##### Table of Contents



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 December 31, 2002 oro
        
        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 0-20488

PSYCHIATRIC SOLUTIONS, INC.

(Exact Name of Registrant as Specified in Its Charter)


DELAWARE
        
        23-2491707(State or Other Jurisdiction of
Incorporation or Organization)
        
        (I.R.S. Employer Identification No.)


113 Seaboard Lane, Suite C-100
Franklin, TN 37067
(Address of Principal Executive Offices, Including Zip Code)

(615) 312-5700

(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:

Title Of Each Class
        
        Name of Each Exchange On Which RegisteredCommon Stock, $.01 par value
        
        Nasdaq National Market


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

Indicate by check mark 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.  o

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2).  Yes o  No x

As of March 1, 2003, 7,738,641 shares of the registrants common stock
were outstanding. As of June 28, 2002, the aggregate market value of the
shares of common stock of the registrant held by non-affiliates of the
registrant was approximately $5,343,758. For purposes of calculating such
aggregate market value, affiliates include the registrant's directors, executive officers and 5%
beneficial owners.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrants definitive proxy statement for its 2003
annual meeting of stockholders to be held on May 6, 2003 are incorporated by
reference into Part III of this Form 10-K.





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TABLE OF CONTENTS



|                                                   |                                                                                                |  |  |  |  |  |  | 
|-------------------------------------------------- | ---------------------------------------------------------------------------------------------- |  |  |  |  |  |  | 
|PART I                                            
|                                                   | Item 1.  Business                                                                             
|                                                   | Item 2.  Properties                                                                           
|                                                   | Item 3.  Legal Proceedings                                                                    
|                                                   | Item 4.  Submission Of Matters To A Vote Of Security Holders                                  
|PART II                                           
|                                                   | Item 5.  Market For Registrants Common Equity And Related Stockholder Matters.               
|                                                   | Item 6.  Selected Financial Data                                                              
|                                                   | Item 7.  Managements Discussion And Analysis Of Financial Condition And Results Of Operations
|                                                   | Item 7A.  Quantitative And Qualitative Disclosures About Market Risk                          
|                                                   | Item 8.  Financial Statements And Supplementary Data                                          
|                                                   | Item 9.  Changes In And Disagreements With Accountants On Accounting And Financial Disclosure 
|PART III                                          
|                                                   | Item 10. Directors And Executive Officers                                                     
|                                                   | Item 11. Executive Compensation                                                               
|                                                   | Item 12. Security Ownership Of Certain Beneficial Owners And Management                       
|                                                   | Item 13. Certain Relationships And Related Party Transactions                                 
|                                                   | Item 14. Controls and Procedures                                                              
|PART IV                                           
|                                                   | Item 15. Exhibits, Consolidated Financial Statement Schedules, And Reports On Form 8-K        
|Signatures                                        
|Certifications                                    
|COMMON STOCK SPECIMEN CERTIFICATE                 
|CONSULTING AGREEMENT - FRED FURMAN                
|CONSULTING AGREEMENT - ALLEN TEPPER               
|EMPLOYMENT AGREEMENT - JACK SALBERG               
|EMPLOYMENT AGREEMENT JOEY JACOBS 08/06/02         
|INDEMNIFICATION AGREEMENT - MARK P CLEIN          
|INDEMNIFICATION AGREEMENT -JOSEPH P DONLAN        
|INDEMNIFICATION AGREEMENT - CHRISTOPHER P GRANT JR
|INDEMNIFICATION AGREEMENT - DAVID S HEER          
|INDEMNIFICATION AGREEMENT - JOEY A JACOBS         
|INDEMNIFICATION AGREEMENT - CHARLES C MCGETTIGAN  
|INDEMNIFICATION AGREEMENT - EDWARD K. WISSING     
|CONSENT UNDER INDEMNIFICATION AGREEMENT           
|FIRST AMENDMENT TO CREDIT AGREEMENT 04/30/02      
|2003 LONG TERM EQUITY PLAN                        
|LIST OF SUBSIDIARIES                              
|CONSENT OF ERNST & YOUNG LLP                      
|906 CERTIFICATIONS OF C.E.O AND C.A.O             



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INDEX

PAGEPART IItem 1. Business
        
        
        1Item 2. Properties
        
        
        16Item 3. Legal Proceedings
        
        
        16Item 4. Submission Of Matters To A Vote Of Security Holders
        
        
        16PART IIItem 5. Market For Registrants Common Equity And Related Stockholder Matters
        
        
        17Item 6. Selected Financial Data
        
        
        17Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
        
        
        18Item 7A. Quantitative and Qualitative Disclosures About Market Risk
        
        
        34Item 8. Financial Statements and Supplementary Data
        
        
        34Item 9. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure
        
        
        34PART IIIItem 10. Directors and Executive Officers
        
        
        34Item 11. Executive Compensation
        
        
        35Item 12. Security Ownership of Certain Beneficial Owners and Management
        
        
        36Item 13. Certain Relationships and Related Party Transactions
        
        
        36Item 14. Controls and Procedures
        
        
        36PART IVItem 15.
Exhibits, Financial Statement Schedules, and Reports on Form 8-K
        
        
        36Signatures
        
        40Certifications
        
        41






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PART I

All references in this Annual Report onForm 10-Kto Psychiatric
Solutions, the Company, we, us or our mean, unless the context
otherwise requires, Psychiatric Solutions, Inc. and its consolidated
subsidiaries.







Item 1.  Business

Overview

Psychiatric Solutions is a leading provider of behavioral health care
services in the United States. As of December 31, 2002, Psychiatric Solutions
owned and operated five free-standing psychiatric facilities which provided
psychiatric services to patients in the Houston, Texas; Austin, Texas; Raleigh,
North Carolina; and Chicago, Illinois areas and managed 48 psychiatric units
for third party acute care hospitals in 14 states. Psychiatric Solutions also
has a contract to provide mental health case management services to
approximately 4,300 children and adults with serious mental illness in the
Nashville, Tennessee area. Psychiatric Solutions objective is to provide
high-quality, cost-effective psychiatric services in the communities it serves.
Through its managed and freestanding psychiatric facilities, Psychiatric
Solutions offers a comprehensive array of behavioral health programs to
critically ill children, adolescents and adults.

Psychiatric Solutions initially developed a services-oriented, broad-based
platform to provide both inpatient and outpatient behavioral health care
services. These services included psychiatric physician practice management,
outpatient treatment facilities, employee assistance plans and psychiatric
contract management services to general acute care hospitals. During the first
two years of operations, Psychiatric Solutions management made
strategic
acquisitions, evaluated their primary business lines and witnessed significant
change in the market for behavioral health providers.

In 1999, management began to reposition Psychiatric Solutions to focus on
inpatient hospital settings. To that end, two post-acute geropsychiatric unit
management companies, Cornerstone Behavioral Health Management and Sunrise
Behavioral Health, Ltd., were acquired in 1999 and 2000, respectively.
Psychiatric Solutions discontinued its physician practice management unit and
related activities during 2000 and sold its employee assistance plan division
in 2001. In 2001, Psychiatric Solutions continued its focus on the ownership of
inpatient facilities by acquiring four freestanding specialty hospitals. On
July 1, 2002, Psychiatric Solutions acquired its fifth inpatient facility.

The Company was incorporated in the State of Delaware in 1988. Our
principal executive offices are located at 113 Seaboard Lane, Suite C-100,
Franklin, Tennessee 37067. Our telephone number is (615) 312-5700.

Recent Developments

The Brown Schools Acquisition. On February 13, 2003, Psychiatric
Solutions signed a definitive agreement for the purchase of six psychiatric
facilities from The Brown Schools, Inc. for $63 million in cash. The six
facilities, which have an aggregate of 790 beds, are located in Austin, San
Antonio and San Marcos, Texas; Charlottesville, Virginia; Colorado Springs,
Colorado; and Tulsa, Oklahoma. For 2002, the facilities produced combined
revenues of $76 million. Psychiatric Solutions expects to consummate the
transaction, which is subject to customary closing conditions, on April 1,
2003. Completion of certain health care regulatory matters may delay the purchase of one
of the facilities until mid-April.

$25 Million Private Placement Of Convertible Preferred Stock. On February
4, 2003 Psychiatric Solutions stockholders approved the private placement of
$25 million of our Series A Convertible Preferred Stock (the preferred stock)
with affiliates of Oak Investment Partners and Salix Ventures and with Brown
Brothers Harriman & Co.s The 1818 Mezzanine Fund II, L.P. The investors are
current investors in Psychiatric Solutions, with Oak Investment Partners and
Salix Ventures (or related entities) being among the co-founders of Psychiatric
Solutions. Representatives of Salix Ventures, Oak Investment Partners, and
Brown Brothers Harriman currently serve on our Board of Directors. We intend to
use the net proceeds from the preferred stock primarily to fund





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acquisitions of freestanding psychiatric patient facilities. The preferred
stock will be issued in two phases: one-half will be issued on April 1, 2003,
and one-half will be issued on July 1, 2003.

HUD Refinancing. Psychiatric Solutions is in the process of refinancing a
portion of its senior credit facility with various loans guaranteed by the U.S.
Department of Housing and Urban Development (HUD). These loans are expected to
be in the aggregate amount of approximately $20 million and will be secured
by real estate and other fixed assets of West Oaks Hospital, Cypress Creek
Hospital, Riveredge Hospital and Texas NeuroRehab Center. This refinancing is
expected to close in four installments (one per hospital). The first
installment, Holly Hill Hospital, closed November 25, 2002. Management
anticipates that this refinancing will result in annual interest expense
savings of approximately $750,000, net of anticipated increases in certain
regulatory expenses.

Merger between PMR Corporation and Psychiatric Solutions, Inc.

On August 5, 2002, PMR Acquisition Corporation, a newly formed,
wholly-owned subsidiary of PMR Corporation (PMR), merged with and into
Psychiatric Solutions, Inc., whose name, subsequent to the merger, was changed
to Psychiatric Solutions Hospitals, Inc. (PSH). The surviving corporation in
the merger was PSH, which became a wholly-owned subsidiary of PMR, a publicly
traded company. In connection with the merger, PMR changed its name to
Psychiatric Solutions, Inc. and, effective August 6, 2002, the shares of
Psychiatric Solutions, Inc., formerly known as PMR Corporation, were approved
for listing on the Nasdaq National Market under the ticker symbol PSYS.

Because the former PSH stockholders own a majority of the surviving
corporations outstanding common stock, the acquisition was a reverse
acquisition and PSH was the acquiring company for accounting purposes. The
condensed consolidated financial statements located in this annual
report on Form 10-K relate to
PSH only prior to August 5, 2002, and to the merged company on and subsequent
to August 5, 2002. Historical financial information relating to PMR
immediately prior to the merger can be found in PMRs quarterly report on Form
10-Q for the quarter ended July 31, 2002, as filed with the
Securities and Exchange Commission (the SEC) on September
16, 2002. For more information relating to the merger, see Note 1 of Notes to
Consolidated Financial Statements.

Description of Services by Segment

Psychiatric Solutions operates in two reportable segments: (i) the
ownership and operation of freestanding inpatient psychiatric facilities and
(ii) the operation of psychiatric units in facilities owned by third parties.
Note 14 of the Notes to Consolidated Financial Statements includes
additional information regarding each of these segments, including the
disclosure of required financial information.

Freestanding Specialty Hospital Division

The freestanding specialty hospital division is currently comprised of
five facilities that offer a complement of behavioral health care treatment and
crisis stabilization services for critically ill children, adolescents and
adults with psychiatric, emotional, substance abuse and behavioral disorders.
Psychiatric Solutions facilities work closely with mental health
professionals, non-psychiatric physicians, emergency rooms and community
agencies that interact with individuals who may need treatment for mental
illness or substance abuse.

A typical treatment program integrates physicians and other patient-care
professionals. For those patients who do not have a personal psychiatrist or
other specialist, Psychiatric Solutions hospital will arrange for the patient
to be seen by a member of its medical staff. Psychiatric Solutions facilities
provide 24-hour skilled nursing observation, daily interventions and oversight
by psychiatrists, and intensive, coordinated treatments by physician-led teams
of mental health care professionals. In addition to traditional inpatient
programs, the facilities also offer less costly treatment alternatives such as
residential treatment, intensive adolescent weekend services, and other
intensive and non-intensive outpatient programs and support group services.

2



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Psychiatric Solutions has acquired the following facilities since September
2001:

1. West Oaks Hospital, Houston, Texas (Southwest Houston). Psychiatric
Solutions acquired West Oaks in September 2001. West Oaks is a 142-bed private
acute care psychiatric facility licensed by the Texas Department of Health and
accredited by the Joint Commission on Accreditation of Healthcare
Organizations (JCAHO). As a Medicare, Medicaid and managed care provider,
West Oaks offers a comprehensive continuum of inpatient, day treatment and
outpatient services and programs for critically ill children, adolescents and
adults.

West Oaks operates the following inpatient programs:

PROGRAM
        
        NUMBER OF LICENSED BEDSAdult Psychiatric Intensive Care
        
        20 bedsAdult General Psychiatric Care
        
        58 bedsSubstance Abuse Program
        
        16 bedsAdolescent Psychiatric Care
        
        32 bedsChild Psychiatric Care
        
        16 beds


West Oaks Demographics. According to 2000 census information, Houston is
the seventh largest city in the U.S. with a population of more than 1.95
million. The population of Houston and surrounding counties is growing more
than 1.6% annually. Between 1990 and 1999 the population of the Houston
Metropolitan Service area grew approximately 20.4% as compared to the national
average of 9.7%.

2. Cypress Creek Hospital, Houston, Texas (Northwest Houston). Psychiatric
Solutions acquired Cypress Creek in September 2001. Cypress Creek is a 94-bed
private acute care psychiatric facility licensed by the Texas Department of
Health and accredited by the JCAHO. As a Medicare, Medicaid and managed care
provider, Cypress Creek provides a comprehensive continuum of inpatient, day
treatment and outpatient services and programs for critically ill children,
adolescents and adults.

Cypress Creek operates the following programs:

PROGRAM
        
        NUMBER OF LICENSED BEDSAdult Psychiatric Intensive Care
        
        14 bedsAdult Intermediate Psychiatric Care
        
        16 bedsAdult General Psychiatric Care
        
        32 bedsAdolescent Psychiatric Care
        
        8 bedsChild Psychiatric Care
        
        8 bedsSubstance Abuse
        
        16 beds


Cypress Creek Demographics. According to 2000 census information, Houston
is the seventh largest city in the United States with a population of more than
1.95 million. The population of Houston and surrounding counties is growing
more than 1.6% annually. Between 1990 and 1999, the population of the Houston
Metropolitan Service area grew approximately 20.4% as compared to the national
average of 9.7%.

3. Texas NeuroRehab Center, Austin, Texas (Travis County). Psychiatric
Solutions acquired Texas NeuroRehab in November 2001. Texas NeuroRehab is a
127-bed private specialty neuropsychiatric/ neurobehavioral hospital and
residential treatment center which offers an extensive range of medical
rehabilitation, brain injury and neurobehavioral treatment programs for
children, adolescents and adults. Long term acute care (LTAC) beds comprise
31 of the 127 beds at Texas NeuroRehab. Texas NeuroRehab is licensed by the
Texas Department of Health and the Texas Department of Protective and
Regulatory Services.

3



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Texas NeuroRehab operates the following programs:

PROGRAM
        
        NUMBER OF LICENSED BEDSLTAC Specialty Hospital
        
        31 bedsNeuropsychiatric/Neurobehavioral Hospital
        
        62 bedsResidential Treatment Center
        
        34 beds


Texas NeuroRehab Demographics. According to 2000 census information, the
Austin metropolitan area is the fourth largest area in Texas, with a population
of more than 1.1 million. Austins population has increased 41.0% from 465,600
in 1990 to 657,000 in 2000. According to the census, historical data indicates
that Austins population has doubled every 20 years.

4. Holly Hill Hospital, Raleigh, North Carolina (Wake County). Psychiatric
Solutions acquired Holly Hill in December 2001. Holly Hill is a 108-bed private
acute care psychiatric and substance abuse facility that provides a
comprehensive continuum of inpatient, day treatment, and intensive outpatient
services and programs for children, adolescents and adults.

Holly Hill operates the following programs:

PROGRAM
        
        NUMBER OF LICENSED BEDSAdult Psychiatric Care
        
        28 bedsAdult Chemical Dependency
        
        28 bedsAdolescent Psychiatric Care
        
        25 bedsChild Psychiatric Care
        
        21 bedsRTC
        
        6 beds


Holly Hill Demographics. According to 2000 census information, the Raleigh
metropolitan area is one of the fastest growing areas in North Carolina with a
population of more than 1.13 million. Wake Countys population has increased
17.0% from 518,466 in 1996 to 606,403 in 2000.

5. Riveredge Hospital, Forest Park, Illinois (Chicago, Cook County).
Psychiatric Solutions acquired Riveredge Hospital on July 1, 2002. Riveredge is
a 210 licensed-bed inpatient psychiatric facility that offers a full continuum
of behavioral health care.

Riveredge Hospital currently operates the following programs:

PROGRAM
        
        NUMBER OF LICENSED BEDSAdult General and Dual Diagnosis Psychiatric Care
        
        76 bedsAdolescent Psychiatric Intensive Care
        
        25 bedsAdolescent Psychiatric Care
        
        71 bedsChild Psychiatric Care
        
        38 beds


Riveredge Demographics. According to 2000 census information, Chicago and
the surrounding area is estimated to have a population of approximately 8
million and Cook Countys population is estimated at approximately 5 million.

Psychiatric Unit Management Division

The psychiatric unit management division develops, organizes and manages
geriatric behavioral health care programs within general acute care hospitals
owned and operated by third parties. The divisions experienced team

4



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administers a broad range of psychiatric health services designed to meet
specific hospital requirements. As of December 31, 2002, Psychiatric Solutions
managed 48 behavioral health units, making Psychiatric Solutions the second
largest provider of psychiatric contract management services in the United
States. Psychiatric Solutions also has a contract to provide mental health case
management services to approximately 4,300 children and adults with serious
mental illness in the Nashville, Tennessee area.

The psychiatric unit management division is dedicated to providing quality
programs with integrity, innovation and sufficient flexibility to develop
individual programs that meet specific facility requirements. The increased
demand for better quality, lower costs and simplified systems places additional
burdens on management teams and clinical departments within hospitals. As a
result, many general acute care hospitals are increasing efficiency by
outsourcing key clinical departments and functions to independent contract
managers that can provide focused expertise.

Psychiatric Solutions offers hospitals a complete menu of management options, including:



| |  | clinical and management infrastructure;
|- |  | ---------------------------------------



| |  | personnel recruitment, staff orientation and supervision;
|- |  | ---------------------------------------------------------



| |  | corporate consultation; and
|- |  | ---------------------------



| |  | performance improvement plans.
|- |  | ------------------------------

Psychiatric Solutions and the client hospital determine the programs and
services to be offered by the hospital. Each contract is tailored to address
the differing needs of the client hospital and its community. Under the
contracts, the hospital is the actual provider of the mental health services
and utilizes its own facilities (including beds for inpatient programs),
support services (such as billing, dietary and housekeeping), and generally its
own nursing staff in connection with the operation of its programs.

Generally, Psychiatric Solutions provides the behavioral health unit of
the client hospital with:



| |  | a psychiatric director who provides administrative management
services and professional direction in all psychiatric matters
relating to patients admitted to the unit, and determines if
patients meet the clinical criteria for admission to the unit;
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | a program manager, who maintains a direct reporting
relationship to the chief executive officer of the client hospital
with respect to the day-to-day operations of the unit. In addition,
the program manager generally:
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Ø provides administrative and training services;
| |  | ------------------------------------------------



| |  | Ø assists with the administrative and clinical criteria for admission to the unit;
| |  | ----------------------------------------------------------------------------------



| |  | Ø determines whether a patient meets the administrative criteria for admission;
| |  | -------------------------------------------------------------------------------



| |  | Ø advises client hospital with respect to issues
relating to compliance with licensing, certification,
accreditation and survey requirements;
| |  | ---------------------------------------------------------------------------------------------------------------------------------------------



| |  | Ø establishes performance improvement standards in
conjunction with the client hospital that are consistent with
the hospitals standards; and
| |  | ----------------------------------------------------------------------------------------------------------------------------------------------



| |  | Ø completes, in conjunction with the hospital,
annual performance evaluations of all unit patient care staff.
| |  | -------------------------------------------------------------------------------------------------------------

5



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| |  | A medical director who provides direction in all
non-psychiatric phases of patient care and provides physician
coverage, including medical care for patients who do not have a
primary physician relationship.
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

While each of the management contracts is tailored to the specific needs
of the client hospital, in general the contracts have an initial term of two to
five years and are extended for successive one year periods unless terminated
by either party. While turnover of contracts is expected, the Company expects
the number of contracts to remain relatively stable. Substantially all of the
management contracts contain non-compete and confidentiality provisions. In
addition, the management contracts typically prohibit the client hospital from
soliciting employees of Psychiatric Solutions during the term of the contract
and for a specified period thereafter.

