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, 1997

                                      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"),  19.5%  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, 1997:
29,396,158.




<PAGE>


                         DOCUMENTS INCORPORATED BY REFERENCE

The following  documents  filed by the Company with the  Securities and Exchange
Commission  are  incorporated  herein  by  reference  and shall be deemed a part
hereof:  (i) the  Company's  Registration  Statement on Form S-4 (No.  33-80987)
under the Securities Act; (ii) the Company's  Quarterly  Report on Form 10-Q for
the quarter ended March 31, 1996 (as amended); (iii) the Company's Annual Report
on Form  10-K  for the  fiscal  year  ended  September  30,  1996;  and (iv) the
Company's  Current  Reports on Form 8-K filed on July 18,  1997,  September  17,
1997, October 29, 1997 and November 19, 1997.



<PAGE>



<TABLE>
                                         MERIT BEHAVIORAL CARE CORPORATION
<CAPTION>
                                                    FORM  10-K

                                                 TABLE OF CONTENTS

<S>     <C>    <C>    <C>    <C>    <C>    <C>
                                                                                                               Page
PART I

         Item 1.           Business........................................................................... 3
         Item 2.           Properties.........................................................................27
         Item 3.           Legal Proceedings................................................................. 27
         Item 4.           Submission of Matters to a Vote of Security Holders............................... 29


PART II

         Item 5.           Market for Registrant's Common Stock and Related
                             Stockholder Matters...............................................................29
         Item 6.           Selected Financial Data.............................................................29
         Item 7.           Management's Discussion and Analysis of Financial
                             Condition and Results of Operations...............................................32
         Item 8.           Financial Statements and Supplementary Data.........................................40
         Item 9.           Changes in and Disagreements with Accountants on
                             Accounting and Financial Disclosures..............................................40

PART III

         Item 10.          Directors and Executive Officers of the Registrant..................................41
         Item 11.          Executive Compensation..............................................................44
         Item 12.          Security Ownership of Certain Beneficial Owners
                             and Management....................................................................53
         Item 13.          Certain Relationships and Related Transactions......................................54


PART IV

         Item 14.          Exhibits, Financial Statement Schedules and
                             Reports on Form 8-K...............................................................57

SIGNATURES.....................................................................................................61

</TABLE>


<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 20 million people as of 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  37,000  third-party  network  providers and  approximately  3,300
third-party treatment facilities, as well as approximately 160 "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).

         On June 30,  1995,  the Company and Medco  Containment  Services,  Inc.
("Medco  Containment"),  the Company's previous owner, entered into an Agreement
and  Plan  of  Merger  (as  amended,  the  "1995  Merger  Agreement")  with  MDC
Acquisition  Corp.  ("MDC"),  a company formed by Kohlberg Kravis Roberts & Co.,
L.P. ("KKR"). Pursuant to the 1995 Merger Agreement, on October 6, 1995, MDC was
merged  with  and  into the  Company  (the  "1995  Merger"),  with  the  Company
continuing as the  surviving  corporation.  Upon  completion of the 1995 Merger,
which was accounted for as a recapitalization,  Medco Containment,  a subsidiary
of  Merck & Co.,  Inc.  ("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.  On September  12, 1997,  the
Company  acquired  CMG  Health,  Inc.  ("CMG"),  a national  managed  behavioral
healthcare company providing services to over 2.5 million people.

     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.

PROPOSED MERGER WITH MAGELLAN HEALTH SERVICES, INC.

         On October 24, 1997,  the Company and Magellan  Health  Services,  Inc.
("Magellan")  entered into an Agreement and Plan of Merger (the "Magellan Merger
Agreement"),  which  provides  that,  subject  to  the  fulfillment  of  certain
conditions, a subsidiary of Magellan will merge (the "Magellan Merger") with and
into the Company.  As a result of the Magellan Merger, the Company will become a
wholly  owned  subsidiary  of Magellan.  Under the terms of the Magellan  Merger
Agreement,  Magellan  will acquire all of the  Company's  outstanding  stock and
other equity  interests for  approximately  $458.3  million in cash,  subject to
certain  adjustments.  In addition,  all options outstanding under the Company's
stock  option  plans will  fully vest or  otherwise  become  exercisable  and be
converted into cash upon closing of the transaction.  Completion of the Magellan
Merger is subject to a number of  conditions,  including  Magellan's  receipt of
sufficient financing for the transaction,  the receipt of certain healthcare and
insurance regulatory approvals,  and other conditions.  One such condition,  the
expiration  of  the  waiting  period  under  the  Hart-  Scott-Rodino  Antitrust
Improvements  Act of 1974, has been satisfied.  In connection with the execution
of the Magellan  Merger  Agreement,  holders of more than 90% of the outstanding
Common Stock of MBC have agreed to vote in favor of the Magellan Merger pursuant
to  Stockholder  Support  Agreements  entered into with  Magellan.  The combined
company will be the nation's largest provider of managed  behavioral  healthcare
services,  with an estimated 52.8 million covered lives under contract, and will
manage behavioral  healthcare programs for over 4,000 customers.  It is expected
that the Magellan Merger will close in the first calender quarter of 1998.

         Consummation  of  the  Magellan   Merger  and  the  related   financing
arrangements would result in events of default under the Indenture,  dated as of
November 22, 1995, as supplemented (the "Indenture"), by and between the Company
and Marine  Midland Bank, as trustee,  under which the Company's  outstanding 11
1/2 Senior  Subordinated Notes due 2005 (the "Notes") were issued. In connection
with the Magellan Merger and as a condition for Magellan to obtain the financing
for the  Magellan  Merger,  the  Company  intends to  refinance  the  Notes.  No
assurance  can be given that such  refinancing  will occur or that the  Magellan
Merger will be consummated.

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
more than $300  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

                                                         4

<PAGE>



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 1997,  approximately 149 million  beneficiaries 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   approximately   78  million
beneficiaries  in 1992,  representing  an approximate 14% 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:

<TABLE>
<CAPTION>
<S>     <C>    <C>    <C>    <C>    <C>    <C>
                                                                                         Beneficiaries
                                                                                             (In                 Percent
     Category of Care                                                                      Millions)(1)          of Total
----------------------------------------------------------------------------------------  ---------------      -----------
Utilization Review/Care Management Programs................................                   39.2                26.3%
Non-Risk-Based Network Programs............................................                   32.0                21.4
Risk-Based Network Programs................................................                   38.9                26.1
Employee Assistance Programs (EAPs)........................................                   28.3                19.0
Integrated Programs........................................................                   10.7                 7.2
  Total....................................................................                  149.1               100.0%

------------
 (1) Source: Open Minds: Managed Behavioral Health Market Share in the United States, 1997-1998,
Gettysburg, Pennsylvania (1997).
</TABLE>

         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

                                                         5

<PAGE>



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  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.

Areas of Growth

         Management believes that the behavioral health managed care industry is
growing across all customer segments 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.  Management
believes that a number of opportunities  exist in the behavioral  health managed
care industry for future growth, primarily for risk-based products, but also for
Medicaid and Medicare recipients and uninsured individuals.

         Risk-Based  Products.  According to Open Minds,  industry enrollment in
risk-based  (capitated) products has grown from approximately 14 million covered
lives in 1993 to  approximately  38.9 million  covered lives in 1997, a compound
annual  growth rate of over 29%.  Despite this growth,  according to Open Minds,
only approximately 26% of total managed behavioral  healthcare covered lives are
enrolled  in  risk-based  products.  The  Company  believes  that the market for
risk-based  products  has grown and will  continue to grow as payors  attempt to
reduce  their  responsibility  for the cost of providing  behavioral  healthcare
while ensuring an appropriate level of access to care.

         Medicaid  Recipients.  Medicaid is a joint state and  federally  funded
program to provide  healthcare  benefits to an  estimated  36 million low income
individuals,   including  welfare  recipients.  According  to  the  Health  Care
Financing  Administration ("HCFA") of the United States Department of Health and
Human Services (the "Department"), federal and state Medicaid spending increased
from $65 billion in 1990 to $165 billion in 1996,  at an average  annual rate of
approximately  16%,  almost  twice as fast as the  annual  increase  in  overall
healthcare  spending.  Furthermore,  according to HCFA,  from 1991 to 1996,  the
number of Medicaid  beneficiaries covered under full managed contracts has grown
at a compound annual rate of approximately 38% per year. The Balanced Budget Act
of 1997 (the "Budget  Act"),  passed by Congress in August 1997,  is expected to
slow the growth of Medicaid spending by accelerating the trend of

                                                         6

<PAGE>



state Medicaid programs toward shifting beneficiaries into managed care programs
in order to control rising costs.

         Despite the recent  percentage  increase in managed care  enrollment of
Medicaid beneficiaries,  Medicaid managed care enrollment as a percentage of all
Medicaid beneficiaries remains small. As of June 1996, according to the National
Institute for Health Care  Management,  only  approximately  35% of all Medicaid
beneficiaries were enrolled in some form of managed care program,  and less than
7% were  enrolled in  risk-based  programs.  The  Company  expects the number of
Medicaid  recipients  enrolled  in managed  behavioral  healthcare  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 managed behavioral healthcare companies to provide services
for Medicaid beneficiaries.  State agencies have also begun to contract directly
with  managed  behavioral  healthcare  companies  to provide  services  to their
Medicaid beneficiaries.  Iowa, Massachusetts,  Nebraska, Maryland, Tennessee and
Montana have decided to "carve out"  behavioral  healthcare  from their  overall
Medicaid  managed care programs and have  contracted or are expected to contract
directly with managed behavioral  healthcare companies to provide such services.
The  provisions  of the Budget Act  related to  Medicaid  give the states  broad
flexibility  to require most  Medicaid  beneficiaries  to enroll in managed care
organizations that only do business with the Medicaid program, without obtaining
a waiver from the  Secretary of the  Department  that was required  under former
law.

         Medicare  Beneficiaries.  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 HCFA, as of January 1, 1997, only approximately 4.9 million,
or 13%, of the  approximately 38 million eligible  Medicare  beneficiaries  were
enrolled in managed  care  programs.  Although  enrollment  has  increased  from
approximately  7% of the eligible  Medicare  beneficiaries  in 1993, it is still
considerably  below that of the  commercial  population.  The  provisions of the
Budget Act related to Medicare  would achieve the projected  savings in Medicare
expenditures by, among other things,  changes in managed care programs  designed
to  increase  enrollment  in  managed  care  plans.  The  increase  in  Medicare
enrollment   would  be  achieved,   in  part,  by  allowing   provider-sponsored
organizations and PPOs to compete with Medicare HMOs for Medicare enrollees.

         Uninsured  Individuals.  Approximately 42 million people, or 16% of the
nation's  total  population,  are 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 uninsured  individuals  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  programs 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:


                                                         7

<PAGE>



         Continue to Pursue Capitated Contracts.  Management believes MBC is the
         leading  provider of  capitated  managed care  programs.  As of January
         1997, according to Open Minds, only 27% 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 status as the leading  provider of  capitated  products,
         will  enable  MBC to  benefit  from the  expected  growth in  capitated
         programs.

         Increase  Penetration of Medicaid Sector. The Company believes that the
         Medicaid  sector  offers a  significant  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  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,  among  other  programs,  the State of Iowa's  Mental
         Health  Access  Program  (the "Iowa  Medicaid  Program"),  the State of
         Tennessee's  TennCare  Partners  Program  ("TennCare") and the State of
         Montana's Mental Health Access Plan.

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, 1997,  and the revenue
attributable to each such program in fiscal 1997:
<TABLE>
<CAPTION>
<S>     <C>    <C>    <C>    <C>    <C>    <C>

Programs                                          Beneficiaries          Percent           Revenue     Percent
                                                               (In Millions, Except Percentages)
Risk-Based Programs......................             10.6               51%             $ 423.5          76%
EAPs.....................................              5.0               24                 55.3          10
Integrated Programs......................              2.5               12                 42.9           8
ASO Programs.............................              2.7               13                 15.4           3
Other....................................                -                -                 18.6           3

  Total..................................             20.8              100%             $ 555.7         100%
</TABLE>

         Risk-Based  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  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  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

                                                         9

<PAGE>




         The following table sets forth the number of  beneficiaries  covered by
MBC in each of its market  segments  as of  September  30,  1997 and the revenue
attributable to each such segment for fiscal 1997:
<TABLE>
<CAPTION>
<S>     <C>    <C>    <C>    <C>    <C>    <C>

     Market                                          Beneficiaries          Percent           Revenue        Percent
                                                                      (In Millions, Except Percentages)
Corporations and Labor Unions............                 7.8              37%                 $105.0          19%
HMOs(1)..................................                 6.2              30                   151.3          27
Blue Cross/Blue Shield and
     Insurance Companies.................                 3.5              17                   105.7          19
Medicaid Programs........................                 1.0               5                   136.5          25
Governmental Agencies
      (including CHAMPUS)................                 2.3              11                    40.1           7
Other....................................                   -               -                    17.1           3
Total....................................                20.8             100%                $ 555.7         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,  the Company's  contract relating to
the State of Montana's Mental Health Access Plan 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

                                                        10

<PAGE>



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.

