SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C. 20549

                                   FORM 10-K

(Mark One)
[ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
      EXCHANGE ACT OF 1934

                 For the Fiscal Year Ended September 30, 1996.

                                      OR

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

                     For the Transition Period from ____ to _____.

                       Commission file number: 33-80987

                       MERIT BEHAVIORAL CARE CORPORATION
            (Exact name of Registrant as specified in its charter)

           Delaware                                   22-3236927
(State or other jurisdiction of                   (I.R.S. Employer
incorporation or organization)                   Identification Number)

     One Maynard Drive                                  07656
   Park Ridge, New Jersey                            (Zip Code)
(Address of principal executive offices)

                                (201) 391-8700
             (Registrant's telephone number, including area code)

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

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

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 [ ]

Indicate by check mark if disclosure of delinquent  filers  pursuant to Item 405
of Regulation  S-K is not contained  herein,  and will not be contained,  to the
best of Registrant's  knowledge,  in definitive proxy or information  statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ X ]

The only class of voting  securities of the Registrant is its common stock,  par
value  $.01  per  share  (the  "Common  Stock"),  17.5%  of  which  is  held  by
non-affiliates  of the Registrant.  The Common Stock is not registered under the
Securities  Act of 1933,  as amended  (the  "Securities  Act"),  is not publicly
traded and does not have a quantifiable market value.

The number of shares of the Common  Stock  outstanding  as of  December 1, 1996:
28,477,800.

                      DOCUMENTS INCORPORATED BY REFERENCE

Certain  exhibits as listed on the Exhibit Index and filed with the Registrant's
Registration  Statement on Form S-4 (No.  33-80987)  under the Securities Act or
its  Quarterly  Report on Form 10-Q/A for the  quarter  ended March 31, 1996 are
incorporated by reference into Part IV of this Form 10-K.


<PAGE>



                       MERIT BEHAVIORAL CARE CORPORATION
                                  FORM  10-K

                               TABLE OF CONTENTS

                                                                          Page
PART I

      Item 1.     Business................................................. 3
      Item 2.     Properties...............................................25
      Item 3.     Legal Proceedings....................................... 26
      Item 4.     Submission of Matters to a Vote of Security Holders..... 28


PART II

      Item 5.     Market for Registrant's Common Stock and Related
                    Stockholder Matters................................... 28
      Item 6.     Selected Financial Data................................. 28
      Item 7.     Management's Discussion and Analysis of Financial
                    Condition and Results of Operations................... 31
      Item 8.     Financial Statements and Supplementary Data............. 39
      Item 9.     Changes in and Disagreements with Accountants on
                    Accounting and Financial Disclosures.................. 39

PART III

      Item 10.    Directors and Executive Officers of the Registrant...... 40
      Item 11.    Executive Compensation.................................. 43
      Item 12.    Security Ownership of Certain Beneficial Owners
                    and Management........................................ 50
      Item 13.    Certain Relationships and Related Transactions.......... 51


PART IV

      Item 14.    Exhibits, Financial Statement Schedules and
                    Reports on Form 8-K................................... 54

SIGNATURES................................................................ 57


                                      2

<PAGE>



                                    PART I
------------------------------------------------------------------------------


Item 1.   Business

GENERAL

      Merit Behavioral Care  Corporation  ("MBC" or the "Company") is one of the
leading behavioral health managed care companies in the United States, arranging
for the  provision of a full  spectrum of  behavioral  healthcare  services on a
nationwide basis.  Behavioral  healthcare involves the treatment of a variety of
behavioral  health  conditions  such as emotional  and mental  health  problems,
substance abuse and other personal concerns that require counseling,  outpatient
therapy or more intensive  treatment  services.  The Company provides behavioral
health  managed care services  through a systematic  clinical  approach with the
objective of  diagnosing  problems  promptly and  designing  treatment  plans to
ensure that patients  receive the appropriate  level of care in an efficient and
cost-effective  manner. The Company manages behavioral  healthcare  programs for
its payor customers  across all segments of the healthcare  industry,  including
health maintenance  organizations ("HMOs"), Blue Cross/Blue Shield organizations
and other insurance companies, corporations and labor unions, federal, state and
local governmental  agencies, and various state Medicaid programs. The Company's
programs  covered  more than 15 million  people as of September  30,  1996,  and
management  expects  that,  based on new  programs  awarded to the Company as of
December 1, 1996,  the Company  will  arrange for the  provision  of  behavioral
healthcare  services  for more than 19 million  people in its fiscal  year ended
September 30, 1997.

      The  Company's   clinical   care  program   includes  the  use  of  intake
coordinators  and  professional  case  managers  who  coordinate  and manage the
delivery  of  treatment  services.  The  Company  offers  a  full  continuum  of
behavioral   healthcare   services   through   contractual   arrangements   with
approximately  30,000  third-party  network  providers and  approximately  2,400
third-party treatment facilities, as well as approximately 450 "staff providers"
employed by professional  corporations (the "Professional  Corporations")  which
provide treatment services  principally on behalf of the Company.  The Company's
third-party  network and staff providers include  psychiatrists,  psychologists,
licensed  clinical  social  workers,  marriage,  family  and  child  therapists,
licensed  clinical  professional  counselors  and  nurses.   Treatment  services
arranged  for and  managed by MBC  include  outpatient  care  programs  (such as
counseling and therapy), intermediate care programs (such as sub-acute emergency
care,  intensive  outpatient  programs  and partial  hospitalization  services),
inpatient  treatment services and alternative care services (such as residential
treatment,  home- and  community-based  programs and  rehabilitative and support
services).

      The Company has engaged in the provision of behavioral health managed care
programs  since 1985,  and has expanded its services and  increased  its revenue
through  significant  growth  in its  customer  base and a series  of  strategic
acquisitions,  joint ventures and other arrangements. In 1985, Albert S. Waxman,
Ph.D., the Company's Chairman and Chief Executive Officer,  co-founded  American
Biodyne, Inc., the Company's principal predecessor  ("American Biodyne"),  which
completed  an  initial  public  offering  in  1991.  In  December  1992,   Medco
Containment Services,  Inc. ("Medco Containment")  acquired American Biodyne and
combined  American  Biodyne's   behavioral  health  managed  care  and  employee
assistance program ("EAP") business with EAP operations  previously  acquired by
Medco Containment. In March 1993, MBC was formed as a holding company for all of
Medco  Containment's  behavioral  health  managed  care and EAP  operations.  In
November 1993, Medco Containment was acquired by Merck & Co., Inc. ("Merck").


                                      3

<PAGE>



      On June 30,  1995,  the  Company  and Medco  Containment  entered  into an
Agreement  and Plan of Merger (as  amended,  the  "Merger  Agreement")  with MDC
Acquisition  Corp.  ("MDC"),  a company formed by Kohlberg Kravis Roberts & Co.,
L.P.  ("KKR").  Pursuant to the Merger  Agreement,  on October 6, 1995,  MDC was
merged with and into the Company (the "Merger"),  with the Company continuing as
the surviving  corporation.  Upon completion of the Merger,  which was accounted
for as a  recapitalization,  Merck  retained  15.0% of the  Common  Stock of the
post-Merger  Company,  and  affiliates  of KKR  and  members  of MBC  management
(together  with  related   entities)  owned   approximately   73.9%  and  11.1%,
respectively, of the post-Merger Common Stock.

      The principal  executive offices of the Company are located at One Maynard
Drive,  Park Ridge, New Jersey 07656 and the Company's  telephone number at that
address  is  (201)  391-8700.   Unless  the  context  indicates  otherwise,  all
references  to  the  "Company"  or  "MBC"  shall  mean  Merit   Behavioral  Care
Corporation and its consolidated subsidiaries.

BEHAVIORAL HEALTH MANAGED CARE INDUSTRY

Overview

      Behavioral  healthcare  costs have increased  significantly  in the United
States in recent years.  According to industry sources, the direct medical costs
of behavioral  health problems,  combined with the indirect costs,  such as lost
productivity due to mental illness and alcohol and drug abuse, were estimated at
$314  billion in 1990.  In  addition,  according  to  industry  sources,  direct
behavioral  healthcare  treatment  costs in 1995 amounted to  approximately  $80
billion,  or 8% of total  healthcare  industry  spending.  In  response to these
escalating costs,  behavioral  health managed care companies,  such as MBC, have
been formed.  These companies focus on care management  techniques with the goal
of improving  early  access to care,  assuring an  effective  match  between the
patient and the behavioral healthcare  provider's  specialty,  and arranging for
the provision of an appropriate level of care in a cost-efficient  and effective
manner.  As behavioral  health managed care companies have expanded  access to a
full continuum of care, the result has been a significant  decrease in occupancy
rates and average  lengths of stay for inpatient  facilities  and an increase in
outpatient treatment and alternative care services.

      According  to  Open  Minds,  a  leading  behavioral   healthcare  industry
publication,  as of January  1996,  approximately  124.7  million  beneficiaries
(67.8% of the  approximately  184 million American  beneficiaries  covered under
health  insurance,  excluding  Medicare)  were covered by some form of specialty
behavioral  health  managed care plan (i.e., a program  typically  operated by a
vendor specializing in behavioral health managed care services). This figure has
grown from 78 million  beneficiaries  in 1992,  representing  an approximate 12%
compound annual growth rate.

Segmentation

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

                                         Beneficiaries
                                             (In                Percent
     Category of Care                     Millions)(1)          of Total
-------------------------------------  ---------------         -----------
Utilization Review/Case Management Programs  38.0                 30.5%
Non-Risk-Based Network Programs..........    29.2                 23.4
Risk-Based Network Programs..............    27.4                 22.0

                                      4

<PAGE>



EAPs.....................................    20.2                 16.2
Integrated Programs......................     9.9                  7.9
                                        ------------           -----------
Total....................................   124.7                100.0%

------------
(1) Source:  Open Minds:  Managed Behavioral Health Market Share in
the United States, Gettysburg, Pennsylvania (1996).

      These categories of care are described briefly below:

      Utilization Review/Case Management Programs. Under utilization review/case
management  programs, a behavioral health managed care company manages and often
arranges for treatment,  but does not assume any of the  responsibility  for the
cost of providing treatment services.  These programs are typically  categorized
as administrative services only ("ASO") programs.

      Non-Risk-Based  Network Programs.  Under non-risk-based  network programs,
which also are typically  categorized  as ASO programs,  the  behavioral  health
managed care company  provides a full array of managed care services,  including
selecting,   credentialling  and  managing  a  network  of  providers  (such  as
psychologists,  psychiatric  hospitals,  substance  abuse  clinics,  etc.),  and
performs   utilization  review,   claims   administration  and  case  management
functions;  however,  the third-party payor remains  responsible for the cost of
providing the treatment services rendered.

      Risk-Based  Network  Programs.  Under  risk-based  network  programs,  the
behavioral  health  managed  care  company  assumes  all  or a  portion  of  the
responsibility  for the cost of providing a full or specified range of treatment
services.  Most of  these  programs  have  payment  arrangements  in  which  the
behavioral  health managed care company  agrees to provide  services in exchange
for a fixed fee per covered member per month (a "capitated" program) that varies
depending on the profile of the beneficiary population,  or otherwise shares the
responsibility  for providing all or some portion of the treatment services at a
specific cost per person.  Under these programs,  the behavioral  health managed
care  company not only  approves and  monitors a course of  treatment,  but also
arranges  and pays  for the  provision  of  patient  care  (either  through  its
third-party network providers or staff providers or some combination thereof).

      Employee Assistance Programs. An EAP is a worksite-based  program designed
to assist in the early  identification  and resolution of productivity  problems
associated with behavioral  conditions or other personal  concerns of employees.
Under an EAP, staff or network providers or other affiliated  clinicians provide
assessment  and  referral  services to employee  beneficiaries.  These  services
consist of  evaluating a patient's  needs and, if indicated,  providing  limited
counseling and/or  identifying an appropriate  provider,  treatment  facility or
other resource for more intensive treatment services.

      Integrated  EAP/Behavioral Health Managed Care Programs. EAPs are utilized
in a preventive role and in facilitating  early intervention and brief treatment
of behavioral  healthcare  problems before more extensive treatment is required.
Consequently,  EAPs often are marketed and sold in tandem with behavioral health
managed  care  programs  through  "integrated"  product  offerings.   Integrated
programs offer employers  comprehensive  management and treatment of all aspects
of behavioral  healthcare by consolidating  EAP and managed care services into a
single program.



Trend Toward Integrated Behavioral Healthcare Organizations

                                      5

<PAGE>



       An integrated  behavioral  healthcare  organization  combines delivery of
treatment  services  directly to patients with  behavioral  health  managed care
services.  The  advantage of this  combination  is the ability of an  integrated
behavioral   healthcare   organization  to  manage  care  more  efficiently  and
cost-effectively  than traditional  behavioral  health managed care companies by
providing  services  directly to  beneficiaries,  rather than  arranging for the
delivery  of  care  through  contracts  with  network  providers  and  treatment
facilities. As the behavioral health managed care market has developed, pressure
on behavioral health managed care companies to provide high quality care at more
competitive rates has begun to result in closer relationships between behavioral
health managed care companies and providers of care. The Company  believes that,
in the  future,  these  two  groups  will  continue  to  join  together  through
acquisitions, joint ventures and other arrangements,  thereby forming integrated
behavioral healthcare organizations.

Areas of Growth

      Management  believes that the  behavioral  health managed care industry is
growing  across all patient  segments,  particularly  with  respect to capitated
programs,  as payors of behavioral healthcare benefits are seeking to reduce the
costs  of  treatment  and  shift  the  responsibility  for  such  costs to other
entities,  while  maintaining  high quality  care.  The Company also expects the
number of beneficiaries  covered under capitated  programs to increase,  as HMOs
increase  their  penetration  of  the  healthcare  services  market.  Management
believes that a number of opportunities  exist in the behavioral  health managed
care industry for future  growth,  particularly  in the  Medicaid,  Medicare and
uninsured markets.

      Medicaid Market. Medicaid is a joint state and federally funded program to
provide healthcare  benefits to approximately 36 million low income individuals,
including  welfare  recipients.  A 1995 article in Health Care Financing  Review
reported that, from 1991 to 1994,  federal and state Medicaid spending increased
at an  average  annual  rate of  approximately  11%,  as  compared  to an annual
increase  in  overall  healthcare  spending  of  approximately  7.5%.  Moreover,
Medicaid costs were  projected to rise from an estimated  $138.4 billion in 1995
to $333.4 billion in 2005. State Medicaid  programs have recently begun to shift
beneficiaries into managed care programs in order to control rising costs.

      Despite the increase in managed care enrollment of Medicaid beneficiaries,
the  Medicaid  market  remains  unpenetrated  to a large  extent by managed care
organizations.  As  of  June  1995,  according  to  the  Health  Care  Financing
Administration  ("HCFA")  of the United  States  Department  of Health and Human
Services,  only approximately 32% of all Medicaid beneficiaries were enrolled in
some form of managed care  program.  The Company  expects the number of Medicaid
recipients  enrolled in  behavioral  health  managed  care  programs to increase
through two avenues:  (i) subcontracts  with HMOs and (ii) direct contracts with
state agencies.  As HMOs increase their penetration of the Medicaid market,  the
Company expects that many HMOs will continue to (or begin to)  subcontract  with
behavioral  health  managed  care  companies  to provide  services  for Medicaid
beneficiaries.  State  agencies  have  also  begun  to  contract  directly  with
behavioral  health  managed  care  companies  to provide  behavioral  healthcare
services to their  Medicaid  beneficiaries.  At least five  states have  already
"carved out" behavioral healthcare from their overall Medicaid programs and have
contracted  directly with  behavioral  health  managed care companies to provide
these services.  As of October 1996, 15 other states had received  approval from
HCFA for a Section  1115  waiver  that would  allow  those  states to  implement
mandatory  statewide Medicaid managed care programs,  while 11 other states were
seeking similar approval.

      Medicare Market. Medicare is a federally funded healthcare program for the
elderly. Medicare has experienced an increase in its beneficiary population over
the  past  several  years,  as  well as  rapidly  escalating  healthcare  costs.
According  to the  Congressional  Budget  Office,  Medicare  spending  has  been
projected to increase from an estimated  $176 billion in 1995 to $460 billion by
2005. Currently, only

                                      6

<PAGE>



approximately 4.6 million,  or 12.3%, of the approximately 37.4 million eligible
Medicare  beneficiaries are enrolled in managed care programs.  While enrollment
has increased from  approximately 7% of the eligible  Medicare  beneficiaries in
1993,  it is  still  considerably  below  that of the  commercial  and  Medicaid
populations. Management believes that in response to increased healthcare costs,
the Medicare market will shift into managed care programs in the future.  To the
extent that managed care plans  increase  their  penetration  among the Medicare
beneficiary  population,  the Company believes the Medicare market will continue
to represent an  opportunity  for growth among  behavioral  health  managed care
companies.

      Uninsured Market. In 1995,  approximately 41 million people, or 15% of the
nation's  total  population,  were not covered by any form of health  insurance.
Recently,  certain states have enacted mandatory health insurance  programs that
automatically  enroll all uninsured persons in managed care plans. To the extent
that managed care plans increase their  penetration  among this large  uninsured
population,  the Company  believes  that the  uninsured  market will continue to
represent  an  opportunity  for growth  among  behavioral  health  managed  care
companies.

GROWTH STRATEGY

      The Company's objective is to expand its presence in both existing and new
behavioral  health managed care markets by building on MBC's (i) proven clinical
care  methodology,  (ii) leading  position and experience in managing  capitated
programs,  (iii) diverse and expanding customer base,  particularly with respect
to  HMOs  and  corporations,   and  (iv)  experienced  and   clinically-oriented
management team. As part of its strategy, the Company intends to:

      Continue to Pursue  Capitated  Contracts.  Management  believes MBC is the
      leading provider of capitated  managed care programs,  covering over twice
      as many beneficiaries under risk-based programs as its closest competitor.
      As of January 1996, according to Open Minds, only 22% of all beneficiaries
      covered by specialty behavioral health managed care programs were enrolled
      in risk-based or capitated programs.  The Company believes that the market
      for  capitated  managed care  services will continue to increase at a more
      rapid rate than the overall  market for  behavioral  health  managed  care
      services  because  capitated  compensation  arrangements  allow  payors to
      reduce  their  risk  with  respect  to the  cost of  providing  behavioral
      healthcare  services  while  continuing to provide  access to high quality
      care.  Management  believes  that MBC's  past  experience  and  success in
      managing capitated  contracts for HMOs,  corporations and other payors, as
      well as its leading capitated market position,  will enable MBC to benefit
      from the expected market growth in capitated programs.

      Increase  Penetration of Medicaid  Market.  The Company  believes that the
      Medicaid  market  offers  the  greatest  opportunity  for  growth  in  the
      behavioral  health  managed care industry  over the near term.  Management
      believes  that as more state  governmental  agencies  turn to managed care
      organizations  to administer their Medicaid  programs,  MBC's expertise in
      managing  capitated  programs,   its  developing  experience  in  managing
      Medicaid  populations and its existing business  relationships  with HMOs,
      place the Company in a position to  capitalize  on this  potential  growth
      opportunity.  MBC  currently  manages care for Medicaid  beneficiaries  in
      connection  with the State of Iowa's  Mental  Health  Access  Program (the
      "Iowa Medicaid  Program") and the State of Tennessee's  TennCare  Partners
      Program ("TennCare"), and also has contracts with HMOs focused on Medicaid
      beneficiary populations in eight other states.

     Expand Direct  Treatment  Services  Capability.  The Company  intends to
     further develop its  capability  to provide  behavioral  healthcare
     treatment  services directly to beneficiaries through its

                                      7

<PAGE>



      subsidiary, Continuum Behavioral Healthcare Corporation ("Continuum"). The
      Company has entered,  and intends to continue to enter, into acquisitions,
      joint ventures and other  arrangements  with providers and facilities with
      the objective of creating  broad,  integrated  regional and local provider
      and facility networks. Through this strategy, the Company hopes to enhance
      its ability to bid for and more efficiently operate capitated managed care
      programs,  as well as to market  Continuum's  direct treatment services to
      third-party  payors of behavioral  healthcare  benefits,  including  other
      managed care companies.

PROGRAMS AND SERVICES

      The following table sets forth the number of beneficiaries  covered by MBC
for each type of program  offered as of  September  30,  1996,  and the  revenue
attributable to each such program in fiscal 1996:
<TABLE>
<CAPTION>

Programs                     Beneficiaries    Percent      Revenue     Percent
                                    (In Millions, Except Percentages)
<S>                                   <C>         <C>       <C>         <C>
Capitated Programs..................  8.2         52%       $ 334.2     73%
EAPs................................  3.8         25           46.9     10
Integrated Programs.................  2.4         15           40.4      9
ASO Programs........................  1.3          8           13.0      3
Other...............................    -          -           23.3      5
                                   ------     -------      --------   -----
  Total............................  15.7        100%       $ 457.8    100%
                                     ====        ====       =======   =====
</TABLE>

      Capitated  Programs.   Under  the  Company's   risk-based  or  "capitated"
programs,  the Company  typically  arranges for the provision of a full range of
outpatient,  intermediate and inpatient  treatment  services to beneficiaries of
its customers'  healthcare benefit plans,  primarily through fee arrangements in
which  MBC  assumes  all or a  portion  of the  responsibility  for the  cost of
providing  such  services.  The Company  arranges for the provision of treatment
services  pursuant to a managed network model,  under which care is delivered by
third-party  network  providers  and,  where  appropriate,  the Company's  staff
providers. Management believes that the Company's mix of third-party network and
staff providers,  as well as its experience in pricing  capitated  contracts and
managing  the  provision  of care,  allows it to  structure  programs  to meet a
customer's specific healthcare benefits requirements.

      Employee  Assistance  Programs.   The  Company's  EAPs  typically  provide
assessment and referral services to employees of MBC's customers in an effort to
assist in the early  identification  and  resolution  of  productivity  problems
associated  with  employees who are impaired by  behavioral  conditions or other
personal concerns. For many EAP customers,  MBC also provides limited outpatient
therapy  (typically  limited to eight or fewer  sessions) to patients  requiring
such services. For these services, the Company typically is paid a fixed fee per
member per month;  however,  the Company is usually not responsible for the cost
of  providing  care beyond these  services.  If further  services are  necessary
beyond limited outpatient therapy,  the Company will refer the beneficiary to an
appropriate  provider  or  treatment  facility.  A  substantial  majority of the
Company's  existing customer  contracts are EAP contracts.  Management  believes
that MBC is the leading provider (based on the number of beneficiaries  covered)
of EAPs in the behavioral healthcare industry.

      Integrated   EAP/Behavioral  Health  Managed  Care  Programs.   Under  its
integrated programs, the Company typically establishes an EAP to function as the
"front end" of a managed care  program  that  provides a full range of services,
including more intensive  treatment services not covered by the EAP. The Company
usually  manages the EAP and accepts all or some of the  responsibility  for the
cost of any

                                      8

<PAGE>



additional treatment required upon referral out of the EAP, thus integrating the
two products and using both MBC's case  management and clinical care  techniques
to manage the provision of care.

      ASO  Programs.  Under its ASO  programs,  the  Company  provides  services
ranging from utilization review and claims administration to the arrangement for
and  management  of a full range of  patient  treatment  services,  but does not
assume any of the responsibility for the cost of providing treatment services.

CUSTOMERS, CONTRACTS AND MARKETING

Customers

      The following table sets forth the number of beneficiaries  covered by MBC
in  each of its  market  segments  as of  September  30,  1996  and the  revenue
attributable to each such segment for fiscal 1996:
 <TABLE>
 <CAPTION>

Market                   Beneficiaries  Percent       Revenue    Percent
                               (In Millions, Except Percentages)
<S>                                <C>     <C>          <C>            <C>
Corporations and Labor Unions...  6.7     43%          $ 93.2        20%
HMOs(1).........................  3.7     24            105.8        23
Blue Cross/Blue Shield and
     Insurance Companies........  3.0     19             88.1        19
Medicaid Programs...............  1.1      7            120.3        26
Governmental Agencies
      (including CHAMPUS).......  1.0      6             32.3         7
Other...........................   .2      1             18.1         5
                                -----  -----            -----     -----
  Total.......................   15.7    100%         $ 457.8       100%
                                 ====    ====           =====      ====
</TABLE>

 ---------------
(1) For  purposes of this table,  the HMO  segment  excludes  HMOs that focus on
Medicaid,  Civilian  Health  and  Medical  Program  of  the  Uniformed  Services
("CHAMPUS") or state employee plan beneficiary populations.

Contracts

      The Company's contracts with customers typically have terms of one to five
years,  and in certain  cases  contain  renewal  provisions  (at the  customer's
option) for  successive  terms of between one and two years  (unless  terminated
earlier).  Substantially all of these contracts are immediately  terminable with
cause and many, including the Company's agreement with the State of Iowa for the
Iowa  Medicaid  Program  (the "Iowa  Mental  Health  Contract"),  the  Company's
contract  relating  to the  TennCare  program  and the  Company's  contracts  in
connection  with the Empire Joint Venture (as described  below),  are terminable
without cause by the customer either upon the provision of requisite  notice and
the passage of a specified period of time (typically between 60 and 180 days) or
upon the  occurrence  of other  specified  events.  In addition,  the  Company's
contracts with federal, state and local governmental agencies, under both direct
contracts and subcontract arrangements with HMOs, generally are conditioned upon
financial  appropriations by one or more governmental agencies.  These contracts
generally can be terminated or modified by the agency or HMO, as applicable,  if
such  appropriations  are not made.  In the  ordinary  course of  business,  the
Company's  business  arrangements  with certain  customers  may continue  beyond
expiration of the stated term of the applicable contracts while the terms of new
or renewed  contracts  are being  negotiated.  In such cases,  the  customer may
terminate the arrangements at any time.


                                      9

<PAGE>



Marketing and Sales

      The Company's marketing and sales organization is managed by the Company's
Chief  Marketing  Officer  and is  structured  to  address  the  Company's  four
principal market segments:  (i) HMOs; (ii) Blue Cross/Blue Shield  organizations
and  insurance  companies,  and  federal,  state and local  governmental  agency
employee programs (including CHAMPUS);  (iii) corporations and labor unions; and
(iv) public  entitlement  programs  (including  Medicaid and Medicare).  Each of
these four market  segments is overseen by a General  Manager who reports to the
Chief  Marketing  Officer.   For  each  specific  market,  the  Company  employs
integrated  teams of Sales  Managers  and  Account  Managers  who work under the
supervision of the General  Manager for that market.  The Sales Managers and the
Account Managers,  together with the Company's clinical management organization,
work closely to ensure that new customer programs are implemented  successfully,
services delivered meet contract specifications and customer and member concerns
are promptly and effectively addressed.

      The Company's sales and account management activities are supported by the
Company's Market Services staff,  who assist in generating sales leads;  prepare
proposals  and  responses to formal  Requests for  Proposals  ("RFPs");  provide
product development support;  perform competitive analyses;  and train personnel
for program  implementation.  Marketing  personnel  also support the delivery of
services to existing accounts through assistance with program implementation and
development  of customer  communications  materials  such as program  brochures,
summary plan descriptions and orientation documentation.

RECENT ACQUISITIONS, JOINT VENTURES AND OTHER SIGNIFICANT TRANSACTIONS

      Empire.  In September 1995, the Company  invested $12.0 million to acquire
an 80% interest in a five-year  joint venture (the "Empire Joint  Venture") with
Empire  Blue  Cross and Blue  Shield  ("Empire")  to provide  behavioral  health
managed care  services in 28 counties in the State of New York to  approximately
750,000 enrollees as of September 30, 1995. After the repayment of the Company's
initial  investment  and the direct  payment by Empire to the Company of certain
administrative  fees, risk charges and other amounts,  the profits of the Empire
Joint Venture will be  distributed  80% to MBC and 20% to Empire.  In connection
with the Empire Joint  Venture,  Empire has the right at any time to require the
Company to purchase  Empire's interest therein at a cash price equal to the fair
market value of such  interest.  In addition,  Empire may  terminate  the Empire
Joint Venture at any time for  convenience  on written notice to the Company and
upon  payment to the  Company of a  specified  portion  of the  Company's  $12.0
million  investment  (which portion declines over time and as repayments of such
investment are made to MBC during the life of the venture),  together with up to
$2.0  million  of  expenses  incurred  by the  Company  in  connection  with the
termination of the venture.

      Choate. In October 1995, a subsidiary of Continuum  acquired Choate Health
Management,  Inc.  and certain  related  entities  (collectively,  "Choate"),  a
Massachusetts-based  integrated  behavioral  healthcare  organization,  for $8.7
million in cash at closing plus $1.3 million paid in July 1996.  The Company may
be required to make additional payments relating to Choate based upon its future
financial performance.

      ProPsych.   In  December  1995,  the  Company  acquired   ProPsych,   Inc.
("ProPsych"),  a  Florida-based  behavioral  health  managed care  company.  The
Company acquired  ProPsych for an initial payment of $0.1 million,  a payment of
$2.9  million in January  1996 and a final  payment of $0.4  million in November
1996.


                                      10

<PAGE>



      Royal Health Care.  In January  1996,  the Company  formed a joint venture
with the hospital  sponsors of Neighborhood  Health  Providers LLC ("NHP") under
the name "Royal Health Care LLC" ("Royal"), in which each of the Company and NHP
holds 50% of the equity  interests.  Royal,  in turn,  and Empire  have formed a
second joint venture company, Empire Community Delivery Systems LLC ("ECDS"), in
which  Royal and Empire  hold 33 1/3% and 66 2/3%,  respectively,  of the equity
interests.  Empire and ECDS have entered into an agreement under which ECDS will
exclusively manage and operate, on behalf of Empire, healthcare benefit programs
(covering all services except behavioral healthcare and vision care) in the five
New York City boroughs for Medicaid beneficiaries enrolled in Empire plans. Each
of  Empire  and Royal  will  provide  specified  administrative  and  management
services  to ECDS to support  its  delivery  of  services  to Empire  under such
agreement. Moreover, each of ECDS and Royal will hold specified equity interests
in certain independent practice associations (IPAs) providing treatment services
to the Empire Medicaid  beneficiaries.  In addition,  Empire has entered into an
agreement  with the Empire Joint  Venture (80% of which is owned by the Company,
as described above) to exclusively provide all behavioral healthcare services in
New York City to such  Empire  Medicaid  enrollees.  The  Royal  and ECDS  joint
ventures and related agreements have five-year terms, with up to three five-year
renewals (subject to applicable regulatory approvals). Each such venture and the
behavioral health agreement also contains customary termination provisions.

