<PAGE>
 
================================================================================


                       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, 1998

                                       OR

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


                               ------------------


                         Commission file number 0-21982

                            DIAMETRICS MEDICAL, INC.
                 Incorporated pursuant to the Laws of Minnesota


                               ------------------


       Internal Revenue Service -- Employer Identification No. 41-1663185

                  2658 Patton Road, Roseville, Minnesota 55113
                                 (612) 639-8035

                               ------------------

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 [ ]

The total number of shares of the registrant's Common Stock, $.01 par value,
outstanding on October 30, 1998, was 23,378,217.


================================================================================
<PAGE>
 
                            DIAMETRICS MEDICAL, INC.

                                                                            Page
                                                                            ----
Part I -- FINANCIAL INFORMATION

     Item 1.  Consolidated Financial Statements (unaudited)
              Consolidated Statements of Operations:
                Three Months Ended September 30, 1998 and 1997.................3
                Nine Months Ended September 30, 1998 and 1997..................3
              Consolidated Balance Sheets as of September 30, 1998
                and December 31, 1997..........................................4
              Consolidated Statements of Cash Flows:
                Nine Months Ended September 30, 1998 and 1997..................5
              Notes to Consolidated Financial Statements.......................6
     Item 2.  Management's Discussion and Analysis of Results of Operations
                and Financial Condition........................................8

     Item 3.  Quantitative and Qualitative Disclosures About Market Risk......13


Part II -- OTHER INFORMATION

     Item 1.  Legal Proceedings...............................................14
     Item 2.  Changes in Securities...........................................14
     Item 3.  Defaults Upon Senior Securities.................................14
     Item 4.  Submission of Matters to a Vote of Security Holders.............14
     Item 5.  Other Information...............................................14
     Item 6.  Exhibits and Reports on Form 8-K................................15
     Signature................................................................16

                                       2
<PAGE>

                        PART I -- FINANCIAL INFORMATION


Item 1. Consolidated Financial Statements.

                            DIAMETRICS MEDICAL, INC.
                      CONSOLIDATED STATEMENTS OF OPERATIONS
                                   (UNAUDITED)

<TABLE>
<CAPTION>
                                                        Three Months Ended                   Nine Months Ended
                                                          September 30,                        September 30,
                                                     1998              1997               1998                1997
                                                 ------------       ------------       ------------       ------------
<S>                                              <C>                <C>                <C>                <C>
Net sales                                        $  3,102,430       $  2,829,279       $  8,571,181       $  7,391,924
Cost of sales                                       2,946,478          3,018,947          8,159,236          8,668,467
                                                 ------------       ------------       ------------       ------------
       Gross profit (loss)                            155,952           (189,668)           411,945         (1,276,543)
                                                 ------------       ------------       ------------       ------------

Operating expenses:
       Research and development                     1,729,984          1,782,933          4,909,526          5,344,396
       Sales and marketing                          2,243,197          1,917,018          5,879,759          5,860,444
       General and administrative                     888,657            936,330          2,540,366          2,874,344
       Restructuring and other charges                   --              134,939               --              298,143
                                                 ------------       ------------       ------------       ------------
       Total operating expenses                     4,861,838          4,771,220         13,329,651         14,377,327
                                                 ------------       ------------       ------------       ------------

Operating loss                                     (4,705,886)        (4,960,888)       (12,917,706)       (15,653,870)
Other expense, net                                    (86,468)          (192,379)          (504,281)          (525,444)
                                                 ------------       ------------       ------------       ------------
Net loss                                         $ (4,792,354)      $ (5,153,267)      $(13,421,987)      $(16,179,314)
                                                 ============       ============       ============       ============

Basic and diluted net loss per common share      $      (0.21)      $      (0.25)      $      (0.62)      $      (0.90)
                                                 ============       ============       ============       ============
Weighted average number of
common shares outstanding                          22,548,936         20,279,062         21,530,709         17,935,053
                                                 ============       ============       ============       ============
</TABLE>

See accompanying notes to consolidated financial statements.

                                       3
<PAGE>
 
                            DIAMETRICS MEDICAL, INC.
                           CONSOLIDATED BALANCE SHEETS
                                   (UNAUDITED)

<TABLE>
<CAPTION>
                                                                    September 30,        December 31,
                                                                        1998                 1997
                                                                    -------------       -------------
<S>                                                                 <C>                 <C>
ASSETS
      Current assets:
           Cash and cash equivalents                                $   4,170,486       $   3,358,684
           Marketable securities                                        6,558,430           8,401,642
           Accounts receivable                                          5,058,444           3,768,528
           Inventories                                                  4,253,590           3,588,218
           Prepaid expenses and other current assets                      715,404             311,173
                                                                    -------------       -------------
                Total current assets                                   20,756,354          19,428,245
                                                                    -------------       -------------

      Property and equipment                                           20,135,486          18,060,127
           Less accumulated depreciation and amortization             (13,084,981)        (10,674,155)
                                                                    -------------       -------------
                                                                        7,050,505           7,385,972
                                                                    -------------       -------------
      Other assets                                                      1,861,013           2,217,089
                                                                    -------------       -------------
                                                                    $  29,667,872       $  29,031,306
                                                                    =============       =============