Business Strategy

Psychiatric Solutions plans to continue to pursue the acquisition of
additional facilities, although no assurance can be given that Psychiatric
Solutions will be able to successfully execute this plan. Psychiatric Solutions
believes that there are a number of attractive freestanding hospital
acquisition candidates available for purchase at attractive valuations.
Psychiatric Solutions utilizes the following acquisition criteria:



| |  | Number one or two market position within growing, urban areas
with low capital expenditure requirements;
|- |  | --------------------------------------------------------------------------------------------------------



| |  | Minimum licensed hospital beds of 50 to 75;
|- |  | -------------------------------------------



| |  | Positive EBITDA (1); and
|- |  | ------------------------



| |  | Opportunity for revenue growth and margin improvement through
introducing new programs, intensive marketing and recruiting
additional inpatient psychiatrists.
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------

(1) EBITDA is defined as income from continuing operations before interest
expense (net of interest income), income taxes, depreciation, amortization, and
extraordinary items. EBITDA, as presented, may not be comparable to similarly
titled measures of other companies.

Psychiatric Solutions has developed a pipeline of potential
specialty psychiatric hospital acquisitions in various stages of evaluation and
negotiation. On February 13, 2003, Psychiatric Solutions signed a definitive
agreement for the purchase of six psychiatric facilities from The Brown
Schools, Inc. See Recent Developments.

Psychiatric Solutions strategy upon acquiring an inpatient facility is to
improve operations by focusing on continuing to provide high quality cost
effective patient care. The focus on revenue growth is to maintain and grow
that facilitys admissions and revenues through improvements to marketing and
community education. A key opportunity for revenue growth is renegotiating
managed care agreements. Further organic growth is possible through adding
capacity in existing programs.

Psychiatric Solutions also increases the focus on reducing costs by
challenging staffing ratios and benefits costs. Psychiatric Solutions also
participates in a group purchasing cooperative to reduce supplies expense.

Psychiatric Solutions believes that substantial opportunities exist to
provide psychiatric contract management services to general acute care
hospitals in the United States. General acute care hospitals are increasingly outsourcing
key clinical departments to independent management companies because they lack
the expertise to (i) manage and operate specialized clinical programs, (ii)
assess the programs for effectiveness and results, (iii) market and develop
programs, and (iv) design and operate programs that satisfy specialized
regulatory, licensing, accreditation and reimbursement requirements.

6



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Management Contracts

At December 31, 2002, Psychiatric Solutions had a total of 48 management
contracts with general acute care hospitals located in 14 states as shown
below:

STATE
        
        NUMBER OF CONTRACTSArkansas
        
        
        2California
        
        
        3Indiana
        
        
        4Iowa
        
        
        3Louisiana
        
        
        2Minnesota
        
        
        4Mississippi
        
        
        4Missouri
        
        
        4Ohio
        
        
        4Oklahoma
        
        
        5Pennsylvania
        
        
        4Tennessee
        
        
        7Texas
        
        
        1Washington
        
        
        1Total Contracts
        
        
        48


While Psychiatric Solutions, Inc. expects the volume of contracts to
remain relatively stable from year to year, the actual number of contracts may increase or
decrease in the normal course of business as new contracts are negotiated and
older contracts expire.

Reimbursement

Psychiatric Solutions, as a participant in the health care industry, is
affected by the numerous laws and regulations that govern the operations of its
facilities and programs at the federal, state and local levels. These laws and
regulations include, but are not necessarily limited to, matters such as
licensure, accreditation, government health care program participation
requirements, reimbursement for patient services, quality of patient care and
Medicare and Medicaid fraud and abuse. Changes in these laws and regulations,
such as reimbursement policies of Medicare and Medicaid programs, budget cuts
or other legislative, regulatory or judicial actions could have an unforeseen
material adverse effect on the financial position, results of operations and
cash flows of the Company.

Medicare

Psychiatric Solutions owned facilities derive approximately 23% of their
revenue from Medicare. As psychiatric facilities, they are exempt from the
inpatient services prospective payment system (PPS) applicable to general
acute care hospitals. Services are cost reimbursed by Medicare, subject to a
per discharge ceiling. Medicare pays for inpatient psychiatric services on the
basis of actual cost, subject to a deductible and coinsurance of 20% of the
providers charges. Medicare makes interim payments to the provider based on an
estimate of the providers cost, and then makes a final settlement based on an
annual cost report filed by the provider.

With respect to revenues derived from psychiatric unit management
services, Psychiatric Solutions bills its fees to the provider as a purchased
management, administrative and consultative support service. Substantially all
of the patients admitted to these programs are eligible for Medicare coverage.
As a result, the providers rely upon payment from Medicare for the services.
Many of the patients are also eligible for Medicaid payments. To the extent
that a hospital deems revenue for a program Psychiatric Solutions manages to be
inadequate, it may seek to terminate its contract with Psychiatric Solutions or
not renew the contract. Similarly, Psychiatric Solutions may not necessarily
solicit new unit management contracts if prospective customers do not believe
that such programs will generate sufficient revenue.

7



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In the mid-1980s, changes in reimbursement rates and procedures included
the creation of the PPS using predetermined
reimbursement rates for diagnosis related groups (DRGs). Behavioral health
facilities, such as Psychiatric Solutions freestanding facilities, are
excluded from the inpatient services PPS, and are instead reimbursed by the
Medicare program based on actual cost, generally subject to a per discharge
ceiling. Capital related costs are not included, but are reimbursed separately
at a rate of 85% of allowable costs. In the Balanced Budget Act of 1997
(BBA-97), Congress significantly revised the Medicare payment provisions for
PPS-excluded hospitals, including psychiatric hospitals. Effective for Medicare
cost reporting periods beginning on or after October 1, 1997, different caps
are applied to psychiatric hospitals target amounts depending upon whether a
hospital was excluded from PPS before or after that date, with higher caps for
hospitals excluded before that date.

Consistent with reimbursement trends for other segments of the health care
services industry, Medicare is expected to shift to PPS for inpatient
psychiatric hospitals in the next several years, possibly as soon as October
2004. The PPS reimbursement system involves a determination by the federal
government of an average, or fair price, for a fixed unit of health care
services, adjusted for regional differences in cost.

Mental health services provided by acute care hospitals which qualify for
a PPS exemption are deemed to be Distinct Part Units (DPUs) and are not
included in the DRG system. Services provided by DPUs are reimbursed on an
actual cost basis, subject to certain limitations. The mental health programs
managed by Psychiatric Solutions which are eligible for reimbursement by the
Medicare program currently meet the applicable requirements for designation as
DPUs and are exempt from the DRG system. In the future, however, it is possible
that Medicare reimbursement for mental health services, including those
provided by programs managed by Psychiatric Solutions, could be under the PPS
system or otherwise altered.

Partial hospitalization is an intensive outpatient program of psychiatric
services provided to patients in place of inpatient care. In an August 1, 2000
rule, a new Medicare per diem payment methodology was established for partial
hospitalization programs. In a November 1, 2002 rule, it was announced that
Medicare would pay a per diem rate of $256.96, of which $51.39 is the
beneficiarys co-insurance, for partial hospitalization assuming that the
services meet Medicares coverage requirement. This amount is adjusted up or
down for differences in wages from area to area. Medicare pays this amount
regardless of whether it is more or less than a hospitals actual costs,
although there is a three-year transition period during which hospitals whose
aggregate costs for Medicare outpatients exceed the Medicare rates will receive
some additional Medicare payments, but not up to the level of full costs. The
Medicare rates for outpatient services should be updated annually, but in the
past when Medicare has adjusted other rates similar to its new rates for
hospital outpatient services, the updates have often been increases in amounts
that were less than the increase in the hospital market basket, i.e., the
increase in costs of items and services purchased by hospitals. In some
instances, Medicare has reduced rates in the updating process.

Although Medicare uses a cost-based reimbursement formula for psychiatric
hospital inpatient services, and has established a rate for partial
hospitalization services of $256.96 per day, Medicare will not pay these full
amounts to a hospital. It will deduct from that rate an amount for patient
coinsurance, or the amount that the patient is expected to pay. Many patients
are unable to pay the coinsurance amount. Even if these patients are also
covered by Medicaid, some states Medicaid programs will not pay the Medicare
coinsurance amount. As a result, the Medicare coinsurance amount will go
uncollected by the provider except to the extent that the provider is partially
reimbursed that amount as a Medicare bad debt as described in the following
paragraph.

To the extent that neither a Medicare patient nor any secondary payor for
that patient pays the Medicare coinsurance amount after a reasonable collection
effort or the patients indigence is documented, the provider is entitled to be
paid 70% of this bad debt by Medicare. However, there are instances when
Medicare denies reimbursement for all or part of claimed bad debts for
coinsurance on Medicare patients on grounds that the provider did not engage in
a reasonable collection effort or that the provider failed to maintain adequate
documentation of its collection effort or of the patients indigence.

The services Psychiatric Solutions provides through psychiatric unit
management contracts have historically been covered by Medicare, as if provided
by the host provider on the basis that the site where the services were
furnished was a provider based site. Historically, a site could assert
provider based status simply by claiming the designation. In April 2000, CMS
adopted new rules requiring a CMS determination that a facility has

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provider based status before a provider can bill Medicare for the services
rendered at the facility. The new rules have been construed by CMS to apply to
inpatient mental health units, and therefore they impact Psychiatric Solutions
psychiatric unit management operations.

As a result of the Benefits Improvement and Protection Act of 2000,
facilities treated as provider-based as of October 1, 2000 were treated as
provider-based until October 1, 2002, the effective date of the April 2000
final regulation. In addition, the April 2000 final regulation specifies
instances when there may be retrospective recoveries of amounts previously paid
if Medicare determines that a site was not provider-based. The regulation
also places significant restrictions on which personnel can be management
employees if the provider based facility is operated under a management
contract.

On August 1, 2002, CMS published changes to the provider-based rules. One
of the most significant changes is that facilities treated as provider-based as
of October 1, 2000 have until the first day of the providers next cost report
period that is on or after July 1, 2003 to comply with the new provider-based
rules. For all other entities, the changes to the provider-based rules became
effective on October 1, 2002. In the final rule, CMS now distinguishes between
on and off-campus provider-based entities by establishing separate requirements
that are dependent on the location of the provider-based entity. The final
rule provides relief from the management contract restrictions for on-campus
entities. Under the current regulation, an off-campus entity that is operated
pursuant to a management contract is not in compliance with the provider-based
criteria if any of its non-management employees are employed by the manager, or
if its administrative functions are not integrated with those of the main
provider. The final rule eliminated all management contract restrictions for
on-campus entities. The final rule provided significantly less relief for
provider-based entities located off the campus of the main provider. The final
rule also specifies that in addition to possible recoupment of amounts
previously paid for providers who bill inappropriately for services of a
provider-based entity, future payments may be adjusted to approximate the
amounts that would be paid for the same services furnished by a freestanding
facility.

Psychiatric Solutions believes the sites it presently manages are
provider-based within the meaning of the final regulation, and Psychiatric
Solutions expects that its provider customers will obtain, or have obtained,
determinations of such provider-based status from Medicare. However, it is
possible that such sites will not obtain approval as provider-based sites or
will lose such approval in the future. In such instances, there may be a loss
of Medicare coverage for services furnished at that site and there may be a
retrospective recovery by Medicare. It is also possible that the provider based
rules could result in termination or non-renewal of management contracts if a
provider does not obtain a determination of provider-based status of an
inpatient unit operated under a management contract.

Medicaid

Psychiatric Solutions cannot predict the extent or scope of changes which
may occur in the ways in which state Medicaid programs contract for and deliver
services to Medicaid recipients. All Medicaid funding is generally conditioned
upon financial appropriations to state Medicaid agencies by the state
legislatures and there are political pressures on such legislatures in terms of
controlling and reducing such appropriations. Consequently, any significant
reduction in funding for Medicaid programs could have a material adverse effect
on Psychiatric Solutions business, financial condition and results of
operations.

Some states may adopt substantial health care reform measures which could
modify the manner in which all health services are delivered and reimbursed,
especially with respect to Medicaid recipients and other
individuals funded by public resources. Many states have enacted or are
considering enacting measures designed to reduce their Medicaid expenditures
and change private health care insurance. Most states have applied for and
been granted Federal waivers from current Medicaid regulations to allow them to
serve some or all of their Medicaid participants through managed care
providers. The reduction in other public resources could have an impact on the
delivery of services to Medicaid recipients. Any significant changes in
Medicaid funding, the structure of a particular states Medicaid program, the
contracting process or reimbursement levels could have a material adverse
impact on Psychiatric Solutions.

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Managed Care and Commercial Insurance Carriers

The Companys facilities are reimbursed for certain behavioral healthcare
services by health maintenance organizations and commercial insurance companies
on either a fee-for-service basis or under contractual arrangements which may
include reimbursement on per-diem, per-diagnosis basis.

These carriers reimburse the facilities or the Company directly for
charges at rates and limits specified in their contracts or policies. Patients
generally remain responsible for any amounts not covered under their insurance
policies.

Annual Cost Reports

All facilities participating in the Medicare program, whether paid on a
reasonable cost basis or under PPS, are required to meet certain financial
reporting requirements. Federal regulations require submission of annual cost
reports covering medical costs and expenses associated with the services
provided by each hospital to Medicare beneficiaries. Annual cost reports
required under the Medicare and Medicaid programs are subject to routine
audits, which may result in adjustments to the amounts ultimately determined to
be due to Psychiatric Solutions under these reimbursement programs. These
audits often require several years to reach the final determination of amounts
earned under the programs. Providers have rights to appeal, and it is common
to contest issues raised in audits of prior years reports.

Regulation and Other Factors

Licensure, Certification And Accreditation

Health care facilities are subject to Federal, state and local regulations
relating to the adequacy of medical care, equipment, personnel, operating
policies and procedures, fire prevention, rate-setting and compliance with
building codes and environmental protection laws. Facilities are subject to
periodic inspection by governmental and other authorities to assure continued
compliance with the various standards necessary for licensing and
accreditation. Management believes that all of the facilities owned and
operated by Psychiatric Solutions are properly licensed under applicable state
laws. All of the facilities owned and operated by Psychiatric Solutions are
certified under Medicare and Medicaid programs and all are accredited by the
JCAHO, the effect of which is to permit the facilities to participate
in the Medicare and Medicaid programs. Should any facility lose its
accreditation by the Joint Commission, or otherwise lose its certification
under the Medicare and/or Medicaid program, the facility would be unable to
receive reimbursement from the Medicare and Medicaid programs. If a provider
contracting with Psychiatric Solutions were excluded from any Federal health
care programs, no services furnished by that provider would be covered by any
Federal health care program. If Psychiatric Solutions were excluded from
Federal health care programs, its owned facilities would not be eligible for
reimbursement by any Federal health care program. In addition, providers would
as a practical matter, cease contracting for Psychiatric Solutions psychiatric
unit management services because they could not be reimbursed for any
management fee amounts they paid to Psychiatric Solutions. Management believes
that the facilities owned and operated by Psychiatric Solutions are in
substantial compliance with current applicable Federal, state, local and
independent review body regulations and standards. The requirements for
licensure, certification and accreditation are subject to change and, in order
to remain qualified, it may be necessary for Psychiatric Solutions to effect
changes in its facilities, equipment, personnel and services. Additionally,
certain of the personnel working at facilities owned and operated by
Psychiatric Solutions are subject to state laws and regulations governing their
particular area of professional practice. Psychiatric Solutions assists its
client hospitals in obtaining required approvals for new programs. Some
approval processes may lengthen the time required for programs to begin
operations.

Certificates Of Need (CON)

The construction or expansion of health care facilities, the acquisition
of existing facilities, the transfer or change of ownership and the addition of
new beds or services may be subject to review by and prior approval of state
regulatory agencies under a CON program. Such laws generally require the
reviewing state agency to determine the public need for additional or expanded
health care facilities and services. Failure to obtain necessary state approval
can result in the inability to expand facilities, add services, complete an
acquisition or change

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ownership. Further, violation of such laws may result in the imposition
of civil sanctions or revocation of a facilitys license.

Federal and State Fraud And Abuse

Participation in any Federal health care program, including the Medicare
and Medicaid programs, is heavily regulated by Federal statute and regulation.
If a hospital fails to substantially comply with the numerous conditions of
participation in the Medicare and Medicaid programs or performs certain
prohibited acts, such hospitals participation in the Federal health care
programs may be terminated, or civil or criminal penalties may be imposed under
certain provisions of the Social Security Act or both. For example, the Social
Security Act prohibits providers and others from soliciting, receiving,
offering or paying, directly or indirectly, any remuneration intended to induce
referrals or patients to receive goods or services covered by a Federal health
care program (the Anti-kickback Statute). In addition to felony criminal
penalties (fines up to $25,000 and imprisonment), the Social Security Act
establishes civil monetary penalties and the sanction of excluding violators
from participation in the Federal health care programs.

The Anti-kickback Statute has been interpreted broadly by Federal
regulators and certain courts to prohibit the intentional payment of anything
of value if even one purpose of the payment is to influence the referral of
Medicare or Medicaid business. Therefore, many commonplace commercial
arrangements between hospitals and physicians could be considered by the
government to violate the Anti-kickback Statute.

As authorized by Congress, the Office of the Inspector General at the
Department of Health and Human Services (OIG) has published final safe harbor
regulations that outline categories of activities that are deemed protected
from prosecution under the Anti-kickback Statute. Currently, there are safe
harbors for various activities, including, but not limited to: investment
interest, space rental, equipment rental, practitioner recruitment, personal
services and management contracts, sale of practice, discounts, employees,
investments in group practices, and ambulatory surgery centers. The fact that
conduct or a business arrangement does not fall within a safe harbor does not
automatically render the conduct or business arrangement unlawful under the
Anti-kickback Statute. The conduct and business arrangements, however, do risk
increased scrutiny by government enforcement authorities.

Psychiatric Solutions has a variety of financial relationships with
physicians who refer patients to its owned facilities, as well as at mental health
programs and facilities it manages. Psychiatric Solutions has contracts with
physicians to serve as medical directors at its owned facilities, as well as at
mental health programs and facilities it manages. Some of the arrangements with
physicians do not expressly meet requirements for safe harbor protection. It
cannot be assured that regulatory authorities that enforce the Anti-kickback
Statute will not determine that any of these arrangements violate the
Anti-kickback Statute or other Federal or state law. This determination could
subject Psychiatric Solutions to liabilities under the Social Security Act,
including criminal penalties, civil monetary penalties and exclusion from
participation in Medicare, Medicaid of other Federal health care programs.

Stark Law

The Social Security Act also includes a provision commonly known as the
Stark Law. This law prohibits physicians from referring Medicare and
Medicaid patients to entities with which they or any of their immediate family
members have a financial relationship if these entities provide certain
designated health services that are reimbursable by Medicare, including
inpatient and outpatient hospital services. Sanctions for violating the Stark
Law include denial of payment, refunding amounts received for prohibited
services, civil monetary penalties of up to $15,000 per prohibited service
provided, and exclusion from Medicare and Medicaid programs. The statute also
provides for a penalty of up to $100,000 for a circumvention scheme. There are
exceptions to the self-referral prohibition for many customary financial
arrangements between physicians and providers, including employment contracts,
leases and recruitment agreements.

On January 4, 2001, CMS issued final regulations, subject to comment,
intended to clarify parts of the Stark Law and some of the exceptions to it.
These regulations are considered the first phase of a two-phase process, with
the remaining regulations to be published at an unknown future date. The phase
one regulations generally became effective January 4, 2002. However, CMS has
delayed until July 7, 2003 the effective date of a portion of the phase one
regulations related to whether percentage-based compensation is deemed to be
set in advance for

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purposes of exceptions to the Stark Law. Psychiatric Solutions cannot
predict the final form these regulations will take or the effect that the final
regulations will have on its operations.

Similar State Laws

Many states in which Psychiatric Solutions operates also have laws that
prohibit payments to physicians for patient referrals similar to the
Anti-Kickback Statute and self-referral legislation similar to the Stark Law.
The scope of these state laws is broad, since they can often apply regardless
of the source of payment for care, and little precedent exists for their
interpretation or enforcement. These statutes typically provide for criminal
and civil penalties as well as loss of facility licensure.

HIPAA and BBA-97

The Health Insurance and Portability and Accountability Act of 1996
(HIPAA) broadened the scope of certain fraud and abuse laws by adding several
criminal provisions for health care fraud offenses that apply to all health
benefit programs. HIPAA also created new enforcement mechanisms to combat
fraud and abuse, including the Medicare Integrity Program and an incentive
program under which individuals can receive up to $1,000 for providing
information on Medicare fraud and abuse that leads to the recovery of at least
$100 of Medicare funds. In addition, Federal enforcement officials now have
the ability to exclude from Medicare and Medicaid any investors, officers and
managing employees associated with business entities that have committed health
care fraud, even if the officer or managing employee had no knowledge of the
fraud. HIPAA was followed by BBA-97, which created additional fraud and abuse
provisions, including civil penalties for contracting with an individual or
entity that the provider knows or should know is excluded from a Federal health
care program.

Other Fraud and Abuse Provisions

The Social Security Act also imposes criminal and civil penalties for
making false claims and statements to Medicare and Medicaid. False claims
include, but are not limited to, billing for services not rendered or for
misrepresenting actual services rendered in order to obtain higher
reimbursement, billing for unnecessary goods and services, and cost report
fraud. Criminal and civil penalties may be imposed for a number of other
prohibited activities, including failure to return known overpayments, certain
gainsharing arrangements, and offering remuneration to influence a Medicare or
Medicaid beneficiarys selection of a health care provider. Like the
Anti-kickback Statute, these provisions are very broad. Careful and accurate
coding of claims for reimbursement, including preparing cost reports, must be
performed to avoid liability

The Federal False Claims Act and Similar State Laws

A factor affecting the health care industry today is the use of the
Federal False Claims Act and, in particular, actions brought by individuals on
the governments behalf under the False Claims Acts qui tam, or
whistleblower, provisions. Whistleblower provisions allow private individuals
to bring actions on behalf of the government alleging that the defendant has
defrauded the Federal government.

