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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2015

Or

o         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                  to

Commission File Number 000-50194

HMS HOLDINGS CORP.

(Exact name of registrant as specified in its charter)

(Registrant’s Telephone Number, Including Area Code)

(214) 453-3000

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for shorter period that the registrant was required to submit and post such files).  x Yes o No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o  No x

As of November 3, 2015, there were approximately 86,008,337 shares of the registrant’s common stock (par value $0.01 per share) outstanding.

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HMS HOLDINGS CORP. AND SUBSIDIARIES

QUARTERLY REPORT ON FORM 10-Q

FOR THE QUARTER ENDED SEPTEMBER 30, 2015

INDEX

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Special Note Regarding Forward-Looking Statements

This Quarterly Report on Form 10-Q contains “forward-looking statements” within the meaning of the U.S. Private Securities Litigation Reform Act of 1995. From time to time, we also provide forward-looking statements in other materials we release to the public, as well as oral forward-looking statements. Such statements give our expectations or forecasts of future events; they do not relate strictly to historical or current facts.

We have tried, wherever possible, to identify such statements by using words such as “anticipate,” “estimate,” “expect,” “project,” “intend,” “plan,” “believe,” “will,” “target,” “seek,” “forecast” and similar expressions and references to guidance. In particular, these include statements relating to future actions, business plans, objectives and prospects, future operating or financial performance or results of current and anticipated services, acquisitions and the performance of companies we have acquired, sales efforts, expenses, interest rates and the outcome of contingencies, such as financial results.

We cannot guarantee that any forward-looking statement will be realized. Forward-looking statements are based on our current expectations and assumptions regarding our business, the economy and other future conditions. Should known or unknown risks or uncertainties materialize, or should underlying assumptions prove inaccurate, actual results could differ materially from past results and those anticipated, estimated or projected. We caution you, therefore, against relying on any of these forward-looking statements. They are neither statements of historical fact nor guarantees or assurances of future performance. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in our Annual Report on Form 10-K and Part II of this Form 10-Q, and in particular, the risks discussed under the heading “Risk Factors” in Part I, Item 1A of our Annual Report on Form 10-K and Part II, Item 1A of this Form 10-Q and those discussed in other documents we file with the Securities and Exchange Commission.

Any forward-looking statements made by us in this Quarterly Report on Form 10-Q speak only as of the date on which they are made. Factors or events that could cause actual results to differ may emerge from time to time and it is not possible for us to predict all of them. We undertake no obligation to publicly update forward-looking statements, whether as a result of new information, future events or otherwise, except as may be required by law. You are advised, however, to consult any further disclosures we make on related subjects in our filings with the Securities and Exchange Commission, including but not limited to our Current Reports on Form 8-K.

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HMS HOLDINGS CORP. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share amounts)

See accompanying notes to the unaudited consolidated financial statements.

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HMS HOLDINGS CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(in thousands, except per share amounts)

(unaudited)

See accompanying notes to unaudited consolidated financial statements.

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HMS HOLDINGS CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

For the Nine Months Ended September 30, 2015

(in thousands, except share amounts)

(unaudited)

See accompanying notes to the unaudited consolidated financial statements.

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HMS HOLDINGS CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

See accompanying notes to the unaudited consolidated financial statements.

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HMS HOLDINGS CORP. AND SUBSIDIARIES

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

For the Three and Nine Months Ended September 30, 2015 and 2014

(unaudited)

1.              Basis of Presentation

The accompanying unaudited Consolidated Financial Statements of HMS Holdings Corp., its subsidiaries and its affiliates (“we,” “our” and “us”) have been prepared in accordance with United States Generally Accepted Accounting Principles (“U.S. GAAP”), for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by U.S. GAAP for complete financial statements. In the opinion of management, the unaudited interim financial statements furnished herein include all adjustments necessary for a fair presentation of our financial position at September 30, 2015, the results of our operations for the three and nine months ended September 30, 2015 and 2014 and cash flows for the nine months ended September 30, 2015 and 2014. Interim unaudited financial statements are prepared on a basis consistent with our annual financial statements. The financial statements included herein should be read in conjunction with the financial statements and notes included in our Annual Report on Form 10-K for the year ended December 31, 2014, which we refer to as our Annual Report. There have been no significant changes to our critical accounting policies since December 31, 2014.

The preparation of our unaudited consolidated financial statements requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities, primarily accounts receivable, intangible assets, accrued expenses, estimated allowance for appeals and estimated liability for appeals, the disclosure of contingent liabilities at the date of the unaudited consolidated financial statements and the reported amounts of revenue and expenses during the reporting periods. Our actual results could differ from those estimates.

These unaudited consolidated financial statements include our accounts and transactions and those of our wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

Certain reclassifications were made to prior period amounts to conform to the current period presentation.

2.              Summary of Significant Accounting Policies

As of September 30, 2015, we have accrued an estimated liability for appeals and estimated allowance for appeals based on our historical experience with this activity under our customers’ contracts. Any future changes to any of our customer contracts, including further modifications to the transition plan for incumbent Medicare Recovery Audit Contractors (“RAC”), may require us to apply different assumptions that could affect our estimated liability for future periods. We similarly accrue an allowance against accounts receivable related to fees yet to be collected, based on the same estimates used to establish the estimated liability for appeals of fees received. Our inability or failure to correctly estimate or accrue the estimated liabilities and allowance for appeals or accounts receivable could adversely affect our revenue in current or future periods.

Estimated liability for appeals and estimated allowance for appeals as of September 30, 2015 are as follows (in thousands):

(1)             Includes appeals, closures or other adjustments.

(2)             Includes $2,650 and $4,824 related to estimated allowance for appeals that apply to uncollected accounts receivable as of September 30, 2015 and December 31, 2014, respectively.

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In the first nine months of 2015 and 2014, within our estimated allowance for appeals found in favor of providers, $6.0 million and $22.2 million, respectively, was activity associated with our Medicare RAC contract with the Centers for Medicare & Medicaid Services.

Allowance for doubtful accounts as of September 30, 2015 is as follows (in thousands):

Our financial instruments are categorized into a three-level fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used to measure fair value fall within different levels of the hierarchy, the category level is based on the lowest priority level input that is significant to the fair value measurement of the instrument. In the event the fair value is not readily available or determinable, the financial instrument is carried at cost and referred to as a cost method investment. The evaluation of whether an investment’s fair value is less than cost is determined by using a disclosed fair value estimate, if one is available, otherwise, it is determined by evaluating whether an event or change in circumstances has occurred that may have a significant adverse effect on the fair value of the investment (an impairment indicator). We are not aware of any identified events or change in circumstances that would have a significant adverse effect on the carrying value of our cost method investments. Financial instruments recorded at fair value on our unaudited consolidated balance sheets are categorized as follows:

·           Level 1: Observable inputs such as quoted prices in active markets;

·           Level 2: Inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and

·           Level 3: Unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions.

The carrying amounts for our cash equivalents, accounts receivable, accounts payable and accrued expenses approximate fair value due to the short-term nature of their maturities. The carrying value of our revolving credit facility approximates fair value based upon the variable rate terms.