LIABILITIES AND SHAREHOLDERS' EQUITY
      Current liabilities:
           Accounts payable                                         $   2,378,542       $   2,261,822
           Accrued expenses                                             2,412,897           3,687,597
           Short-term borrowings and current portion of
                long-term liabilities                                     513,733             969,950
                                                                    -------------       -------------
                Total current liabilities                               5,305,172           6,919,369
                                                                    -------------       -------------

      Long-term liabilities:
           Long-term liabilities, excluding current portion             8,245,073           8,537,742
           Other liabilities, excluding current portion                   432,317             431,145
                                                                    -------------       -------------
                Total liabilities                                      13,982,562          15,888,256
                                                                    -------------       -------------

      Shareholders' equity:
           Common stock, $.01 par value: 35,000,000 authorized
                23,378,217 and 20,889,945 shares issued and
                outstanding                                               233,782             208,899
           Additional paid-in capital                                 130,638,843         113,970,247
           Cumulative translation adjustment                              (32,583)             19,584
           Accumulated deficit                                       (115,154,732)       (101,055,680)
                                                                    -------------       -------------
                Total shareholders' equity                             15,685,310          13,143,050
                                                                    -------------       -------------
                                                                    $  29,667,872       $  29,031,306
                                                                    =============       =============
</TABLE>

See accompanying notes to consolidated financial statements.

                                       4
<PAGE>
 
                            DIAMETRICS MEDICAL, INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                   (UNAUDITED)

<TABLE>
<CAPTION>
                                                                                     Nine Months Ended
                                                                                       September 30,
                                                                                  1998               1997
                                                                              ------------       ------------
<S>                                                                           <C>                <C>
Cash flows from operating activities:
      Net loss                                                                $(13,421,987)      $(16,179,314)
      Adjustments to reconcile net loss to net
        cash used in operating activities:
           Depreciation and amortization                                         2,500,615          3,077,761
           Other                                                                     6,952            (89,526)
           Change in operating assets and liabilities:
                Accounts Receivable, net                                        (1,290,537)          (505,123)
                Inventories                                                       (811,666)           643,382
                Prepaid expenses and other current assets                         (305,473)            75,214
                Accounts payable and accrued expenses                           (1,078,761)           (98,810)
                                                                              ------------       ------------
                    Net cash used in operating activities                      (14,400,857)       (13,076,416)
                                                                              ------------       ------------

Cash flows from investing activities:
      Purchases of property and equipment                                       (1,846,619)        (2,466,031)
      Purchases of marketable securities                                        (6,501,680)       (22,899,465)
      Proceeds from maturities of marketable securities                          8,401,642         12,400,000
      Other                                                                          5,735            164,080
                                                                              ------------       ------------
                    Net cash provided by (used in) investing activities             59,078        (12,801,416)
                                                                              ------------       ------------

Cash flows from financing activities:
      Principal payments on borrowings                                          (1,232,488)           (87,312)
      Proceeds from short-term borrowings                                          990,000               --
      Proceeds from long-term borrowings                                              --            1,058,626
      Net proceeds from the issuance of preferred stock                               --           11,900,000
      Net proceeds from the issuance of common stock                            16,684,029         13,053,739
      Principal payments under capital lease obligations                          (506,398)          (812,203)
                                                                              ------------       ------------
                    Net cash provided by financing activities                   15,935,143         25,112,850
                                                                              ------------       ------------


Effect of subsidiary's year-end change on cash and cash equivalents               (664,819)              --
Effect of exchange rate changes on cash and cash equivalents                      (116,743)            14,749
                                                                              ------------       ------------

                    Net increase (decrease) in cash and cash equivalents           811,802           (750,233)

Cash and cash equivalents at beginning of period                                 3,358,684          2,451,993
                                                                              ------------       ------------

Cash and cash equivalents at end of period                                    $  4,170,486       $  1,701,760
                                                                              ============       ============

Supplemental disclosure of cash flow information:
      Cash paid during the period for interest                                $  1,296,369       $    298,734
                                                                              ============       ============
</TABLE>

See accompanying notes to consolidated financial statements.

                                       5
<PAGE>
 
                            DIAMETRICS MEDICAL, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                               September 30, 1998
                                   (Unaudited)

(1)  UNAUDITED FINANCIAL STATEMENTS

     The interim consolidated financial statements of Diametrics Medical, Inc.
     (the "Company") are unaudited and have been prepared by the Company in
     accordance with generally accepted accounting principles for interim
     financial information, pursuant to the rules and regulations of the
     Securities and Exchange Commission. Pursuant to such rules and regulations,
     certain financial information and footnote disclosures normally included in
     the financial statements have been condensed or omitted. However, in the
     opinion of management, the financial statements include all adjustments,
     consisting of normal recurring accruals, necessary for a fair presentation
     of the interim periods presented. Operating results for these interim
     periods are not necessarily indicative of results to be expected for the
     entire year, due to seasonal, operating and other factors.