When a defendant is determined by a court of law to be liable under the
False Claims Act, the defendant may be required to pay three times the actual
damages sustained by the government, plus mandatory civil penalties of between
$5,500 and $11,000 for each separate false claim. There are many potential
bases for liability under the False Claims Act. Liability often arises when an
entity knowingly submits a false claim for reimbursement to the Federal
government. The False Claims Act defines the term knowingly broadly. Thus,
although simple negligence will not give rise to liability under the False
Claims Act, submitting a claim with reckless disregard to its truth or falsity
constitutes knowing submission under the False Claims Act and, therefore,
will qualify for liability.

In some cases, whistleblowers and the Federal government have taken the
position that providers who allegedly have violated other statutes, such as the
Anti-kickback Statute and the Stark Law, have thereby submitted false claims
under the False Claims Act. A number of states have adopted their own
whistleblower provisions whereby a private party may file a civil lawsuit on
behalf of the state in state court. From time to time, companies in the health
care industry, including Psychiatric Solutions, may be subject to actions under
the False Claims Act.

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Administrative Simplification and Privacy Requirements

Most of Psychiatric Solutions activities require Psychiatric Solutions to
receive or use confidential medical information about individual patients.
Federal and some state legislation restrict the use and disclosure of
confidential medical information and the fact of treatment. There are specific
requirements permitting disclosure, but inadequate or incorrect disclosure,
even if inadvertent or negligent, can trigger substantial criminal and other
penalties.

The Administrative Simplification Provisions of HIPAA require the use of
uniform electronic data transmission standards for health care claims and
payment transactions submitted or received electronically. These provisions
are intended to encourage electronic commerce in the health care industry. On
August 17, 2000, HHS published final regulations establishing electronic data
transmission standards that all health care providers must use when submitting
or receiving certain health care transactions electronically. Compliance with
these regulations is required by October 16, 2002. However, the Administrative
Simplification Compliance Act extended the compliance date until October 16,
2003 for entities that file a plan with HHS that demonstrates how they intend
to comply with the regulations by the extended deadline. The Company has filed
such plans and received extensions accordingly.

The Administrative Simplification Provisions also require HHS to adopt
standards to protect the security and privacy of health-related information.
HHS proposed regulations containing security standards on August 12, 1998. On
February 20, 2003, the final security rule was announced along with
modifications to the HIPAA electronic data transactions and code set standards.
The security rule requires health care providers to implement organizational,
physical and technical practices to protect the security of electronically
maintained or transmitted health-related information. In addition, HHS
released final regulations containing privacy standards in December 2000.
These privacy regulations became effective in April 2001, but compliance with
these regulations is not required until April 2003. The privacy regulations
extensively regulate the use and disclosure of individually identifiable
health-related information, whether communicated electronically, on paper or
orally. The regulations also provide patients with significant new rights
related to understanding and controlling how their health information is used
or disclosed. The security regulations and the privacy regulations could
impose significant costs on Psychiatric Solutions facilities in order to
comply with these standards. The costs of conforming Psychiatric Solutions
systems to provide the privacy, security and transaction standard conformance
required by HIPAA may require substantial cost investment in software,
computers, policies and procedures, employee training and other goods and
services. Until the standards are implemented in final form, Psychiatric
Solutions cannot know the full extent of these costs for implementing the
requirements the regulations impose.

Violations of the Administrative Simplification Provisions could result in
civil penalties of up to $25,000 per type of violation in each calendar year
and criminal penalties of up to $250,000 per violation. In addition, there are
numerous legislative and regulatory initiatives at the Federal and state levels
addressing patient privacy concerns. Facilities will continue to remain
subject to any Federal or state privacy-related laws that are more restrictive
than the privacy regulations issued under the Administrative Simplification
Provisions. These statutes vary and could impose additional penalties.

Corporate Practice Of Medicine/Fee Splitting

Some states have laws that prohibit corporations and other entities from
employing physicians and practicing medicine for a profit or that prohibit
certain direct and indirect payments or fee-splitting arrangements between
health care providers that are designed to induce or encourage the referral of
patients to, or the recommendation of, particular providers for medical
products and services. Possible sanctions for violation of these restrictions
include loss of license and civil and criminal penalties. In addition,
agreements between a corporation and a physician may be considered void and
unenforceable. These statutes vary from state to state, are often vague and
have seldom been interpreted by the courts or regulatory agencies. Although
Psychiatric Solutions exercises care to structure its arrangements with health
care providers to comply with the relevant state law, there can be no assurance
that government officials charged with responsibility for enforcing these laws
will not assert that Psychiatric Solutions, or certain transactions in which it
is involved, is in violation of such laws, or that such laws ultimately will be
interpreted by the courts in a manner consistent with the interpretation of
Psychiatric Solutions.

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Health Care Industry Investigations

Significant media and public attention has focused in recent years on the
hospital industry. Because the law in this area is complex and constantly
evolving, ongoing or future governmental investigations or litigation may
result in interpretations that are inconsistent with industry practices,
including Psychiatric Solutions practices. It is possible that governmental
entities could initiate investigations or litigation in the future at
facilities owned or managed by Psychiatric Solutions and that such matters
could result in significant penalties as well as adverse publicity. It is also
possible that Psychiatric Solutions executives and mangers could be included
in governmental investigations or litigation or named as defendants in private
litigation.

Health Care Reform

Health care, as one of the largest industries in the United States,
continues to attract much legislative interest and public attention. In recent
years, various legislative proposals have been introduced or proposed in
Congress and in some state legislatures that would affect major changes in the
health care system, either nationally or at the state level. Proposals that
have been considered include cost controls on hospitals, insurance market
reforms to increase the availability of group health insurance to small
businesses, patients bill of rights and requirements that all businesses offer
health insurance coverage to their employees. The cost of certain proposals
would be funded in significant part by reductions in payments by government
programs, including Medicare and Medicaid, to health care providers such as
hospitals. There can be no assurance that future health care legislation or
other changes in the administration or interpretation of governmental health
care programs will not have a material adverse affect on the business,
financial condition or results of operations of Psychiatric Solutions.

Insurance

As is typical in the health care industry, Psychiatric Solutions is
subject to claims and legal actions by patients in the ordinary course of
business. To cover these claims, Psychiatric Solutions maintains professional
malpractice liability insurance and general liability insurance in amounts it
believes to be sufficient for its operations, although it is possible that some
claims may exceed the scope of the coverage in effect. At various times in the
past, the cost of malpractice insurance and other liability insurance has risen
significantly. Therefore, there can be no assurance that such insurance will
continue to be available at reasonable prices which would allow Psychiatric
Solutions to maintain adequate levels of coverage.

Conversion Legislation

Many states have enacted or are considering enacting laws affecting the
conversion or sale of not-for-profit hospitals. These laws, in general,
include provisions relating to attorney general approval, advance notification
and community involvement. In addition, state attorneys general in states
without specific conversion legislation may exercise authority over these
transactions based upon existing law. In many states there has been an
increased interest in the oversight of not-for-profit conversions. The
adoption of conversion legislation and the increased review of not-for-profit
hospital conversions may limit Psychiatric Solutions ability to grow through
acquisitions of not-for-profit hospitals.

Compliance Program

Psychiatric Solutions is committed to ethical business practices and to
operating in accordance with all applicable laws and regulations. Psychiatric
Solutions Corporate Compliance Program was established to ensure that all
employees have a solid framework for business, legal, ethical, and employment
practices. Our Compliance Program establishes mechanisms to aid in the
identification and correction of any actual or perceived violations of any
Company policies or procedures or any other applicable rules and regulations.
Employee training is a key component of the Corporate Compliance Program. All
employees receive training during orientation and annually thereafter. With
the advent of the HIPAA regulations, our goal is to have all employees trained
prior to regulatory deadlines. Subsequent to the initial HIPAA training of all
employees, this component will be merged into the annual compliance training.
In addition, the Company requires its executive management to sign and adopt a
strict Code of Ethics.

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Sources Of Revenue

In its freestanding psychiatric hospital division, Psychiatric Solutions
receives payment for services rendered from private insurers, including managed
care plans, the Federal government under the Medicare program, state
governments under their respective Medicaid programs and directly from
patients. For the year ended December 31, 2002, approximately 48% of
Psychiatric Solutions revenues were generated from commercial providers and
other sources, while Federal and state Medicare and Medicaid programs comprised
approximately 52%.

The fees received by Psychiatric Solutions for its services under
management contracts are paid directly by its client hospitals. The client
hospitals receive reimbursement under either Medicare or Medicaid programs or
from payments from insurers, self-funded benefit plans or third-party payors
for the mental health services provided to patients of the programs managed by
Psychiatric Solutions. Subject to certain recently enacted caps in
reimbursement amounts, the Medicare program reimburses general acute care
hospitals for the cost of providing mental health services to eligible
patients. These costs include Psychiatric Solutions management fee, as well as
allocated overhead costs to the facility.

Employees

As of February 28, 2003, Psychiatric Solutions employed approximately
1,680 employees, of whom approximately 1,140 are full-time employees.
Approximately 1,250 employees staff the freestanding psychiatric facilities,
approximately 400 employees staff the management contracts and approximately 30
are in corporate management including finance, accounting, development,
utilization review, training and education, information systems, member
services, and human resources. None of Psychiatric Solutions employees is
subject to a collective bargaining agreement and Psychiatric Solutions believes
that its employee relations are good.

Insurance

Mental health care and information services are always subject to the risk
of liability. In recent years, participants in the mental health care industry
have become subject to an increasing number of lawsuits that allege malpractice
or other related legal theories. These lawsuits often involve large claims and
significant defense costs. For the years ended December 31, 2000 and 2001, and
through December, 2002, we have obtained professional and general liability
insurance for claims in excess of $100,000, up to a maximum of $1 million per
occurrence and $3 million aggregate, with an additional $5 million in excess
coverage. On December, 2002, the deductible on individual malpractice
claims was raised to $3 million and the insured limit to $10 million mitigate
the increases in the cost of professional and general liability insurance and
to increase coverage for additional exposures due to acquisitions. The reserve
for professional and general liability risks is based on historical claims,
demographic factors, industry trends, severity factors, and other actuarial
assumptions calculated by an independent third party. This estimate is
discounted to its present value using a 5% discount rate. This estimated
accrual for professional and general liabilities could be significantly
affected should current and future occurrences differ from historical claim
trends and expectations. Psychiatric Solutions has established a captive insurance company to
manage this additional self insured retention. While claims are monitored
closely when estimating professional and general liability accruals, the
complexity of the claims and wide range of potential outcomes often hampers
timely adjustments to the assumptions used in these estimates. Psychiatric
Solutions believes that its insurance coverage conforms to industry standards.
There are no assurances, however, that Psychiatric Solutions insurance will
cover all claims (e.g., claims for punitive damages), or that claims in excess
of Psychiatric Solutions insurance coverage will not arise. A successful
lawsuit against Psychiatric Solutions that is not covered by, or is in excess
of, our insurance coverage may have a material adverse effect on our business,
financial condition and results of operations.

Competition

The freestanding psychiatric hospital industry and the psychiatric unit
management industry are both highly competitive and highly fragmented. The
industry is subject to continual changes in the method in which services are
provided and the types of companies providing such services. Psychiatric
Solutions competes with several national competitors and many regional and
local competitors, some of which have greater resources than Psychiatric
Solutions. In addition, some of its competitors are owned by governmental
agencies and supported by tax revenues,

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and others are owned by nonprofit corporations and may be supported to a
large extent by endowments and charitable contributions. Such support is not
available to Psychiatric Solutions facilities.

The largest competitors in the freestanding psychiatric hospital and
psychiatric unit management industry are:



| |  | Ardent Health Services, which operates approximately 23
psychiatric facilities and two medical/surgical hospitals;
|- |  | ------------------------------------------------------------------------------------------------------------------



| |  | Universal Health Services (NYSE: UHS), which operates 38
psychiatric facilities and 134 acute care facilities; and
|- |  | ------------------------------------------------------------------------------------------------------------------



| |  | Horizon Health Corporation (NasdaqNM: HORC), which operates
110 psychiatric unit management contracts, 27 rehabilitation unit
contracts and employee assistance programs covering 3.2 million
lives.
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

In addition, Psychiatric Solutions freestanding psychiatric facilities
and managed psychiatric units compete for patients with other providers of
mental health care services, including other freestanding psychiatric
facilities, general acute care hospitals, independent psychiatrists and
psychologists.

Psychiatric Solutions also competes with hospitals, nursing homes,
clinics, physicians offices and contract nursing companies for the services of
registered nurses. Registered nurses are in limited supply and there can be no
assurance that Psychiatric Solutions will be able to attract a sufficient
number of registered nurses for its growing needs.

Available information

Psychiatric Solutions makes available free of charge through its website,
which you can find at www.psysolutions.com, our annual report on Form 10-K,
quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to
these reports filed or furnished pursuant to Section 13(a) or 15(d) of the
Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after we electronically file
such material with, or furnish it to, the SEC.







Item 2.  Properties

Psychiatric Solutions principal executive offices are located in
approximately 7,745 square feet of leased space in Franklin, Tennessee. The
Company does not anticipate that it will experience any difficulty in renewing
its lease upon its expiration in December 2006, or obtaining different space on
comparable terms if such lease is not renewed. In addition, Psychiatric
Solutions owns the properties acquired with the five hospital acquisitions
described above. Other facilities and programs are operated under management
contracts. Psychiatric Solutions believes its executive offices and its
hospital property and equipment are generally well maintained, in good
operating condition and adequate for its present needs. See
Business-Description of Services by Segment.







Item 3.  Legal Proceedings

Psychiatric Solutions is subject to various claims and legal actions which
arise in the ordinary course of business. In the opinion of management,
Psychiatric Solutions is not currently a party to any proceeding which would
have a material adverse effect on Psychiatric Solutions financial condition or
results of operations.







Item 4.  Submission Of Matters To A Vote Of Security Holders

None.

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PART II







Item 5.  Market For Registrants Common Equity And Related Stockholder Matters.

The Companys common stock has traded on the Nasdaq National Market under
the symbol PSYS since August 6, 2002. Prior to August 6, 2002, the Companys
common stock was traded on the Nasdaq National Market under the symbol PMRP.
See description of PMR merger transaction in Part I, Item 1 of this Form 10-K
and in Note 1 to the Notes to Consolidated Financial Statements.

The table below sets forth, for the calendar quarters indicated, the high
and low sales prices per share as reported on the Nasdaq National Market for
Psychiatric Solutions and, prior to August 6, 2002, for PMRs common stock.
The stock prices have been adjusted to reflect a 1-for-3 reverse stock split
effected on August 5, 2002.

High
        
        Low2002First Quarter
        
        $
        7.68
        
        
        $
        4.89Second Quarter
        
        $
        11.43
        
        
        $
        3.72Third Quarter
        
        $
        6.75
        
        
        $
        4.75Fourth Quarter
        
        $
        5.94
        
        
        $
        5.002001First Quarter
        
        $
        6.00
        
        
        $
        3.38Second Quarter
        
        $
        5.25
        
        
        $
        3.81Third Quarter
        
        $
        4.77
        
        
        $
        3.63Fourth Quarter
        
        $
        6.42
        
        
        $
        4.38


At the
close of business on March 25, 2003, there were approximately
146 holders of record of Psychiatric Solutions common stock.

In the third quarter of fiscal year 2000, PMRs board of directors
declared a special dividend of $4.50 per share of common stock payable to
stockholders of record on January 26, 2000. The total amount of the dividend
was approximately $10.6 million. In the third quarter of fiscal year 2001,
PMRs board of directors declared a special cash dividend of $1.00 per share of
common stock payable on December 29, 2000 to stockholders of record on December
21, 2000. The total amount of the dividend was approximately $7.3 million. On
May 6, 2002, PMRs board of directors declared a special cash dividend of $5.10
per share of common stock payable on May 24, 2002 to the stockholders of record
as of the close of business on May 17, 2002. The total amount of the dividend
was approximately $12.3 million. The Company currently intends to retain
future earnings for use in the expansion and operation of its business.
Borrowings may limit the ability to pay dividends. The payment of any future
cash dividends will be determined by the Board of Directors in light of
conditions then existing, including Psychiatric Solutions earnings, financial
condition and capital requirements, restrictions in financing agreements,
business opportunities and conditions, and other factors. See Managements
Discussion and Analysis of Financial Condition and Results of Operations -
Liquidity and Capital Resources.







Item 6.  Selected Financial Data

The selected financial data presented below for the years ended December
31, 2002, 2001 and 2000, and at December 31, 2002 and December 31, 2001, are
derived from the audited Consolidated Financial Statements of the Company
included elsewhere in this Report on Form 10-K. The selected financial data for
the years ended December 31, 1999 and 1998, and at December 31, 2000, 1999 and
1998, are derived from the audited consolidated financial statements of the
Company not included herein. The selected financial data presented below should
be read in conjunction with Managements Discussion and Analysis of Financial
Condition and Results of Operations and with the Consolidated Financial
Statements of the Company and Notes thereto included elsewhere in this Report.

17



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##### Table of Contents



Psychiatric Solutions, Inc.Selected Financial DataAs of and for the Years Ended December 31,2002
        
        2001
        
        2000
        
        1999
        
        1998(in thousands, except per share amounts)Statement of Operations Data:Revenue
        
        $
        113,912
        
        
        $
        43,999
        
        
        $
        23,502
        
        
        $
        4,500
        
        
        $
        1,533Salaries, wages and employee benefits
        
        
        62,326
        
        
        
        26,183
        
        
        
        15,257
        
        
        
        4,350
        
        
        
        2,819Professional fees
        
        
        14,373
        
        
        
        7,039
        
        
        
        3,771
        
        
        
        990
        
        
        
        288Provision for bad debts
        
        
        3,681
        
        
        
        662
        
        
        
        467
        
        
        
        529
        
        
        
        68Other operating expenses
        
        
        21,521
        
        
        
        4,283
        
        
        
        2,055
        
        
        
        619
        
        
        
        705Depreciation
and amortization(1)
        
        
        1,770
        
        
        
        945
        
        
        
        757
        
        
        
        234
        
        
        
        122Interest expense
        
        
        5,564
        
        
        
        2,660
        
        
        
        1,723
        
        
        
        371
        
        
        
        98109,235
        
        
        
        41,772
        
        
        
        24,030
        
        
        
        7,093
        
        
        
        4,100Income (loss) from continuing operations before
income taxes
        
        
        4,677
        
        
        
        2,227
        
        
        
        (528
        )
        
        
        (2,593
        )
        
        
        (2,567
        )Benefit from income taxes
        
        
        (1,007
        )
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        Income (loss) from continuing operations
        
        $
        5,684
        
        
        $
        2,227
        
        
        $
        (528
        )
        
        $
        (2,593
        )
        
        $
        (2,567
        )Basic earnings (loss) per share from continuing
operations
        
        $
        0.93
        
        
        $
        0.44
        
        
        $
        (0.11
        )
        
        $
        (0.64
        )
        
        $
        (0.75
        )Shares used in computing basic earnings (loss) per
share from continuing operations
        
        
        6,111
        
        
        
        5,010
        
        
        
        4,817
        
        
        
        4,062
        
        
        
        3,416Diluted earnings (loss) per share from continuing
operations
        
        $
        0.86
        
        
        $
        0.42
        
        
        $
        (0.11
        )
        
        $
        (0.64
        )
        
        $
        (0.75
        )Shares used in computing diluted earnings (loss)
per share from continuing operations
        
        
        6,986
        
        
        
        5,309
        
        
        
        4,817
        
        
        
        4,062
        
        
        
        3,416Balance sheet data:Total assets
        
        $
        90,138
        
        
        $
        54,294
        
        
        $
        26,356
        
        
        $
        13,154
        
        
        $
        10,161Total liabilities
        
        
        59,589
        
        
        
        45,056
        
        
        
        20,120
        
        
        
        7,338
        
        
        
        3,106Long-term obligations, including current portion
        
        
        44,944
        
        
        
        37,261
        
        
        
        17,240
        
        
        
        6,428
        
        
        
        




---

|(1) |  | Refer to the Notes to Consolidated Financial Statements regarding the
non-amortization provisions of goodwill for transactions completed
subsequent to June 30, 2001 and effective for fiscal years ending after
December 15, 2001.
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------







Item 7.  Managements Discussion And Analysis Of Financial Condition And Results Of Operations

The following discussion and analysis should be read in conjunction with
the selected financial data and the accompanying consolidated financial
statements and related notes thereto included in this annual report on Form
10-K.

