil Monetary Penalties Law, the OIG could move to exclude our provider entities from participation in the federal health care programs.

Limitations of our director and officer liability insurance and potential indemnification obligations could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

As discussed in Item 3, Legal Proceedings, several of our current and former directors and officers have been sued based on allegations that they participated in accounting fraud and other illegal activities. Several of our insurance carriers have filed lawsuits against us and are attempting to have our directors’ and officers’ liability policies that provide coverage for those claims voided or cancelled or have advised us that they do not intend to provide coverage with respect to those pending actions. If the insurance companies are successful in rescinding or denying coverage to us and/or some of our current and former directors and officers, our ability to reach a settlement with plaintiffs in the securities, derivative, and other litigation could be adversely affected. The failure to reach a settlement could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

Under our bylaws and certain indemnification agreements, we may have an obligation to indemnify our current and former officers and directors. The failure of our policies to cover expenses incurred or liabilities imposed in connection with the pending actions against certain of our past and present directors and officers who we may be required to indemnify may have a material adverse effect on our business, financial condition, results of operations, and cash flows.

Risks Related to Our Financial Condition

Our substantial indebtedness may severely limit cash flow available for our operations and could impair our ability to service debt or obtain additional financing, if necessary.

We are highly leveraged. As of December 31, 2004, we had $3.5 billion of long-term debt outstanding, all of which we will need to repay or refinance by 2015, including $675.3 million of which we will need to repay or refinance at various times through 2007 (assuming noteholders exercise their options to require us to repurchase notes in 2007). The substantial amount of payments due on our outstanding debt and other payment obligations could, among other things:

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Our ability to satisfy interest payment obligations on our outstanding debt will depend largely on our future performance. Although we believe we have a solid core business and we have implemented a business plan to position HealthSouth for a successful restructuring, we are subject to numerous contingent liabilities and are subject to prevailing economic conditions and to financial, business, and other factors beyond our control. As a result, we cannot assure you that we will be able to generate sufficient cash flow to service our interest payment obligations under our outstanding debt, or that cash flows, future borrowings, or equity financing will be available for the payment or refinancing of our debt. To the extent we are not successful in repaying or negotiating renewals of our borrowings or in arranging new financing, our business and results of operations will be materially and adversely affected.

We have significant cash obligations relating to government settlements that, in addition to our indebtedness, may limit cash flow available for our operations and could impair our ability to service debt or obtain additional financing, if necessary.

In addition to being highly leveraged, we have significant cash obligations we must meet in the near future as a result of recent settlements with various federal agencies. Specifically, we will be paying the remaining balance of our $325 million settlement in quarterly installments over the next three years to satisfy our obligations under a settlement described in Item 1, Business, “Medicare Program Settlement.” Furthermore, we will pay $100 million to the SEC in five installments over a two year period beginning in the fourth quarter of 2005, as described in Item 1, Business, “SEC Settlement.”

We have determined that our internal controls are currently ineffective. The lack of internal controls could adversely affect our financial condition and ability to carry out our strategic business plan.

As discussed in Item 9A, Controls and Procedures, our new management team, under the supervision and with the participation of our chief executive officer and chief financial officer, conducted an evaluation of the effectiveness of the design and operation of HealthSouth’s internal controls. They concluded that, as of December 31, 2003, HealthSouth’s disclosure controls and procedures were not effective. In addition, based on work to date, our management, including the chief executive officer and chief financial officer, has concluded that, as of December 31, 2003, HealthSouth’s internal control over financial reporting was not effective. In addition, based on our preliminary assessments to date, we have concluded that our internal control over financial reporting as of December 31, 2004 is not effective. Although we have made substantial improvements in our internal controls, if we are unsuccessful in our focused effort to permanently and effectively remedy the weaknesses in our financial reporting mechanisms and internal controls and to establish and maintain effective corporate governance practices, our financial condition and ability to carry out our strategic business plan, our ability to report our financial condition and results of operations accurately and in a timely manner, and our ability to earn and retain the trust of our patients, physician partners, employees, and security holders could be adversely affected.

Risks Related to Our Business

The continuing time, effort, and expense relating to internal and external investigations, the restatement of historical financial statements, and the development and implementation of improved internal controls and procedures, may have an adverse effect on our business.

In addition to the challenges of the various government investigations and extensive litigation we face, our new management team has spent considerable time and effort dealing with internal and external investigations

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involving our historical accounting and internal controls, and in developing and implementing accounting policies and procedures, disclosure controls and procedures, and corporate governance policies and procedures. The significant time and effort spent may have adversely affected our operations and may continue to do so in the future.

Current and prospective investors, patients, physician partners, and employees may react adversely to the restatement of our historical financial statements and our inability to file in a timely manner all of our SEC filings.

Our future success depends in large part on the support of our current and future investors, patients, physician partners, and employees. The restatement of our historical financial statements and our inability to file on a timely basis all of our SEC filings has caused negative publicity about us, has resulted in the delisting of our common stock from the NYSE, and has, and may continue to have, a negative impact on the market price of our securities. In addition, the restatement of our historical financial statements and our inability to file all of our SEC filings in a timely manner could cause current and future patients and physician partners to lose confidence in our company, which may affect their willingness to provide care for us or receive care from us. Finally, employees and prospective employees may factor in these considerations relating to our stability and the value of any equity incentives in their decision-making regarding employment opportunities.

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

We are required to comply with extensive and complex laws and regulations at the federal, state, and local government levels. These laws and regulations relate to, among other things:

In the future, changes in these laws and regulations could subject our current or past practices to allegations of impropriety or illegality or could require us to make changes in our investment structure, facilities, equipment, personnel, services, capital expenditure programs, operating procedures, and contractual arrangements.

If we fail to comply with applicable laws and regulations, we could be subjected to liabilities, including (1) criminal penalties, (2) civil penalties, including monetary penalties and the loss of our licenses to operate one or more of our facilities, and (3) exclusion or suspension of one or more of our facilities from participation in the Medicare, Medicaid, and other federal and state health care programs.

If we fail to comply with our new Corporate Integrity Agreement, we could be subject to severe sanctions.

In December 2004, we entered into a new corporate integrity agreement with the OIG to promote our compliance with the requirements of Medicare, Medicaid, and all other federal health care programs. Under that agreement, which is effective for five years from January 1, 2005, we are subject to certain administrative

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requirements and are subject to review of certain Medicare reimbursement procedures by an Independent Review Organization. Our failure to comply with the material terms of the corporate integrity agreement could lead to suspension or exclusion from further participation in federal health care programs, including Medicare and Medicaid, which currently account for a substantial portion of our revenues. Any of these sanctions would have a material adverse effect on our business, financial condition, results of operations, and cash flows.