     These statements should be read in conjunction with the financial
     statements and related notes which are incorporated by reference in the
     Company's Annual Report on Form 10-K for the year ended December 31, 1997.

(2)  RECLASSIFICATIONS

     Certain 1997 amounts in the Consolidated Balance Sheets have been
     reclassified from prior reported balances to conform to the 1998
     presentation.

(3)  INVENTORIES

     Inventories are summarized as follows:

                                        September 30,     December 31,
                                            1998              1997
                                         ----------        ----------
     Raw materials                       $1,089,374        $  957,049
     Work-in-process                        783,864           442,527
     Finished goods                       2,380,352         2,188,642
                                         ----------        ----------
                                         $4,253,590        $3,588,218
                                         ==========        ==========

(4)  NEW ACCOUNTING PRONOUNCEMENTS

     In June 1997, the Financial Accounting Standards Board (the "FASB") issued
     Statement of Financial Accounting Standards ("SFAS") No. 131, "Disclosure
     About Segments of an Enterprise and Related Information". SFAS 131 is
     effective for the fiscal year ending December 31, 1998 and establishes
     standards for disclosure about products, geography and major customers. The
     Company expects that implementation of this standard will not have a
     material effect on its financial statement disclosures.

     In February 1998, the FASB issued SFAS 132, "Employers' Disclosure about
     Pensions and Other Postretirement Benefits". SFAS 132 is effective for the
     fiscal year ending December 31, 1998, and standardizes the disclosure
     requirements for pensions and other postretirement benefits. The Company
     expects that implementation of this standard will not have a material
     effect on its financial statement disclosures.

                                       6
<PAGE>
 
     In June 1998, the FASB issued SFAS 133, "Accounting for Derivative
     Instruments and Hedging Activities". SFAS 133 establishes accounting and
     reporting standards requiring that every derivative instrument (including
     certain derivative instruments embedded in other contracts) be recorded in
     the balance sheet as either an asset or liability measured at its fair
     value. SFAS 133 is effective for fiscal years beginning after June 15,
     1999. The Company expects that implementation of this standard will not
     have a material effect on its financial statement disclosure.

(5)  COMPREHENSIVE LOSS

     As of January 1, 1998, the Company adopted SFAS 130, "Reporting
     Comprehensive Income". SFAS 130 establishes new rules for the reporting and
     display of comprehensive income (loss) and its components; however, the
     adoption of the Statement had no impact on the Company's net loss or
     shareholders' equity. For the Company, SFAS 130 requires changes in the
     shareholders' equity account (cumulative translation adjustment) to be
     included as a component of comprehensive loss.

     The following table sets forth the computation of comprehensive loss:

<TABLE>
<CAPTION>
                                       Three Months Ended               Nine Months Ended
                                          September 30,                   September 30,
                                       1998           1997             1998             1997
                                   -----------     -----------     ------------     ------------
<S>                                <C>             <C>             <C>              <C>
     Net loss                      $(4,792,354)    $(5,153,267)    $(13,421,987)    $(16,179,314)

     Change in cumulative
       translation adjustment          (58,443)        (30,678)         (52,167)        (118,524)
                                   -----------     -----------     ------------     ------------

     Comprehensive loss            $(4,850,797)    $(5,183,945)    $(13,474,154)    $(16,297,838)
                                   ===========     ===========     ============     ============
     Basic and diluted
       comprehensive loss
       per common share            $     (0.22)    $     (0.26)    $      (0.63)    $      (0.91)
                                   ===========     ===========     ============     ============
</TABLE>


(6)  CHANGE IN YEAR END OF SUBSIDIARY

     Effective January 1, 1998, the Company changed the year-end of its
     wholly-owned subsidiary, Diametrics Medical, Ltd. (DML) to December 31 from
     November 30 to produce a consistent reporting period for the consolidated
     entity. As a result of this change in year-end, DML's net results of
     operations for the month of December 1997 were closed to beginning
     accumulated deficit on the balance sheet as of January 1, 1998. The impact
     of this change was an increase in the beginning accumulated deficit of
     approximately $677,000.

(7)  SHAREHOLDERS' EQUITY

     On August 4, 1998, the Company completed the sale in a private placement of
     2,142,858 shares of Common Stock at a price of $7.00 per share, resulting
     in proceeds to the Company of $15,000,006. The purchasers also received
     five-year warrants to purchase 714,286 shares of Common Stock at $8.40 per
     share, providing additional future funding potential of $6,000,000. The
     warrants are exercisable immediately and are callable after a twelve month
     waiting period if the Common Stock closing price exceeds certain levels for
     twenty consecutive trading days.

                                       7
<PAGE>
 
     In addition, the Company issued Convertible Senior Secured Fixed Rate Notes
     to an investor group, with proceeds aggregating $7,300,000. The notes are
     due in five years, require quarterly interest payments at a rate of 7% per
     annum, and are convertible into the Company's Common Stock at $8.40 per
     share. Proceeds of the notes were paid by the investor group directly to
     another debtor of the Company to retire existing debt.

     The Company expects to use the net proceeds from the private placement of
     equity securities for product development, sales and marketing and other
     general corporate purposes.