Overview

As of December 31, 2002, Psychiatric Solutions owned and operated five
free-standing psychiatric facilities which provided psychiatric services to
patients in the Houston, Texas; Austin, Texas; Raleigh, North Carolina; and
Chicago, Illinois areas and managed 48 psychiatric units for third party acute
care hospitals in 14 states. Psychiatric Solutions also has a contract to
provide mental health case management services to approximately 4,300 children
and adults with serious mental illness in the Nashville, Tennessee area.
Psychiatric Solutions objective is to provide high-quality, cost-effective
psychiatric services in the communities it serves.
Through its managed and freestanding psychiatric facilities, Psychiatric
Solutions offers a comprehensive array of behavioral health programs to
critically ill children, adolescents and adults. It currently operates in two
reportable

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##### Table of Contents



segments: (i) the ownership and operation of freestanding inpatient
psychiatric facilities and (ii) the operation of psychiatric units in
facilities owned by third parties.

Impact Of Acquisitions

Acquiring free-standing psychiatric facilities is a key part of
Psychiatric Solutions business strategy. Because Psychiatric Solutions has
grown through acquisitions accounted for as purchases, it is difficult to make
meaningful comparisons between its financial statements for the fiscal periods
presented. In addition, because Psychiatric Solutions owns a relatively small
number of facilities, an individual acquisition may have a material effect on
its overall operating performance. At the time a hospital is acquired,
Psychiatric Solutions implements a number of measures to lower costs and may
make significant investments in the facility. Therefore, the financial
performance of a newly acquired hospital may adversely affect the Companys
overall performance in the short-term.

On August 31, 1999 Psychiatric Solutions purchased all of the outstanding
stock of Cornerstone Behavioral Health Services Inc. (Cornerstone) for
approximately $4.6 million. Cornerstone managed approximately 20
geropsychiatric units in acute care hospitals situated primarily in suburban
communities in the South and Midwest.

Effective May 1, 2000, Psychiatric Solutions acquired the equity of
Sunrise Behavioral Health, Ltd. (Sunrise), a manager of inpatient psychiatric
units in acute care hospitals, for approximately $13 million, net of
approximately $2.1 million of assumed liabilities. The acquisition was financed
through the assumption of certain liabilities, borrowings under a credit
agreement, and the issuance of seller-financed subordinated convertible notes.

On September 1, 2001, Psychiatric Solutions acquired the assets of Cypress
Creek Hospital and West Oaks Hospital in Houston, Texas for approximately $12.1
million, net of approximately $2.1 million of assumed liabilities. The
acquisition was financed through a seller-financed subordinated convertible
note as well as other long-term borrowings.

Effective November 1, 2001, Psychiatric Solutions acquired the assets of
Texas NeuroRehab Hospital in Austin, Texas for approximately $7.6 million, net
of approximately $800,000 of assumed liabilities, which was financed through a
seller-financed subordinated convertible note and additional long-term
borrowings.

On December 1, 2001, Psychiatric Solutions acquired the assets of Holly
Hill Hospital in Raleigh, North Carolina for approximately $7.6 million, net of
approximately $758,000 of assumed liabilities, which was financed through
long-term borrowings under a line of credit.

On July 1, 2002, Psychiatric Solutions acquired all of the capital stock
of Aeries Healthcare Corporation and its wholly owned subsidiary, Aeries
Healthcare of Illinois, Inc. for $16.8 million, net of approximately $4.3
million of assumed liabilities, prior to certain adjustments. Aeries Healthcare
of Illinois owns the assets and operations of Riveredge Hospital located near
Chicago, Illinois. The acquisition was financed in part through an amendment to
Psychiatric Solutions senior credit facility.

On
August 5, 2002, Psychiatric Solutions merged with PMR, a publicly traded
operator of case management programs in Tennessee and a manager of two
outpatient psychiatric programs with one acute care hospital in California.
For accounting purposes, the merger was treated as a purchase of PMR by
Psychiatric Solutions. PMR shareholders were issued approximately 2.4 million
shares of Psychiatric Solutions common stock. The Company acquired
approximately $6.0 million in cash in the PMR transaction. Psychiatric
Solutions was guaranteed approximately $5.2 million in cash as a part of the
PMR transaction. Any additional monies above $5.2 million as well as
subsequent collections of certain legacy receivables of PMR, if any, received
by Psychiatric Solutions are payable to certain former PMR shareholders as
defined in the Contingent Value Rights Agreement (CVR). During the fourth
quarter of 2002, the Company paid approximately $738,000 to CVR holders.
Additional future payments to CVR holders may be necessary; however, the
Company cannot anticipate the amount or timing of such payments as they are
contingent upon the Company collecting certain legacy receivables of PMR.

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##### Table of Contents



On February 13, 2003, Psychiatric Solutions signed a definitive agreement
for the purchase of six psychiatric facilities from The Brown Schools, Inc. for
$63 million in cash. The six facilities, which have an aggregate of 790 beds,
are located in Austin, San Antonio and San Marcos, Texas; Charlottesville,
Virginia; Colorado Springs, Colorado; and Tulsa, Oklahoma. For 2002, the
facilities produced combined revenues of $76 million. Consummation of the
transaction, which is subject to customary closing conditions, is expected on
April 1, 2003. Completion of certain health care regulatory matters may delay the purchase
of one of the facilities until mid-April. The Company intends to
finance the acquisition through proceeds from the issuance of its
Series A Convertible Preferred Stock and its amended senior
credit facility with CapitalSource Finance.

Sources Of Revenue

Patient Service Revenue

Patient service revenue is generated by Psychiatric Solutions facilities
as a result of services provided to patients within the hospital setting.
Patient service revenue is reported on an accrual basis in the period in which
services are rendered, at established rates, regardless of whether collection
in full is expected. Patient service revenue includes amounts estimated by
management to be reimbursable by Medicare and Medicaid under provisions of cost
or prospective reimbursement formulas in effect. Amounts received are generally
less than the established billing rates of the facilities and the differences
are reported as deductions from patient service revenue at the time the service
is rendered. For the year ended December 31, 2002, patient service revenue
comprised approximately 72% of total revenue.

Management Fee Revenue

Management fee revenue is earned by Psychiatric Solutions unit management
division. The psychiatric unit management division receives contractually
determined management fees and director fees from hospitals and clinics for
providing psychiatric management and development services. For the year ended
December 31, 2002, management fee revenue comprised approximately 28% of total
revenue.

20



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##### Table of Contents



Results Of Continuing Operations

The following table sets forth, for the periods indicated, Psychiatric
Solutions operating results (in thousands):

Years Ended December 31,2002
        
        2001
        
        2000Amount
        
        %
        
        Amount
        
        %
        
        Amount
        
        %Revenue
        
        $
        113,912
        
        
        
        100.0
        %
        
        $
        43,999
        
        
        
        100.0
        %
        
        $
        23,502
        
        
        
        100.0
        %Salaries, wages, and employee
benefits
        
        
        62,326
        
        
        
        54.7
        %
        
        
        26,183
        
        
        
        59.6
        %
        
        
        15,257
        
        
        
        64.9
        %Professional fees
        
        
        14,373
        
        
        
        12.6
        %
        
        
        7,039
        
        
        
        16.0
        %
        
        
        3,771
        
        
        
        16.0
        %Supplies
        
        
        5,325
        
        
        
        4.7
        %
        
        
        1,241
        
        
        
        2.8
        %
        
        
        421
        
        
        
        1.8
        %Provision for bad debts
        
        
        3,681
        
        
        
        3.2
        %
        
        
        662
        
        
        
        1.5
        %
        
        
        467
        
        
        
        2.0
        %Other operating expenses
        
        
        15,934
        
        
        
        14.0
        %
        
        
        3,042
        
        
        
        6.9
        %
        
        
        1,634
        
        
        
        7.0
        %EBITDA (1)
        
        
        12,273
        
        
        
        10.8
        %
        
        
        5,832
        
        
        
        13.3
        %
        
        
        1,952
        
        
        
        8.3
        %Depreciation
and amortization(2)
        
        
        1,770
        
        
        
        1.6
        %
        
        
        945
        
        
        
        2.1
        %
        
        
        757
        
        
        
        3.2
        %Other non-operating expenses
        
        
        262
        
        
        
        0.2
        %
        
        
        
        
        
        
        0.0
        %
        
        
        
        
        
        
        0.0
        %Interest expense
        
        
        5,564
        
        
        
        4.9
        %
        
        
        2,660
        
        
        
        6.0
        %
        
        
        1,723
        
        
        
        7.3
        %Income (loss) from continuing operations
before income taxes and extraordinary
items
        
        
        4,677
        
        
        
        4.1
        %
        
        
        2,227
        
        
        
        5.1
        %
        
        
        (528
        )
        
        
        -2.2
        %Benefit from income taxes
        
        
        (1,007
        )
        
        
        -0.9
        %
        
        
        
        
        
        
        0.0
        %
        
        
        
        
        
        
        0.0
        %Income (loss) from continuing operations
before extraordinary items
        
        
        5,684
        
        
        
        5.0
        %
        
        
        2,227
        
        
        
        5.1
        %
        
        
        (528
        )
        
        
        -2.2
        %Extraordinary loss from early retirement of
debt, net of income taxes of $223 for 2001
        
        
        
        
        
        
        
        
        
        
        (1,237
        )
        
        
        -2.8
        %
        
        
        
        
        
        
        Income
(loss) from continuing operations net of extraordinary items
        
        $
        5,684
        
        
        
        5.0
        %
        
        $
        990
        
        
        
        2.3
        %
        
        $
        (528
        )
        
        
        -2.2
        %




---

|(1) |  | EBITDA is defined as income from continuing operations before interest
expense (net of interest income), income taxes, depreciation, amortization, and
extraordinary items. While you should not consider EBITDA in isolation or as a
substitute for net income, operating cash flows or other cash flow statement
data determined in accordance with accounting principles generally accepted in
the United States, management understands that EBITDA is a commonly used
analytical indicator within the health care industry and also serves as a
measure of leverage capacity and debt service ability. EBITDA, as presented,
may not be comparable to similarly titled measures of other companies.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(2) |  | Refer to the Notes to the
Consolidated Financial Statements regarding the non-amortization
provisions of goodwill for transactions completed subsequent to June 30, 2001 and effective for fiscal years ending after December 15,
2001.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Year Ended December 31, 2002 Compared To Year Ended December 31, 2001

Revenue. Revenue from continuing operations was $113.9 million for the
year ended December 31, 2002 compared to $44.0 million for the year ended
December 31, 2001, an increase of $69.9 million or 158.9%. Revenue from owned
facilities accounted for $81.9 million of the 2002 results compared to $16.0
million of the 2001 results, an increase of $65.9 million or 411.9%. The
increase in revenues from owned facilities relates to full year operations
during 2002 of the four facilities purchased during the last four months of
2001 as well as the purchase of a fifth facility at the beginning of the third
quarter of 2002. Revenue from unit management contracts accounted for $32.0
million of the 2002 results compared to $28.0 million of the 2001 results, an
increase of $4.0 million or 14.3%. The increase in revenues from unit
management contracts relates to the additional unit management operations
acquired in the merger with PMR Corporation.

Salaries, wage, and employee benefits. Salaries, wages and employee
benefits expense was $62.3 million, or 54.7% of 2002 revenue, for the year
ended December 31, 2002 compared to $26.2 million, or 59.6% of 2001 revenue,
for the year ended December 31, 2001. Salaries, wages and employee benefits
expense from owned facilities was $47.0 million in 2002, or 57.4% of 2002
revenue from owned facilities, compared to $9.5 million in

21



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##### Table of Contents



2001, or 59.4% of 2001 revenue from owned facilities. This decrease in
salaries, wages and employee benefits expense as a percentage of revenue from
owned facilities relates to cost containment efforts within the Companys owned
facilities. Salaries, wages and employee benefits expense from unit management
contracts was $13.2 million in 2002, or 41.3% of 2002 revenue from unit
management contracts, compared to $15.5 million in 2001, or 55.4% of 2001
revenue from unit management contracts. This decrease in salaries, wages and
employee benefits expense as a percentage of revenue from unit management
contracts relates to the Companys acquisition from PMR of a contract to
provide case management services in the Nashville, Tennessee area. All costs
to provide these services are recorded in other operating expenses because the
actual services provided are subcontracted. Salaries, wages and employee
benefits expense for the Companys corporate office was $2.1 million for 2002
compared to $1.2 million for 2001 as the result of the addition of staff
necessary to manage the acquisitions completed during late 2001 and 2002.

Professional fees. Professional fees were $14.4 million, or 12.6% of 2002
revenue, for the year ended December 31, 2002 compared to $7.0 million, or
16.0% of 2001 revenue, for the year ended December 31, 2001.Professional fees
from owned facilities were $10.3 million in 2002, or 12.6% of 2002 revenue from
owned facilities, compared to $2.6 million in 2001, or 16.3% of 2001 revenue
from owned facilities. This decrease in professional fees from owned facilities
as a percentage of revenue from owned facilities relates to the acquisition of
new facilities that are less dependent upon professional fees for operations.
Professional fees from unit management contracts were $3.5 million in 2002, or
10.9% of 2002 revenue from unit management contracts, compared to $4.1 million
in 2001, or 14.6% of 2001 revenue from unit management contracts. This decrease
in professional fees from unit management contracts as a percentage of revenue
from unit management contracts relates to cost containment efforts within the
unit management division, as well as classification of the costs to provide
case management services in the Nashville, Tennessee area. Professional fees
for the Companys corporate office were approximately $500,000 in 2002 compared
to approximately $300,000 in 2001. The increase in professional fees at the
Companys corporate office relate to accounting, legal, and other services
required as a public company.

Supplies.Supplies expense was $5.3 million, or 4.7% of 2002 revenue, for
the year ended December 31, 2002 compared to $1.2 million, or 2.8% of 2001
revenue, for the year ended December 31, 2001. Supplies expense at owned
facilities comprises almost the entire amount of supplies expense for the
Company as a whole. Supplies necessary at owned facilities include medical,
pharmaceutical and office supplies. The increase in supplies expense as a
percentage of revenue relates to the acquisitions completed during
late 2001 and 2002. Supplies expense for the
unit management division and the corporate office consist of office supplies
and are negligible to supplies expense overall.

Provision for bad debts. The provision for bad debts was $3.7 million, or
3.2% of 2002 revenue, for the year ended December 31, 2002 compared to
$662,000, or 1.5% of 2001 revenue, for the year ended December 31, 2001. The
provision for bad debts at owned facilities was $3.5 million in 2002, or 4.3%
of 2002 owned hospital revenue, compared to approximately $400,000 in 2001, or
2.5% of 2001 owned hospital revenue. This increase in provision for bad debts
at owned facilities as a percentage of owned facilities revenue relates to
changes in payer mix and the impact of acquisitions. The provision for bad
debts related to unit management contracts was approximately $200,000 in 2002,
or less than 1% of 2002 revenue from unit management contracts, compared to
approximately $250,000 in 2001, or less than 1% of 2001 revenue from unit
management contracts.

Other operating expenses. Other operating expenses were approximately
$15.9 million, or 14.0% of 2002 revenue, for the year ended December 31, 2002
compared to $3.0 million, or 6.9% of 2001 revenue, for the year ended December
31, 2001. Other operating expenses for owned facilities were $6.6 million in
2002, or 8.1% of 2002 owned facilities revenue, compared to $1.0 million in 2001,
or 6.3% of 2001 owned facilities revenue. This increase in other operating
expenses for owned facilities as a percentage of owned facilities revenue relates
primarily to increased insurance costs in 2002. Other operating expenses for
unit management contracts was $7.9 million in 2002, or 24.7% of 2002 unit
management revenue, compared to $1.6 million in 2001, or 5.7% of 2001 unit
management revenue. This increase in other operating expenses for unit
management contracts as a percentage of unit management revenue is attributable
to the contract to provide case management services in the Nashville,
Tennessee area where actual services provided are subcontracted. Other operating
expenses at the Companys corporate office increased to $1.3 million in 2002
from approximately $400,000 in 2001 primarily due to increased insurance costs
in 2002.

22



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Depreciation and amortization. Depreciation and amortization expense was
$1.8 million for the year ended December 31, 2002 compared to $945,000 for the
year ended December 31, 2001, an increase of approximately $800,000 or 87.3%.
This increase in depreciation and amortization expense is the result of full
year operations in 2002 for the facilities purchased in the last four months of
2001 as well as 2002 acquisitions.

Interest expense. Interest expense was $5.6 million for the year ended
December 31, 2002 compared to $2.7 million for the year ended December 31,
2001, an increase of $2.9 million or 107.4%. The increase in interest expense
is due to borrowings under Psychiatric Solutions senior credit facility as
well as subordinated debt obtained to fund acquisitions in 2001 and 2002.

Year Ended December 31, 2001 Compared To Year Ended December 31, 2000

Revenue. Revenue from continuing operations was $44.0 million for the
fiscal year ended December 31, 2001 compared to $23.5 million for the fiscal
year ended December 31, 2000, an increase of $20.5 million or 87.2%. Hospital
acquisitions during fiscal year 2001 accounted for approximately $16.0 million
of the increase in revenues during the fiscal year ended December 31, 2001.
Additionally, the increase reflects the fact that the operations of Sunrise
were included for all of 2001 as compared to eight months during 2000.

Salaries, wages, and employee benefits. Salaries, wages, and employee
benefits expense was $26.2 million for the fiscal year ended December 31, 2001,
compared to $15.3 million for the fiscal year ended December 31, 2000, an
increase of $10.9 million or 71.2%. Of this increase, $9.5 million related to
the addition of personnel stemming from the acquisitions in 2001.

Professional fees. Professional fees were $7.0 million for the fiscal year
ended December 31, 2001, compared to $3.8 million for the fiscal year ended
December 31, 2000, an increase of $3.2 million or 84.2%. This increase relates
primarily to the acquisition of Sunrise in May 2000.

Provision for doubtful accounts. The provision for doubtful accounts was
$662,000 for the fiscal year ended December 31, 2001, compared to $467,000 for
the fiscal year ended December 31, 2000, an increase of $195,000 or 41.8%. This
increase is attributable to approximately $400,000 of provision for doubtful
accounts related to hospital acquisitions which is offset by improved
collections experience related to Psychiatric Solutions management contracts.
The provision for doubtful accounts as a percentage of revenue increased from
1.1% for the fiscal year ended December 31, 2000 to 1.5% for the fiscal year
ended December 31, 2001.

Other operating expenses. Other operating expenses were approximately $4.3
million for the fiscal year ended December 31, 2001, compared to $2.1 million
for the fiscal year ended December 31, 2000, an increase of $2.2 million or
108.5%. This increase is attributable to acquisitions during fiscal year 2001.

Depreciation and amortization. Depreciation and amortization expense was
$945,000 for the fiscal year ended December 31, 2001 compared to $757,000 for
the fiscal year ended December 31, 2000, an increase of $188,000 or 24.8%.
This increase is attributable to acquisitions during fiscal year 2001.

Interest expense. Interest expense was $2.6 million for the fiscal year
ended December 31, 2001 compared to $1.7 million for the fiscal year ended
December 31, 2000, an increase of $937,000 or 54.4%. The increase in interest
expense is due to borrowings under Psychiatric Solutions line of credit as
well as obtaining seller-financed convertible notes to fund acquisitions in
2001.

Liquidity And Capital Resources

As of December 31, 2002, Psychiatric Solutions had working capital of $2.4
million, including cash and cash equivalents of $2.4 million, compared to a
working capital deficit of $3.6 million at December 31, 2001. Working capital
includes amounts due under the terms of Psychiatric Solutions revolving credit
agreement, which totaled $5.4 million at December 31, 2002 and $11.1 million at
December 31, 2001. The revolving credit agreement requires that all
non-governmental cash receipts be applied to reduce the outstanding balance
under the revolving credit agreement. Such amounts can then be
re-borrowed to the extent that borrowing capacity remains under

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the revolving line of credit. The decrease in the working capital deficit
is primarily due to cash acquired of approximately $6.0 million in the PMR
transaction.

Cash
provided by operating activities increased from $6.8 million for
the year
ended December 31, 2001 to $8.9 million for the year ended December 31, 2002.
The increase in cash flows from operating activities was due to the acquisition
of facilities in the third and fourth quarters of 2001 and third quarter of
2002. Cash provided by investing activities increased from approximately $2.0
million for the year ended December 31, 2001 to $4.2 million for the year ended
December 31, 2002. This increase was due to cash acquired of approximately $6.0
million in the PMR transaction offset by cash used in capital purchases of $1.5
million and other assets of $612,000 during the year ended December 31, 2002.
Psychiatric Solutions was guaranteed approximately $5.2 million in cash as a
part of the PMR transaction. Any additional monies above the $5.2 million as
well as subsequent collections of certain legacy receivables of PMR, if any,
received by Psychiatric Solutions are payable to certain former PMR
shareholders as defined in the Contingent Value Rights Agreement (CVR).
During the fourth quarter of 2002, the Company paid approximately $738,000 to
CVR holders. Additional future payments to CVR holders may be necessary,
however the Company cannot anticipate the amount or timing of such payments as
they are contingent upon the Company collecting certain legacy receivables of
PMR.

Cash used in financing activities increased from $7.8 million for the year
ended December 31, 2001 to $12.0 million for the year ended December 31, 2002.
This increase was due primarily to principal payments on long-term debt.