Goodwill, representing the excess of acquisition costs over the fair value of assets and liabilities of acquired businesses, is subject to a periodic assessment for impairment in accordance with Accounting Standards Codification (“ASC”) 350—Intangibles, Goodwill and Other. We assess goodwill for impairment on an annual basis as of June 30 of each year or more frequently if an event occurs or changes in circumstances would more likely than not reduce the fair value of a reporting unit below its carrying amount. Our assessment of goodwill impairment is at the HMS Holdings Corp. entity level as we operate as a single reporting unit.

We have the option to perform a qualitative assessment to determine if impairment is more likely than not to have occurred. If we can support the conclusion that it is more likely than not that the fair value of a reporting unit is greater than its carrying amount, then we would not need to perform the two-step impairment test for that reporting unit. If we cannot support such a conclusion, or we do not elect to perform the qualitative assessment, then the first step of the goodwill impairment test is used to identify potential impairment by comparing the fair value of a reporting unit with its carrying amount, including goodwill.

There are no impairment charges related to goodwill for any of the periods presented.

Recently Issued Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board (“FASB”) issued an Accounting Standards Update (“ASU”) that amends the FASB ASC by creating a new Topic 606, Revenue from Contracts with Customers. The new guidance will supersede the revenue recognition requirements in Topic 605, Revenue Recognition, and most industry-specific guidance on revenue recognition throughout the Industry Topics of the Codification.

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The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To achieve that core principle, an entity should apply the following steps:

Step 1: Identify the contract(s) with a customer.

Step 2: Identify the performance obligations in the contract.

Step 3: Determine the transaction price.

Step 4: Allocate the transaction price to the performance obligations in the contract.

Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation.

In addition, an entity should disclose sufficient qualitative and quantitative information to enable users of financial statements to understand the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers.

The amendments in this ASU are effective for annual reporting periods beginning after December 15, 2017, including interim periods within such annual reporting periods, with early adoption permitted to the original effective date of January 1, 2017. This amendment is to be either retrospectively adopted to each prior reporting period presented or retrospectively with the cumulative effect of initially applying this ASU recognized at the date of initial application. In July 2015, the FASB approved the option to defer this new revenue recognition standard by one year and allow early adoption as of the original effective date, but has not issued an ASU to effect this change. We continue to evaluate the impact of the adoption of this guidance to our consolidated financial statements.

In June 2014, FASB issued ASU 2014-12, Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period (“ASU 2014-12”). ASU 2014-12 brings consistency to the accounting for share-based payment awards that require a specific performance target to be achieved in order for employees to become eligible to vest in the awards. Effective January 1, 2015, we adopted the provisions of ASU 2014-12. The adoption of this guidance did not have a material effect on our consolidated financial statements.

In April 2015, FASB issued ASU 2015-03, Simplifying the Presentation of Debt Issuance Costs (“ASU 2015-03”). ASU 2015-03 simplifies the presentation of debt issuance costs by requiring that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The recognition and measurement guidance for debt issuance costs are not affected by ASU 2015-03. In August 2015, FASB issued ASU 2015-15, Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements (“ASU 2015-15”). ASU 2015-15 clarifies the presentation and measuring of debt issuance costs incurred in connection with line-of-credit arrangements given the lack of guidance on this topic in ASU 2015-03. For line-of-credit arrangements, an entity can continue to present debt issuance costs as an asset and amortize the deferred debt issuance costs ratably over the term of the line-of-credit arrangement. ASU 2015-03, as amended, is effective for annual reporting periods beginning after December 15, 2015, including interim periods within such annual reporting periods with early adoption permitted. ASU 2015-03 is to be retrospectively adopted to each prior reporting period presented. We do not expect the adoption of this guidance to have a material effect on our consolidated financial statements.

In April 2015, FASB issued ASU 2015-05, Intangibles — Goodwill and Other — Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement (“ASU 2015-05”). ASU 2015-05 provides explicit guidance to help companies evaluate the accounting for fees paid by a customer in a cloud computing arrangement and clarifies that if a cloud computing arrangement includes a software license, the customer should account for the license consistent with its accounting for other software licenses. If the arrangement does not include a software license, the customer should account for the arrangement as a service contract. ASU 2015-05 is effective for annual reporting periods beginning after December 15, 2015, including interim periods within such annual reporting periods with early adoption permitted. We do not expect the adoption of this guidance to have a material effect on our consolidated financial statements.

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3.                                      Intangible Assets

Intangible assets consisted of the following at September 30, 2015 and December 31, 2014 (in thousands):

Estimated amortization expense for intangible assets is expected to approximate the following (in thousands):

For the three and nine months ended September 30, 2015, amortization expense related to intangible assets was $5.0 million and $15.2 million, respectively. For the three and nine months ended September 30, 2014, amortization expense related to intangible assets was $5.2 million and $15.6 million, respectively.

4. Accounts Payable, Accrued Expenses and Other Liabilities

Accounts payable, accrued expenses and other liabilities at September 30, 2015 and December 31, 2014 consisted of the following (in thousands):

5.              Income Taxes

Our effective tax rate decreased to 38.1% from 42.0% for the three months ended September 30, 2015 and 2014, respectively, and decreased to 41.3% from 42.4% for the nine months ended September 30, 2015 and 2014, respectively, primarily due to changes in state apportionments and permanent differences. The principal differences between the statutory rate and our effective rate are state taxes and permanent differences.

In April 2015, legislation was signed changing New York City tax law, which resulted in us recognizing approximately $0.6 million in discrete tax expense during the second quarter of 2015. This discrete item had no impact on the effective tax rate for the three months ended September 30, 2015 and a 1.3% impact for the nine months ended September 30, 2015.

During the three and nine month period ended September 30, 2015, the Company recorded a discrete income tax benefit of $0.3 million from the release of an accrued liability for unrecognized tax benefits due to lapse in statute of limitations. This discrete item had an approximate tax rate impact of 2.8% and 1.1% for the three and nine months ended September 30, 2015, respectively.

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During the nine months ended September 30, 2015, we utilized $4.0 million in tax deductions arising from stock-based compensation, which resulted in an excess tax benefit of $1.5 million that was recorded to capital in excess of par value and an offsetting reduction to taxes payable.

As of September 30, 2015 and 2014, the total amount of unrecognized tax benefits was approximately $1.1 million and $1.6 million, respectively (net of the federal benefit for state issues) that, if recognized, would favorably affect our future effective tax rate. As of September 30, 2015 and 2014, the accrued liability for interest expense and penalties related to unrecognized tax benefits was $0.4 million and $0.3 million, respectively. We include interest expense and penalties in the provision for income taxes in the unaudited Consolidated Statements of Comprehensive Income. The amount of interest expense (net of federal and state income tax benefits) and penalties in the unaudited Consolidated Statements of Comprehensive Income for the nine months ended September 30, 2015 and 2014 was immaterial. We do not expect any significant change in unrecognized tax benefits during the next twelve months.