(8)  SUBSEQUENT EVENT

     On October 1, 1998, the Company entered into an exclusive Distribution
     Agreement with Johnson & Johnson Professional, Inc. for worldwide market
     development and distribution of the Company's Neurotrend(TM) Monitoring
     System.

     In addition, Johnson & Johnson Development Corporation has committed to
     purchase up to $5,000,000 of the Company's Common Stock at the Company's
     option over the twelve month period ending September 30, 1999 at the then
     current market value, not to exceed $7.00 per share.

(9)  RELATED PARTY TRANSACTIONS

     Effective March 31, 1998, the Company secured a $1,000,000 receivable
     backed credit line with DVI Business Credit Corporation. DVI Business
     Credit Corporation is a business unit of DVI, Inc., which shares a common
     director with the Company. The loan agreement requires the Company's
     accounts receivable collections to be applied to reduce the loan balance,
     including advances, interest and fees. All advances under the line of
     credit bear interest on the unpaid principal amount at a fluctuating rate
     equal to the Prime Rate plus three percent. Interest is payable monthly in
     arrears. The loan agreement requires the monthly payment of an annualized
     unutilized loan fee equal to one half of one percent (.5%) of the
     difference between the committed available loan amount and the average
     outstanding loan balance. The Company has no outstanding balance drawn on
     the line of credit as of September 30, 1998.

     Beginning November 26, 1996, the Company entered into three note agreements
     totaling $1,557,933 with DVI, Inc. The loan agreements require principal
     and interest payments in monthly installments at varying amounts through
     September 2002, at annual interest rates ranging from 10.1% to 10.95%.
     Maturity dates of the notes range from December 1, 2001 to September 25,
     2002, and all notes are secured by equipment.


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

     Statements regarding the Company's expectations about new and existing
     products, future financial performance, Year 2000 concerns and other
     forward looking statements are subject to various risks and uncertainties,
     including, without limitation, demand and acceptance of new and existing
     products, technological advances and product obsolescence, competitive
     factors and the availability of capital to finance growth. These and other
     risks are discussed in greater detail in Exhibit 99 filed with this Form
     10-Q for the quarter ended September 30, 1998. When used in this Form 10-Q,
     and in future filings by the Company with the Securities and Exchange
     Commission, in the Company's press releases, presentations to securities
     analysts or investors, in oral statements made by or with the approval of
     an executive officer of the Company, the words or phrases "believes,"
     "may," "will," "expects," "should," "continue," "anticipates," "intends,"
     "will likely result," "estimates," "projects," or similar expressions and
     variations thereof are intended to identify such forward-looking
     statements.

                                       8
<PAGE>
 
     SUMMARY

     Diametrics Medical, Inc. (the "Company"), which began operations in 1990,
     is engaged in the development, manufacturing and marketing of critical care
     blood and tissue analysis systems, which provide immediate or continuous
     diagnostic results at the point of patient care.

     Since its commencement of operations in 1990, the Company has transitioned
     from a development stage company to a full-scale development, manufacturing
     and sales organization. As of September 30, 1998, the primary funding for
     the operations of the Company has been approximately $130 million raised
     through public and private sales of its equity securities and issuance of
     convertible promissory notes.

     The Company has two product lines. The first are Point of Care blood
     testing products (IRMA SL, IDMS, Capillary Collection Device and the
     AVOXimeter 4000) based on electrochemical and optical technology, and the
     second are Continuous Monitoring products (Paratrend 7, Neurotrend, Neocath
     1000 and Neotrend) based primarily on fiberoptic technology.

     RESULTS OF OPERATIONS

     SALES - Sales of the Company's products were $3,102,430 and $8,571,181 for
     the three and nine months ended September 30, 1998, compared to $2,829,279
     and $7,391,924 for the same periods in the prior year, increases of 10% and
     16%, respectively. The increase for the three and nine months ended
     September 30, 1998 over the prior year reflects a 6% and 17% increase in
     sales of instruments, respectively, and a 15% increase in disposable
     cartridge and sensor sales in both periods.

     International sales accounted for 74% and 62% of total sales for the three
     and nine months ended September 30, 1998, compared to international sales
     of 67% and 62% for the same periods in 1997.

     Point of Care testing products represented 72% and 64% of sales for the
     three and nine months ended September 30, 1998, compared to 67% and 57% of
     sales for the comparable periods in 1997. Continuous Monitoring products
     made up the remainder of sales.

     Point of Care testing products revenue was comprised of 67% ($1,492,337)
     and 61% ($3,304,161) of instrument related revenue and 33% ($730,800) and
     39% ($2,157,056) of disposable cartridge related revenue for the three and
     nine months ended September 30, 1998, respectively. Continuous monitoring
     products revenue was comprised of 34% ($300,074) and 38% ($1,185,897) of
     instrument related revenue and 66% ($579,219) and 62% ($1,924,068) of
     disposable sensor revenue for the three and nine months ended September 30,
     1998, respectively.