Marketing and Sales

         The Company markets its services through its three operating divisions:
(i) the Employer and Union Division;  (ii) the HMO/Insurance Division; and (iii)
the Public Sector  Division  (including  Medicaid and  Medicare).  Each of these
three operating  divisions,  organized by the type of customer to be served,  is
overseen  by a  President  who reports to MBC's  President  and Chief  Operating
Officer.  For each specific  industry  segment,  the Company employs  integrated
teams of Sales Managers and Account  Managers who work under the  supervision of
the operating  division  President 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 ACQUISITION OF CMG HEALTH, INC.

         In September 1997, the Company acquired all of the capital stock of CMG
Health,  Inc. ("CMG"),  a national  behavioral health managed care company.  The
acquisition was effected  through the merger of a subsidiary of the Company with
CMG, as a result of which CMG became a wholly owned  subsidiary  of the Company.
The holders of CMG's common stock received  approximately $48.7 million in cash,
739,358 shares of Common stock and rights to receive certain additional cash and
stock  consideration  based upon future  events and the  post-closing  financial
performance  of CMG.  The Company  financed  the  acquisition  by  executing  an
extension of its existing credit facility. CMG was founded in 1986, and prior to
its acquisition by the Company,  served over 2.5 million lives on behalf of more
than 20 clients through a network consisting of approximately 7,600 providers in
34 states.  The  acquisition  of CMG expands MBC's  presence in the provision of
behavioral health services to three key behavioral healthcare sectors:  Medicaid
carve-out  programs,  CHAMPUS  programs and HMO  products.  CMG arranges for the
provision of mental health services for Medicaid-eligible and other lower income
residents in the State of Montana under that state's  Mental Health Access Plan.
In  addition,  CMG is also a  provider  of mental  health  benefits  to  CHAMPUS
beneficiaries in CHAMPUS Regions 3 and 4 through Choice Behavioral Healthcare

                                                        11

<PAGE>



Partnership,  in  which  CMG is a 50%  partner.  CMG  also  provides  behavioral
healthcare  services to more than 20 HMOs,  including  Humana  Inc.,  in various
regions of the United States.

OTHER RECENT ACQUISITIONS, JOINT VENTURES AND 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.  In March 1997, the term of the
Empire Joint  Venture was extended to eight  years,  subject to the  termination
rights described above.

         Choate. In October 1995, the Company 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 1997.  In September
1997, the Company sold Choate to UHSMS,  Inc., an affiliate of Universal  Health
Services, Inc., for approximately $4.8 million. The Company recognized a pre-tax
loss of approximately $6.9 million in connection with the transaction.

         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.

         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.  In addition, MBC, NHP and Empire have formed
a second joint venture company,  Empire Community Delivery Systems LLC ("ECDS"),
in which MBC, NHP and Empire hold 16 2/3%, 16 2/3% and 66 2/3%, respectively, of
the equity interests. Empire and ECDS have entered into an agreement under which
ECDS will exclusively manage and

                                                        12

<PAGE>



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, MBC and NHP
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, Oklahoma City, Oklahoma,  St. Louis and Southern Illinois (the "St. Louis
Area"),  and Delaware and Pennsylvania (the "Delaware Valley Area"). The Company
commenced  providing  services under the program for North Texas August 1, 1996,
the TriState  Area  September 5, 1996,  Oklahoma  City on July 1, 1997,  the St.
Louis Area on  September 1, 1997,  and the  Delaware  Valley Area on November 1,
1997.  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 is subject to certain  rights of  termination in
favor of  Prudential,  including the right to terminate  upon certain  change of
control  transactions  (including the Magellan  Merger).  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"), and served  approximately  500,000
members as of September 30, 1997. The Company and TBH are

                                                        13

<PAGE>



parties to an agreement (the "BHO  Agreement")  under which they operate a joint
program  to  service  TennCare  beneficiaries  through  such BHO.  Under the BHO
Agreement,  the Company shares in 51%, and TBH shares 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 TennCare program commenced July 1, 1996. The current term
of the TennCare program is 18 months  commencing July 1, 1997 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  commenced
April 1, 1997 and services  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.

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.


                                                        14

<PAGE>



         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.

                  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

                                                        15

<PAGE>



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.

         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

                                                        16

<PAGE>



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.

         National  Committee for Quality  Assurance.  The National Committee for
Quality Assurance ("NCQA"),  an independent  national managed care accreditation
organization,  has established operating standards for independent evaluation of
the quality of care and  services  provided to enrolled  members in managed care
insurance plans (primarily HMOs). Currently,  MBC participates in NCQA audits in
connection  with  certain HMO  customers.  Although  NCQA has yet to release its
standards for managed care arrangements with managed care plans other than HMOs,
the Company's  non-HMO  clients are  increasingly  expecting MBC to  demonstrate
compliance with existing NCQA standards.

         MBC has  initiated  the  process  to  become  accredited  as a  managed
behavioral  healthcare  organization ("MBHO") under NCQA standards by filing the
requisite  corporate  application  and undergoing an NCQA corporate  audit.  The
corporate survey focused on policy, standards and corporate oversight processes.
NCQA's 1998  regional  surveys will focus on direct care and service  processes.
While the corporate audit does not generate an independent  accreditation score,
MBC's  corporate   compliance   assessment  will  be  integrated  with  regional
compliance to determine regional accreditation.

         A regional  pre-assessment  audit is  anticipated  to be conducted  for
MBC's New York  metropolitan area operation in the late spring of 1998, with the
accreditation  survey  scheduled for fall of 1998.  The regional  pre-assessment
audit will not yield a score, but will provide MBC with NCQA's assessment of the
Company's readiness for the actual survey. The accreditation survey is generally
conducted 4-6 months following the pre-assessment audit.

                                                        17

<PAGE>



Due to contractual requirements,  the Company has also applied for accreditation
surveys in Florida and Kentucky.  Expected surveys for both states are scheduled
for September  1998, with results  expected  approximately  90 days  thereafter.
Failure by MBC to obtain NCQA MBHO  accreditation  could have a material adverse
effect on the Company.

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,  1997,  MBC had  contractual
arrangements with  approximately  37,000 third-party  network  providers.  MBC's
network providers are independent contractors located throughout the local areas
in which MBC's customers' 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  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, 1997, the Professional  Corporations  employed  approximately  160
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.

                                                        18

<PAGE>



         Facilities.  As of September 30, 1997, MBC had contractual arrangements
with approximately 3,300 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.   AMISYS(R),   a  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, is the Company's  primary system.  In addition to AMISYS(R),
because MBC has grown in part through recent acquisitions,  the Company utilizes
four other  operating  systems to 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. The four other primary  information  systems utilized by
MBC, in addition to AMISYS (R),  are:  (i) servers,  supporting  the delivery of
services to certain of the Company's HMOs, federal, state and local governmental
agencies  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;  and (iv) a DEC VAX 4500  system,  supporting  the  delivery of
services principally to customers in the State of Texas.

         The Company  believes  that  AMISYS(R),  in  conjunction  with  various
client-server  applications,  will  enable the  Company's  intake  coordinators,
clinical case managers and claims reviewers to 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

                                                        19

<PAGE>



Amisys,  Inc.;  however,  the Company has made  approximately  $10.5  million of
custom  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 calendar 1996, and
implemented  AMISYS(R) in a number of additional locations during fiscal 1997 to
service new business,  including Texas, Oklahoma, Colorado, Arizona, Florida and
selected new accounts.

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,  the  Company
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.


                                                        20

<PAGE>
EMPLOYEES

         As of September  30, 1997,  the Company  employed  approximately  3,600
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 372 additional
persons,  approximately  160 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, 1997 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.

         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.

                                                        21

<PAGE>




         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

                                                        22

<PAGE>



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 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
license  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.  As a result of this  review,  the NAIC
developed  a  "health  organizations   risk-based  capital"  formula,   designed
specifically for managed care  organizations,  that establishes a minimum amount
of capital  necessary  for a managed  care  organization  to support its overall
operations, allowing consideration for the organization's size and risk profile.
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  may  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

                                                        23

<PAGE>



of such  requirements  could  increase the Company's  cost of doing business and
could delay the  Company's  conduct or  expansion of its business in some areas.
The licensure  process under state insurance laws can be lengthy and, unless the
applicable  state  regulatory  agency  allows the Company to continue to operate
while the licensure process is ongoing,  the Company could experience a material
adverse  effect on its  operating  results  and  financial  condition  while its
licensure application is pending. 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  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 its TPA  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 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

                                                        24

<PAGE>

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  increase the Company's  costs of assembling  and  administering  provider
networks and could, therefore, 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.

         Direct Contracting with Licensed Insurers. 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 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.

         Other Regulation of Healthcare Providers.  The Company's business is 
affected indirectly by regulations imposed upon healthcare providers.  
Regulations imposed upon healthcare providers include provisions relating to 
the conduct of, and ethical considerations

                                                        25

<PAGE>

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.   The   Health   Insurance   Portability   and
Accountability  Act of 1996  ("HIPAA")  included a provision  that prohibits the
wrongful disclosure of certain  "individually  identifiable health information."
HIPAA  requires the Secretary of the  Department of Health and Human Services to
adopt  standards  relating to the  transmission  of such health  information  by
healthcare  providers and healthcare  plans.  Although the Company believes that
such regulations do not at present  materially impair the Company's  operations,
there  can be no  assurance  that  such  indirect  regulations  will  not have a
material adverse effect on the Company in the future.

         Regulation  of  Customers.   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.  Although 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

                                                        26

<PAGE>

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 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

                                                        27

<PAGE>

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  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.

         In August 1997,  Congress enacted the Budget Act. The  Medicare-related
provisions of the Budget Act are designed to reduce Medicare  expenditures  over
the next five years by $115 billion, compared to projected Medicare expenditures
before adoption of the Budget Act. The Congressional  Budget Office projected in
July 1997 that $43.8 billion of the reductions  would come from reduced payments
to hospitals,  $21.8 billion from increased enrollment in managed care plans and
$11.7 billion from reduced payments to physicians and ambulatory care providers.
The five-year savings in projected Medicare payments to physicians and hospitals
would be achieved under the Budget Act by reduced fee-for-service  reimbursement
and by changes in managed  care  programs  designed  to increase  enrollment  of
Medicare   beneficiaries  in  managed  care  plans.  The  increase  in  Medicare
enrollment  in  managed  care  plans  would  be  achieved  in part  by  allowing
provider-sponsored organizations and preferred provider organizations to compete
with Medicare HMOs for Medicare enrollees.

         The  Medicaid-related  provisions  of the  Budget Act are  designed  to
achieve net federal  Medicaid  savings of $14.6 billion over the next five years
and $56.4 billion over the next ten

                                                        28

<PAGE>



years. The Budget Act achieves  federal Medicaid savings in three areas.  First,
two-thirds  of  the  savings  over  the  next  ten  years  are  attributable  to
limitations  on  federal  matching  payments  to states  for  reimbursements  to
"disproportionate  share" hospitals.  The next largest source of federal savings
is a provision  allowing  states to shift the cost of Medicare  deductibles  and
coinsurance  requirements  for  low-income  Medicare  beneficiaries  from  their
Medicaid  programs to  physicians  and other  providers.  Most of the  remaining
savings  derive  from the  repeal of the  "Boren  Amendment"  and other  minimum
payment  guarantees  for hospitals,  nursing homes and community  health centers
that service Medicaid patients.  These changes may have an adverse effect on the
Company  if they  result in reduced  payment  levels  for  providers  of managed
behavioral healthcare services.

         The  Medicaid-related  provisions  of the Budget  Act also give  states
broad  flexibility  to require most  Medicaid to enroll in managed care products
that  only  cover  Medicaid  recipients  without  obtaining  a  waiver  from the
Secretary of the  Department of Health and Human  Services.  The Budget Act also
allows states to limit the number of managed care  organizations  with which the
state will  contract to deliver care to Medicaid  beneficiaries.  These  changes
could  have a  positive  impact on the  Company's  business,  if they  result in
increased enrollment of Medicaid beneficiaries in managed care organizations and
increased  Medicaid  spending on managed care.  However,  these changes also may
have an adverse  effect on the Company if a number of states decide to limit the
number of managed care organizations with which they will contract and to select
the organization solely on the basis of the cost of care.

         MBC cannot  predict the effect of the Budget  Act, or other  healthcare
reform  measures that may be adopted by Congress or state  legislatures,  on its
operations  and no  assurance  can be given that  either the Budget Act or other
healthcare reform measures will not have an 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.

         Risk-Based Programs. In order for the Company's risk-based 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

                                                        29

<PAGE>



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 37  contracts  with MBC  which
accounted for  approximately  54% of the Company's revenue for fiscal 1997. 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.

         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 AMISYS(R), which is
expected to provide  advantages  over the Company's  other  current  information
systems.   The  Company  has  implemented  of  AMISYS(R)  into  certain  of  its
operations,  transitioned  certain  programs  supported  by its  other  existing
systems to AMISYS(R) and is continuing to migrate its other operating 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.