We file income tax returns with the U.S. Federal government and various state jurisdictions. We are no longer subject to U.S. Federal income tax examinations for years before 2012. We operate in a number of state and local jurisdictions, most of which have never audited our records. Accordingly, we are subject to state and local income tax examinations based upon the various statutes of limitations in each jurisdiction. We are currently being examined by the State of New York.

6.     Credit Agreement

In May 2013, we entered into a $500 million five-year, amended and restated revolving credit agreement (“2013 Credit Agreement”) with certain financial institutions and Citibank, N.A. as Administrative Agent. No principal payments were made against our revolving credit facility during the nine months ended September 30, 2015. During the nine months ended September 30, 2014, we made principal payments of $35.0 million. The $197.8 million principal balance of our revolving credit facility is due in May 2018.

The 2013 Credit Agreement provides for an initial $500 million revolving credit facility, and, under specified circumstances, the revolving credit facility can be increased or one or more incremental term loan facilities can be added, provided that the incremental credit facilities do not exceed in the aggregate the sum of (a) $75 million plus (b) an additional amount not less than $25 million, so long as our total secured leverage ratio, calculated giving pro forma effect to the requested incremental borrowing and other customary and appropriate pro forma adjustment events, including any permitted acquisitions, is no greater than 2.5:1.0. The amount available to borrow is based on certain borrowing base calculations found in our 2013 Credit Agreement. The 2013 Credit Agreement is collateralized by our assets.

The 2013 Credit Agreement contains certain customary representations and warranties, affirmative and negative covenants and events of default. The 2013 Credit Agreement requires us to comply, on a quarterly basis, with certain principal financial covenants, including a maximum consolidated leverage ratio of 3.25:1.00 and a minimum interest coverage ratio of 3.00:1.00. As of September 30, 2015, we were in compliance with all of the terms of the 2013 Credit Agreement.

The interest rates applicable to the revolving credit facility are, at our option, either (a) the LIBOR multiplied by the statutory reserve rate plus an interest margin ranging from 1.50% to 2.25% based on our consolidated leverage ratio, or (b) a base rate (which is equal to the greatest of (a) Citibank’s prime rate, (b) the federal funds effective rate plus 0.50% and (c) the one-month LIBOR plus 1.00% plus an interest margin ranging from 0.50% to 1.25% based on our consolidated leverage ratio). The applicable interest rate was 2.08% at September 30, 2015.  We pay an unused commitment fee on the revolving credit facility during the term of the 2013 Credit Agreement ranging from 0.375% to 0.50% per annum based on our consolidated leverage ratio.

Our obligations under the 2013 Credit Agreement may be accelerated upon the occurrence of an event of default, which includes customary events of default including, without limitation, payment defaults, failures to perform affirmative covenants, failure to refrain from actions or omissions prohibited by negative covenants, the inaccuracy of representations or warranties, cross-defaults, bankruptcy and insolvency related defaults, defaults relating to judgments, defaults due to certain ERISA related events and a change of control default.

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The interest expense and the commitment fees on the unused portion of our revolving credit facility are as follows (in thousands):

At September 30, 2015 and December 31, 2014, the unamortized balance of deferred origination fees and debt issue costs were $5.4 million and $7.0 million, respectively. For the three months ended September 30, 2015 and 2014, we amortized $0.5 million of interest expense related to our deferred origination fees and debt issue costs in each of the respective periods. For the nine months ended September 30, 2015 and 2014, we amortized $1.5 million and $1.6 million of interest expense related to our deferred origination fees and debt issue costs in each of the respective periods.

Although we expect that operating cash flows will continue to be a primary source of liquidity for our operating needs, the revolving credit facility may be used for general corporate purposes, including acquisitions, if necessary.

As part of our contractual agreement with a customer, we have an outstanding irrevocable letter of credit for $3.0 million, which we established against the revolving credit facility. The letter of credit will expire on June 30, 2016.

7.     Earnings Per Share

Basic income per share is calculated by dividing net income by the weighted average number of common shares outstanding during the period. Diluted income per share is calculated by dividing net income by the weighted average number of common shares and dilutive common share equivalents outstanding during the period. Our dilutive common share equivalents consist of stock options and restricted stock awards and units.

The following table reconciles the basic to diluted weighted average common shares outstanding using the treasury stock method (in thousands, except per share data):

Basic and diluted

For the three months ended September 30, 2015 and 2014, 3,708,228 and 2,251,303 stock options, respectively, and 71,581 and 2,367 restricted stock units, respectively, were not included in the diluted earnings per share calculation because the effect would have been anti-dilutive.

For the nine months ended September 30, 2015 and 2014, 3,490,887 and 2,395,158 stock options, respectively, 169,682 and 79,947 restricted stock awards and units, respectively, were not included in the diluted earnings per share calculation because the effect would have been anti-dilutive.

8.       Stock-Based Compensation

Total stock-based compensation expense charged as a selling, general and administrative expense in our unaudited Consolidated Statements of Comprehensive Income related to our stock compensation plans was $3.1 million and $2.9 million for the three months ended September 30, 2015 and 2014, respectively, and $10.2 million and $9.1 million for the nine months ended September 30, 2015 and 2014, respectively.

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Stock Options

Presented below is a summary of our stock option activity for the nine months ended September 30, 2015 (in thousands, except for weighted average exercise price and weighted average remaining contractual terms):

For awards subject to service-based vesting conditions, we recognize stock-based compensation expense, net of estimated forfeitures, equal to the grant date fair value of stock options on a straight-line basis over the requisite service period, which is generally the vesting term. For awards subject to both performance and service-based vesting conditions, we recognize stock-based compensation expense using the straight-line recognition method when it is probable that the performance condition will be achieved. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

The fair value of each option grant with service-based vesting conditions was estimated using a Black-Scholes option-pricing valuation model. The performance share awards granted in 2014 and 2015 are market condition awards as attainment is based on the performance of our common stock for the relevant performance period. These awards were valued on the date of grant using a Monte Carlo simulation model.

Expected volatilities are calculated based on the historical volatility of our common stock. Management monitors stock option exercises and employee termination patterns to estimate forfeiture rates within the valuation model. Separate groups of employees that have similar historical exercise behavior are considered separately for valuation purposes. The expected holding period of options represents the period of time that options granted are expected to be outstanding. The expected terms of options granted are based on our historical experience for similar types of stock option awards. The risk-free interest rate is based on U.S. Treasury Notes.

The weighted average grant-date fair value per share of the stock options granted during the three months ended September 30, 2015 and 2014 was $3.80 and $7.24, respectively. We estimated the fair value of each stock option grant on the date of grant using a Black-Scholes option-pricing valuation model and the weighted-average assumptions set forth in the following table:

During the three months ended September 30, 2015 and 2014, we issued 105,462 shares and 36,016 shares, respectively, of our common stock upon the exercise of outstanding stock options and received proceeds of $0.8 million and $0.1 million, respectively.

For the three months ended September 30, 2015 and 2014, stock-based compensation expense for stock options was $1.4 million and $1.7 million, respectively.