     The Company's revenues are affected principally by the number of
     instruments, both monitors and IRMA analyzers, placed with customers and
     the rate at which disposable sensors and cartridges are used in connection
     with these products. As of September 30, 1998, the Company has sold over
     2,800 instruments. Disposable sensor and cartridge units sold for the three
     and nine months ended September 30, 1998 increased 34% and 36%,
     respectively, over the same periods in 1997. As the Company grows, it is
     expected that the Company's growing customer base will increase its rate of
     usage of disposable products, with the result that overall disposable
     product sales will exceed that of instrument sales.

     The Company's revenue in the fourth quarter and full year 1998 is targeted
     to exceed that of the same periods in 1997 as a result of further planned
     expansion of the blood and tissue analysis product lines and continued
     market penetration of existing products.

                                       9
<PAGE>
 
     COST OF SALES. Cost of sales totaled $2,946,478 and $8,159,236, or 95% of
     revenue for the three and nine months ended September 30, 1998, compared to
     $3,018,947 and $8,668,467, or 107% and 117% of revenue for the same periods
     in the prior year, respectively. The significant period-to-period
     improvement in the Company's cost of sales as a percentage of revenue
     reflects increased cartridge volumes and the impact of cost controls and
     manufacturing process changes. These improvements resulted in the
     achievement in the third quarter of 1998 of the Company's fourth
     consecutive positive quarterly gross margin. The Company is targeting a
     positive gross margin for the full year 1998, as a result of new product
     introductions and continued reductions in unit product costs, stemming from
     increased sales volumes and further expected improvements in manufacturing
     yields.

     OPERATING EXPENSES. Research and development expenditures were $1,729,984
     and $4,909,526 for the three and nine months ended September 30, 1998,
     compared to $1,782,933 and $5,344,396 for the same periods in the prior
     year. The decline in expenses is primarily impacted by reductions in
     headcount of 15%, largely in the Company's U.S. operations, and cost and
     process improvements implemented during 1997.

     Sales and marketing expenses totaled $2,243,197 and $5,879,759 for the
     three and nine months ended September 30, 1998, compared to $1,917,018 and
     $5,860,444 for the same periods in 1997. The increase between quarterly
     periods is primarily due to the timing of significant expenditures for
     advertising and promotion and increases in costs to inservice the Company's
     products with new customers.

     General and administrative expenses totaled $888,657 and $2,540,366 for the
     three and nine months ended September 30, 1998, compared to $936,330 and
     $2,874,344 for the same periods in 1997. The period-to-period decreases
     reflect the impact of 12% and 26% reductions in headcount for the three and
     nine months ended September 30, 1998, respectively, primarily in the
     Company's U.S. operations, and cost improvements implemented during 1997.

     Total 1998 operating expenses are expected to be below 1997 levels.

     OTHER EXPENSE. Net other expense was $86,468 and $504,281 for the three and
     nine months ended September 30, 1998, compared to $192,379 and $525,444 for
     the same periods in the prior year, a decrease of $105,911 and $21,163,
     respectively. The Company realized interest income of $119,420 and $301,233
     for the three and nine months ended September 30, 1998, compared to
     $204,814 and $463,449 for the same periods in the prior year. The
     period-to-period decrease reflects the impact of lower average cash
     balances, primarily due to the timing of the Company's private equity
     placements in 1997 and 1998. Private equity placements in 1997 occurred in
     January and June with proceeds of approximately $20,000,000, while the 1998
     private equity placement occurred in August, with proceeds of approximately
     $15,000,000.

     Interest expense totaled $202,988 and $640,819 for the three and nine
     months ended September 30, 1998, compared to $268,889 and $798,524 for the
     same periods in 1997. The period-to-period decrease primarily reflects the
     reduction in the amount of higher interest bearing capital lease debt
     relative to total debt outstanding.

     NET LOSS. The net loss for the three and nine months ended September 30,
     1998 was $4,792,354 and $13,421,987, compared to $5,153,267 and $16,179,314
     for the same periods in 1997. Compared to the three and nine months ended
     September 30, 1997, the net loss decreased 7% and 17%, respectively, for
     the same periods in 1998. This decrease reflects the revenue growth
     previously discussed, coupled with the impact of headcount reductions
     implemented during 1997 and increased production volumes. The Company is
     targeting continued improvement in net loss in future quarters.

                                       10
<PAGE>
 
     LIQUIDITY AND CAPITAL RESOURCES

     At September 30, 1998, the Company had working capital of $15,451,182, a
     decrease of $1,013,788 from the working capital reported at September 30,
     1997. The decrease primarily reflects the impact of the amount and timing
     of proceeds from the private equity placements in January and June 1997 and
     August 1998, and net cash used in operating activities for the nine months
     ended September 30, 1998, partially offset by proceeds from the issuance of
     Common Stock from warrant and option exercises.

     Net cash used in operating activities totaled $14,400,857 for the nine
     months ended September 30, 1998, compared to $13,076,416 for the same
     period in 1997. This was the result of net losses of $13,421,987 and
     $16,179,314 for these same periods in 1998 and 1997, respectively, adjusted
     by changes in key operating assets and liabilities, primarily accounts
     receivable, inventories and accounts payable and accrued expenses.