Reductions or changes in reimbursement from government or third party payors could adversely affect our operating results.

We derive a substantial portion of our net operating revenues from the Medicare and Medicaid programs. In 2003, 42.7% of our consolidated net operating revenues were derived from Medicare, 2.1% were derived from Medicaid, 31.3% were derived from managed care and other plans, 9.4% were derived from workers’ compensation payors, and 14.5% were derived from other revenue sources. There are increasing pressures from many payors to control health care costs and to reduce or limit increases in reimbursement rates for medical services. Our operating results could be adversely affected by changes in laws or regulations governing the Medicare and Medicaid programs. See this Item, “Sources of Revenue.”

Historically, Congress and some state legislatures have periodically proposed significant changes in the health care system. Many of these changes have resulted in limitations on and, in some cases, significant reductions in the levels of, payments to health care providers for services under many government reimbursement programs. See this Item, “Regulation” for a discussion of potential changes to the health care system that could materially and adversely affect our business, financial condition, results of operations, and cash flows.

In particular, the revised 75% Rule, which is discussed in this Item, “Sources of Revenues,” is the single biggest operating risk we face. Our inpatient division has begun to deny admissions of certain types of patients at several locations in an attempt to ensure compliance with the revised 75% Rule. We project this reduction in census, unless mitigated, will have a materially adverse impact on the inpatient segment’s revenues. We previously estimated that the revised 75% Rule could negatively impact our net operating revenues by $95 million to $100 million in 2005. Our inpatient division is taking steps to mitigate the impact of the revised 75% Rule, and we previously estimated the impact to our net operating revenues to be approximately $50 million to $55 million when our mitigation strategies are taken into consideration. In the second quarter of 2005, as many of our facilities approach the end of their cost reporting years, we have seen a greater than anticipated decline in inpatient volumes, a significant portion of which is attributable to the revised 75% Rule. Accordingly, the financial impact estimated could be greater than previously disclosed.

Our relationships with third-party payors, such as HMOs and PPOs, are generally governed by negotiated agreements. These agreements set forth the amounts we are entitled to receive for our services. We could be adversely affected in some of the markets where we operate if we are unable to negotiate and maintain favorable agreements with third-party payors.

The adoption of more restrictive Medicare coverage policies at the national and/or local levels could have an adverse impact on our ability to obtain Medicare reimbursement for inpatient rehabilitation services.

Medicare providers also can be negatively affected by the adoption of coverage policies, either at the national or local levels, describing whether an item or service is covered and under what clinical circumstances it is considered to be reasonable, necessary, and appropriate. In the absence of a national coverage determination, local Medicare fiscal intermediaries and carriers may specify more restrictive criteria than otherwise would apply nationally. For instance, Cahaba Government Benefit Administrators, the fiscal intermediary for Alabama, has issued a local coverage determination setting forth very detailed criteria it proposes to use in determining the medical appropriateness of services provided by IRFs. We cannot predict whether other Medicare contractors will adopt additional local coverage determinations or other policies or how these will affect us.

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Our facilities face national, regional, and local competition for patients from other health care providers.

We operate in a highly competitive industry. Although we are the largest provider of ambulatory surgery and rehabilitative health care services, and one of the largest providers of outpatient diagnostic services, in the United States, in any particular market we may encounter competition from local or national entities with longer operating histories or other competitive advantages. There can be no assurance that this competition, or other competition which we may encounter in the future, will not adversely affect our business, financial condition, results of operations, or cash flows.

Competition for staffing may increase our labor costs and reduce profitability.

Our operations are dependent on the efforts, abilities, and experience of our management and medical support personnel, such as physical therapists, nurses, and other health care professionals. We compete with other health care providers in recruiting and retaining qualified management and support personnel responsible for the daily operations of each of our facilities. In some markets, the availability of physical therapists, nurses, and other medical support personnel has become a significant operating issue to health care providers. This shortage may require us to continue to enhance wages and benefits to recruit and retain qualified personnel or to hire more expensive temporary personnel. We also depend on the available labor pool of semi-skilled and unskilled employees in each of the markets in which we operate. If our labor costs increase, we may not be able to raise rates to offset these increased costs. Because a significant percentage of our revenues consist of fixed, prospective payments, our ability to pass along increased labor costs is limited. Our failure to recruit and retain qualified management, physical therapists, nurses, and other medical support personnel, or to control our labor costs, could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

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

Our business depends upon the efforts of the physicians who provide health care services at our facilities and/or refer their patients to our facilities and the strength of our relationships with these physicians. Each physician referring or treating patients at one of our facilities may also practice at other facilities not owned by us.

At each of our facilities, our business could be adversely affected if a significant number of key physicians or a group of physicians:

Our stock trades on the over-the-counter “Pink Sheets” market and our stock price may be volatile.

In March 2003, the NYSE delisted our common stock. Shortly thereafter, our stock began trading in the over-the-counter “Pink Sheets” market under the symbol HLSH. Although we plan to apply for listing of our stock on either the NYSE or the NASDAQ in 2006, we may not be successful in that effort. Our stock price has been volatile during the past two years and may continue to be volatile for the foreseeable future.

Our principal executive offices are located in Birmingham, Alabama, where we own and maintain a headquarters building of approximately 200,000 square feet located on an 85-acre corporate campus. In addition to our headquarters building, we lease or own nearly 1,300 facilities through various consolidated entities to

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support our operations. Our leases generally have initial terms of 5 years, but range from 1 to 99 years. Most of our leases contain options to extend the lease period for up to 5 additional years. Our consolidated entities are sometimes responsible for property taxes, property and casualty insurance, and routine maintenance expenses. Other than our headquarters campus, our acute care hospital located in Birmingham, Alabama, and our “Digital Hospital” described below, none of our other properties is material to our business. Each of our material properties is used by our corporate and other segment, except our Digital Hospital, which is not in use but is held by our corporate and other segment. We have pledged all the property of HealthSouth Corporation as collateral to secure the performance of our obligations under our amended and restated credit agreement. For additional information about our amended and restated credit agreement, see Note 10, Long-term Debt, to our accompanying consolidated financial statements.

We also currently own, and from time to time may acquire, certain other improved and unimproved real properties in connection with our business. See Note 7, Property and Equipment, to our accompanying consolidated financial statements for more information about the properties we own and certain related indebtedness.