We recognized excess income tax benefit of approximately $21,000 and $17,000 from the exercise of stock options in our unaudited Consolidated Statement of Shareholders’ Equity for the three months ended September 30, 2015 and 2014, respectively.

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During the nine months ended September 30, 2015 and 2014, we issued 577,559 shares and 352,057 shares, respectively, of our common stock upon the exercise of outstanding stock options and received proceeds of $4.2 million and $3.3 million, respectively.

For the nine months ended September 30, 2015 and 2014, stock-based compensation expense for stock options was $4.5 million and $5.3 million, respectively.

We recognized excess income tax benefit of $1.5 million and $0.9 million from the exercise of stock options in our unaudited Consolidated Statement of Shareholders’ Equity for the nine months ended September 30, 2015 and 2014, respectively.

As of September 30, 2015, there was $11.1 million of total unrecognized compensation cost, adjusted for estimated forfeitures, related to stock options outstanding, which is expected to be recognized over a weighted-average period of 1.16 years.

The total intrinsic value of options exercised (the difference in the market price of our common stock on the exercise date and the price paid by the optionees to exercise the options) for the three months ended September 30, 2015 and 2014 was $0.2 million and $0.6 million, respectively.

The total intrinsic value of options exercised for the nine months ended September 30, 2015 and 2014 was $5.9 million and $3.9 million, respectively.

Restricted Stock Units

Our non-employee members of our Board of Directors and certain employees have received restricted stock units under the Fourth Amended and Restated 2006 Stock Plan (the “2006 Stock Plan”). The fair value of restricted stock units is estimated based on the closing sale price of our common stock on the NASDAQ Global Select Market on the date of issuance. The total number of restricted stock units expected to vest is adjusted by estimated forfeiture rates. Shares withheld to pay taxes upon the vesting of restricted stock units are retired.

For the three months ended September 30, 2015, we granted 5,642 restricted stock units with an aggregate fair market value of approximately $49,000. For the three months ended September 30, 2014, we granted 14,518 restricted stock units with an aggregate fair market value of $0.3 million.

For the three months ended September 30, 2015 and 2014, stock-based compensation expense for restricted stock units was $1.7 million and $1.2 million, respectively.

For the nine months ended September 30, 2015, we granted 665,326 restricted stock units with an aggregate fair market value of $11.1 million. For the nine months ended September 30, 2014, we granted 261,282 restricted stock units with an aggregate fair market value of $5.3 million.

For the nine months ended September 30, 2015 and 2014, stock-based compensation expense for restricted stock units was $5.7 million and $3.7 million, respectively.

At September 30, 2015, 1,240,052 restricted stock units remained unvested and there was $15.8 million of unamortized compensation cost related to these restricted stock units, which is expected to be recognized over the remaining weighted-average vesting period of 1.29 years.

A summary of the status of our restricted stock units and of changes in restricted stock units outstanding under the 2006 Stock Plan for the nine months ended September 30, 2015 is as follows (in thousands, except for weighted average grant date fair value per unit):

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Restricted Stock Awards

We did not issue restricted stock awards during the three and nine months ended September 30, 2015 and 2014. There was no stock-based compensation expense related to previously granted stock awards for the nine months ended September 30, 2015. Stock-based compensation expense related to previously granted restricted stock awards was $0.1 million for the nine months ended September 30, 2014, which was recorded in the first quarter of 2014.

9.   Commitments and Contingencies

Legal Proceedings

From time to time, we may be subject to investigations, legal proceedings and other disputes arising in the ordinary course of our business, including but not limited to regulatory audits, billing and contractual disputes and employment-related matters. We record accruals for outstanding legal matters when we believe it is probable that a loss will be incurred and the amount can be reasonably estimated. We evaluate, on a quarterly basis, developments in legal matters that could affect the amount of any accrual and developments that would make a loss contingency both probable and reasonably estimable. If a loss contingency is not both probable and estimable, we do not establish an accrued liability. We believe that none of our accruals for outstanding legal matters are material in the aggregate to our financial position.

Our contractual relationships, including those with federal and state government entities, subject our operations, billing and business practices to scrutiny and audit, including by multiple agencies and levels of government, as well as to frequent transitions and changes in the personnel responsible for oversight of our contractual performance. From time to time, we may have contractual disputes with our customers arising from differing interpretations of contractual provisions that define our rights, obligations, scope of work or terms of payment, and with associated claims of liability for inaccurate or improper billing for reimbursement of contract fees, or for sanctions or damages for alleged performance deficiencies. Resolution of such disputes may involve litigation or may require that we accept some amount of loss or liability in order to avoid customer abrasion, negative marketplace perceptions and other disadvantageous results that could adversely affect our business, financial condition, results of operations and cash flows.

Kern Health Systems: In August 2011, in the Superior Court of the State of California, County of Los Angeles, Kern Health Systems (“KHS” or “Plaintiff”) sought to recover in excess of $7.0 million exclusive of interest, attorneys’ fees and costs, against Allied Management Group Special Investigation Unit, Inc. (“AMG”), Dennis Demetre and Lori Lewis (collectively, “Defendants”), jointly and severally, on causes of action for breach of contract, professional negligence, intentional misrepresentation, negligent misrepresentation and unfair business practices under the California Business and Professions Code. On June 9, 2014, the jury issued its verdict in favor of all Defendants, and against KHS, on all causes of action except negligent misrepresentation. On that cause of action, the jury issued a verdict against all Defendants, jointly and severally, in the sum of $1.38 million. The negligent misrepresentation verdict was based on representations to KHS allegedly made by AMG and former owner Dennis Demetre in the spring of 2008, prior to our acquisition of AMG. We believe that the jury erroneously awarded damages based on an error inasmuch as the jury unanimously found that Defendants (through Demetre) made the negligent misrepresentation to KHS while having reasonable grounds for believing the representation to be true. Based on the jury’s verdict, we believe we are properly characterized as the prevailing party on the breach of contract claim. AMG has filed an appeal of the verdict and is seeking to recover its attorneys’ fees and costs in the sum of approximately $2.3 million. We have not recorded an obligation on this matter at this time, as we have appealed this decision and believe it is probable that we will prevail on the appeal of this matter, although there are risks and uncertainties related to any litigation, including appeals, and neither we nor our counsel can assure litigation results. Pending the appeal process, we were required to obtain a surety bond in the amount of 150% of the final judgment amount, or approximately $2.2 million, which was collateralized by a cash deposit and is reflected in Other current assets on our unaudited Consolidated Balance Sheet at September 30, 2015.