     Net accounts receivable increased $1,290,537 for the nine months ended
     September 30, 1998, compared to $505,123 for the same period in 1997. The
     larger increase in the current period is primarily due to increased sales
     in the first nine months of 1998 compared to the same period in the prior
     year and the timing of sales and related customer payments.

     Inventories increased $811,666 and decreased $643,382 for the nine months
     ended September 30, 1998 and 1997, respectively. The increase in the
     current period is due to increased inventory levels needed to begin
     internal assembly of the Company's IRMA SL instruments and to meet an
     expected increase in sales demand. The prior period decrease was due
     primarily to an improvement in inventory turnover during the period,
     stemming from improved inventory management.

     Accounts payable and accrued expenses decreased $1,078,761 and $98,810 for
     the nine months ended September 30, 1998 and 1997, respectively. The
     current period decrease is primarily due to reductions in product upgrade
     accruals as upgrades are completed, combined with timing of payments to
     vendors and employees. The decrease in the prior period was primarily due
     to timing of vendor and payroll-related payments.

     Net cash provided by investing activities totaled $59,078 for the nine
     months ended September 30, 1998 compared to net cash used in investing
     activities of $12,801,416 for the nine months ended September 30, 1997.
     This change is primarily due to the amounts and timing of private equity
     placements, which reduced the amount of cash available for the purchase of
     marketable securities in 1998.

     At September 30, 1998, the Company had property and equipment of
     $20,135,486, up from $17,676,137 at September 30, 1997, less accumulated
     depreciation of $13,084,981 and $9,912,360 at September 30, 1998 and 1997,
     respectively. The $713,272 net decrease in the cost of property and
     equipment is primarily the result of continued depreciation of the assets,
     offset by approximately $2,340,000 of capital additions, consisting
     primarily of investments in development and production equipment and
     instruments for internal use in R&D and sales. Approximately $3,000,000 of
     the Company's property and equipment were financed through capital lease
     obligations at September 30, 1998. In 1998, the Company expects total
     capital expenditures and new lease commitments to approximate $2,700,000
     for the year, primarily reflecting investments to support new product
     development and production.

     Net cash provided by financing activities totaled $15,935,143 and
     $25,112,850 for the nine months ended September 30, 1998 and 1997,
     respectively. The decrease is primarily due to the amount and timing of
     private equity placements in January and June of 1997 and August of 1998.

     At September 30, 1998, the Company had U.S. net operating loss and research
     and development tax credit carryforwards for income tax purposes of
     approximately $100,000,000 and $900,000, respectively. Pursuant to the Tax
     Reform Act of 1986, use of the Company's net operating loss 

                                       11
<PAGE>
 
     carryforwards may be limited if a cumulative "change in ownership" of more
     than 50% occurs within any three year period. In connection with prior
     sales by the Company of its securities in public and private offerings, the
     Company has experienced a "change in ownership." As a result, the
     utilization of the Company's net operating loss and certain credit
     carryforwards incurred prior to these changes are subject to annual
     limitations.

     The Company's foreign subsidiary also has net operating loss carryforwards
     of approximately $44,000,000 which can be carried forward indefinitely.

     As reflected in the accompanying consolidated financial statements, the
     Company has incurred net losses of $4,792,354 and $13,421,987,
     respectively, for the three and nine months ended September 30, 1998. In
     addition, the Company has incurred net losses and has had negative cash
     flows from operating activities since inception. In August 1998, the
     Company completed a private equity placement which generated net cash
     proceeds to the Company of $15,000,006. Also, as part of an exclusive
     Distribution Agreement initiated on October 1, 1998, the Company entered
     into a $5,000,000 Put Option and Stock Purchase Agreement with Johnson &
     Johnson Development Corporation who has committed to purchase up to
     $5,000,000 of the Company's Common Stock at the Company's option over the
     twelve month period ending September 30, 1999. The Company believes
     currently available funds and cash generated from projected operating
     revenues, supplemented by employee stock plans, warrant exercises, asset
     based credit and corporate alliances, will meet the Company's working
     capital needs through 1999. If the amount or timing of funding from these
     sources or cash requirements vary materially from those currently planned,
     the Company could require additional capital. The Company's long-term
     capital requirements will depend upon numerous factors, including the rate
     of market acceptance of the Company's products and the level of resources
     devoted to expanding the sales and marketing organization, manufacturing
     capabilities and research and development activities. While there can be no
     assurance that adequate funds will be available when needed or on
     acceptable terms, management believes that the Company will be able to
     raise adequate funding if needed.

     Effective March 31, 1998, the Company secured a $1,000,000 receivable
     backed credit line. The loan agreement requires the Company's accounts
     receivable collections to be applied to reduce the loan balance, including
     advances, interest and fees. The Company has no outstanding balance drawn
     on the line of credit as of September 30, 1998.

     YEAR 2000 COMPLIANCE

     The Company is addressing the issues associated with computing difficulties
     that may affect existing computer systems as a result of programming code
     malfunction in distinguishing 21st century dates from 20th century dates
     (the "Year 2000" issue). The Year 2000 issue is a pervasive problem
     affecting many information technology systems and embedded technologies in
     all industries. The Company has identified teams of internal staff to
     review its products; its internal financial, manufacturing and other
     process control systems; and its interface with major customers and
     suppliers in order to assess and remediate Year 2000 concerns.