      Prudential.  In June 1996, the Company entered into an Alliance  Agreement
(the  "Alliance  Agreement")  with The Prudential  Insurance  Company of America
("Prudential"),   under  which  Prudential   selected  the  Company  to  provide
behavioral  health  managed care  services to enrollees in specified  Prudential
health  benefit  plans in certain areas of the country.  The Alliance  Agreement
contemplates that Prudential, from time to time, will designate geographic areas
in which the Company  will  provide  such  services.  Pursuant  to the  Alliance
Agreement, to date the Company has been selected to service Prudential enrollees
in New York State, Connecticut and New Jersey (the "TriState Area"), North Texas
and  Chicago,  Illinois.  The Company  commenced  providing  services  under the
program for North Texas August 1, 1996,  the TriState Area September 5, 1996 and
Chicago  December 1, 1996.  The Alliance  Agreement has an initial term of three
years and six months  (expiring  December 31, 1999),  and will be  automatically
renewed for a period of two years unless either party notifies the other that it
does not intend to renew the  Alliance  Agreement.  The  Alliance  Agreement  is
subject to certain rights of  termination in favor of Prudential.  Pursuant to a
separate  agreement with Prudential,  the Company assumed the responsibility for
providing  services  to those  Prudential  members  currently  serviced  through
Prudential's  service center  operations in Houston,  Texas. The Houston program
commenced August 1, 1996.

      TennCare.  In July 1996, the State of Tennessee  implemented  the TennCare
program,  a  mental  health  and  substance  abuse  benefits  program  servicing
principally Medicaid eligibles and uninsured  individuals residing in the State.
Two behavioral health  organizations  ("BHOs") were selected to provide services
in connection  with such  program.  One such BHO is comprised of the Company and
Tennessee  Behavioral Health,  Inc. ("TBH"), a behavioral health company located
in Knoxville,  Tennessee  (the  "TBH-MBC  BHO")  serving  approximately  500,000
members as of September 30, 1996.  The Company and TBH entered into an agreement
(the "BHO Agreement") under which they have agreed to operate a joint program to
service TennCare  beneficiaries through such BHO. Pursuant to the BHO Agreement,
TBH entered  into a direct  contract  with the State to service  those  TennCare
beneficiaries  allocated  to the TBH-MBC BHO;  the  Company,  in turn,  provides
designated  services on behalf of TBH in performing its contract with the State.
Under the BHO  Agreement,  the Company  will share in 51%, and TBH will share in
49%, of the profits and losses from their joint  operation of the  program,  and
each of the  Company and TBH holds  one-half of the voting  power on all program
decisions. The BHO Agreement provides that the TBH-MBC BHO will remain in effect
until the earlier of (i) the  termination  of the  TennCare  program or (ii) the
fourth anniversary of the BHO Agreement. The

                                      11

<PAGE>



term  of  the  TennCare  program  is 12  months  commencing  July  1,  1996  and
automatically  renews for successive  12-month periods unless either party gives
notice of its  intention not to renew.  The contract  between the State and TBH,
however,  is  subject to certain  rights of  termination  in favor of the State,
including the right to terminate for convenience.

      CHAMPUS Regions 7 and 8. In August 1996, TriWest Healthcare Alliance Corp.
("TriWest"), with which the Company previously entered into a Services Agreement
(the "Services Agreement") to provide behavioral health managed care services as
TriWest's  subcontractor,  entered  into a prime  contract  with the  Office  of
CHAMPUS  ("OCHAMPUS") to provide  services to CHAMPUS  beneficiaries  in certain
geographic  areas,  principally in the southwest and  midwestern  United States,
designated  as CHAMPUS  Regions 7 and 8. This  CHAMPUS  program is  expected  to
service  approximately  740,000  beneficiaries  in such  regions.  The  Services
Agreement has a term which is coterminous with that of TriWest's prime contract,
which has a term of one year with four option  periods  exercisable by OCHAMPUS.
The prime  contract,  however,  is subject to certain  rights of  termination in
favor of OCHAMPUS,  including  the right of OCHAMPUS to terminate  such contract
for convenience.  Subject to certain rights of OCHAMPUS to delay  implementation
of the program,  this CHAMPUS program is expected to commence April 1, 1997 with
a phase-in period to begin prior to that date.

OPERATIONS

Administrative Structure

      Divisional,  Regional and Area Operations. The Company's behavioral health
managed care programs and EAPs are operated through an integrated service system
consisting of three divisions,  which are organized into a national region and a
number of geographic regions  (collectively,  the "Regions").  These Regions are
divided  into a number of separate  area  operations  ("Areas"),  with each Area
having  independent  administrative  and  management  capabilities.  All  of the
Regions are supported by the Company's  National Service Center,  located in St.
Louis,  Missouri (the  "National  Service  Center").  MBC's  National  Region is
primarily  responsible for servicing  national  corporate  accounts.  Particular
programs (such as state employee plans or Medicaid programs),  however,  require
local  implementation  due to the nature of the  services  provided  or customer
requirements. Thus, each of the Areas delivers services to its local or regional
customers in a manner similar to the National Region's delivery of services on a
wider geographic scale to the Company's national accounts.

      National  Service  Center.  The  National  Service  Center is an  integral
component  of MBC's  administrative  and  clinical  operations,  serving  as the
headquarters of the National  Region and the center for policy  decisions on key
clinical and operations matters nationwide.  The National Service Center also is
responsible  for providing  back-up to the other Regions for certain  aspects of
Regional administration,  oversight and service delivery.  Functions provided by
the National Service Center's 500-plus member support staff include:

            Centralized Client Services.  The National Service Center provides a
24-hour  call center  that  performs  after-hours  crisis  intervention.  During
business  hours,  operators  at the call center  also serve as customer  service
representatives,  providing  basic  benefit and  provider  network  information,
supporting claims payment activities and responding to customer inquiries.

            Network   Administration   Services.  The  National  Service  Center
supports  and  coordinates  provider  network  administration  needs,  including
credentialling and recredentialling  functions,  while Region and Area personnel
design  and  plan  the  Region's  network,  recruit  and  interview  candidates,
negotiate contracts with providers and perform on-site examinations of potential
facility providers.

                                      12

<PAGE>




            Claims Administration Services. The National Service Center provides
centralized  claims  processing  and payment  services for most of the Company's
clients and programs. Processing claims includes verifying eligibility and third
party liability and coordinating payments with other third party payors.

            Management  Information  Services.  The National  Service  Center is
responsible for the operation,  development and  implementation of the Company's
management information systems, including the AMISYS(R) system described below.

            Clinical  Oversight.  The  Company's  clinical  management  team  is
located at the National  Service  Center and sets  standards  for all Region and
Area  network  personnel,  including  guidelines  regarding  contractual  terms,
credentialling  criteria and provider  oversight  procedures.  In addition,  the
National Service Center supports other clinical operations, including monitoring
of Area utilization performance, personnel training and quality management.

Clinical Care Operations

      The Company manages care through a systematic,  clinical approach with the
objective of  diagnosing  problems  promptly and  designing  treatment  plans to
ensure that patients  receive the appropriate  level of care in an effective and
cost-efficient  manner.  The  fundamental  principle  of  MBC's  methodology  in
managing care is that the efficacy,  quality and  cost-effectiveness of care are
enhanced by an accurate  diagnosis and a targeted  clinical  assessment early in
the therapeutic process that is followed by appropriate treatment.

      In order to access the Company's  provider network,  a beneficiary in need
of behavioral  healthcare  services typically initiates contact with the Company
by calling the appropriate  toll-free  telephone  number,  whereupon a specially
trained intake coordinator will assess the patient's eligibility and arrange for
inpatient  admission or referral to an appropriate  provider.  Beneficiaries  in
crisis will call the  toll-free  number or present  themselves  at an  inpatient
facility,  whereupon  a  clinician  will  assess the  patient's  needs  and,  if
indicated,  arrange for an inpatient  admission or a referral to an  appropriate
provider.  In both cases,  the provider,  in  consultation  with a clinical case
manager  employed by the Company,  will develop and  implement a treatment  plan
designed to meet the patient's needs.  The designated  provider and case manager
remain in contact throughout the course of the patient's  treatment in an effort
to achieve an effective and efficient outcome. The provider's efficiency and the
quality of the treatment outcome are monitored by Company personnel, with a view
to  determining  which  providers  and  treatment  programs  produce the highest
quality outcomes in the most efficient manner. As part of MBC's case management,
the Company's clinical services personnel prepare and review utilization reports
on a daily basis and monitor on a regular basis key clinical statistics, such as
referrals and facility admissions, average lengths of stay and recidivism.

      The Company's clinical care program includes the following components:

      Intake.  Upon  responding to a call to the Company's  toll-free  telephone
number,  the intake  coordinator  asks a series of questions  designed to assess
whether the beneficiary requires crisis  intervention,  verifies eligibility and
refers the caller to an appropriate  provider.  By having one individual  verify
eligibility  and arrange for referral to a provider,  the process is streamlined
for the beneficiary and made cost-effective for MBC.


                                      13

<PAGE>



      Crisis Intervention. The Company provides crisis intervention on a 24-hour
basis. As part of these services,  clinicians attempt to stabilize the patient's
condition,  assess the  patient's  particular  needs and, if  indicated,  make a
referral for services or authorize  reimbursement  for admission to an inpatient
facility.

      Case  Management.  Typically,  within  24  hours  of  a  crisis  inpatient
admission or after initial  assessment by an outpatient  provider,  the provider
and MBC's case manager agree on a treatment  plan for the patient.  Throughout a
patient's  full  course  of  assessment  and  treatment,  an  MBC  case  manager
coordinates  all aspects of the delivery of services with network  providers and
facilities by consulting with the providers regarding a course of treatment. The
Company's case  management  procedures are based on  comprehensive  and flexible
clinical  guidelines and treatment  protocols that are developed  internally and
are consistent with established industry standards. Intake coordinators and case
managers  are  supervised  by the  Company's  senior  clinical  staff,  who  are
available for consultation and review the work of case managers and offer advice
and suggestions for  improvement.  Where required,  standardized  inpatient case
management  procedures and protocols of the Company have been  accredited by the
Utilization Review Accreditation Committee ("URAC"), an independent organization
based in Washington, D.C.

      Quality  Management.  MBC has  procedures  in  place  to  monitor  quality
assurance (including the recruitment, credentialling,  recredentialling,  hiring
and  orientation of providers and  facilities),  quality  assessment  (including
continuous audits of clinical  utilization data,  telephonic  response times and
claims accuracy) and quality improvement (such as provider profiling and problem
identification and resolution).  The Company's quality management program begins
with the initial selection of network and staff providers.  Candidates for these
positions  must  satisfy  an  extensive  set  of  professional   and  experience
requirements.  In addition,  many of the  Company's  providers  also complete an
interview process designed to evaluate the practitioner's  knowledge of clinical
principles  and standards of ethical  behavior.  Staff  providers  typically are
required to complete  orientation training in the Company's treatment philosophy
and  administrative  practices  and are  expected  to  participate  in  periodic
continuing  education sessions.  Network providers typically must participate in
periodic case conferences and accrue accredited  continuing education credits to
enhance their skills in a behavioral  health managed care delivery  system.  The
Company's   continuing   education  programs  are  accredited  by  the  American
Psychological  Association for continuing  education credit and by the Institute
of Behavioral Healthcare for continuing education units.

NETWORK AND STAFF PROVIDERS; FACILITIES

     The Company's behavioral health managed care and EAP treatment services are
provided  by a  combination  of  third-party  network  providers  and  treatment
facilities as well as staff  providers.  Network and staff  providers  include a
variety of specialized  behavioral  healthcare  personnel such as psychiatrists,
psychologists,  licensed clinical social workers, substance abuse counselors and
other professionals.

      Network  Providers.   As  of  September  30,  1996,  MBC  had  contractual
arrangements with  approximately  30,000 third-party  network  providers.  MBC's
network providers are independent contractors located throughout the local areas
in which MBC's customer's beneficiary populations reside. Network providers work
out of their own offices,  although staff  providers and other  resources of the
Company are available to assist them with consultation and other needs.  Network
providers include both individual  practitioners,  as well as group practices or
other licensed centers or programs. Network providers typically execute standard
contracts with the Company for which they are typically paid by the Company on a
fee-for-service  basis.  In some cases,  network  providers  are paid on a "case
rate"  basis,  whereby the  provider is paid a set rate for an entire  course of
treatment, or through other risk sharing

                                      14

<PAGE>



arrangements.  A network  provider's  contract with the Company  typically has a
one-year  term,  with automatic  renewal at the Company's  option for successive
one-year terms, and generally may be terminated  without cause by the Company or
the provider upon 30 to 90 days notice.

      Staff Providers.  Staff providers are behavioral healthcare  practitioners
employed  by the  Professional  Corporations  to  provide  behavioral  treatment
services  principally to covered  beneficiaries  of certain MBC customers  under
contracts between the Professional Corporations and the Company. As of September
30,  1996,  the  Professional  Corporations  employed  approximately  450  staff
providers.  Certain staff providers are also  responsible for the supervision of
network  providers,   crisis  assessment  and  monitoring  compliance  with  the
Company's  quality  management  procedures.  The Company  pays the  Professional
Corporations  a  professional   service  fee  under  a  participating   provider
agreement;  individual staff providers are paid by their respective Professional
Corporations  on a salary  basis.  In  addition,  the Company  provides  certain
administrative  and management  services to each Professional  Corporation under
separate  administrative  services  agreements.  These  agreements  between  the
Company and each  Professional  Corporation  typically have a one-year term that
automatically  renews  for  successive  one-year  terms  and  generally  may  be
terminated by the Company upon 30 days notice  following a substantial  decrease
in enrollment of beneficiaries  of plans to which the  Professional  Corporation
provides services.

      Facilities.  As of September 30, 1996,  MBC had  contractual  arrangements
with approximately 2,400 third-party treatment  facilities,  including inpatient
psychiatric  and substance  abuse  facilities,  intensive  outpatient  programs,
partial   hospitalization   facilities,   community  health  centers  and  other
community-based  programs,   rehabilitative  and  support  programs,  and  other
intermediate  care and alternative care facilities or programs.  This variety of
facilities  and programs  enables the Company to offer patients a full continuum
of care and refer  patients to the most  appropriate  facility or program within
that continuum.  Typically,  the Company contracts with facilities on a per diem
or  fee-for-service  basis and,  in some cases,  on a "case  rate" or  capitated
basis.  The contracts  between the Company and  inpatient  and other  facilities
typically are for one year terms and, in some cases, are automatically renewable
at the  Company's  option.  Facility  contracts  are usually  terminable  by the
Company upon 30 to 120 days notice.

INFORMATION SYSTEMS

      The  Company has  dedicated  substantial  resources  to  implementing  and
utilizing  information  systems  required  to manage the  delivery  of care in a
cost-effective  manner.  Because the Company  has grown in part  through  recent
acquisitions,  the Company currently  employs a number of different  information
systems in the operation of its behavioral health managed care and EAP business.
Although functionally independent of one another,  together these systems enable
the  Company to track  program  enrollee  membership  and verify  beneficiaries'
eligibility  for  coverage,   access  program   benefits,   record  and  monitor
authorizations  for treatment and cost of care,  and process and pay claims.  In
its current operations,  the Company utilizes five primary systems: (i) servers,
supporting  the delivery of services to certain of the Company's  HMO,  federal,
state and local governmental agency, and Blue Cross/Blue Shield organization and
insurance  company  customers;  (ii) a  system  operating  on a  Hewlett-Packard
HP/9000 platform,  supporting the delivery of services principally to certain of
the Company's HMO and insurance company  customers;  (iii) an IBM AS/400 system,
supporting  the  delivery  of  services  principally  to the  Company's  EAP and
integrated/EAP  managed care customers;  (iv) a DEC VAX 4500 system,  supporting
the delivery of services principally to customers in the State of Texas; and (v)
AMISYS(R),  a new,  centralized  system operating on a  Hewlett-Packard  HP/3000
platform which is intended to more fully integrate the Company's  operations and
achieve additional efficiencies in the overall management of care.


                                      15

<PAGE>



      The Company  believes  that  AMISYS(R)  will enable the  Company's  intake
coordinators,  clinical case managers and claims  reviewers to more  efficiently
determine   eligibility  for  coverage,   authorize  and  manage  treatment  and
adjudicate and process claims.  The Company also believes AMISYS(R) will enhance
the services  provided to both its customers and  beneficiaries  while  creating
cost  efficiencies  for the  Company  by,  among  other  things,  measuring  the
effectiveness  of providers  and  treatment  programs,  monitoring  outcomes and
enabling the Company to  customize  networks  and rate  structures.  It is MBC's
intention to utilize AMISYS(R) to support most significant  programs implemented
by MBC in the foreseeable  future.  The Company licenses  AMISYS(R) from Amisys,
Inc.;  however,  the Company has made  approximately  $10 million of proprietary
enhancements  to AMISYS(R) in order to adapt  AMISYS(R) for use in the Company's
business.

      To assist in the  implementation  of,  and  transition  of its other  four
systems to,  AMISYS(R),  MBC entered into an AMISYS  Implementation  and Systems
Integration  Services  Agreement  with Perot  Systems  Corporation  ("Perot") in
January 1996 (the "Perot  Agreement").  As contemplated by the Perot  Agreement,
the Company, utilizing both MBC and Perot personnel, has discontinued its use of
most of the servers  formerly  operating in its Area  offices and replaced  such
systems with AMISYS(R). In addition, the Company also intends to discontinue use
of its  Hewlett-Packard  HP/9000 platform and replace it with AMISYS(R) over the
next few years.  The  Company,  with Perot's  assistance,  also began to utilize
AMISYS(R) to support certain of MBC's current programs during calender 1996, and
implemented  AMISYS(R) in a number of  additional  locations  during the year to
service new business.

CONTINUUM AND INTEGRATED BEHAVIORAL HEALTHCARE ORGANIZATION
STRATEGY

      The Company is continuing to pursue its integrated  behavioral  healthcare
organization   strategy  by  building  its  direct  healthcare  delivery  system
capabilities  through  Continuum.  The Company  has begun to develop  integrated
delivery systems in selected  geographic  markets to provide treatment  services
directly to  beneficiaries  of healthcare  benefit  plans,  in part by expanding
staff offices in certain areas and increasing  efficiency through more stringent
clinical  policies and  supervision.  In addition to its staff office base,  the
Company  is  building   its  direct   delivery   system   capabilities   through
acquisitions, joint ventures and exclusive marketing and other arrangements with
provider  groups to enable the  Company  to  provide a wide range of  behavioral
health treatment  services in particular  geographic areas, from outpatient care
through intermediate levels of care (such as partial hospitalization,  intensive
outpatient  programs and residential  treatment programs) to inpatient care. For
example,  in January  1994,  the Company  established a close  affiliation  with
Washton Institute, an alcoholism and substance abuse clinical operation that has
been a long-standing  member of the Company's  provider  network in the New York
metropolitan  area.  Washton  Institute is a central  component of the Company's
plan to develop its integrated delivery  capabilities in the New York City area.
The Company intends to establish  other clinical  practices based on the Washton
Institute model in other regions of the country.  In addition,  in October 1995,
the  Company  acquired  Choate.  The  Company  intends  to build  upon  Choate's
significant  presence  in New England and expand  Choate's  integrated  delivery
system into states in which MBC has significant business.

      By providing care in an integrated setting, the Company expects to be able
to deliver more focused,  higher quality  services to better meet each patient's
individual needs. By both managing care and providing  treatment  services,  the
Company  intends to more  effectively  manage the delivery of services along the
full continuum of care, improve the quality and  cost-effectiveness of services,
enhance its ability to market programs and enter new markets,  market  Continuum
as a treatment provider to payors and other managed care companies,  and capture
a higher percentage of behavioral healthcare spending. Some of the Company's EAP
contracts require the Company to refer beneficiaries under those

                                      16

<PAGE>



EAPs to  staff  providers;  however,  certain  of the  Company's  EAP  contracts
prohibit the Company from making such referrals.  These prohibitions will limit,
to an extent,  the Company's  ability to provide services to such  beneficiaries
through Continuum.

COMPETITION

      The  industry  in which  the  Company  conducts  its  business  is  highly
competitive.   The  Company  competes  with  large  insurance  companies,  HMOs,
preferred provider organizations ("PPOs"),  third-party administrators ("TPAs"),
provider  groups  and  other  managed  care  companies.  Many  of the  Company's
competitors are significantly  larger and have greater financial,  marketing and
other  resources  than the  Company,  and some of MBC's  competitors  provide  a
broader  range  of  services.   The  Company  may  also  encounter   substantial
competition  in the  future  from new  market  entrants.  Many of the  Company's
customers that are managed care  companies  may, in the future,  seek to provide
behavioral   health  managed  care  and  EAP  services  to  their  employees  or
subscribers   directly  or  through   affiliated   organizations,   rather  than
contracting with the Company for such services. In addition,  Continuum competes
with a wide range of large and  established  providers of behavioral  healthcare
treatment  services,  most of which have greater  experience  in the delivery of
care, and many of which have greater  financial and other resources.  Because of
competition,  the Company does not expect to be able to rely on price  increases
to achieve  revenue  growth and  expects to  continue  experiencing  pressure on
direct operating margins.

EMPLOYEES

      As of September 30, 1996, the Company employed approximately 2,800 persons
who perform executive and  administrative  functions and engage in marketing and
sales,  clinical,  development,  customer  service  and  other  activities.  The
Professional   Corporations  employed   approximately  485  additional  persons,
approximately  450 of  whom  are  staff  providers,  on such  date.  None of the
employees  of the  Company  or the  Professional  Corporations  is  covered by a
collective  bargaining  agreement.  The Company considers its relationships with
its employees to be good.

INSURANCE

      The Company currently maintains  professional liability insurance with per
claim and aggregate coverage limits per annual term of the policy. The policy is
subject to  self-insured  retentions  on a per claim  basis and on an  aggregate
basis and must be  renewed  annually.  The  policy is a  "claims  made"  policy,
meaning that if a person were to file suit against the Company after the term of
the policy with respect to an alleged  injury that occurred while the policy was
in force, the policy would not cover any costs or judgments  arising  therefrom.
The Company  renewed the policy  effective  October 6, 1996 for a one-year term.
The  Company's  professional  liability  policy  also  covers  the  Professional
Corporations  and certain of the  Company's  administrative  staff that  provide
services to the Company.  The current  coverage  terms have been in effect since
January 1, 1994.

      With the exception of certain EAP providers, as described below, it is the
Company's   policy  to  require  each  network  and  staff   provider  to  carry
professional  liability insurance in a minimum amount per claim and in a minimum
aggregate  amount per year for physicians and doctoral level  psychologists,  as
well as all other providers. Historically, the Company has provided professional
liability  insurance for its EAP providers.  The Company has, however,  begun to
phase out such  coverage  and to require  its EAP  providers  to carry their own
professional liability insurance in the same amounts as the Company requires its
staff providers to carry.


                                      17

<PAGE>



      All of the  insurance  coverage  described  above is  subject  to  various
coverage limits,  self-insured  retentions and other conditions and limitations.
There can be no assurance  that any such  insurance  will be sufficient to cover
any judgments,  settlements or costs relating to any actions or claims,  or that
any such  insurance  will be  available  to the  Company or its network or staff
providers  in the future on  favorable  terms,  if at all. If the Company or its
providers  are unable to secure  adequate  insurance  in the  future,  or if the
insurance carried by the Company or its providers is not sufficient to cover any
judgments,  settlements  or costs  relating to any present or future  actions or
claims,  there is no  assurance  that the Company or its  providers  will not be
subject to other  liabilities  which might have a material adverse effect on the
Company.

      The  Company  also  maintains  general  liability,  property,  automobile,
workers compensation and other insurance. The Company believes that it maintains
insurance coverage customary in the behavioral healthcare services industry, and
that such  insurance  is  adequate  as to the risks  covered  and the amounts of
coverage.

REGULATION

      The managed healthcare industry and the provision of behavioral healthcare
treatment  services  are subject to  extensive  and  evolving  state and federal
regulation.  The  Company  is subject  to  certain  state laws and  regulations,
including those governing: (i) the licensing of insurance companies, HMOs, PPOs,
TPAs  and  companies  engaged  in  utilization  review;  (ii) the  licensing  of
healthcare  professionals,  including restrictions on business corporations from
practicing,  controlling  or  exercising  excessive  influence  over  behavioral
healthcare  services through the direct employment of psychiatrists or, in a few
states,  psychologists and other behavioral healthcare professionals;  and (iii)
the establishment and operation of behavioral  healthcare programs,  clinics and
facilities.  These laws and regulations vary considerably  among states, and the
Company may be subject to different types of laws and  regulations  depending on
the specific  regulatory  approach adopted by each state to regulate the managed
care business and the provision of behavioral  healthcare treatment services. In
addition,  the Company is subject to certain state and federal laws by virtue of
its  relationships  with its  staff  and  network  providers  and  with  certain
customers,  such as governmental  agencies and HMOs maintaining  health benefits
programs for Medicaid  and Medicare  beneficiaries,  and as a result of the role
the Company assumes in connection with managing its customers'  employee benefit
plans.

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

       Licensure.  Certain  regulatory  agencies  having  jurisdiction  over the
Company  possess  discretionary  powers  when  issuing or  renewing  licenses or
granting  approval of proposed  actions such as mergers,  a change in ownership,
transfer or assignment of licenses and certain intracorporate transactions.  One
or multiple  agencies may require as a condition  of such  licensure or approval
that the

                                      18

<PAGE>



Company  cease or modify  certain  of its  operations  in order to  comply  with
applicable regulatory  requirements or policies. In addition, the time necessary
to obtain  licensure or approval varies from state to state, and difficulties in
obtaining  a  necessary  licensure  or  approval  may  result  in  delays in the
Company's plans to expand  operations in a particular  state and, in some cases,
lost business  opportunities.  Compliance  activities,  mandated  changes in the
Company's operations,  delays in the expansion of the Company's business or lost
business opportunities as a result of regulatory  requirements or policies could
have a material adverse effect on the Company.

      Insurance, HMO and PPO Activities. To the extent that the Company operates
or is deemed to operate in one or more states as an insurance company,  HMO, PPO
or  similar  entity,  it may  be  required  to  comply  with  certain  laws  and
regulations  that,  among  other  things,  may  require  the Company to maintain
minimum levels of deposits,  capital,  surplus,  reserves or net worth.  In many
states,  entities  that  assume risk under  contracts  with  licensed  insurance
companies or HMOs have not been considered by state  regulators to be conducting
an insurance or HMO business.  As a result, the Company has not sought licensure
as either an insurer or HMO in  certain  states.  The  National  Association  of
Insurance  Commissioners  (the "NAIC") has undertaken a comprehensive  review of
the  regulatory  status of entities  arranging  for the  provision of healthcare
services through a network of providers that, like the Company,  may assume risk
for the cost and  quality of  healthcare  services,  but that are not  currently
licensed as an HMO or similar entity.  The NAIC initiative will likely result in
the adoption of a model NAIC  regulation  in the areas of health plan  standards
and financial  solvency  standards for such entities,  which could be adopted by
individual  states in whole or in part.  Individual  states  have also  recently
adopted their own regulatory initiatives that generally subject entities such as
the Company to additional  regulation in the area of insurance or HMO standards,
including but not limited to requiring licensure, and greater financial solvency
protections.  These  laws and  regulations  may also  limit the  ability  of the
Company  to  pay  dividends,   make  certain   investments   and  repay  certain
indebtedness.  Licensure as an insurance  company,  HMO or similar  entity could
also subject the Company to  regulations  governing  reporting  and  disclosure,
mandated benefits, and other traditional insurance regulatory requirements.  PPO
regulations to which the Company may be subject typically require the Company to
register  with the state and  provide  information  concerning  its  operations,
particularly   relating  to  provider  and  payor  contracting.   Based  on  the
information  presently  available  to it, the Company  does not believe that the
imposition of requirements related to maintaining prescribed levels of deposits,
capital,  surplus,  reserves or net worth,  or complying  with other  regulatory
requirements   applicable  to  its  insurance  company,   HMO,  PPO  or  similar
operations, would have a material adverse effect on the Company. Notwithstanding
the foregoing,  the imposition of such requirements increases the Company's cost
of doing  business  and can delay the  Company's  conduct  or  expansion  of its
business  in some  areas.  In  addition,  failure  by the  Company to obtain and
maintain required licenses  typically also constitutes an event of default under
the Company's  contracts  with its  customers.  The loss of business from one or
more of the Company's major customers as a result of such an event of default or
otherwise could have a material adverse effect on the Company.

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

                                      19

<PAGE>



regulations  adopted  in the future  would not have such a result,  particularly
since the  nature,  scope and  specific  requirements  of such  provisions  vary
considerably among states that have adopted regulations of this type.

      There is a trend among  states to require  licensure or  certification  of
entities  performing  utilization  review or TPA  activities;  however,  certain
federal courts have held that such licensure  requirements  are preempted by the
Employee  Retirement  Income Security Act of 1974, as amended  ("ERISA").  ERISA
preempts  state  laws  that  mandate  employee   benefit   structures  or  their
administration,   as  well  as  those  that  provide   alternative   enforcement
mechanisms.  The Company  believes that certain of its activities  performed for
its  self-insured  employee  benefit plan  customers  are exempt from  otherwise
applicable  state  licensing  or  registration  requirements  based upon federal
preemption  under ERISA and has relied on this general  principle in determining
not to seek  licensure for certain of its  activities  in many states.  Existing
case law is not uniform on the applicability of ERISA preemption with respect to
state  regulation of TPA  activities.  There can be no assurance that additional
licensure  will not be  required  with  respect  to  utilization  review  or TPA
activities in certain states.

      "Any  Willing  Provider"  Laws.  Several  states in which the Company does
business have also  adopted,  or are expected to adopt,  "any willing  provider"
laws. Such laws typically impose upon insurance  companies,  HMOs or other types
of  third-party  payors an obligation to contract  with, or pay for the services
of, any healthcare  provider willing to meet the terms of the payor's  contracts
with similar providers. The Company is not subject to such laws in any states in
which it currently does business,  although it has undertaken to comply with any
willing provider  contracting  requirements at the request of certain customers.
In addition, the Company could become subject to such laws in the future if they
are adopted by states in which the Company is licensed as an insurance  company,
HMO or similar  entity,  or if the Company's  customers  become  subject to such
laws. Compliance with any willing provider laws could significantly increase the
Company's costs of contracting with providers and have a material adverse effect
on its operations.

      Professional  Services.  The provision of behavioral  healthcare treatment
services by psychiatrists, psychologists and other providers is subject to state
regulation  with respect to the practice of licensed  healthcare  professionals,
limitations on the ability of business corporations to directly provide, control
or  exercise  excessive  influence  over the  services  of  licensed  healthcare
professionals,  and  limitations  on  fee-splitting  and payments for referrals.
Although under the Company's  programs all direct  clinical  services other than
brief counseling  services typically are provided by licensed  professionals who
are  either  staff  providers  employed  by or  under  contract  with one of the
Professional Corporations, or are network providers under independent contractor
arrangements  with the Company,  state  regulatory  authorities or courts may in
certain instances determine that these relationships between the Company and the
Professional  Corporations  are  unenforceable.  With  respect to the  Company's
crisis  intervention  program,  additional  licensure of clinicians  who provide
telephonic assessment or stabilization services to beneficiaries who are calling
from  out-of-state may be required if such assessment or stabilization  services
are deemed by regulatory  agencies to be treatment provided in the beneficiary's
state.  The  Company  believes  that it could,  if  necessary,  restructure  its
operations to comply with changes in the  interpretation  or enforcement of such
laws and  regulations,  and that such  restructuring  would not have a  material
adverse  effect on its  operations.  However,  the risk of such a  determination
could grow as the Company expands its relationships with providers.

      In contrast to certain  states,  regulators in several states in which the
Company  does  business  have  adopted  policies  that  require HMOs or, in some
instances,  insurance  companies,  to contract directly with licensed healthcare
providers,  entities or provider  groups,  such as IPAs,  for the  provision  of
treatment services,  rather than with unlicensed intermediary companies. In such
states, the Company's

                                      20

<PAGE>



customary  model  of  contracting  directly  with its  customers  may need to be
modified so that, for example,  the  Professional  Corporations  or IPAs (rather
than the  Company)  contract  directly  with the HMO or  insurance  company,  as
appropriate,  for the provision of treatment  services.  The Company  intends to
work with a number of these HMO customers to  restructure  existing  contractual
arrangements,  upon contract  renewal or in  renegotiations,  so that the entity
which contracts with the HMO directly is a Professional  Corporation or IPA. The
Company does not expect this method of  contracting  to have a material  adverse
effect on its operations.

      The Company's business is affected  indirectly by regulations imposed upon
healthcare  providers  and the  Company's  customers.  Regulations  imposed upon
healthcare  providers include provisions relating to the conduct of, and ethical
considerations involved in, the practice of psychiatry,  psychology, social work
and related behavioral healthcare  professions and, in certain cases, the common
law  duty  to  warn  others  of  danger  or  to  prevent  patient   self-injury.
Confidentiality and patient privacy  requirements are particularly strict in the
field of behavioral healthcare services, and additional legislative  initiatives
relating to confidentiality are expected. Regulations imposed upon the Company's
customers include, among other things, benefits mandated by statute,  exclusions
from  coverages  prohibited  by statute,  procedures  governing  the payment and
processing of claims,  record keeping and reporting  requirements,  requirements
for  and  payment  rates   applicable  to  coverage  of  Medicaid  and  Medicare
beneficiaries,  provider  contracting and enrollee rights,  and  confidentiality
requirements. While the Company believes that such regulations do not at present
materially impair the Company's operations,  there can be no assurance that such
indirect  regulation  will not have a material  adverse effect on the Company in
the future.

       Healthcare  Programs,   Clinics  and  Facilities.  The  Company  is  also
generally  affected  directly by  regulations  applicable  to the  operation  of
healthcare programs, clinics and facilities. Regulations governing the operation
of  behavioral  health  programs,  clinics  and  facilities  include  provisions
relating to program, clinic or facility design, ownership,  operation, treatment
procedures and medical records. In some instances,  state laws require ownership
of clinics or facilities by licensed  practitioners or individuals  (rather than
corporations).  In such cases, the Company  maintains its relationship  with the
clinic or facility other than through direct shareholder status, such as through
management   services  agreements  between  the  Company  and  the  Professional
Corporations.  If the  Company's  contractual  relationships  with the  licensed
clinics or facilities are deemed to convey an improper ownership interest in, or
improper control of, the clinic or facility, changes in the Company's operations
in the affected states could be required,  and such contracts could  potentially
be  unenforceable.  The  existence  of such  restrictions  in a given  state may
present  greater  risks  and may limit  business  opportunities  as the  Company
endeavors to expands its relationships  with providers.  Such restrictions could
have a material adverse effect on the Company.

      ERISA.  Certain of the Company's services are subject to the provisions of
ERISA.   ERISA   governs   certain   aspects   of   the   relationship   between
employer-sponsored healthcare benefit plans and certain providers of services to
such plans through a series of complex laws and regulations  that are subject to
periodic  interpretation  by the Internal  Revenue Service and the Department of
Labor. In some circumstances,  and under certain customer contracts, the Company
may be  expressly  named as a  "fiduciary"  under  ERISA,  or be  deemed to have
assumed  duties that make it an ERISA  fiduciary,  and thus be required to carry
out its  operations  in a manner  that  complies  with ERISA  requirements.  The
Company  believes  that it  complies  with ERISA  requirements  in all  material
respects,  and that continuing ERISA compliance efforts will not have a material
adverse effect on the Company.

Medicaid  and  Medicare.  The  Company  provides  and may in the future  provide
services  to some  program  beneficiaries  who  are  also  beneficiaries  of the
Medicaid program, the Medicare program, other

                                      21

<PAGE>



government  sponsored  healthcare  programs,  such as  CHAMPUS,  or the  Federal
Employees  Health  Benefits  Program.  The Company's  compensation  for services
provided to such  beneficiaries  has historically been governed by the contracts
with its customers having government program recipients, as applicable, enrolled
in their healthcare  benefits plans.  Such customers  typically have been either
governmental  agencies  or HMOs.  The  Company  must also  comply  with any cost
reporting or other reporting  requirements  imposed by such government sponsored
programs,  as well as any  reimbursement  limitations  on what it may charge the
program  or program  beneficiaries.  Such  requirements  may limit the amount of
reimbursements  that MBC may receive from these  programs or subject the Company
to periodic audits.  The compensation  received by the Company for such services
under its private customer contracts generally has not been affected by Medicaid
or Medicaid fee schedules or similar cost  containment  measures;  however,  the
Company's provision of services to Medicaid  beneficiaries,  or beneficiaries of
other  government  sponsored  healthcare  plans,  through direct  contracts with
federal,  state or local government agencies, is affected by such measures,  and
there can be no assurance that future legislation will not materially  adversely
affect the Company's  compensation  for services  provided to  beneficiaries  of
government  sponsored healthcare programs under contracts with either government
agencies or HMOs or other similar entities.

      The provision of services to beneficiaries of federally funded  healthcare
programs may also subject the Company to various federal "fraud and abuse" laws,
including "anti-kickback" and "physician self-referral" laws. Similar state laws
could also govern the  provision  of services to  beneficiaries  of state funded
healthcare  programs such as Medicaid.  The federal  anti-kickback laws prohibit
the knowing and willful solicitation, receipt or offering of any remuneration or
consideration, directly or indirectly, to induce or in exchange for referrals of
patients or for the ordering of services covered by federally funded  healthcare
programs  (excluding the Federal  Employees  Health Benefits  Program) and state
funded  healthcare   programs,   including   Medicaid.   The  federal  physician
self-referral  laws impose  restrictions on physician  referrals of patients for
certain  designated  healthcare  services  to  certain  entities  with which the
physician or any  immediate  family member has a  compensation  or investment or
ownership  interest,  and prevents the entity in question  from  lawfully  being
reimbursed  under the  Medicaid and  Medicare  program for  patients  improperly
referred to it.  Thus,  these laws could impair the  Company's  ability to enter
into  certain  types  of  arrangements   with  physicians  or  other  healthcare
providers.  Certain  state  self-referral  laws  might  apply to other  types of
providers  as  well  as  a  broader  class  of  payors.   With  respect  to  its
non-governmental  operations,  the  Company  may be subject to similar  laws and
regulations in a number of states, and proposed federal legislation would expand
the  scope of some or all of the  fraud and  abuse  restrictions  to cover  many
private payors of healthcare  benefits.  Penalties for violating  existing fraud
and  abuse  laws  include  civil  monetary  penalties,  criminal  sanctions  and
exclusion from participation in the Medicaid and Medicare programs.  The Company
believes  that its existing  operations  comply with such state and federal laws
and regulations based on their current interpretation and enforcement;  however,
because the fraud and abuse laws, particularly  anti-kickback  provisions,  have
been  broadly  construed  to prohibit  transactions  in which any purpose of the
transaction violates the law, many transactions  potentially could be held to be
improper.  Uncertainty as to the scope and  application of such laws  continues;
therefore,  there can be no assurance  that future  regulatory  and  enforcement
actions will not result in an  interpretation of these laws and regulations that
would require the Company to  materially  change its  operations or  contractual
relationships in order to remain in compliance therewith.

      Other  Proposed  Legislation.  In the last  five  years,  legislation  has
periodically  been  introduced at the state and federal level  providing for new
regulatory programs and materially revising existing  regulatory  programs.  Any
such legislation,  if enacted,  could materially  adversely affect the Company's
business,  financial condition or results of operations.  Such legislation could
include both federal and state bills  affecting the Medicaid  programs which may
be pending in or recently passed by state

                                      22

<PAGE>



legislatures  and which are not yet  available  for  review and  analysis.  Such
legislation could also include proposals for national health insurance and other
forms of federal regulation of health insurance and healthcare  delivery.  It is
not  possible  at this time to  predict  whether  any such  legislation  will be
adopted at the federal or state level, or the nature,  scope or applicability to
the  Company's  business  of  any  such  legislation,  or  when  any  particular
legislation  might be  implemented.  No  assurance  can be  given  that any such
federal  or state  legislation  will not have a material  adverse  effect on the
Company.

CAUTIONARY STATEMENTS

      This Form 10-K includes "forward-looking statements" within the meaning of
Section 27A of the Securities Act and Section 21E of the Exchange Act.  Although
the Company believes that its plans,  intentions and  expectations  reflected in
such  forward-looking  statements are reasonable,  it can give no assurance that
such plans, intentions or expectations will be achieved.  Important factors that
could  cause   actual   results  to  differ   materially   from  the   Company's
forward-looking  statements are set forth below and elsewhere in this Form 10-K.
All forward-looking  statements attributable to the Company or persons acting on
behalf  of  the  Company  are  expressly  qualified  in  their  entirety  by the
cautionary statements set forth below.

      Capitated  Programs.  In order for the Company's capitated contracts to be
profitable,  MBC must  accurately  estimate the rate of service  utilization  by
beneficiaries  enrolled in its programs. The Company's assumptions as to service
utilization  rates and costs may not accurately  and  adequately  reflect actual
utilization  rates and costs,  and increases in behavioral  healthcare costs and
higher than  anticipated  utilization  rates,  significant  aspects of which are
outside  the  Company's  control,  could  cause  expenses  associated  with such
contracts  to exceed the  Company's  revenue  for such  contracts.  Furthermore,
certain of such contracts  require the Company to reserve a specified  amount of
cash as financial  assurance that it can meet its obligations  thereunder.  Such
amounts are not available to the Company for general corporate purposes.

      Customer Contracts.  Substantially all of the Company's customer contracts
are  immediately  terminable for cause,  and many,  including some of MBC's most
significant contracts,  are terminable without cause by the customer or upon the
occurrence of certain other  specified  events.  The Company is aware of several
contracts expiring in fiscal 1997 that will not be renewed; however, the Company
does not believe the loss of such  contracts  will result in a material  adverse
effect on its results of operations. The Company's ten largest behavioral health
managed  care  customers  had  36  contracts   with  MBC  which   accounted  for
approximately  49% of the Company's  revenue for fiscal 1996. Such contracts may
not be  extended  or  successfully  renegotiated,  and the  terms  of any new or
renegotiated contracts  (particularly  financial terms) may not be comparable to
those of existing contracts. The loss of certain of these contracts could have a
material adverse effect on the Company.

      Competition.  The  industry in which the Company  conducts its business is
highly competitive.  The Company competes with large insurance companies,  HMOs,
PPOs,  TPAs,  provider  groups and other  managed  care  companies.  Many of the
Company's  competitors  are  significantly  larger and have  greater  financial,
marketing and other  resources than the Company,  and some of MBC's  competitors
provide a broader range of services.  The Company may also encounter substantial
competition  in the  future  from new  market  entrants.  Many of the  Company's
customers that are managed care  companies  may, in the future,  seek to provide
behavioral   health  managed  care  and  EAP  services  to  their  employees  or
subscribers   directly  or  through   affiliated   organizations,   rather  than
contracting  with the Company for such  services.  Because of  competition,  the
Company does not expect to be able to rely on price increases to achieve revenue
growth  and  expects  to  continue  experiencing  pressure  on direct  operating
margins.


                                      23

<PAGE>



      Key  Management.  The Company's  growth depends largely upon the abilities
and experience of certain key management personnel.  The loss of the services of
one or more of such key personnel  could have a material  adverse  effect on the
Company.

      Information Systems.  The Company's operation of its programs,  as well as
the implementation of its growth strategy, is dependent on its ability to store,
retrieve,  process and manage data. Interruption of data processing capabilities
for any  extended  period of time,  loss of stored data,  programming  errors or
other  system-related  problems  could  have a  material  adverse  effect on the
Company.  An integral  part of the  Company's  strategy to improve its operating
efficiency and  management of care involves its investment in a new  information
system,  AMISYS(R),  which is expected to provide  advantages over the Company's
other current information  systems.  The Company has begun the implementation of
AMISYS(R)  into  certain of its  operations,  and has  commenced  the process of
transitioning  certain  programs  supported  by its other  existing  systems  to
AMISYS(R). The installation and implementation of AMISYS(R) involves the risk of
unanticipated  delay and  expense.  Failure to  complete  the  modifications  to
AMISYS(R)  required  to  adapt  such  system  to the  Company's  business  or to
successfully  implement  AMISYS(R) into its operations  could  adversely  impact
MBC's  operating  efficiency and management of care and could result in the loss
of existing  customers,  difficulties in attracting new customers,  increases in
operating expenses and other adverse consequences.

      Control by KKR.  KKR  Associates  and its  General  Partners  control  the
Company,  having the power to elect its  directors and appoint  management.  The
interests  of KKR and its General  Partners  may not always be  consistent  with
those of the Company's equity and debt holders and other constituencies.

      Dependence on Government Spending for Managed Healthcare; New Legislation.
A  significant  portion  of the  market  for the  Company's  services  is funded
directly or indirectly by governmental  agencies,  including  Medicaid programs.
Any  reduction in government  spending for such  programs  could have a material
adverse  effect on the  Company.  In  addition,  the  Company's  contracts  with
governmental  agencies generally are conditioned upon financial  appropriations,
especially with respect to Medicaid programs.  These contracts  generally can be
terminated or modified by the customer if such  appropriations are not made. The
Company's  strategy for growth depends in part on the engagement of managed care
organizations  to provide  services to  governmental  agencies,  especially with
respect  to  Medicaid  programs.  If such  engagements  do not  occur or if such
contracts do not provide adequate pricing terms, the Company could be materially
adversely affected. In addition, legislation has periodically been introduced at
the state and federal level providing for new regulatory programs and materially
revising existing regulatory programs.  Any such legislation,  if enacted, could
materially  adversely  affect the Company.  The Company is unable to predict the
impact  on  the  Company's  operations  of  future  regulations  or  legislation
affecting government healthcare programs, or the healthcare industry in general.

      Regulation.  The  Company's  business  is subject to  extensive  state and
federal  regulation.  State  laws and  regulations  vary  considerably,  and the
Company may be subject to different types of laws and  regulations  depending on
the specific  regulatory  approach adopted by each state. State and federal laws
regulate  the  Company's  relationships  with its  providers  and  with  certain
customers,  such as  governmental  agencies  and  HMOs  servicing  Medicaid  and
Medicare  beneficiaries,  and its management of its customers'  employee benefit
plans.  Because  regulation of the Company's  business is evolving,  new laws or
regulations  applicable  to the Company may be enacted,  and  existing  laws and
regulations  may be  interpreted  to  apply  to the  Company's  operations  in a
different manner than previously  thought.  Any such development may require the
Company to secure  additional  licenses or restructure  its operations to comply
with  such laws and  regulations.  Any delay or  failure  to secure or  maintain
licenses

                                      24

<PAGE>



or otherwise  comply with  applicable  laws and regulations or to so restructure
operations could lead to lost business opportunities and have a material adverse
effect on the Company.

      Professional  Liability;  Insurance.  The Company is regularly  subject to
lawsuits alleging malpractice and related legal theories,  some of which involve
situations  in which  participants  in the  Company's  programs  have  committed
suicide. The Company may also be subject to claims of professional liability for
alleged negligence in performing utilization  management activities,  as well as
for acts and omissions of the Company's staff and network providers. The Company
could also become subject to claims for the costs of healthcare services denied.
There can be no assurance that the Company's  procedures for limiting  liability
have been or will be  effective,  or that one or more  lawsuits  will not have a
material adverse effect on the Company in the future.  While the Company carries
professional  liability  insurance,   it  is  subject  to  certain  self-insured
retentions,  may not apply in certain circumstances and may not be sufficient to
cover all damages or costs relating to present or future claims. Upon expiration
thereof,  sufficient  insurance  may  not be  available  to the  Company  or its
providers on favorable  terms,  if at all. If the Company or its  providers  are
unable to secure adequate  insurance in the future,  or if the insurance carried
by the Company or its providers is not  applicable or is not sufficient to cover
any damages or costs relating to any present or future  claims,  the Company and
its providers could be subject to a liability that could have a material adverse
effect on the Company.

      Substantial  Leverage  and Related  Considerations.  The Company  incurred
substantial indebtedness in connection with the Merger, and is highly leveraged.
Such  indebtedness  included  borrowings  under a $205.0  million  senior credit
facility (the "Senior  Credit  Facility")  provided  under the Credit  Agreement
dated as of  October  6,  1995,  as  amended,  among the  Company,  the  lending
institutions  listed therein and The Chase Manhattan  Bank,  N.A., as Agent (the
"Credit  Agreement")  entered  into  in  connection  with  the  Merger,  and the
Company's  11 1/2%  Senior  Subordinated  Notes  due  2005  (the  "Notes").  The
Company's ability to make scheduled payments of principal of, or to pay interest
on, or to  refinance  its  indebtedness  (including  the Notes),  depends on its
future performance,  which, to a certain extent, is subject to general economic,
financial,  competitive,  legislative,  regulatory  and other factors beyond its
control.  There can be no assurance  that the  Company's  business will generate
sufficient cash flow from  operations or that future working capital  borrowings
will  be  available  in an  amount  sufficient  to  enable  MBC to  service  its
indebtedness,  including the Notes, or make necessary capital expenditures.  The
Notes are general  unsecured  obligations of the Company and are subordinated in
right of payment to all Senior Indebtedness (as defined in the indenture for the
Notes (the  "Indenture")) of the Company (which includes all indebtedness  under
the Senior Credit Facility).

Item 2.   Properties

      The Company's  principal  executive  offices,  with  approximately  37,500
square feet in the aggregate,  are located in Park Ridge, New Jersey;  the lease
for the Company's headquarters expires in 2006. The Company leases approximately
195,500  square feet in the  aggregate  for the National  Service  Center in St.
Louis, Missouri, under three leases expiring between 2001 and 2003. In addition,
the Company leases approximately 64,000 square feet in the aggregate in New York
City relating to the Empire Joint Venture and other business;  the lease for the
New York City space expires in 2008.  The Company also  maintains an office with
approximately 24,800 square feet in the aggregate in San Francisco,  California;
the lease for the San  Francisco  office  expires in 1997.  As of September  30,
1996, the Company also maintained  approximately  150 other offices in 31 states
under  leases  which have terms of up to 10 years and range in size up to 30,000
square feet. Management believes that the Company's offices and other properties
are adequate for its current  needs and that suitable  additional  space will be
available as required.


                                      25

<PAGE>



Item 3.   Legal Proceedings

      The management  and  administration  of the delivery of behavioral  health
managed care and EAP services,  and the direct  provision of  behavioral  health
treatment services,  entail significant risks of liability. In recent years, the
Company  and its network and staff  providers  have been  subject to a number of
actions  and claims  alleging  malpractice,  professional  negligence  and other
related  legal  theories.  Many of these  actions  and claims  seek  substantial
damages and therefore  require the Company to incur  significant  fees and costs
related to their defense.

      From time to time,  the  Company is subject to various  actions and claims
arising from the acts or omissions of its staff  providers,  its employees,  its
network  providers or other parties.  In the normal course of its business,  the
Company  receives  reports  relating to  suicides  and other  serious  incidents
involving patients enrolled in the Company's  programs.  Such incidents may give
rise to  malpractice,  professional  negligence  and other  related  actions and
claims against the Company,  its employees and its network and staff  providers.
As the number of  beneficiaries  covered  by the  Company  grows,  the number of
providers  employed by the Professional  Corporations or under contract with the
Company  increases and the nature and scope of services  provided by the Company
in its managed care and EAP  business  expands,  actions and claims  against the
Company (and, in turn,  possible  legal  liability)  predicated on  malpractice,
professional  negligence  or other  related  legal  theories  can be expected to
increase. In addition, as Continuum's business develops,  the Company may become
subject to  additional  actions and claims  alleging  malpractice,  professional
negligence  and  other  related  theories  arising  from the  behavioral  health
treatment services rendered directly to patients by Continuum.

      The Company  carries  insurance  in respect of  liabilities  arising  from
actions and claims based on alleged  malpractice,  professional  negligence  and
other  related  theories.  The  Company's  staff  providers are also required to
maintain  professional  liability  insurance on a per claim and aggregate basis.
All  such  insurance  is  subject  to  various  coverage  limits,   self-insured
retentions and other  limitations  and  conditions.  To the extent the Company's
customers are entitled to indemnification under their contracts with the Company
relating to  liabilities  they incur arising from the operation of the Company's
programs,  such indemnification may not be covered under the Company's insurance
policies.  In  addition,  to the extent  that  certain  actions  and claims seek
punitive and compensatory damages arising from alleged intentional misconduct by
the Company,  such damages, if awarded, may not be covered, in whole or in part,
by the Company's  insurance  policies.  In the ordinary course of business,  the
Company is also  subject to actions  and claims with  respect to its  employees,
staff providers,  network providers and suppliers of services.  The Company does
not believe that any pending  action against the Company  alleging  malpractice,
professional  negligence or other related  theories will have a material adverse
effect on the Company.  To date, claims and actions against the Company alleging
professional  negligence  have  not  resulted  in  material  liabilities  to the
Company;  however,  there can be no assurance  that pending or future actions or
claims for professional liability will not have a material adverse effect on the
Company.

      From time to time, the Company receives  notifications from and engages in
discussions  with  various  governmental  agencies  concerning  its business and
operations. As a response to these contacts with regulators, the Company in many
instances  implements  changes to its operations,  revises its filings with such
agencies  and/or seeks  additional  licenses to conduct its business.  In recent
years,  in  response  to  governmental  agency  inquiries  or  discussions  with
regulators,  the Company has  determined to seek  licensure as a single  service
HMO, TPA or utilization review agent in one or more jurisdictions.

      The Company was recently involved in legal proceedings related to the Iowa
Mental Health Contract. The proceedings arose out of the initial decision of the
Iowa Department of Human Services (the "Iowa DHS") in May 1994 to award the Iowa
Mental Health Contract to Value Behavioral Health,

                                      26

<PAGE>



Inc. (the  "Competitor").  The Company contested the decision on the basis that,
among other things,  the  Competitor  should have been  disqualified  because of
certain   conflicts  of  interest.   After  the  Iowa  DHS  denied  the  Company
administrative  relief, the Company filed suit in the District Court of Iowa for
Polk County (the "Iowa  District  Court").  In October  1994,  the Iowa District
Court disqualified the Competitor from performing services under the Iowa Mental
Health  Contract  because of  various  conflicts  of  interest.  The  Competitor
appealed the Iowa  District  Court  decision to the Iowa Supreme  Court.  In the
meantime,  in January 1995,  the Company and the Iowa DHS signed the  definitive
Iowa Mental Health Contract, under which the Company commenced services in March
1995.  Subsequently,  in  July  1996,  the  Iowa  Supreme  Court  dismissed  the
Competitor's  appeal and  affirmed  the Iowa  District  Court  decision.  To the
Company's knowledge, the Competitor has not petitioned the U.S. Supreme Court to
review the Iowa Supreme  Court  ruling;  consequently,  management  believes the
legal proceedings surrounding the Iowa Mental Health Contract are concluded.

      In October  1996, a group of eight  plaintiffs  purporting to represent an
uncertified  class of  psychiatrists,  psychologists and clinical social workers
brought an action under the federal antitrust laws in the United States District
Court for the  Southern  District of New York  against  nine  behavioral  health
managed care organizations,  including the Company (collectively,  "Defendants")
entitled Edward M. Stephens, Jose A. Yaryura-Tobias,  Judith Green, Ph.D., Fugen
Neziroglu,  Ph.D.,  Ona Robinson,  Ph.D.,  Laurie A. Baum,  C.S.W.,  Agnes Wohl,
C.S.W., and The On-Step Institute For Mental Health Research, Inc., individually
and on behalf of all others  similarly  situated,  v. CMG Health,  FHC  Options,
Inc., Foundation Health PsychCare Services,  Inc., Green Spring Health Services,
Inc.,  Human Affairs  International,  Inc.,  Merit  Behavioral  Care Corp.,  MCC
Behavioral Care Inc.,  United  Behavioral  Systems,  Inc., and Value  Behavioral
Health, Inc., 96 Civ. 7798 (KMW). The complaint alleges that Defendants violated
section 1 of the Sherman Act by  engaging in a  conspiracy  to fix the prices at
which  Defendants  purchase  services from mental  healthcare  providers such as
plaintiffs.  The complaint  further alleges that  Defendants  engaged in a group
boycott to exclude  mental  healthcare  providers from  Defendants'  networks in
order to  further  the  goals of the  alleged  conspiracy.  The  complaint  also
challenges  the  propriety of  Defendants'  capitation  arrangements  with their
respective  customers,  although  it  is  unclear  from  the  complaint  whether
plaintiffs allege that Defendants  unlawfully conspired to enter into capitation
arrangements with their respective customers. The complaint seeks treble damages
against  Defendants  in  an  unspecified  amount  and  a  permanent   injunction
prohibiting  Defendants  from  engaging in the alleged  conduct  which forms the
basis of the complaint,  plus costs and attorneys'  fees.  Defendants must move,
answer or otherwise  respond with respect to the complaint in January 1997.  The
Company intends to vigorously defend itself in this litigation.  However,  there
can be no assurance that the outcome of this litigation will be favorable to the
Company.  An  unfavorable  outcome could have a material  adverse  effect on the
Company.



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

      The Company did not submit any matters to a vote of its  security  holders
during the fourth quarter of the fiscal year covered by this report.


                                    PART II
------------------------------------------------------------------------------


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


                                      27

<PAGE>



      There is no established  public trading market for the Common Stock. There
were 27 holders of the Common  Stock at  December  1, 1996.  The Company has not
paid dividends on the Common Stock to date and does not currently  intend to pay
dividends  on the  Common  Stock  in the  foreseeable  future.  The  payment  of
dividends is  restricted by the Senior Credit  Facility and the  Indenture.  See
Note 6 to the Company's  consolidated  financial statements set forth in Part IV
below.

Item 6.   Selected Financial Data

     The following  selected  historical  financial  data were derived from, and
should  be read in  conjunction  with,  the  historical  consolidated  financial
statements  of the  Company  and of  MBC  prior  to  the  acquisition  of  Medco
Containment by Merck  (referred to herein as the  "Predecessor"),  including the
respective notes thereto, included elsewhere herein. The historical consolidated
financial  statements of the Predecessor for the fiscal year ended September 30,
1992 are unaudited.  The  historical  consolidated  financial  statements of the
Predecessor  for the fiscal  year ended  September  30, 1993 and the period from
October 1, 1993 through November 17, 1993 and of the Company for the period from
November  18, 1993  through  September  30, 1994 and for the fiscal  years ended
September  30,  1995 and 1996 are  audited.  See  "Management's  Discussion  and
Analysis of Financial Condition and Results of Operations."

                                      28

<PAGE>

<TABLE>
<CAPTION>


                         Predecessor(6)                       MBC                    MBC
                       Fiscal Year Ended              Nov. 18, 1993 Fiscal Year    Fiscal Year
                       September 30,     Oct.1-Nov17     to          Ended          Ended
                       1992        1993      1993    Sept. 30, 1994 Sept. 30,1995  Sept. 30, 1996(10)
                       ----        ----      ----      ---------     --------      ----------

Income Statement Data:
<S>                  <C>     <C>       <C>         <C>        <C>            <C>
Revenue                $121.6      $197.4    $31.0       $245.9     $361.5         $457.8
Operating expenses(1)   111.9.      180.5     29.3        225.4      335.8          426.2
Amortization of intan.    1.4         1.8      0.3         17.1       21.4           25.8
Restructuring charge      ---         1.7      ---          ---        ---            3.0
                       ------      ------    -----       ------      ------        ------
  Operating income(2)     8.3        13.4      1.4          3.4        4.3            2.8
Other expense (income)(3) 0.4        (0.6)    (0.1)        (0.8)      (1.5)          (2.8)
Interest expense                                                                     23.8
Merger costs.........      --         2.4      ---          ---        ---            4.0
                       -------     -------   -----        ------     -------       -------
 Income (loss) before income
   taxes and cumulative effect
   of accounting change   7.9        11.6      1.5          4.2        5.8          (22.2)
Provision (benefit) for
  income taxes            3.1         6.1      0.6          2.1        4.5           (5.3)
                       -------     -------   ------       ------     -------        ------
   Income (loss) before
     cumulative effect of
     accounting change    4.8         5.3      0.9          2.1        1.3          (16.9)
Cumulative effect of
  accounting change(10)    --          --       --           --         --           (1.0)
                       -------     -------    ------      ------      -------       ------
Net income (loss)    $    4.8     $    5.5   $ 0.9      $   2.1     $  1.3         $(17.9)
                       =======     =======    ======      ======      ======        ======
Pro forma net 
 income (loss) for 
 the effect of
 the accounting 
 change(19)          $    4.8     $    5.5   $ 0.9      $  2.1      $  0.3         $(16.9)
                       =======     ========   ======      ======      ======        ======
Deficiency of earnings
  to fixed charges(7)                                                              $(22.2)
                                                                                    ======

Balance Sheet Data (at end of periods):
Cash, cash equivalents and
  short-term marketable 
  securities(5)      $   9.5      $  21.9                $ 32.7      $ 34.1        $ 53.0
Total assets            60.2         91.9                 259.3       305.4         344.8
Due to parent
(noninterest bearing)    0.9          5.9                  37.9        70.8           ---
Long-term debt                                                                      254.0
Stockholders' equity    31.3         47.0                 121.0       122.3         (29.5)

Other Data:
Adjusted EBITDA(4)      11.8         20.0      2.2         25.5        34.0          45.1
Adjusted EBITDA margin(8)9.7%        10.1%     7.1%        10.4%        9.4%          9.9%
Cash provided by
 operating activies   $  1.9       $ 18.3    $ 2.9       $ 19.2      $ 26.1        $ 28.6
Cash used for investing
  activities            (1.5)       (17.3)    (1.6)       (43.3)      (54.2)        (41.3)
Cash provided by financing
  activities             0.9          4.9      0.5         31.6        32.9          30.6
Depreciation and
  amortization(9)        3.2          4.3      0.7         21.3        28.2          36.5
Capital expenditures:
  Information systems    ---          8.6      0.2         15.0        23.2          15.7
  Other capital 
       expenditures      2.3          1.0      1.0          1.8         8.3           8.1
                       ------       ------    ------      ------      ------        ------
Total capital
       expenditures      2.3          9.6      1.2         16.8        31.5          23.8
</TABLE>

                                           29

<PAGE>



Notes to Selected Financial Data:

(1)  Represents  the sum of  direct  service  costs  and  selling,  general  and
administrative expenses.

(2) Operating income equals income before income taxes, interest expense,  other
income and expense and merger costs.

(3) Represents  primarily  interest income,  except for 1992 which includes $0.3
million  of  expenses  related  to  a  legal  settlement  and  $0.4  million  of
acquisition-related expenses.

(4) "Adjusted EBITDA"  represents the sum of operating income,  depreciation and
amortization,  and other income and expense,  excluding restructuring charges in
1993 and 1996,  and other  non-recurring  charges  in 1992.  Adjusted  EBITDA is
presented  because a similar  measure is used in the covenants  contained in the
Indenture and MBC believes that Adjusted EBITDA is a widely  accepted  financial
indicator  of a company's  ability to service  debt.  However,  Adjusted  EBITDA
should not be construed as an alternative to MBC's operating income,  net income
or cash flow  from  operating  activities  (as  determined  in  accordance  with
generally  accepted  accounting  principles)  and should not be  construed as an
indication of MBC's operating performance or as a measure of MBC's liquidity. In
addition,  items  excluded  from  EBITDA,  such  as  restructuring  charges  and
depreciation and amortization,  are significant  components in understanding and
assessing the Company's financial performance.

(5) Includes restricted cash and short-term  marketable securities classified as
a long-term  asset.  See  "Management's  Discussion  and  Analysis of  Financial
Condition and Results of  Operations--Liquidity  and Capital  Resources--Cash in
Claims Funds and Restricted Cash."

(6) On November 18, 1993, Merck acquired all of the outstanding  shares of Medco
Containment in a transaction  accounted for by the purchase method.  The amounts
related to periods  prior to November  18, 1993,  were derived from  Predecessor
financial statements.  The historical cost basis of the Predecessor differs from
that of the Company  due to the  allocation  of a portion of the total  purchase
price of Medco Containment to the Company's assets and liabilities.

(7) For purposes of this  computation,  earnings  consist of income before taxes
plus fixed  charges.  Fixed  charges  consist  of  interest  expense  (including
amortization  of  deferred  financing  fees) and  one-third  of rental  expense,
representing  that portion of rental expense deemed by MBC to be attributable to
interest.  For the period  presented,  earnings were insufficient to cover fixed
charges  and,  therefore,  such  deficiency  is presented  above.  The ratios of
earnings  to fixed  charges  for the  periods  prior to  October 6, 1995 are not
presented   because  the  Company  did  not  have  interest   expense  prior  to
consummation of the Merger.

(8)  "Adjusted  EBITDA  margin"  represents  Adjusted  EBITDA as a percentage of
revenue.  As noted in footnote (4) above,  Adjusted EBITDA is presented  because
MBC believes it is a widely accepted financial  indicator of a company's ability
to service debt.  However,  Adjusted EBITDA margin should not be construed as an
alternative to MBC's  operating  income as a percentage of revenue or net income
as a  percentage  of revenue (as derived  from  operating  income and net income
determined  in  accordance  with  generally  accepted  accounting   principles).
Adjusted  EBITDA  margin  should  not be  construed  as an  indication  of MBC's
operating performance or as a measure of MBC's liquidity.

(9) Excludes amortization of deferred financing costs.


                                      30

<PAGE>



(10) Effective October 1, 1995, the Company changed its method of accounting for
deferred  start-up  costs  related to new  contracts  or  expansion  of existing
contracts (i) to expense costs  relating to start-up  activities  incurred after
commencement of services under the contract,  and (ii) to limit the amortization
period for deferred  start-up  costs to the initial  contract  period.  Prior to
October  1,  1995,  the  Company  capitalized  start-up  costs  related  to  the
completion of the provider networks and reporting systems beyond commencement of
contracts and, in limited instances,  amortized the start-up costs over a period
that included the initial renewal term  associated with the contract.  Under the
new policy,  the Company does not defer  contract  start-up costs after contract
commencement or include the initial renewal term in the amortization period. The
change was made to  increase  the focus on  controlling  costs  associated  with
contract start-ups.

The Company recorded a pre-tax charge of $1.8 million ($1.0 million after taxes)
in its fiscal 1996 first quarter results of operations as a cumulative effect of
the change in accounting.  Had the Company adopted this accounting  principle in
the prior year,  fiscal 1995 net income would have been $0.3 million.  There was
no pro forma effect of this change for fiscal years prior to 1995.

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

OVERVIEW

Effect on MBC of Merck's Acquisition of Medco Containment

      Merck acquired Medco Containment, the Company's former parent, on November
18, 1993 in a transaction  that was accounted  for by the purchase  method.  For
purposes of this  "Management's  Discussion and Analysis of Financial  Condition
and Results of Operations," the Company's  results of operations for fiscal 1994
include both the results of operations of the  Predecessor  from October 1, 1993
through  November  17, 1993,  and of the Company from  November 18, 1993 through
September 30, 1994. The effect of the acquisition of Medco  Containment by Merck
was to increase the goodwill and other intangibles and related deferred taxes of
the  Company;  the  Company's  subsequent  results of  operations  reflect  such
increases.

Revenue

      Typically,  the Company  charges each of its HMO, Blue  Cross/Blue  Shield
organization,  insurance  company,  corporate,  union,  governmental  and  other
customers a flat monthly  capitation fee for each  beneficiary  enrolled in such
customer's  behavioral  health managed care plan or EAP. This  capitation fee is
generally paid to MBC in the current month.  Contract  revenue billed in advance
of  performing  related  services is deferred  and  recognized  ratably over the
period to which it  applies.  For a number of the  Company's  behavioral  health
managed  care  programs,  the  capitation  fee is divided  into  outpatient  and
inpatient  fees,  which  are  recognized   separately.   Outpatient  revenue  is
recognized  monthly as it is received;  inpatient revenue is recognized  monthly
and is in most cases (i) paid to the Company monthly (in cases where the Company
is  responsible  for the payment of inpatient  claims) or in certain  cases (ii)
retained by the  customer  for payment of  inpatient  claims.  When the customer
retains  the  inpatient   revenue,   actual  inpatient  costs  are  periodically
reconciled  to  amounts  retained  and the  Company  receives  the excess of the
amounts  retained over the cost of services,  or reimburses  the customer if the
cost of services exceeds the amounts retained. In certain instances, such excess
or deficiency is shared between the Company and the customer.

      The Company's  revenue  increased by $79.5 million,  or 40.3%, from fiscal
1993 to fiscal  1994,  by $84.6  million,  or 30.6%,  from fiscal 1994 to fiscal
1995, and by $96.3 million, or 26.6%, from fiscal

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<PAGE>



1995 to  fiscal  1996.  Such  revenue  growth  has been  derived  from  existing
customers, new customers,  acquisitions,  joint ventures and other arrangements.
For existing  customers,  revenue growth has resulted from increased  membership
serviced under existing  behavioral  health managed care and EAP contracts,  and
from additional contracts with such customers offering new programs or expanding
into new  geographical  areas.  The  comparability  of revenue from the relevant
periods has also been affected by the various  acquisitions,  joint ventures and
other arrangements discussed in this Form 10-K.

Direct Service Costs and Margins

      Direct service costs are comprised principally of expenses associated with
managing,   supervising   and  providing  the  Company's   services,   including
third-party  network  provider  charges,  various  charges  associated  with the
Professional  Corporations,  inpatient  facility charges,  costs associated with
members of management  principally  engaged in the Company's clinical operations
and their support staff, and rent for certain offices  maintained by the Company
in connection with the delivery of services. Direct service costs are recognized
in the month in which services are expected to be rendered. Network provider and
facility charges for authorized  services that have not been reported and billed
to the Company  (known as incurred  but not  reported  expenses,  or "IBNR") are
estimated  and  accrued  based  on  historical  experience,  current  enrollment
statistics, patient census data and other information.

      The Company has  experienced  an  increase  in direct  service  costs as a
percentage  of revenue  (which  have been  offset to varying  degrees by various
initiatives  described  below) primarily as a result of changing product mix and
pricing  pressure  associated  with both the  competitive  bid  process  for new
contracts and  negotiations to extend existing  contracts.  The portion of MBC's
revenue (73% for fiscal 1996)  attributable  to capitated  managed care programs
has  continuously  been  increasing.  Because  capitated  managed care  programs
require  the Company to incur  greater  direct  service  costs than EAPs and ASO
managed care programs,  the direct profit margins  attributable to such programs
are lower than the direct profit  margins  attributable  to the Company's  other
programs.  The Company is continuing to focus on reducing  direct service costs.
Efforts  intended to reduce these costs include:  (i)  negotiating  better rates
and/or  different  compensation  arrangements  (such as  retainer  arrangements,
volume  discounts,  case rates and capitation of fees) with third-party  network
providers and treatment  facilities;  (ii) contracting with treatment facilities
that  provide a broader  spectrum of  treatment  programs in an effort to expand
beneficiary  access to a  broader  continuum  of care,  thereby  achieving  more
cost-effective treatment; (iii) focusing management and clinical care techniques
on patients  requiring  more  intensive  treatment  services to assure that such
patients receive the appropriate level of care in a cost-efficient and effective
manner;  (iv)  implementing a new  information  system intended to enable MBC to
improve the  productivity  and efficiency of its operations;  (v) increasing the
overall  efficiency of MBC's staff provider  system by closing or  consolidating
less  efficient  staff  offices,  streamlining  operations  and  increasing  the
efficiency  of  remaining  staff  offices;  and (vi)  increasing  the  Company's
capability to provide direct treatment services, thereby allowing MBC to deliver
more cost-effective services.

Selling, General and Administrative Expenses

      Selling,  general and administrative expenses are comprised principally of
corporate and regional overhead  expenses,  such as marketing and sales,  legal,
finance,   information   systems  and  administrative   expenses,   as  well  as
professional  and  consulting  fees,  and the  compensation  of  members  of the
Company's  senior   management.   The  Company  expects  selling,   general  and
administrative  expenses to grow over the near term,  primarily due to growth in
information  systems expenses related to the implementation of AMISYS(R) as well
as  increases  in regional  administration  and sales and  marketing  operations
necessary to support the growth of the Company's business;  however, the Company
expects selling, general and administrative expenses to grow at a rate less than
that of anticipated revenue growth

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<PAGE>



in fiscal 1997. There can be no assurance,  however,  that  anticipated  revenue
growth will occur or that any such  revenue  growth will occur at a rate greater
than the rate of growth in selling, general and administrative expenses.

Amortization of Intangibles

      As a result of Merck's  acquisition of Medco Containment in November 1993,
the Company's financial  statements include an allocation by Merck of the excess
of its cost over fair  market  value of the net  assets  acquired.  Accordingly,
goodwill  and  other  acquisition-related  intangibles  in the  amount of $160.0
million were recorded on the Company's balance sheet as of November 1993 and are
being  amortized over various  periods.  A noncurrent  deferred tax liability of
$47.8 million was established to reflect the tax  consequences of the difference
between the financial and tax reporting bases of the identified intangibles. The
Company's  total goodwill also includes  goodwill  associated with the Company's
acquisition of BenesYs,  Inc.  ("BenesYs"),  a Houston-based  behavioral  health
managed  care  organization,  and of  certain  assets of Washton  Institute.  In
addition,  the acquisition of Choate in October 1995, the payment made to Empire
in connection  with the Empire Joint Venture in September  1995, the acquisition
of ProPsych in December 1995,  and various  contingent  consideration  payments,
together with the goodwill recognized from the BenesYs and Washton transactions,
resulted  in the  incurrence  of  additional  goodwill  of  approximately  $62.6
million.  Amortization of  acquisition-related  intangibles was $17.2 million in
fiscal 1994, $20.1 million in fiscal 1995, and $22.8 million in fiscal 1996.

      The Company also  capitalizes  certain  start-up  expenses  related to new
contracts and amortizes  these amounts over the life of the contracts.  When the
Company  enters into a new  contract or  significantly  expands  services for an
existing  customer,  the Company  typically incurs up-front  start-up costs that
historically  have  ranged  from  $50,000 to $2.5  million  per  program.  These
start-up   costs  include,   among  other  things,   the  costs  of  recruiting,
interviewing and training providers and support staff,  establishing offices and
other  facilities,  acquiring  furniture,  computers  and other  equipment,  and
implementing  information  systems.  As of  September  30, 1996,  the  Company's
balance  sheet  reflected  $6.1  million  of  deferred  start-up  costs,  net of
amortization, categorized under long-term assets.

Liquidity

      The Company's  liquidity is affected by the one- to four-month lag between
the time the Company receives cash from capitation  payments under new contracts
and the  time  when the  Company  pays  the  claims  for  services  rendered  by
third-party  network  providers  and  treatment   facilities  relating  to  such
capitation payments.  During the first few months of a new contract, the Company
builds cash  balances as  capitation  payments  are  received  and also builds a
payables balance as direct service costs are accrued based on expected levels of
service.  After the first several months of a contract,  monthly claims payments
typically increase to normal levels and the contract generates cash more in line
with  the  expected  profit  margin  for  that  contract.  When  a  contract  is
terminated,  monthly  capitation  payments  cease on contract  termination,  but
claims for services  rendered prior to  termination  continue to be received and
paid for several months. This post-contract termination period is often referred
to as the  "run-off"  period.  To  date,  contract  terminations  have not had a
material impact on the Company's liquidity.

Recent Accounting Pronouncements

      In March 1995, the Financial  Accounting  Standards Board issued Statement
of  Financial  Accounting  Standards  ("SFAS")  No.  121,  "Accounting  for  the
Impairment of Long-Lived  Assets and for  Long-Lived  Assets to be Disposed Of."
SFAS 121 establishes accounting standards for the impairment of

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<PAGE>



long-lived assets and certain  identified  intangibles to be disposed of or held
and used by an entity.  SFAS 121 is effective for fiscal years  beginning  after
December 15,  1995.  The Company will adopt SFAS 121 in fiscal 1997 and does not
expect its implementation to have a material effect on its results of operations
or its financial condition.

      In October 1995,  the FASB issued SFAS 123,  "Accounting  for  Stock-Based
Compensation." SFAS 123 establishes financial accounting and reporting standards
for stock-based  employee  compensation  plans. SFAS 123 is effective for fiscal
years  beginning  after  December 15,  1995.  The Company will adopt SFAS 123 in
fiscal 1997 and does not expect its  implementation to have a material effect on
its results of operations or its financial condition.

RESULTS OF OPERATIONS

Selected Operating Results

The  following  table sets forth certain  statement of  operations  items of MBC
expressed as a percentage of revenue:

                                         Fiscal Year Ended September 30,
                                           1994       1995        1996
                                          -----       ----        ----

Revenue.............................      100.0%     100.0%      100.0%
Direct service costs................       77.1       79.1        79.0
                                         ------      ------      ------
  Direct profit margin..............       22.9       20.9        21.0
Selling, general and administrative
  expenses..........................       14.9       13.8        14.1
Amortization of intangibles.........        6.3        5.9         5.7
Restructuring charge................        ---        ---         0.6
                                        --------    --------    -------
   Operating Income.................        1.7        1.2         0.6
Other income........................        0.3        0.4         0.6
Interest expense....................        ---        ---        (5.2)
Merger costs........................        ---        ---        (0.8)
                                        --------    --------    -------
Income (loss) before income taxes and
  cumulative effect of accounting change    2.1         1.6       (4.8)
Provision (benefit) for income taxes...     1.0         1.2       (1.1)
                                         -------     -------     -------
Income (loss) before cumulative effect
    of accounting change............        1.1%        0.4%      (3.7)%
                                         =======     =======     =======

Adjusted EBITDA margin..............       10.0%        9.4%       9.9%

Fiscal 1996 Compared to Fiscal 1995

      Revenue.  Revenue increased by $96.3 million,  or 26.6%, to $457.8 million
for fiscal 1996 from $361.5  million for fiscal 1995.  Of this  increase,  $87.7
million was  attributable to the inclusion of revenue for the entire period from
certain  contracts  that  commenced  during  the  prior  fiscal  year as well as
additional revenue from existing customers  generated by an increase in both the
number of  programs  managed by the Company on behalf of such  customers  and an
increase in the number of  beneficiaries  enrolled in such customers'  programs;
and $26.4 million was  attributable to new customers  commencing  service in the
current  year,  the majority of which was derived from two  contracts  totalling
$20.9 million.  In addition,  the Company's  acquisitions of Choate and ProPsych
contributed an

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<PAGE>




additional  $18.4 million in revenue for fiscal 1996.  These  revenue  increases
were partially  offset by a $36.2 million decrease in revenue as a result of the
termination of certain  contracts,  five of which accounted for $21.1 million of
such decrease.  Certain of these  contracts had terminated in various periods of
the prior fiscal year.  Contract price  increases were not a material  factor in
the increase in revenue.

      Direct Service Costs.  Direct service costs increased by $75.7 million, or
26.5%, to $361.7 million for fiscal 1996 from $286.0 million for fiscal 1995. As
a percentage of revenue,  direct  service costs  decreased from 79.1% for fiscal
1995 to 79.0% for fiscal  1996.  This net  decrease in the direct  service  cost
percentage  was due to a variety  of  largely  offsetting  factors.  The  direct
service cost percentage was positively  impacted by lower inpatient  utilization
in fiscal 1996 as compared to the prior year related to a  significant  contract
with an HMO  focused  on the  Medicaid  beneficiary  population.  Such  decrease
resulted  from  the   implementation  of  changes  in  program   management  and
modification of the clinical treatment protocols applicable to such contract. In
addition,  the  Company  started to realize  the  benefits  in fiscal  1996 of a
nationwide  recontracting  program  with  providers  which  began in the  second
quarter of such year.  The Company is  continuing  its efforts to reduce  direct
service costs to mitigate the effects of pricing pressure,  which is expected to
continue in fiscal 1997,  associated  with the  competitive  bid process for new
contracts and negotiations to extend existing contracts. The direct service cost
percentage  was adversely  impacted by the loss in the fourth  quarter of fiscal
1995 of two  contracts  with higher than  average  direct  profit  margins and a
renewal of a  significant  contract on lower  pricing  terms.  In addition,  the
Company earned a lower than average direct profit margin on a significant  state
Medicaid  program  which was not in effect for the entire twelve month period in
the prior year.  Furthermore,  in the fourth quarter of fiscal 1996, the Company
commenced  providing  services  under the TennCare  program.  Due to the unusual
structure of the TennCare program,  the direct profit margin under such contract
was lower than the Company's average direct profit margin for fiscal 1996 and is
expected  to  continue to be lower in future  periods.  The Company  anticipates
that,  in light of the  relative  significance  of the  TennCare  program to the
Company,  the full year effect of this program will cause the Company's  overall
direct service cost percentage to increase over such percentage for fiscal 1996.

      Selling,  General  and  Administrative  Expenses.   Selling,  general  and
administrative  expenses increased by $14.7 million,  or 29.5%, to $64.5 million
for fiscal  1996 from $49.8  million  for fiscal  1995.  The  increase  in total
selling,  general and administrative  expenses was primarily attributable to (i)
growth in  marketing  and sales  administrative  staff,  corporate  and regional
management and support  systems  associated  with the higher sales volume,  (ii)
expenses associated with the expansion of the Company's National Service Center,
which will allow for growth  beyond  MBC's  current  needs,  and (iii)  expenses
related to the planned deployment of the Company's new information systems. As a
percentage of revenue, selling, general and administrative expenses increased to
14.1% for fiscal 1996 from 13.8% for fiscal 1995. The increase in such expenses,
coupled with unanticipated  delays in the planned start dates of significant new
contracts  (including  TennCare)  secured  by the  Company,  contributed  to the
increase in selling,  general and  administrative  expenses as a  percentage  of
revenue. With respect to the TennCare program, the Company anticipates that such
program will not require additional selling, general and administrative expenses
in fiscal 1997. This is expected to result in a decline in the Company's overall
selling,  general  and  administrative  expenses as a  percentage  of revenue in
fiscal 1997,  which should offset the expected  increase  described above in the
Company's 1997 direct service cost percentage.

      Amortization of Intangibles. Amortization of intangibles increased by $4.5
million,  or 21.0%,  to $25.9  million  for fiscal  1996 from $21.4  million for
fiscal 1995.  The increase was primarily due to an increase in  amortization  of
goodwill recognized in connection with the acquisitions of Choate and

                                      35

<PAGE>



ProPsych  and  the  Empire  Joint  Venture,  as  well  as to  increases  in  the
amortization of deferred contract start-up costs related to new contracts.

      Restructuring  Charge. The Company recorded a pre-tax restructuring charge
of $3.0 million related to a plan, adopted and approved in the fourth quarter of
1996, to restructure its staff offices by exiting certain geographic markets and
streamlining Continuum's field and administrative management organization.  This
decision was in response to the results of underperforming locations affected by
the lack of sufficient  patient flow in the  geographic  areas serviced by these
offices and the Company's ability to purchase healthcare services at lower rates
from the network.  In addition,  it was  determined the Company would be able to
expand  beneficiary  access to specialists and other providers thereby achieving
more  cost-effective  treatment and to favorably shift a portion of the economic
risk, in some cases, of providing outpatient  healthcare to the provider through
the  use  of  case  rates  and  other  alternative  reimbursement  methods.  The
restructuring  charge is comprised primarily of accruals for employee severance,
real property lease  terminations  and write-off of certain assets in geographic
markets which are being exited.  The Company  anticipates the restructuring plan
will be substantially completed by February 28, 1997.

      Other  Income  (Expense).  For  fiscal  1996,  other  income  and  expense
consisted of (i) interest  expense of $23.8 million  incurred as a result of the
increase in long-term debt resulting  from the Merger;  (ii) merger  expenses of
$4.0 million  consisting  primarily of professional and advisory fees; and (iii)
interest  and other  income of $2.8 million  relating  primarily  to  investment
earnings on the Company's short-term investments and restricted cash balances.

      Income  Taxes.  The  Company  recorded a benefit for income  taxes  during
fiscal 1996 based upon the Company's pre-tax loss in such period.  The resulting
income tax  benefit has been  partially  offset by the  nondeductible  nature of
certain merger costs.

Cumulative Effect of Accounting Change

      Effective  October 1, 1995,  the Company  changed its method of accounting
for deferred  start-up  costs  related to new contracts or expansion of existing
contracts (i) to expense costs  relating to start-up  activities  incurred after
commencement of services under the contract,  and (ii) to limit the amortization
period  for  deferred  start-up  costs  incurred  prior to the  commencement  of
services to the initial contract  period.  Prior to October 1, 1995, the Company
capitalized  start-up costs related to the  completion of the provider  networks
and  reporting  systems  beyond   commencement  of  contracts  and,  in  limited
instances,  amortized the start-up costs over a period that included the initial
renewal term  associated  with the contract.  Under the new policy,  the Company
does not defer contract  start-up costs after contract  commencement  or include
the initial  renewal  term in the  amortization  period.  The change was made to
increase the focus on controlling costs associated with contract start-ups.

      The Company  recorded a pre-tax charge of $1.8 million ($1.0 million after
taxes) in the first quarter of fiscal 1996 as a cumulative effect of a change in
accounting. The pro forma impact of this change for the year ended September 30,
1995 would be to increase costs and expenses by $1.8 million ($1.0 after taxes).
There was no pro forma effect on periods prior to fiscal 1995. The effect of the
change on the current year presented cannot be reasonably estimated.




Fiscal 1995 Compared to Fiscal 1994

                                      36

<PAGE>



      Revenue.  Revenue increased by $84.6 million,  or 30.6%, to $361.5 million
for fiscal 1995 from $276.9  million for fiscal 1994.  Of this  increase,  $42.8
million was attributable to additional revenue from existing customers generated
by an increase  in both the number of programs  managed by MBC on behalf of such
customers  and an  increase  in the  number of  beneficiaries  enrolled  in such
customers'  programs,  as well as the inclusion of revenue for the entire period
from certain contracts that commenced in the prior period; and $55.4 million was
attributable to new customers,  including two contracts in the HMO market, seven
contracts in the corporate market,  five contracts with HMOs focused on Medicaid
beneficiary  populations,  one contract in the governmental agencies market, the
Iowa  Mental  Health  Contract  and one month of the Empire  Joint  Venture.  In
addition,  the full year  impact  of  BenesYs,  acquired  in 1994,  and  Washton
Institute,  from which MBC  acquired  certain  assets and with which the Company
entered  into an  exclusive  affiliation  arrangement  in 1994,  contributed  an
additional  $7.2 million in revenue.  These  revenue  increases  were  partially
offset by a $20.7 million  decrease in revenue as a result of the termination of
certain  contracts,  five of which accounted for $16.9 million of such decrease.
Contract price increases were not a material factor in the increase in revenue.

      Direct Service Costs.  Direct service costs increased by $72.6 million, or
34.0%, to $286.0 million for fiscal 1995 from $213.4 million for fiscal 1994. As
a percentage of revenue,  direct  service costs  increased from 77.1% for fiscal
1994 to 79.1% for fiscal 1995.  These  increases were  principally  due to lower
than average direct  operating  margins  generated under two Medicaid  contracts
implemented in fiscal 1995 and the loss of a Blue Cross/Blue Shield organization
contract  that had a higher than  average  direct  operating  margin.  (The Blue
Cross/Blue  Shield  organization   terminated  its  contract  when  it  made  an
investment in a competitor of the Company.) These increases were also the result
of an increase in the percentage of revenue  derived from  capitated  contracts,
which generally have higher direct service costs, as well as a change in the mix
of capitated contracts.

      Selling,  General  and  Administrative  Expenses.   Selling,  general  and
administrative  expenses  increased by $8.6 million,  or 20.6%, to $49.8 million
for fiscal 1995 from $41.3  million for fiscal 1994. As a percentage of revenue,
selling,  general and administrative expenses decreased to 13.8% for fiscal 1995
from  14.9%  for  fiscal  1994.  The  increase  in total  selling,  general  and
administrative  expenses was  primarily  attributable  to growth in  information
systems  staff,  marketing  and sales and  administrative  staff,  corporate and
regional management, and support systems; however, these expenses were allocated
over a larger  revenue  base,  leading to the  decrease in selling,  general and
administrative expenses as a percentage of revenue.

      Amortization of Intangibles. Amortization of intangibles increased by $4.0
million,  or 22.7%,  to $21.4  million  for fiscal  1995 from $17.4  million for
fiscal  1994,  primarily  due to the  amortization,  for  the  full  period,  of
intangibles  allocated  to the  Company  as a result  of the  purchase  of Medco
Containment  by  Merck  in  November  1993,  as  well  as to  increases  in  the
amortization of deferred start-up costs related to new contracts.

      Income Taxes. The provision for income taxes increased by $1.8 million, or
66.7%,  to $4.5  million in fiscal 1995 from $2.7  million in fiscal  1994.  The
effective combined federal and state income tax rate was 77.3% in fiscal 1995 as
compared  to 47.7% in  fiscal  1994.  The  increase  in such rate was due to (i)
amortization,  for the full period, of non-deductible  goodwill allocated to the
Company  as a result of the  purchase  of Medco  Containment  by Merck;  (ii) an
increase  in  certain  non-deductible  expenses  incurred  in  1995  which  were
significant  relative to the amount of pretax  income;  and (iii) a shift of the
Company's income to states having higher statutory income tax rates.

Liquidity and Capital Resources


                                      37

<PAGE>



      General.  For fiscal 1996,  operating  activities  provided  cash of $28.5
million,   investing  activities  used  cash  of  $41.3  million  and  financing
activities  provided cash of $30.6 million,  resulting in a net increase in cash
and cash  equivalents  of $17.8  million.  Investing  activities  in fiscal 1996
consisted  principally  of (i) capital  expenditures  of $23.8  million  related
primarily to the continued  development of the Company's new information systems
and expansion of the Company's  National Service Center;  (ii) payments totaling
$2.9  million  for  funding  under  joint  ventures  with  Neighborhood   Health
Providers, LLC, Community Health Network of Connecticut,  Inc., and Royal Health
Care LLC; and (iii)  payments  totaling  $12.7 million for the  acquisitions  of
Choate and ProPsych.

Merger  Indebtedness.  In October 1995,  the Company  completed  the Merger.  In
connection with the Merger,  Merck received $326.0 million in cash (which amount
reflects various purchase price  adjustments) and retained  approximately 15% of
the Common Stock of the post-Merger Company. The Merger was financed with $115.0
million of new cash equity from  affiliates of KKR and Company  management.  The
balance of the  transaction  was funded  with a $75.0  million  bridge loan (the
"Bridge  Loan")  provided by an affiliate  of KKR and $155.0  million of initial
borrowings under the Senior Credit Facility.  Such funds were utilized to redeem
Common Stock for $258.1 million,  repay amounts due Merck of $67.9 million,  and
pay certain  fees and  expenses  related to the Merger.  In November  1995,  the
Company  issued  $100.0  million in  aggregate  principal  amount of its 11 1/2%
Senior  Subordinated  Notes due 2005 (the "Private Notes"),  the net proceeds of
which  were  applied to repay the  Bridge  Loan and a portion  of the  revolving
credit facility of the Senior Credit Facility (the "Revolving Credit Facility").
In March 1996,  the Company  exchanged the Private  Notes for $100.0  million in
aggregate principal amount of the Notes. As of September 30, 1996, $34.0 million
of revolving loans and $0.4 million of letters of credit were outstanding  under
the Revolving Credit Facility, and approximately $50.6 million was available for
future borrowing.

      Adjusted EBITDA.  Adjusted EBITDA, a financial  measure used in the Credit
Agreement and the  Indenture,  increased by $11.1  million,  or 32.6%,  to $45.1
million for the twelve  months ended  September  30, 1996 from $34.0 million for
the twelve months ended September 30, 1995.

      Acquisitions.  In  October  1995,  the  Company  acquired  Choate for $8.7
million;  in July  1996,  the  Company  made an interim  payment  of  contingent
consideration to Choate's former  shareholders of $1.3 million.  The Company may
be obligated to make additional  contingent payments relating to Choate based on
the 1996 and 1997  pre-tax  income of Choate.  In  December  1995,  the  Company
acquired  ProPsych for an initial  payment of $0.1 million and a payment of $2.9
million made in January 1996. In November 1996, the Company paid $0.4 million to
the former shareholders of ProPsych in full settlement of any and all contingent
consideration  due to such former  shareholders.  From time to time, the Company
has engaged in and continues to engage in preliminary  discussions  with respect
to potential acquisitions and joint ventures.

      Cash in Claims Funds and  Restricted  Cash. As of September 30, 1996,  the
Company had total cash balances  (including cash  equivalents) of $53.0 million,
of which $33.2 million was restricted under certain  contractual,  fiduciary and
regulatory  requirements;  moreover, of such amount, $5.7 million was classified
as a long-term asset on the Company's  balance sheet.  Under certain  contracts,
the  Company is  required  to  establish  segregated  claims  funds into which a
portion  of its  capitation  fee is held  until  a  reconciliation  date  (which
reconciliation  typically occurs  annually).  Until that time, cash funded under
these  arrangements  is  unavailable  to the Company for purposes other than the
payment of  claims.  In  addition,  California  and  Illinois  state  regulatory
requirements restrict access to cash held by the Company's  subsidiaries in such
states.  As of September 30, 1996,  the Company also held surplus cash balances,
classified as cash and cash  equivalents,  as required by the contracts  held by
the Company

                                      38

<PAGE>



relating  to both the  State  of Iowa and the  State  of  Tennessee  to  provide
behavioral  health  managed  care  services  to each of those  state's  Medicaid
populations.

      Availability of Cash. Historically,  the Company has funded its operations
primarily with cash generated from operations and through the funding of certain
acquisitions,  investments and other  transactions by its former parent,  Merck.
The Company  expects to finance its capital  requirements  in the future through
existing cash balances,  cash generated from operations and borrowings under its
revolving  credit  facility.  Based  upon the  current  level of cash flows from
operations and  anticipated  growth,  the Company  believes that available cash,
together with available  borrowings  under the Revolving  Credit  Facility,  and
other sources of liquidity,  will be adequate to meet the Company's  anticipated
future  requirements for working capital,  capital  expenditures,  and scheduled
payments of  principal  and  interest on its  indebtedness  for the  foreseeable
future.  There can be no assurance,  however,  that the Company's  business will
generate  sufficient  cash flow from  operations or that future working  capital
borrowings  will be available in an amount  sufficient  to enable MBC to service
its indebtedness, including the Notes, or make necessary capital expenditures.

Seasonality

      MBC's revenue and direct service costs are affected to a certain degree by
seasonality in the Company's  business.  The Company's  existing revenue base is
relatively  consistent due to the nature of its contracts;  however, new revenue
generated  through  increases in membership  and customer  programs  varies each
month.  The  greatest  fluctuations  usually  occur in January  and, to a lesser
extent,  July, as these are the primary  enrollment  periods for most healthcare
benefit plans. January and July are also months in which the Company commences a
significant portion of its programs for new customers,  as HMOs and corporations
typically  contract for  healthcare  services on a calendar year basis and state
governments  usually  operate on a  mid-year  contracting  cycle.  Nevertheless,
behavioral  health  managed care  programs for new customers may begin any time;
for example,  some of the Company's  largest  programs to date,  the Iowa Mental
Health  Contract  and the  Empire  Joint  Venture,  began on  March 1,  1995 and
September 1, 1995,  respectively.  In addition,  direct service costs  generally
vary with revenue;  however, they are also affected by seasonality.  Utilization
of services (and  therefore,  direct  service costs) for HMOs,  Blue  Cross/Blue
Shield organizations and insurance companies generally tend to be higher overall
in the  Company's  first and second  fiscal  quarters  (ending in  December  and
March). Direct service costs also increase in MBC's second fiscal quarter to the
extent of annual wage increases for employees.

Inflation

      The  effects of  inflation  on MBC's  financial  condition  and results of
operations were not material during any of the periods presented.

Item 8.   Financial Statements and Supplementary Data

      The  financial  statements  of the  Company set forth on pages F-1 through
F-21 hereof are incorporated herein by reference.

Item  9.  Changes  in and  Disagreements  with  Accountants  on  Accounting  and
Financial Disclosures

      None

                                   PART III

                                      39

<PAGE>



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


Item 10.  Directors and Executive Officers of the Registrant

Directors and Executive Officers

     The  following  table  sets  forth  certain  information   regarding  MBC's
directors and executive officers:
<TABLE>
<CAPTION>


     NAME                    AGE          POSITION
-------------------------  -----------  -----------------------------------------------------
<S>                          <C>                                        
Albert S. Waxman, Ph.D        56        Chairman and Chief Executive Officer
Henry R. Kravis               52        Director
George R. Roberts             53        Director
Edward A. Gilhuly             37        Director
Todd A. Fisher                31        Director
Ronald D. Geraty, M.D.        50        Executive Vice President, New Business
                                        Development and Director; President of
                                        Continuum
Arthur H. Halper              49        Executive Vice President, Chief
                                        Financial Officer and Director
Michael G. Lenahan, Esq.      37        Executive Vice President, Mergers &
                                        Acquisitions, General Counsel and Secretary      
David B. Stone                50        Executive Vice President and Chief
                                        Marketing Officer
Richard C. Surles, Ph.D.      52        Executive Vice President, Operations
Terry R. Thompson             38        Executive Vice President, Business Operations
                                        and Director
</TABLE>

Albert S. Waxman,  Ph.D. has served as Chief Executive Officer and as a Director
of MBC since its  incorporation in March 1993. Dr. Waxman has served as Chairman
of the Board of Directors of MBC since  December 1994 and served as  Co-Chairman
of the Board of Directors of MBC from March 1993 until December 1994. Dr. Waxman
also served as  President  of MBC from March 1993  through  December  1993.  Dr.
Waxman was a  co-founder  of American  Biodyne and has served as its Chairman or
Co-Chairman  since 1985,  its Chief  Executive  Officer since December 1990, and
also served as its President from May 1990 until April 1993. Since January 1990,
Dr. Waxman has served as Chief  Executive  Officer of both  Novatech  Management
Corporation and Waxman  Enterprises,  private venture capital firms.  Since June
1990,  Dr.  Waxman has served as a member of the Board of  Directors  of Norland
Corporation,  a medical device company in the  osteoporosis  field,  and Oestech
Inc., a medical device company.  Dr. Waxman founded  Diasonics,  Inc., a medical
imaging  company,  where he served as  Chairman  of the Board,  Chief  Executive
Officer and President  from 1977 through 1987.  Dr. Waxman holds Ph.D.  and M.S.
degrees in  electrical  engineering  from  Princeton  University,  where he is a
member  of the  advisory  council  of the  School  of  Engineering  and  Applied
Sciences,  and a B.S. degree in electrical  engineering from City College of New
York.

Henry R.  Kravis  became a Director  of MBC in  October  1995.  Mr.  Kravis is a
Founding  Partner  of KKR and KKR  Associates  and is a  member  of the  limited
liability company which serves as the General Partner of KKR. Mr. Kravis is also
a  director  of  AutoZone,   Inc.,  Borden,   Inc.,   Bruno's,   Inc.,  Duracell
International,  Inc.,  Flagstar  Companies,  Inc.,  Flagstar  Corporation,  IDEX
Corporation,   K-III   Communications   Corporation,   Newsquest   Capital  PLC,
Owens-Illinois,  Inc.,  Owens-Illinois  Group,  Inc.,  Safeway Inc., Union Texas
Petroleum Holdings, Inc. and World Color Press, Inc.

                                      40

<PAGE>




George R. Roberts  became a Director of MBC in October  1995.  Mr.  Roberts is a
Founding  Partner  of KKR and KKR  Associates  and is a  member  of the  limited
liability  company  which serves as the General  Partner of KKR. Mr.  Roberts is
also a director  of  AutoZone,  Inc.,  Borden,  Inc.,  Bruno's,  Inc.,  Duracell
International,  Inc.,  Flagstar  Companies,  Inc.,  Flagstar  Corporation,  IDEX
Corporation,   K-III   Communications   Corporation,   Newsquest   Capital  PLC,
Owens-Illinois,  Inc.,  Owens-Illinois  Group,  Inc.,  Safeway Inc., Union Texas
Petroleum Holdings, Inc. and World Color Press, Inc.

Edward A. Gilhuly  became a Director of MBC in October 1995.  Mr.  Gilhuly was a
General  Partner of KKR from January 1995 until January  1996,  when he became a
member of the limited  liability  company which serves as the General Partner of
KKR. Mr. Gilhuly is also a General Partner of KKR Associates and, prior to 1995,
was an  Executive of KKR. Mr.  Gilhuly is also a director of  Doubletree  Hotels
Corporation,  Layne Christensen Company,  Owens-Illinois,  Inc.,  Owens-Illinois
Group, Inc., Red Lion Properties, Inc. and Union Texas Petroleum Holdings, Inc.

Todd A. Fisher became a Director of MBC in October 1995.  Mr. Fisher has been an
Executive of KKR since June 1993 and a Limited  Partner of KKR Associates  since
December  1993.  From 1992 to June 1993, Mr. Fisher was an associate at Goldman,
Sachs & Co. Prior to 1992, Mr. Fisher attended the Wharton School of Business at
the University of Pennsylvania.

Ronald D. Geraty, M.D. has served as a Director of MBC since May 1996, President
of Continuum since its formation in July 1994 and an Executive Vice President of
MBC since its  incorporation in March 1993. Dr. Geraty has also served as Senior
Vice President,  New Business Development of American Biodyne since May 1992 and
as Vice President of American  Biodyne from December 1991 to May 1992. He served
as President of Assured Health Systems,  Inc.  (acquired by American  Biodyne in
1991) from  September  1989 through May 1992.  In  addition,  he is currently an
Instructor in Psychiatry at the Harvard Medical School. Dr. Geraty holds an M.D.
from the Loma Linda University  School of Medicine,  Loma Linda,  California and
attended Columbia Union College in Washington, D.C.

Arthur H.  Halper  has  served  as a  Director  of MBC  since  May 1996,  and as
Executive Vice President and Chief Financial Officer of MBC since December 1994.
Mr. Halper served as Executive Vice President,  Mergers and  Acquisitions of MBC
from November 1993 to December 1994, and as Senior Vice President of Finance and
Treasurer of MBC from its incorporation in March 1993 through November 1993. Mr.
Halper has also served as Chief Financial Officer,  Executive Vice President and
Treasurer of American  Biodyne since  December 1994, and served as a Senior Vice
President of American  Biodyne from  January  1994 to December  1994,  as a Vice
President  of American  Biodyne  from March 1993 to January 1994 and as Regional
Vice President of American Biodyne for the Mid-Atlantic Region from January 1992
through  March 1993.  Mr. Halper also has served as Chief  Operating  Officer of
AGCA,  Inc.  (acquired by American  Biodyne in 1992) since  November  1990.  Mr.
Halper,  a  Certified  Public  Accountant,  holds  a  B.A.  degree  in  Business
Administration from Rutgers University.

Michael G.  Lenahan,  Esq. has served as  Executive  Vice  President,  Mergers &
Acquisitions  of MBC since  January  1996,  Executive  Vice  President,  General
Counsel  and  Secretary  of MBC since  November  1993,  and  General  Counsel or
Executive  Vice  President,  Legal of  American  Biodyne and each of MBC's other
subsidiaries  since  January  1994.  Mr.  Lenahan  held  the  position  of  Vice
President-Legal  of Medco  Containment  from March 1993 until August 1995. Prior
thereto,  Mr.  Lenahan was an associate with the New York law firm of Shearman &
Sterling. Mr. Lenahan holds a J.D. degree from New York University School of Law
and a B.A. degree in Political  Science from the State University of New York at
Binghamton.

                                      41

<PAGE>




David B.  Stone has  served as  Executive  Vice  President  and Chief  Marketing
Officer of MBC since June 1994 and served as Senior Vice  President  of MBC from
January 1994 to June 1994.  Mr. Stone also served as Vice  President of MBC from
its  incorporation  in March  1993 to  January  1994.  Mr.  Stone has  served as
President of Personal  Performance  Consultants,  Inc. ("PPC"),  a subsidiary of
MBC,  since  August 1994 and served as Senior  Vice  President  of Managed  Care
Services  and Chief  Marketing  Officer of PPC from June 1993 until August 1994.
From  August  1988 to April  1992,  Mr.  Stone was Vice  President  of Sales and
Marketing for Preferred Health Care, Ltd. and Chief Marketing  Officer of Empire
Mental Health Choice,  a joint venture  between  Preferred  Health Care Ltd. and
Empire. Mr. Stone holds an M.S.W. degree from the Columbia School of Social Work
and an M.B.A. degree from Pace University.

Richard C. Surles,  Ph.D. has served as an Executive Vice President of MBC since
November  1994.  In October 1995,  Dr. Surles  assumed the position of Executive
Vice  President,  Service System  Development of MBC and,  commencing in January
1996,  became Executive Vice President,  Operations of MBC. Dr. Surles served as
the New York State  Commissioner  of Mental Health from October 1987 to November
1994.  Dr.  Surles holds a Ph.D.  degree in  Administration  and  Organizational
Behavior from the University of North Carolina.

Terry R.  Thompson  has served as a Director  of MBC since  October  1996 and as
Executive Vice President, Business Operations of MBC since September 1996. Prior
to  joining  MBC,  Mr.  Thompson  was an  executive  of Medco  Containment  from
September 1990 to January 1996. Most recently,  Mr. Thompson served as Executive
Vice President of Operations of Merck/Medco Managed Care, Inc., and as President
and  a  Director  of  National  Pharmacies,   Inc.,  NRx  Services,  Inc.,  Paid
Prescriptions,  Inc. and a number of other  subsidiaries  of Medco  Containment,
from October 1994 to January  1996.  Mr.  Thompson  also served as a Senior Vice
President  of Synetic,  Inc.  ("Synetic"),  at such time a  subsidiary  of Medco
Containment,  and was responsible for five of Synetic's  institutional  pharmacy
companies  from October 1993 to October  1994.  From  September  1991 to October
1993, Mr. Thompson held the position of Senior Vice President-Eastern  Region of
Medco Containment, and from September 1990 to September 1991 he served as a Vice
President  and  General  Manager  for  the  company.   Prior  to  joining  Medco
Containment,  Mr. Thompson worked for Federal Express  Corporation  from 1975 to
1990,  holding various  positions  during such period,  serving most recently as
Managing  Director,  Boston  Operations.  Mr.  Thompson  serves  on the Board of
Directors of The Entertainment  Connection,  Inc., an Internet products company,
and Operation Link-Up, a not-for-profit  corporation dedicated to Paterson,  New
Jersey high school  students.  Mr. Thompson holds a B.B.A.  degree in Management
from Memphis State University.

      Messrs. Kravis and Roberts are first cousins.

Recent Changes

      In November  1996, the Company  entered into an employment  agreement with
John P.  Docherty,  M.D.,  under which Dr.  Docherty will assume the position of
Executive  Vice  President  and Chief Medical  Officer of the Company  effective
March 1, 1997.

     Effective May 31, 1996,  Richard S. Chung,  M.D. resigned from his position
as Executive Vice President and Chief Clinical Officer of the Company. Effective
April 1, 1996, Shannon R. Kennedy, Ph.D. resigned from his position as President
and Chief  Operating  Officer of the Company.  In December  1995,  Philip Morlan
resigned from his position as Executive  Vice  President  and Chief  Information
Officer of the  Company.  Upon the  departure  of each such  executive  from the
Company, MBC purchased

                                      42

<PAGE>



all shares of Common  Stock  acquired  by such  executive  on October 6, 1995 in
connection with the Merger.

Item 11.  Executive Compensation

      The following  table sets forth in summary form all  compensation  for all
services  rendered in all  capacities to the Company paid or accrued  during the
three fiscal years ended  September 30, 1996 to the Chief  Executive  Officer of
the Company and the four other most highly compensated executive officers of the
Company  (collectively,  with the Chief Executive Officer,  the "Named Executive
Officers").  Such table represents historical compensation and is not indicative
of future compensation to be received by the Named Executive Officers.
<TABLE>

<CAPTION>
                     Historical Summary Compensation Table
                                                                 Long Term
                         Annual Compensation                    Compensation
                                                                 Securities
                                                    Other Annual Underlying      All Other
Named Executive Officer     Year   Salary    Bonus  Compensation MBC Options    Compensation(2)
                                                                     (#)

<S>                            <C>        <C>                      <C>                
Albert S. Waxman, Ph.D.      1996  $435,000 $ 65,250    ---          2,800,000       ---
     Chairman and            1995   405,417   70,000    ---             ---          ---
     Chief Executive Officer 1994   400,000   86,262    ---             ---          ---

Ronald D. Geraty, M.D.       1996   275,000   41,250    ---            300,000    $1,000
   Executive Vice President, 1995   241,750   27,125    ---             ---          800
   Business Development;     1994   217,000   32,688    ---             ---          800
   President of Continuum

Arthur H. Halper             1996   250,000   37,500    ---            150,000     1,500
   Executive Vice President  1995   210,000   20,625    ---             ---        1,200
   Chief Financial Officer   1994   165,000   32,209    ---             ---        1,200

Richard C. Surles, Ph.D      1996  250,000   100,000  $77,977(1)       120,000       ---
   Executive Vice President  1995  177,083         0    ---             ---          ---
   Operations                1994        0         0    ---             ---          ---

David B. Stone               1996  225,000    33,750    ---            300,000     1,900
   Executive Vice President  1995  225,000    24,771    ---             ---        1,500
   Chief Marketing Officer   1994  180,082    10,079    ---             ---        1,500
</TABLE>

----------------------
(1) Represents  reimbursement  of expenses in connection
with  Dr.  Surles'  relocation  to the  Company's  corporate  headquarters.

(2) Represents the Company's  matching  contribution  under the Merit Behavioral
Care Corporation 401(k) Plan.


                                            43

<PAGE>





Options/SAR Grants in Fiscal 1996

      The following table  summarizes  options to acquire shares of Common Stock
granted in fiscal 1996 to the Named Executive Officers.
<TABLE>
<CAPTION>

                                Individual Grants                               Potential Realizable Value
                  Number of           % of Total                                 of Assumed Annual Rates
                  Securities          Options Granted     Exercise             of Stock Price Appreciation
                  Underlying           to Employees         Price    Expiration        for Option Term
Name              Options Granted     in Fiscal Year       $/Share      Date            5%          10%
----              ---------------     --------------       -------    ---------      ----------------------
                        (#)
<S>                <C>               <C>       <C>              <C>   <C>           <C>        
Albert S. Waxman   2,800,000               42.9%            $5.00     10/06/2005     $8,804,525 $22,312,394
Ronald D. Geraty     300,000                4.6              5.00     10/06/2005        943,342   2,390,614
Arthur H. Halper     150,000                2.3              5.00     10/06/2005        471,671   1,195,307
Richard C. Surles    120,000                1.8              5.00     10/06/2005        377,337     956,245
David B. Stone       300,000                4.6              5.00     10/06/2005        943,342   2,390,614
</TABLE>

Aggregated  Option/SAR  Exercises  in  Last  Fiscal  Year  and  Fiscal  Year-End
Option/SAR Values

      The following  table  sets  forth the  number of shares  covered  by both
exercisable and unexercisable  options to acquire shares of Common Stock held by
the Named Executive Officers as of September 30, 1996.
<TABLE>
<CAPTION>

                                                                                        Value of Unexercised
                                     Number of Securities                                  In the Money
                                 Underlying Unexercise Options/SARs                       Options/SARs at
                                       at Fiscal Year End                                 Fiscal Year End(1)

                         Shares
                       Acquired        Value
Name                  on Exercise      Realized     Exercisable     Unexercisable     Exercisable    Unexercisable
----                  -----------      --------     ------------    -------------     -----------    -------------
                                                                          #)
<S>                                                     <C>                                   
Albert S. Waxman           --             --             --           2,800,000            --              --
Ronald D. Geraty           --             --             --             300,000            --              --
Arthur H. Halper           --             --             --             150,000            --              --
Richard C. Surles          --             --             --             120,000            --              --
David B. Stone             --             --             --             300,000            --              --


</TABLE>

--------------
(1)Until  such time there is a public  market in which the  Common  Stock may be
   traded,  the value of such options is determined  under a formula  delineated
   under the 1995 Option Plan. As of September 30, 1996,  based on such formula,
   no value was associated with such options.











                                            44

<PAGE>



   The  following  table  sets  forth  the  number  of  shares  covered  by both
exercisable and unexercisable options to acquire shares of common stock of Merck
held by the Named Executive Officers as of September 30, 1996.
<TABLE>
<CAPTION>

                                                                                            Value of Unexercised
                             Number of Securities                                               In the Money
                     Underlying Unexercised Merck Optins/SARs                                 Merck Options/SARs
                               at Fiscal Year End                                            at Fiscal Year End(1)
                     Shares
                   Acquired        Value
Name(2)          on Exercise    Realized     Exercisable   Unexercisable               Exercisable    Unexercisable
                     (#)                          (#)             (#)
<S>               <C>           <C>            <C>                 <C>                      <C>               <C> 
Albert S. Waxman     86,685    $3,781,881      471,047          109,262                 $23,099,156       $5,293,198
Ronald D. Geraty        ---          ---         9,363            6,070                     428,939          247,808
Arthur H. Halper      1,098        53,739       24,280           12,141                   1,163,862          581,979
David B. Stone        9,743       439,385          ---            4,857                         ---          233,792
</TABLE>

----------------
(1)Values for  "in-the-money"  options represent the positive spread between the
   respective exercise prices of outstanding  options and $70.375,  the value of
   the common  stock of Merck as of September  30, 1996,  as reported on the New
   York Stock Exchange Composite Tape.
(2)Richard C. Surles holds no options to acquire shares of common stock
   of Merck.

Compensation Committee Interlocks and Insider Participation

     The  Compensation  Committee  of MBC's Board of  Directors  is comprised of
Messrs.  Gilhuly and Fisher.  Mr.  Gilhuly is a member of the limited  liability
company which serves as the General Partner of KKR and is also a General Partner
of KKR  Associates.  Mr. Fisher is an Executive of KKR and a Limited  Partner of
KKR Associates.  KKR Associates  beneficially  owned 73.7% of MBC's  outstanding
Common Stock as of December 1, 1996. As a General Partner of KKR Associates, Mr.
Gilhuly  may be  deemed  to  share  beneficial  ownership  of the  Common  Stock
beneficially  owned by KKR Associates;  however,  Mr. Gilhuly disclaims any such
beneficial ownership.

Compensation of Directors

      Each director who is not an employee of the Company  receives an aggregate
annual fee of $25,000, payable in quarterly installments. Directors who are also
employees of the Company receive no remuneration for serving as directors.

Management Incentive Plan

      The Board of Directors of MBC has adopted an Annual Incentive Plan for Key
Employees of MBC (the "Incentive  Plan").  The Incentive Plan provides that each
fiscal   year   MBC   senior   management   will   designate   as   participants
("Participants")  in the  Incentive  Plan  those  employees  of MBC who are in a
position to  significantly  impact the performance of the Company.  Participants
will be  eligible  to  receive  payments  under the  Incentive  Plan  equal to a
specified  percentage  of their base  salaries  if the Company  attains  certain
performance goals set by the Compensation Committee.

1995 Merit Stock Option Plan

      In October 1995,  MBC adopted the 1995 Stock  Purchase and Option Plan for
Employees of Merit  Behavioral  Care  Corporation  and  Subsidiaries  (the "1995
Option Plan") providing for the issuance of up to 8,561,000 shares of authorized
but unissued or reacquired shares of Common Stock, subject to


                                      45

<PAGE>



adjustment  to reflect  certain  events such as stock  dividends,  stock splits,
recapitalization,  mergers or  reorganizations  of or by the  Company.  The 1995
Option  Plan is  intended  to assist the  Company in  attracting  and  retaining
employees  of  outstanding  ability and to promote the  identification  of their
interests with those of the  stockholders  of the Company.  The 1995 Option Plan
permits the  issuance of Common  Stock (the  "Purchase  Stock") and the grant of
Non-Qualified  Stock Options (the "1995  Options") to purchase  shares of Common
Stock (the issuance of Purchase  Stock and the grant of Options  pursuant to the
Plan  being  a "1995  Grant").  Unless  sooner  terminated  by  MBC's  Board  of
Directors, the 1995 Option Plan will expire on October 6, 2005. Such termination
will not  affect  the  validity  of any 1995  Grant  outstanding  on the date of
termination.

      Each individual 1995 Option  agreement  provides that, upon certain events
(each,  an  "Acceleration  Event"),  the 1995  Options  will become  immediately
exercisable.  The 1995 Option  agreements  provide  that an  Acceleration  Event
occurs if the  participant's  employment  with the Company is terminated by such
participant for "good reason" or by the Company without "cause" (each as defined
in the MBC Management  Stockholder's  Agreements  (as defined))  within one year
following certain change in control events.

      The 1995 Option Plan provides  generally  that the exercise  price of 1995
Options and the  purchase  price of any Common Stock  granted for  consideration
will not be less than 50% of the fair market  value per share of Common Stock on
the  date of such  1995  Grant.  Each  participant  in the 1995  Option  Plan is
required to enter into a stockholder's  agreement with MBC substantially similar
to the MBC Management Stockholder's Agreements described below.

      The  Compensation  Committee of MBC's Board of Directors  administers  the
1995 Option  Plan,  including,  without  limitation,  the  determination  of the
employees to whom 1995 Grants will be made, the number of shares of Common Stock
subject to each 1995  Grant,  and the  various  terms of such 1995  Grants.  The
Compensation  Committee of MBC's Board of Directors  may from time to time amend
the terms of any 1995 Grant,  but, except for adjustments  made upon a change in
the Common  Stock of the  Company by reason of a stock  split,  spin-off,  stock
dividend,    stock    combination   or    reclassification,    recapitalization,
reorganization,  consolidation, change of control, or similar event, such action
shall not adversely  affect the rights of any participant  under the 1995 Option
Plan with  respect  to the  Purchase  Stock and the 1995  Options  without  such
participant's  consent.  MBC's  Board of  Directors  retains the right to amend,
suspend or terminate the 1995 Option Plan.

1996 Merit Stock Option Plan

      In  January  1996,  MBC  adopted  the Merit  Behavioral  Care  Corporation
Employee  Stock Option Plan (the "1996 Option Plan")  providing for the issuance
of up to 1,000,000  shares of authorized  but unissued or  reacquired  shares of
Common  Stock,  subject to adjustment  to reflect  certain  events such as stock
dividends, stock splits,  recapitalization,  mergers or reorganizations of or by
the Company.  The 1996 Option Plan is intended to provide incentive to employees
of MBC to remain in the employ of the Company and to increase  their interest in
the success of the Company through the grant of stock options. Substantially all
full-time  employees  of MBC  (other  than those  receiving  1995  Options)  who
commenced  employment  with MBC  prior  to  January  1,  1996  are  eligible  to
participate  in the 1996 Option Plan.  The 1996 Option Plan permits the grant of
Non-Qualified  Stock Options (the "1996  Options") to purchase  shares of Common
Stock (each such grant of 1996  Options  being a "1996  Grant").  Unless  sooner
terminated  by the MBC Board of  Directors,  the 1996 Option Plan will expire on
January 1, 2006. Such termination will not affect the validity of any 1996 Grant
outstanding as the date of termination.



                                      46

<PAGE>



      The Compensation  Committee of the MBC Board of Directors  administers the
1996 Plan, including, without limitation, the determination of employees to whom
1996 Grants will be made,  the number of shares of Common Stock  subject to each
1996 Grant, and the terms of such 1996 Grant. 1996 Grants to participants  under
the 1996 Option Plan are  determined  based on their  length of service with the
Company,  with reference to the following service categories:  (a) less than one
year; (b) one to two years;  (c) two to three years;  and (d) greater than three
years.  Each  participant  will be required to execute an agreement  with MBC (a
"1996 Option  Agreement")  containing  the following  terms,  among others:  the
number of 1996 Options;  the exercise price therefor;  and the vesting  schedule
for the 1996 Options.

      The 1996 Option  Agreements  prohibit the participants  from  transferring
1996  Options,  subject  to  enumerated  exceptions.  The 1996  Options  are not
exercisable  until  after  the date  when at least  25% of the then  outstanding
shares of Common Stock (on a fully diluted basis) have been sold in underwritten
public  offerings  under the  Securities  Act (the "Public  Company  Date") and,
thereafter,  only when the shares of Common Stock  underlying  such 1996 Options
have been  registered  under the Securities Act and qualified  under  applicable
state  "blue  sky"  laws,  or MBC has  determined  that an  exemption  from such
registration  and "blue sky"  qualification  is  available.  In  addition,  upon
termination of the  participant's  employment with MBC at any time, all unvested
1996 Options will be canceled and, if such  termination is for Cause (as defined
in the 1996 Option  Agreements),  all vested  Options also will be canceled.  If
such  employment is terminated  prior to the Public  Company Date without Cause,
MBC will have the right for three  years after such  termination  to require the
participant  to surrender for  cancellation  all vested 1996 Options in exchange
for a payment  determined  under the 1996 Option  Plan.  If such  employment  is
terminated without Cause after the Public Company Date, the participant's vested
1996 Options will remain exercisable for 90 days following such termination.

      The MBC Board of  Directors  has  reserved the right to amend or terminate
the 1996  Option  Plan,  provided  that no such  amendment  or  termination  may
adversely affect the rights of participants in their 1996 Options.

Employment Agreements

      Albert S.  Waxman.  American  Biodyne  has  entered  into an  amended  and
restated  employment  agreement,  dated as of August 17,  1992 and amended as of
October 1, 1993, with Albert S. Waxman.  The agreement  provides that Dr. Waxman
will be employed by American Biodyne for a period of five years and will receive
a base salary of $400,000 plus a yearly  discretionary  bonus.  Such annual base
salary has been  subsequently  increased.  American  Biodyne may  terminate  the
agreement  for cause or by mutual  agreement  with Dr.  Waxman.  Dr.  Waxman may
terminate the  agreement for good reason.  If American  Biodyne  terminates  the
agreement for reasons other than cause or if Dr. Waxman terminates the agreement
for good  reason,  Dr.  Waxman  will be  entitled to (i) receive his base salary
until the earliest of five years, death or the occurrence of a circumstance that
constitutes  cause or (ii) elect the employment  status of Chairman  Emeritus of
American Biodyne.

     Michael G. Lenahan.  The Company and Medco Containment have entered into an
employment agreement, dated as of February 1, 1995, with Michael G. Lenahan. The
agreement provides that Mr. Lenahan will be employed by the Company for a period
of three years and receive a base  salary of  $200,000  per year,  plus a yearly
discretionary  bonus and certain other fringe benefits.  Such annual base salary
has been  subsequently  increased.  Mr.  Lenahan may terminate the agreement for
cause  or upon a change  of  control  of MBC.  The  Company  may  terminate  the
agreement  for  cause,  without  cause  upon 30 days'  written  notice or if Mr.
Lenahan  becomes  disabled.  If Mr.  Lenahan  terminates the agreement or if the
Company  terminates the agreement  without cause, he is entitled to work for the
Company  as a  consultant  for a  period  of one year and to be paid at the base
compensation rate in effect at the time of


                                      47

<PAGE>



termination or, at his election,  to assume a senior level position in the legal
department of Medco Containment.

      Richard C. Surles.  The Company has entered into an employment  agreement,
effective January 16, 1995, with Richard C. Surles.  The agreement provides that
Dr.  Surles will be employed  by the Company for the period  ending  January 16,
1998 and receive (i) a minimum base salary of $250,000  per year,  plus a yearly
discretionary  bonus,  (ii) loans in connection with his relocation and (iii) an
advance  on his  salary  in the  form  of a loan of  $25,000.  The  Company  may
terminate  the agreement for cause,  if Dr. Surles  becomes  disabled or without
cause.  Dr. Surles may  terminate  the agreement  upon not less than six months'
written  notice.  If the Company  terminates the agreement  without  cause,  Dr.
Surles will be entitled to receive (i) his base  compensation for the balance of
the  term of the  agreement  (but in no  event  less  than  one  year)  and (ii)
insurance and medical benefits for the same term as base compensation is paid.

      David B. Stone. The Company,  American Biodyne and PPC have entered into a
management  agreement,  dated April 27,  1992 and amended as of April 30,  1993,
with David B. Stone.  The agreement  provides for an initial  employment  period
that ended on March 31,  1995 and was  automatically  renewed  according  to its
terms for an additional two years.  The agreement  provides that Mr. Stone shall
receive a minimum base annual  salary of $176,000,  plus a  discretionary  bonus
based on targeted  performance  objectives,  and certain  other  benefits.  Such
annual base salary has been subsequently increased.  Mr. Stone may terminate the
agreement  for good reason and the Company may terminate the agreement for cause
or if Mr. Stone becomes disabled. If Mr. Stone terminates the agreement for good
reason or if the Company  terminates  the  agreement  for reasons other than for
cause,  Mr. Stone will be entitled to  compensation  equal to the greater of (i)
his then  current  salary at the time of  entering  into the  agreement  for the
remainder  of the term (up to two years) or (ii) his then  current  salary for a
period of one year.

      Terry R. Thompson.  The Company has entered into an employment  agreement,
effective  as of  September  3, 1996,  with  Terry R.  Thompson.  The  agreement
provides  that Mr.  Thompson  will  receive a base salary of  $350,000  per year
during his employment with the Company,  plus a yearly  discretionary  bonus and
certain other fringe benefits.  The employment agreement remains in effect until
terminated  (i) by the Company (with or without cause) upon the provision to Mr.
Thompson of six months'  prior notice,  (ii) by the Company upon Mr.  Thompson's
death or disability, or (iii) by Mr. Thompson for good reason upon the provision
by Mr.  Thompson of six months'  prior  notice.  If the Company  terminates  Mr.
Thompson's  employment without cause, or Mr. Thompson  terminates his employment
with the Company for good reason,  Mr.  Thompson will be entitled to receive (i)
his base  compensation  for 12  months  from the  date of  termination  and (ii)
insurance and medical  benefits for the same term as base  compensation is paid.
In accordance with such agreement,  Mr. Thompson acquired shares of Common Stock
under an  agreement  having  substantially  the same terms as an MBC  Management
Stockholder's  Agreement  and  received  a grant  of  1995  Options.  Under  the
employment agreement,  the Company has agreed that, in the event Mr. Thompson is
offered and accepts a  promotion,  he will receive an  additional  grant of 1995
Options.

Severance Agreements

     On  October  6,  1995,  the  Company  entered  into  severance   agreements
(collectively,  the "Severance  Agreements")  with Dr. Waxman,  Dr. Geraty,  Mr.
Halper, Mr. Lenahan, Mr. Stone and Dr. Surles. Each Severance Agreement provides
that if, prior to October 6, 2000, (i) the Company terminates  employment of the
applicable  officer for reasons  other than for "cause" (as defined  therein) or
(ii) the officer  terminates  employment on his own initiative for "good reason"
(as defined therein), such officer


                                      48

<PAGE>



will be entitled,  for a period of twelve months, to be paid the excess, if any,
of his base salary at the time of such  termination over any other payments made
by the Company to such officer under other  employment or consulting  agreements
then in effect.

MBC Management Stockholder's Agreements

      In  connection  with the  Merger  and from  time to time  thereafter,  the
Company has entered into  stockholder's  agreements  (each,  an "MBC  Management
Stockholder's Agreement") with all management employees that are stockholders of
MBC or holders of any 1995  Options  (each,  an "MBC  Management  Stockholder").
Pursuant to each MBC  Management  Stockholder's  Agreement,  the MBC  Management
Stockholder may not transfer any shares of Common Stock acquired thereby or upon
exercise of vested 1995 Options  (collectively,  the "Plan Shares")  within five
years after the purchase date thereof,  except as described below and except (a)
for certain  transfers  to family  members,  similar  transfers in the nature of
estate  planning  and in  connection  with the loans  described  under  "Certain
Relationships  and Related  Transactions,"  (b)  pursuant to a Qualified  Public
Offering (as defined  therein),  in which event only a stated  percentage of his
Plan Shares  becomes  transferable  or (c)  pursuant to certain  sales of Common
Stock by MBC Associates, L.P., an affiliate of KKR ("MBC Associates"),  in which
event the MBC Management  Stockholder is entitled to sell a stated percentage of
his Plan Shares.  Each MBC Management  Stockholder's  Agreement provides the MBC
Management  Stockholder  with the right to (a) require the Company to repurchase
all of his Plan  Shares  and pay him a stated  price  for  cancellation  of 1995
Options upon a Permitted  Retirement (as defined therein),  death or disability,
(b) until the later of five years after the purchase date or the first Qualified
Public  Offering,  have the  Company  register a stated  percentage  of his Plan
Shares under the Securities Act in connection with certain public offerings, and
(c) prior to the fifth  anniversary  of the first  Public  Offering  (as defined
therein),  include a stated  percentage of his Plan Shares in any sale of Common
Stock by MBC Associates or an affiliate to any non-affiliated person (other than
a Public Offering).  Each MBC Management  Stockholder's  Agreement also provides
the Company with (a) prior to a Public  Offering,  the right of first refusal to
buy Plan Shares owned by each MBC Management Stockholder on essentially the same
terms and  conditions as such MBC Management  Stockholder  proposes in a sale of
his Plan Shares to another purchaser, (b) the right to repurchase all of the MBC
Management Stockholder's Plan Shares and pay him a stated price for cancellation
of his 1995 Options upon certain  events,  including  termination  of employment
(with or without cause) or an unpermitted  transfer of Plan Shares and (c) prior
to the fifth anniversary of the first Public Offering,  the right to require the
MBC Management Stockholder to sell a stated percentage of his Plan Shares in any
sale of Common Stock by MBC  Associates  or an  affiliate to any  non-affiliated
person  (other than a Public  Offering).  Upon a "change of control" (as defined
therein) of the Company, the transfer restrictions,  right of first refusal, and
certain other rights with respect to sale and  repurchase of the Plan Shares and
cancellation of 1995 Options as described above will lapse.

      The  repurchase  price  of  the  Plan  Shares  under  the  MBC  Management
Stockholder's  Agreements depends upon the nature of the event that triggers the
repurchase  and  whether  such  repurchase  occurs  at the  election  of the MBC
Management  Stockholder or the Company.  Generally,  if the repurchase is at the
participant's  election,  the repurchase  price per share will be the greater of
purchase price paid by the MBC Management  Stockholder (the "Plan Share Purchase
Price") and the market price;  if the Common Stock is not then publicly  traded,
the  repurchase  price per share will be the Plan Share  Purchase Price plus the
increase, if any, in book value per share since the date of purchase of the Plan
Shares.

      Generally,  if the repurchase is at the Company's election, the repurchase
price per share  will be the  lesser  of (a) the  market  price and (b) the Plan
Share Purchase Price plus a stated  percentage (the  "Percentage") of the amount
by which the market price exceeds the Plan Share Purchase  Price;  if the Common
Stock is not then publicly  traded,  the repurchase  price per share will be the
lesser of (a) the


                                      49

<PAGE>



Base Value Per Share (as defined below) and (b) the Plan Share  Purchase  Price,
plus the Percentage  multiplied by the increase, if any, in book value per share
since the date of the purchase of the Plan Shares.  The  Percentage is 0% during
the first year  following  the MBC  Management  Stockholder's  purchase  of Plan
Shares, and increases annually thereafter (up to 100%) in increments of 20%. The
"Base Value Per Share" equals the Plan Share  Purchase  Price per share plus the
change  (positive  or  negative)  in book value per share  since the date of the
purchase.

      If the Company  repurchases  Plan Shares as described  above, it also must
pay the MBC Management  Stockholder the excess,  if any, of the repurchase price
applied  to the  repurchase  of Plan  Shares,  over the  exercise  prices of the
applicable 1995 Options,  multiplied by the number of Exercisable Option Shares.
Each MBC Management Stockholder's Agreement defines Exercisable Option Shares as
shares of Common Stock which, at the time of  determination,  could be purchased
by the MBC Management  Stockholder upon exercise of his outstanding  exercisable
1995 Options.

      Each MBC  Management  Stockholder's  Agreement  also  contains  noncompete
provisions,  pursuant to which each MBC Management  Stockholder has agreed,  for
the term of his  employment  and one year  thereafter,  not to produce,  sell or
distribute,  directly or indirectly,  any product or service sold or distributed
by the Company or its affiliated entities. The Company may extend the noncompete
period  for one  additional  year by giving  notice  thereof  and paying the MBC
Management Stockholder an amount equal to his annual base salary,  calculated as
of the time of termination of employment (the "Noncompete  Amount").  If the MBC
Management  Stockholder's  employment  with the  Company is  terminated  without
"cause"  or  for  "good  reason"  (each  as  defined  therein),  the  noncompete
requirements  will apply to the first year  following  termination of employment
only if the Company pays the MBC Management Stockholder the Noncompete Amount.

Item 12.  Security Ownership of Certain Beneficial Owners and Management

      The  following  table sets forth  certain  information  known to MBC as of
December 1, 1996 regarding the  beneficial  ownership of Common Stock by (i) all
persons  who own  beneficially  more  than 5% of the  Common  Stock,  (ii)  each
director of MBC, (iii) the Chief Executive  Officer of MBC and each of the Named
Executive Officers and (iv) all directors and executive officers as a group.
<TABLE>
<CAPTION>

                                                                        Percentage
                                                    Number of            of Common
     Beneficial Owner                                 Shares               Stock
-----------------------------------------------  --------------------  -------------
<S>           <C>                                                            <C>                   <C>  
KKR Associates(1)                                     21,000,000            73.7%
   9 West 57th Street
   New York, NY 10019
Merck & Co., Inc.(2)                                   4,262,800            15.0
   One Merck Drive
   Whitehouse Station, NJ 08889
The Albert S. Waxman Family
   Charitable Remainder Unitrust(3)                    1,000,000             3.5
                                      50

<PAGE>



Albert S. Waxman(4)                                    1,055,100             3.7
Ronald D. Geraty(5)                                      100,000             0.4
David B. Stone(5)                                        100,000             0.4
Arthur H. Halper(6)                                       50,000             0.2
Richard C. Surles(7)                                      40,000             0.1
All directors and executive officers as a 
     group (11 persons)                                1,495,100             5.3
</TABLE>
                                                ----------------           -----
  Total                                               27,757,900           97.5%
           

(1)Shares of Common Stock shown as beneficially owned by KKR Associates are held
by MBC  Associates and KKR Partners II, L.P. ("KKR Partners II"); KKR Associates
is the sole  general  partner of both MBC  Associates  and KKR  Partners  II and
possesses  sole voting and  investment  power with respect to such  shares.  KKR
Associates is a limited partnership,  the general partners of which are Henry R.
Kravis,  George R. Roberts,  Robert I. MacDonnell,  Paul E. Raether,  Michael W.
Michelson,  Michael T. Tokarz,  James H. Greene,  Jr., Perry Golkin,  Clifton S.
Robbins,  Scott M. Stuart and Edward A.  Gilhuly.  Messrs.  Kravis,  Roberts and
Gilhuly are also  directors of the Company.  Such  individuals  may be deemed to
share  beneficial  ownership  of the shares shown as  beneficially  owned by KKR
Associates. Such individuals disclaim beneficial ownership of any such shares.

(2)Represents  shares  held by  Medco  Holdings  Corp.,  a  subsidiary  of Medco
Containment, which is a wholly owned subsidiary of Merck.

(3)Represents  shares held by The Albert S. Waxman Family  Charitable  Remainder
Unitrust,  of which Albert S. Waxman is trustee.  As trustee,  Dr. Waxman may be
deemed to have beneficial ownership of the shares shown as beneficially owned by
such trust. Dr. Waxman disclaims beneficial ownership of any such shares.

(4)Does not include  options to acquire  560,000 shares of Common Stock that are
exercisable within 60 days of the date hereof.

(5)Does not include  options to acquire  60,000  shares of Common Stock that are
exercisable within 60 days of the date hereof.

(6)Does not include  options to acquire  30,000  shares of Common Stock that are
exercisable within 60 days of the date hereof.

(7)Does not include  options to acquire  24,000  shares of Common Stock that are
exercisable within 60 days of the date hereof.

(8)Does not include  options to acquire  764,000  shares of Common  Stock in the
aggregate that are exercisable within 60 days of the date hereof.

Item 13.  Certain Relationships and Related Transactions

     Transactions  with KKR. KKR  Associates  beneficially  owned 73.7% of MBC's
outstanding  Common Stock as of December 1, 1996.  Messrs.  Kravis,  Roberts and
Gilhuly,  directors of the Company, are members of the limited liability company
which serves as the General Partner of KKR and also are General  Partners of KKR
Associates.  Mr. Fisher,  also a director of the Company, is an Executive of KKR
and a Limited  Partner of KKR  Associates.  KKR, an affiliate of KKR Associates,
received a fee of


                                      51

<PAGE>



$5.5 million for  negotiating  the Merger and arranging  the financing  therefor
and,  from time to time in the  future,  KKR may  receive  customary  investment
banking  fees  for  services   rendered  to  the  Company  in  connection   with
divestitures,  acquisitions and certain other transactions. In addition, KKR has
agreed to render  management,  consulting and financial  services to the Company
for an initial annual fee of $300,000. During fiscal 1996, KKR received $400,000
in fees for such services.  Executives of KKR who also serve as directors of the
Company receive customary directors' fees.

      In  connection  with the Merger,  the Company  incurred  $75.0  million of
subordinated indebtedness under the Bridge Loan provided by MBC Associates,  the
general partner of which is KKR  Associates.  A portion of the net proceeds from
the  offering of the Private  Notes in  November  1995 (which were  subsequently
exchanged for the Notes) was applied to repay all indebtedness outstanding under
the Bridge Loan (including accrued interest).

      MBC Associates  and KKR Partners II  (collectively,  the "KKR  Investors")
have the right, under certain  circumstances and subject to certain  conditions,
to require  the Company to register  under the  Securities  Act shares of Common
Stock held by them pursuant to a registration  rights agreement  entered into in
connection  with  the  Merger  and  certain   stockholders'   agreements.   Such
registration  rights will  generally  be available  to the KKR  Investors  until
registration  under the Securities  Act is no longer  required to enable them to
resell  the Common  Stock  owned by them.  Such  registration  rights  agreement
provides,  among  other  things,  that  the  Company  will pay all  expenses  in
connection with the first six  registrations  requested by the KKR Investors and
in  connection  with any  registration  commenced  by the  Company  as a primary
offering. In addition,  other stockholders besides the KKR Investors,  including
the MBC  Management  Stockholders  and Medco  Containment,  will be  allowed  to
participate  in any  registration  process,  subject to certain  conditions  and
exceptions.

     Transactions  with Management.  In connection with the Merger,  certain MBC
Management  Stockholders borrowed all or a portion of the purchase price for the
Plan  Shares  acquired  by them  pursuant  to their  respective  MBC  Management
Stockholder's Agreements.  Dr. Waxman borrowed $5.0 million; Dr. Surles borrowed
$200,000;  Dr. Geraty borrowed $250,000;  Mr. Stone borrowed  $250,000;  and Mr.
Morlan,  the Company's  former  Executive Vice  President and Chief  Information
Officer,  borrowed  $100,000.  In addition,  in connection  with his purchase of
shares of Common Stock, Mr. Thompson borrowed $500,000.  All such borrowings are
evidenced by promissory notes from the applicable MBC Management Stockholder and
are secured by a pledge of such MBC Management  Stockholder's Plan Shares.  Each
promissory  note  provides  for the  payment of  interest  at a rate of 6.5% per
annum. The promissory notes of Dr. Waxman, Dr. Surles and Mr. Thompson mature on
December 31, 2000. In connection with Mr. Morlan's  separation from the Company,
the  Company  acquired  Mr.  Morlan's  shares of Common  Stock.  As part of such
transaction,  the Company  cancelled Mr.  Morlan's  promissory  note.  Mr. Stone
repaid his loan in  November  1995,  and Dr.  Geraty  repaid his loan in October
1996.

      Dr.  Waxman owns all of the shares of LNY Corp.,  a limited  partner of 38
Newbury Ventures/MBC Limited Partnership ("38 Newbury").  In connection with the
Merger,  the Company entered into a Stock Purchase and  Stockholder's  Agreement
(the "38 Newbury Stockholder's Agreement"), dated as of October 6, 1995, with 38
Newbury and MBC Associates.  Pursuant to the 38 Newbury Stockholder's Agreement,
38 Newbury  purchased  600,000  shares of Common Stock for $3.0 million.  The 38
Newbury  Stockholder's  Agreement  provides  the Company with the right of first
refusal to purchase  shares of Common Stock on the same terms and  conditions as
are  proposed by a third party offer at any time prior to a Public  Offering (as
defined therein). Also under the 38 Newbury Stockholder's Agreement, at any time
prior to the fifth anniversary of the first Public Offering,  (i) MBC Associates
may  require 38  Newbury  to include a pro rata  portion of its shares of Common
Stock in any


                                      52

<PAGE>



sale by MBC  Associates  of its holdings of Common Stock and (ii) 38 Newbury has
the  option  to  include  a pro rata  portion  of its  shares in any sale by MBC
Associates  of its  holdings  of  Common  Stock.  The 38  Newbury  Stockholder's
Agreement further provides that, upon the later of the first Public Offering and
the fifth  anniversary  of the Stock Closing (as defined  therein),  the parties
will be  bound  by  certain  provisions  of the  registration  rights  agreement
discussed above between the Company and the KKR Investors.

      Transactions  with Merck and Medco  Containment.  In  connection  with the
Merger,  the  Company  entered  into  a  stockholders'   agreement  (the  "Medco
Stockholders' Agreement") with the KKR Investors and Medco Containment (together
with the KKR Investors, the "Stockholders").

      Pursuant to the Medco Stockholders'  Agreement,  Medco Containment has the
right to  include  a pro rata  portion  of its  shares  of  Common  Stock in any
proposed  transfer of KKR  Investors'  Common Stock (other than to affiliates of
the KKR  Investors)  at the same  price per  share  and upon the same  terms and
conditions  as such shares of KKR  Investors'  Common Stock would be sold to the
proposed  transferee.  The Medco  Stockholders'  Agreement also provides the KKR
Investors with the right to require Medco  Containment to sell all of its shares
of Common Stock in a proposed  transfer by the KKR  Investors of 100% of the KKR
Investors' Common Stock.

      Medco  Containment  will have the right,  on two  occasions  following the
earlier to occur of (i) 180 days after the  initial  public  offering  of Common
Stock and (ii) five  years from the  closing  date of the  Merger,  to cause the
Company to file a registration  statement in connection  with the sale of shares
of Common Stock held by Medco Containment. The Company has agreed to pay certain
expenses of such offerings. The Stockholders will, upon request, execute 180 day
market  stand-off  agreements in connection  with the initial public offering of
Common Stock,  if so requested by the  underwriters  for such an initial  public
offering.

      After the Company's initial public offering, each time the Company files a
registration statement (other than on Form S-4 or S-8) in connection with a sale
of shares of Common  Stock by the  Company,  the KKR  Investors  or any of their
respective Affiliates (as defined therein), the Company, at the request of Medco
Containment,  will use its reasonable  efforts to effect the registration of all
shares of Common Stock owned by Medco  Containment  that the Company has been so
requested  to  register  by Medco  Containment.  In the event that the  managing
underwriter or underwriters determines that a proposed offering including shares
of Medco  Containment  and the KKR  Investors  exceeds  the  number of shares of
Common Stock that can be sold without  having a  significant  adverse  effect on
such offering or that inclusion of such Stockholders' shares would significantly
and  adversely  affect  the  offering,  the  number  of  shares  held by the KKR
Investors and Medco Containment, if any, to be registered shall be in proportion
to the relative sizes of their holdings of Common Stock.

      In certain  circumstances,  including  the issuance of Common Stock by the
Company to  Affiliates of the KKR  Investors,  Medco  Containment  will have the
right to  subscribe  for and purchase  additional  shares of Common Stock at the
same  price  and  upon the same  terms  and  conditions  so as to  enable  Medco
Containment to maintain its percentage of ownership of shares of Common Stock as
of the time of the  Company's  proposal  to issue  shares  of Common  Stock.  In
addition,  Medco  Containment has the right to designate a person to observe all
Board of Directors' meetings and to approve certain transactions with affiliates
(other than  transactions  as to which no approval of  institutional  lenders is
required).

      Pursuant to the Merger Agreement,  Medco Containment  agreed to abide by a
confidentiality provision relating to all information it possesses regarding the
Company.  A portion of the purchase  price for the Company was  allocated to the
consideration paid to Merck in connection with the Merger.


                                      53

<PAGE>




      In the ordinary course of business,  the Company  provides EAP services to
certain  divisions of Merck and behavioral health managed care services to Medco
Containment.

                                          PART IV


Item 14.   Exhibits, Financial Statement Schedules, and Reports on Form 8-K

(1) Financial  Statements.  See accompanying  Index to Financial  Statements and
Financial Statement Schedules on page 58.

(2)  Financial  Statement   Schedules.   See  accompanying  Index  to  Financial
Statements and Financial Statement Schedules on page 58.

(3) Exhibits (Numbered in accordance with Item 601 of Regulation S-K).
<TABLE>
<CAPTION>


 Exhibit                                                                            Sequentially
 Number     Description                                                             Numbered Pages
----------- ----------------------------------------------------                    --------------
<S>  <C>                                                   <C> <C>              
     2.1    Agreement and Plan of Merger, dated as of June 30, 1995, among Medco
            Containment Services,  Inc., Medco Behavioral Care Corporation and             *
            MDC Acquisition Corp.
     2.2    Amendment  to Agreement  and Plan of Merger,  dated as of October 6,
            1995, among Medco Containment Services, Inc., Medco Behavioral                 *
            Care Corporation and MDC Acquisition Corp.
     3.1    Certificate of Incorporation, as amended, of Merit Behavioral                  *
            Care Corporation.
     3.2    Certificate of Merger.                                                         *
     3.3    By-Laws of Merit Behavioral Care Corporation.                                  *         
     4.1    Indenture, dated as of November 22, 1995, between Merit
            Behavioral  Care  Corporation  and Marine  Midland  Bank, as truste            *
            relating  to  $100,000,000  aggregate  principal  amount  of 11 1/2%
            Senior Subordinated Notes due 2005.
     4.2    Registration Rights Agreement,  dated as of November 17, 1995, among
            Merit Behavioral Care Corporation, BT Securities Corporation,  Chase           *
            Securities,  Inc.,  Morgan  Stanley & Co.  Incorporated  and  Smith
            Barney Inc.
     4.3    Specimen  Form of 11  1/2%  Senior  Subordinated  Notes  due  2005             *
            (included as part of Exhibit 4.1)
     4.4    Specimen  Form of 11  1/2%  Senior  Subordinated  Notes  due  2005             *
            (included as part of Exhibit 4.1 hereto)
   10.1     Credit  Agreement,   dated  as  of  October  6,  1995,  among  Medco
            Behavioral Care  Corporation,  Chase Manhattan Bank,  N.A., as agent           *
            and the various lending institutions parties thereto.
   10.2     First  Amendment to Credit  Agreement,  dated as of October 6, 1995,
            among Merit  Behavioral Care  Corporation,  Chase  Manhattan  Bank,            *
            N.A., as agent,  Bankers Trust Company,  as documentation  agent and
            the various lending institutions party thereto.
   10.3     Second Amendment to Credit Agreement, dated as of December 1,


                                            54

<PAGE>



            1995, among Merit Behavioral Care Corporation, Chase Manhattan Bank,
            N.A., as agent,  and the various lending  institutions and New Banks           *
            (as defined) party thereto.
   10.4     Purchase Agreement, dated as of November 17, 1995, among
            Merit Behavioral Care Corporation, BT Securities Corporation,                  *
            Chase Securities, Inc., Morgan Stanley & Co. Incorporated
            and Smith Barney Inc.
   10.5     Sub-Sublease Agreement, dated as of August 17, 1993, between
            Electronic Data Systems Corporation and Medco Behavioral                       *
            Care Systems Corporation.
   10.6     Lease with respect to the corporate headquarters in
            Park Ridge, New Jersey.                                                        *
   10.7     Agreement for the License/Sublicense of Computer Software
            Products and the Purchase of Computer Equipment, dated as of                   *
            April 28, 1993, between American International Healthcare, Inc. (now
            Amisys, Inc.) and Medco Behavioral Care Systems Corporation.
   10.8     1995 Stock Purchase and Option Plan for Employees of Merit                     *
            Behavioral Care Corporation and Subsidiaries.
   10.9     Management Incentive Plan.                                                     *
   10.9.1   1996 Merit Behavioral Care Corporation Employee Stock Option Plan.             *
   10.10    Stockholder's Agreement, dated as of October 6, 1995, among
            Medco Behavioral Care Corporation, Albert S. Waxman and                        *
            MBC Associates, L.P.
   10.10.1  Non-Qualified Stock Option Agreement, dated as of October 6, 1995,            ***
            between Medco Behavioral Care Corporation and Albert S. Waxman
   10.11    Stockholder's  Agreement,  dated as of October 6, 1995,  among Medco
            Behavioral  Care  Corporation,  Albert S. Waxman  Family  Charitable           *
            Remainder Unitrust, Albert S. Waxman and MBC Associates, L.P.
   10.12    Stock Purchase and Stockholder's  Agreement,  dated as of October 6,
            1995,  among  Medco  Behavioral  Care  Corporation,   38  Newbury              *
            Ventures/MBC Limited Partnership and MBC Associates, L.P.
   10.13    Amended and Restated Employment Agreement, dated as of August
            17, 1992, between American Biodyne, Inc. and Albert S. Waxman (the             *
            "Waxman Employment Agreement.")
   10.14    Amendment to the Waxman Employment Agreement, dated as of                      *
            October 1, 1993.
   10.16    Employment  Agreement,  dated as of  February  1, 1995,  among Medco           *
            Behavioral Care Corporation, Medco Containment Services, Inc.
            and Michael G. Lenahan.
   10.17    Employment Agreement, dated as of January 18, 1996, between Merit              *
            Behavioral Care Corporation and Richard C. Surles.
   10.18    Management Agreement, dated as of April 27, 1992, between American
            Biodyne, Inc. and David B. Stone (the "Stone Management Agreement").           *
   10.19    Amendment to the Stone Management Agreement, dated as of
            April 30, 1993, among American Biodyne, Inc., Medco Behavioral                 *
            Care Corporation, Personal Performance Consultants, Inc. and
            David B. Stone.
   10.21    Severance  Agreement,  dated as of October 6,  1995,  between  Medco           *
            Behavioral Care Corporation and Ron Geraty.
   10.22    Severance Agreement, dated as of October 6, 1995, between Medco                *


                                            55

<PAGE>



            Behavioral Care Corporation and Arthur Halper.
   10.24    Severance Agreement, dated as of October 6, 1995, between Medco                *
            Behavioral Care Corporation and Michael G. Lenahan.
   10.25    Severance Agreement, dated as of October 6, 1995, between Medco                *
            Behavioral Care Corporation and Dennis Moody.
   10.26    Severance Agreement, dated as of October 6, 1995, between Medco                *
            Behavioral Care Corporation and David B. Stone.
   10.27    Severance Agreement, dated as of October 6, 1995, between Medco                *
            Behavioral Care Corporation and Richard C. Surles.
   10.28    Severance Agreement, dated as of October 6, 1995, between Medco                *
            Behavioral Care Corporation and Albert S. Waxman.
   10.29    Registration Rights Agreement, dated as of October 6, 1995, among              *
            MDC Acquisition Corp., MBC Associates, L.P. and KKR Partners II, L.P.
   10.30    Stockholders' Agreement, dated as of October 6, 1995, among Medco
            Behavioral Care Corporation, MBC Associates, L.P., KKR Partners II,            *
            L.P. and Medco Containment Services, Inc.
   10.31    Amisys Implementation and Systems Integration Services Agreement
            between Perot Systems Corporation and Merit Behavioral Care                    **
            Corporation, effective as of January 12, 1996 (confidential
            treatment requested)
   10.32    Lease Agreement dated as of August 14, 1991 between Cooke                      ***
            Properties, Inc. and Empire Blue Cross and Blue Shield
   10.33    Assignment and Assumption of Lease dated as of May 31, 1996 between            ***
            Empire Blue Cross and Blue Shield and Merit Behavioral
            Care Corporation
   10.34    First Supplemental Agreement, dated as of May 31, 1996 between                 ***
            Chrysler Properties Inc. (formerly, Cooke Properties, Inc.) and
            Merit Behavioral Care Corporation
   10.35    Second Supplemental Agreement, dated as of October 1, 1996 between             ***
            Chrysler Properties Inc. and Merit Behavioral Care Corporation
   10.36    First Amendment to Lease Agreement, dated as of July 1, 1996 with              ***
            respect to corporate headquarters in Park Ridge, New Jersey by and
            between Sartak Holdings, Inc. and Merit Behavioral Care Corporation
   10.37    Employment Agreement, dated as of September 3, 1996, between                   ***
            Merit Behavioral Care Corporation and Terry R. Thompson.
   21.1     Subsidiaries of Merit Behavioral Care Corporation.                             ***
   25.1     Statement of Eligibility and Qualification (Form T-1) under the Trust           *
            Indenture Act of 1939 of Marine Midland Bank (bound separately).
   27.1     Financial Data Schedule (electronic filing only).
 ----------------------
</TABLE>



* Incorporated by reference to the Company's  Registration Statement on Form S-4
(Commission  File No.  33-80987).  

**  Incorporated  by reference to the  Company's  Form 10-Q/A for the  quarterly
period ended March 31, 1996. 

***Filed herewith.

      (4)   Reports  on Form 8-K.  No  current  reports  on Form 8-K were  filed
            during the fourth  quarter of MBC's fiscal year ended  September 30,
            1996.


                                            56

<PAGE>



                                        SIGNATURES

      Pursuant  to the  requirements  of Section  13 or 15(d) 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.

                                    MERIT BEHAVIORAL CARE CORPORATION


                                    By: /s/ Albert S. Waxman
                                          Albert S. Waxman
                                          Chairman and Chief Executive Officer

            Pursuant to the requirements of the Securities Exchange Act of 1934,
this  Report  on Form  10-K has been  signed  by the  following  persons  in the
capacities and on the dates indicated.

Signature                        Title                         Date

/s/ Albert S. Waxman             Chairman and Chief            December 23, 1996
---------------------------------
Albert S. Waxman                 Executive Officer


/s/ Arthur H. Halper             Executive Vice President,     December 23, 1996
---------------------------------
Arthur H. Halper                 Chief Financial Officer
                                 and Director


/s/ Ronald D. Geraty             Executive Vice President,     December 23, 1996
---------------------------------
Ronald D. Geraty                 New Business Development
                                 and Director


/s/ Terry R. Thompson            Executive Vice President,     December 23, 1996
---------------------------------
Terry R. Thompson                Business Operations
                                 and Director


/s/ Henry R. Kravis              Director                      December 23, 1996
---------------------------------
Henry R. Kravis


/s/ George R. Roberts            Director                      December 23, 1996
---------------------------------
George R. Roberts


/s/ Edward A. Gilhuly            Director                      December 23, 1996
---------------------------------
Edward A. Gilhuly


/s/ Todd A. Fisher               Director                      December 23, 1996
---------------------------------
Todd A. Fisher


                                            57

<PAGE>



                       INDEX TO FINANCIAL STATEMENTS AND
                         FINANCIAL STATEMENT SCHEDULES


Financial Statements

         Independents Auditors' Report.........................F-1

         Consolidated Balance Sheets...........................F-2

         Consolidated Statements of Operations.................F-3

         Consolidated Statements of Stockholders' Equity.......F-4

         Consolidated Statements of Cash Flows.................F-5

         Notes to Consolidated Financial Statements............F-6

Financial Statement Schedules

         All schedules for which provision is made in the applicable regulations
of the  Securities  and  Exchange  Commission  are omitted  because they are not
required  under the related  instructions  or are not applicable or the required
information  is shown in the  Consolidated  Financial  Statements  or the  notes
thereto.


                                      58

<PAGE>







To the Board of Directors

Merit Behavioral Care Corporation

We have audited the accompanying consolidated balance sheets of Merit Behavioral
Care  Corporation  (the  "Company") as of September  30, 1996 and 1995,  and the
related consolidated  statements of operations,  stockholder's  equity, and cash
flows for the twelve month periods ended September 30, 1996 and 1995, the period
from November 18, 1993 to September 30, 1994 (Successor periods), and the period
from October 1, 1993 to November 17, 1993 (Predecessor period).  These financial
statements   are  the   responsibility   of  the   Company's   management.   Our
responsibility  is to express an opinion on these financial  statements based on
our audits.

We  conducted  our  audits  in  accordance  with  generally   accepted  auditing
standards. Those standards require that we plan and perform the audits to obtain
reasonable assurance about whether the financial statements are free of material
misstatement.  An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements.  An audit also includes
assessing the  accounting  principles  used and  significant  estimates  made by
management,  as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion,  the financial  statements  referred to above present fairly, in
all  material  respects,   the  financial  position  of  Merit  Behavioral  Care
Corporation as of September 30, 1996 and 1995, and the results of its operations
and its cash flows for the twelve months  periods  ended  September 30, 1996 and
1995,  the period from  November  18, 1993 to  September  30,  1994,  (Successor
periods), and the period from October 1, 1993 to November 17, 1993, (Predecessor
period) in conformity with generally accepted accounting principles.

As discussed  in Note 3 to the  financial  statements,  on November 18, 1993 the
Company was acquired in an  acquisition  accounted for as a purchase,  and a new
basis  of  accounting  was  established.   Therefore  the  financial  statements
subsequent  to November 17, 1993  (Successor)  are not  comparable  to the prior
financial statements (Predecessor).

As discussed in Note 4 to the financial  statements,  effective October 1, 1995,
the Company  changed its method of  accounting  for deferred  contract  start-up
costs related to new contracts or expansion of existing contracts.


/s/ Deloitte & Touche LLP
December 12, 1996

                                      F-1


<PAGE>
<TABLE>
<CAPTION>


                         MERIT BEHAVIORAL CARE CORPORATION SUCCESSOR
                                   AND PREDECESSOR COMPANY
                                 CONSOLIDATED BALANCE SHEETS
                                    (dollars in thousands)



                                                                    September 30,

                                                                  1996         1995
   ASSETS
Current Assets:
<S>                                                             <C>        <C>
Cash and cash equivalents.................................      $ 47,375   $ 29,531
Accounts receivable, net of allowance for 
   doubtful accounts of $1,996 and $525...................        28,383     27,648
Short-term marketable securities..........................           ---      1,143
Deferred income taxes.....................................         2,296      1,944
Other current assets......................................         2,481      2,625
    Total current assets..................................        80,535     62,891
Property, plant and equipment, net........................        67,880     54,974
Other Assets :
Goodwill and other intangibles, net of accumulated amortization of
     $59,781 and $37,017..................................       162,849    171,139
Restricted cash...........................................         5,668      3,485
Deferred financing costs, net of accumulated amortization 
      of $1,142...........................................        11,362        ---
Other.....................................................        16,507     12,931
                                                                 196,386    187,555
Total assets..............................................     $ 344,801   $305,420

    LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable..........................................        $5,888  $   3,623
Claims payable............................................        57,611     42,631
Deferred revenue..........................................         6,577      9,582
Accrued interest..........................................         5,008        ---
Current portion of long-term debt.........................           500        ---
Other current liabilities.................................        13,079      9,294
      Total current liabilities...........................        88,663     65,130

Due to parent (noninterest bearing).......................           ---     70,813
Long-term debt............................................       253,500        ---
Deferred income taxes.....................................        30,669     44,744
Other long-term liabilities...............................         1,451      2,400

Commitments and Contingencies

Stockholders' Equity:
Common stock (40,000,000 shares authorized, $0.01 par value,
   28,398,800 shares issued at September 30, 1996)........           284         10
Additional paid in capital................................        (9,756)   118,877
Retained (deficit) earnings...............................       (14,435)     3,446
Notes receivable from officers............................        (5,470)       ---

                                                                 (29,377)   122,333
Less common stock in treasury  (21,000 shares)............          (105)       ---
   Total stockholders' equity.............................       (29,482)   122,333
Total liabilities and stockholders' equity................      $344,801   $305,420
</TABLE>

               The accompanying notes are an integral part of these statements.
                                      
                                      F-2
<PAGE>



                             MERIT BEHAVIORAL CARE CORPORATION SUCCESSOR
                                       AND PREDECESSOR COMPANY
<TABLE>

<CAPTION>
                                CONSOLIDATED STATEMENTS OF OPERATIONS
                                       (dollars in thousands)


                                               Successor                          Predecessor
                                    Twelve months    Twelve months                  
                               ended September 30, ended September 30, 11/18/93      10/01/93
                                         1996           1995         to 9/30/94    to 11/17/93
          
<S>                                      <C>           <C>            <C>            <C>    
Revenue.............................     $457,830      $361,549       $245,858       $31,030
Expenses:
  Direct service costs..............      361,684       286,001        189,633        23,782
  Selling, general and administrative      64,523        49,823         35,726         5,537
  Amortization of intangibles.......       25,869        21,373         17,153           264
  Restructuring charge..............        2,995          ---             ---           ---
                                          455,071       357,197        242,512        29,583
Operating income....................        2,759         4,352          3,346         1,447
Other income (expense)
  Interest income and other.........        2,838         1,498            846           102
  Interest expense..................      (23,826)         ---             ---          ---
  Merger costs......................       (3,972)         ---             ---          ---
                                          (24,960)        1,498            846           102
(Loss) income before income taxes
  and cumulative effect of accounting
  change............................      (22,201)        5,850          4,192         1,549
(Benefit) provision for income taxes       (5,332)        4,521          2,075           665
(Loss) income before cumulative effect
  of accounting change..............      (16,869)        1,329          2,117           884
Cumulative effect of accounting change
  for deferred contract start-up costs, net
  of tax benefit of $757............       (1,012)         ---            ---           ---
Net (loss) income...................    $ (17,881)     $  1,329       $  2,117      $    884
Pro forma net (loss) income  
  assuming the new method of 
  accounting  for deferred
  contract start-up costs is applied
  retroactively....................     $ (16,869)    $     317       $  2,117      $    884
</TABLE>

                  The   accompanying   notes  are  an  integral  part  of  these
statements.

                                      F-3
<PAGE>



                             MERIT BEHAVIORAL CARE CORPORATION SUCCESSOR
                                       AND PREDECESSOR COMPANY
<TABLE>
<CAPTION>

                           CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                                       (dollars in thousands)

                                                                                Retained     Notes
                                        Common Stock           Additional      (Deficit)    Receivable     Common Stock
                                       Shares     Amount     Paid In Capital    Earnings   from Officers   in Treasury
Balance September 30, 1993
<S>                                   <C>                     <C>                            <C>        
(Predecessor).......................  1,000,000   $ 10       $   31,310         $ 15,690      $ ---        $  ---
Repurchase of warrants issued by
  American Biodyne..................       ---     ---             (429)            ---         ---           ---
Net income..........................       ---     ---              ---             884         ---           ---
Balance November 17, 1993
(Predecessor).......................  1,000,000     10           30,881           16,574        ---           ---
Allocation of goodwill and other
  intangibles and related tax effect, net  ---     ---           71,422              ---        ---           ---
Transfer of retained earnings to additional
  paid in capital in connection with the
  acquisition of Medco by Merck.....        ---    ---           16,574          (16,574)       ---           ---
Net income..........................        ---    ---              ---            2,117        ---           ---
Balance September 30, 1994..........  1,000,000     10          118,877            2,117        ---           ---
Net income..........................        ---    ---              ---            1,329        ---           ---
Balance September 30, 1995..........  1,000,000     10          118,877            3,446        ---           ---
Recapitalization from merger:
  Redemption of common stock........   (915,754)    (9)        (258,129)             ---        ---           ---
  Merger with MDC Acquisition Corp..    415,023      4          104,996              ---        ---           ---
  Stock dividend.................... 24,763,531    247             (247)             ---        ---           ---
  Issuance of stock to management...  3,156,000     32           15,748              ---     (5,800)          ---
  Deferred taxes associated with merger     ---    ---            7,594              ---        ---           ---
Tax benefit from exercise of Merck
  stock options.....................        ---    ---            1,505              ---        ---           ---
Repayment of notes receivable.......        ---    ---              ---              ---        265           ---
Cancel note receivable..............    (20,000)   ---             (100)             ---        100           ---
Repurchase of common stock..........        ---    ---              ---              ---        ---          (600)
Sale of common stock................        ---    ---              ---              ---        (35)          495
Net loss............................        ---    ---              ---          (17,881)       ---           ---
Balance September 30, 1996.......... 28,398,800 $  284         $ (9,756)        $(14,435)   $ (5,470)       $(105)
</TABLE>





                  The   accompanying   notes  are  an  integral  part  of  these
statements.

                                      F-4
<PAGE> 

<TABLE>

<CAPTION>
                             MERIT BEHAVIORAL CARE CORPORATION SUCCESSOR
                                       AND PREDECESSOR COMPANY
                                CONSOLIDATED STATEMENTS OF CASH FLOWS
                                       (dollars in thousands)

                                           Successor                             Predecessor
                                      Twelve months   Twelve months
                                 ended September 30,ended September 30, 11/18/93   10/01/93
                                            1996         1995         to 9/30/94  to 11/17/93
CASH FLOWS FROM OPERATING
  ACTIVITIES:
<S>                                      <C>            <C>            <C>          <C>     
Net (Loss) Income....................... $(17,881)      $ 1,329        $ 2,117      $  884
Adjustments to reconcile net (loss) income to
  net cash provided by operating activities:
  Cumulative effect of accounting change    1,012           ---            ---         ---
  Depreciation and amortization.........   36,527        28,150         21,282         722
  Amortization of deferred financing costs  1,142           ---            ---         ---
  Deferred taxes and other..............   (6,068)          379         (4,390)        ---
  Restructuring charge..................    2,995           ---            ---         ---
Changes in operating assets and liabilities,
net of the effect of acquisitions:
  Accounts receivable...................      265        (8,545)        (6,990)        (603)
  Other current assets..................      536          (995)           (44)         226
  Deferred contract start-up costs......   (4,816)       (6,231)        (1,181)         (39)
  Accounts payable and accrued liabilities 14,864        11,982          8,447        1,711
Net cash provided by operating activities  28,576        26,069         19,241        2,901
CASH FLOWS FROM INVESTING
  ACTIVITIES:
  Purchases of property, plant and equipment(23,808)    (31,529)       (16,801)      (1,211)
  Cash used for acquisitions, net of cash acquired                    
                                            (12,676)     (9,580)       (23,380)         ---
  Investments in and advances to joint ventures          
                                             (2,931)    (14,860)        (1,550)         ---
  Repayments of advances from joint ventures    420         ---            ---          ---
  Sales (purchases) of marketable securities  1,143       3,533           (890)         (11)
  Long-term restrictions placed on cash.     (2,183)       (211)          (217)         ---
  Change in non-current assets and other     (1,282)     (1,503)          (446)        (380)
  Net cash used for investing activities    (41,317)    (54,150)       (43,284)      (1,602)
CASH FLOWS FROM FINANCING
  ACTIVITIES:
  Proceeds from capital contribution....    114,980         ---            ---           ---
  Borrowings from parent................        ---      32,882         31,536           525
  Proceeds from bridge loan.............     75,000         ---            ---           ---
  Proceeds from revolving credit facility   163,500         ---            ---           ---
  Proceeds from senior term loans.......    120,000         ---            ---           ---
  Proceeds from sale of notes...........    100,000         ---            ---           ---
  Redemption of common stock............   (258,138)        ---            ---           ---
  Repayment of due to parent............    (67,878)        ---            ---           ---
  Repayment of bridge loan..............    (75,000)        ---            ---           ---
  Repayment of revolving credit facility   (129,500)        ---            ---           ---
  Payment of financing costs............    (12,504)        ---            ---           ---
  Other.................................        125         ---            ---           ---
  Net cash provided by financing activities  30,585      32,882         31,536           525
 INCREASE IN CASH AND
  CASH EQUIVALENTS......................     17,844       4,801          7,493         1,824
  Cash and cash equivalents at beginning
  of period.............................     29,531      24,730         17,237        15,413
CASH AND CASH EQUIVALENTS AT
  END OF PERIOD.........................   $ 47,375     $29,531        $24,730       $17,237
</TABLE>


                  The   accompanying   notes  are  an  integral  part  of  these
statements.


    
                                      F-5

<PAGE>


                             MERIT BEHAVIORAL CARE CORPORATION SUCCESSOR
                                       AND PREDECESSOR COMPANY
                             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  September 30, 1996, 1995 and 1994
                                       (dollars in thousands)

1.  ORGANIZATION

Merit  Behavioral Care Corporation (the "Company") was incorporated in the State
of  Delaware in March 1993 as a wholly  owned  subsidiary  of Medco  Containment
Services,  Inc.  ("Medco").  Through  its  wholly-owned  subsidiaries,  American
Biodyne,  Inc.  ("American  Biodyne") and PPC Group, Inc.  ("PPC"),  the Company
manages  behavioral  healthcare  programs for payors  across all segments of the
healthcare industry, including health maintenance organizations, Blue Cross/Blue
Shield  organizations  and other  insurance  companies,  corporations  and labor
unions,  federal,  state and local  governmental  agencies,  and  various  state
Medicaid programs.  Behavioral healthcare involves the treatment of a variety of
behavioral  health  conditions  such as emotional  and mental  health  problems,
substance abuse and other personal concerns that require counseling,  outpatient
therapy or more intensive treatment services.

On November 18, 1993,  Merck & Co., Inc.  ("Merck")  acquired all of the
outstanding  shares of Medco (See Note 3).

On October 6, 1995,  the  Company  completed a merger  (the  "Merger")  with MDC
Acquisition  Corp.  ("MDC"),  a company formed by Kohlberg Kravis Roberts & Co.,
L.P.  ("KKR"),  whereby MDC was merged with and into the Company.  In connection
with the  Merger,  the  Company  changed  its name from  Medco  Behavioral  Care
Corporation to Merit Behavioral Care Corporation (See Note 2).

2.  MERGER

Prior to the Merger,  the Company was a wholly-owned  subsidiary of Merck & Co.,
Inc.  ("Merck").  As a result of the  Merger,  KKR and  Company  management  and
related entities own  approximately  85% of the post-Merger  common stock of the
Company.  In connection with the Merger,  Merck received $326,016 in cash (which
reflects various final purchase price  adjustments)  and retained  approximately
15.0% of the common stock of the post-Merger  Company.  The Merger was accounted
for as a  recapitalization  which  resulted in a charge to equity of $258,138 to
reflect the  redemption of common stock.  In  conjunction  with the Merger,  the
Company paid a stock dividend of approximately 49.6 shares for each share of the
Company's stock then outstanding.

The Merger was financed with $114,980 of new cash equity, consisting of $105,000
from affiliates of KKR and $9,980 from Company  management and related  entities
("Management").  Management  acquired an  additional  $5,800 of equity which was
funded by loans from the Company. The balance of the transaction was funded with
a $75,000  bridge loan (the "Bridge  Loan")  provided by an affiliate of KKR and
$155,000 of initial borrowings under a $205,000 senior credit facility among the
Company,  The Chase  Manhattan Bank, N.A. and Bankers Trust Company (the "Senior
Credit Facility").  The  aforementioned  proceeds were utilized to redeem common
stock for $258,138, repay amounts due Merck of $67,878, and pay certain fees and
expenses related to the Merger. Of the total fees and expenses,  $5,500 was paid
to KKR.

3.  BASIS OF PRESENTATION

On November 18, 1993,  Merck acquired all the  outstanding  shares of Medco in a
transaction  accounted  for  by  the  purchase  method.  As  a  result  of  this
acquisition,  a new  basis  of  accounting  was  established  and as  such,  the
appraised  value of the Company's  assets and  liabilities  was recognized as of
November 18, 1993.

The financial  position,  results of operations and cash flows prior to November
18, 1993 are deemed to be Predecessor  Company financial  statements and are not
comparable with the financial  statements of the Successor Company.  The portion
of  the  total  purchase  price  for  Medco  paid  by  Merck  allocated  to  the
accompanying  financial  statements and the  determination  of fair value of the
identifiable assets and liabilities of the Company was

                                      F-6
<PAGE>


                             MERIT BEHAVIORAL CARE CORPORATION SUCCESSOR
                                       AND PREDECESSOR COMPANY
                       NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)

3.  BASIS OF PRESENTATION--(Continued)

determined by independent appraisal.

The  appraisal   determined  that  identified   intangible  assets,   consisting
principally  of customer  contracts,  had an  appraised  value of  $112,000  and
related  deferred taxes of $47,800 at the  acquisition  date.  These  identified
intangible  assets are being  amortized on a straight line basis over a weighted
average life of 12 years.  Based on the  allocation of the purchase price to the
net tangible and identified intangible assets and liabilities of the Company, an
excess  of the  allocated  purchase  price  over  the fair  value of net  assets
acquired of  approximately  $47,988 was recorded as goodwill.  Such  goodwill is
being amortized on a straight line basis over 40 years.

Amounts  included in the footnotes  relating to results of  operations  for 1994
include amounts for the period from October 1, 1993 to September 30, 1994.

Certain prior year amounts have been reclassified to conform to the current year
presentation.

4.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Use of Estimates

The preparation of financial  statements in conformity  with generally  accepted
accounting principles requires management to make estimates and assumptions that
affect  the  reported  amounts  of assets  and  liabilities  and  disclosure  of
contingent  assets and  liabilities at the date of the financial  statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.

Principles of Consolidation

The consolidated  financial  statements  include the accounts of the Company and
its  majority-owned  subsidiaries.  All  significant  intercompany  balances and
transactions have been eliminated.

Cash and Cash Equivalents

The  Company  considers  all  liquid  investment  instruments  with an  original
maturity of three  months or less to be the  equivalent  of cash for purposes of
balance sheet presentation.

Included in cash and cash  equivalents at September 30, 1996 and 1995 is $11,713
and  $7,048,  respectively,  of cash  held  under the  terms of  certain  of the
Company's  customer  contracts that require a claims fund to be established  and
segregated  for the purpose of paying  customer  behavioral  healthcare  claims.
Under  these  arrangements,  a  reconciliation  process is  typically  conducted
annually  between  the  customer  and the  Company  to  determine  the amount of
unexpended funds, if any,  accruing to the Company.  This cash is unavailable to
the Company for  purposes  other than the payment of customer  claims until such
reconciliation  process has been  completed.  The amount of cash held under such
arrangements in excess of anticipated  customer claims at September 30, 1996 and
1995 was $4,267 and $4,513, respectively.

The Company held a surplus cash balance of $9,685 and $8,920 as of September 30,
1996 and 1995,  respectively,  as required by the  Company's  contract  with the
State of Iowa. In addition,  at September 30, 1996 the Company held surplus cash
balances  of $5,244 as  required by various of the  Company's  other  contracts.
These  contracts  required the  segregation of such cash as financial  assurance
that the Company can meet its obligations thereunder.


                                      F-7

4.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(Continued)

The Company has a subsidiary organized in the state of Missouri that is licensed
to do  business  as a  foreign  corporation  in the State of  California  and is
subject  to  regulation  by the  Department  of  Corporations  of the  State  of
California.  Pursuant to these regulatory requirements,  certain amounts of cash
are  retained  for  the use of  this  subsidiary.  Included  in  cash  and  cash
equivalents  at  September  30,  1996 and 1995 is $900 and  $201,  respectively,
subject to such requirements.

Restricted Cash

At September  30, 1996 and 1995,  $7,168 and $6,376,  respectively,  of cash and
marketable  securities  were  held  by  subsidiaries  of the  Company  that  are
organized and regulated under state law as insurance  companies.  Such insurance
companies  are  required to maintain  certain  minimum  statutory  deposits  and
reserves  with  respect to the payment of future  claims.  The amount of cash in
excess of the liabilities of such subsidiaries and not available for dividend to
the Company without prior regulatory approval was $5,510 and $3,128 at September
30, 1996 and 1995, respectively. As a result, such amounts of cash held by these
subsidiaries  have been  classified  as a  long-term  asset in the  accompanying
consolidated balance sheets.

In the ordinary course of business,  the Company has pledged certain  short-term
investments  as collateral in support of various  leases for office space.  Such
investments are unavailable  for general  corporate  purposes until such time as
the lease expires.  At September 30, 1996 and 1995, $158 and $357 of investments
were collateralized  under such arrangements,  and are classified as a long-term
asset in the accompanying consolidated balance sheets.

Short-Term Marketable Securities

Short-term marketable securities consist of certificates of deposit,  carried at
amortized cost which approximates market.

Property, Plant and Equipment

Property,  plant and  equipment  are  stated at cost.  For  financial  reporting
purposes, depreciation is provided principally on a straight line basis over the
estimated useful lives of the assets as follows:

               Machinery and equipment....................         5 Years
               Integrated managed care information system.         7 Years
               Furniture and fixtures.....................       15 Years
               Leasehold improvements.....................       Life of lease

Expenditures for maintenance, repairs and renewals of minor items are charged to
operations as incurred. Major betterments are capitalized.

Construction-in-progress  primarily represents costs incurred in the development
of an integrated managed care information system (the "System").  In addition to
purchased  hardware  and  software  costs,  the payroll and related  benefits of
employees who are  exclusively  engaged in the development and deployment of the
System are capitalized. The System was substantially complete in October 1995 at
which time the Company began  installing the System in various area and regional
offices in the Company's service delivery system. As the System is



                                      F-8


4.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(Continued)

installed in an office,  the office is allocated a ratable  portion of the total
cost of the System,  at which time the  allocated  cost is  depreciated  over an
estimated useful life of 7 years.

Goodwill and Other Intangibles

The Company  amortizes costs in excess of the net assets of businesses  acquired
on a  straight  line  basis  over  periods  not to exceed  40 years.  Contingent
consideration  is  charged  to  goodwill  when  paid and is  amortized  over the
remaining  life  of  such  goodwill,   not  to  exceed  40  years.  The  Company
periodically reviews the carrying value of goodwill to assess recoverability and
other than temporary  impairments.  If an evaluation is required,  the estimated
future  undiscounted  cash flows  associated with the asset would be compared to
the asset's  carrying  amount to determine  if a  write-down  to market value or
discounted cash flow is required.  Goodwill and intangible  assets  consisted of
the following at September 30, 1996 and 1995:

                                                             1996          1995
                                                             ----          ----
               Customer Contracts..................      $ 80,000       $ 80,000
               Provider Network....................        12,000         12,000
               Trade Names and other...............        20,000         20,000
               Goodwill............................       110,630         96,156
                                                         $222,630       $208,156

Deferred Contract Start-up Costs

The Company defers contract start-up costs related to new contracts or expansion
of existing  contracts that require the  implementation  of separate,  dedicated
service  delivery  teams,   provider   networks  and  delivery  systems  or  the
establishment  of a local  clinical  organization  in a new  geographic  area to
service the new program.  The Company defers only costs which (i) are separately
identified,  incremental and segregated from ordinary operating  expenses;  (ii)
provide a direct,  quantifiable  benefit to future periods;  and (iii) are fully
recoverable from contract  revenues directly  attributable to such benefit.  The
incremental  costs  deferred  by  the  Company  include,   among  other  things,
consulting  fees,  salary  costs,  travel  costs,  office  costs and network and
reporting  system  development  costs.  Consulting  fees deferred by the Company
relate  primarily to the  recruitment,  credentialling  and  contracting  of the
particular  customer's  provider  network.  The salary costs relate primarily to
employees  of  the  Company  dedicated  to  clinical  protocol  design,  network
development   activities   and  program   reporting  and   information   systems
customization  for the specific  customer.  These  contract  start-up  costs are
capitalized  and amortized on a straight line basis over the initial term of the
related contract.  The amortization periods range from one to five years, with a
weighted-average  life at  September  30,  1996 of 3.3  years.  Amortization  of
deferred  contract  start-up  costs was $2,848,  $1,315 and $247 for the periods
ended September 30, 1996, 1995 and 1994, respectively.  During the periods ended
September 30, 1996, 1995 and 1994, the Company deferred  contract start-up costs
of $4,816,  $6,231 and $1,220,  respectively.  Other non-current  assets include
$6,077 and $5,865 of unamortized  deferred  contract start-up costs at September
30, 1996 and 1995, respectively.

Effective  October 1, 1995,  the Company  changed its method of  accounting  for
deferred  start-up  costs  related to new  contracts  or  expansion  of existing
contracts (i) to expense costs  relating to start-up  activities  incurred after
commencement of services under the contract,  and (ii) to limit the amortization
period for deferred  start-up  costs to the initial  contract  period.  Prior to
October  1,  1995,  the  Company  capitalized  start-up  costs  related  to  the
completion of the provider networks and reporting systems beyond commencement of
contracts and, in limited instances,  amortized the start-up costs over a period
that included the initial renewal term  associated with the contract.  Under the
new policy,  the Company does not defer  contract  start-up costs after contract
commencement,  or amortize  start-up costs beyond the initial  renewal term. The
change was made to  increase  the focus on  controlling  costs  associated  with
contract start-ups.

                                      F-9

4.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(Continued)

The pro forma effect of the change,  had the Company adopted this new accounting
policy in prior years,  is to decrease total assets by $1,769 and decrease total
liabilities by $757 as of September 30, 1995, and to increase costs and expenses
by $1,769 ($1,012 after taxes) for the year ended September 30, 1995.  There was
no pro forma effect of this change on the year ended  September  30,  1994.  The
effect of the change on the current year period  presented  cannot be reasonably
estimated.

Revenue Recognition

Typically,  the Company charges each of its customers a flat monthly  capitation
fee for each beneficiary  enrolled in such customer's  behavioral health managed
care plan or EAP. This  capitation  fee is generally  paid to the Company in the
current month. Contract revenue billed in advance of performing related services
is deferred and  recognized  ratably over the period to which it applies.  For a
number of the Company's behavioral health managed care programs,  the capitation
fee is  divided  into  outpatient  and  inpatient  fees,  which  are  recognized
separately.

Outpatient revenue is recognized monthly as it is received; inpatient revenue is
recognized  monthly  and is in most cases (i) paid to the  Company  monthly  (in
cases where the Company is responsible  for the payment of inpatient  claims) or
in certain cases (ii) retained by the customer for payment of inpatient  claims.
When the customer  retains the inpatient  revenue,  actual  inpatient  costs are
periodically  reconciled to amounts retained and the Company receives the excess
of the amounts retained over the cost of services, or reimburses the customer if
the cost of services exceeds the amounts retained.  In certain  instances,  such
excess  or  deficiency  is  shared  between  the  Company  and the  customer.  A
significant   portion  of  the  Company's  revenue  is  derived  from  capitated
contracts.

Direct Service Costs

Direct  service  costs are comprised  principally  of expenses  associated  with
managing,   supervising   and  providing  the  Company's   services,   including
third-party  network  provider  charges,   inpatient  facility  charges,   costs
associated  with  members of  management  principally  engaged in the  Company's
clinical  operations  and their  support  staff,  and rent for  certain  offices
maintained  by the Company in connection  with the delivery of services.  Direct
service costs are  recognized in the month in which  services are expected to be
rendered.  Network  provider and facility  charges for authorized  services that
have not been  reported  and billed to the Company  (known as  incurred  but not
reported  expenses,  or "IBNR") are  estimated  and accrued  based on historical
experience,  current  enrollment  statistics,  patient  census  data  and  other
information.  Such costs are  included  in the caption  "Claims  payable" in the
accompanying consolidated balance sheets.

Income Taxes

Deferred taxes are provided for the expected  future income tax  consequences of
events that have been recognized in the Company's financial statements. Deferred
tax assets and  liabilities  are determined  based on the temporary  differences
between the financial statement carrying amounts and the tax bases of assets and
liabilities  using  enacted  tax  rates in  effect  in the  years  in which  the
temporary differences are expected to reverse.

Disclosure of Fair Value of Financial Instruments

The carrying  amount  reported in the  consolidated  balance sheets for cash and
cash equivalents,  accounts receivable, accounts payable and accrued liabilities
approximates fair value because of the immediate or short-term maturity of these
financial  instruments.  The  Company  believes  the  carrying  value  of a note
receivable from a software  development  company is a reasonable estimate of the
fair value of the underlying intellectual property that secures repayment of the
note. The carrying amount of loans made to certain joint ventures engaged in the
development of

                                      F-10

4.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(Continued)

Medicaid  programs  (Note 9)  approximates  fair value  which was  estimated  by
discounting  future cash flows using rates at which  similar loans would be made
to borrowers  with similar credit  ratings.  The carrying value for the variable
rate debt outstanding  under the Senior Credit Facility (as described in Note 6)
approximates the fair value. The fair value of the Company's senior subordinated
notes (see Note 6) is estimated  to be $106,125 at September  30, 1996 (based on
quoted market prices) which compares to the carrying value of $100,000.

Concentrations of Credit Risk

Financial  instruments that potentially subject the Company to concentrations of
credit risk consist  principally of trade receivables.  Concentrations of credit
risk with  respect to trade  receivables  are limited due to the large number of
customers  comprising  the Company's  customer  base and the  dispersion of such
customers across different businesses and geographic regions.

5.  PROPERTY, PLANT, AND EQUIPMENT

Property, plant and equipment consisted of the following at September 30:

                                                            1996            1995
        Machinery and equipment....................      $ 44,896       $ 33,815
        Integrated managed care information system.        28,349         ---
        Furniture and fixtures.....................        12,795         10,677
        Leasehold improvement......................         2,977          2,477
        Construction-in-progress...................        ---            18,723
                                                           89,017         65,692
        Accumulated depreciation and
          amortization.............................       (21,137)       10,718)
                                                          $67,880        $54,974


Depreciation  and  amortization  related to property,  plant and  equipment  was
$10,658,  $6,776 and $4,587 for the periods ended  September 30, 1996,  1995 and
1994, respectively.

6.  LONG-TERM DEBT

At September 30, 1996, long-term debt consists of the following:

        Revolving Loans ....................     $  34,000
        Senior Term Loan A.................         70,000
        Senior Term Loan B..................        50,000
        Notes...............................       100,000
                                                   254,000
        Less current portion................          (500)
                                                  $253,500


Senior  Credit  Facility - In October  1995,  the Company  entered into a credit
agreement (the "Credit Agreement"), which provides for secured borrowings from a
syndicate  of  lenders.  The Senior  Credit  Facility  consists of (i) a six and
one-half year revolving credit facility providing for up to $85,000 in revolving
loans,  which includes  borrowing capacity available for letters of credit of up
to $20,000,  and (ii) a term loan facility  providing for up to $120,000 in term
loans,  consisting  of a $70,000  senior  term loan with a  maturity  of six and
one-half years ("Senior Term Loan A"),

                                      F-11

6. LONG-TERM DEBT-(Continued)

and a $50,000 senior term loan with a maturity of eight years ("Senior Term Loan
B"). At September  30, 1996,  $34,000 of  revolving  loans and three  letters of
credit totaling $425 were outstanding  under the Revolving Credit Facility,  and
approximately $50,575 was available for future borrowing.

The annual  amortization  schedule  of the  Senior  Term Loans is $500 in fiscal
1997,  $3,000 in 1998,  $10,500 in 1999,  $13,000  in 2000,  $20,500 in 2001 and
$72,500  thereafter.  The Senior Term Loans are subject to mandatory  prepayment
(i) with the  proceeds of certain  asset sales and (ii) on an annual  basis with
50% of the Company's  Excess Cash Flow (as defined in the Credit  Agreement) for
so long as the ratio of the  Company's  Total  Debt (as  defined  in the  Credit
Agreement)  to  annual  Earnings  Before  Interest,   Taxes,   Depreciation  and
Amortization  ("EBITDA" as defined in the Credit  Agreement) is greater than 3.5
to 1.0.

The Company is charged a commitment fee calculated at an  EBITDA-dependent  rate
ranging  from .250% to 0.500% per annum of the  commitment  under the  Revolving
Credit Facility in effect on each day. The Company is charged a letter of credit
fee  calculated  at an  EBITDA-dependent  rate ranging from 0.375% to 1.750% per
annum of the face amount of each letter of credit and a fronting fee  calculated
at a rate equal to 0.250% per annum of the face amount of each letter of credit.
Loans under the Credit  Agreement  bear  interest at  EBITDA-dependent  floating
rates,  which are,  at the  Company's  option,  based upon (i) the higher of the
Federal funds rate plus 0.5%,  or bank prime rates,  or (ii)  Eurodollar  rates.
Rates on borrowing  outstanding  under the Senior Credit Facility  averaged 8.3%
for the year ended September 30, 1996.

Notes - On November 22, 1995, the Company issued  $100,000  aggregate  principal
amount of 11 1/2% senior subordinated notes due 2005 (the "Private Notes"),  the
net proceeds of which were applied to repay the Bridge Loan  (including  accrued
interest) and a portion of the revolving loans under the Senior Credit Facility.
On March 20,  1996,  the  Company  exchanged  the  Private  Notes  for  $100,000
aggregate  principal amount of 11 1/2% Senior  Subordinated  Notes due 2005 that
are registered  under the  Securities  Act of 1933 (the "Notes").  The Notes are
senior subordinated, unsecured obligations of the Company.

The Company may be obligated to purchase at the holders' option all or a portion
of the Notes upon a change of control or asset sale, as defined in the indenture
for the Notes  (the  "Notes  Indenture").  The Notes are not  redeemable  at the
Company's option prior to November 15, 2000, except that at any time on or prior
to November 15, 1998, under certain  conditions the Company may redeem up to 35%
of the  initial  principal  amount of the Notes  originally  issued with the net
proceeds of a public offering of the common stock of the Company. The redemption
price is equal to 111.50% of the  principal  amount if the  redemption  is on or
prior to November  15,  1997,  and 110.50% if the  redemption  is on or prior to
November 15, 1998.  From and after  November 15, 2000, the Notes will be subject
to  redemption  at the option of the  Company,  in whole or in part,  at various
redemption prices,  declining from 105.75% of the principal amount to par on and
after November 15, 2004. The Notes mature on November 15, 2005.

The Credit Agreement and the Notes Indenture contain restrictive covenants that,
among  other  things  and under  certain  conditions,  limit the  ability of the
Company to incur additional indebtedness,  to acquire (including a limitation on
capital  expenditures) or to dispose of assets or operations,  to incur liens on
its property or assets,  to make  advances,  investments  and loans,  and to pay
dividends. The Company must also satisfy certain financial covenants and tests.

Borrowings  under the Credit  Agreement are secured by a first  priority lien on
the capital stock of and certain of the Company's subsidiaries.


                                      F-12

7.  NOTES RECEIVABLE FROM OFFICERS

In October 1995, the Company loaned several  officers an aggregate of $5,800 for
the  purchase  of  common  stock  of the  Company;  subsequent  to  the  Merger,
additional  loans  totaling $35 were made to officers for the purchase of shares
from  treasury.  Each loan is  represented  by a  promissory  note  which  bears
interest at a rate of 6.5% per annum.

These notes are full recourse obligations of the officers, are collateralized by
the  pledge of common  stock of the  Company  held by such  officers  and may be
prepaid  in part or in full  without  notice or  penalty.  One note for $250 was
repaid as of December  31,  1995,  another note for $100 was canceled in January
1996 and a third note for $15 was repaid in July 1996. The remaining outstanding
notes are due as  follows:  $250 in 1997,  $20 in 1998 and  $5,200 in 2001.  The
notes are  shown as a  reduction  of  stockholders'  equity in the  accompanying
consolidated balance sheets.

8.  ACQUISITIONS

On October 5, 1995,  the Company  acquired  Choate Health  Management,  Inc. and
certain related entities ("Choate"), a Massachusetts-based integrated behavioral
healthcare  organization.  The purchase price consisted of an initial payment of
$8,730 and subsequent  contingent  payments to the former shareholders of Choate
based on future  financial  performance.  Contingent  consideration  related  to
Choate is calculated at six times  calendar year 1997 pre-tax  income of Choate,
less $9,278. An interim payment relating to such contingent consideration in the
amount of $1,278 was made by the Company to the former shareholders of Choate in
July 1996; such payment was recorded as goodwill.  An additional interim payment
of the Choate contingent consideration may be required based on the 1996 pre-tax
income of Choate. Any additional  payments related to Choate will be recorded as
goodwill.

On December 19, 1995, the Company paid an initial $50 with a subsequent  payment
of  $2,950  in  January  1996  to  acquire  ProPsych,   Inc.   ("ProPsych"),   a
Florida-based  behavioral health managed care company. As of September 30, 1996,
the  Company  recorded  additional  goodwill  in the  amount of $400 for a final
contingent payment made to the former shareholders of ProPsych in November 1996.

In August  1996,  the  Company  paid  approximately  $340 to acquire  Orion Life
Insurance Company ("Orion"), a Delaware life and health insurance company. Orion
holds insurance  licenses in 17 states and provides the Company with the ability
to underwrite  future business in those states should a customer  require that a
licensed insurance entity underwrite its behavioral health program.

On February 28, 1994, the Company acquired Group Plan Clinic,  Inc. and BenesYs,
Inc.  (collectively   "BenesYs"),   behavioral  health  managed  care  companies
principally  serving the Texas market.  The purchase price for BenesYs consisted
of an initial payment of $9,757 and subsequent contingent payments of $1,500 for
the extension of certain  customer  contracts.  The Company was obligated to pay
additional  consideration  upon the achievement of certain financial targets for
the 12 months  ended  December 31, 1994.  In  September  1995,  the Company paid
$8,550 to the former  shareholders  of BenesYs in full settlement of any and all
contingent consideration due to such former shareholders.

On January 31, 1994,  the Company  completed a series of  transactions  with The
Washton  Institute,  Inc.  ("Washton"),  a provider of outpatient  treatment and
counseling  services for  alcoholism  and  substance  abuse in the New York city
area.  As a result of such  transactions,  the  Company  acquired  the  clinical
protocols of Washton,  entered into management and  affiliation  agreements with
Washton, and licensed to Washton the use of the acquired clinical protocols on a
nonexclusive  basis.  The purchase price for such protocols and other  interests
consisted of an initial payment at closing of $2,240 and a subsequent payment of
$650 in April  1995  that was  based on the  achievement  of  certain  financial
targets for the 12 months ended December 31, 1994.

                                      F-13

8.  ACQUISITIONS--(Continued)

The transactions discussed above have been recorded using the purchase method of
accounting.  The excess of the purchase  price over the estimated  fair value of
the assets acquired in these  acquisitions was $39,276 as of September 30, 1996.
The results of operations  of the  companies  acquired have been included in the
consolidated financial statements commencing with the aforementioned acquisition
dates.  Pro forma results of operations  have not been presented for the Choate,
ProPsych,  and Orion acquisitions because the effect of the acquisitions was not
significant.

In April  1992,  Medco  issued  584,452  shares of its common  stock,  valued at
$13,019,  to acquire PPC.  PPC  provides  Employee  Assistance  Program  ("EAP")
services   principally  to  the  corporate   marketplace.   Goodwill  and  other
intangibles  amounting to $14,315 were recognized in the accompanying  financial
statements  as a  result  of  this  transaction.  In  June  1994,  Medco  made a
contractual  payment of $5,000 to the former  owners of PPC which was based upon
the achievement of certain financial performance targets for the 24 months ended
December 31, 1993. In August 1994,  Medco agreed to pay the former owners of PPC
additional  consideration of $3,723 in full settlement of any and all contingent
consideration due them for achievement of certain financial  performance targets
for periods subsequent to December 31, 1993.

In February 1994, Medco made a final contingent  payment of $2,108 to the former
shareholders of a behavioral  health managed care company  purchased by American
Biodyne in October 1991.

In November  1993,  the Company  reacquired  stock  warrants  for $429 that were
previously  issued by  American  Biodyne  in January  1991.  The  warrants  were
originally  issued by American Biodyne in  consideration  for the acquisition of
certain  clinical  protocols  from a behavioral  health managed care company and
gave the holder  the right to  receive  additional  shares of  American  Biodyne
common  stock  based upon  certain  performance  targets.  The cash  payment was
charged to additional paid in capital.

In April 1993, Medco issued 394,259 shares of its common stock valued at $10,000
for the settlement of contingent  consideration due the former shareholders of a
behavioral  health managed care company purchased by American Biodyne in January
1992.  The Company also made cash payments in the periods  ending  September 30,
1994 and 1993 totaling  $475 to a former  principal and employee of such company
in connection with such settlement.

The  transactions  with Washton,  the  acquisition  of BenesYs,  investments  in
certain  joint  ventures  (Note 9),  and  certain  contingent  performance-based
payments were funded by advances from Medco. These advances are reflected in the
caption "Due to parent" in the  accompanying  balance  sheet as of September 30,
1995.

9.  JOINT VENTURES

In March  1994,  the  Company  entered  into a joint  venture  partnership  with
Community Sector Systems,  Inc.  ("CSS"),  a software  development  company,  to
market a proprietary clinical information, communications and case documentation
software package. The Company contributed $125 in capital,  loaned $1,375 to CSS
in 1994 and made an  additional  loan of $300 to CSS in 1995.  In the event of a
default on the loan,  the  Company  has a security  interest  in the  underlying
intellectual property.

In April 1995, the Company entered into a joint venture with Neighborhood Health
Providers,  LLC ("NHP"), an organization consisting of five hospitals located in
Brooklyn  and Queens,  New York,  under  which the Company  agreed to fund up to
$1,650  of  NHP's  Medicaid  program  development  costs  in the form of $150 in
capital  contributions  and $1,500 in  unsecured  debt,  in exchange  for an 80%
interest in such joint  venture.  As of September 30, 1996 and 1995, the Company
had advanced $1,500 and $1,026 to NHP, respectively.

Also in April 1995,  the Company  entered into a  contractual  arrangement  with
Community  Health  Network  of  Connecticut,   Inc.  ("CHN"),   an  organization
consisting of 11 not-for-profit  health centers in Connecticut,  under which the
Company has agreed to provide CHN with up to a total of $4,000 in unsecured debt
to help finance

                                      F-14

9.  JOINT VENTURES--(Continued)

CHN's Medicaid program development costs. As of September 30, 1996 and 1995, the
Company had advanced $2,079 and $1,800 to CHN, respectively.

In September 1995, the Company paid $12,010 to Empire Blue Cross and Blue Shield
("Empire") for the right to provide  behavioral  health managed care services to
approximately  750,000 of their  enrollees in the State of New York for a period
of five years. In connection  therewith,  the Company formed a limited liability
company  (the  "Empire  Joint  Venture")  with the Company and Empire  receiving
ownership  interests  of 80% and 20%,  respectively.  The payment was charged to
goodwill and is being amortized over the life of the underlying contract.

In January 1996, the Company  formed a joint venture with the hospital  sponsors
of NHP under the name "Royal  Health Care LLC"  ("Royal"),  in which each of the
Company and NHP holds 50% of the equity interests. During 1996, the Company made
a capital  contribution  in the amount of $200 to Royal,  as well as provided an
unsecured loan in the amount of $1,561. Royal, in turn, and Empire have formed a
second joint venture company, Empire Community Delivery Systems LLC ("ECDS"), in
which  Royal and Empire  hold 33 1/3% and 66 2/3%,  respectively,  of the equity
interests.  Empire and ECDS have entered into an agreement under which ECDS will
exclusively  manage  and  operate,  on behalf of  Empire,  health  care  benefit
programs (covering all services except behavioral healthcare and vision care) in
the five New York City  boroughs for Medicaid  beneficiaries  enrolled in Empire
plans.  Each of Empire  and Royal  will  provide  specified  administrative  and
management  services to ECDS to support its delivery of services to Empire under
such  agreement.  Moreover,  each of ECDS and Royal will hold  specified  equity
interests  in  certain  independent   practice   associations  (IPAs)  providing
treatment services to the Empire Medicaid beneficiaries. In addition, Empire has
entered into an agreement with the Empire Joint Venture to exclusively  provide,
on behalf of Empire, all behavioral healthcare services in New York City to such
Empire  Medicaid  enrollees.  The  Royal and ECDS  joint  ventures  and  related
agreements have five year terms, with up to three five-year renewals (subject to
applicable regulatory approvals).  Each such venture and agreement also contains
customary termination provisions.  The Company is accounting for its interest in
Royal using the equity method.

The  receivables  from,  and the  investments  in, CSS,  NHP,  CHN and Royal are
reflected in "other assets" in the accompanying balance sheets.

10.  INCOME TAXES

Prior to the Merger, the Company filed a consolidated  federal income tax return
with Merck.  Though no formal tax sharing  agreement existed between the Company
and Merck,  the Company computed federal income taxes on a separate return basis
and recorded such taxes in the caption "Due to parent".

The components of income tax expense  (benefit) for the periods ended  September
30, are as follows:

                                                 1996       1995           1994
        Current:
           Federal.......................... $   ---       $3,030         $5,748
           State............................     736        1,112          1,974
                                                 736        4,142          7,722
        Deferred :
           Federal .........................  (5,495)         200        (3,692)
           State............................    (573)         179        (1,290)
                                              (6,068)         379        (4,982)
        Total...............................$ (5,332)      $4,521         $2,740


                                      F-15

10.  INCOME TAXES--(Continued)

The  difference  between the U.S.  federal  statutory tax rate and the Company's
effective tax rate are as follows:


                                                 1996         1995         1994

        U.S. federal statutory tax rate.....    (35.0)%       $35.0%       35.0%
        State income taxes (net of federal benefit)
                                                  0.4          14.4          7.8
        Merger expenses.....................      5.8           ---          ---
        Goodwill............................      2.3          13.1          3.4
        Expenses without tax benefit.......       2.0          13.9          ---
        Other...............................      0.5           0.9          1.5
        Effective tax rate..................    (24.0)%        77.3%       47.7%


At September 30, 1996, the Company had $23,707 of deferred income tax assets and
$52,080  of  deferred  income  tax  liabilities   which  have  been  netted  for
presentation  purposes. The significant components of these amounts are shown on
the balance sheet as follows:

<TABLE>
<CAPTION>

                                               1996                           1995
                                        Current      Non Current        Current    Non Current
                                         Asset        Liability          Asset      Liability

<S>                                    <C>            <C>              <C>          <C>     
Provision for estimated expenses....   $  2,630       $  2,161         $ 2,283      $  2,618
Capitalized expenses................       (334)       (1,436)            (339)       (1,562)
Net operating loss carryforwards....        ---         9,170              ---           ---
Accelerated depreciation............        ---       (14,605)             ---       (11,145)
Intangible asset differences........        ---       (25,959)             ---       (34,655)
                                        $ 2,296      $(30,669)         $ 1,944      $(44,744)

</TABLE>

Management believes that the deferred tax assets will be fully realized based on
future  reversals of existing taxable  temporary  differences.  As a result,  no
valuation  allowance has been  provided.  At September 30, 1996, the Company had
U.S. federal net operating loss  carryforwards of approximately  $25,580 for tax
purposes.  Approximately  $5,920  of the  carryforwards  expire  in 2010 and the
remainder expire in 2011.


                                      F-16

<PAGE>


11.  COMMITMENTS AND CONTINGENCIES

a. Leases

The Company leases office  facilities and equipment under various  noncancelable
operating leases.

At  September  30,  1996,  the  minimum   aggregate  rental   commitments  under
noncancelable leases, excluding renewal options, are as follows:
 ........
               1997.......................................   $12,506
               1998.......................................    10,604
               1999.......................................     8,569
               2000.......................................     7,255
               2001.......................................     6,272
               Thereafter.................................    15,019
               Minimum lease payments.....................    60,225
               Less amounts representing sublease income..    (1,884)
                                                             $58,341

Several of the leases contain escalation provisions due to increased maintenance
costs and taxes. Scheduled rent increases are amortized on a straight-line basis
over the lease term.  Total rent  expense for the periods  ended  September  30,
1996, 1995 and 1994 amounted to $13,059, $10,115 and $9,652, respectively.

b.  Employment Agreements

The Company and certain of its  subsidiaries  have  employment  agreements  with
various officers and certain other management  personnel that provide for salary
continuation for a specified number of months under certain  circumstances.  The
aggregate  commitment  for future  salaries at  September  30,  1996,  excluding
bonuses, was approximately $6,016.

c.  Legal Proceedings

In  October  1996,  a group of  eight  plaintiffs  purporting  to  represent  an
uncertified class of psychiatrists and clinical social workers brought an action
under the federal  antitrust  laws in the United States  District  Court for the
Southern  District of New York  against  nine  behavioral  health  managed  care
organizations, including the Company (collectively, "Defendants"). The complaint
alleges that Defendants  violated  section 1 of the Sherman Act by engaging in a
conspiracy to fix the prices at which Defendants  purchase  services from mental
healthcare  providers such as  plaintiffs.  The complaint  further  alleges that
Defendants  engaged in a group boycott to exclude  mental  healthcare  providers
from  Defendants'  networks  in  order  to  further  the  goals  of the  alleged
conspiracy.   The  complaint  also   challenges  the  propriety  of  Defendents'
capitation arrangements with their respective customers,  although it is unclear
from  the  complaint  whether  plaintiffs  allege  that  Defendants   unlawfully
conspired to enter into capitation arrangements with their respective customers.
The complaint seeks treble damages against  Defendants in an unspecified  amount
and a permanent injunction  prohibiting  Defendants from engaging in the alleged
conduct which forms the basis of the complaint,  plus costs and attorneys' fees.
Defendants must move,  answer or otherwise respond with respect to the complaint
in January  1997.  The  Company  intends  to  vigorously  defend  itself in this
litigation.  No amounts are recorded on the books of the Company in anticipation
of a loss as a result of this contingency.

The Company is engaged in various  other legal  proceedings  that have arisen in
the ordinary  course of its  business.  The Company  believes  that the ultimate
outcome of such  proceedings  will not have a material  effect on the  Company's
financial position, liquidity or results of operations.

                                      F-17

d.  Insurance

Under the Company's professional liability insurance policy, coverage is limited
to the period in which a claim is asserted, rather than when the incident giving
rise to such claim  occurred.  The Company has obtained  professional  liability
insurance through October 6, 1997;  however, in the event the Company was unable
to obtain  professional  liability  insurance at the  expiration  of the current
policy  period,  it is possible  that the Company  would be uninsured for claims
asserted  after  the  expiration  of  the  current  policy  period.   Historical
experience  of the Company does not indicate that losses,  if any,  arising from
claims  asserted  after the  expiration  of the current  professional  liability
policy period would have a material effect on the Company's  financial position,
liquidity or results of operations.

12.  RELATED PARTY TRANSACTIONS

During the period ended September 30, 1996, the Company paid consulting fees and
board fees to KKR totaling  approximately $5,900. Of such amount, $5,500 related
to the Merger and associated financing transactions.

In addition to the amounts  advanced by the parent for acquisition  transactions
described  in Note 8, Medco  disbursed  funds on behalf of the  Company  for the
payment of certain of the Company's U.S.  federal,  state and local income taxes
prior to the Merger.

Included in expense for the periods ended  September 30, 1996, 1995 and 1994 are
charges totaling $1,218, $703 and $467, respectively,  related to a prescription
drug benefit program administered by Medco.

The  average  balance  due to the parent  (Medco)  for fiscal  1995 and 1994 was
$40,996 and $4,472, respectively;  such balance was repaid in full on October 6,
1995 in connection with the Merger. A summary of intercompany  activity with the
parent is as follows:

        Due to parent, October 1, 1993.............              $ 1,403
        Allocation of costs from parent............                  407
        Intercompany purchases.....................                  402
        Income taxes paid by parent................               10,494
        Cash transfers from parent.................               25,225
        Due to parent, September 30, 1994..........               37,931

        Allocation of costs from parent............                  379
        Intercompany purchases.....................                  659
        Income taxes paid by parent................                3,795
        Cash transfer from parent..................               28,049
        Due to parent, September 30,1995...........               70,813

        Adjustment to income taxes paid by parent .               (2,935)
        Repayment made in connection with the Merger             (67,878)
        Due to parent, September 30,1996...........$                 ---


13.  RESTRUCTURING CHARGE

The Company recorded a pre-tax restructuring charge of $2,995 related to a plan,
adopted and approved in the fourth  quarter of 1996,  to  restructure  its staff
offices by exiting certain geographic markets and streamlining Continuum's field
and administrative management organization. This decision was in response to the
results of underperforming  locations affected by the lack of sufficient patient
flow in the geographic areas serviced by these

                                      F-18

13.  RESTRUCTURING CHARGE--(continued)

offices and the Company's ability to purchase healthcare services at lower rates
from the network.  In addition,  it was  determined the Company would be able to
expand  beneficiary  access to specialists and other providers thereby achieving
more  cost-effective  treatment and to favorably shift a portion of the economic
risk, in some cases, of providing outpatient  healthcare to the provider through
the  use  of  case  rates  and  other  alternative  reimbursement  methods.  The
restructuring  charge is comprised primarily of accruals for employee severance,
real property lease  terminations  and write-off of certain assets in geographic
markets which are being exited.  The Company  anticipates the restructuring plan
will be substantially completed by February 28, 1997.

14.  MAJOR CUSTOMERS

For fiscal 1996,  1995 and 1994, no customer  accounted for more than 10% of the
Company's operating revenues.

15.  EMPLOYEE BENEFIT PLAN

The Company has a 401(k) savings plan covering  substantially  all employees who
have completed one year of active employment during which 1,000 hours of service
has been  credited.  Under the plan,  an employee may elect to  contribute  on a
pre-tax basis to a retirement  account up to 15% of the employee's  compensation
up to the maximum annual  contributions  permitted by the Internal Revenue Code.
The Company matches employee  contributions at the rate of 25% of the employee's
contributions to the 401(k) savings plan, up to a maximum of 6% of an employee's
annual compensation.  Effective January 1, 1997, the Company will match employee
contributions  at the rate of 50% of the employee's  contributions to the 401(k)
savings plan, up to a maximum of 6% of an employee's annual compensation.

The Company's  401(k)  savings plan  contribution  recognized as expense for the
periods  ended  September  30,  1996,  1995 and 1994 was  $542,  $330 and  $327,
respectively.

16.  STOCK OPTIONS AND AWARDS

In October 1995, the Company adopted the 1995 Stock Purchase and Option Plan for
Employees of Merit  Behavioral  Care  Corporation  and  Subsidiaries  (the "1995
Option Plan"). The 1995 Option Plan provides for the issuance of up to 8,561,000
shares of common stock to key  employees  of the  Company.  The 1995 Option Plan
permits  the  issuance  of common  stock and the  grant of  non-qualified  stock
options (the "1995  Options") to purchase  shares of common stock.  The exercise
price of 1995  Options  will not be less than 50% of the fair  market  value per
share of common  stock on the date of such grant.  Such options vest at the rate
of 20% per year over a period of five years.


                                      F-19

16.  STOCK OPTIONS AND AWARDS--(Continued)

In January  1996,  the Company  adopted a second stock  option  plan,  the Merit
Behavioral  Care  Corporation  Employee Stock Option Plan ("1996 Employee Option
Plan").  The 1996 Employee Option Plan,  which covers all employees not included
in the 1995 Option  Plan whose  employment  commenced  prior to January 1, 1996,
provides  for the  issuance  of up to  1,000,000  shares of common  stock of the
Company.  The 1996 Employee Option Plan permits the issuance of common stock and
the grant of  non-qualified  stock  options  (the "1996  Employee  Options")  to
purchase  shares of common stock.  The 1996 Employee  Options vest on the fourth
anniversary of the date of grant,  provided that the employee  remains  employed
with the Company on such date. The 1996 Employee  Options are exercisable  after
an initial  public  offering  of common  stock of the  Company  meeting  certain
requirements.

Information regarding the Company's stock option plans is summarized below:
<TABLE>
<CAPTION>

                                                                             1996
                                                                 1995      Employee
                                                             Option Plan  Option Plan
               Shares under option:
<S>                                       <C>                                                      
                   Outstanding at October 1, 1995.........          ---        ---
                   Granted................................     5,698,000    835,175
                   Canceled...............................      (585,000)  (119,625)
                   Outstanding at September 30, 1996......     5,113,000    715,550

               Option price per share:
                   At September 30, 1996..................        $ 5.00     $ 7.50

</TABLE>

Prior to the Merger, employees of the Company participated in stock option plans
administered by Merck. Pursuant to these plans, options were granted at the fair
market value of Merck common stock on the date of grant and generally  vest over
a period of five years.  The Company realizes an income tax benefit when Company
employees  exercise  either a)  nonqualified  Merck stock  options;  or b) Merck
incentive stock options, assuming the underlying common stock is sold within one
year from the date that the incentive  stock option was exercised.  This benefit
results in a decrease in tax  liabilities  and an increase in additional paid in
capital.  During  1996,  the  Company  recorded a tax benefit of $1,505 from the
exercise of Merck options.  Information  regarding the options outstanding under
these  plans held by  employees  of the  Company  at  September  30,  1996 is as
follows:

                                                                    Option Price
                                                 Shares               Per Share
                                                  
           Vested...........................     905,504        $3.78 to $35.75
           Unvested.........................     391,169        $3.78 to $35.75
           Total............................   1,296,673


Through September 30, 1995, employees of the Company participated in an Employee
Stock Purchase Plan administered by Merck. The stock plan permitted employees of
the Company to purchase Merck common stock at the end of each quarter at a price
equal to 85% of the fair market value at that date.


                                      F-20

<PAGE>


17.  SUPPLEMENTAL INFORMATION

Supplemental   cash  flow  information  and  noncash   investing  and  financing
activities are as follows:

<TABLE>
<CAPTION>
                                             1996           1995           1994
<S>     <C>    <C>    <C>    <C>    <C>    <C>
        Supplemental Cash Flow Information:
           Cash paid for income taxes....... $1,100        $2,167        $1,858
           Cash paid for interest........... 17,676           ---           ---

        Supplemental Noncash Investing and
          Financing Activities:
           Record deferred taxes associated
              with the Merger...............  7,594           ---           ---
Exercise of Merck stock options.............  1,505           ---           ---
           Acquisitions:
               Fair value of assets acquired,
                 other than cash............ 14,360           ---        15,429
               Liabilities assumed.......... (2,962)          ---       (3,907)
               Consideration paid........... 11,398           ---        11,522
               Contingent consideration.....  1,278         9,580        11,858
           Cash used for acquisitions,
             net of cash acquired...........$12,676       $ 9,580       $23,380

</TABLE>

18.  RECENTLY ISSUED ACCOUNTING STANDARDS

In March 1995,  the Financial  Accounting  Standards  Board issued  Statement of
Financial  Accounting Standards ("SFAS") No. 121, "Accounting for the Impairment
of  Long-Lived  Assets and for  Long-Lived  Assets to be Disposed  Of." SFAS 121
establishes  accounting  standards for the  impairment of long-lived  assets and
certain identified  intangibles to be disposed of or held and used by an entity.
SFAS 121 is effective for fiscal years  beginning  after  December 15, 1995. The
Company   will  adopt  SFAS  121  in  fiscal   1997  and  does  not  expect  its
implementation  to have a material  effect on its results of  operations  or its
financial condition.

In  October  1995,  the  FASB  issued  SFAS  123,  "Accounting  for  Stock-Based
Compensation". SFAS 123 establishes financial accounting and reporting standards
for stock-based  employee  compensation  plans. SFAS 123 is effective for fiscal
years  beginning  after  December 15,  1995.  The Company will adopt SFAS 123 in
fiscal 1997 and does not expect its  implementation to have a material effect on
its results of operations or its financial condition.


                                      F-21