Dennis Demetre and Lori Lewis: In July 2012, two of AMG’s former owners, Dennis Demetre and Lori Lewis (the “Plaintiffs”), filed an action in the Supreme Court of the State of New York, claiming an undetermined amount of damages alleging that various actions unlawfully deprived the Plaintiffs of the acquisition earn-out portion of the purchase price of AMG under the applicable Stock Purchase Agreement (the “SPA”) and that we had breached certain contractual provisions under the SPA. The Plaintiffs filed a second amended complaint with two causes of action for breach of contract and one cause of action for breach of implied covenant of good faith and fair dealing. Although the Plaintiffs have also alleged an action based on fraud, the court dismissed that claim and further denied their subsequent appeal to resurrect the dismissed claim. We filed a counterclaim for breach of contract arising out of the Plaintiffs’ failure to indemnify us for costs, including attorneys’ fees arising out of our defense of the Kern Health Systems matter described above and for fraud and negligent misrepresentation arising out of the Plaintiffs’ misrepresentations concerning capabilities of their software platform. On July 13, 2015, the court granted in part and denied in part the Plaintiffs’ motion to dismiss our counterclaims, allowing our counterclaim for breach of contract to proceed but dismissing our

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counterclaims for fraud and negligent misrepresentation. This case continues in the discovery phase. We believe we have a meritorious defense and will continue to defend this matter vigorously, although there are risks and uncertainties related to any litigation.

Restrictive Covenants, Trade Secret, Contract and other Causes of Action in Texas and New York: We are the plaintiff in lawsuits filed in August 2014, entitled HMS Holdings Corp., et al. v. Public Consulting Group, Inc., James Gambino and Jason Ramos, in the District Court of Dallas County, Texas, Cause No. DC-14-09047 (the “Texas Action”), and HMS Holdings Corp., et al. v. Matthew Arendt, Sean Curtin and Danielle Lange, in the New York State Supreme Court, Albany County, Index No. A00754/2014 (the “New York Action”). In July 2015, we filed a third lawsuit, entitled HMS Holdings Corp., et al. v. Elena Moiseenko and Joseph Flora, in the New York State Supreme Court, Albany County, Index No. 900859/2015 (the “Second New York Action”). These suits allege that, in violation of their respective contractual, statutory and common law obligations to us, defendants Public Consulting Group, Inc. (“PCG”), Joseph Flora and former HMS employees Gambino, Ramos, Arendt, Curtin, Lange and Moiseenko unlawfully misappropriated our confidential, proprietary and trade secret information and committed other wrong doing. Flora is a former Director of the Bureau of Third-Party Liability at the New York State Office of the Medicaid Inspector General (“OMIG”) who was subsequently hired as a so-called consultant by PCG and provided an unredacted copy of our third-party liability (“TPL”) contract, containing our confidential information, to PCG while being paid as a so-called consultant by PCG. The lawsuits seek damages and injunctive relief and assert causes of action including breach of contract, breach of fiduciary duty and misappropriation of trade secrets. Through discovery and forensic investigation in the lawsuits, we uncovered the wrongful destruction of evidence by one or more defendants and sought judicial relief in the New York Action against those defendants. On May 19, 2015, the New York court concluded that defendants Curtin and Lange engaged in egregious misconduct and issued an order granting our motion for spoliation of evidence, which ordered that Curtin and Lange repay our associated attorneys’ fees and costs without reimbursement by defendant PCG and that Lange was reported to the New York State Bar Association for professional misconduct. After a motion from Curtin and Lange seeking reargument, the New York court amended its May 19, 2015 order to allow Curtin and Lange to seek reimbursement or indemnification of the awarded attorneys’ fees and costs from PCG. We are seeking reimbursement of approximately $0.45 million from Curtin and Lange pursuant to the court’s sanction order.

We also have sought injunctions in both the Texas and New York Actions. On July 10, 2015, the court in the Texas Action issued an order granting a temporary injunction against PCG, Gambino and Ramos. The Texas court found that we had proved the existence of unlawful conduct and had demonstrated a probable right to recovery at trial regarding our claims against PCG, Gambino and Ramos, including claims involving the misappropriation of our confidential, proprietary and trade secret information and the improper solicitation of our employees in violation of our agreements with PCG. The Texas court further found that an injunction was necessary to avoid imminent and irreparable harm to us. As such, the Texas court entered a temporary injunction that enjoined, in pertinent part: (i) PCG from accessing or using any of our confidential or proprietary information, including, but not limited to, in order to solicit, divert or take away the TPL business of any State Medicaid or other healthcare agency; (ii) PCG from using the services of Curtin or Lange (who are defendants in the New York Action as discussed herein) to solicit, review, prepare or submit proposals for, or to in any way provide services related to TPL for PCG; (iii) PCG from using certain of its prior Request for Proposal (“RFP”) responses that contain or were prepared using our confidential information in its preparation of any future PCG TPL response; (iv) Gambino and Ramos from using any of our confidential information or from developing, assisting or advising on PCG TPL proposals for our customer RFPs; and (v) PCG from soliciting any of our employees except as may be permitted under prior agreements between us and PCG (the “Texas Injunction”). The Texas Injunction was ordered to remain in place through the time of trial in the Texas Action, which the court has initially set for March 2016. As a condition to obtaining the Texas Injunction, we were required to post a surety bond in the amount of $0.5 million. On August 3, 2015, we filed an appeal of the Texas Injunction to, among other things, expand upon the relief the trial court awarded to include an injunction against PCG’s providing TPL services to State Medicaid agencies through the time of trial. PCG, Gambino and Ramos filed a cross-appeal which we are opposing. On August 14, 2015, PCG filed a counterclaim against us in the Texas Action claiming damages for alleged business disparagement and for tortious interference with an existing contract and prospective business relations. Our answer to PCG’s counterclaim was filed on September 8, 2015 denying the counterclaim. Additionally, on October 6, 2015, PCG moved for partial summary judgment on our claims related to certain PCG TPL proposals. We intend to file a response opposing PCG’s motion.

On July 14, 2015, the court in the New York Action issued its decision and order on our motion for a preliminary injunction. The New York court found that our trade secret protection had not been waived and that we were entitled to continued protection, and that we had successfully established a likelihood of prevailing on our non-solicitation claims against Curtin, Lange and Arendt and on our trade secret misappropriation claims against Curtin and Lange; however, the court held that injunctive relief in the New York Action was not necessary due to the Texas Injunction. The court’s order also preserved our right to again seek injunctive relief in the New York Action in the event of a change of status regarding the Texas Injunction. The New York court has set a tentative trial date for June 2016.

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On August 4, 2015, the court in the Second New York Action issued an order to show cause and entered a temporary restraining order against defendants Moiseenko and Flora enjoining them from using, disclosing or otherwise misappropriating our confidential, proprietary and trade secret information pending the court’s final determination of our motion for a preliminary injunction in this matter, which is still pending. This Action, along with the Texas and New York Actions, continue in the discovery phase.

As previously disclosed, on July 17, 2015, we received notice that re-procurement of the TPL contract with the New Jersey Department of Human Services had been awarded to PCG. After document production issues are resolved with the New Jersey Department of Human Services, we intend to file a protest with the State of New Jersey Division of Purchase and Property (the “Division”) challenging the contract award to PCG. Pursuant to chapter 12 of the New Jersey Administrative Code, “[i]f the contract award is protested . . . the Division shall not award the contract in question until a final decision is rendered by the Director [of the Division] on the merits of the protest. The Director [of the Division] may award the contract, notwithstanding the receipt of a protest . . . if the failure to award the contract will result in substantial cost to the State or if public exigency so requires. In such event, the Director [of the Division] shall notify all interested parties.” N.J.A.C. 17:12–3.3(c). As previously disclosed in our Current Report on Form 8-K filed with the SEC on October 1, 2015, we entered into a 60-day extension on our current contract through November 29, 2015.