Over the past 18 months we have sold approximately $40 million in land and buildings, not including properties sold in connection with the sale of operating facilities. We sold one acute care hospital in June 2001 and another in October 2003. We are currently exploring a sale of our only remaining acute care hospital, which has 219 licensed beds and is located in Birmingham, Alabama, as well as our “Digital Hospital,” which is currently under construction in Birmingham, Alabama. As of December 31, 2004, we had invested $190 million in the Digital Hospital project and estimate it will require an additional $200 million to complete. We have not signed a definitive agreement with respect to the sale of either hospital and there can be no assurance any sale will take place. See Note 7, Property and Equipment, to our accompanying consolidated financial statements, for a discussion of the significant impairment charge we recognized in 2003 relating to the Digital Hospital, as well as the additional impairment charge we plan to recognize in 2004.

Our headquarters, facilities, and other properties are suitable for their respective uses and are, in general, adequate for our present needs. Our properties are subject to various federal, state, and local statutes and ordinances regulating their operation. Management does not believe that compliance with such statutes and ordinances will materially affect our business, financial condition, or results from operations.

Investigations and Proceedings Commenced by the SEC, the Department of Justice, and Other Governmental Authorities

In September 2002, the Securities and Exchange Commission (the “SEC”) notified us that it was conducting an investigation of trading in our securities that occurred prior to an August 27, 2002 press release concerning the impact of new Medicare billing guidance on our expected earnings. On February 5, 2003, the United States District Court for the Northern District of Alabama issued a subpoena requiring us to provide various documents in connection with a criminal investigation of us and certain of our directors, officers, and employees being conducted by the United States Attorney for the Northern District of Alabama. On March 18, 2003, agents from the Federal Bureau of Investigation (the “FBI”) executed a search warrant at our headquarters in connection with the United States Attorney’s investigation and were provided access to a number of financial records and other materials. The agents simultaneously served a grand jury subpoena on us on behalf of the criminal division of the Department of Justice (“DOJ”). Some of our employees also received subpoenas.

On March 19, 2003, the SEC filed a lawsuit captioned Securities and Exchange Commission v. HealthSouth Corp., et al., CV-03-J-0615-S, in the United States District Court for the Northern District of Alabama. The complaint alleges that we overstated earnings by at least $1.4 billion since 1999, and that this overstatement

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occurred because our then-Chairman and Chief Executive Officer, Richard M. Scrushy, insisted that we meet or exceed earnings expectations established by Wall Street analysts.

The SEC states in its complaint that our actions and those of Mr. Scrushy violated and/or aided and abetted violations of the antifraud, reporting, books-and-records, and internal controls provisions of the federal securities laws. Specifically, the SEC charged us with violations of Section 17(a) of the Securities Act of 1933 (the “Securities Act”) and Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Securities Exchange Act of 1934 (the “Exchange Act”), and Exchange Act Rules 10b-5, 12b-20, 13a-1, and 13a-13. The SEC sought a permanent injunction against us, civil money penalties, disgorgement of ill-gotten gains and losses avoided, as well as prejudgment interest. On March 19, 2003, we consented to the entry of an order by the court that (1) required us to place in escrow all extraordinary payments (whether compensation or otherwise) to our directors, officers, partners, controlling persons, agents, and employees, (2) prohibited us and our employees from destroying documents relating to our financial activities and/or the allegations in the SEC’s lawsuit against us and Mr. Scrushy, and (3) provided for expedited discovery in the lawsuit brought by the SEC. In an order entered May 7, 2003, the court stayed the SEC’s lawsuit pending the resolution of any criminal charges against Mr. Scrushy.

On June 6, 2005, the SEC approved a settlement (the “SEC Settlement”) with us relating to this lawsuit. Under the terms of the SEC Settlement, we have agreed, without admitting or denying the SEC’s allegations, to be enjoined from future violations of certain provisions of the securities laws. We have also agreed to pay a $100 million civil penalty and disgorgement of $100 to the SEC in installments over two years, beginning in the fourth quarter of 2005. We consented to the entry of a final judgment (which judgment was entered by the United States District Court for the Northern District of Alabama, Southern Division) to implement the terms of the SEC Settlement. See Item 1, Business, “SEC Settlement,” for additional information about the SEC Settlement. Mr. Scrushy remains a defendant in the lawsuit.

On November 4, 2003, Mr. Scrushy was charged in federal court on 85 counts of wrongdoing in connection with his actions while employed by us. A superseding indictment of 58 counts, released on September 29, 2004, added charges of obstruction of justice and perjury while consolidating and eliminating some of the 85 counts of conspiracy, mail fraud, wire fraud, securities fraud, false statements, false certifications, and money laundering that were previously charged. The superseding indictment also seeks the forfeiture of $278 million in property from Mr. Scrushy allegedly derived from his offenses. The trial of Mr. Scrushy on the charges set forth in the superseding indictment began on January 25, 2005 and is ongoing. Some of the charges have been dismissed by the court.

On April 10, 2003, the DOJ’s civil division notified us that it was expanding its investigation (which began with the lawsuit United States ex rel. Devage v. HealthSouth Corp., et al., C.A. No. SA-98-EA-0372-FV, filed in the United States District Court for the Western District of Texas, as discussed in Item 1) into allegations of fraud associated with Medicare cost reports submitted by us for fiscal years 1995 through 2002. We subsequently received subpoenas from the Office of Inspector General (the “OIG”) of the United States Department of Health and Human Services and requests from the DOJ’s civil division for documents and other information regarding this investigation. As described in Item 1, “Medicare Program Settlement,” on December 30, 2004, we announced that we had entered into a global settlement agreement with the DOJ’s civil division and other parties to resolve the primary claims made in the Devage litigation, although the DOJ’s civil division continues to review certain self-disclosures made by us to the OIG.

In the summer of 2003, we discovered certain irregular payments made to a foreign official under a consulting agreement entered into in connection with an October 2000 agreement between us and the Sultan Bin Abdul Aziz Foundation to manage an inpatient rehabilitation hospital in Riyadh, Saudi Arabia. We notified the DOJ immediately, and we have cooperated fully with the investigation. One former executive pled guilty to charges of wire fraud in connection with the irregular payments, and another former executive pled guilty to charges of making a false statement to government investigators in connection with the investigation. Two additional former executives have been acquitted of charges that they participated in the fraud. We terminated the

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October 2000 agreement and entered into a new agreement, effective January 1, 2004, to manage the Riyadh facility. Effective October 2004, we terminated our relationship with the Sultan Bin Abdul Aziz Foundation and the Riyadh facility entirely.

At least 17 of our former officers, including all five of our former chief financial officers, have agreed to plead guilty to federal criminal charges filed in connection with the investigations described above. These individuals pled guilty to a variety of charges, including securities fraud, accounting fraud, filing false tax returns, making a false statement to governmental authorities, falsifying books and accounts, wire fraud, conspiracy, and falsely certifying financial information with the SEC.