                                                        30

<PAGE>



         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 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 1995  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

                                                        31

<PAGE>

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 1995  Merger  and the Notes.
Further,  the Company  borrowed an additional $80 million in connection with its
acquisition of CMG in September  1997.  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),  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 2003.  As of September  30,
1997, the Company also maintained  approximately  150 other offices in 32 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.

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

                                                        32

<PAGE>



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,  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
the Company.

         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.

         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,

                                                        33

<PAGE>



"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.  In  January  1997,
Defendants  filed a  motion  to  dismiss  the  complaint.  On July 21,  1997,  a
court-appointed  magistrate  judge  issued a report  and  recommendation  to the
District Court  recommending  that  Defendants'  motion to dismiss the complaint
with prejudice be granted. On August 5, 1997, plaintiffs filed objections to the
magistrate judge's report and recommendation;  such objections have not yet been
heard.  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

         There is no  established  public  trading  market for the Common Stock.
There were approximately 70 holders of the Common Stock at December 1, 1997. 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.


                                                        34

<PAGE>



Item 6.   Selected Financial Data

     The following audited 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.   See  "Management's
Discussion and Analysis of Financial Condition and Results of Operations."

                                                        35

<PAGE>

<TABLE>
<CAPTION>


                                          Predecessor(6)                                    MBC
                           Fiscal Year Ended Oct. 1, 1993 Nov. 18, 1993      Fiscal Years Ended September 30,
                            September 30,       to             to
                                 1993     Nov. 17, 1993  Sept. 30, 1994         1995      1996(10)      1997
<S>     <C>    <C>    <C>    <C>    <C>    <C>

Income Statement Data:
Revenue ......................$197.4          $31.0          $245.9             $361.5     $457.8       $555.7
Operating expenses(1)......... 180.5           29.3           225.4              335.8      426.2        517.0
Amortization of intangibles...   1.8            0.3            17.1               21.4       25.8         26.9
Restructuring charge..........   1.7            ---             ---                ---        3.0          ---
  Operating income (2)...... .  13.4            1.4             3.4                4.3        2.8         11.8
Other expense (income)(3)....   (0.6)          (0.1)           (0.8)              (1.5)      (2.8)        (3.5)
Interest expense..............   ---            ---             ---                ---       23.8         25.1
Loss on disposed of subsidiary.. ---            ---             ---                ---        ---          6.9
Merger costs and special charges 2.4            ---             ---                ---        4.0          1.3
   Income (loss) before income
     taxes and cumulative
     effect of accounting change11.6             1.5            4.2                5.8      (22.2)       (18.0)
Provision (benefit) for
  income taxes                   6.1             0.6            2.1                4.5       (5.3)        (4.1)
   Income (loss) before
     cumulative effect of
     accounting change.........  5.5             0.9            2.1                1.3       (16.9)      (13.9)
Cumulative effect of
  accounting change (10)......   ---             ---            ---                ---       (1.0)         ---
Net income (loss)                5.5          $  0.9          $ 2.1              $ 1.3     $(17.9)      $(13.9)
Pro forma net income
  (loss) for the effect of
  the accounting change(10)...  $5.5          $  0.9          $ 2.1              $ 0.3     $(16.9)      $(13.9)
Deficiency of earnings
  to fixed charges(7)...........                                                           $(22.2)      $(18.0)

Balance Sheet Data (at end of periods):
Cash, cash equivalents and
  short-term marketable
  securities(5)............  $  21.9                        $ 32.7              $ 34.1     $ 53.0     $   95.2
Total assets.................   91.9                         259.3               305.4      344.8     $  468.7
Due to parent
  (noninterest bearing).......   5.9                          37.9                70.8        ---          ---
Long-term debt................                                                              254.0        329.5
Stockholders' equity (deficit)  47.0                         121.0               122.3      (29.5)       (25.9)

Other Data:
Adjusted EBITDA(4).........     20.0            2.2           25.5                34.0       45.1         54.7
Adjusted EBITDA margin(8)       10.1%           7.1%          10.4%                9.4%       9.9%         9.8%
Cash provided by
  operating activities........$ 18.3          $ 2.9          $19.2              $ 26.1     $ 28.6       $ 26.9
Cash used for investing
  activities...............    (17.3)          (1.6)         (43.3)              (54.2)     (41.3)       (62.1)
Cash provided by financing
  activities.................... 4.9            0.5           31.6                32.9       30.6         75.2
Depreciation and
  amortization(9)..............  4.3            0.7           21.3                28.2       36.5         39.4
Capital expenditures:
  Information systems.........   8.6            0.2           15.0                23.2       15.7         16.3
 Other capital expenditures.    1.0            1.0            1.8                 8.3        8.1           7.7
Total capital expenditures       9.6            1.2           16.8                31.5       23.8         24.0

                                                               36
</TABLE>

<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,  cumulative  effect of
accounting change,  interest expense,  other income and expense and merger costs
and special charges.

(3) Represents primarily interest income.

(4) "Adjusted EBITDA"  represents the sum of operating income,  depreciation and
amortization,  and other income and expense,  excluding restructuring charges in
1993 and 1996. 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 1995 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

                                                        37

<PAGE>



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.

(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

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 in most cases is (i) paid to the

                                                        38

<PAGE>



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.

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
Company's  staff offices,  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, adjudication decisions, 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  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 EAP 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  EAP and ASO  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;  and (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.


                                                        39

<PAGE>



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 in the future.  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  acquisitions  of Group Plan Clinic,  Inc.,  and of BenesYs,  Inc.
(collectively,  "BenesYs"),  a  Houston-based  behavioral  health  managed  care
organization,  and CMG. In addition,  the payment  made to Empire in  connection
with the Empire Joint Venture, the acquisition of ProPsych in December 1995, and
various contingent consideration payments, together with the goodwill recognized
from the BenesYs and CMG transactions,  resulted in the incurrence of additional
goodwill of approximately  $117.8 million.  Amortization of  acquisition-related
intangibles was $20.1 million in fiscal 1995,  $23.0 million in fiscal 1996, and
$23.8 million in fiscal 1997.

         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, 1997,  the  Company's
balance  sheet  reflected  $9.0  million  of  deferred  start-up  costs,  net of
amortization, categorized under long-term assets.


                                                        40

<PAGE>

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 commensurate
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 June 1997, the Financial  Accounting Standards Board issued SFAS No.
131, Disclosures about Segments of an Enterprise and Related Information,  which
will be  effective  for the  Company  beginning  October 1,  1998.  SFAS No. 131
redefines  how  operating  segments are  determined  and requires  disclosure of
certain  financial  and  descriptive  information  about a  company's  operating
segments.  The Company has not yet  completed its analysis with respect to which
operating segments of its business it will provide such information.


                                                        41

<PAGE>

RESULTS OF OPERATIONS

Selected Operating Results

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

                                                                Fiscal Year Ended September 30,
<S>                                                           <C>              <C>               <C> 
                                                              1995             1996              1997

Revenue..........................................            100.0%            100.0%           100.0%
Direct service costs.............................             79.1              79.0             80.9
  Direct profit margin...........................             20.9              21.0             19.1
Selling, general and administrative
  expenses.......................................             13.8              14.1            12.2
Amortization of intangibles......................              5.9               5.7             4.8
Restructuring charge.............................              ---               0.6             ---
   Operating Income..............................              1.2               0.6             2.1
Other income.....................................              0.4               0.6             0.6
Interest expense.................................              ---              (5.2)           (4.5)
Loss on disposal of subsidiary...................              ---               ---            (1.2)

Merger costs and special charges.................              ---              (0.8)           (0.2)
Income (loss) before income taxes and
  cumulative effect of accounting change                       1.6              (4.8)           (3.2)
Provision (benefit) for income taxes.............              1.2              (1.1)           (0.7)
Income (loss) before cumulative effect
    of accounting change......................                 0.4%             (3.7)%          (2.5)%

Adjusted EBITDA margin...................                      9.4%              9.9%            9.8%
</TABLE>

Fiscal 1997 Compared to Fiscal 1996

         Revenue.  Revenue  increased  by $97.9  million,  or  21.4%,  to $555.7
million for fiscal 1997 from $457.8  million for fiscal 1996. Of this  increase,
$71.3  million  was  attributable  to the  inclusion  of  revenue  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 $65.8
million was  attributable  to new  customers  commencing  service in the current
year, a  significant  portion of which was derived from the  Company's  contract
relating to CHAMPUS Regions 7 and 8, under which services  commenced on April 1,
1997.  In addition,  the  Company's  acquisition  of CMG on  September  12, 1997
contributed an additional $7.0 million in revenue for fiscal

                                                        42

<PAGE>



1997. These revenue  increases were partially offset by a $46.2 million decrease
in revenue as a result of the termination of certain contracts, $29.1 million of
which was due to contract  terminations  that occurred 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 $87.9 million,
or 24.3%, to $449.6 million for fiscal 1997 from $361.7 million for fiscal 1996.
As a percentage of revenue,  direct  service costs  increased  from 79.0% in the
prior year period to 80.9% in the current year period. The increase in cost as a
percentage of revenue was due primarily to the lower than average  direct profit
margin  earned  on the  TennCare  Partners  and  the  Delaware  County  Medicaid
programs,  partially offset by a year over year decline in healthcare  treatment
services  utilization  in the  Company's  overall  business.  In  addition,  the
Delaware County carve-out  program replaced a program under which  beneficiaries
previously  received their mental health benefit  through  membership in various
HMOs servicing this area. Direct profit margins under contracts that the Company
held with  certain  of these  HMOs,  which  terminated  or  membership  in which
decreased  substantially as a result of the Delaware County program, were higher
than the direct profit margins for the Delaware County program and the Company's
overall  average  direct  profit  margins.  Excluding the effect of the TennCare
Partners and the Delaware County contracts,  however,  the Company experienced a
decline in the  direct  service  cost  percentage  as a result of overall  lower
healthcare  utilization in the current year period as compared to the prior year
period, due to the Company's continued development and deployment of alternative
treatment  programs  designed to achieve more  cost-effective  treatment and the
Company's  increased  focus on  clinical  care  techniques  directed at patients
requiring more  intensive  treatment  services.  Also  positively  impacting the
direct cost percentage were the effect of (i) a nationwide recontracting program
with  providers  which began in the second  quarter of fiscal 1996, and (ii) the
closing of certain  underperforming staff offices pursuant to a plan implemented
by MBC in the fourth quarter of 1996.

         Selling,  General and  Administrative  Expenses.  Selling,  general and
administrative expenses increased by $2.9 million, or 4.5%, to $67.4 million for
fiscal 1997 from $64.5 million for fiscal 1996.  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 both the  Company's  National  Service  Center
located in St. Louis,  Missouri and the Company's  headquarters  located in Park
Ridge,  New Jersey,  (iii)  expenses  related to the planned  deployment  of the
Company's  new  information  systems,  and (iv)  inclusion  of CMG's  results of
operations  since the  acquisition  date. As a percentage  of revenue,  selling,
general  and  administrative  expenses  decreased  from  14.1% in the prior year
period  to 12.2% in the  current  year  period  primarily  as a result  of these
expenses being allocated over a larger revenue base. Contributing  significantly
to this decrease were the TennCare  Partners and the Delaware  County  programs,
which are large,  self-contained programs requiring minimal selling, general and
administrative expenses or Company operational support,  thereby mitigating,  in
large part, the effects of their lower than average

                                                        43

<PAGE>



direct service cost margins described above.

         Amortization of Intangibles.  Amortization of intangibles  increased by
$1.0  million,  or 4.0%, to $26.9 million for fiscal 1997 from $25.9 million for
fiscal 1996.  The increase was primarily due to an increase in  amortization  of
goodwill  recognized in connection with the  acquisitions of ProPsych and CMG as
well as to increases in the  amortization  of deferred  contract  start-up costs
related to new contracts.

         Other  Income  (Expense).  For fiscal  1997,  other  income and expense
consisted of (i) interest expense of $25.1 million related to debt incurred as a
result of the 1995 Merger in October  1995,  (ii)  interest  and other income of
$3.5  million  relating  primarily  to  investment  earnings  on  the  Company's
short-term  marketable  securities and restricted cash and investment  balances,
(iii) a loss of $6.9 million  recognized  in  September  1997 on the disposal of
Choate,  (iv) $0.7 million of expenses  associated with uncompleted  acquisition
transactions,  and (v) $0.6  million  of  nonrecurring  employee  benefit  costs
associated  with the exercise of stock options by employees of the Company under
plans  administered by Merck. The year over year increase in interest expense of
$1.2 million was  primarily  attributable  to (i) the full period  impact of the
indebtedness  incurred in October 6, 1995 by the Company in connection  with the
1995 Merger;  (ii) the full period impact of the Notes, which bore interest at a
higher rate than the bridge  financing  facility  that the Notes  replaced,  and
(iii) the increase in the senior credit  facility as a result of the acquisition
of CMG.  The year over year  increase  in  interest  income of $0.7  million was
primarily  attributable to both an increase in average invested cash balances as
compared  to the prior year  period and  interest  earned on advances to certain
joint ventures.

         Income  Taxes.  The Company  recorded a benefit for income taxes during
fiscal 1997, based upon the Company's pre-tax loss in such period.

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  totaling
$20.9 million.  In addition,  the Company's  acquisitions of Choate and ProPsych
contributed  an  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.