In addition, as previously disclosed in our Current Report on Form 8-K filed with the SEC on August 24, 2015, we received notice that following a competitive re-procurement process, the New York State OMIG had selected us for award of the new Medicaid Third Party Liability Match and Recovery Services contract. On September 23, 2015, PCG filed a protest of the award with the New York Office of the State Comptroller. On October 8, 2015, we filed a response opposing PCG’s protest.

While we believe our legal claims are meritorious, there are inherent uncertainties in any litigation, and there can be no assurances that we will ultimately prevail at trial or with the protests, or that the rulings in these proceedings are or will be adequate to protect our confidential or trade secret information.

Letter of Credit

During the second quarter, the letter of credit was amended (see Note 6). The required balance was reduced from $4.6 million to $3.0 million. The expiration date of the letter of credit is June 30, 2016.

10.          Equity

Repurchases of Shares of Common Stock

On July 30, 2015, our Board of Directors approved a share repurchase program authorizing the repurchase of up to $75 million of our common stock from time to time on the open market or in privately negotiated transactions. The repurchase program is authorized through July 30, 2017, and may be suspended or discontinued at any time. Repurchased shares will be available for use in connection with reissuance under our stock plans and for other corporate purposes. Repurchases may also be made under a Rule 10b5-1 plan, which would permit shares to be repurchased when we might otherwise be precluded from doing so under insider trading laws. The timing and amount of any shares repurchased under the program will be determined by our management based on its evaluation of market conditions and other factors. During the current quarter, we repurchased $25 million of our common stock pursuant to this authorization and a 10b5-1 plan.

The summary of our repurchases of our common stock through the date hereof is as follows:

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11.          Subsequent Events

In connection with the preparation of these unaudited Consolidated Financial Statements, an evaluation of subsequent events was performed through the date these unaudited Consolidated Financial Statements were issued.

On October 28, 2015, the Compensation Committee of the Board of Directors authorized stock option awards and restricted stock units to be granted on November 11, 2015 to our employees and the non-employee members of our Board of Directors. The stock options and restricted stock units vest over a range of one to four years.

On October 31, 2015, we entered into a separation, waiver and general release agreement (the “Separation Agreement”) with Eugene V. DeFelice, pursuant to which he resigned as Executive Vice President, General Counsel and Secretary, effective November 15, 2015. In exchange for Mr. DeFelice’s commitments under the Separation Agreement, including his commitment to provide post-employment transition and cooperation assistance regarding currently pending litigation and other ongoing legal matters as we reasonably request, extended non-compete and non-solicitation terms, a general release of claims and additional non-disclosure obligations, Mr. DeFelice is entitled to receive (i) up to two years base salary continuation, (ii) up to two times his annual target bonus amount, (iii) the premium costs associated with 18 months of continued group medical insurance coverage and (iv) continued vesting of currently outstanding equity awards under the terms of, and at the regular vesting schedule applicable, under our equity incentive plans and his prior equity incentive awards.

There are no other events that have occurred that would require adjustments to or disclosure in our unaudited Consolidated Financial Statements.

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Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations

We begin Management’s Discussion and Analysis of Financial Condition and Results of Operations with a business overview discussion. We then present the critical accounting policies that we believe are important to understanding the assumptions and judgments incorporated in our reported financial results followed by a discussion of our results of operations. We provide an analysis of our liquidity and capital resources, including discussions of our sources of capital, cash flows and financial commitments and present the effects of recent accounting pronouncements.

The following discussion and analysis of financial condition and results of operations should be read in conjunction with the other sections of this Quarterly Report on Form 10-Q and with our Annual Report on Form 10-K for the year ended December 31, 2014 as filed with the Securities and Exchange Commission (“SEC”). In addition to historical consolidated financial information, the following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this Quarterly Report on Form 10-Q, particularly in Part II, Item 1A. “Risk Factors” and in Part I, Item 1A. “Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2014 as filed with the SEC.

Business Overview

We operate in the U.S. healthcare insurance benefit cost containment marketplace. We provide coordination of benefits services to government and private healthcare payers and sponsors to ensure that the responsible party pays healthcare claims. Our payment integrity services ensure that healthcare claims billed are accurate and appropriate. Together, these various services help customers recover amounts from liable third parties; prevent future improper payments; reduce fraud, waste and abuse; and ensure regulatory compliance.

Our customers are government health agencies, including the Centers for Medicare & Medicaid Services (“CMS”), and commercial health plans, government and private employers, child support agencies and other healthcare payers and sponsors.

As of September 30, 2015, we served CMS, the Veterans Health Administration (“VHA”), 46 state Medicaid programs and the District of Columbia. We also provided services to approximately 240 commercial customers and supported their multiple lines of business, including Medicaid managed care, Medicare Advantage and group and individual health. We also served as a subcontractor for certain business outsourcing and technology firms.

We have grown both organically and through targeted acquisitions. Initially, we provided coordination of benefits services to state Medicaid agencies. When Medicaid began to delegate members to managed care organizations, we began providing similar coordination of benefits services to those plans. We began furnishing payment integrity services in 2007 and have since acquired several businesses to expand our service offerings. In 2009, we began providing cost containment services for Medicare with our acquisition of IntegriGuard, LLC, which is now doing business as our wholly owned subsidiary HMS Federal, providing fraud, waste and abuse analytical services to the Medicare program, VHA and the Department of Defense. In 2009 and 2010, we began providing cost containment services to large self-funded employers through our acquisitions of Verify Solutions, Inc. and Chapman Kelly, Inc. In 2011, we expanded our payment integrity services among federal, state and commercial payers with our acquisition of HealthDataInsights, Inc. (“HDI”). HDI provides improper payment identification services for government and commercial health plans, and is the Medicare RAC in CMS Region D, covering 17 states and three U.S. territories. In December 2012, we extended our workers’ compensation recovery services to commercial health plans through our asset purchase of MedRecovery Management, LLC.

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Healthcare Environment

In March 2010, the Patient Protection and Affordable Care Act (“ACA”) was signed into law and in June 2012, the U.S. Supreme Court upheld the constitutionality of the ACA, ruling that the federal government could not condition continued receipt of a state’s existing Medicaid funding on its agreement to implement Medicaid expansion. As of September 30, 2015, 30 states and the District of Columbia have committed to expanding their Medicaid programs and/or have begun to implement Medicaid expansion. Based on CMS National Health Expenditure (“NHE”) Projections for 2014-2024, in 2015, Medicare programs will cover approximately 55 million people and Medicaid/Children’s Health Insurance Program (“CHIP”) programs will cover approximately 76 million people.