Securities Litigation

On June 24, 2003, the United States District Court for the Northern District of Alabama consolidated a number of separate securities lawsuits filed against us under the caption In re HealthSouth Corp. Securities Litigation, Master Consolidation File No. CV-03-BE-1500-S (the “Consolidated Securities Action”). The Consolidated Securities Action included two prior consolidated cases (In re HealthSouth Corp. Securities Litigation, CV-98-J-2634-S and In re HealthSouth Corp. 2002 Securities Litigation, Consolidated File No. CV-02-BE-2105-S) as well as six lawsuits filed in 2003. Including the cases previously consolidated, the Consolidated Securities Action comprised over 40 separate lawsuits. The court divided the Consolidated Securities Action into two subclasses:

On January 8, 2004, the plaintiffs in the Consolidated Securities Action filed a consolidated class action complaint. The complaint names us as a defendant, as well as more than 30 of our current and former employees, officers and directors, the underwriters of our debt securities, and our former auditor. The complaint alleges, among other things, (1) that we misrepresented or failed to disclose certain material facts concerning our business and financial condition and the impact of the Balanced Budget Act of 1997 on our operations in order to artificially inflate the price of our common stock, (2) that from January 14, 2002 through August 27, 2002, we misrepresented or failed to disclose certain material facts concerning our business and financial condition and the impact of the changes in Medicare reimbursement for outpatient therapy services on our operations in order to artificially inflate the price of our common stock, and that some of the individual defendants sold shares of such stock during the purported class period, and (3) that Richard M. Scrushy instructed certain former senior officers and accounting personnel to materially inflate our earnings to match Wall Street analysts’ expectations, and that senior officers of HealthSouth and other members of a self-described “family” held meetings to discuss the means by which our earnings could be inflated and that some of the individual defendants sold shares of our common stock during the purported class period. The consolidated class action complaint asserts claims under Sections 11, 12(a)(2) and 15 of the Securities Act, and claims under Sections 10(b), 14(a), 20(a) and 20A of the Exchange Act.

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We have moved to dismiss in part the claims against us. We continue discussions with the parties to this litigation and await a ruling on the identity of the lead plaintiff and lead counsel in the Stockholder Securities Action.

On March 17, 2004, an individual securities fraud action captioned Amalgamated Gadget, L.P. v. HealthSouth Corp., 4-04CV-198-A, was filed in the United States District Court for the Northern District of Texas. The complaint made allegations similar to those in the Consolidated Securities Action and asserted claims under the federal securities laws and Texas state law based on the plaintiff’s purchase of $24 million in face amount of 3.25% convertible debentures. The court denied our motion to transfer the action to the United States District Court for the Northern District of Alabama, and also denied our motion to dismiss. This action has been settled by the agreement of the parties and dismissed with prejudice.

On November 24, 2004, an individual securities fraud action captioned Burke v. HealthSouth Corp., et al., 04-B-2451 (OES), was filed in the United States District Court of Colorado against us, some of our former directors and officers, and our former auditors. The complaint makes allegations similar to those in the Consolidated Securities Action and asserts claims under the federal securities laws and Colorado state law based on plaintiff’s alleged receipt of unexercised options and his open-market purchases of our stock. By order dated May 3, 2005, the action was transferred to the United States District Court for the Northern District of Alabama, where it remains pending.

Derivative Litigation

Between 1998 and 2004, a number of lawsuits purporting to be derivative actions (i.e., lawsuits filed by shareholder plaintiffs on our behalf) were filed in several jurisdictions, including the Circuit Court for Jefferson County, Alabama, the Delaware Court of Chancery, and the United States District Court for the Northern District of Alabama. Most of these lawsuits have been consolidated as described below:

When originally filed, the primary allegations in the Tucker case involved self-dealing by Richard M. Scrushy and other insiders through transactions with various entities allegedly controlled by Mr. Scrushy. The complaint was amended four times to add additional defendants and include claims of accounting fraud,

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improper Medicare billing practices, and additional self-dealing transactions. The Second Amended Complaint, filed on March 21, 2003, added Ernst & Young LLP as a defendant and alleged it was liable for negligently, wantonly, and/or recklessly failing to perform its professional obligations as an independent auditor. The Third Amended Complaint, filed on August 8, 2003, added UBS as a defendant and alleged that it was liable for breaching its fiduciary duties to us and for aiding and abetting the accounting fraud by “falsely promoting” our stock despite knowledge of inflated financial information. The other consolidated cases contain similar claims.

On September 8, 2003, a derivative lawsuit captioned Teachers Retirement Sys. of Louisiana v. Scrushy, C.A. No. 20529-NC, was filed in the Delaware Court of Chancery. The complaint contains allegations similar to those made in the Tucker case, class claims, as well as a request for relief seeking an order compelling us to hold an annual meeting of stockholders. On December 2, 2003, we announced a settlement of the plaintiff’s claims seeking an annual meeting of stockholders. The Court of Chancery has stayed the remaining claims in favor of earlier-filed litigation in Alabama. This case was not consolidated with In re HealthSouth Corp. Shareholders Litigation.

On November 19, 2004, a derivative lawsuit captioned Campbell v. HealthSouth Corp., Scrushy, et al., CV-04-6985, was filed in Circuit Court of Jefferson County, Alabama, alleging that we wrongfully refused to file with the Internal Revenue Service refund requests for overpayment of taxes and seeking an order allowing the plaintiff to file claims for refund of excess tax paid by us. This suit was filed just prior to the voluntary dismissal of a similar suit brought by the same plaintiff in the United States District Court for the Northern District of Alabama. We have informed the plaintiff that we intend to file any appropriate applications for tax refunds within the applicable time periods, consistent with the advice of our tax counsel. This lawsuit was not consolidated with the Tucker case because it involves different claims. It is still pending.

Litigation by and Against Former Independent Auditors

On March 18, 2005, Ernst & Young LLP filed a lawsuit captioned Ernst & Young LLP v. HealthSouth Corp., CV-05-1618, in the Circuit Court of Jefferson County, Alabama. The complaint asserts that the filing of the claims against us was for the purpose of suspending any statute of limitations applicable to those claims. The complaint alleges that we provided Ernst & Young LLP with fraudulent management representation letters, financial statements, invoices, bank reconciliations, and journal entries in an effort to conceal accounting fraud. Ernst & Young LLP claims that as a result of our actions, Ernst & Young LLP’s reputation has been injured and it has and will incur damages, expense, and legal fees. Ernst & Young LLP seeks recoupment and setoff of any recovery against Ernst & Young LLP in the Tucker case, as well as litigation fees and expenses, damages for loss of business and injury to reputation, and such other relief to which it may be entitled. On April 1, 2005, we answered Ernst & Young LLP’s claims and asserted counterclaims alleging, among other things, that from 1996 through 2002, when Ernst & Young LLP served as our independent auditors, Ernst & Young LLP acted recklessly and with gross negligence in performing its duties, and specifically that Ernst & Young LLP failed to perform reviews and audits of our financial statements with due professional care as required by law and by its contractual agreements with us. Our counterclaims further allege that Ernst & Young LLP either knew of or, in the exercise of due care, should have discovered and investigated the fraudulent and improper accounting practices being directed by Richard M. Scrushy and certain other officers and employees, and should have reported them to our board of directors and the Audit Committee. The counterclaims seek compensatory and punitive damages, disgorgement of fees received from us by Ernst & Young LLP, and attorneys’ fees and costs.