In conjunction with the acquisition of Holly Hill Hospital in December
2001, Psychiatric Solutions entered into a senior credit facility of $33.2
million with CapitalSource Finance (2001 Senior Credit Facility). The 2001
Senior Credit Facility was amended on June 28, 2002 to provide for an
additional $7.95 million pursuant to a new non-revolving term note. The 2001
Senior Credit Facility, as amended, includes two lines of credit for a total
credit facility of $41.15 million, made up of $23.65 million of non-revolving
term loans and a $17.5 million revolving working capital line of credit. Both
lines are secured by substantially all of Psychiatric Solutions assets and the
stock of its subsidiaries. The term loans accrue interest at the Citibank, N.A.
prime rate plus 4.25% to 4.75%. The revolving line of credit accrues interest
at the Citibank, N.A. prime rate plus 2%, subject to a floor of 7.25%, and is due in November 2004. At
December 31, 2002, the interest rate under the revolving credit
facility was 7.25%. Until the due date,
Psychiatric Solutions may borrow, repay and re-borrow an amount not to exceed
the lesser of $17.5 million or the borrowing base (as defined in the 2001
Senior Credit Facility, which was $15.6 million at
December 31, 2002). On July 1, 2002, Psychiatric Solutions drew $2.9
million on the revolving line of credit in connection with its purchase of
Riveredge Hospital. As of December 31, 2002, the Company had $12.1 million
available under the revolving line of credit. Under the revolving line of
credit, all of Psychiatric Solutions collections, except for Medicare and
Medicaid payments, are deposited into lockbox accounts controlled by the
lender. The funds deposited in the lockbox are applied to outstanding
borrowings with the lender on a daily basis. As a result, the outstanding
borrowings under the revolving line of credit are classified as short term as
of December 31, 2001 and December 31, 2002. Psychiatric Solutions must pay an
unused fee in the amount of 0.05% per month of the monthly unused portion of
the 2001 Senior Credit Facility. Such fees were approximately $50,000 as of
December 31, 2002.

The 2001 Senior Credit Facility contains customary covenants which
include: (i) a specified monthly patient census for any owned, operated or
leased facilities, (ii) a limitation on capital expenditures, sales of assets,
mergers, changes of ownership and management, new lines of business and
dividends and (iii) maintenance of minimum interest coverage, net leverage and
fixed charge ratios.As of December 31, 2002, Psychiatric Solutions was in
compliance with all applicable debt covenant requirements. Should Psychiatric
Solutions results of operations or cash flows decline and result in violation
of one or more of these covenants, amounts outstanding under the 2001 Senior
Credit Facility could become immediately payable and additional borrowings
could be restricted. As of December 31, 2002, approximately $22.7 million was
outstanding.

In
October 2000, Psychiatric Solutions issued subordinated notes totaling
$1.0 million to certain of its stockholders (the Bridge Loan). In
connection with the Bridge Loan, Psychiatric Solutions issued warrants to
purchase a total of 398,579 shares of its Series B preferred stock. The Bridge
Loan was used to fund short-term working capital requirements and accrued
interest at 10% per annum, payable monthly. The Bridge Loan was paid in full in
April 2002. The warrants were exercised by Bridge Loan holders, notably Oak
Management and certain of

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its affiliates and Acacia Venture and certain of its affiliates, on August
1, 2002, and, in conjunction with the PMR merger, converted to 124,700 shares
of common stock on August 5, 2002.

In connection with the acquisition of Sunrise in May 2000, Psychiatric
Solutions issued subordinated convertible notes in the amount of $3.6 million.
These convertible notes are due May 1, 2005 and accrue interest at 9% per
annum. The principal amount of these convertible notes is convertible into
shares of the Companys common stock at conversion prices of $8.53 to
$9.59 per share.

In 2001, Psychiatric Solutions also issued promissory notes totaling $4.5 million
in connection with its acquisitions of three facilities. One note in the amount
of $2.5 million accrues interest at 9% per annum and matured on June 30, 2002.
Psychiatric Solutions paid off this note in full with a portion of the proceeds
of its subordinated debt offering described below. The remaining $2.0 million
note accrues interest at 9% per annum and is due June 30, 2005. Among other
customary covenants, both notes contain cross default covenants triggered by a
default of any other indebtedness of at least $1.0 million. Psychiatric
Solutions was in compliance with these covenants as of December 31, 2002.

On June 28, 2002, Psychiatric Solutions entered into a securities purchase
agreement with 1818 Mezzanine Fund II, L.P. (1818 Fund) to issue up to $20
million of senior subordinated notes with detachable nominal warrants. At the
closing on June 28, 2002, a total of $10 million of the senior subordinated
notes were issued. Approximately $7.5 million of the proceeds were used to fund
a portion of the acquisition of Riveredge Hospital, and approximately $2.5
million of the proceeds were used to reduce current indebtedness. The remaining
$10 million of senior subordinated notes may be issued to fund additional
acquisitions of free-standing psychiatric facilities and for general working
capital purposes, subject generally to approval by the 1818 Fund. The notes
have a term of seven years and bear interest at 12% annually, payable
quarterly. The notes provide for a prepayment penalty of 6%, 3% and 1% if the
notes are prepaid prior to the first anniversary, second anniversary and third
anniversary of the closing date, respectively. The notes grant the holders the
right to require prepayment in the event of a change of control of Psychiatric
Solutions, subject to a prepayment penalty of 1% if redeemed on or before the
third anniversary of the closing date. The notes also contain customary
covenants which include: (i) a specified monthly patient census for any owned,
operated or leased facilities, (ii) limitations on sales of assets (iii)
maintenance of minimum interest coverage, leverage and fixed charge ratios.

In connection with the issuance of the senior subordinated notes, Psychiatric Solutions issued detachable stock purchase warrants for the
purchase of 372,412 shares of the Companys stock at an exercise price of $.01
per share. As of the date of issuance, the Companys shares were valued at
$5.43 per share such that the fair value of the warrants totaled approximately
$2.0 million. Under Accounting Principles Board Opinion No. 14, Psychiatric
Solutions is required to allocate a portion of the cash proceeds received from
the notes to the stock purchase warrants with the offset recorded as a note
discount and then amortized to the face value of the notes over the life of the
notes. Under EITF 00-19, the Company is required to reclassify the amount
initially recognized as capital in excess of par value to a long term liability
and changes in fair value recorded to operations. For each $1 increase in
stock price, Psychiatric Solutions will be required to record non cash expense
of approximately $372,000. The stock purchase warrants contain provisions that
allow the issuer to put their warrants, or stock after exercise, back to
Psychiatric Solutions at fair market value for cash or for the deliverance of
shares. The put price under the agreement would approximate $2 million or
require the deliverance 371,841 shares as of December 31, 2002.

On
February 4, 2003, Psychiatric Solutions stockholders approved the
private placement of $25 million of our Series A Convertible Preferred Stock
(the preferred stock) with affiliates of Oak Investment Partners and Salix
Ventures and with Brown Brothers Harriman & Co.s The 1818 Mezzanine Fund II,
L.P. The investors are current investors in Psychiatric Solutions, with Oak
Investment Partners and Salix Ventures (or related entities) being among the
co-founders of Psychiatric Solutions. Representatives of Oak
Investment Partners, Salix Ventures and
Brown Brothers Harriman currently serve on our Board of Directors. We intend to use the net proceeds from the
preferred stock primarily to fund acquisitions of freestanding psychiatric
patient facilities. The preferred stock will be issued in two phases:
one-half
will be issued on April 1, 2003, and one-half will be issued on July 1, 2003.

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On November 25, 2002, the Company entered into a mortgage loan agreement
to borrow $4,928,000 from the U.S. Department of Housing and Urban Development
(HUD), secured by real estate located at Holly Hill Hospital in Raleigh, NC.
Interest accrues on the HUD loan at 5.95% and principal and interest are
payable in 420 monthly installments through December 2037. The Company used
proceeds from the loan to replace $4,385,000 of its senior term loan
with CapitalSource Finance, pay certain refinancing costs, and fund required escrow amounts
for future improvements to the property.

On
February 13, 2003, Psychiatric Solutions entered into a
definitive agreement for the purchase of six psychiatric facilities
from The Brown Schools, Inc. for $63 million in cash. In
connection with the closing of this acquisition, which is expected to
occur on April 1, 2003, the Company plans to amend its 2001
Senior Credit Facility with CapitalSource Finance to increase its
revolving line of credit from $17.5 million to
$25.0 million and to enter into a new non-revolving term note of
approximately $36.0 million. Psychiatric Solutions intends to
finance this acquisition through proceeds from the issuance of its
preferred stock and its amended 2001 Senior Credit Facility.

Psychiatric
Solutions believes that its working capital on hand, cash flows from
operations and additional borrowings under the existing line of
credit will be sufficient to fund the Companys operating needs, planned
capital expenditures and debt service requirements for the next 12 months. Psychiatric Solutions intends to
acquire additional psychiatric facilities and is actively seeking
strategic acquisitions
that fit its corporate growth strategy. Management continually assesses its capital needs and
will likely seek additional financing, including debt or equity, to
fund potential acquisitions or for other corporate purposes. In
negotiating such financing, there can be no assurance that the
Company will be able to raise additional capital on terms
satisfactory to the Company. Failure to obtain additional financing
on reasonable terms could have a negative effect on the Company's
plans to acquire additional psychiatric facilities.

Contractual Obligations

Payments Due by Period (in thousands 000)Less than
        
        
        
        
        
        More thanTotal
        
        1 year
        
        1-3 years
        
        4-5 years
        
        5 yearsLong-term debt
        
        $
        43,822
        
        
        $
        7,070
        
        
        $
        21,817
        
        
        $
        52
        
        
        $
        14,883Lease obligations
        
        
        2,303
        
        
        
        862
        
        
        
        980
        
        
        
        461
        
        
        
        Informations systems commitments
        
        
        1,460
        
        
        
        724
        
        
        
        552
        
        
        
        184
        
        
        
        Total obligations
        
        $
        47,585
        
        
        $
        8,656
        
        
        $
        23,349
        
        
        $
        697
        
        
        $
        14,883


The carrying value of our total long-term debt, including current
maturities, of $43.8 million and $36.5 million at December 31, 2002 and
December 31, 2001, respectively, approximated fair value. We had $22.7 million
of variable rate debt outstanding at December 31, 2002. At the December 31,
2002 borrowing level, a hypothetical 10% increase in interest rates would
decrease net income and cash flows by approximately $200,000.

Impact Of Inflation

Although inflation has not had a material impact on Psychiatric Solutions
results of operations, the health care industry is very labor intensive and
salaries and benefits are subject to inflationary pressures as are rising
supply costs which tend to escalate as vendors pass on the rising costs through
price increases. Some of Psychiatric Solutions freestanding specialty
psychiatric facilities are experiencing the effects of the tight labor market,
including a shortage of nurses, which has caused and may continue to cause an
increase in its salaries, wages and benefits expense in excess of the inflation
rate. Although Psychiatric Solutions cannot predict its ability to cover future
cost increases, management believes that through adherence to cost containment
policies, labor management and reasonable price increases, the effects of
inflation on future operating margins should be manageable. Psychiatric
Solutions ability to pass on increased costs associated with providing health
care to Medicare and Medicaid patients is limited due to various federal, state
and local laws which have been enacted that, in certain cases, limit its
ability to increase prices. In addition, as a result of increasing regulatory
and competitive pressures and a continuing industry wide shift of patients into
managed care plans, Psychiatric Solutions ability to maintain margins through
price increases to non-Medicare patients is limited.

The psychiatric health care industry is typically not directly impacted by
periods of recession, erosions of consumer confidence or other general economic
trends as most health care services are not considered a component of
discretionary spending. However, Psychiatric Solutions facilities may be
indirectly negatively impacted to the extent such economic conditions result in
decreased reimbursements by federal or state governments or managed care
payers. Psychiatric Solutions is not aware of any economic trends that would
prevent it from being able to remain in compliance with all of its debt
covenants and to meet all required obligations and commitments in the near
future.

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Critical Accounting Policies

Psychiatric Solutions consolidated financial statements have been
prepared in accordance with accounting principles generally accepted in the
United States. In preparing its financial statements, Psychiatric Solutions is
required to make estimates and assumptions that affect the reported amounts of
assets, liabilities, revenues, and expenses included in the financial
statements. Estimates are based on historical experience and other information
currently available, the results of which form the basis of such estimates.
While Psychiatric Solutions believes its estimation processes are reasonable,
actual results could differ from those estimates. The following represent the
estimates considered most critical to Psychiatric Solutions operating
performance and involve the most subjective and complex assumptions and
assessments.

Allowance for doubtful accounts

Psychiatric Solutions ability to collect outstanding patient receivables
from third party payors and receivables due under its management contracts is
critical to its operating performance and cash flows.

With regard to patient receivables, the allowance for doubtful accounts is
approximately 17% of the accounts receivable balance net of contractual
discounts as of December 31, 2002. The primary collection risk for these
receivables lies with uninsured patient accounts or patient accounts for which
primary insurance has paid but a patient portion remains outstanding.
Psychiatric Solutions estimates the allowance for doubtful accounts primarily
based upon the age of the accounts since patient discharge date. Psychiatric
Solutions continually monitors its accounts receivable balances and utilizes
cash collection data to support its estimates of the provision for doubtful
accounts. Significant changes in payor mix or business office operations could
have a significant impact on Psychiatric Solutions results of operations and
cash flows.

With regard to receivables due under management contracts, the allowance
for doubtful accounts is approximately 24% of the accounts receivable balance
at December 31, 2002. The primary collection risk is attributable to
contractual disputes. Psychiatric Solutions estimates the allowance for
doubtful accounts for these receivables based primarily upon the specific
identification of potential collection issues. As with its patient receivables,
Psychiatric Solutions continually monitors its accounts receivable balances and
utilizes cash collection data to support its estimates of the provision for
doubtful accounts.

Allowances for contractual discounts

The Medicare regulations and various managed care contracts are often
complex and may include multiple reimbursement mechanisms for different types
of services provided in Psychiatric Solutions facilities and cost settlement
provisions requiring complex calculations and assumptions subject to
interpretation. Psychiatric Solutions estimates the allowance for contractual
discounts on a payor-specific basis given its interpretation of the applicable
regulations or contract terms. The services authorized and provided and related
reimbursement are often subject to interpretation that could result in payments
that differ from Psychiatric Solutions estimates. Additionally, updated
regulations and contract renegotiations occur frequently necessitating
continual review and assessment of the estimation process by management.

Professional and General Liability

The Company is subject to medical malpractice and other lawsuits due to
the nature of the services provided. For the years ended December 31, 2000 and
2001, and through December 5, 2002, the Company has obtained professional and
general liability insurance for claims in excess of $100,000, up to a maximum
of $1 million per occurrence and $3 million aggregate, with an additional $5
million in excess coverage. On December 6, 2002, the deductible on individual
malpractice claims was raised to $3 million and the insured limit to $10
million to mitigate the increases in the cost of professional and general
liability insurance and to increase coverage for additional exposures due to
acquisitions. The reserve for professional and general liability risks is based
on historical claims, demographic factors, industry trends, severity factors,
and other actuarial assumptions calculated by an independent third party. This
estimate is discounted to its present value using a 5% discount rate. This
estimated accrual for professional and general liabilities could be
significantly affected should current and future occurrences

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differ from historical claim trends and expectations. The Company has
established a captive insurance company to manage this additional self insured
retention. While claims are monitored closely when estimating professional and
general liability accruals, the complexity of the claims and wide range of
potential outcomes often hampers timely adjustments to the assumptions used in
these estimates. The reserve for professional and general liability was
$743,000 as of December 31, 2002. The Company has no reserves recorded in
previous years because substantially all of the risk was insured.

Income taxes

As part of the Companys process for preparing its consolidated financial
statements, management is required to compute income taxes in each of the
jurisdictions in which it operates. This process involves estimating the
current tax benefit or expense of future deductible and taxable temporary
differences. The future deductible and taxable temporary differences are
recorded as deferred tax assets and liabilities which are components of the
Companys balance sheet. Management then assesses the realizability of the
deferred tax assets based on reversals of deferred tax liabilities and, if
necessary, estimates of future taxable income. If management determines that
some or all of a deferred tax asset will more likely than not be realized, then
a valuation allowance is recorded against the deferred tax asset. Management
must also assess the impact of acquisitions on the realization of deferred tax
assets subject to a valuation allowance to determine if all or a portion of the
valuation allowance will be offset by reversing taxable differences or future
taxable income of the acquired entity. To the extent the valuation allowance
can be reversed due to the estimated future taxable income of an acquired
entity, then the Companys valuation allowance is reduced accordingly as an
adjustment to purchase price.

Forward-Looking Statements

This Annual Report on Form 10-K and other materials the Company has filed
or may file with the Securities and Exchange Commission, as well as information
included in oral statements or other written statements made, or to be made, by
senior management of the Company, contain, or will contain, disclosures which
are forward-looking statements within the meaning of the safe harbor
provisions of The Private Securities Litigation Reform Act of 1995.
Forward-looking statements include all statements that do not relate solely to
historical or current facts and can be identified by the use of words such as
may, will, expect, believe, intend, plan, estimate, project,
continue, should and other comparable terms. These forward-looking
statements are based on the current plans and expectations of management and
are subject to a number of risks and uncertainties, including those set forth
below, that could significantly affect the Companys current plans and
expectations and future financial condition and results.

The Company undertakes no obligation to publicly update or revise any
forward-looking statements, whether as a result of new information, future
events or otherwise. Shareholders and investors are cautioned not to unduly
rely on such forward-looking statements when evaluating the information
presented in the Companys filings and reports.

While it is not possible to identify all of these factors, we continue to
face many risks and uncertainties that could cause actual results to differ materially from those forward-looking statements, including:



| |  | potential competition which alters or impedes our acquisition
strategy by decreasing our ability to acquire additional facilities
on favorable terms;
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------



| |  | our ability to improve the operations of acquired facilities;
|- |  | -------------------------------------------------------------



| |  | our ability to maintain favorable and continuing
relationships with physicians who use our facilities;
|- |  | ------------------------------------------------------------------------------------------------------



| |  | our limited operating history;
|- |  | ------------------------------



| |  | our ability to receive timely additional financing on terms
acceptable to us to fund our acquisition strategy and capital
expenditure needs;
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------

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| |  | risks inherent to the health care industry, including the
impact of unforeseen changes in regulation, reimbursement rates from
federal and state health care programs or managed care companies and
exposure to claims and legal actions by patients and others;
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | our ability to ensure confidential information is not
inappropriately disclosed and that we are in compliance with federal
and state health information privacy standards; and
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | our ability to comply with federal and state governmental
regulation covering healthcare-related products and services
on-line, including the regulation of medical devices and the
practice of medicine and pharmacology.
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

In addition, future trends for pricing, margins, revenues and
profitability remain difficult to predict in the industries that we serve.

Risk Factors

If Psychiatric Solutions fails to comply with extensive laws and
government regulations, it could suffer penalties or be required to make
significant changes to its operations.

The health care industry is required to comply with extensive and complex
laws and regulations at the Federal, state and local government levels relating
to, among other things:



| |  | billing for services;
|- |  | ---------------------



| |  | relationships with physicians and other referral sources:
|- |  | ---------------------------------------------------------



| |  | adequacy of medical care;
|- |  | -------------------------



| |  | quality of medical equipment and services;
|- |  | ------------------------------------------



| |  | qualifications of medical and support personnel;
|- |  | ------------------------------------------------



| |  | confidentiality, maintenance and security issues associated with
health-related information and medical records;
|- |  | ----------------------------------------------------------------------------------------------------------------



| |  | licensure;
|- |  | ----------



| |  | hospital rate or budget review;
|- |  | -------------------------------



| |  | operating policies and procedures; and
|- |  | --------------------------------------



| |  | addition of facilities and services.
|- |  | ------------------------------------

Among these laws are the Anti-kickback Statute and the Stark Law. These
laws impact the relationships that Psychiatric Solutions may have with
physicians and other referral sources. The OIG has enacted safe harbor
regulations that outline practices that are deemed protected from prosecution
under the Anti-kickback Statute. Psychiatric Solutions current financial
relationships with physicians and other referral sources may not qualify for
safe harbor protection under the Anti-kickback Statute. Failure to meet a safe
harbor does not mean that the arrangement automatically violates the
Anti-kickback Statute, but may subject the arrangement to greater scrutiny.
Further, Psychiatric Solutions cannot guarantee that practices that are outside
of a safe harbor will not be found to violate the Anti-kickback Statute.

In order to comply with the Stark Law, Psychiatric Solutions financial
relationships with physicians and their immediate family members must meet an
exception. Psychiatric Solutions attempts to structure its

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relationships to meet an exception to the Stark Law, but the regulations
implementing the exceptions, some of which are still under review, are detailed
and complex, and Psychiatric Solutions cannot guarantee that every relationship
fully complies with the Stark Law.

If Psychiatric Solutions fails to comply with the Anti-kickback Statute,
the Stark Law or other applicable laws and regulations, it could be subjected
to liabilities, including criminal penalties, civil penalties (including the
loss of its licenses to operate one or more facilities), and exclusion of one
or more facilities from participation in the Medicare, Medicaid and other
Federal and state health care programs. See Item 1. Business  Regulation
and Other Factors.

Because many of these laws and regulations are relatively new, Psychiatric
Solutions does not always have the benefit of significant regulatory or
judicial interpretation of these laws and regulations. In the future,
different interpretations or enforcement of these laws and regulations could
subject Psychiatric Solutions current or past practices to allegations of
impropriety or illegality or could require Psychiatric Solutions to make
changes in its facilities, equipment, personnel, services, capital expenditure
programs and operating expenses. A determination that Psychiatric Solutions
has violated these laws, or the public announcement that it is being
investigated for possible violations of these laws, could have a material
adverse effect on its business, financial condition, results of operations or
prospects and Psychiatric Solutions business reputation could suffer
significantly. In addition, Psychiatric Solutions is unable to predict whether
other legislation or regulations at the Federal of state level will be adopted,
what form such legislation or regulation will take or their impact.

Other companies within the health care industry continue to be the subject of
federal and state investigations, which increases the risk that Psychiatric
Solutions may become subject to investigations in the future.

Both federal and state government agencies as well as private payors have
heightened and coordinated civil and criminal enforcement efforts as part of
numerous ongoing investigations of health care organizations. These
investigations relate to a wide variety of topics, including:



| |  | cost reporting and billing practices;
|- |  | -------------------------------------



| |  | quality of care;
|- |  | ----------------



| |  | financial relationships with referral sources;
|- |  | ----------------------------------------------



| |  | medical necessity of services provided; and
|- |  | -------------------------------------------



| |  | treatment of indigent patients.
|- |  | -------------------------------

The Office of Inspector General of the Department of Health and Human
Services and the U.S. Department of Justice have, from time to time, undertaken
national enforcement initiatives that focus on specific billing practices or
other suspected areas of abuse. Moreover, health care providers are subject to
civil and criminal false claims laws, including the federal False Claims Act,
which allows private parties to bring whistleblower lawsuits against private
companies doing business with or receiving reimbursement under government
programs. Some states have adopted similar state whistleblower and false claims
provisions. Publicity associated with the substantial amounts paid by other
health care providers to settle these lawsuits may encourage current and former
employees of Psychiatric Solutions and other health care providers to bring
whistleblower lawsuits. Any investigations of Psychiatric Solutions or its
executives or managers could result in significant liabilities or penalties as
well as adverse publicity.

As a provider of health care services, Psychiatric Solutions is subject to
claims and legal actions by patients and others.

Facilities acquired by Psychiatric Solutions may have unknown or
contingent liabilities, including liabilities related to patient care and
liabilities for failure to comply with health care laws and regulations, which
could result in large claims and significant defense costs. Although
Psychiatric Solutions generally seeks indemnification covering these matters
from prior owners of facilities it acquires, material liabilities for past
activities of acquired

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facilities may exist and such prior owners may not be able to satisfy
their indemnification obligations. Psychiatric Solutions is also susceptible to
being named in claims brought related to patient care and other matters at
facilities owned by third parties and operated by Psychiatric Solutions.

To protect Psychiatric Solutions from the cost of these claims,
professional malpractice liability insurance and general liability insurance
coverage is maintained in amounts and with deductibles common in the industry.
On December 6, 2002, the deductible on individual malpractice claims was raised
to $3 million and the insured limit to $10 million to mitigate the increases in
the cost of professional and general liability insurance and to increase
coverage for additional exposures due to acquisitions. The reserve for
professional and general liability risks is based on historical claims,
demographic factors, industry trends, severity factors, and other actuarial
assumptions calculated by an independent third party. This estimate is
discounted to its present value using a 5% discount rate. This estimated
accrual for professional and general liabilities could be significantly
affected should current and future occurrences differ from historical claim
trends and expectations. Psychiatric Solutions has established a captive insurance company to
manage this additional self insured retention. While claims are monitored
closely when estimating professional and general liability accruals, the
complexity of the claims and wide range of potential outcomes often hampers
timely adjustments to the assumptions used in these estimates. This insurance
coverage may not cover all claims or continue to be available at a reasonable
cost, especially given the significant increase in insurance premiums generally
experienced in the health care industry.

If federal or state health care programs or managed care companies reduce
reimbursement rates or methods of reimbursement for services provided, revenues
may decline.

A large portion of Psychiatric Solutions revenue comes from the Medicare
and Medicaid programs. In recent years, federal and state governments have made
significant changes in these programs. These changes have, in certain
instances, decreased the amount of money Psychiatric Solutions receives for its
services. Future federal and state legislation may further reduce the payments
received for services provided or increase the timing of reimbursement payments
to the Company.

Insurance and managed care companies and other third parties from whom
Psychiatric Solutions receives payment are increasingly attempting to control
health care costs by requiring that facilities discount their services in
exchange for exclusive or preferred participation in their benefit plans. This
trend may continue and may reduce the payments received by Psychiatric
Solutions for its services.

If competition decreases the ability to acquire additional facilities on
favorable terms, Psychiatric Solutions may be unable to execute its acquisition
strategy.

Competition among hospitals and other health care providers in the United
States has intensified in recent years due to cost containment pressures,
changing technology, changes in government regulation and reimbursement,
changes in practice patterns (such as shifting from inpatient to outpatient
treatments), the impact of managed care organizations and other factors. An
important part of Psychiatric Solutions business strategy is to acquire
facilities in growing urban markets. Some facilities and health care providers
that compete with Psychiatric Solutions have greater financial resources and a
larger, more experienced development staff focused on identifying and
completing acquisitions. In addition, some competitors are owned by
governmental agencies or not-for-profit corporations supported by endowments
and charitable contributions, and can finance capital expenditures on a
tax-exempt basis. Any or all of these factors may impede Psychiatric Solutions
business strategy.

If Psychiatric Solutions fails to improve the operations of acquired
facilities, it may be unable to achieve its growth strategy.

Psychiatric Solutions may be unable to maintain profitability or operating
cash flows at any existing hospital or other acquired facility, effectively
integrate the operations of any acquisitions or otherwise achieve the intended
benefit of its growth strategy.

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State efforts to regulate the sale of facilities operated by not-for-profit
entities could prevent Psychiatric Solutions from acquiring additional
facilities and executing its business strategy.

Hospital acquisitions generally require a longer period to complete than
acquisitions in many other industries and are subject to additional regulatory
uncertainty. Many states have adopted legislation regarding the sale or other
disposition of facilities operated by not-for-profit entities. In other states
that do not have specific legislation, the attorneys general have demonstrated
an interest in these transactions under their general obligations to protect
charitable assets from waste. These legislative and administrative efforts
focus primarily on the appropriate valuation of the assets divested and the use
of the proceeds of the sale by the non-profit seller. In addition, the
acquisition of facilities in certain states requires advance regulatory
approval under certificate of need or state licensure regulatory regimes.
These state-level procedures could seriously delay or even prevent Psychiatric
Solutions from acquiring facilities, even after significant transaction costs
have been incurred.

Additional financing will be necessary to fund Psychiatric Solutions
acquisition program and capital expenditures, and additional financing may not
be available when needed.

Psychiatric Solutions acquisition program requires substantial capital
resources. Likewise, the operation of existing facilities requires ongoing
capital expenditures for renovation, expansion and the upgrade of equipment and
technology.

Psychiatric Solutions may not receive additional financing on satisfactory
terms. In addition, Psychiatric Solutions level of indebtedness at any time
may restrict its ability to borrow additional funds. If Psychiatric Solutions
is not able to obtain financing, then it may not be in a position to consummate
acquisitions or undertake capital expenditures.

Recently acquired businesses and businesses acquired in the future will expose
Psychiatric Solutions to increased operating risks.

Psychiatric Solutions acquired four facilities in 2001, one hospital in
2002, and expects to acquire 6 additional facilities in 2003.

This expansion exposes the Company to additional business and operating
risks and uncertainties, including:



| |  | our ability to effectively manage the expanded activities;
|- |  | ----------------------------------------------------------



| |  | our ability to realize our investment in the expanded facilities;
|- |  | -----------------------------------------------------------------



| |  | our exposure to unknown liabilities; and
|- |  | ----------------------------------------



| |  | our ability to meet contractual obligations.
|- |  | --------------------------------------------

If Psychiatric Solutions is unable to manage this expansion efficiently or
effectively, or is unable to attract and retain additional qualified management
personnel to run the expanded operations, this could result in a material
adverse effect on the Company.

Psychiatric Solutions depends on its relationships with physicians who use its
facilities.

Psychiatric Solutions business depends upon the efforts and success of
the physicians who provide health care services at its facilities and the
strength of the relationships with these physicians.

The business of Psychiatric Solutions could be adversely affected if a
significant number of physicians or a group of physicians:



| |  | terminate their relationship with, or reduce their use of, the facilities;
|- |  | --------------------------------------------------------------------------

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| |  | fail to maintain acceptable quality of care or to otherwise adhere to professional standards;
|- |  | ---------------------------------------------------------------------------------------------



| |  | suffer damage to their reputation; or
|- |  | -------------------------------------



| |  | exit the market entirely.
|- |  | -------------------------

Psychiatric Solutions depends on its key management personnel.

Psychiatric Solutions is highly dependent on its senior management team,
which has many years of experience addressing the broad range of concerns and
issues relevant to the business of Psychiatric Solutions. Psychiatric Solutions
has entered into employment agreements with Joey A. Jacobs, Chief Executive
Officer, and Jack Salberg, Chief Operating Officer, which include
non-competition and non-solicitation provisions. Key man life insurance
policies are not maintained on any member of senior management other than Mr.
Jacobs. The loss of key management or the inability to attract, retain and
motivate sufficient numbers of qualified management personnel could have a
material adverse effect on Psychiatric Solutions. Psychiatric Solutions Chief
Financial Officer position is currently vacant.

Psychiatric Solutions has a limited operating history.

Psychiatric Solutions began operations in 1997 and acquired its first
hospital in 2001. Because of its limited operating history, Psychiatric
Solutions has limited insight into trends that may emerge in its industry and
that affect its business. As a result, there can be no assurance that
Psychiatric Solutions will achieve satisfactory operating results.

Psychiatric Solutions stock price could be volatile.

The market price of Psychiatric Solutions common stock could fluctuate
significantly in response to various factors, including:



| |  | problems in achieving revenue enhancements and operating efficiencies;
|- |  | ----------------------------------------------------------------------



| |  | actual and estimated earnings and cash flows;
|- |  | ---------------------------------------------



| |  | quarter-to-quarter variations in operating results;
|- |  | ---------------------------------------------------



| |  | changes in market conditions in the mental health or behavioral health care industries;
|- |  | ---------------------------------------------------------------------------------------



| |  | changes in general economic conditions;
|- |  | ---------------------------------------



| |  | fluctuations in the securities markets in general;
|- |  | --------------------------------------------------



| |  | operating results differing from analysts estimates; and
|- |  | ---------------------------------------------------------



| |  | changes in analysts earnings estimates.
|- |  | ----------------------------------------

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Item 7A.  Quantitative And Qualitative Disclosures About Market Risk

Information
on quantitative and qualitative disclosure about market risk is
included in Part II, Item 7 of this annual report on Form 10-K under
the caption Managements Discussion and Analysis of Financial
Condition and Results of Operations  Liquidity and
Capital Resources  Contractual Obligations.







Item 8.  Financial Statements And Supplementary Data

Information with respect to this Item is contained in the Companys
Consolidated Financial Statement beginning on Page F-1 of this annual report on Form 10-K.







Item 9.  Changes In And Disagreements With Accountants On Accounting And Financial Disclosure

None.







PART III







Item 10. Directors And Executive Officers

Directors

The information relating to Directors of the Company set forth in the
Companys Proxy Statement relating to the 2003 Annual Meeting of Stockholders
under the caption Election of Directors is incorporated herein by reference.

Executive Officers of the Registrant

The executive officers of the Company are:

Name
        
        Age
        
        PositionsJoey A. Jacobs
        
        
        49
        
        
        President and Chief Executive OfficerSteven T. Davidson
        
        
        45
        
        
        Chief Development Officer and SecretaryJack R. Salberg
        
        
        54
        
        
        Chief Operating OfficerJack Polson
        
        
        36
        
        
        Chief Accounting OfficerBrent Turner
        
        
        37
        
        
        Vice President, Treasurer and Investor Relations


34



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Joey
A. Jacobs, President and Chief Executive Officer. Mr. Jacobs
co-founded Psychiatric Solutions and has served
as its President and Chief Executive Officer since April 1997. Prior to founding Psychiatric
Solutions, Mr. Jacobs served for 21 years in various capacities with Hospital
Corporation of America (HCA, also formerly known as Columbia and
Columbia/HCA), most recently as President of the Tennessee Division. Mr.
Jacobs background at HCA also includes serving as president of HCAs Central
Group, vice president of the Western Group, assistant vice president of the
Central Group and assistant vice president of the Salt Lake City Division.

Steven T. Davidson, Chief Development Officer. Mr. Davidson has served as
Chief Development Officer of Psychiatric Solutions since August 1997 and has
over 20 years of health care experience. Prior to joining Psychiatric
Solutions, Mr. Davidson served as the Director of Development at HCA from 1991
until 1997. Mr. Davidson also served as a Senior Audit Supervisor and Hospital
Controller during his term at HCA, which began in 1983, where he supervised
audits of hospitals and other corporate functions. Prior to joining HCA, Mr.
Davidson was employed by Ernst & Young LLP as a Senior Auditor. Mr. Davidson is
a Certified Public Accountant and a member of the American Institute of
Certified Public Accountants.

Jack Salberg, Chief Operating Officer. Mr. Salberg has served as Chief
Operating Officer of Psychiatric Solutions since May 2000 and has more than 29
years of operational experience in both for-profit and non-profit health care
sectors. Prior to joining Psychiatric Solutions, Mr. Salberg served as
president and chief executive officer of Sunrise Healthcare from 1996 to 2000.
In addition, Mr. Salberg served for ten years in various capacities with
American Healthcorp, most recently as senior vice president with specific
responsibilities for multi-facility contract management. Mr. Salberg also spent
three years as head of Health Group, Inc.s psychiatric division. In addition,
Mr. Salberg was employed for four years with Humana Corporation as a hospital
executive director and seven years with Arden Hill Hospital, an independent
hospital, as its associate executive director.

Jack E. Polson, Chief Accounting Officer. Mr. Polson has served as the
Chief Accounting Officer of Psychiatric Solutions since August 2002. Prior to
being appointed Chief Accounting Officer, Mr. Polson served as Controller for
Psychiatric Solutions since June 1997. From June 1995 until joining Psychiatric
Solutions, Mr. Polson served as controller for Columbia Healthcare Network, a
risk-bearing physician health organization. From May 1992 until June 1995, Mr.
Polson served as an internal audit supervisor for HCA.

Brent Turner, Vice President, Treasurer and Investor Relations. Mr.
Turner has served as the Vice President, Treasurer and Investor Relations of
Psychiatric Solutions since February 2003. From April 2002 until joining
Psychiatric Solutions, Mr. Turner served as Executive Vice President and Chief
Financial Officer of Educational Services, a privately-held owner and operator
of schools for children with learning disabilities. From November 2001 until
March 2002, Mr. Turner served as Senior Vice President of Business Development
for The Brown Schools, a provider of educational and therapeutic services for
at-risk youth. From 1996 until January 2001, Mr. Turner was with Corrections
Corporation of America, a private prison system, serving as Treasurer from 1998
to 2001.

Section 16(a) Compliance

The information relating to Section 16(a) beneficial ownership reporting
compliance set forth in the Companys Proxy Statement relating to the 2003
Annual Meeting of Stockholders under the caption Security Ownership of Certain
Beneficial Owners and Management is incorporated herein by reference.







Item 11. Executive Compensation

The information set forth in the Companys Proxy Statement relating to the
2003 Annual Meeting of Stockholders under the caption Executive Compensation
is incorporated herein by reference. The Comparative Performance Graph and the
Compensation Committee Report on Executive Compensation also included in the
Proxy Statement are expressly not incorporated herein by reference.

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Item 12. Security Ownership Of Certain Beneficial Owners And Management

The information set forth in the Companys Proxy Statement relating to the
2003 Annual Meeting of Stockholders under the caption Security Ownership of
Certain Beneficial Owners and Management is incorporated herein by reference.







Item 13. Certain Relationships And Related Party Transactions

The information set forth in the Companys Proxy Statement relating to the
2003 Annual Meeting of Stockholders under the caption Certain Relationships
and Related Transactions is incorporated herein by reference.







Item 14. Controls and Procedures

Within the 90 days prior to the date of this report, we carried out an
evaluation, under the supervision and with the participation of management,
including our Chief Executive Officer and Chief Accounting Officer, of the
effectiveness of the design and operation of our disclosure controls and
procedures pursuant to Exchange Act Rule 13a-14. Based upon that evaluation,
the Chief Executive Officer and Chief Accounting Officer concluded that our
disclosure controls and procedures are effective in timely alerting them to
material information relating to the Company (including its consolidated
subsidiaries) required to be included in our periodic SEC filings. There have
been no significant changes in internal controls or in other factors that could
significantly affect internal controls subsequent to the date of our most
recent evaluation.







PART IV







Item 15. Exhibits, Financial Statement Schedules, and Reports On Form 8-K

(a)(1)
and (a)(2) List of Financial Statements and Financial Statement
Schedules

The Consolidated Financial Statements of the Company required to be
included in Part II, Item 8 are indexed on Page F-1
and submitted as a separate section of this report. All schedules are omitted because they are not applicable or are not required, or because the required information is included
 in the Consolidated Financial Statements or Notes in this report.

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(a)(3) Exhibits

ExhibitNumber
        
        Description of
Exhibit2.1
        
        Agreement and Plan of Merger by and between PMR
Corporation, PMR Acquisition Corporation and
Psychiatric Solutions, Inc. dated May 6, 2002, as
amended by Amendment No. 1 dated as of June 10, 2002
and Amendment No. 2 as of July 9, 2002 (incorporated by reference to Annex A to Amendment No. 1 to the Companys
Registration Statement on Form S-4, filed on July 11,
2002 (Reg. No. 333-90372) (the S-4 Amendment).2.2
        
        Stock Purchase Agreement, dated as of June 20, 2002, by
and among the shareholders of Aeries Healthcare
Corporation, a Delaware corporation and Psychiatric
Solutions, Inc., a Delaware corporation and/or its
designated affiliate (incorporated by reference to
Exhibit 10.14 to the S-4 Amendment).3.1
        
        The Companys Restated Certificate of Incorporation,
filed with the Delaware Secretary of State on March
9, 1998 (incorporated by reference to Exhibit 3.1 to
the Companys Annual Report on Form 10-K for the
fiscal year ended April 30, 1998) (the 1998 10-K).3.2
        
        Amendment to the Companys Restated Certificate of
Incorporation, filed with the Delaware Secretary of
State on August 5, 2002 (incorporated by reference to
Exhibit 3.2 to the Companys Quarterly Report on Form
10-Q for the quarter ended July 31, 2002).3.3
        
        The Companys Amended and Restated Bylaws (incorporated
by reference to Exhibit 3.2 to the Companys Annual
Report on Form 10-K for the fiscal year ended April
30, 1997 (the 1997 10-K).4.1
        
        Reference is made to Exhibits 3.1, 3.2 and 3.3.4.2*
        
        Common Stock Specimen Certificate.4.3
        
        Contingent Value Rights Agreement dated August 2, 2002
(incorporated by reference to Exhibit 4.1 to the
Companys Current Report on Form 8-K, filed on August
5, 2002).4.4
        
        Warrant to purchase shares of Common Stock issued by
Psychiatric Solutions, Inc. to the 1818 Mezzanine
Fund II L.P. dated June 28, 2002 (incorporated by
reference to Exhibit 10.19 to the S-4 Amendment).4.5
        
        Proposed Certificate of Amendment to the Amended and
Restated Certificate of Incorporation of Psychiatric
Solutions, Inc. (incorporated by reference to
Appendix A of the Companys Preliminary Proxy
Statement filed January 6, 2003).4.6
        
        Stock Purchase Agreement dated as of January 6, 2003 by
and among the Company and the Purchasers named
therein (incorporated by reference to Appendix B of
the Companys Preliminary Proxy Statement filed
January 6, 2003).4.7
        
        Registration Rights Agreement dated as of January 6,
2003 by and among the Company and the Purchasers
named therein (incorporated by reference to Appendix
C of the Companys Preliminary Proxy Statement filed
January 6, 2003).4.8
        
        Proposed Certificate of Designations, Preferences and
Rights of Series A Convertible Preferred Stock of the
Company (incorporated by reference to Appendix D of
the Companys Preliminary Proxy Statement filed
January 6, 2003).4.9
        
        Third Amended and Restated Voting Agreement dated as of
January 6, 2003, by and among the Company and certain
holders of the Companys capital stock named therein
(incorporated by reference to Exhibit 4.5 of the
Companys Current Report on Form 8-K, filed on
January 6, 2003).10.1
        
        Amended and Restated Promissory Note between Mark P.
Clein and PMR Corporation in the amount of $59,554,
dated as of May 1, 2002 (incorporated by reference to
Exhibit 10.1 to the Companys Registration Statement
on Form S-4, filed on June 12, 2002 (Reg. No.
333-90372)) (the S-4).10.2
        
        Amended and Restated Promissory Note between Mark P.
Clein and PMR Corporation in the amount of
$278,504.82, dated as of May 1, 2002 (incorporated by
reference to Exhibit 10.2 to the S-4).10.3
        
        Amended and Restated Promissory Note between Fred D.
Furman and PMR Corporation in the amount of
$256,623.60, dated as of May 1, 2002 (incorporated by
reference to Exhibit 10.3 to the S-4).10.4
        
        Amended and Restated Promissory Note between Fred D.
Furman and PMR Corporation in the amount of
$209,317.15, dated as of May 1, 2002 (incorporated by
reference to Exhibit 10.4 to the S-4).