As enrollment in these government healthcare programs continues to grow, there is increased pressure on states to contain the growth of state and federal Medicaid spending and to provide more access to healthcare for low-income individuals. According to the CMS NHE Projections for 2014-2024, Medicare programs are projected to spend approximately $646 billion in 2015, an increase of $29 billion compared to the 2014 estimate. In 2015, Medicaid/CHIP programs are projected to spend approximately $560 billion, an increase of $43 billion compared to the 2014 estimate. In response to the budgetary pressure facing the states, the rising cost of care and the number of beneficiaries, the use of managed care arrangements in Medicaid continues to grow. In addition, states are expanding the use of managed care organizations to new regions within the state or are using managed care arrangements to serve beneficiaries with more complex conditions. Of the 31 Medicaid programs that are expanding under the ACA, all but five currently contract in some form with comprehensive managed care organizations to administer benefits to their Medicaid members.

Another result of the ACA is the increasing complexity in determining eligibility, as well as the shifting of members from Medicaid government premium subsidies to the health insurance exchange marketplaces and potentially back to Medicaid due to changes in income.

Customers

In July 2015, in connection with the re-procurement of the third-party liability (“TPL”) services contract with the New Jersey Department of Human Services, we received notice from the State of New Jersey Division of Purchase and Property, Procurement Bureau (the “Division”) of its intent to award the new TPL contract to competitor Public Consulting Group (“PCG”). We intend to file a protest challenging the Division’s award once document production issues have been resolved with the New Jersey Department of Human Services. In accordance with the New Jersey Administrative Code, our current contract was extended for an additional 60 days through November 29, 2015.

As we have previously disclosed, on August 24, 2015, the New York State Office of the Medicaid Inspector General (“OMIG”) provided us notice of an award of the new Medicaid Third Party Liability Match and Recovery Services contract. The award is contingent upon the successful execution of an agreement, which is expected to be for a term of five years, commencing January 7, 2016 through January 6, 2021, with an option to extend the term for two additional one-year periods. Our current contract with the New York State OMIG expires on January 6, 2016. On September 23, 2015, PCG filed a protest with the New York Office of the State Comptroller challenging the award. Our response opposing PCG’s protest was filed on October 8, 2015.

There are risks and uncertainties inherent in legal proceedings and contract award protests, and an unfavorable outcome from such protests, including a failure to overturn an award we are protesting or a successful challenge of a contract award where we are the original awardee, could have a material adverse effect on our financial condition, results of operations and cash flows.

Our Medicare RAC contract with CMS is through our wholly-owned subsidiary HDI. As previously disclosed, in August 2015, CMS initiated discussions with HDI regarding a proposed modification that would extend the term of the existing contract through July 31, 2016 and further allow HDI to invoice for recoupments received and to support the appeal process from August 1, 2016 to January 31, 2018. The proposed modification also provides that HDI would be required to continue to record/set aside an appeal reserve for potential contractual liabilities in the event that overpayment decisions are overturned on appeal. As of the date of this filing, HDI has not yet entered into the modification. On October 16, 2015, CMS announced its intent to issue a new request for proposal for recovery audit services, including those currently performed by HDI, on or about November 1, 2015. We intend to submit a proposal and are currently preparing for the re-procurement process with respect to this contract. The timing and outcome of the new Medicare RAC contract awards continue to remain uncertain.

In connection with the Medicare RAC contract, in August 2014, CMS announced it would settle with hospitals willing to withdraw inpatient status claims currently pending in the appeals process by offering to pay hospitals 68% for all eligible claims they had billed to Medicare. In June 2015, CMS notified HDI that CMS has determined that Medicare RACs, including HDI, would be entitled only to the contract contingency fee on the settled amounts of the claims, or 32% of the original inpatient claim

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amounts, and that based on the initial lists of finalized settlements, HDI shall pay back to CMS approximately $28.6 million due to adjustments in RAC contingency fees. CMS further advised that as the hospital settlement project continues, additional settlement lists will be matched to RAC claims which may result in updated amounts on those previously provided. During our initial analysis of the backup data that CMS has provided, we have identified a number of errors in settled claims and recognize that other data may be inaccurate and may also be incomplete. While there are uncertainties in any dispute resolution and results cannot be guaranteed, HDI has previously advised CMS that it disagrees with CMS’ interpretation of the contract. HDI accrues an estimated liability for appeals based on the amount of fees that are subject to appeals, closures or other adjustments, which we estimate are probable of being returned to providers following a successful appeal. We similarly accrue an allowance against accounts receivables related to fees yet to be collected. A portion of our reserve for estimated liability for appeals recorded as of September 30, 2015 may apply to this population. While we intend to continue our analysis and discussions with CMS regarding CMS’ determination, which includes requesting additional support and accurate backup documentation for specific audits, there could be a material negative impact on our financial condition, results of operations and cash flows to the extent that (i) any final determination of amounts owed by HDI to CMS under the current Medicare RAC contract materially exceeds our accrued reserves for such appeals, (ii) HDI is required to return certain fees which have been paid or (iii) HDI’s ability to collect fees for audits already performed is affected.

Under CMS Rule 1599-F, Hospital Inpatient Admission Order and Certification and Two Midnight Benchmark for Inpatient Hospital Admissions for the Fiscal Year 2014 Inpatient Prospective Payment System / Long-Term Care Hospital (the “Two Midnight Rule”), CMS redefined the requirements for an inpatient stay with a new formal time-based standard. The Two Midnight Rule, effective October 2013, initially stated that surgical procedures, diagnostic tests and other treatments (in addition to services designated as inpatient-only), are generally appropriate for inpatient hospital admission and payment under Medicare Part A when a physician (i) expects the beneficiary to require a stay that crosses at least two midnights and (ii) admits the beneficiary to the hospital based upon that expectation. As part of the Rule’s implementation, CMS first suspended the Medicare RACs’ review of inpatient hospital claims paid between October 1, 2013 and September 30, 2014 to determine whether the inpatient hospital admission and patient status was appropriate. In accordance with the passage of certain legislative acts, CMS subsequently extended the delay of the Rule’s enforcement and Medicare RAC review of Two Midnight Rule claims through September 30, 2015. On August 12, 2015, CMS further extended a partial enforcement delay through December 31, 2015.

On October 30, 2015, as part of CMS’ final outpatient payment rule, Calendar Year (CY) 2016 Hospital Outpatient Prospective Payment System, CMS released updates to the Two Midnight Rule that provide, among other things, that inpatient admissions where a physician expects the patient to need less than two midnights would be payable under Medicare Part A on a case-by-case basis as determined by the physician responsible for such patient’s care and that the medical record must include documentation supporting inpatient stay was necessary. In addition, CMS further announced that initial medical reviews of short inpatient stays would be conducted by Quality Improvement Organizations (“QIOs”) rather than by Medicare Administrative Contractors (“MACs”) or Medicare RACs. CMS indicated that the recovery audit program would instead focus on conducting reviews of hospitals with consistently high denial rates. CMS also clarified that beginning in January 2016, Medicare RACs would conduct patient status reviews only for providers referred by QIOs.