ERISA Litigation

In 2003, six lawsuits were filed in the United States District Court for the Northern District of Alabama against us and some of our current and former officers and directors alleging breaches of fiduciary duties in connection with the administration of our Employee Stock Benefit Plan (the “ESOP”). These lawsuits have been consolidated under the caption In re HealthSouth Corp. ERISA Litigation, Consolidated Case No. CV-03-BE-1700-S. The plaintiffs filed a consolidated complaint on December 19, 2003 that alleges, generally, the

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fiduciaries to the ESOP breached their duties to loyally and prudently manage and administer the ESOP and its assets in violation of sections 404 and 405 of the Employee Retirement Income Security Act of 1974, 29 U.S.C. § 1001 et seq. (“ERISA”), by failing to monitor the administration of the ESOP, failing to diversify the portfolio held by the ESOP, and failing to provide other fiduciaries with material information about the ESOP. The plaintiffs seek actual damages including losses suffered by the plan, imposition of a constructive trust, equitable and injunctive relief against further alleged violations of ERISA, costs pursuant to 29 U.S.C. § 1132(g), and attorneys’ fees. The plaintiffs also seek damages related to losses under the plan as a result of alleged imprudent investment of plan assets, restoration of any profits made by the defendants through use of plan assets, and restoration of profits that the plan would have made if the defendants had fulfilled their fiduciary obligations. The parties to this litigation are actively involved in settlement negotiations.

Insurance Coverage Litigation

In 2003, approximately 14 insurance companies filed complaints in state and federal courts in Alabama, Delaware, and Georgia alleging that the insurance policies issued by those companies to us and/or some of our directors and officers should be rescinded on grounds of fraudulent inducement. The complaints also seek a declaration that we and/or some of our current and former directors and officers are not covered under various insurance policies. These lawsuits challenge the majority of our director and officer liability policies, including our primary director and officer liability policy in effect for the claims at issue. Actions filed by insurance companies in the United States District Court for the Northern District of Alabama were consolidated for pretrial and discovery purposes under the caption In re HealthSouth Corp. Insurance Litigation, Consolidated Case No. CV-03-BE-1139-S. Three lawsuits filed by insurance companies in the Circuit Court of Jefferson County, Alabama have been consolidated with the Tucker case for discovery and other pretrial purposes. Cases related to insurance coverage that were filed in Georgia and Delaware have been dismissed. We have filed counterclaims against a number of the plaintiffs in these cases alleging, among other things, bad faith for wrongful failure to provide coverage.

Litigation by Former Officers

Richard M. Scrushy filed two lawsuits against us in the Delaware Court of Chancery. One lawsuit, captioned Scrushy v. HealthSouth Corp., C.A. No. 20357-NC, filed on June 10, 2003, sought indemnification and advancement of Mr. Scrushy’s legal fees. The other lawsuit, captioned Scrushy v. Gordon, et al., C.A. No. 20375, filed June 16, 2003, named us and our then-current directors as defendants and petitioned the court to enjoin the defendants from excluding Mr. Scrushy from board meetings and from conducting the business of HealthSouth exclusively through the meetings of the Special Committee. The second lawsuit also sought access to certain information, including meetings of the Special Committee. Both lawsuits were voluntarily dismissed without prejudice.

On August 22, 2003, Anthony Tanner, our former Secretary and Executive Vice President—Administration and Secretary, filed a petition in the Circuit Court of Jefferson County, Alabama, captioned In re Tanner, CV-03-5378, seeking permission to obtain certain information through the discovery process prior to filing a lawsuit. That petition was voluntarily dismissed with prejudice on August 11, 2004. On December 29, 2004, Mr. Tanner filed a lawsuit in the Circuit Court of Jefferson County, Alabama, captioned Tanner v. HealthSouth Corp., CV-04-7715, alleging that we breached his employment contract by failing to pay certain retirement benefits. The complaint requests damages, a declaratory judgment, and a preliminary injunction to require payment of past due amounts under the contract and reinstatement of the claimed retirement benefits.

On December 23, 2003, Jason Hervey, one of our former officers, filed a lawsuit captioned Hervey v. HealthSouth Corp., et al., CV-03-8031, in the Circuit Court of Jefferson County, Alabama. The complaint sought compensatory and punitive damages in connection with our alleged breach of his employment contract. We settled this lawsuit in 2005.

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Litigation Against Former Officers

On June 10, 2004, we filed a collection action in the Circuit Court of Jefferson County, Alabama, captioned HealthSouth Corp. v. James Goodreau, CV-04-3619, to collect unpaid loans in the original principal amount of $55,500 that we made to James A. Goodreau, our former Director of Corporate Security, while he was a HealthSouth employee. Mr. Goodreau has asserted counterclaims against us seeking monetary damages in an unspecified amount and equitable relief based upon his contention that he was promised lifetime employment with us by Mr. Scrushy. This case is still pending.

On August 30, 2004, we filed a collection action in the United States District Court for the Northern District of Alabama, captioned HealthSouth Corp. v. Daniel J. Riviere, CV-04-CO-2592-S, to collect unpaid loans in the original principal amount of $3,163,421 that we made to Daniel J. Riviere, our former President – Ambulatory Services Division, while he was a HealthSouth employee. Mr. Riviere filed a six-count counterclaim against us on April 5, 2005 seeking (1) severance benefits exceeding $2 million under a written employment agreement dated March 18, 2003, (2) a declaratory judgment that the non-compete clause in his employment agreement is void, (3) damages in an unspecified amount based on stock allegedly purchased and held by him in reliance on misrepresentations made by Richard M. Scrushy, (4) $500,000 in lost profits based allegedly on us forcing him to sell shares of our common stock after he was terminated, (5) damages in an unspecified amount based on our alleged conversion of the cash value of certain insurance policies after his termination, and (6) set-off of any award from his counterclaim against unpaid loans we made to him. On April 5, 2005, Mr. Riviere commenced a Chapter 7 bankruptcy case in the U.S. Bankruptcy Court for the Northern District of Florida, Case No. 05-30718-LMK, and this lawsuit is stayed pending resolution of the bankruptcy proceedings.

Litigation by Former Medical Director

On April 5, 2001, Helen M. Schilling, one of our former medical directors, filed a lawsuit captioned Helen M. Schilling, M.D. v. North Houston Rehabilitation Associates d/b/a HealthSouth Houston Rehabilitation Institute, Romano Rehabilitation Hospital, Inc. and Anne Leon, Cause No. 01-04-02243-CV, in the 410^th Judicial District Court of Montgomery County, Texas. The plaintiff claimed, among other things, that we wrongfully terminated her medical director agreement. On November 5, 2003, after a jury trial, the court entered a final judgment awarding the plaintiff $465,000 in compensatory damages and $865,000 in exemplary damages. We appealed the judgment and settled the case while on appeal in 2005.

Certain Regulatory Actions

The False Claims Act, 18 U.S.C. § 287, allows private citizens, called “relators,” to institute civil proceedings alleging violations of the False Claims Act. These so-called qui tam, or “whistleblower,” cases are sealed by the court at the time of filing. The only parties privy to the information contained in the complaint are the relator, the federal government, and the presiding court. We recently settled one qui tam lawsuit, Devage, which is discussed in Item 1. We are aware of two other qui tam lawsuits, Mathews and Colbert, which are discussed below. It is possible that additional qui tam lawsuits have been filed against us and that we are unaware of such filings or have been ordered by the presiding court not to discuss or disclose the filing of such lawsuits. Thus, we may be subject to liability exposure under one or more undisclosed qui tam cases brought pursuant to the False Claims Act.

On April 1, 1999, a plaintiff relator filed a lawsuit captioned United States ex rel. Mathews v. Alexandria Rehabilitation Hospital, CV-99-0604, in the United States District Court for the Western District of Louisiana. On February 29, 2000, the United States elected not to intervene in the lawsuit. The complaint alleged, among other things, that we filed fraudulent reimbursement claims under the Medicare program on a nationwide basis. The district court dismissed the False Claims Act allegations of two successive amended complaints. However, the district court’s dismissal of the third amended complaint with prejudice was partially reversed by the United States Court of Appeals for the Fifth Circuit on October 22, 2002. The case was remanded to the district court,

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and our subsequent motion to dismiss was denied on February 21, 2004. The case will proceed into discovery on False Claims Act allegations concerning one HealthSouth facility during a specific timeframe.

On January 30, 2001, a plaintiff relator filed a lawsuit captioned United States ex rel. Colbert v. Blue Cross and Blue Shield of Alabama and HealthSouth Corp., CV-01-C-0292-S, in the United States District Court for the Northern District of Alabama. The lawsuit, in which the United States did not intervene, alleged, among other things, that we conspired with Blue Cross and Blue Shield of Alabama (“Blue Cross”) to hinder Blue Cross’ investigative functions in administering the Medicare program by having Blue Cross terminate, on a pretextual basis, the relator’s employment with Blue Cross. The complaint also claimed that we conspired with Blue Cross to (1) violate the whistleblower retaliation provision of the False Claims Act by having Blue Cross terminate the relator’s employment and (2) have certain unidentified false claims allowed or paid by Blue Cross under the Medicare program. The parties filed a joint stipulation of dismissal with prejudice and the case has been dismissed.

Americans with Disabilities Act Litigation

On April 19, 2001 a nationwide class action now captioned Michael Yelapi, et al. v. St. Petersburg Surgery Center, et al., Case No:8:01-CV-787-T-17EAJ, was filed in the United States District Court for the Middle District of Florida alleging violations of the Americans with Disabilities Act, 42 U.S.C. § 12181, et seq. (the “ADA”) and the Rehabilitation Act of 1973, 92 U.S.C. § 792 et seq. (the “Rehabilitation Act”) at our facilities. The complaint alleges violations of the ADA and Rehabilitation Act for the purported failure to remove barriers and provide accessibility to our facilities, including reception and admitting areas, signage, restrooms, phones, paths of access, elevators, treatment and changing rooms, parking, and door hardware. As a result of these alleged violations, the plaintiffs are seeking an injunction ordering that we make necessary modifications to achieve compliance with the ADA and the Rehabilitation Act, as well as attorneys’ fees. We have entered into a settlement agreement with the plaintiffs that would require us to correct any deficiencies under the ADA and the Rehabilitation Act at all of our facilities. We are awaiting an order approving the settlement agreement from the court.

General Medicine, P.C. and Meadowbrook Actions

Pursuant to a Plan and Agreement of Merger dated February 17, 1997, Horizon/CMS Healthcare Corporation (“Horizon/CMS”) became a wholly-owned subsidiary of HealthSouth Corporation. At the time of the merger, there was pending against Horizon/CMS in the United States District Court for the Eastern District of Michigan a lawsuit captioned General Medicine, P.C. v. Horizon/CMS Healthcare Corporation, CV-96-72624. The complaint alleged that Horizon/CMS wrongfully terminated a contract with General Medicine, P.C. (“General Medicine”) for the provision of medical directorship services to long-term care facilities owned and/or operated by Horizon/CMS. Effective December 31, 2001, while this litigation was pending, we sold all of our stock in Horizon/CMS to Meadowbrook Healthcare Corporation (“Meadowbrook”) pursuant to a Stock Purchase Agreement dated November 2, 2001. On May 3, 2004, Horizon/CMS consented to the entry of a $376 million final judgment in favor of General Medicine (the “Consent Judgment”). At the time of the Consent Judgment, we had no ownership or other interest in Horizon/CMS.

On August 16, 2004, General Medicine filed a lawsuit captioned General Medicine, P.C. v. HealthSouth Corp., CV-04-958, in the Circuit Court of Shelby County, Alabama, seeking to recover the amount of the Consent Judgment from us. The complaint alleges that while Horizon/CMS was a wholly-owned subsidiary of HealthSouth Corporation and General Medicine was an existing creditor of Horizon/CMS, we caused Horizon/CMS to transfer assets to us thereby rendering Horizon/CMS insolvent and unable to pay its creditors. The complaint asserts that these transfers were made for less than a reasonably equivalent value and/or with the actual intent to defraud creditors of Horizon/CMS, including General Medicine, in violation of the Alabama Uniform Fraudulent Transfer Act. General Medicine’s complaint requests relief including the avoidance of the subject

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transfers of assets, attachment of the assets transferred to us, appointment of a receiver over the transferred properties, and a monetary judgment for the value of properties transferred.

On February 28, 2005, the Circuit Court of Shelby County, Alabama entered an order transferring the General Medicine case to the Circuit Court of Jefferson County, Alabama, where it was assigned case number CV-05-1483. On April 28, 2005, we filed an “Answer and Third-Party Complaint” denying liability and joining Meadowbrook as a third-party defendant in the lawsuit. In our Third-Party Complaint, we seek a judgment declaring that Meadowbrook is contractually obligated under the Stock Purchase Agreement dated November 2, 2001, to indemnify us and hold us harmless against the claims asserted by General Medicine in its complaint. Meadowbrook has filed a declaratory judgment action against us in the Circuit Court of Shelby County, Alabama, captioned Meadowbrook Healthcare Corporation v. HealthSouth Corp., CV-04-1131, seeking a declaration that it is not contractually obligated to indemnify us against General Medicine’s complaint. On May 9, 2005, the Circuit Court of Shelby County, Alabama entered an order transferring the Meadowbrook case to the Circuit Court of Jefferson County, Alabama, where it was assigned case number CV-05-3042. We have filed a Motion to Consolidate the General Medicine and Meadowbrook cases.

For additional information about Meadowbrook, see Note 7, Property and Equipment, to the accompanying consolidated financial statements.

Massachusetts Real Estate Actions

On February 3, 2003, HRPT Properties Trust (“HRPT”) filed a lawsuit against Senior Residential Care/North Andover, Limited Partnership (“SRC”) in the Land Court for the Commonwealth of Massachusetts captioned HRPT Properties Trust v. Senior Residential Care/North Andover, Limited Partnership, Misc. Case No. 287313, in which it claimed an ownership interest in certain parcels of real estate in North Andover, Massachusetts and alleged that SRC unlawfully occupied and made use of those properties. On March 17, 2003, we (and our subsidiary, Greenery Securities Corp.) moved to intervene in this case claiming ownership of the disputed property pursuant to an agreement that involved the conveyance of five nursing homes. We seek to effect a transfer of title to the disputed property by HRPT to us or our nominee.

On April 16, 2003, Senior Housing Properties Trust (“SNH”) and its wholly owned subsidiary, HRES1 Properties Trust (“HRES1”), filed a lawsuit against us in Land Court for the Commonwealth of Massachusetts captioned Senior Housing Properties Trust and HRES1 Properties Trust v. HealthSouth Corporation, Misc. Case No 289182, seeking reformation of a lease pursuant to which we, through subsidiaries, operate the Braintree Rehabilitation Hospital in Braintree, Massachusetts and the New England Rehabilitation Hospital in Woburn, Massachusetts. HRES1 and SNH allege that certain of our representatives made false statements regarding our financial condition, thereby inducing HRES1 to enter into lease terms and other arrangements to which it would not have otherwise agreed. HRES1 and SNH have since amended their complaint to add claims for rescission and damages for fraud. HRES1 and SNH seek to reform the lease to increase the annual rent from $8.7 million to $10.3 million, to increase the repurchase option price at the end of the lease term to $80.3 million from $40 million, and to change the lease term to expire on January 1, 2006 instead of December 31, 2011. We filed an answer to the complaint and amended complaint denying the allegations, and we asserted claims against HRPT and counterclaims against SNH and HRES1 for breach of contract, reformation, and fraud based on the failure to convey title to the property in North Andover. We also seek damages incurred as a result of that failure to convey.

The two actions in the Land Court have been consolidated for all purposes, and the parties are still in the discovery phase of the proceedings. A trial will be scheduled after December 1, 2005.

In a related action, on November 2, 2004, we filed a lawsuit in the Commonwealth of Massachusetts, Middlesex County Superior Court, captioned HealthSouth Corporation v. HRES1 Properties Trust, Case No 04-4345, in response to our receipt of a notice from HRES1 Properties Trust (“HRES1”) purporting to

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terminate our lease governing the Braintree Rehabilitation Hospital in Braintree, Massachusetts and the New England Rehabilitation Hospital in Woburn, Massachusetts due to our alleged failure to furnish quarterly and annual financial information pursuant to the terms of the lease. In the lawsuit, we seek a declaration that we are not in default of our obligations under the lease, as well as an injunction preventing HRES1 from terminating the lease, taking possession of the property on which the hospitals and facilities are located, and assuming or acquiring the hospital businesses and any licenses related thereto. We filed an amended complaint asserting violations of the Massachusetts unfair and deceptive business practices statute. On November 8, 2004, HRES1 and SNH, its parent, filed a counterclaim seeking a declaration that it lawfully terminated the lease and an order requiring us to use our best efforts to transfer the licenses for the hospitals and to continue to manage the hospitals during the time necessary to effect such transfer. The case is currently pending.

Other Litigation

On September 17, 1998, John Darling, who was one of the federal False Claims Act relators in the now-settled Devage case (see discussion in Item 1), filed a lawsuit captioned Darling v. HealthSouth Sports Medicine & Rehabilitation, et al., 98-6110-CI-20, in the Circuit Court for Pinellas County, Florida. The complaint alleges that Mr. Darling was injured while receiving physical therapy during a 1996 visit to a HealthSouth outpatient rehabilitation facility in Clearwater, Florida. The complaint was amended in December 2004 to add a punitive damage claim. This amended complaint alleges that fraudulent misrepresentations and omissions by us resulted in the injury to Mr. Darling. We recently participated in an unsuccessful court-ordered mediation. The case is scheduled for trial in July 2005.

We have been named as a defendant in two lawsuits brought by individuals in the Circuit Court of Jefferson County, Alabama, Nichols v. HealthSouth Corp., CV-03-2023, filed March 28, 2003, and Hilsman v. Ernst & Young, HealthSouth Corp., et al., CV-03-7790, filed December 12, 2003. The plaintiffs allege that we, some of our former officers, and our former auditor engaged in a scheme to overstate and misrepresent our earnings and financial condition. The plaintiffs seek compensatory and punitive damages. On March 24, 2003, a lawsuit captioned Warren v. HealthSouth Corp., et al., CV-03-5967, was filed in the Circuit Court of Montgomery County, Alabama. The lawsuit, which claims damages for the defendants’ alleged negligence, wantonness, fraud and breach of fiduciary duty, was transferred to the Circuit Court of Jefferson County, Alabama. Each of the lawsuits described in this paragraph has been consolidated with the Tucker case for discovery and other pretrial purposes.

On June 30, 2004, two physical therapy providers in New Jersey filed a class action lawsuit captioned William Weiss Physical Therapy, et al., v. HealthSouth Corporation, et al., Docket No. BER-L-10218-04 (N.J. Super.) in the Superior Court of New Jersey. The nine count complaint alleges certain unfair trade practices in offering physical therapy services in violation of the New Jersey Physical Therapy Licensing Act of 1983. This case has been dismissed with prejudice.