     The Company's information technology (IT) systems consist of computer
     hardware systems and software supplied by third parties. IT systems in the
     Company's U.S. operation are Year 2000 compliant. The Company has
     identified necessary software and hardware upgrades to achieve compliance
     for IT systems in its UK operations, with completion scheduled for mid
     1999, allowing adequate time for testing and training.

     The Company's assessment of internal systems includes a review of
     non-information technology (non IT) systems (systems that contain embedded
     technology in manufacturing or process control equipment containing
     microprocessors or other similar circuitry). This assessment includes a
     review of the Company's internal manufacturing equipment and facilities
     (including building maintenance, security, electrical, lighting, fire
     protection, telephone, heating and cooling systems). Based upon this
     review, the Company believes that its manufacturing processes and equipment
     company wide are Year 2000 compliant. Internal process control equipment
     affecting the 

                                       12
<PAGE>
 
     Company's U.S. facility has been determined to be Year 2000 compliant.
     Control equipment affecting the Company's UK facility is currently under
     review, with necessary modifications, if any, scheduled for completion by
     June 1999.

     The Company has assessed Year 2000 compliance of its products offered for
     sale to customers, and believes that all are currently compliant. Contacts
     are being made with the Company's customers regarding test procedures they
     can apply to verify compliance of the Company's products.

     The Company has identified third parties with which it has material
     relationships, including suppliers of components for its products and
     providers of critical utility services. The majority of the raw materials
     and purchased components used to manufacture the Company's products are
     readily available. Most of the raw materials are or may be obtained from
     more than one source. A small number of these materials, however, are
     unique in their nature, and are therefore single sourced. The Company has
     contacted all major U.S. third party suppliers and has received
     representations that if not currently compliant, each has plans in place to
     ensure that products purchased by the Company from such suppliers will
     function properly in the Year 2000 and that such suppliers' internal
     systems will be Year 2000 compliant no later than June 1999. The Company is
     in the process of contacting all major international suppliers to assess
     their status of compliance, and expects to complete that process by March
     31, 1999. The Company is also currently evaluating alternative supplier
     sources in cases where it is single sourced. These actions are intended to
     help mitigate the possible external impact of the Year 2000 problem. Even
     assuming that all material third parties confirm that they are or expect to
     be Year 2000 compliant by December 31, 1999, it is not possible to state
     with certainty that such parties will be so compliant. It is impossible to
     fully assess the potential consequences in the event service interruptions
     from component suppliers occur or in the event that there are disruptions
     in such infrastructure areas as utilities, communications, transportation,
     banking and government.

     The total estimated incremental cost required to address the Company's Year
     2000 compliance is approximately $150,000, including the cost of software
     and hardware upgrades. The Company expects the majority of this cost to be
     incurred in 1999. The actual cost, however, could exceed this estimate.
     These costs are not expected to have a material effect on the Company's
     financial position, results of operations or cash flows.

     Based upon its assessments to date, the Company believes it will not
     experience any material disruption in its operations as a result of Year
     2000 problems in its products, in its internal financial, manufacturing and
     other process control systems, or in its interface with major customers and
     suppliers. However, if major suppliers, including those providing component
     parts, electricity, communications and transportation services, experience
     difficulties resulting in disruption of critical supplies or services to
     the Company, a shutdown of the Company's operations could occur for the
     duration of the disruption. As previously noted, the Company is working on
     minimizing the component supply risk by evaluating alternative suppliers in
     cases where it is single-sourced, with completion of this evaluation
     expected by June 1999. The Company has not yet developed a contingency plan
     to provide for continuity of normal business operations in the event the
     other described problem scenarios arise, but it will assess the need to
     develop such a plan based upon the outcome of compliance areas currently
     under review, and the results of remaining survey feedback from its major
     suppliers. Assuming no major disruption in service from critical third
     party providers, the Company believes that it will be able to manage the
     Year 2000 transition without any material effect on the Company's results
     of operations or financial position. There can be no assurance, however,
     that unexpected difficulties will not arise and, if so, that the Company
     will be able to timely develop and implement a contingency plan.

     INTRODUCTION OF THE EURO

     The countries of the European Union are expected to adopt a single currency
     known as the "Euro". The Euro will come into existence on January 1, 1999,
     and is intended to become the lead currency for Europe, with national
     currencies expressed as a denomination of the Euro. During the three-and-a-
     half year transition period following its introduction, countries will be
     allowed to transact business both in the Euro and in their own currencies.
     On July 1, 2002, the Euro will be the sole official currency in European
     Union countries.

     The Company is in the process of addressing the issues raised by the
     introduction of the Euro. The Company does not presently expect that the
     introduction and use of the Euro will result in any material increase in
     costs to the Company. While the Company will continue to evaluate the
     impact of the Euro introduction over time, based upon currently available
     information, management does not believe that the introduction of the Euro
     currency will have a material adverse impact on the Company's financial
     condition or overall trends in results of operations.

     Item 3. Quantitative and Qualitative Disclosure About Market Risk

     Not Applicable.

                                       13
<PAGE>
 
                           PART II - OTHER INFORMATION

     Item 1. Legal Proceedings

     None

     Item 2. Changes in Securities

     On August 4, 1998, the Company completed the sale in a private placement of
     2,142,858 shares of Common Stock at a price of $7.00 per share, resulting
     in proceeds to the Company of $15,000,006. The purchasers also received
     five-year warrants to purchase 714,286 shares of Common Stock at $8.40 per
     share, providing additional future funding potential of approximately
     $6,000,000. The warrants are exercisable immediately and are callable after
     a twelve month waiting period if the Common Stock closing price exceeds
     certain levels for twenty consecutive trading days. Proceeds from the sale
     of shares of Common Stock will be used for product development, sales and
     marketing and other general corporate purposes.

     In addition, the Company issued Convertible Senior Secured Fixed Rate Notes
     to an investor group, with proceeds aggregating $7,300,000. The notes are
     due in five years, require quarterly interest payments at a rate of 7% per
     annum, and are convertible into the Company's Common Stock at $8.40 per
     share. Proceeds of the notes were used to retire other debt of the Company.

     The Company also issued 15,360 shares of the Company's Common Stock in July
     1998, to certain parties involved in the private equity placement, as part
     of a financial advisory relationship. The shares of Common Stock and the
     notes were sold pursuant to Section 4(2) of the Securities Act of 1933, as
     amended.

     Item 3. Defaults Upon Senior Securities

     None

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

     None

     Item 5. Other Information

     On October 1, 1998, the Company entered into an exclusive Distribution
     Agreement with Johnson & Johnson Professional, Inc. for worldwide market
     development and distribution of the Company's Neurotrend(TM) Monitoring
     System.

     In addition, Johnson & Johnson Development Corporation has committed to
     purchase up to $5,000,000 of the Company's Common Stock at the Company's
     option during the twelve month period ending September 30, 1999, at the
     then current market value, not to exceed $7.00 per share.

                                       14
<PAGE>
 
     Item 6. Exhibits and Reports on Form 8-K

     a. Exhibits

<TABLE>
<CAPTION>
     Exhibit                                                                                  Method
       No.                             Description                                           of Filing
     -------                           -----------                                           ---------
<S>                <C>                                                                    <C>
      10.1*        Distribution Agreement, dated October 1, 1998, between 
                   the Company and Johnson & Johnson Professional, Inc.                   Filed herewith

      10.2         Put Option and Stock Purchase Agreement, dated October 1, 
                   1998, between the Company and Johnson & Johnson Development 
                   Corporation                                                            Filed herewith

      10.3         Severance Pay Agreement (in the event of Change of Control) 
                   dated July 31, 1998, between the Company and David T. Giddings         Filed herewith

      10.4         Form of Severance Pay Agreement (in the event of Change of 
                   Control) dated July 31, 1998, between the Company and its 
                   executive officers                                                     Filed herewith

      10.5         Form of Severance Pay Agreement (in the event of Termination 
                   Without Cause) dated July 31, 1998, between the Company and 
                   its executive officers                                                 Filed herewith

      27           Financial Data Schedule                                                Filed herewith

      99           Cautionary Factors Under the Private Securities Litigation 
                   Reform Act                                                             Filed herewith
</TABLE>


     *    Pursuant to Rule 24b-2 of the Securities Exchange Act of 1934, as
          amended, confidential portions of Exhibit 10.1 have been deleted and
          filed separately with the Securities and Exchange Commission pursuant
          to a request for confidential treatment.

     b. Reports on Form 8-K.

          None

                                       15
<PAGE>
 
                            DIAMETRICS MEDICAL, INC.


SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.



DIAMETRICS MEDICAL, INC.




By: /s/ Laurence L. Betterley
    -----------------------------
    Laurence L. Betterley
    Senior Vice President
    and Chief Financial Officer
    (and Duly Authorized Officer)


Dated: November 16, 1998

                                       16
<PAGE>
 
                            DIAMETRICS MEDICAL, INC.
                                 EXHIBIT INDEX

Exhibit
  No.                          Description
-------                        -----------

10.1*  Distribution Agreement, dated October 1, 1998, between the Company and
       Johnson & Johnson Professional, Inc.

10.2   Put Option and Stock Purchase Agreement, dated October 1, 1998, between
       the Company and Johnson & Johnson Development Corporation

10.3   Severance Pay Agreement (in the event of Change of Control) dated 
       July 31, 1998, between the Company and David T. Giddings

10.4   Form of Severance Pay Agreement (in the event of Change of Control) dated
       July 31, 1998, between the Company and its executive officers

10.5   Form of Severance Pay Agreement (in the event of Termination Without
       Cause) dated July 31, 1998, between the Company and its executive
       officers

27     Financial Data Schedule

99     Cautionary Factors Under the Private Securities Litigation Reform Act

*    Pursuant to Rule 24b-2 of the Securities Exchange Act of 1934, as amended,
     confidential portions of Exhibit 10.1 have been deleted and filed
     separately with the Securities and Exchange Commission pursuant to a
     request for confidential treatment.