These reviews have historically been a significant finding for the recovery audit program; as a result, the Two Midnight Rule, including the recently proposed changes to the Rule, and the continued suspension of these reviews by the Medicare RACs could continue to have a material impact on our future revenue if HDI is awarded a new Medicare RAC contract, depending upon, among other factors, how the Two Midnight Rule is applied by providers, the review strategies ultimately approved by CMS and the ramifications of the shift in enforcement responsibility of the Rule from MACs and Medicare RACs to QIOs.

Critical Accounting Policies

Since the date of our Annual Report on Form 10-K for the year ended December 31, 2014, there have been no changes to our critical accounting policies. Refer to the items disclosed as our Critical Accounting Policies in Part II, Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our Annual Report on Form 10-K for the year ended December 31, 2014 as filed with the SEC.

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SUMMARY OF OPERATING RESULTS

Three Months Ended September 30, 2015 Compared to Three Months Ended September 30, 2014

The following table sets forth, for the periods indicated, certain items in our unaudited Consolidated Statements of Comprehensive Income expressed as a percentage of revenue:

Revenue for the three months ended September 30, 2015 was $118.4 million, an increase of $4.6 million, or 4.0%, compared to revenue of $113.8 million for the three months ended September 30, 2014. This increase resulted from a $6.4 million increase in revenue generated from new customers and a $3.2 million increase in revenue from the Medicare RAC contract.  For the three months ended September 30, 2015, these increases were partially offset by a $2.7 million decrease related to changes in the yield and scope of projects from existing customers and differences in the timing of when customer projects were completed in the current quarter compared to the same quarter in the prior year and a $2.3 million decrease related to contract expirations.

Compensation expense as a percentage of revenue was 35.7% for the three months ended September 30, 2015, compared to 37.2% for the three months ended September 30, 2014. Compensation expense was $42.3 million for the current quarter, a decrease of $0.1 million, or 0.2%, compared to compensation expense of $42.4 million for the same quarter in the prior year. This decrease reflects a $1.2 million decrease in fringe benefits expense partially offset by an increase in variable compensation of $1.1 million. During the three months ended September 30, 2015, we averaged 1,977 employees, a 7.0% decrease compared to our average of 2,126 employees during the quarter ended September 30, 2014. The reduction in headcount is related to Medicare RAC support warranted from a business point of view by the reduction in that contract and various other reductions related to employee terminations in the prior and the current fiscal year.

Data processing expense as a percentage of revenue was 8.5% for the three months ended September 30, 2015, compared to 8.6% for the three months ended September 30, 2014. Data processing expense was $10.0 million for the current quarter, an increase of $0.2 million, or 2.0%, compared to data processing expense of $9.8 million for the same quarter in the prior year. Continuous improvements to our technology infrastructure and developments in transaction processing resulted in higher expenses in the current quarter. This increase largely reflects additional software costs of $0.5 million primarily related to software maintenance expenses partially offset by a $0.6 million decrease in hardware related costs primarily due to depreciation expense.

Occupancy expense as a percentage of revenue was 3.5% for the three months ended September 30, 2015, compared to 3.9% for the three months ended September 30, 2014. Occupancy expense was $4.2 million for the three months ended September 30, 2015, compared to $4.5 million for the three months ended September 30, 2014. This decrease is a result of additional unoccupied office space due to the reduced headcount of operations personnel. Beginning in fiscal year 2015, the cost of unoccupied office space in any of our locations is classified as a selling, general and administrative expense.

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Direct project expense as a percentage of revenue was 11.7% for the three months ended September 30, 2015, compared to 8.7% for the three months ended September 30, 2014. Direct project expense for the current quarter was $13.9 million, an increase of $4.0 million, or 40.4%, compared to direct project expense of $9.9 million for the same quarter in the prior year. This increase is primarily a result of a $1.3 million increase in medical charts expense and a $1.2 million increase in subcontractor fees to help augment resources based on volume fluctuations.

Other operating costs as a percentage of revenue were 5.6% for the three months ended September 30, 2015, compared to 6.0% for the three months ended September 30, 2014. Other operating costs for the current quarter were $6.6 million, a decrease of $0.2 million, or 2.9%, compared to other operating costs of $6.8 million for the same quarter in the prior year. The decrease primarily resulted from decreases in travel expenses and employee relocation expenses.   Increases of $1.6 million for subcontractor and consulting expenses were offset by decreases of $1.0 million for temporary staffing expenses and $0.6 million for printing and supplies expenses.

Amortization of acquisition-related software and intangible assets as a percentage of revenue was 5.9% for the three months ended September 30, 2015, compared to 6.4% for the three months ended September 30, 2014. Amortization of acquisition-related software and intangible assets for the current quarter was $7.0 million, compared to amortization expense of $7.2 million for the same quarter in the prior year. This expense consists primarily of amortization of customer relationships, trade names and software. This decrease primarily resulted from certain of our intangible assets becoming fully amortized in the prior fiscal year.

Selling, general and administrative expense as a percentage of revenue was 18.1% for the three months ended September 30, 2015 compared to 17.0% for the three months ended September 30, 2014. Selling, general and administrative expense for the current quarter was $21.4 million, an increase of $2.1 million, or 10.9%, compared to $19.3 million for the same quarter in the prior year. This increase resulted largely from a $2.3 million increase in compensation expense, consisting primarily of fringe benefits and salary expense. Other expenses decreased by $0.2 million primarily as a result of a $1.2 million decrease in legal expenses, which was partially offset by a $1.0 million increase in professional fees, including accounting and consulting fees and temporary staffing. During the three months ended September 30, 2015, we averaged 218 corporate employees in the sales, general and administrative group, a 2.2% decrease compared to our average of 223 corporate employees in that group during the same quarter in the prior year.

Operating income for the three months ended September 30, 2015 was $13.0 million, a decrease of $0.9 million, or 6.5%, compared to operating income of $13.9 million for the three months ended September 30, 2014.

Interest expense was $1.9 million and $2.0 million for the three months ended September 30, 2015 and 2014, respectively. Interest expense represents borrowings under our revolving credit facility, amortization of deferred financing costs, commitment fees for our revolving credit facility and issuance fees for our letter of credit. Interest income was $11,000 for both the current quarter and the same quarter in the prior year, respectively.

We recorded income tax expense of $4.2 million for the three months ended September 30, 2015, compared to income tax expense of $5.0 million for the three months ended September 30, 2014, a decrease of $0.8 million. Income before income taxes decreased $0.9 million for the current quarter compared to income before income taxes for the same quarter in the prior year. Our effective tax rate decreased to 38.1% for the current quarter from 42.0% for the same quarter in the prior year, primarily due to changes in state apportionments and permanent differences. The principal difference between the statutory rate and our effective rate are state taxes and permanent differences.

Net income and comprehensive income of $6.9 million for the three months ended September 30, 2015 represents a $0.1 million decrease compared to net income and comprehensive income for the three months ended September 30, 2014 of $7.0 million. This is primarily due to a $0.9 million decrease in operating income offset by a $0.8 million decrease in income taxes.

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Nine Months Ended September 30, 2015 Compared to Nine Months Ended September 30, 2014

The following table sets forth, for the periods indicated, certain items in our unaudited Consolidated Statements of Comprehensive Income expressed as a percentage of revenue: