SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                   FORM 10-KSB
                                  ANNUAL REPORT

              ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                         SECURITIES EXCHANGE ACT OF 1934
                   For the fiscal year ended December 31, 1998

                           Commission file No. 0-11447

                                  DATAKEY, INC.
                 (Name of small business issuer in its charter)

         MINNESOTA                                          41-1291472
(State of incorporation or organization)    (I.R.S. Employer Identification No.)

              407 West Travelers Trail, Burnsville, Minnesota 55337
                    (Address of principal executive offices)

Issuer's telephone number, including area code:  (612) 890-6850
Securities registered pursuant to Section 12(b) of the Act:   NONE
Securities registered pursuant to Section 12(g) of the Act:   
                     Common Stock, par value $.05 per share
                                (Title of Class)

Check whether the Issuer (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 Issuer was required to file such
reports) and (2) has been subject to such filing requirements for the last 90
days.    YES X    NO ____

Check if there is no disclosure of delinquent filers pursuant to Item 405 of
Regulation S-B contained herein and no disclosure will be contained, to the best
of Issuer's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-KSB or any amendment to
this Form 10-KSB. [ ]

Issuer's revenues for its most recent fiscal year: $5,870,250.

The aggregate market value of the voting stock (Common Stock) held by
non-affiliates was approximately $4,800,000 based upon the closing sale price of
the Issuer's Common Stock on March 19, 1999.

As of March 19, 1999, there were 3,103,259 shares of the Issuer's Common Stock
outstanding.

                       DOCUMENTS INCORPORATED BY REFERENCE

         Part II of this Annual Report on Form 10-KSB incorporates by reference
information (to the extent specific sections are referred to herein) from the
Issuer's Annual Report to Shareholders for the year ended December 31, 1998 (the
"1998 Annual Report"). Portions of the Company's definitive Proxy Statement for
its Annual Meeting of Shareholders to be held on May 26, 1999 are incorporated
by reference pursuant to Rule 12b-23 into Items 9, 10 and 11 of Part III.

Transitional Small Business Disclosure Format (check one)  YES  [  ]   NO  [ X ]



<PAGE>


                                     PART I


ITEM 1.  DESCRIPTION OF BUSINESS

General

         Datakey, Inc. (the "Company") was incorporated under the laws of the
State of Minnesota in 1976 under the name "The Systems Group, Inc." In 1980, the
Company changed its name to Datakey, Inc. The Company provides product,
subsystem and system solutions to record, store and transmit electronic
information. Datakey also manufactures and sells products and systems directed
to the information security market which enable user identification and
authentication, secure data exchange and information validation. It also
provides OEM products, consisting of proprietary memory keys, cards and other
custom-shaped tokens that serve as a convenient way to carry electronic
information and are packaged to survive in portable environments.

         The Company's first portable memory products, consisting of an
electronic key and support electronics, were introduced in 1981 for applications
requiring convenient storage, transportation and management of information. The
Company's current products utilize semiconductor technology to provide a storage
device more versatile than conventional portable information products such as
keys, badges and magnetic stripe cards. The Company's current product line of
portable memory devices and associated interface products provide up to
16,384,000 bits of data storage which are used in a wide range of applications
including communications security, computer security, facility security, vending
and process control.

         Each of the Company's portable memory systems consist of one or more
portable memory devices, access devices and, for certain models, interface
modules containing microprocessors. These components, together with the user's
processor-based equipment, function as an integrated system allowing
instantaneous processing of personalized data carried within a portable data
carrier. Through the incorporation of advanced semiconductor memory technology,
the Company's portable memory device is able to store and carry substantial
amounts of information. When the memory device is used in conjunction and with
the other components of the Company's system, information can be selectively
altered, added to or erased, as required, to effectively and reliably manage or
control a particular activity or transaction.

         The Company has introduced end-user systems that utilize smart cards or
smart keys and are designed to provide advanced information security utilizing
digital signatures and encryption. These systems incorporate hardware and
software to provide a higher level of security than is obtainable with current
software only solutions.

Current Products and Products Under Development

Electronic Products (EP)

         Portable Memory Devices. Portable memory devices are electronic devices
which store information. They have a plastic exterior, are in the forms of keys,
cards, or custom shaped tokens and encapsulate semiconductor memory. Certain
devices have been designed to store information which may be retrieved, altered,
erased or updated; while other devices have been designed to store one-time
programmable information which may be retrieved but not altered or updated. The
storage capacities of the Company's portable memory devices range from 1,024

<PAGE>

bits to 16,384,000 bits. The portable memory devices are priced generally
between $2 and $100 per unit, depending on capacities and quantities purchased.