                                                        44

<PAGE>



         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 Partners  program.  Due to the
unusual  structure of the TennCare  Partners  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.

         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 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  the TennCare  Partners  program)  secured by the Company,
contributed to the increase in selling, general and administrative expenses as a
percentage of revenue.

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


                                                        45

<PAGE>



         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 the field and administrative management organization of
Continuum Behavioral Healthcare  Corporation,  a subsidiary of the Company. 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 its provider network. In addition, it was determined that 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 was comprised primarily of accruals for employee severance,
real property lease  terminations  and write-off of certain assets in geographic
markets  which were  being  exited.  The  restructuring  plan was  substantially
completed during fiscal 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 1995 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  from
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

                                                        46

<PAGE>



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 fiscal 1996
cannot be reasonably estimated.

Liquidity and Capital Resources

         General.  For fiscal 1997,  operating activities provided cash of $26.9
million,   investing  activities  used  cash  of  $62.1  million  and  financing
activities  provided cash of $75.2 million,  resulting in a net increase in cash
and cash  equivalents  of $40.0  million.  Investing  activities  in fiscal 1997
consisted  principally  of (i) capital  expenditures  of $24.0  million  related
primarily to the continued  development of the Company's new information systems
and  expansion of the National  Service  Center,  (ii) payments  totaling  $35.2
million  (net of cash  acquired)  for the  acquisition  of CMG,  (iii)  payments
totaling $2.6 million for funding under joint venture agreements, primarily with
Empire Community Delivery Systems,  LLC and Community Sector Systems,  Inc., and
(iv)  expenditures  of $4.1 million for the purchase of  short-term  investments
made to satisfy obligations under contracts held by the Company.

         Acquisition.  On September  12, 1997,  the Company  acquired all of the
outstanding capital stock of CMG for $48.7 million in cash and 739,358 shares of
the  Company's  common stock valued at $5.5  million.  In addition,  the Company
agreed to absorb  certain  expenses and other  obligations of CMG totaling up to
$5.4 million. CMG is a Maryland-based national managed care company serving over
30 customers through a network consisting of approximately 7,600 providers in 34
states.  CMG currently  provides  behavioral health managed care services to 2.5
million people under full risk capitation,  ASO and other funding  arrangements.
The  clients  include  state and local  governments,  Blue  Cross  /Blue  Shield
organizations, HMOs and insurance companies. As additional consideration for the
acquisition,  the Company may be required to make certain future contingent cash
and stock  payments  over the next two years to the former  shareholders  of CMG
based upon the  performance of certain CMG customer  contracts.  Such contingent
cash  payments  are  subject  to an  aggregate  maximum  of $23.5  million.  The
acquisition  was  accounted  for using the  purchase  method.  Accordingly,  the
purchase price was allocated to assets  acquired  based on their  estimated fair
values. This treatment resulted in approximately $64.7 million of cost in excess
of net tangible  assets  acquired as of September 30, 1997. Such excess is being
amortized  on a straight  line basis over  periods  ranging up to 40 years.  The
inclusion of CMG from the date of acquisition did not have a significant  impact
on the Company's results of operations.

         Senior  Indebtedness.  As of  September  30,  1997,  $30.0  million  of
revolving loans and $8.3 million of letters of credit were outstanding under the
revolving  credit  facility of the  Company's  Credit  Agreement  with The Chase
Manhattan Bank, N.A. (the "Senior Credit  Facility"),  and  approximately  $46.7
million was available for future borrowing.

         Adjusted EBITDA.  Adjusted EBITDA, a financial measure used in the 
Senior Credit

                                                        47

<PAGE>



Facility  and the  Indenture,  increased  by $9.6  million,  or 21.3%,  to $54.7
million for fiscal 1997 from $45.1 million for 1996.

         Cash in Claims Funds and Restricted Cash. As of September 30, 1997, the
Company  had total  cash,  cash  equivalents  and  investment  balances of $95.2
million,  of which  $51.3  million was  restricted  under  certain  contractual,
fiduciary and regulatory  requirements;  moreover,  of such amount, $3.7 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, 1997,  the Company also held surplus cash balances,
classified as cash and cash equivalents and short-term marketable securities, as
required by the contracts held by the Company relating to Medicaid  programs for
the States of Iowa and Montana and the TennCare  Partners  and  Delaware  County
Medicaid programs described above.

         Availability of Cash. Prior to the 1995 Merger,  the Company 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  currently and in the future  expects to finance is
capital  requirements  through  existing  cash  balances,  cash  generated  from
operations  and  borrowings  under the revolving  credit  facility of the Senior
Credit  Facility.  Based upon the current level of cash flow 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.

         Pending  Acquisition  of MBC.  On October  24,  1997,  the  Company and
Magellan  signed the Magellan  Merger  Agreement,  under which a  subsidiary  of
Magellan will merge into the Company.  As a result of the Magellan  Merger,  the
Company will become a wholly owned  subsidiary  of Magellan.  Under the terms of
the Magellan  Merger  Agreement,  Magellan  will  purchase all of the  Company's
outstanding stock and other equity interests for  approximately  $460 million in
cash and  refinance  the  Company's  existing  debt.  Completion of the Magellan
Merger is subject to a number of  conditions,  including  Magellan's  receipt of
financing for the transaction,  the receipt of certain  healthcare and insurance
regulatory approvals, and other conditions.

Item 8.   Financial Statements and Supplementary Data

         The financial  statements of the Company set forth on pages F-1 through
F-23 hereof are incorporated herein by reference.

                                                        48

<PAGE>



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

         None

                                 PART III
---------------------------------------------------------------------------


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>

<S>     <C>    <C>    <C>    <C>    <C>    <C>
     NAME                                                  AGE          POSITION
-----------------------------------------------------  -----------  -----------------------------------------
Albert S. Waxman, Ph.D....................           57       Chairman and Chief Executive
                                                              Officer
Arthur H. Halper.............................        50       President and Chief Operating Officer
Henry R. Kravis...............................       53       Director
George R. Roberts...........................         54       Director
Edward A. Gilhuly...........................         38       Director
Todd A. Fisher.................................      32       Director
John A. Budnick, III..........................       39       Executive Vice President and Chief
                                                              Financial Officer
John P. Docherty, M.D.....................           53       Executive Vice President and Chief
                                                              Medical Officer
Ronald D. Geraty, M.D.....................           51       Executive Vice President, New Business
                                                              Development and Director
Michael G. Lenahan, Esq..................            38       Executive Vice President, Mergers &
                                                              Acquisitions, General Counsel and Secretary
David B. Stone..............................         51       President, Employer & Union
                                                              Division
Richard C. Surles, Ph.D.....................         53       President, Advanced Clinical Delivery
Terry R. Thompson..........................          39       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

                                                        49

<PAGE>



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, Inc. ("American Biodyne"),  which was acquired
by Medco  Containment  in 1992,  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.

Arthur H. Halper has served as a Director of MBC since May 1996 and as President
and Chief  Operating  Officer of MBC since August  1997.  Mr.  Halper  served as
Executive Vice President and Chief  Financial  Officer of MBC from December 1994
to August 1997, Executive Vice President, Mergers and Acquisitions,  of MBC from
November  1993 to  December  1994 and  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.

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  managing  member of the
Executive Committee of the limited liability company which serves as the General
Partner of KKR. Mr. Kravis is also a director of Amphenol Corporation, AutoZone,
Inc.,  Borden,  Inc.,  Bruno's,  Inc.,  Evenflo & Spalding  Holdings Corp.,  The
Gillette  Company,  IDEX  Corporation,  KinderCare  Learning  Center,  Inc., KSL
Recreation   Group,   Inc.,   Newsquest  Capital  PLC,   Owens-Illinois,   Inc.,
Owens-Illinois  Group,  Inc.,  Primedia Inc.,  Safeway Inc.,  Sotheby's Holdings
Inc., Union Texas Petroleum Holdings, Inc. and World Color Press, Inc.

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  managing  member of the
Executive

                                                        50

<PAGE>



Committee of the limited  liability  company which serves as the General Partner
of KKR. Mr. Roberts is also a director of Amphenol Corporation,  AutoZone, Inc.,
Borden,   Inc.,   Bruno's,   Inc.,  Evenflo  &  Spalding  Holdings  Corp.,  IDEX
Corporation,  KinderCare  Learning  Center,  Inc., KSL Recreation  Group,  Inc.,
Newsquest  Capital  PLC,  Owens-Illinois,   Inc.,  Owens-Illinois  Group,  Inc.,
Primedia 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
Corporation,  Layne Christensen Company,  Owens-Illinois,  Inc.,  Owens-Illinois
Group, 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. Mr. Fisher is also a director of Layne Christensen Company.

John A. Budnick,  III has served as Executive Vice President and Chief Financial
Officer  of MBC  since  August  1997.  Mr.  Budnick  served  as  Executive  Vice
President,  Finance from January 1997 to August 1997,  Senior Vice  President of
Finance from  January  1995 to January  1997 and Vice  President of Finance from
April 1994 to January  1995.  Prior to joining  MBC, Mr.  Budnick  worked in the
finance  department of Medco  Containment from September 1991 to April 1994. Mr.
Budnick,  a  Certified  Public  Accountant,   holds  a  B.S.degree  in  Business
Administration from Georgetown University.

John P. Docherty,  M.D. has served as Executive Vice President and Chief Medical
Officer of MBC since March 1997. Dr. Docherty  previously served as the Chief of
the Psychosocial  Treatments Research Branch of the National Institute of Mental
Health,  and has held faculty positions with Yale University,  Tufts University,
Harvard University and the University of California at Los Angeles. Dr. Docherty
founded Northeast Psychiatric Associates,  P.C., a private psychiatric practice,
where he held the position of President and Executive  Medical  Director.  He is
currently on the faculty of Cornell  University  Medical  College and chairs the
National  Institute  on Drug  Abuse  (NIDA),  Treatment  Development  and Review
Committee. Dr. Docherty holds an M.D. degree from the University of Pennsylvania
School of Medicine.

Ronald D.  Geraty,  M.D.  has served as a Director  of MBC since May 1996 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

                                                        51

<PAGE>



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.

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  (other than CMG and its  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.

David B. Stone has served as  President,  Employer  and Union  Division,  of MBC
since August 1997, as Executive  Vice President and Chief  Marketing  Officer of
MBC from June  1994 to August  1997 and 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 to 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 President, Advanced Clinical Delivery, of
MBC since August 1997 and Executive  Vice President of MBC from November 1994 to
August  1997.  Dr.  Surles  assumed the position of  Executive  Vice  President,
Service  System  Development,  of MBC in October 1995 and,  from January 1996 to
August 1997, was 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  served as a Director of MBC from October 1996 to October 1997
and as Executive Vice President,  Business Operations of MBC from September 1996
to November 1997.  Effective November 18, 1997, Mr. Thompson resigned all of his
positions and directorships with MBC and its subsidiaries.

         Messrs. Kravis and Roberts are first cousins.


                                                        52

<PAGE>



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, 1997 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.

Historical Summary Compensation Table
 
<TABLE>
<CAPTION>
<S>     <C>    <C>    <C>    <C>    <C>    <C>
                                                                                         Long Term
                                    Annual Compensation                                 Compensation
                                                                                         Securities
                                                                         Other Annual    Underlying         All Other
Named Executive Officer                 Year      Salary      Bonus      Compensation     MBC Options     Compensation(1)
                                                                                               (#)
Albert S. Waxman, Ph.D.                   1997   $558,750       ---           ---                  ---            ---
     Chairman and                         1996    435,000    $ 65,250         ---             2,800,000           ---
     Chief Executive Officer              1995    405,417      70,000         ---                  ---            ---

Terry R. Thompson                         1997    350,000       ---           ---                  ---            ---
   Executive Vice President,              1996     29,167       4,375         ---              350,000            ---
   Business Operations

Arthur H. Halper                          1997     331,250      ---           ---              150,000          $3,000
   President and                          1996     250,000     37,500         ---              150,000           1,500
   Chief Operating Officer                1995     210,000     20,625         ---                  ---           1,200

Ronald D. Geraty, M.D.                    1997     275,000      ---           ---                  ---           4,125
   Executive Vice President, New          1996     275,000     41,250         ---              300,000           1,000
   Business Development                   1995     241,750     27,125         ---                  ---             800

Michael G. Lenahan                        1997     262,750     50,000         ---              150,000           1,900
   Executive Vice President,              1996     222,634      ---           ---              150,000             950
   Mergers and Acquisitions and           1995      79,000      ---           ---                  ---             ---
   and General Counsel
----------------------
</TABLE>

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


                                                                 53

<PAGE>


Options/SAR Grants in Fiscal 1997

         The  following  table  summarizes  options to acquire  shares of Common
Stock granted in fiscal 1997 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>
                                 (#)
Albert S. Waxman               ---            ---              ---          ---              ---               ---
Ronald D. Geraty               ---            ---              ---          ---              ---               ---
Arthur H. Halper               ---            ---              ---          ---              ---               ---
Michael G. Lenahan          150,000          11.3%          $ 7.50      8/31/2007         707,506          1,792,960
Terry R. Thompson              ---            ---              ---          ---              ---               ---

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

         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, 1997.

<TABLE>
<CAPTION>
                                                                                       Value of Unexercised
                                       Number of Securities                                In the Money
                                 Underlying Unexercised Options/SARs                     ptions/SARs  at
                                         at Fiscal Year End                             Fiscal Year End(1)

<S>     <C>    <C>    <C>    <C>    <C>    <C>
                                  Shares
                                Acquired        Value
Name                           on Exercise      Realized     Exercisable     Unexercisable     Exercisable    Unexercisable
                                                                                (#)
Albert S. Waxman                  ---            ---             560,000      2,240,000            ---           ---
Ronald D. Geraty                  ---            ---              60,000        240,000            ---           ---
Arthur H. Halper                  ---            ---              60,000        240,000            ---           ---
Michael G. Lenahan                ---            ---              30,000        270,000            ---           ---
Terry R. Thompson                 ---            ---              70,000        280,000            ---           ---

</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,  1997,  based on such
     formula, no value was associated with such options.












                                                                 54

<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, 1997.

<TABLE>
<CAPTION>
                                                                                        Value of Unexercised
                              Number of Securities                                        In the Money
                       Underlying Unexercised Merck Options/SARs                         Merck Options/SARs
                                at Fiscal Year End                                      at Fiscal Year End(1)
                             Shares
                          Acquired        Value
<S>     <C>    <C>    <C>    <C>    <C>    <C>
Name                    on Exercise    Realized     Exercisable   Unexercisable               Exercisable    Unexercisable
                             (#)                     (#)                 (#)
Albert S. Waxman          10,000        $678,200       461,048         109,261               $36,244,716       $8,523,232
Ronald D. Geraty          12,100         649,260           ---             ---                      ---              ---
Arthur H. Halper          36,421       2,324,035           ---             ---                      ---              ---
Michael G.  Lenahan       36,420       2,140,039         4,316          21,711                   319,677        1,616,428
Terry R. Thompson            ---             ---           ---             ---                      ---              ---

----------------
</TABLE>

(1)  Values for "in-the-money" options represent the positive spread between the
     respective exercise prices of outstanding options and $99.938, the value of
     the common stock of Merck as of September  30, 1997, as reported on the New
     York Stock Exchange Composite Tape.

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 71.4% of MBC's outstanding Common
Stock as of  December  1,  1997.  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


                                                        55

<PAGE>



8,561,000  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 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 Magellan Merger  Agreement  provides that
the vesting of all 1995 Options will become accelerated upon consummation of the
Magellan Merger.

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,  1997  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.


                                                        56

<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 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.

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 Magellan Merger  Agreement  provides that the Board of Directors of MBC will
take such actions as are necessary to enable holders of 1996 Options to exercise
all of their outstanding 1996 Options upon consummation of the Magellan Merger.

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.  Dr. Waxman has agreed that,  subject to and upon consummation
of the Magellan Merger, he will become 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


                                                        57

<PAGE>



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  termination  or,  at his  election,  to  assume  a senior  level
position in the legal department of Medco Containment.  Mr. Lenahan's employment
agreement will terminate upon consummation of the Magellan Merger.

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 has been  automatically  renewed  according to
its terms until March 31,  1999.  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.

John P.  Docherty,  M.D. The Company has entered into an  employment  agreement,
effective March 1, 1997, with John P. Docherty, M.D. The agreement provides that
during Dr.  Docherty's  employment  with the Company he shall  receive a minimum
base salary of $250,000 per year, plus a yearly discretionary bonus. The Company
may  terminate  the agreement for cause,  if Dr.  Docherty  becomes  disabled or
without  cause.  Dr.  Docherty may terminate  the  agreement  upon not less than
thirty days' written  notice.  If the Company  terminates the agreement  without
cause prior to March 1, 2000, Dr.  Docherty will be entitled to receive his base
compensation  for a defined  period of time that is not less two  years.  If the
Company terminates the agreement without cause after March 1, 2000, Dr. Docherty
will be entitled to receive his base  compensation  for a defined period of time
that is not less one year.  In either  case,  Dr.  Docherty  will be entitled to
receive insurance and medical benefits for the same term as base compensation is
paid.

Terry R. Thompson.  The Company entered into an employment agreement,  effective
as of September 3, 1996, with Terry R. Thompson. The agreement provided that Mr.
Thompson  would 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 Company and Mr. Thompson executed a separation  agreement,  dated
November  18,  1997,  whereby Mr.  Thompson  resigned  all officer and  director
positions with the Company. Under the separation agreement, Mr. Thompson will be
paid, as severance  compensation,  his annual base salary  through  December 31,
1998. In


                                                        58

<PAGE>



addition,  Mr.  Thompson  will  retain  the  100,000  shares of Common  Stock he
purchased in 1996 and 140,000 of the 1995 Options granted to Mr. Thompson.

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  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.  In addition,  Mr.
Budnick has a severance agreement with the Company that provides that he will be
entitled to one year of base compensation if his employment is terminated by the
Company other than for "cause".

Non-Competition Agreements

In connection with the execution of the Magellan Merger  Agreement,  each of Dr.
Waxman and Messrs.  Halper,  Lenahan and Budnick entered into a  non-competition
agreements with Magellan and the Company (the "Non-Competition Agreements"). The
Non-Competition  Agreements provide that, effective upon the consummation of the
Magellan Merger,  the applicable  executive will not compete against the Company
in the  behavioral  health  managed  care and EAP business for a period of three
years after the closing of the Magellan  Merger.  In  consideration  of entering
into such  Non-Competition  Agreement,  each  executive  will  receive  payments
totaling two times his current base compensation, which payments will be in lieu
of any other severance  consideration  otherwise payable to such executive under
any  employment,  severance  or other  agreement  to which the  Company and such
executive are parties.

MBC Management Stockholder's Agreements

In connection with the 1995 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  and others 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


                                                        59

<PAGE>



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 the 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 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.

Certain  MBC  Management   Stockholder's   Agreements  also  contain  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


                                                        60

<PAGE>



"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.


                                                        61

<PAGE>




Item 12.  Security Ownership of Certain Beneficial Owners and Management

         The following table sets forth certain  information  known to MBC as of
December 1, 1997 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>
<S>     <C>    <C>    <C>    <C>    <C>    <C>

                                                                                            Percentage
                                                                            Number of        of Common
     Beneficial Owner                                                        Shares           Stock
-------------------------------------------------------------------  --------------------  -------------
KKR Associates(1)...................................................         21,000,000           71.4%
   9 West 57th Street
   New York, NY 10019
Merck & Co., Inc.(2)..................................................        4,262,800           14.5
   One Merck Drive
   Whitehouse Station, NJ 08889
The Albert S. Waxman Family
   Charitable Remainder Unitrust(3).......................................     1,000,000           3.4
Albert S. Waxman(4)........................................................    1,055,100           3.6
Ronald D. Geraty(5).........................................................     100,000           0.3
Terry R. Thompson(6)......................................................       100,000           0.3
Arthur H. Halper(7).........................................................     100,000           0.3
Michael G. Lenahan(8)......................................................      100,000           0.3
All directors and executive officers as a group (9 persons)(9).............    1,677,100           5.7
                                                                       --------------------  ------------
  Total...................................................................    27,939,900          95.0%
</TABLE>

(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  1,120,000  shares of Common Stock that
are exercisable within 60 days of the date hereof.


                                                        62

<PAGE>



(5) Does not include  options to acquire 120,000 shares of Common Stock that are
exercisable within 60 days of the date hereof.

(6) Does not include  options to acquire 140,000 shares of Common Stock that are
exercisable within 60 days of the date hereof.

(7) Does not include  options to acquire 120,000 shares of Common Stock that are
exercisable within 60 days of the date hereof.

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

(9) Does not include options to acquire  1,707,200 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 71.4% of MBC's
outstanding  Common Stock as of December 1, 1997.  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 $5.5 million for negotiating the 1995 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 renders  management,  consulting  and  financial  services to the
Company.  During  fiscal 1997 and 1996,  KKR  received  $500,000  and  $400,000,
respectively,  in fees for such  services.  Executives  of KKR who also serve as
directors of the Company receive customary directors' fees. Upon consummation of
the Magellan Merger,  KKR will receive a financial advisory fee from MBC of $5.0
million.

         In connection with the 1995 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 1995  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 1995 Merger, 
certain MBC Management Stockholders borrowed all or a portion of the purchase
price for the Plan Shares acquired by them pursuant to


                                                        63

<PAGE>



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 their purchases of Common Stock, Mr. Thompson,  Mr. Halper,  Mr.
Budnick,  Mr. Lenahan and Dr. Docherty borrowed  $500,000,  $250,000,  $375,000,
$375,000  and  $80,000,  respectively.  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,  Mr.  Thompson,  Mr. Halper,  Mr.
Budnick and Dr.  Docherty  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, Dr. Geraty repaid
his loan in October 1996 and Mr. Lenahan  repaid his loan in October 1997.  Upon
consummation of the Magellan Merger,  all such outstanding  loans will be repaid
in full.

         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
1995  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 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
1995 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 1995 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.


                                                        64

<PAGE>




         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 1995 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 1995 Merger.

         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.


                                                        65

<PAGE>


<TABLE>
<CAPTION>
<S>     <C>    <C>    <C>    <C>    <C>    <C>

                                          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 F-1.

         (2)      Financial Statement Schedules.  See accompanying Index to Financial Statements and Financial
                  Statement Schedules on page F-1.

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

  Exhibit                                                                                            Sequentially
 Number                                               Description                                    Numbered Pages
-----------       ----------------------------------------------------------------------         --------------------
     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.
     2.3          Agreement and Plan of Merger by and among Merit Behavioral Care                             *
                  Corporation, Merit Merger Corp., and CMG Health, Inc. dated as of
                  July 14, 1997.
     2.4          Form of Stockholder Support Agreement by and between Humana, Inc.                           *
                  in favor of Merit Behavioral Care Corporation, Merit Merger Corp., and
                  CMG Health, Inc. dated as of July 14, 1997.
     2.5          Form of  Stockholder  Support  Agreement,  by and  between  and                             *
                  individual in favor of Merit  Behavioral  Care  Corporation,
                  Merit Merger Corp., and CMG Health, Inc.
                  dated as of July 14, 1997.
     2.6          Agreement and Plan of Merger, dated as of October 24, 1997, among                           *
                  Merit Behavioral Care Corporation, Magellan Health Services, Inc.
                  and MBC Merger Corporation.
     2.7          Stockholder Support Agreement, dated as of October 24, 1997, by MBC                         **
                  Associates, L.P., KKR Partners II, L.P., 38 Newbury Ventures/MBC Limited
                  Partnership, Albert S. Waxman and the Albert S. Waxman Family Charitable
                  Remainder Unitrust to and for the benefit of Magellan Health Services, Inc.
     2.8          Form of  Non-Competition  Agreement,  dated as of October  24,
                  1997, among Magellan Health Services, Inc., MBC and certain                                 **
                  key individual employees of MBC.
     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 trustee,                            *


                                                                 66

<PAGE>



                  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,
                  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


                                                                 67

<PAGE>



                  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                             *
                  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)


                                                                 68

<PAGE>



   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.
   10.38          Employment and Consulting Agreement  by and between CMG Health, Inc.,
                  and  Alan J. Shusterman dated July 14, 1997.                                                    *
    10.39         Letter Agreement by and between Douglass A. Kay, M.D. and CMG Health, Inc.
                  and Merit Behavioral Care Corporation.                                                          *
    10.40         Employment Agreement by and between the Company and John P. Docherty,
                  M.D., dated as of November 26, 1996.                                                            **
    25.1          Statement of Eligibility and Qualification (Form T-1) under the Trust                           *
                  Indenture Act of 1939 of Marine Midland Bank.
    27.1          Financial Data Schedule (electronic filing only).                                               **
 ----------------------

 *   Filed previously.
 ** Filed herewith.
</TABLE>
<TABLE>
<CAPTION>

<S>     <C>    <C>    <C>    <C>    <C>    <C>

         (4)      Reports on Form 8-K.

                  1.       Current Report on Form 8-K filed July 18, 1997 related to the Company's agreement to acquire
                           CMG Health, Inc.

                  2.       Current Report on Form 8-K filed July 29, 1997 related to the Company's corporate restructuring.

                  3.       Current Report on Form 8-K filed September 17, 1997 related to the closing of the acquisition of
                           CMG Health, Inc.

                  4.       Current Report on Form 8-K filed October 29, 1997 related to Magellan Health Services, Inc.
                           agreement to acquire the Company.



                                                                 69

<PAGE>



                  5.       Current  Report on Form 8-K filed  November  19, 1997
                           related to the Company's Management's  Discussion and
                           Analysis  of  Financial   Condition  and  Results  of
                           Operations  and  Audited  Financial  Statements  also
                           filed as part of this Annual Report on Form 10-K.


</TABLE>
                                                                 70

<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, Ph.D.
                                  Albert S. Waxman, Ph.D.
                                  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.
<TABLE>
<CAPTION>
<S>     <C>    <C>    <C>    <C>    <C>    <C>

Signature                                        Title                                       Date


/s/ Albert S. Waxman, Ph.D.                      Chairman and Chief                          December 29, 1997
Albert S. Waxman, Ph.D.                          Executive Officer


/s/ Arthur H. Halper                             President,                                  December 29, 1997
Arthur H. Halper                                 Chief Operating Officer
                                                 and Director

/s/ Ronald D. Geraty                             Executive Vice President,                   December 29, 1997
Ronald D. Geraty                                 New Business Development
                                                 and Director

/s/ Henry R. Kravis                              Director                                    December 29, 1997
Henry R. Kravis


/s/ George R. Roberts                            Director                                    December 29, 1997
George R. Roberts


/s/ Edward A. Gilhuly                            Director                                    December 29, 1997
Edward A. Gilhuly


/s/ Todd A. Fisher                               Director                                    December 29, 1997
Todd A. Fisher

</TABLE>

                                                                 71

<PAGE>
<TABLE>
<CAPTION>
<S>     <C>    <C>    <C>    <C>    <C>    <C>


                                         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
</TABLE>

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.








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, 1997 and 1996,  and the
related consolidated  statements of operations,  stockholders'  equity, and cash
flows for each of the three years in the period ended September 30, 1997.  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, 1997 and 1996, and the results of its operations
and its cash flows for each of the three years in the period ended September 30,
1997, in conformity with generally accepted accounting principles.

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
Deloitte & Touche

November 12, 1997

New York, New York

<PAGE>


<TABLE>
<CAPTION>
                                         MERIT BEHAVIORAL CARE CORPORATION
                                            CONSOLIDATED BALANCE SHEETS
                                              (dollars in thousands)


                                                                                    September 30,

<S>                                                                                <C>          <C>
                                                                                   1997         1996
   ASSETS
Current Assets:
Cash and cash equivalents..............................................         $ 87,368     $ 47,375
Accounts receivable, net of allowance for doubtful accounts of $2,603
 and $1,996............................................................           41,884       28,383
Short-term marketable securities.......................................            4,111          ---
Deferred income taxes..................................................            6,616        2,296
Other current assets..................................................            13,129        2,481
    Total current assets...............................................          153,108       80,535

Property, plant and equipment, net.....................................           83,312       67,880
Goodwill and other intangibles, net of accumulated amortization of
     $82,637 and $59,781...............................................          195,192      162,849
Restricted cash and investments........................................            3,727        5,668
Deferred financing costs, net of accumulated amortization of $2,484
     and $1,142........................................................           10,634       11,362
Other assets...........................................................           22,772       16,507
Total assets...........................................................         $468,745     $344,801

    LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable.......................................................         $ 11,347     $  5,888
Claims payable........................................................           102,834       57,611
Deferred revenue.......................................................            8,131        6,577
Accrued interest.......................................................            5,161        5,008
Current portion of long-term debt......................................            6,498          500
Other current liabilities..............................................           18,386       13,079
      Total current liabilities........................................          152,357       88,663

Long-term debt.........................................................          323,002      253,500
Deferred income taxes..................................................           15,388       30,669
Other long-term liabilities............................................            3,862        1,451

Commitments and Contingencies (See Note 11)

Stockholders' Equity:
Common stock (40,000,000 shares authorized, $0.01 par value,
   29,396,158 and 28,398,800 shares issued)............................              294          284
Additional paid in capital.............................................            8,949       (9,756)
Accumulated deficit....................................................          (28,307)     (14,435)
Notes receivable from officers.........................................           (6,800)      (5,470)
                                                                                 (25,864)     (29,377)
Less common stock in treasury  (21,000 shares).........................              ---         (105)
   Total stockholders' equity..........................................          (25,864)     (29,482)
Total liabilities and stockholders' equity.............................         $468,745     $344,801

                   The  accompanying   notes  are  an  integral  part  of  these
statements.
</TABLE>

<PAGE>
<TABLE>

<CAPTION>
                                             MERIT BEHAVIORAL CARE CORPORATION
                                           CONSOLIDATED STATEMENTS OF OPERATIONS
                                                 YEARS ENDED SEPTEMBER 30,
                                                  (dollars in thousands)

<S>                                                     <C>                   <C>                    <C>
                                                        1997                  1996                   1995

Revenue.....................................          $555,717              $457,830              $361,549
Expenses:
  Direct service costs......................           449,563               361,684               286,001
  Selling, general and administrative.......            67,450                64,523                49,823
  Amortization of intangibles...............            26,897                25,869                21,373
  Restructuring charge......................               ---                 2,995                   ---
                                                       543,910               455,071               357,197
Operating income............................            11,807                 2,759                 4,352
Other income (expense):
  Interest income and other.................             3,497                 2,838                 1,498
  Interest expense..........................           (25,063)              (23,826)                  ---
  Loss on disposal of subsidiary............            (6,925)                  ---                   ---
  Merger costs and special charges..........            (1,314)               (3,972)                  ---
                                                       (29,805)              (24,960)                1,498
(Loss) income before income taxes and
    cumulative effect of accounting change..           (17,998)              (22,201)                5,850
(Benefit) provision for income taxes........            (4,126)               (5,332)                4,521
(Loss) income before cumulative effect
  of accounting change......................           (13,872)              (16,869)                1,329
Cumulative effect of accounting change
  for deferred contract start-up costs, net
  of tax benefit of $757....................               ---                (1,012)                  ---
Net (loss) income...........................         $ (13,872)            $ (17,881)             $  1,329
Pro forma net (loss) income  assuming the new method of accounting  for deferred
  contract start-up costs was applied
  retroactively.............................         $ (13,872)            $ (16,869)            $     317

                             The  accompanying  notes  are an  integral  part of
these statements.
</TABLE>

<PAGE>
<TABLE>

 <CAPTION>
                                           MERIT BEHAVIORAL CARE CORPORATION
                                      CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                                                  (dollars in thousands)

                                                                                 Retained Earnings    Notes
                                                     Common Stock       Additional  (Accumulated    Receivable      Common Stock
<S>     <C>    <C>    <C>    <C>    <C>    <C>
                                                 Shares       Amount Paid In Capital  Deficit)     from Officers    in Treasury

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              ---
Cancellation of 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)
Issuance of stock for CMG acquisition.......       739,358       7         5,538          ---          ---              ---
Tax benefit from exercise of Merck
    stock options...........................          ---      ---        11,630          ---          ---              ---
Repayment of notes receivable...............          ---      ---           ---          ---          250              ---
Repurchase of common stock..................          ---      ---           ---          ---          ---              (30)
Sale of common stock........................       258,000       3         1,537          ---       (1,580)             135
Net loss....................................          ---      ---           ---      (13,872)         ---              ---
Balance September 30, 1997..................    29,396,158 $   294       $ 8,949     $(28,307)    $ (6,800)        $    ---




                             The  accompanying  notes  are an  integral  part of
these statements.

</TABLE>

<PAGE>


<TABLE>

<CAPTION>
                                             MERIT BEHAVIORAL CARE CORPORATION
                                           CONSOLIDATED STATEMENTS OF CASH FLOWS
                                                 YEARS ENDED SEPTEMBER 30,
                                                  (dollars in thousands)

<S>                                                       <C>                   <C>                   <C>
                                                          1997                  1996                  1995
CASH FLOWS FROM OPERATING
  ACTIVITIES:
Net (loss) income................................         $(13,872)             $(17,881)              $ 1,329
Adjustments to reconcile net (loss) income to
  net cash provided by operating activities:
  Loss on sale of subsidiary.....................            6,925                  ---                   ---
  Cumulative effect of accounting change.........             ---                  1,012                  ---
  Depreciation and amortization..................           39,400                36,527                28,150
  Amortization of deferred financing costs.......            1,342                 1,142                  ---
  Deferred taxes and other.......................           (4,409)               (6,068)                 379
  Restructuring charge...........................              ---                 2,995                  ---
Changes in operating assets and liabilities, net of the effect of acquisitions:
  Accounts receivable............................           (9,781)                  265                (8,545)
  Other current assets...........................           (2,854)                  536                  (995)
   Deferred contract start-up costs..............           (6,067)               (4,816)               (6,231)
   Accounts payable and accrued liabilities......           16,224                14,864                11,982
Net cash provided by operating activities........           26,908                28,576                26,069
CASH FLOWS FROM INVESTING
  ACTIVITIES:
  Purchases of property, plant and equipment.....          (23,951)              (23,808)              (31,529)
  Cash used for acquisitions, net of cash
      acquired...................................          (35,645)              (12,676)               (9,580)
  Investments in and advances to joint ventures..           (2,595)               (2,931)              (14,860)
  Repayments of advances from joint ventures.....              675                   420                   ---
  Sales (purchases) of marketable securities.....           (4,111)                1,143                 3,533
  Long-term restrictions removed from
     (placed on) cash............................            1,941                (2,183)                 (211)
 Change in non-current assets and other..........            1,558                (1,282)               (1,503)
 Net cash used for investing activities..........          (62,128)              (41,317)              (54,150)
CASH FLOWS FROM FINANCING
  ACTIVITIES:
  Proceeds from capital contribution.............            ---                 114,980                   ---
  Borrowings from parent.........................            ---                    ---                 32,882
  Proceeds from bridge loan......................            ---                  75,000                   ---
  Proceeds from revolving credit facility........          187,500               163,500                   ---
  Proceeds from senior term loans................           80,000               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 senior term loans.................             (500)                  ---                   ---
  Repayment of revolving credit facility.........         (191,500)             (129,500)                  ---
  Payment of financing costs.....................             (602)              (12,504)                  ---
  Other..........................................              315                   125                   ---
  Net cash provided by financing activities......           75,213                30,585                32,882
 INCREASE IN CASH AND
  CASH EQUIVALENTS...............................           39,993                17,844                 4,801
  Cash and cash equivalents at beginning
  of year........................................           47,375                29,531                24,730
CASH AND CASH EQUIVALENTS AT
  END OF YEAR....................................         $ 87,368              $ 47,375               $29,531

                             The  accompanying  notes  are an  integral  part of
these statements.
</TABLE>

<PAGE>

                     MERIT BEHAVIORAL CARE CORPORATION

          NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)

                     MERIT BEHAVIORAL CARE CORPORATION
                NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                      SEPTEMBER 30, 1997, 1996 AND 1995
                           (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"). 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 obtained  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% 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.

<PAGE>

3.  BASIS OF PRESENTATION--(Continued)

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.

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, 1997 and 1996 is $11,020
and  $11,713,  respectively,  of cash held under the terms of  certain  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, 1997 and 1996 was $6,197
and $4,267, respectively.

The Company held  surplus  cash  balances of $29,325 and $13,715 as of September
30, 1997 and 1996, respectively, as required by contracts with various state and
local governmental  entities.  In addition,  at September 30, 1997 and 1996, the
Company  held  surplus  cash  balances  of $3,137 and $1,214,  respectively,  as
required by various other contracts.  These contracts require the segregation of
such cash as  financial  assurance  that the  Company  can meet its  obligations
thereunder.

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 required to be retained for the use of this subsidiary. Included in cash and
cash  equivalents  at September 30, 1997 and 1996 is $0 and $900,  respectively,
under such requirements.


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

Short-Term Marketable Securities

Short-term  marketable  securities consist of treasury notes and certificates of
deposit,  carried at amortized cost which  approximates  fair value.  All of the
Company's short-term  marketable  securities are classified as held-to-maturity.
The Company held  short-term  marketable  securities  in the amount of $4,011 at
September  30, 1997 as required by the Company's  contract  with a  governmental
entity.

Restricted Cash

At September  30, 1997 and 1996,  $6,623 and $7,168,  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 $3,559 and $5,510 at September
30, 1997 and 1996, 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.

All  of  the  Company's  long-term  marketable  investments  are  classified  as
held-to-maturity;  in addition,  such  investments are carried at amortized cost
which approximates fair value.

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:
<TABLE>
<CAPTION>
<S>     <C>    <C>    <C>    <C>    <C>    <C>

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

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

The integrated managed care information  system (the "System")  represents costs
incurred in the development and adaptation of AMISYS(R)  software for use in the
Company's  business.  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 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.

<PAGE>


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

Goodwill and intangible  assets consisted of the following at September 30, 1997
and 1996:
<TABLE>
<CAPTION>

<S>                                                                       <C>              <C>
                                                                          1997             1996
                                                                          ----             ----
                  Customer Contracts..........................          $ 88,074         $ 80,000
                  Provider Network............................            12,000           12,000
                  Trade Names and other.......................            20,000           20,000
                  Goodwill....................................           157,755          110,630
                                                                        $277,829         $222,630
</TABLE>

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,  1997 and  1996 of 4.3 and 3.3  years,
respectively.  Amortization  of  deferred  contract  start-up  costs was $3,096,
$2,848,  and $1,315 for the periods ended  September 30, 1997,  1996,  and 1995,
respectively.  During the periods ended September 30, 1997,  1996, and 1995, the
Company  deferred  contract  start-up  costs  of  $6,067,  $4,816,  and  $6,231,
respectively.  Other non-current assets include $9,036 and $6,077 of unamortized
deferred contract start-up costs at September 30, 1997 and 1996, 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 contract period. The
change was made to  increase  the focus on  controlling  costs  associated  with
contract start-ups.

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. The effect
of the change on fiscal 1996 and 1997 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  Employee  Assistance  Program  ("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

<PAGE>


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

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,  various  charges  associated  with the
Company's  staff offices,  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,  adjudication decisions 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.

Long-Lived Assets

The Financial Accounting Standards Board issued SFAS No. 121, Accounting for the
Impairment of Long-Lived  Assets and for Long-Lived Assets to Be Disposed Of, in
March 1995.  The general  requirements  of this  statement are applicable to the
properties  and  intangible  assets of the Company and require  impairment to be
considered  whenever  events  or  changes  in  circumstances  indicate  that the
carrying  amount  of an asset  may not be  recoverable.  If the sum of  expected
future cash flows  (undiscounted  and without interest charges) is less than the
carrying  amount of the asset,  an impairment  loss is  recognized.  The Company
adopted  this  standard  on October  1, 1996.  No  impairment  losses  have been
identified by the Company.

Stock-Based Compensation Plans

During fiscal 1997, the Company adopted SFAS No. 123, Accounting for Stock-Based
Compensation  ("SFAS  123").  The new  standard  defines a fair value  method of
accounting  for stock  options and similar  equity  instruments.  Under the fair
value method,  compensation cost is measured at the grant date based on the fair
value of the award and is recognized over the service  period,  which is usually
the vesting period. As permitted by SFAS 123,  however,  the Company has elected
to continue to recognize and measure compensation for its stock rights and stock
option plans in accordance with the existing provisions of Accounting Principles
Board Opinion No. 25,  Accounting for Stock Issued to Employees  ("APB 25"). See
Note 16 for pro forma disclosures of net loss as if the fair value-based  method
prescribed by SFAS No. 123 had been applied.

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

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's  short-term  marketable  securities  and
long-term   marketable   investments   are  carried  at  amortized   cost  which
approximates  fair value.  The  carrying  amount of loans made to certain  joint
ventures  engaged in the development of 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 $109,000
at September  30, 1997 (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:
<TABLE>
<CAPTION>

<S>                                                                        <C>              <C>
                                                                           1997             1996
                                                                           ----             ----
         Machinery and equipment..............................          $ 58,988         $ 44,896
         Integrated managed care information system...........            38,914           28,349
         Furniture and fixtures...............................            16,665           12,795
         Leasehold improvements...............................             3,443            2,977
                                                                         118,010           89,017
         Accumulated depreciation and
           amortization.......................................           (34,698)         (21,137)
                                                                         $83,312          $67,880

Depreciation and amortization  related to property,  plant and equipment was $12,503,  $10,658,  and $6,776 for the periods
ended September 30, 1997, 1996, and 1995, respectively.
</TABLE>

6.  LONG TERM DEBT

Long-term debt consisted of the following at September 30:
<TABLE>
<CAPTION>

<S>                                                                   <C>               <C>
                                                                      1997              1996
                                                                      ----              ----
                  Revolving Loans ...................             $  30,000         $  34,000
                  Senior Term Loan A.................                70,000            70,000
                  Senior Term Loan B.................               129,500            50,000
                  Notes..............................               100,000           100,000
                                                                    329,500           254,000
                  Less current portion...............                (6,498)             (500)
                                                                   $323,002          $253,500
</TABLE>

<PAGE>

6.    LONG-TERM DEBT--(Continued)

Senior  Credit  Facility - In October  1995,  the Company  entered into a credit
agreement (the "Credit Agreement"), which provided for secured borrowings from a
syndicate of lenders.  The Senior Credit Facility  consisted  initially of (i) a
six  and  one-half  year  revolving  credit  facility  (the  "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"), and a $50,000 senior term loan with a maturity of eight years ("Senior
Term Loan B"). On September  12, 1997,  the Senior Term Loan B was  increased by
$80,000 to $130,000  with the  maturity  extended one and  one-half  years.  The
additional  borrowings  from Senior Term Loan B were primarily  obtained to fund
the  acquisition  of CMG  Health,  Inc.  ("CMG"),  as  discussed  in  Note 8. At
September  30,  1997,  $30,000  of  revolving  loans and five  letters of credit
totaling  $8,313 were  outstanding  under the  Revolving  Credit  Facility,  and
approximately $46,687 was available for future borrowing. 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 borrowings.

In October  1996, a scheduled  repayment of $500 was made on Senior Term Loan B.
The annual  amortization  schedule  of the Senior  Term Loans is $6,498 in 1998,
$10,000 in 1999,  $12,500 in 2000, $20,000 in 2001, $25,000 in 2002 and $125,502
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. Proceeds in the
amount of $4,735  received in October 1997 as a result of the disposal of one of
the  Company's  subsidiaries  (See Note 17) have been  classified  as current in
accordance with the mandatory prepayment loan provision.  At September 30, 1997,
approximately  $662 has been  classified as current in accordance with mandatory
prepayment requirements for Excess Cash Flow.

The Company is charged a commitment fee calculated at an  EBITDA-dependent  rate
ranging from 0.250% 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 8.1%
and 8.3% for the years ended September 30, 1997 and 1996, respectively.

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 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.


<PAGE>

6.    LONG-TERM DEBT-- (Continued)

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 any
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 certain of the Company's subsidiaries.

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  $1,615  were made to officers  for the  purchase of
shares of common  stock.  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.  Notes receivable totaling
$250 and $265 were repaid during the periods ended  September 30, 1997 and 1996,
respectively.  Also a note for $100 was  canceled in January 1996 for receipt of
shares of common stock. The remaining  outstanding notes are due as follows: $20
in 1998 and $6,780 in 2001. The notes are shown as a reduction of  stockholders'
equity in the accompanying consolidated balance sheets.

8.  ACQUISITIONS

On September 12, 1997,  the Company paid an initial  $48,740 and issued  739,358
shares of Company  common  stock to acquire all of the  capital  stock of CMG, a
Maryland-based   provider  of  managed  behavioral   healthcare  services.   The
acquisition  was  accounted  for as a  purchase  transaction.  The  consolidated
financial  statements of the Company  include the operating  results of CMG from
the date of the acquisition. The purchase price for CMG was allocated to the net
assets acquired based upon their estimated fair values. The Company common stock
issued in the  acquisition  was  assigned a value of $7.50 per share  based on a
valuation  analysis  performed by an independent  third party. The excess of the
purchase price over the net tangible assets acquired  amounted to $64,715 and is
being amortized over periods up to 40 years using the straight-line  method. The
purchase price allocation was based on preliminary  estimates and may be revised
upon final  valuation.  The Company is obligated to make contingent  payments to
the former  shareholders  of CMG if the financial  results of certain  contracts
exceed specified  base-line amounts.  Such contingent payments are subject to an
aggregate maximum of $23,500.  Any such additional  payments will be recorded as
goodwill.

The  following  summary  of the  unaudited  pro forma  consolidated  results  of
operations  of the  Company  for the years  ended  September  30,  1997 and 1996
assumes the CMG  acquisition  occurred  as of the  beginning  of the  respective
periods.  The pro forma results include the combined  historical  results of the
Company  and CMG,  and pro forma  adjustments  to reflect (i)  interest  expense
associated  with the debt incurred to finance the  acquisition,  (ii) changes to
depreciation  and  amortization  related to the allocation of the cost of CMG to
the assets  acquired and liabilities  assumed and (iii)  reductions of salaries,
benefits and certain other costs included in the historical results of CMG which
will be eliminated as a result of the acquisition.  These pro forma results have
been prepared for comparative  purposes only and do not purport to be indicative
of the  results  of  operations  which  actually  would  have  resulted  had the
acquisition  occurred at the beginning of the respective  periods,  or which may
result in the future. 
<TABLE>
<CAPTION>
<S>     <C>    <C>    <C>    <C>    <C>    <C>

                                                                     1997             1996
                  Revenue............................              $653,477          $522,857
                  Net loss...........................               (15,048)          (16,939)

</TABLE>

<PAGE>


8.  ACQUISITIONS--(Continued)

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 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.

On October 5, 1995,  the Company paid an initial $8,730 to acquire Choate Health
Management,  Inc. and certain related entities ("Choate"), a Massachusetts-based
integrated  behavioral  healthcare  organization.  The Company made a contingent
consideration  payment  of $1,278 to the former  shareholders  of Choate in July
1996;  such payment was recorded as goodwill.  In June 1997, the Company and the
former Choate shareholders signed an agreement which provided for the settlement
of the contingent  consideration  related to Choate.  Such agreement required no
further  payments by the  Company.  Choate was sold by the Company in  September
1997 (See Note 17).

In  September  1995,  a  contingent  payment  of $8,550  was made to the  former
shareholders of BenesYs, a subsidiary of the Company,  in full settlement of any
and all contingent consideration due to such former shareholders. In April 1995,
a final  payment of $650 was made  related to the  acquisition  of the  clinical
protocols of the Washton Institute.

9.  JOINT VENTURES

CMG,  which was  acquired  on  September  12,  1997,  is a 50% partner in CHOICE
Behavioral  Health  Partnership  ("Choice"),  a  managed  behavioral  healthcare
company.  The Company  reports its investment in Choice using the equity method.
Although the Company  reports its share of earnings from the joint venture,  the
financial  statements of Choice are not consolidated  with those of the Company.
All revenue of the joint venture is from a contract for the Civilian  Health and
Medical Program of the Uniformed Services ("CHAMPUS") with Humana, Inc.

Summarized financial information of the joint venture,  representing 100% of its
business,  as of September  30, 1997 and for the period from  September 12, 1997
through September 30, 1997, is as follows:

<TABLE>
<CAPTION>
<S>     <C>    <C>    <C>    <C>    <C>    <C>

         Current Assets                     $  38,286         Net Revenues                        $  3,333
         Non-Current Assets                       700         Cost of Providing Services             2,973
           Total Assets                     $  38,986
                                            =========
                                                              Gross Profit                             360
         Total Liabilities                  $  37,141
         Partners' Capital                      1,845         Other Expenses                           106
           Total Liabilities & P.C.         $  38,986         Net Income                          $    254
                                            =========                                             ========
</TABLE>

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 December  1996,
the Company converted the $1,375 loan and the accrued interest receivable on the
loan of $369 into an equity  interest  in CSS,  and made an  additional  capital
contribution  of $500.  Additionally,  in February 1997 the Company  contributed
capital of $350 and loaned CSS $150. As of September 30, 1997, the Company has a
net loan receivable from CSS of $450 and an equity investment in CSS of $2,719.

9.    JOINT VENTURES--(Continued)

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
CHN's Medicaid program development costs. As of September 30, 1997 and 1996, the
Company had net advances to CHN outstanding of $1,732 and $2,079, respectively.

Also, 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
a portion of NHP's Medicaid program  development  costs in the form of $1,500 in
unsecured  debt. As of September 30, 1997 and 1996, the Company had net advances
of $1,500 to NHP.

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 Empire enrollees in the State of New York for a period of
eight 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 the Company and
NHP each holds a 50% equity interest.  Royal has management  services  contracts
with certain  organizations  including NHP and Empire Community Delivery Systems
LLC ("ECDS"). During fiscal 1996, the Company made an equity contribution and an
unsecured  working  capital  loan to Royal  in the  amounts  of $200  and  $228,
respectively.  During  fiscal  1997,  the  Company  made an  additional  capital
contribution of $100 to Royal.

ECDS,  which was formed in fiscal 1996, is a joint venture  company in which the
Company, NHP and Empire hold interests of approximately 16.7%, 16.7%, and 66.6%,
respectively. The Company made capital contributions to ECDS in 1997 and 1996 of
$667 and $458,  respectively.  Also, in 1997 and 1996 the Company provided loans
to NHP, the proceeds of which were used to fund NHP's capital  contributions  to
ECDS,  of $667 and $458,  respectively.  The loans to NHP are  secured  by NHP's
interest in ECDS.  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 receivables  from, and the investments in, CSS, NHP, CHN, Royal and ECDS are
reflected in "other assets" in the accompanying balance sheets.


<PAGE>


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:
<TABLE>
<CAPTION>

<S>                                                        <C>             <C>              <C>
                                                           1997            1996             1995
                                                           ----            ----             ----
         Current:
              Federal................................  $   ---            $  ---           $3,030
              State..................................      283               736            1,112
                                                           283               736            4,142
         Deferred :
              Federal ...............................   (4,848)           (5,495)             200
              State..................................      439              (573)             179
                                                        (4,409)           (6,068)             379
         Total.......................................  $(4,126)         $ (5,332)          $4,521
</TABLE>

The differences  between the U.S.  federal  statutory tax rate and the Company's
effective tax rate are as follows:
<TABLE>
<CAPTION>

<S>                                                           <C>            <C>               <C>
                                                              1997           1996              1995
                                                              ----           ----              ----

         U.S. federal statutory tax rate.............      (35.0)%           (35.0)%           35.0%
         State income taxes (net of federal benefit).        0.6               0.4             14.4
         Capital loss................................        6.9               ---              ---
         Merger expenses.............................        ---               5.8              ---
         Goodwill....................................        3.1               2.3             13.1
         Expenses without tax benefit...............         1.6               2.0             13.9
         Other.......................................       (0.1)              0.5              0.9
         Effective tax rate..........................      (22.9)%           (24.0)%           77.3%
                                                           =====             =====             ====
</TABLE>

At  September  30,  1997  and  1996,   the  Company  had  $46,733  and  $23,707,
respectively,   of  deferred   income  tax  assets  and  $55,505  and   $52,080,
respectively,  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>
<S>     <C>    <C>    <C>    <C>    <C>    <C>

                                                              1997                                  1996
                                                 Current         Non Current          Current          Non Current
                                                  Asset           Liability            Asset            Liability

Provision for estimated expenses............     $   7,023      $       507          $   2,630          $  2,161
Capitalized expenses........................          (407)          (1,224)              (334)           (1,436)
Net operating loss carryforwards............        ---              28,502             ---                9,170
Accelerated depreciation....................        ---             (20,194)            ---              (14,605)
Intangible asset differences................        ---             (22,979)            ---              (25,959)
                                                  $  6,616        $ (15,388)         $   2,296          $(30,669)
                                                  ========        =========          =========          ========
</TABLE>

Management believes that the deferred tax assets will be fully realized based on
future  reversals  of  existing  taxable  temporary  differences  and  projected
operating results of the Company.  As a result, no valuation  allowance has been
provided. At September 30, 1997, the Company had U.S. federal net operating loss
carryforwards of approximately $76,630 for tax purposes. Approximately $5,920 of
the carryforwards  expire in 2010,  $21,460 expire in 2011 and $49,250 expire in
2012.

<PAGE>

11.  COMMITMENTS AND CONTINGENCIES

a. Leases

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

At  September  30,  1997,  the  minimum   aggregate  rental   commitments  under
noncancelable leases, excluding renewal options, are as follows:
<TABLE>
<CAPTION>

<S>               <C>                                                       <C>
                  1998.................................................     $13,469
                  1999.................................................      11,606
                  2000.................................................       9,892
                  2001.................................................       8,699
                  2002.................................................       6,382
                  Thereafter...........................................      18,219
                  Minimum lease payments...............................      68,267
                  Less amounts representing sublease income............      (2,060)
                                                                            $66,207
</TABLE>

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,
1997, 1996 and 1995 amounted to $15,842, $13,059 and $10,115, 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,  1997,  excluding
bonuses, was approximately $2,735.

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.
In January 1997, Defendants filed a motion to dismiss the complaint. On July 21,
1997, a court-appointed  magistrate judge issued a report and  recommendation to
the District Court recommending that Defendants' motion to dismiss the complaint
with prejudice be granted. On August 5, 1997, plaintiffs filed objections to the
magistrate judge's report and recommendation;  such objections have not yet been
heard. 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.

11.   COMMITMENTS AND CONTINGENCIES--(Continued)

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.

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, 1998;  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.

e.  CHAMPUS Contract

On April 1, 1997, the Company began providing  mental health and substance abuse
services,  as a  subcontractor,  to beneficiaries of CHAMPUS in the Southwestern
and Midwestern  United States,  designated as CHAMPUS Regions 7 and 8. The fixed
monthly  amounts  that the Company  receives  for  medical  costs and records as
revenue  are  subject  to a  one-time  retroactive  adjustment  scheduled  to be
determined in August 1998 based upon actual  healthcare  utilization  during the
period known as the "data collection period".  The data collection period is the
year ended  March 31,  1997.  Because of the  inherent  uncertainty  surrounding
factors  included  in the  determination  of the final  retroactive  adjustment,
management  has not been able to quantify a range of potential  adjustment,  and
accordingly  no  adjustments  have been  recorded as of September 30, 1997. As a
result,  the amount of recorded revenue and income from the CHAMPUS contract may
differ  significantly  from the amount  that would  have been  recorded  had the
actual factors been known.

12.  RELATED PARTY TRANSACTIONS

During the period ended September 30, 1997, the Company paid consulting fees and
board fees to KKR totaling approximately $500. 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.

Prior to the  merger,  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
and certain acquisition transactions described in Note 8.

Included in expense for the periods ended  September 30, 1997, 1996 and 1995 are
charges  totaling  $1,467,   $1,218  and  $703,   respectively,   related  to  a
prescription drug benefit program administered by Medco.
<PAGE>


12.  RELATED PARTY TRANSACTIONS--(Continued)

The average balance due to the parent (Medco) for fiscal 1995 was $40,996;  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:
<TABLE>
<CAPTION>

<S>                             <C>                                           <C>
         Due to parent, October 1, 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.....................                $     ---

</TABLE>

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  the field and
administrative   management  organization  of  Continuum  Behavioral  Healthcare
Corporation,  a subsidiary of the Company.  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  that 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  was
comprised  primarily of accruals for employee  severance,  real  property  lease
terminations  and write-off of certain  assets in geographic  markets which were
being exited. The restructuring  plan was substantially  completed during fiscal
1997.

14.  MAJOR CUSTOMERS

For fiscal 1997,  revenue derived from a state Medicaid  contract  accounted for
approximately 12% of the Company's operating revenues. For fiscal 1996 and 1995,
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 50% (25% for periods
prior to January 1, 1997) 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, 1997, 1996 and 1995 was $1,289, $542 and $330, respectively.

16.  STOCK OPTIONS AND AWARDS

Effective October 1, 1996, the Company adopted SFAS No. 123. As permitted by the
standard,  the Company has elected to continue  following the guidance of APB 25
for  measurement  and  recognition of stock-based  transactions  with employees.
Accordingly,  no compensation  cost has been recognized for the Company's option
plans. Had the  determination of compensation cost for these plans been based on
the fair value as of the grant dates for awards under these plans, the Company's
net loss for the years ending  September 30, 1997 and 1996 would have  increased
to the pro forma amounts indicated below:                      
<TABLE>
<CAPTION>
<S>                                                              <C>              <C> 
                                                                 1997             1996
                                                                          ----             ----
                  Net loss:
                    As reported...............................          $(13,872)        $(17,881)
                    Pro forma (unaudited).....................           (15,729)         (19,428)
</TABLE>

The resulting  compensation  expense may not be  representative  of compensation
expense to be incurred on a pro forma basis in future years.

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 permits the issuance of common stock and the
grant of up to 8,561,000  non-qualified  stock  options (the "1995  Options") to
purchase  shares of common stock to key  employees of the Company.  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.  An  option's  maximum  term is 10
years.

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 covers all employees not included in the
1995 Option Plan whose  employment  commenced prior to January 1, 1997. The 1996
Employee  Option Plan permits the grant of up to 1,000,000  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.  An option's maximum term is
10 years.

The fair value of each option  grant is  estimated on the date of grant by using
the   Black-Scholes   option-pricing   model.  The  following   weighted-average
assumptions  were used for grants in the years  ending  September  30,  1997 and
1996:

<TABLE>
<CAPTION>
<S>                                                                                <C>               <C>
                                                                                   1997              1996
                                                                                   ----              ----

                      Expected dividend yield..........................            0.00%             0.00%
                      Expected volatility..............................            1.00%             1.00%
                      Risk-free interest rates.........................            6.44%             6.08%
                      Expected option lives (years)....................            7.0               7.0
</TABLE>

<PAGE>



16.   STOCK OPTIONS AND AWARDS--(Continued)

Information regarding the Company's stock option plans is summarized below:

<TABLE>
<CAPTION>

                                                     1995 Option Plan                1996 Employee Option Plan
                                                             Weighted average                      Weighted average
<S>     <C>    <C>    <C>    <C>    <C>    <C>
                                                  Shares      Exercise Price           Shares        Exercise Price

       Outstanding at October 1, 1995.......         ---                                 ---
       Granted..............................     5,698,000         $5.00               835,175         $7.50
       Canceled.............................      (585,000)        $5.00              (119,625)        $7.50
       Outstanding at September 30, 1996....     5,113,000         $5.00               715,550         $7.50
       Granted..............................     1,327,075         $7.22               254,400         $7.50
       Exercised............................        (3,000)        $5.00                 ---             ---
       Canceled.............................      (202,000)        $5.74              (212,300)        $7.50
       Outstanding at September 30, 1997....     6,235,075         $5.45               757,650         $7.50

</TABLE>

The weighted-average  fair values of options granted during fiscal 1997 and 1996
for  the  1995   Option   Plan  were   $1.42  and   $1.72,   respectively.   The
weighted-average  fair values of options granted during fiscal 1997 and 1996 for
the 1996 Employee Option Plan were $0.87 and $0.01, respectively.

The following table summarizes information about stock options outstanding as of
September 30, 1997:
<TABLE>
<CAPTION>

<S>                                          <C>                       <C>
                                             1995 Option Plan          1996 Employee Option Plan
         Range of exercise price                 $5.00-$7.50                      $7.50
         Weighted-average remaining
           contracted life (years)                  8.38                           8.51
</TABLE>

As of September 30, 1997, 993,600 shares pertaining to the 1995 Option Plan were
exercisable  with an exercise price of $5.00. No shares were exercisable for the
1996 Employee Option Plan as of September 30, 1997.

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 1997 and 1996, the Company recorded tax benefits of $11,630 and
$1,505, respectively,  from the exercise of Merck options. Information regarding
the options  outstanding  under these plans held by  employees of the Company at
September 30, 1997 and 1996 is as follows: 

<TABLE>
<CAPTION>
<S>     <C>    <C>    <C>    <C>    <C>    <C>

                                                          Shares                          Option Price Per Share
                                                    1997             1996                  1997                1996

         Vested.............................       497,353          905,504            $ 3.78 to $25.87    $3.78 to $35.75
         Unvested...........................       127,472          391,169            $21.93 to $22.24    $3.78 to $35.75
         Total..............................       624,825        1,296,673

</TABLE>

16.   STOCK OPTIONS AND AWARDS--(Continued)

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.

17.   DISPOSAL OF SUBSIDIARY

In September 1997, the Company sold Choate for  approximately  $4,775 ($4,735 of
which  was  received  in  October  1997.)  The  Company  recognized  a  loss  of
approximately $6,925 relating to the transaction.

18.  MERGER COSTS AND SPECIAL CHARGES

In fiscal 1997, the Company recognized approximately $733 of expenses associated
with  uncompleted  acquisition  transactions.  Also, the Company  incurred other
special charges of approximately  $581 related to nonrecurring  employee benefit
costs  associated with the exercise of stock options by employees of the Company
under plans  administered by Merck. A significant number of these stock options,
which were granted prior to the Merger, required exercise by September 30, 1997.

19. SUPPLEMENTAL INFORMATION

Supplemental   cash  flow  information  and  noncash   investing  and  financing
activities are as follows:
<TABLE>
<CAPTION>

<S>                                                           <C>              <C>               <C>
                                                              1997             1996              1995
                                                              ----             ----              ----
         Supplemental Cash Flow Information:
              Cash (received) paid for income taxes..    $    (596)           $1,100           $2,167
              Cash paid for interest.................       23,568            17,676              ---

         Supplemental Noncash Investing and
           Financing Activities:
              Record deferred taxes associated
                 with the Merger.....................          ---             7,594              ---
              Exercise of Merck stock options........       11,630             1,505              ---
              Acquisitions:
                  Fair value of assets acquired,
                    other than cash..................       82,412            14,360              ---
                  Liabilities assumed................      (41,622)           (2,962)             ---
                  Total consideration paid...........       40,790            11,398              ---
                  Stock consideration paid...........       (5,545)              ---              ---
                  Cash consideration paid............       35,245            11,398              ---
                  Contingent consideration...........          400             1,278            9,580
              Cash used for acquisitions,
                net of cash acquired.................      $35,645          $ 12,676          $ 9,580

</TABLE>

<PAGE>

20.  RECENTLY ISSUED ACCOUNTING STANDARD

In June 1997,  the  Financial  Accounting  Standards  Board issued SFAS No. 131,
Disclosures about Segments of an Enterprise and Related Information,  which will
be effective for the Company  beginning  October 1, 1998. SFAS No. 131 redefines
how  operating  segments  are  determined  and  requires  disclosure  of certain
financial and descriptive  information about a company's operating segments. The
Company has not yet  completed  its  analysis  with  respect to which  operating
segments of its business it will provide such information

21.   SUBSEQUENT EVENT

On October 24, 1997,  the Company  signed a definitive  merger  agreement  under
which a subsidiary of Magellan Health  Services,  Inc.  ("Magellan")  will merge
into the Company.  As a result of this merger,  the Company will become a wholly
owned subsidiary of Magellan. Under the terms of the merger agreement,  Magellan
will purchase all of the Company's  outstanding stock and other equity interests
for  approximately  $460 million in cash and refinance  the  Company's  existing
debt. In addition,  all options  outstanding  under the 1995 Option Plan and the
1996  Employee  Option  Plan will  fully vest upon  closing of the  transaction.
Completion  of the merger  transaction  is  subject  to a number of  conditions,
including  Magellan's receipt of sufficient  financing for the transaction,  the
expiration   or   early   termination   of  the   waiting   period   under   the
Hart-Scott-Rodino  Antitrust  Improvements  Act of 1974,  the receipt of certain
healthcare and insurance regulatory approvals, and other conditions.