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ExhibitNumber
        
        Description of
Exhibit10.5
        
        Amended and Restated Promissory Note between Susan
Erskine and PMR Corporation in the amount of $20,414,
dated as of May 1, 2002 (incorporated by reference to
Exhibit 10.5 to the S-4).10.6
        
        Consulting Agreement between Mark P. Clein and PMR
Corporation dated as of May 10, 2002 (incorporated by
reference to Exhibit 10.6 to the S-4).10.7*
        
        Consulting Agreement between Fred D. Furman and
Psychiatric Solutions, Inc. dated as of August 6,
2002.10.8*
        
        Consulting Agreement between Allen Tepper and
Psychiatric Solutions, Inc. dated as of August 5,
2002.10.9
        
        Employment Agreement between Fred D. Furman and PMR
Corporation dated as of August 25, 1999 (incorporated
by reference to Exhibit 10.7 to the S-4).10.10
        
        Amendment to Employment Agreement between Fred D.
Furman and PMR Corporation dated as of May 1, 2002
(incorporated by reference to Exhibit 10.9 to the
S-4).10.11
        
        Employment Agreement between Susan D. Erskine and
PMR Corporation dated as of August 25, 1999
(incorporated by reference to Exhibit 10.8 to the
S-4).10.12
        
        Amendment to Employment Agreement between Susan
Erskine and PMR Corporation dated as of May 1, 2002
(incorporated by reference to Exhibit 10.10 to the
S-4).10.13
        
        Employment Agreement between Jack Salberg and
Psychiatric Solutions, Inc. dated as of May 1, 2000
(incorporated by reference to Exhibit 10.12 to the
S-4).10.14*
        
        Employment Agreement between Jack Salberg and
Psychiatric Solutions, Inc. dated as of October 1,
2002.10.15
        
        Amended and Restated Employment Agreement between
Joey Jacobs and Psychiatric Solutions, Inc. dated as
of January 1, 2002 (incorporated by reference to
Exhibit 10.12 to the S-4).10.16*
        
        Second Amended and Restated Employment Agreement
between Joey Jacobs and Psychiatric Solutions, Inc.
dated as of August 6, 2002.10.17*
        
        Indemnification Agreement between Mark P. Clein and
Psychiatric Solutions, Inc. dated as of August 20,
2002.10.18*
        
        Indemnification Agreement between Joseph P. Donlan
and Psychiatric Solutions, Inc. dated as of August
20, 2002.10.19*
        
        Indemnification Agreement between Christopher
Grant, Jr. and Psychiatric Solutions, Inc. dated as
of August 20, 2002.10.20*
        
        Indemnification Agreement between David S. Heer and
Psychiatric Solutions, Inc. dated as of August 20,
2002.10.21*
        
        Indemnification Agreement between Joey A. Jacobs
and Psychiatric Solutions, Inc. dated as of August
20, 2002.10.22*
        
        Indemnification Agreement between Charles C.
McGettigan and Psychiatric Solutions, Inc. dated as
of August 20, 2002.10.23*
        
        Indemnification Agreement between Edward K. Wissing
and Psychiatric Solutions, Inc. dated as of August
20, 2002.10.24*
        
        Consent under Indemnification Agreement between the
Company and members of its Board of Directors dated
as of December    , 2002.10.25
        
        Indemnification Agreement, dated as of June 28, 2002,
by and among the shareholders of Aeries Healthcare
Corporation, a Delaware corporation, and Psychiatric
Solutions, Inc., a Delaware corporation and/or its
designated affiliate (incorporated by reference to
Exhibit 10.15 to the S-4 Amendment).10.26
        
        Securities Purchase Agreement between Psychiatric
Solutions and The 1818 Mezzanine Fund II, L.P. dated
as of June 28, 2002 (incorporated by reference to
Exhibit 10.18 to the S-4 Amendment).10.27
        
        Revolving Credit and Term Loan Agreement dated as of
November 30, 2001, between Psychiatric Solutions,
Inc., certain of its related entities, CapitalSource
Finance, LLC, and the lenders thereunder
(incorporated by reference to Exhibit 10.13 to the
S-4 Amendment).10.28*
        
        First Amendment to Revolving Credit and Term Loan
Agreement dated April 30, 2002 by and among
Psychiatric Solutions and certain of its related
entities, Capital Source Finance, LLC and the lenders
thereunder.10.29
        
        Second Amendment to Revolving Credit and Term Loan
Agreement dated June 28, 2002 by and among
Psychiatric Solutions and certain of its related
entities, Capital Source Finance, LLC and the lenders
thereunder (incorporated by reference to Exhibit
10.20 to the S-4 Amendment).


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ExhibitNumber
        
        Description of
Exhibit10.30
        
        Term Note dated June 28, 2002 in the original
principal amount of $7,950,000 payable to Capital
Source Finance, LLC issued by Psychiatric Solutions
and certain of its related entities. (incorporated by
reference to Exhibit 10.21 to the S-4 Amendment).10.31
        
        Subordinated Promissory Note to Brown Schools Inc.
dated August 31, 2001 in the original principal
amount of $2 million (incorporated by reference to
Exhibit 10.16 to the S-4 Amendment).10.32
        
        Form of Convertible Subordinated Note dated May 5,
2000 to the sellers of Sunrise Behavioral Health in
the original aggregate principal amount of $3.6
million (incorporated by reference to Exhibit 10.17
to the S-4 Amendment).10.33*
        
        The Companys 2003 Long-Term Equity Compensation
Plan.10.34
        
        The Companys 1997 Equity Incentive Plan
(incorporated by reference to Exhibit 10.1 to the
1997 10-K).10.35
        
        Form of Incentive Stock Option Agreement under the
1997 Plan (incorporated by reference to Exhibit 10.2
to the 1997 10-K).10.36
        
        Form of Nonstatutory Stock Option Agreement under
the 1997 Plan (incorporated by reference to Exhibit
10 to the 1997 10-K).10.37
        
        Outside Directors Non-Qualified Stock Option Plan
of 1992 (the 1992 Plan) (incorporated by reference
to Exhibit 10.4 to the 1997 10-K).10.38
        
        Form of Outside Directors Non-Qualified Stock
Option Agreement (incorporated by reference to
Exhibit 10.5 to the 1997 10-K).10.39
        
        The Companys 1997 Incentive and Non-Qualified Stock
Option Plan for Key Personnel (incorporated by
reference to Exhibit 4.4 to the Companys
Registration Statement on Form S-8, filed on October
4, 2002 (Reg. No. 333-100635)).10.40
        
        Management and Affiliation Agreement dated April 13,
1995 between Mental Health Cooperative, Inc. and
Tennessee Mental Health Cooperative, Inc. with
Addendum (incorporated by reference to Exhibit 10.14
to the 1997 10-K) (Tennessee Mental Health
Cooperative, Inc. subsequently changed its name to
Collaborative Care Corporation).10.41
        
        Second Addendum to Management and Affiliation
Agreement dated November 1, 1996 between Mental
Health Cooperative, Inc. and Collaborative Care
Corporation (incorporated by reference to Exhibit
10.15 to the Companys Registration Statement on Form
S-2 (Reg. No. 333-36313)(the S-2)).10.42
        
        Provider Services Agreement dated April 13, 1995,
between Tennessee Mental Health Cooperative, Inc. and
Mental Health Cooperative, Inc. (incorporated by
reference to Exhibit 10.15 to the 1997 10-K)
(Tennessee Mental Health Cooperative, Inc.
subsequently changed its name to Collaborative Care
Corporation).10.43
        
        Provider Agreement dated December 4, 1995, between
Tennessee Behavioral Health, Inc. and Tennessee
Mental Health Corporations, Inc. (incorporated by
reference to Exhibit 10.19 to the 1998 10-K).10.44
        
        Addendum No. 1 to Provider Agreement dated December
4, 1995, between Tennessee Behavioral Health, Inc.
and Tennessee Mental Health Cooperative, Inc.
(incorporated by reference to Exhibit 10.20 to the
1998 10-K).10.45
        
        Addendum No. 2 to Provider Agreement dated February
4, 1996, between Tennessee Behavioral Health, Inc.
and Tennessee Mental Health Cooperative, Inc.
(incorporated by reference to Exhibit 10.21 to the
1998 10-K).10.46
        
        Provider Participation Agreement dated December 1,
1995, among Green Spring Health Services, Inc.,
AdvoCare, Inc. and Tennessee Mental Health
Cooperative, Inc. (incorporated by reference to
Exhibit 10.22 to the 1998 10-K).10.47
        
        Amendment to Provider Participation Agreement dated
February 13, 1996, among Green Spring Health
Services, Inc., AdvoCare of Tennessee, Inc. and
Tennessee Mental Health Cooperative, Inc.
(incorporated by reference to Exhibit 10.23 to the
1998 10-K).21.1*
        
        List of Subsidiaries.23.1*
        
        Consent of Ernst & Young LLP, Independent Auditors.99.1*
        
        Section 906 Certifications of Chief Executive Officer
and Chief Accounting Officer.




---

|    |  |                                                        
|--- |  | -------------------------------------------------------
|   
|(*) |  | Filed herewith                                         
|   
|() |  | Management contract or compensatory plan or arrangement

(b) Reports on Form 8-K

On
October 7, 2002 Psychiatric
Solutions filed a Report on Form 8-K/A, which amended its Report on
Form 8-K filed on August 6, 2002 relating to the merger of
Psychiatric Solutions, Inc. and PMR Corporation.

On
November 12, 2002 Psychiatric Solutions filed a Report on Form 8-K,
which reported the issuance of a press release announcing the operating results
of Psychiatric Solutions for the quarter ended September 30, 2002.

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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.

Psychiatric Solutions, Inc.By:
        
        /s/ Joey A. JacobsJoey A. Jacobs
Chief Executive Officer


Dated: March 27, 2003

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

Signature
        
        Title
        
        Date/s/ Joey A. JacobsJoey A. Jacobs
        
        Chairman of the Board, President
and Chief Executive Officer
(Principal Executive Officer)
        
        March 27, 2003/s/ Jack E. PolsonJack E. Polson
        
        Chief Accounting Officer
(Principal Accounting Officer)
        
        March 27, 2003/s/ Mark P. CleinMark P. Clein
        
        Director
        
        March 27, 2003/s/ Joseph P. DonlanJoseph P. Donlan
        
        Director
        
        March 27, 2003/s/ Christopher Grant, Jr.Christopher Grant, Jr.
        
        Director
        
        March 27, 2003/s/ David S. HeerDavid S. Heer
        
        Director
        
        March 27, 2003/s/ Charles C. McGettiganCharles C. McGettigan
        
        Director
        
        March 27, 2003/s/ Edward WissingEdward Wissing
        
        Director
        
        March 27, 2003/s/ Ann H. LamontAnn H. Lamont
        
        Director
        
        March 27, 2003


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PSYCHIATRIC SOLUTIONS, INC.
 
CERTIFICATION PURSUANT TO
18 U.S.C. §1350, AS ADOPTED PURSUANT TO
SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002

I, Joey A. Jacobs, certify that:

1.   I have reviewed this annual report on Form 10-K of Psychiatric Solutions, Inc.;

2.   Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;

3.   Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;

4.   The registrants other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

a) Designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this annual report is being prepared;

b) Evaluated the effectiveness of the registrants disclosure controls and
procedures as of a date within 90 days prior to the filing date of this annual
report (the Evaluation Date); and

c) Presented in this annual report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;

5.   The registrants other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrants auditors and the audit
committee of registrants board of directors (or persons performing the
equivalent function):

a) All significant deficiencies in the design or operation of internal
controls which could adversely affect the registrants ability to record,
process, summarize and report financial data and have identified for the
registrants auditors any material weaknesses in internal controls; and

b) Any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrants internal controls;
and

6.   The registrants other certifying officers and I have indicated in this
annual report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.

Date:  March 27, 2003
        
        /s/ Joey A. JacobsJoey A. Jacobs
Chief Executive Officer


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PSYCHIATRIC SOLUTIONS, INC.
 
CERTIFICATION PURSUANT TO
18 U.S.C. §1350, AS ADOPTED PURSUANT TO
SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002

I, Jack E. Polson, certify that:

1.   I have reviewed this annual report on Form 10-K of Psychiatric Solutions,
Inc.;

2.   Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;

3.   Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;

4.   The registrants other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

a) Designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this annual report is being prepared;

b) Evaluated the effectiveness of the registrants disclosure controls and
procedures as of a date within 90 days prior to the filing date of this annual
report (the Evaluation Date); and

c) Presented in this annual report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;

5.   The registrants other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrants auditors and the audit
committee of registrants board of directors (or persons performing the
equivalent function):

a)   All significant deficiencies in the design or operation of internal
controls which could adversely affect the registrants ability to record,
process, summarize and report financial data and have identified for the
registrants auditors any material weaknesses in internal controls; and

b)   Any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrants internal controls;
and

6.   The registrants other certifying officers and I have indicated in this
annual report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.

Date:  March 27, 2003
        
        /s/ Jack E. PolsonJack E. Polson
Chief Accounting Officer


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PSYCHIATRIC SOLUTIONS, INC.

FORM 10-K  ITEM 8 AND
ITEM 15(a)(1) AND (2)

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES

|                                   |                                                                                                      |  |      |     | 
|---------------------------------- | ---------------------------------------------------------------------------------------------------- |  | ---- | --- | 
|                                   |                                                                                                      |  | PAGE
|                                   |                                                                                                      |  |     
|Annual Financial Statements        |                                                                                                      |  |      |    
|Report of Independent Auditors     |                                                                                                      |  | F-2  |    
|Consolidated Financial Statements: |                                                                                                      |  |      |    
|                                   | Consolidated Balance Sheets, December 31, 2002 and 2001                                              |  |      | F-3 | 
|                                   | Consolidated Statements of Operations for the years ended
December 31, 2002, 2001 and 2000           |  |      | F-4 | 
|                                   | Consolidated Statements of Stockholders Equity for the years
ended December 31, 2002, 2001 and 2000 |  |      | F-5 | 
|                                   | Consolidated Statements of Cash Flows for the years ended
December 31, 2002, 2001 and 2000           |  |      | F-6 | 
|                                   | Notes to Consolidated Financial Statements                                                           |  |      | F-8 | 

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REPORT OF INDEPENDENT AUDITORS

To the Board of Directors and Stockholders Psychiatric Solutions, Inc.

We have audited the accompanying consolidated balance sheets of Psychiatric
Solutions, Inc. as of December 31, 2002 and 2001 and the related consolidated
statements of operations, stockholders equity and cash flows for each of the
three years in the period ended December 31, 2002. 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 auditing standards generally
accepted in the United States. 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 consolidated financial position of Psychiatric
Solutions, Inc. at December 31, 2002 and 2001, and the consolidated results of
its operations and its cash flows for each of the three years in the period
ended December 31, 2002 in conformity with accounting principles generally
accepted in the United States.

As discussed in Note 1 to the consolidated financial statements, the Company
changed its method of accounting for goodwill and intangible assets.

ERNST & YOUNG LLP

Nashville, Tennessee
March 7, 2003

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PSYCHIATRIC SOLUTIONS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands)

|                                           |                                                                                                               |   |              |        |      |   |        |        |  
|------------------------------------------ | ------------------------------------------------------------------------------------------------------------- | - | ------------ | ------ | ---- | - | ------ | ------ | -
|                                           |                                                                                                               |   | December 31,
|                                           |                                                                                                               |   |             
|                                           |                                                                                                               |   | 2002         |        | 2001
|                                           |                                                                                                               |   |              |        |     
|ASSETS                                     |                                                                                                               |   |              |        |      |   |        |       
|Current assets:                            |                                                                                                               |   |              |        |      |   |        |       
|                                           | Cash                                                                                                          |   | $            | 2,392  |      |   | $      | 1,262  |  
|                                           | Accounts receivable, less allowance for doubtful accounts of
$5,284 and $3,940, respectively                  |   |              | 19,473 |      |   |        | 17,477 |  
|                                           | Prepaids and other                                                                                            |   |              | 2,219  |      |   |        | 819    |  
|                                           |                                                                                                               |   |              |        |      |   |        |       
|Total current assets                       |                                                                                                               |   | 24,084       |        |      |   | 19,558 |       
|Property and equipment:                    |                                                                                                               |   |              |        |      |   |        |       
|                                           | Land                                                                                                          |   |              | 6,808  |      |   |        | 5,260  |  
|                                           | Buildings                                                                                                     |   |              | 25,475 |      |   |        | 11,670 |  
|                                           | Equipment                                                                                                     |   |              | 3,253  |      |   |        | 1,631  |  
|Less accumulated depreciation              |                                                                                                               |   | (1,989       | )      |      |   | (581   | )     
|                                           |                                                                                                               |   |              |        |      |   |        |       
|                                           |                                                                                                               |   | 33,547       |        |      |   | 17,980 |       
|Cost in excess of net assets acquired      |                                                                                                               |   | 28,822       |        |      |   | 15,208 |       
|Contracts, net                             |                                                                                                               |   | 607          |        |      |   | 914    |       
|Other assets                               |                                                                                                               |   | 3,078        |        |      |   | 634    |       
|                                           |                                                                                                               |   |              |        |      |   |        |       
|Total assets                               |                                                                                                               | $ | 90,138       |        |      | $ | 54,294 |       
|                                           |                                                                                                               |   |              |        |      |   |        |       
|LIABILITIES AND STOCKHOLDERS EQUITY       |                                                                                                               |   |              |        |      |   |        |       
|Current liabilities:                       |                                                                                                               |   |              |        |      |   |        |       
|                                           | Accounts payable                                                                                              |   | $            | 3,338  |      |   | $      | 1,902  |  
|                                           | Salaries and benefits payable                                                                                 |   |              | 4,825  |      |   |        | 2,532  |  
|                                           | Other accrued liabilities                                                                                     |   |              | 6,482  |      |   |        | 3,361  |  
|                                           | Revolving line of credit                                                                                      |   |              | 5,383  |      |   |        | 11,150 |  
|                                           | Current portion of long-term debt                                                                             |   |              | 1,687  |      |   |        | 4,237  |  
|                                           |                                                                                                               |   |              |        |      |   |        |       
|Total current liabilities                  |                                                                                                               |   | 21,715       |        |      |   | 23,182 |       
|Long-term debt, less current portion       |                                                                                                               |   | 36,752       |        |      |   | 20,951 |       
|Deferred tax liability                     |                                                                                                               |   | 258          |        |      |   | 383    |       
|Other liabilities                          |                                                                                                               |   | 864          |        |      |   | 540    |       
|                                           |                                                                                                               |   |              |        |      |   |        |       
|Total liabilities                          |                                                                                                               |   | 59,589       |        |      |   | 45,056 |       
|Stockholders equity:                      |                                                                                                               |   |              |        |      |   |        |       
|                                           | Preferred stock, $0.01 par value, 16,700 shares authorized; no
shares issued                                  |   |              |       |      |   |        |       |  
|                                           | Common stock, $0.01 par value, 35,000 shares authorized;
7,739 and 4,990 issued and outstanding, respectively |   |              | 77     |      |   |        | 50     |  
|                                           | Additional paid-in capital                                                                                    |   |              | 35,008 |      |   |        | 19,149 |  
|                                           | Notes receivable from stockholders                                                                            |   |              | (259   | )    |   |        |       |  
|                                           | Accumulated deficit                                                                                           |   |              | (4,277 | )    |   |        | (9,961 | )
|                                           |                                                                                                               |   |              |        |      |   |        |       
|Total stockholders equity                 |                                                                                                               |   | 30,549       |        |      |   | 9,238  |       
|                                           |                                                                                                               |   |              |        |      |   |        |       
|Total liabilities and stockholders equity |                                                                                                               | $ | 90,138       |        |      | $ | 54,294 |       
|                                           |                                                                                                               |   |              |        |      |   |        |       

See accompanying notes.