         Access Device. The access device is the element into which a portable
memory device is inserted to provide the interconnection between the portable
memory device and the electronic interface circuitry or the host processor-based
equipment. It is through this physical interconnection that the data contained
in the portable memory device is transmitted to the electronic interface or to
the host interface. Several models of the access device have been developed to
handle the Company's different portable memory devices. The access devices are
priced generally between $15 and $120 per unit, depending on models and
quantities purchased.

         Interface. The interface is the electronics control module between the
access device and a customer's processor-based equipment. This module is used
with the Company's serial communication key and contains all the necessary
electronics to control information within the key and to coordinate the
information requests of the host equipment. This communication process is
managed by the system's firmware, which is a software program existing within
the interface. For some applications, this firmware structures, secures and
verifies the information within the portable device, and may allow separate
groups or files of data to reside in a single portable device and be secure from
access except by equipment authorized to manage a particular group or file of
data. The interface is priced between $70 and $120 per unit, depending on models
and quantities purchased.

Integrated System Solutions (ISS)

         For the past three years, Datakey has been developing "token-based"
(smart card or smart key) products that provide advanced information security
solutions to the problems of organizations, worldwide. The first release of
these token-based information security systems was introduced in September 1997
and additional versions were introduced in 1998. In addition to other versions,
the Company expects to launch a new version of SignaSURE CIP in the second half
of 1999. The launch and success of such products is dependent on further
successful development efforts and market acceptance, along with other risks.
See "Forward Looking Statements."

         SignaSURE CIP. Password-based software programs that implement
public-key cryptography technology for information security offer easier
operation and improved data integrity over older symmetric cryptography
software. Password-based security, however, is insufficient for networks with
connections, such as the Internet, outside of the organization. The Company's
SignaSURE CIP (Cryptographic Interface Provider) is designed to solve this
problem, allowing the Internet to be used safely for electronic commerce.

         SignaSURE CIP allows users and value-added resellers to upgrade their
software-only systems to token-based information security and gain the benefit
of secure Internet operation. Token-based information security implements a
two-level security scheme--something that is owned (a hardware token) and
something that is known (a password to activate the token)--for a much stronger
level of security than password-based software solutions. SignaSURE CIP provides
token add-ons to Cryptoki (PKCS-11) standard information security interface
applications and for applications that incorporate Microsoft's CryptoAPI (API).
These products offer "load, plug and play" convenience for strong information
security.

         SignaSURE CIP products include a user-unique smart card or smart key
that holds the critical information to perform the cryptographic functions
necessary for information privacy and data integrity, a companion reader/writer
that plugs into a computer's serial port, PCMCIA port or floppy disk drive, and
software which is loaded into the workstation and interfaces to the application
program. The Company introduced, in September 1997, a version of SignaSURE CIP

<PAGE>

that utilizes the standard PKCS #11 (Cryptoki) Interface and then in January
1998, it released a version that utilizes either the PKCS#11 interface or
Microsoft's CryptoAPI.

         SignaSURE DTK. As public-key information security continues to grow,
due to the technology's adoption by well-known software companies such as
Microsoft and Netscape, software developers are implementing public-key
information security into their specialized applications. Because no easy method
was previously available for application developers to implement a token-based
public key infrastructure (PKI), the Company developed its SignaSURE DTK
(Developers Tool Kit) so that developers could easily and cost-effectively
launch their applications with the much stronger, token-based information
security.

         SignaSURE DTK is a turnkey package that the Company designed to allow
software developers to integrate Datakey hardware tokens and a PKI into their
applications. DTK includes up to three main components: hardware cryptographic
tokens, interface and integration software and security infrastructure products.
DTK is available in four configurations ranging from a token with a
reader/writer and integration software, to the full PKI configuration that
issues and manages hardware tokens and digital certificates. This product
flexibility allows user-developers who utilize SignaSURE DTK to integrate just
what is needed for their application. The Company began selling the SignaSURE
DTK in mid-1997.

         SignaSURE ESS. Many organizations have made the transition from large
mainframe systems to more flexible, but much less secure, client-server networks
and intranets. Client-server networks and intranets allow digital information to
reside on networks, rather than at the desktop so many authorized users can
access the same information. Authorized users may include company employees,
suppliers and customers who can be connected to the network, or located remotely
from the enterprise. With the advent of the Internet, information transmission
over any distance can be accomplished quickly and cost effectively, but not
securely. Datakey believes its SignaSURE ESS (Enterprise Security Suite) offers
a solution to manage a network, intranet and Internet computing structure to
allow only authorized users access to information. Information can then be
transmitted securely and stored safely on both private and public networks
without privacy and data integrity concerns.

         SignaSURE ESS is an integrated "end-to-end" data security system that
the Company believes will assure secure network access, confidential information
exchange, integrity of data and transaction non-repudiation. Secure,
personalized smart tokens are employed within a PKI to provide a higher level of
information security than is provided by software-only solutions. Security
functions are integrated into applications like Microsoft Office(TM), thereby
providing seamless security operation to the user. SignaSURE ESS will operate
over the Internet, and wide and local area networks enabling secure information
exchange for all users, whether local or remote to the enterprise.

         SignaSURE ESS includes a user-personalized smart card or smart key and
companion reader/writer for workstation or laptop that perform the functions
necessary for information privacy and data integrity. It also incorporates
client software that manages secure information and interfaces to applications,
and server-based, enterprise infrastructure hardware and software that
initialize SignaSURE ESS and continuously ensure that all users are authorized.
ESS also includes an optional secure stand-alone workstation to initialize cards
and provide backup of private keys for recovery purposes. The Company plans to
release SignaSURE ESS in the second half of 1999.


<PAGE>

         The following chart shows the Company's SignaSURE products:

                                           SignaSURE Product
Attribute                                  CIP    DTK    ESS
------------- --------------------------   ---    ---    ---
Customer      Organizational End-User       x             x
              Software Developer                   x   
                                                       
System Type   Integrated Solution                         x
              Add-on Subsystem              x          
              Component                            x   
                                                       
Application   Information Security          x             x
              Token Integration             x      x   
                                                       
Hardware      Datakey Smart Token           x      x      x
              Datakey Reader/Writer         x      x      x
                                                       
Software      Security Solution                           x
              Token Interface               x      x   
                                                     

Year 2000

         The Company's new products are designed to accept either two digits or
four digits in designating the year. As a result, these products can distinguish
the year 2000 from the year 1900; therefore, the Company does not believe the
year 2000 will cause any material problems. See also "Management's Discussion &
Analysis--Year 2000."


Research and Development

         During 1997 and 1998, the Company continued the development of portable
memory devices to expand its line of standard products as well as newly designed
custom products. The Company also continued its development of token-based
information security products.

         As the need for computer security products continues to grow, the
Company has been expending significant effort into development and improvement
of token-based computer information security systems. The Company's SignaSURE
line of information security products, which were initially released for sale
during 1997, are designed to provide encryption and digital signatures required
for electronically generated documents on computer networks.

         The technology involved in information security systems is undergoing
rapid expansion and advancement which could result in the development of new
products and systems which may make the Company's present information security
products obsolete. The initial development effort for the Company's information
security products was completed in 1997 but the Company must continue to improve
its present information security products in order to remain competitive.

         In 1998 and 1997, research and development expenses were $1,673,000 and
$3,186,000, respectively. The Company expects that research and development
expenses in 1999 will be greater than in 1998.


<PAGE>

Manufacturing

         The Company's in-house manufacturing capabilities include
microelectronic assembly, plastic injection molding, automated surface mount
assembly, and general electronic assembly. The Company also utilizes independent
subcontractors from time to time to perform certain manufacturing functions. The
Company provides a 90-day warranty on domestic sales, a 180-day warranty on
sales to its international distributors to cover the longer shelf life of the
Company's products, and a 180-day warranty on sales to the government.

         In an effort to more efficiently produce products, to reduce product
costs, and to increase its manufacturing flexibility, the Company intends to
continue to improve certain manufacturing processes and add capital equipment to
its manufacturing operations. While the Company believes that these steps will
provide a greater level of control over, and flexibility in, its manufacturing
processes, there are no assurances that the Company's ability to produce
products and to meet required delivery schedules will be sufficiently improved
to meet the demands created by increased sales and more complex manufacturing
processes.

Sources of Supply

         The Company purchases a microprocessor, with its proprietary operating
masked into the chip, from a single source supplier. The Company intends to
continue purchasing microprocessors from this supplier during 1999 but will
continue to evaluate alternative sources of supply.

         Due to the unique nature of these cryptographic microprocessors, there
are currently a limited number of alternative sources of supply and, due to
different operating systems and other characteristics, one supplier's
microprocessors are not easily interchanged with another. Should the present
source of supply become inadequate or inferior to other offerings in the future
or should it experience unforeseen Year 2000 issues, the Company will be
required to incur a significant cost and possibly experience a gap in supply to
switch to a new supplier.

         The Company has several qualified sources from which to purchase
printed circuit boards and electronic components for most of its standard
portable memory devices. The components for the Company's products are, in
general, available from multiple suppliers. Some of the plastic components are
molded on the Company's in-house molding equipment or suppliers' molding
equipment using Company-owned tooling.

         The Company purchases integrated circuits primarily through nationwide
multivendor distributors. If, for any reason, the Company would have to cancel
or reduce a particular integrated circuit order, it might thereafter have to pay
a higher price for the integrated circuits. Since general economic conditions
have an effect on the supply and cost of integrated circuits, there is no
guarantee that the Company will be able to obtain adequate quantities of
integrated circuits to meet all of its production needs during periods of short
supply.

Significant Customer

         The Company sells its electronic products to a number of commercial
original equipment manufacturers and other customers, including governmental
entities. At this time, the Company is not dependent on any one customer or few
customers, the loss of which would have a material adverse effect on its
business.


<PAGE>

Marketing

         General. While there appears to be a broad range of applications and
potential customers for portable memory devices, no single application group has
evidenced strong, long-term growth potential. The diversity of potential
applications has made it difficult for the Company to focus its limited
marketing resources. In 1997, sales to EP customers decreased to $5,868,000, and
in 1998 they decreased to $5,241,000. As sales to new customers come on line,
the Company believes that commercial EP sales may increase in 1999.

         ISS products for the information security marketplace were introduced
in 1997 and resulted in revenue of $629,000 during 1998. In 1999, the Company
expects revenue from these products to increase significantly as additional
pilot programs are commenced and certain customers convert into production mode.
As with any new product line, revenue will depend on customer acceptance, the
extent of which is difficult to assess at this time.

         Market for EP Products. To date, most applications in the commercial
and government market have used the Data Key for electronic security and
equipment control applications. The Company is seeking to develop other
long-term business in this market. The Company markets its products to domestic
and international customers using the following channels:

                  Domestic. The Company markets its portable memory devices
domestically through a combination of direct and indirect sales personnel. In
addition, it utilizes advertising, trade shows and direct mail to reach its
buying audience. In 1998 and 1997, EP sales to domestic customers, and the
corresponding percentage of total revenue, were approximately $3,650,000 (62%)
and $4,068,000 (68%), respectively.

                  International. The Company presently markets its portable
memory devices internationally through an independent sales agent in the United
Kingdom and agents and/or distributors in Australia, Belgium, the Netherlands,
Germany, Ireland, Spain, Italy and Sweden. The Company has customers in other
countries who are handled on a direct basis from the Company's headquarters in
the United States. The Company intends to expand into other international market
areas in the future. In 1998 and 1997, EP sales to international customers, and
the corresponding percentage of total revenue, were approximately $1,591,000
(27%) and $1,800,000 (30%), respectively.

         Market for ISS Products. Datakey markets and sells its advanced
information security products (the initial offerings in its ISS line) through a
combination of direct sales and marketing personnel, dealers, distributors,
value added resellers and system integrators/developers.

         The direct sales and marketing personnel concentrate primarily on
relationships with large security-conscious organizations either through direct
or indirect contact, establishing alliances with system integrators/developers
and setting up dealer/distributor relationships for its products. The future
revenue of Datakey ISS products is dependent on the success of a new and
untested marketing and direct sales organization. Also, see "Outlook and Risks"
in the Management's Discussion and Analysis contained in the Company's 1998
Annual Report, portions of which are included in Exhibit 13.1 of this Report.

Backlog

         As of March 13, 1999, the Company had an order backlog, totaling
approximately $2,053,000, including approximately $748,000 with no scheduled
shipment date or with scheduled shipment dates after 1999. Although the orders

<PAGE>

generally contain scheduled shipment dates, they may be accelerated, delayed or
canceled at the customer's request. The Company does not believe that the
current backlog is necessarily indicative of future backlog levels.

Competition

         Electronic Products. The Company's primary competition for electronic
products sold to original equipment manufacturers is presently, and is expected
to remain, conventional portable information systems, such as keys and cards,
and more advanced portable information systems including those in the familiar
credit card format, such as "smart cards," Personal Computer Memory Card
Industry Association (PCMCIA) cards, magnetic stripe cards, bar-code cards and
laser technology cards. The Company's products, when used as a portable data
base, may also compete with centralized data base systems. Many of the
manufacturers of these portable information devices and systems are large,
well-established companies.

         A number of European and Japanese firms continue to develop and refine
the smart card technologies. Some of these companies have established branch
offices in the United States to explore the United States market. To date, the
smart card has been used primarily in Europe, where it has been implemented
extensively in prepaid telephone systems and more recently in loyalty programs
and various cashless vending applications. In the United States, smart cards are
currently being used mainly in field trial environments. Although the Company
does not have complete information about the status of these trials, the Company
believes that, in time, the smart card will be successfully developed and could
become a competitor, especially in those markets which have a history of using a
card or a preference for card-type devices.

         Memory cards, such as PCMCIA standard cards, are functionally
equivalent to the Company's portable memory devices in that they utilize
semiconductor memory in card-shaped devices made of plastic. Memory cards
generally have larger memory capacities than the devices currently offered by
the Company and historically incorporated volatile, battery-backed memory
elements. More recently, nonvolatile (principally "Flash Memory") memory
elements which do not require battery backup have become more prominent. They
are used in such applications as laser printer fonts, instrumentation,
electronic lettering machines and fax/modems, and are also used as replacements
or "add ons" to diskettes and hard drives for data storage in certain desktop,
notebook and smaller portable computers.

         Magnetic stripe cards are relatively inexpensive and are used
extensively in the access control industry and in the banking and credit card
industries. These markets are not priority markets for the Company's portable
information devices. Magnetic stripe cards are not conveniently updated, have
limited storage capacity and generally have a useful life of one or two years.
As a result, the Company believes its products are technologically superior and
may be more cost-effective for applications requiring more complex technologies.

         Other portable memory devices, including one in a "button" form and
others in shapes similar to the Data Key, are becoming more common in the
marketplace. Many of these competing devices utilize similar semiconductor
components and electronic interfaces. The Company expects competition from these
alternative devices to continue in the future.

         Another technology utilizes a strip of reflective material which is
laminated into a card. Information is inscribed on this material through use of
a laser beam. Since these cards can contain several million bits of information,
the Company believes that this technology will be a competitor in portable
information markets where very large information storage capacities are required
and instantaneous management of information is not essential.


<PAGE>

         The Company's ability to compete in the portable information market
will depend primarily on its ability to demonstrate superior product performance
at cost-effective prices and on the enhanced features of its system which make
it more effective than competing systems.

         Integrated System Solutions. Datakey currently offers token-based
(smart card, smart key) information security systems which are primarily
utilized in encryption for electronic mail privacy, private and secure file
transfer and digital signatures for electronic document authentication. The
Company is continuing a significant product development effort to expand the
applications and ease-of-use of its products and systems. See
"Products--Integrated System Solutions."

         Competition in the information security business is varied with
companies offering hardware solutions, software solutions and combinations of
hardware and software solutions. As awareness for security on the Internet,
company intranets and on other local area networks has increased over the past
few years, many companies have introduced software and/or hardware based
products to provide security. These products range from software-based password
only systems to firewalls, which may be very sophisticated. Other applications
are using hand held hardware devices, commonly referred to as tokens, to provide
access to networks and, in some cases, use encryption and digital signatures to
further secure networks.

         The Company's advanced information security products, some of which are
released and some of which are currently in development, are based upon a smart
card or smart key and utilize encryption and digital signatures. They also
include extensive software to make the system user-friendly and seamless with
common desktop software packages. The Company feels this will provide a unique
combination of advanced security features at a reasonable selling price. There
are several companies operating in this highly competitive and rapidly changing
marketplace, however, and many of such companies have strong name recognition
and vast financial resources. The Company believes it can compete on the basis
of its unique design and ease of use. The initial reception to the Company's
products in the marketplace, beginning in late 1997, has been encouraging and
sales of evaluation units and units for pilot programs have been progressing
very well. There are no assurances, however, that the existing and future
products will, in the long term, be accepted in the marketplace.

Patents and Trademarks

         The Company has been granted several patents by the United States
Patent and Trademark Office relative to the Data Key, its key interface and its
overall portable information device technology. The Company has sought and will,
when appropriate, continue to seek patent protection in several foreign
countries. The federal registration of the Datakey trademark was approved in
1985. In an industry characterized by rapid technological change, the Company
believes that the knowledge, experience and creativity of its employees will
prove to be more important than patent protection.

Employees

         As of March 13, 1999, the Company employs 60 full-time employees, 15 of
whom are involved in manufacturing, 3 in materials handling, 2 in quality
assurance, 14 in engineering, 16 in marketing/sales and 10 in general and
administrative areas. In addition, the Company uses contract labor during peak
production times and for major projects. The Company's employees are not subject
to a collective bargaining agreement, and the Company believes that its employee
relations are good.


<PAGE>

Forward Looking Statements

Certain statements made in this Form 10-KSB, which are summarized here, are
forward-looking statements that involve risk and uncertainties, and actual
results may be materially different. Factors that could cause actual results to
differ include, but are not limited to, those identified:

o    The expectation that Datakey in the second half of 1999 will introduce
     SignaSURE ESS and a new version of SignaSURE CIP, is subject to the risk of
     unanticipated problems or delays in development and depends upon market
     acceptance and demand, as well as other general market conditions and
     competitive conditions within this market, including the introduction of
     products by competitors.
o    The expectation that the Company will continue to improve its manufacturing
     processes, leading to more efficient production, depends on the Company's
     ability to monitor such processes and to add capital equipment to its
     manufacturing operations.
o    The expectation that commercial EP sales may increase in 1999 depends on
     acceptance by new customers identified by the Company's sales
     representatives, as well as other general market conditions and competitive
     conditions.
o    The expectation that the Company will expand sales in international markets
     depends on the acceptance of its products in such markets, the quality and
     performance of the Company's products as compared to competitive products,
     the effectiveness of relatively new marketing and sales personnel, and
     other general market and competitive conditions within such markets.

ITEM 2.  DESCRIPTION OF PROPERTY

         The Company's corporate offices and manufacturing facility, located at
407 West Travelers Trail, Burnsville, Minnesota, consists of 18,488 square feet.
Approximately one-half of the space is used for manufacturing and warehousing,
and the balance for present and future office space. All of this space is rented
under a lease which extends through June 1999. The Company also utilizes
approximately 2,400 square feet in a nearby office under a sublease that expires
in May 1999. The annualized rent expense for the space currently occupied is
$160,000, plus a portion of the operating expenses and real estate taxes. The
Company is currently negotiating with its present landlord to extend its lease
for an additional five years and to add approximately 6,500 square feet of
adjoining space to provide for relocation of personnel from the nearby office
and also for future expansion. The Company is also evaluating proposals from two
other parties for similar space in the nearby vicinity. The Company intends to
make a decision on space by April 15, 1999.

ITEM 3.  LEGAL PROCEEDINGS

         There are no material legal proceedings pending to which the Company is
a party or of which any of its property is the subject.

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

         There were no matters submitted to a vote of security holders during
the fourth quarter of fiscal year 1998.


<PAGE>

                                     PART II

ITEM 5.           MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

         The Company's common stock is traded on the Nasdaq National Market
System under the symbol DKEY. The high and low sale prices for the common stock
by quarter as reported by Nasdaq are set forth in the following table for 1998
and 1997.

         On March 12, 1999, the Company had approximately 1,100 shareholders,
including approximately 800 beneficial owners. The Company has never paid
dividends on its common stock and does not plan to in the foreseeable future.
                                                         Sale Prices
                                                    High      Low
1998
   1st Quarter.................................     $4        $2 3/4
   2nd Quarter.................................     $7 1/2    $2 5/8
   3rd Quarter.................................     $6 7/8    $2 7/8
   4th Quarter.................................     $3 3/4    $1 15/16

1997
   1st Quarter.................................     $4 7/8    $2 1/4
   2nd Quarter.................................     $4 7/8    $1 7/8
   3rd Quarter.................................     $4 1/4    $3
   4th Quarter.................................     $4 1/4    $3 1/8

ITEM 6.  MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION

         The information required by Item 6 is incorporated by reference from
the Company's 1998 Annual Report, a portion of which is included herewith in
Exhibit 13.1 to this Report.

ITEM 7.  FINANCIAL STATEMENTS

         The following financial statements of the Company are included
as part of Exhibit 13.1 to this Report:

                                                                          
         Independent Auditor's Report                                     
         Consolidated Balance Sheets as of December 31, 1998 and 1997     
         Consolidated Statements of Operations for Years Ended
            December 31, 1998 and 1997                                    
         Consolidated Statements of Stockholders' Equity for Years 
            Ended December 31, 1998 and 1997                              
         Consolidated Statements of Cash Flows for Years Ended 
            December 31, 1998 and 1997                                    
         Notes to Consolidated Financial Statements                       



<PAGE>

ITEM 8.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND 
         FINANCIAL DISCLOSURE

         None.

                                    PART III

ITEM 9.  DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS, 
         COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT

         The information required by Item 9 regarding the Company's directors
and executive officers is incorporated by reference to the Company's proxy
statement for its 1999 Annual Meeting of Shareholders under the captions
"Determination of Number and Election of Directors" and "Executive Officers of
the Company." The Company's proxy statement will be filed pursuant to Rule 14a-3
within 120 days after the close of the fiscal year for which this report is
filed.

         The information relating to compliance with Section 16(a) of the
Exchange Act is incorporated by reference to the Company's proxy statement for
its 1999 Annual Meeting of Shareholders under the caption "Section 16(a)
Beneficial Ownership Compliance."

ITEM 10. EXECUTIVE COMPENSATION

         The information required by Item 10 is incorporated by reference to the
Company's proxy statement for its 1999 Annual Meeting of Shareholders under the
caption "Executive Compensation."

ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

         The information required by Item 11 is incorporated by reference to the
Company's proxy statement for its 1999 Annual Meeting of Shareholders under the
caption "Security Ownership of Management and Certain Beneficial Owners."

ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

         None.

ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K

         (a)      Exhibits

         The following exhibits are included in this report: See "Exhibit Index"
immediately following the financial statements following the signature page of
this Form 10-KSB.

         (b)      Reports on Form 8-K

         No reports on Form 8-K were filed by the Company during the quarter
ended December 31, 1998.



<PAGE>

                                   SIGNATURES

         Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Issuer has caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.

Dated:  March 30, 1999                DATAKEY, INC.


                                      BY:   /s/ Carl P. Boecher
                                            Carl P. Boecher
                                            Chief Executive Officer and Director
                                            (Principal Executive Officer)

         Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed by the following persons on behalf of the Company,
in the capacities, and on the dates, indicated:

                                POWER OF ATTORNEY

         Each person whose signature appears below constitutes and appoints Carl
P. Boecher and Alan G. Shuler as his true and lawful attorneys-in-fact and
agents, each acting alone, with full power of substitution and resubstitution,
for him and in his name, place and stead, in any and all capacities, to sign any
or all amendments to this Annual Report on Form 10-KSB and to file the same,
with all exhibits thereto, and other documents in connection therewith, with the
Securities and Exchange Commission, granting unto said attorneys-in-fact and
agents, acting alone, full power and authority to do and perform each and every
act and thing requisite and necessary to be done in and about the premises, as
fully to all intents and purposes as he might or could do in person, hereby
ratifying and confirming said attorneys-in-fact and agents, acting alone, or his
substitute or substitutes, may lawfully do or cause to be done by virtue
thereof.

SIGNATURES                     TITLES                                  DATE
                         
/s/ Carl P. Boecher          Chief Executive Officer and         March 30, 1999
Carl P. Boecher              Director (Principal Executive
                             Officer)
                         
/s/ Alan G. Shuler           Vice President and Chief            March 30, 1999
Alan G. Shuler               Financial Officer (Principal
                             Financial and Accounting Officer)
                         
/s/ Thomas R. King           Director and Secretary              March 30, 1999
Thomas R. King           
                         
/s/ Terrence W. Glarner      Director                            March 30, 1999
Terrence W. Glarner      
                         
/s/ Gary R. Holland          Chairman of the Board of            March 30, 1999
Gary R. Holland              Directors
                         
/s/ Eugene W. Courtney       Director                            March 30, 1999
Eugene W. Courtney       
                         
/s/ John H. Underwood        Director                            March 30, 1999
John H. Underwood        
                       

<PAGE>



                                  DATAKEY, INC.

                         EXHIBIT INDEX TO ANNUAL REPORT
                                 ON FORM 10-KSB
                   For the Fiscal Year Ended December 31, 1998

Exhibit 
 No.         Description

3.1      Restated Articles of Incorporation, as amended 

3.2      Bylaws, as Amended (Incorporated by reference to Exhibit 3.2 to Form
         10-K for fiscal year ended December 31, 1988)

10.1     1987 Datakey, Inc. Stock Option Plan (Incorporated by reference to
         Exhibit 10.7 to Form 10-K for fiscal year ended December 31, 1987)*

10.2     Amendment dated March 15, 1991 to 1987 Datakey, Inc. Stock Option Plan
         (Incorporated by reference to Exhibit 10.5 to Form 10-K for fiscal year
         ended December 31, 1991)*

10.3     Amendments dated July 1, 1995 and March 19, 1996 to 1987 Datakey, Inc.
         Stock Option Plan (Incorporated by reference to Exhibit 10.5 to Form
         10-KSB for fiscal year ended December 31, 1996)*

10.4     License Agreement between CTS Corporation and the Company dated March
         9, 1988 (Incorporated by reference to Exhibit 10.8 to Form 10-K for
         fiscal year ended December 31, 1987)

10.5     Lease between the Company and Kraus-Anderson, Inc. dated June 3, 1987,
         as amended on February 10, 1988, December 23, 1988, February 13, 1992
         and April 1, 1992 (Incorporated by reference to Exhibit 10.12 to Form
         10-K for fiscal year ended December 31, 1991)

10.6     Manufacturing Agreement between Duncan Industries and the Company dated
         August 27, 1993 (Incorporated by reference to Exhibit 10.16 to Form
         10-KSB for fiscal year ended December 31, 1993)

10.7     Employment Agreement between Alan G. Shuler and the Company dated
         January 1, 1995 (Incorporated by reference to Exhibit 10 to Form 10-QSB
         for fiscal year ended July 1, 1995)*

10.8     Consulting Agreement between Gary R. Holland and the Company dated
         November 1, 1995 (Incorporated by reference to Exhibit 10.19 to Form
         10-KSB for fiscal year ended December 31, 1995)*

10.9     Amendment dated February 11, 1997 to Consulting Agreement between Gary
         R. Holland and the Company dated November 1, 1995 (Incorporated by
         reference to Exhibit 10.18 to Form 10-KSB for fiscal year ended
         December 31, 1996)*

10.10    Employment Agreement between Carl P. Boecher and the Company dated
         January 1, 1997 (Incorporated by reference to Exhibit 10.19 to Form
         10-KSB for fiscal year ended December 31, 1996)*

10.11    Separation Agreement and Release between John H. Underwood and the
         Company dated January 1, 1997 (Incorporated by reference to Exhibit
         10.20 to Form 10-KSB for fiscal year ended December 31, 1996)*


<PAGE>

10.12    1997 Management Incentive Plan, as amended March 10, 1997 (Incorporated
         by reference to Exhibit 10 to Form 10-QSB for fiscal quarter ended June
         28, 1997)*

10.13    Lease Amendment No. 5 dated December 17, 1996 to Lease between the
         Company and Kraus-Anderson, Inc. dated June 3, 1987 (Incorporated by
         reference to Exhibit 10.22 to Form 10-KSB for fiscal year ended
         December 31, 1996)

10.14    Employment Agreement between Michael L. Sorensen and the Company dated
         April 16, 1997 (Incorporated by reference to Exhibit 10.14 to Form
         10-KSB for fiscal year ended December 31, 1997)*

10.15    1997 Stock Option Plan (Incorporated by reference to Exhibit 10.15 to
         Form 10-KSB for fiscal year ended December 31, 1997)*

10.16    Forms of Incentive and Nonqualified Stock Option Agreements under 1997
         Stock Option Plan (Incorporated by reference to Exhibit 10.16 to Form
         10-KSB for fiscal year ended December 31, 1997)*

13.1     Portions of 1998 Annual Report, including 1998 Financial Statements and
         Management's Discussion and Analysis

21.1     Subsidiaries of the Company (Incorporated by reference to Exhibit 21.1
         to Form 10-KSB for fiscal year ended December 31, 1994)

23.1     Independent Accountant's Consent

24.1     Power of attorney for Carl P. Boecher, Alan G. Shuler, Thomas R. King,
         Terrence W. Glarner, Gary R. Holland, Eugene W. Courtney and John H.
         Underwood (included on the signature page of this Form 10-KSB)

27       Financial Data Schedule (filed with electronic version only)

* Designates a management contract or compensatory plan or arrangement.