On May 13, 2003, Plano Hospital Investors, Inc. (“Plano”) filed a complaint captioned Plano Hospital Investors, Inc., et al., v. HealthSouth Corp., et al., Cause No. 219-1416-03, in the 219th Judicial District Court of Collin County, Texas. Plano is a limited partner in Collin County Rehab Associates Limited Partnership, a partnership in which we, through wholly owned subsidiaries, are the general partner and hold limited partner interests. Plano alleges that we conducted unauthorized and improper sweeps of partnership funds into a HealthSouth centralized cash management account instead of a partnership account, that we improperly received late partnership distributions, and that the predecessor general partner took a negative capital contribution improperly increasing its interest, and upon the sale of that interest to us, our interest, in the partnership. The plaintiff seeks injunctive relief and unspecified damages. The parties to this lawsuit are currently engaged in settlement negotiations.

On December 28, 2004, we commenced a collection action in the Circuit Court of Jefferson County, Alabama, captioned HealthSouth Medical Center, Inc. v. Neurological Surgery Associates, P.C., CV-04-7700, to

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collect unpaid loans in the original principal amount of $275,000 made to Neurological Surgery Associates, P.C. (“NSA”), pursuant to a written Practice Guaranty Agreement. The purpose of the loans was to enable NSA to employ a physician who would bring necessary specialty skills to patients served by both NSA and our acute-care hospital in Birmingham, Alabama. NSA has asserted counterclaims that we breached verbal promises to lease space and employees from NSA, to pay NSA for billing and coding services performed by NSA on behalf of the subject physician-employee, and to pay NSA to manage the subject physician-employee.

On April 15, 2004, Klemett L. Belt, Jr. filed a complaint captioned Belt v. HealthSouth Corp., CV-2004-02517, in the Second Judicial District Court of Bernalillo County, New Mexico. Mr. Belt, a former executive officer and director of Horizon/CMS Healthcare Corporation, entered into a Non-Competition and Retirement Agreement with Horizon/CMS that we subsequently assumed in our acquisition of Horizon/CMS pursuant. Mr. Belt alleged in his complaint that he was entitled to retirement benefits, life insurance and, in the event of certain events of default, liquidated damages pursuant to a contractual provision requiring that the life insurance policies be fully paid and permitting Mr. Belt to receive a lump sum cash payment in lieu of certain unpaid retirement benefits. Mr. Belt alleges that we defaulted under the terms of the agreement due to our nonpayment of insurance policy premium payments beginning on December 31, 2003. As a result of our alleged default under the agreement, Mr. Belt sought liquidated damages in lieu of retirement benefits, payment of insurance policy premiums, amounts sufficient to compensate Mr. Belt for excess income taxes, interest, expenses, attorneys’ fees, and such other relief as may be determined by the court. We entered into a settlement agreement with Mr. Belt pursuant to which we must pay certain damages and relinquish our right to receive returned insurance premiums, if any, under a split dollar arrangement.

On March 16, 2004, we commenced a solicitation of consents seeking approval of proposed amendments to, and waivers under, the indentures governing our 6.875% Senior Notes due 2005, 7.375% Senior Notes due 2006, 7.000% Senior Notes due 2008, 8.500% Senior Notes due 2008, 8.375% Senior Notes due 2011, 7.625% Senior Notes due 2012, and 10.750% Senior Subordinated Notes due 2008 on issues relating to our inability to provide current financial statements and our ability to incur indebtedness under certain circumstances. On May 7, 2004, we announced that we were amending the solicitation of consents from holders of our 10.750% Senior Subordinated Notes due 2008 to further conform the definition of “Refinancing Indebtedness” in the indenture governing our 10.750% Senior Subordinated Notes to the definition in the indentures governing our senior notes. On June 24, 2004, we announced that we had closed all of our consent solicitations for our outstanding public debt. The vote totals for the consents are set forth on the following table:

In connection with the consummation of the consent solicitations, we executed the following supplemental indentures as of May 14, 2004:

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We also executed the following supplemental indentures as of June 24, 2004:

PART II

Market Information

On March 19, 2003, after the Securities and Exchange Commission issued an Order of Suspension of Trading, the New York Stock Exchange suspended trading in our common stock, which was then listed under the symbol HRC. That same day, Standard & Poor’s announced that it removed our common stock from the S&P 500 Index. The NYSE continued the trading halt and eventually delisted our common stock. On March 25, 2003, immediately following the delisting from the NYSE, our stock began trading in the over-the-counter “Pink Sheets” market under the symbol HLSH.

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The following table sets forth the high and low bid quotations per share of HealthSouth common stock as reported on the over-the-counter market from March 25, 2003 through December 31, 2004 and the high and low reported sale prices for HealthSouth common stock as reported on the NYSE Composite Transactions Tape for prior periods. The stock price information is based on published financial sources. Over-the-counter market quotations reflect inter-dealer prices, without retail mark-up, mark-down or commissions, and may not necessarily represent actual transactions.

Holders

As of May 31, 2005, there were 397,063,445 shares of HealthSouth common stock issued and outstanding, net of treasury shares, held by approximately 8,597 holders of record.

Dividends

We have never paid cash dividends on our common stock, and we do not anticipate paying cash dividends in the foreseeable future. In addition, the terms of our principal bank credit agreement and the indentures covering some of our publicly traded debt securities restrict our ability to pay cash dividends on our common stock if we do not meet specified financial requirements. We currently anticipate that any future earnings will be retained to finance our operations and reduce debt.

Recent Sales of Unregistered Securities

Between December 5, 2003 and January 20, 2004 we sold 230,750 unregistered shares of common stock to various employees pursuant to the exercise of outstanding stock options. The aggregate consideration for these sales was $869,460. In 2004 we issued 468,057 shares of restricted stock to various directors and executive

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officers in reliance on Section 4(2) of the Securities Act of 1933, as amended. There was no monetary consideration for these issuances.

Securities Authorized for Issuance Under Equity Compensation Plans

The information required by Item 201(d) of Regulation S-K is provided under Item 12, Security Ownership of Certain Beneficial Owners and Management, “Securities Authorized for Issuance Under Equity Compensation Plans,” which is incorporated herein by reference.

Purchases of Equity Securities

The following table provides information regarding the repurchase of our common stock made during the period covered by this report. None of the repurchases identified below were made as part of a publicly announced plan or program, and there are no current repurchase plans or programs in place.

We derived the selected historical consolidated financial data presented below from our audited consolidated financial statements and related notes included elsewhere in this annual report. You should refer to Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, and the notes to our accompanying consolidated financial statements for additional information regarding the financial data presented below, including matters that might cause this data not to be indicative of our future financial condition or results of operations. In addition, you should note the following information regarding the selected historical consolidated financial data presented below.

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