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PSYCHIATRIC SOLUTIONS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands except for per share amounts)

|                                                             |                                                                                                 |   |                         |        |      |   |        |       |   |   |        |        |  
|------------------------------------------------------------ | ----------------------------------------------------------------------------------------------- | - | ----------------------- | ------ | ---- | - | ------ | ----- | - | - | ------ | ------ | -
|                                                             |                                                                                                 |   | Year Ended December 31,
|                                                             |                                                                                                 |   |                        
|                                                             |                                                                                                 |   | 2002                    |        | 2001 |   | 2000  
|                                                             |                                                                                                 |   |                         |        |      |   |       
|Revenue                                                      |                                                                                                 | $ | 113,912                 |        |      | $ | 43,999 |       |   | $ | 23,502 |       
|Salaries, wages and employee benefits                        |                                                                                                 |   | 62,326                  |        |      |   | 26,183 |       |   |   | 15,257 |       
|Professional fees                                            |                                                                                                 |   | 14,373                  |        |      |   | 7,039  |       |   |   | 3,771  |       
|Supplies                                                     |                                                                                                 |   | 5,325                   |        |      |   | 1,241  |       |   |   | 421    |       
|Rentals and leases                                           |                                                                                                 |   | 870                     |        |      |   | 328    |       |   |   | 376    |       
|Other operating expenses                                     |                                                                                                 |   | 15,326                  |        |      |   | 2,714  |       |   |   | 1,258  |       
|Provision for bad debts                                      |                                                                                                 |   | 3,681                   |        |      |   | 662    |       |   |   | 467    |       
|Depreciation and amortization                                |                                                                                                 |   | 1,770                   |        |      |   | 945    |       |   |   | 757    |       
|Interest expense                                             |                                                                                                 |   | 5,564                   |        |      |   | 2,660  |       |   |   | 1,723  |       
|                                                             |                                                                                                 |   |                         |        |      |   |        |       |   |   |        |       
|                                                             |                                                                                                 |   | 109,235                 |        |      |   | 41,772 |       |   |   | 24,030 |       
|                                                             |                                                                                                 |   |                         |        |      |   |        |       |   |   |        |       
|Income (loss) from continuing operations
before income taxes |                                                                                                 |   | 4,677                   |        |      |   | 2,227  |       |   |   | (528   | )     
|                                                             | Provision for (benefit from) income taxes                                                       |   |                         | (1,007 | )    |   |        |      |   |   |        |       |  
|                                                             |                                                                                                 |   |                         |        |      |   |        |       |   |   |        |       
|Income (loss) from continuing operations                     |                                                                                                 |   | 5,684                   |        |      |   | 2,227  |       |   |   | (528   | )     
|Discontinued operations before
extraordinary item:           |                                                                                                 |   |                         |        |      |   |        |       |   |   |        |       
|                                                             | Income from operations of
discontinued lines of business                                        |   |                         |       |      |   |        | 89    |   |   |        | 350    |  
|                                                             | Gain (loss) on disposal of discontinued
lines of business, net of income taxes
of $223 for 2001 |   |                         |       |      |   |        | 1,499 |   |   |        | (1,738 | )
|                                                             |                                                                                                 |   |                         |        |      |   |        |       |   |   |        |       
|Income (loss) from discontinued operations                   |                                                                                                 |   |                        |        |      |   | 1,588  |       |   |   | (1,388 | )     
|                                                             |                                                                                                 |   |                         |        |      |   |        |       |   |   |        |       
|Net income (loss) before extraordinary item                  |                                                                                                 |   | 5,684                   |        |      |   | 3,815  |       |   |   | (1,916 | )     
|Loss from early retirement of debt                           |                                                                                                 |   |                        |        |      |   | (1,237 | )     |   |   |       |       
|                                                             |                                                                                                 |   |                         |        |      |   |        |       |   |   |        |       
|Net income (loss)                                            |                                                                                                 | $ | 5,684                   |        |      | $ | 2,578  |       |   | $ | (1,916 | )     
|                                                             |                                                                                                 |   |                         |        |      |   |        |       |   |   |        |       
|Basic earnings per share:                                    |                                                                                                 |   |                         |        |      |   |        |       |   |   |        |       
|                                                             | Income (loss) from continuing operations                                                        |   | $                       | 0.93   |      |   | $      | 0.44  |   |   | $      | (0.11  | )
|                                                             | Income (loss) from discontinued operations                                                      |   |                         |       |      |   |        | 0.32  |   |   |        | (0.29  | )
|                                                             | Loss from early retirement of debt                                                              |   |                         |       |      |   |        | (0.25 | ) |   |        |       |  
|                                                             |                                                                                                 |   |                         |        |      |   |        |       |   |   |        |       
|Net income (loss)                                            |                                                                                                 | $ | 0.93                    |        |      | $ | 0.51   |       |   | $ | (0.40  | )     
|                                                             |                                                                                                 |   |                         |        |      |   |        |       |   |   |        |       
|Diluted earnings per share:                                  |                                                                                                 |   |                         |        |      |   |        |       |   |   |        |       
|                                                             | Income (loss) from continuing operations                                                        |   | $                       | 0.86   |      |   | $      | 0.42  |   |   | $      | (0.11  | )
|                                                             | Income (loss) from discontinued operations                                                      |   |                         |       |      |   |        | 0.30  |   |   |        | (0.29  | )
|                                                             | Loss from early retirement of debt                                                              |   |                         |       |      |   |        | (0.23 | ) |   |        |       |  
|                                                             |                                                                                                 |   |                         |        |      |   |        |       |   |   |        |       
|Net income (loss)                                            |                                                                                                 | $ | 0.86                    |        |      | $ | 0.49   |       |   | $ | (0.40  | )     
|                                                             |                                                                                                 |   |                         |        |      |   |        |       |   |   |        |       
|Shares used in computing per share amounts:                  |                                                                                                 |   |                         |        |      |   |        |       |   |   |        |       
|                                                             | Basic                                                                                           |   |                         | 6,111  |      |   |        | 5,010 |   |   |        | 4,817  |  
|                                                             | Diluted                                                                                         |   |                         | 6,986  |      |   |        | 5,309 |   |   |        | 4,817  |  

See accompanying notes.

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PSYCHIATRIC SOLUTIONS, INC.
CONSOLIDATED STATEMENTS STOCKHOLDERS EQUITY
(in thousands)

|                             |                                                 |  |              |       |            |   |            |    |              |   |         |        |       |   |       |      |   |   |         |        |   |   |        |        |  
|---------------------------- | ----------------------------------------------- |  | ------------ | ----- | ---------- | - | ---------- | -- | ------------ | - | ------- | ------ | ----- | - | ----- | ---- | - | - | ------- | ------ | - | - | ------ | ------ | -
|                             |                                                 |  |              |       |            |   |            |    |              |   |         |        |       |   | Notes |      |   |   |         |        |   |   |       
|                             |                                                 |  | Common Stock |       | Additional |   | Receivable |    |              |   |         |        |       |   |      
|                             |                                                 |  |              |       | Paid-In    |   | from       |    | Accumulated  |   |         |        |      
|                             |                                                 |  | Shares       |       | Amount     |   | Capital    |    | Stockholders |   | Deficit |        | Total
|                             |                                                 |  |              |       |            |   |            |    |              |   |         |        |      
|Balance at December 31, 1999 |                                                 |  | 4,668        |       |            | $ | 47         |    |              | $ | 16,393  |        |       | $ |      |      |   | $ | (10,623 | )      |   | $ | 5,817  |       
|                             | Common stock issued                             |  |              | 417   |            |   |            | 4  |              |   |         | 2,330  |       |   |       |     |   |   |         |       |   |   |        | 2,334  |  
|                             | Net loss                                        |  |              |      |            |   |            |   |              |   |         |       |       |   |       |     |   |   |         | (1,916 | ) |   |        | (1,916 | )
|                             |                                                 |  |              |       |            |   |            |    |              |   |         |        |       |   |       |      |   |   |         |        |   |   |        |       
|Balance at December 31, 2000 |                                                 |  | 5,085        |       |            |   | 51         |    |              |   | 18,723  |        |       |   |      |      |   |   | (12,539 | )      |   |   | 6,235  |       
|                             | Common stock issued                             |  |              | 4     |            |   |            |   |              |   |         | 720    |       |   |       |     |   |   |         |       |   |   |        | 720    |  
|                             | Reacquired common stock                         |  |              | (99   | )          |   |            | (1 | )            |   |         | (294   | )     |   |       |     |   |   |         |       |   |   |        | (295   | )
|                             | Net income                                      |  |              |      |            |   |            |   |              |   |         |       |       |   |       |     |   |   |         | 2,578  |   |   |        | 2,578  |  
|                             |                                                 |  |              |       |            |   |            |    |              |   |         |        |       |   |       |      |   |   |         |        |   |   |        |       
|Balance at December 31, 2001 |                                                 |  | 4,990        |       |            |   | 50         |    |              |   | 19,149  |        |       |   |      |      |   |   | (9,961  | )      |   |   | 9,238  |       
|                             | Common stock and options
issued with PMR merger |  |              | 2,421 |            |   |            | 24 |              |   |         | 15,361 |       |   |       | (259 | ) |   |         |       |   |   |        | 15,126 |  
|                             | Value of warrants issued                        |  |              |      |            |   |            |   |              |   |         | 330    |       |   |       |     |   |   |         |       |   |   |        | 330    |  
|                             | Exercise of stock options and
warrants          |  |              | 328   |            |   |            | 3  |              |   |         | 50     |       |   |       |     |   |   |         |       |   |   |        | 53     |  
|                             | Issuance of stock options                       |  |              |      |            |   |            |   |              |   |         | 118    |       |   |       |     |   |   |         |       |   |   |        | 118    |  
|                             | Net income                                      |  |              |      |            |   |            |   |              |   |         |       |       |   |       |     |   |   |         | 5,684  |   |   |        | 5,684  |  
|                             |                                                 |  |              |       |            |   |            |    |              |   |         |        |       |   |       |      |   |   |         |        |   |   |        |       
|Balance at December 31, 2002 |                                                 |  | 7,739        |       |            | $ | 77         |    |              | $ | 35,008  |        |       | $ | (259  | )    |   | $ | (4,277  | )      |   | $ | 30,549 |       
|                             |                                                 |  |              |       |            |   |            |    |              |   |         |        |       |   |       |      |   |   |         |        |   |   |        |       

See accompanying notes.

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PSYCHIATRIC SOLUTIONS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

|                                                                                                              |                                                                             |                                           |        |                         |        |      |       |        |      |   |        |       |      |  
|------------------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------- | ----------------------------------------- | ------ | ----------------------- | ------ | ---- | ----- | ------ | ---- | - | ------ | ----- | ---- | -
|                                                                                                              |                                                                             |                                           |        | Year Ended December 31,
|                                                                                                              |                                                                             |                                           |        |                        
|                                                                                                              |                                                                             |                                           |        | 2002                    |        | 2001 |       | 2000  
|                                                                                                              |                                                                             |                                           |        |                         |        |      |       |       
|Operating Activities                                                                                          |                                                                             |                                           |        |                         |        |      |       |        |      |   |        |      
|Net income (loss)                                                                                             |                                                                             | $                                         | 5,684  |                         |        | $    | 2,578 |        |      | $ | (1,916 | )    
|Adjustments to reconcile net income (loss) to
net cash provided by (used in) continuing
operating activities: |                                                                             |                                           |        |                         |        |      |       |        |      |   |        |      
|                                                                                                              | Depreciation and amortization                                               |                                           |        | 1,770                   |        |      |       | 945    |      |   |        | 757   |     
|                                                                                                              | Provision for doubtful accounts                                             |                                           |        | 3,681                   |        |      |       | 662    |      |   |        | 467   |     
|                                                                                                              | Accretion of detachable warrants                                            |                                           |        | 677                     |        |      |       | 704    |      |   |        | 166   |     
|                                                                                                              | Non-cash stock compensation expense                                         |                                           |        | 118                     |        |      |       |       |      |   |        |      |     
|                                                                                                              | Amortization of loan costs                                                  |                                           |        | 419                     |        |      |       | 172    |      |   |        | 69    |     
|                                                                                                              | Release of deferred tax asset valuation allowance                           |                                           |        | (1,332                  | )      |      |       |       |      |   |        |      |     
|                                                                                                              | Extraordinary loss on extinguishment of debt                                |                                           |        |                        |        |      |       | 1,237  |      |   |        |      |     
|                                                                                                              | Additional reserve on stockholder notes                                     |                                           |        | 92                      |        |      |       |       |      |   |        |      |     
|                                                                                                              | Loss (income) from discontinued operations                                  |                                           |        |                        |        |      |       | (1,588 | )    |   |        | 1,388 |     
|                                                                                                              | Long-term interest accrued                                                  |                                           |        | 324                     |        |      |       | 324    |      |   |        | 216   |     
|                                                                                                              | Changes in operating assets and liabilities,
net of effect of acquisitions: |                                           |        |                         |        |      |       |        |      |   |        |       |     
|                                                                                                              |                                                                             | Accounts receivable                       |        |                         | (1,348 | )    |       |        | 392  |   |        |       | (641 | )
|                                                                                                              |                                                                             | Prepaids and other current assets         |        |                         | (399   | )    |       |        | (118 | ) |        |       | (74  | )
|                                                                                                              |                                                                             | Accounts payable                          |        |                         | (2,523 | )    |       |        | (247 | ) |        |       | 47   |  
|                                                                                                              |                                                                             | Salaries and benefits payable             |        |                         | 1,504  |      |       |        | 783  |   |        |       | 62   |  
|                                                                                                              |                                                                             | Accrued liabilities and other liabilities |        |                         | 255    |      |       |        | 947  |   |        |       | (718 | )
|                                                                                                              |                                                                             |                                           |        |                         |        |      |       |        |      |   |        |      
|Net cash provided by (used in) continuing
operating activities                                                |                                                                             |                                           | 8,922  |                         |        |      | 6,791 |        |      |   | (177   | )    
|Investing activities:                                                                                         |                                                                             |                                           |        |                         |        |      |       |        |      |   |        |      
|Cash acquired (paid) for acquisitions, net of cash
paid or acquired                                           |                                                                             |                                           | 6,243  |                         |        |      | (305  | )      |      |   | (9,529 | )    
|Capital purchases of leasehold improvements,
equipment and software                                           |                                                                             |                                           | (1,470 | )                       |        |      | (116  | )      |      |   | (106   | )    
|Change in net assets of discontinued operations                                                               |                                                                             |                                           |       |                         |        |      | 2,388 |        |      |   | 939    |      
|Other assets                                                                                                  |                                                                             |                                           | (612   | )                       |        |      |      |        |      |   | (23    | )    
|                                                                                                              |                                                                             |                                           |        |                         |        |      |       |        |      |   |        |      
|Net cash provided by (used in) investing activities                                                           |                                                                             |                                           | 4,161  |                         |        |      | 1,967 |        |      |   | (8,719 | )    

(Continued)

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##### Table of Contents



PSYCHIATRIC SOLUTIONS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

|                                                                                       |                                                                     |   |                         |         |      |   |        |         |   |   |       |        |  
|-------------------------------------------------------------------------------------- | ------------------------------------------------------------------- | - | ----------------------- | ------- | ---- | - | ------ | ------- | - | - | ----- | ------ | -
|                                                                                       |                                                                     |   | Year Ended December 31,
|                                                                                       |                                                                     |   |                        
|                                                                                       |                                                                     |   | 2002                    |         | 2001 |   | 2000  
|                                                                                       |                                                                     |   |                         |         |      |   |       
|Financing activities:                                                                  |                                                                     |   |                         |         |      |   |        |         |   |   |       |       
|Net principal (payments) borrowings on long-term debt                                  |                                                                     | $ | (11,772                 | )       |      | $ | (6,956 | )       |   | $ | 6,440 |       
|Payment of loan costs                                                                  |                                                                     |   | (234                    | )       |      |   | (880   | )       |   |   | (289  | )     
|Proceeds from issuance of common stock                                                 |                                                                     |   | 53                      |         |      |   | 4      |         |   |   | 1,917 |       
|                                                                                       |                                                                     |   |                         |         |      |   |        |         |   |   |       |       
|Net cash (used in) provided by financing activities                                    |                                                                     |   | (11,953                 | )       |      |   | (7,832 | )       |   |   | 8,068 |       
|Net increase in cash                                                                   |                                                                     |   | 1,130                   |         |      |   | 926    |         |   |   | (828  | )     
|Cash at beginning of the year                                                          |                                                                     |   | 1,262                   |         |      |   | 336    |         |   |   | 1,164 |       
|                                                                                       |                                                                     |   |                         |         |      |   |        |         |   |   |       |       
|Cash at end of the year                                                                |                                                                     | $ | 2,392                   |         |      | $ | 1,262  |         |   | $ | 336   |       
|                                                                                       |                                                                     |   |                         |         |      |   |        |         |   |   |       |       
|Supplemental Cash Flow Information:                                                    |                                                                     |   |                         |         |      |   |        |         |   |   |       |       
|                                                                                       | Interest paid                                                       |   | $                       | 3,905   |      |   | $      | 1,717   |   |   | $     | 1,401  |  
|                                                                                       |                                                                     |   |                         |         |      |   |        |         |   |   |       |       
|Effect of Acquisitions:                                                                |                                                                     |   |                         |         |      |   |        |         |   |   |       |       
|                                                                                       | Assets acquired, net of cash acquired                               |   | $                       | 34,868  |      |   | $      | 30,978  |   |   | $     | 16,134 |  
|                                                                                       | Liabilities assumed                                                 |   |                         | (8,862  | )    |   |        | (3,661  | ) |   |       | (2,559 | )
|                                                                                       | Notes payable issued                                                |   |                         |        |      |   |        | (4,500  | ) |   |       | (4,000 | )
|                                                                                       | Common stock and stock options issued                               |   |                         | (15,385 | )    |   |        |        |   |   |       | (46    | )
|                                                                                       | Long-term debt issued                                               |   |                         | (16,864 | )    |   |        | (22,512 | ) |   |       |       |  
|                                                                                       |                                                                     |   |                         |         |      |   |        |         |   |   |       |       
|                                                                                       | Cash (acquired) paid for acquisitions, net of
cash paid or acquired |   | $                       | (6,243  | )    |   | $      | 305     |   |   | $     | 9,529  |  
|                                                                                       |                                                                     |   |                         |         |      |   |        |         |   |   |       |       
|Significant Non-cash Transactions:                                                     |                                                                     |   |                         |         |      |   |        |         |   |   |       |       
|Issuance of detachable stock warrants as
consideration for Bridge Loan                 |                                                                     | $ | 330                     |         |      | $ | 718    |         |   | $ | 373   |       
|                                                                                       |                                                                     |   |                         |         |      |   |        |         |   |   |       |       
|Issuance of detachable stock warrants as
consideration for subordinated debt financing |                                                                     | $ | 2,018                   |         |      | $ |       |         |   | $ |      |       
|                                                                                       |                                                                     |   |                         |         |      |   |        |         |   |   |       |       
|Financing of early debt termination fee                                                |                                                                     | $ |                        |         |      | $ | 818    |         |   | $ |      |       
|                                                                                       |                                                                     |   |                         |         |      |   |        |         |   |   |       |       
|Financing of loan costs                                                                |                                                                     | $ | 2,004                   |         |      | $ |       |         |   | $ |      |       
|                                                                                       |                                                                     |   |                         |         |      |   |        |         |   |   |       |       

See accompanying notes.

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##### Table of Contents



PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002

1. Summary of Significant Accounting Policies

Description of Business

Psychiatric Solutions, Inc. (the Company or PSI) was incorporated in 1988
as a Delaware corporation with its corporate office in Franklin, Tennessee. The
Company manages behavioral health units and owns psychiatric facilities.

The Company has formed two operating divisions: (1) Psychiatric Unit
Management, and (2) Freestanding Specialty Hospitals. The Psychiatric Unit
Management division provides psychiatric management and development services to
behavioral health units in hospitals and clinics. The Freestanding Specialty
Hospitals division includes owned psychiatric facilities. As of December 31,
2002, the Company managed 48 behavioral health units and owned five psychiatric
facilities in three states.

Basis of Consolidation

The consolidated financial statements include the accounts of the Company and
its wholly-owned subsidiaries. All significant intercompany balances and
transactions are eliminated in consolidation.

Cash

Cash consists of demand deposits held at financial institutions. The Company
places its cash in financial institutions that are federally insured and limits
the amount of credit exposure with any one financial institution.

Accounts Receivable

Accounts receivable vary according to the type of service being provided.
Accounts receivable for the Psychiatric Unit Management division is comprised
of contractually determined fees for services rendered. Such amounts are
recorded net of estimated bad debts. Concentration of credit risk is limited by
the number of customers.

Accounts receivable for the Freestanding Specialty Hospitals division are
comprised of patient service revenue and are recorded net of contractual
adjustments and estimated bad debts. Such amounts are owed by various
governmental agencies, insurance companies and private patients. Medicare
comprised approximately 14% and 17% of net patient receivables at December 31,
2002 and 2001, respectively. Medicaid comprised approximately 28% and 14% of
net patient receivables at December 31, 2002 and 2001, respectively.
Concentration of credit risk from other payers is limited by the number of
patients and payers.

Income Taxes

The Company accounts for income taxes under the liability method. Under this
method, deferred tax assets and liabilities are determined based upon
differences between the financial statement carrying amounts and tax bases of
assets and liabilities and are measured using the enacted tax laws that will be
in effect when the differences are expected to reverse.

Long-Lived Assets
     Property and Equipment

Property and equipment are stated at cost and depreciated using the
straight-line method over the useful lives of the assets, which range from 25
to 35 years for buildings and improvements and 2 to 7 years for equipment.
Leasehold improvements are amortized on a straight-line basis over the shorter
of the lease term or estimated useful lives of the assets. Depreciation expense
was $1,408,000 and $279,000 for the years ended December 31, 2002 and 2001,
respectively.

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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002

Cost in Excess of Net Assets Acquired (Goodwill)

During July 2001, the Financial Accounting Standards Board (FASB) issued
Statements of Financial Accounting Standards No. 141, Business Combinations
(SFAS 141) and No. 142, Goodwill and Other Intangible Assets (SFAS 142).
These statements made significant changes to the accounting for business
combinations, goodwill, and intangible assets.

SFAS 141 eliminates the pooling of interests method of accounting for business
combinations. In addition, it further clarifies the criteria for recognition of
intangible assets separately from goodwill. SFAS 141 was effective for
transactions completed subsequent to June 30, 2001. The application of SFAS
141 did not have a material effect on the Companys results of operations or
financial position.

Under SFAS 142, goodwill and intangible assets with indefinite lives are no
longer amortized but are reviewed at least annually for impairment. The
amortization provisions of SFAS 142 apply to goodwill and intangible assets
acquired after June 30, 2001. With respect to goodwill and intangible assets
acquired prior to July 1, 2001, the Company adopted SFAS 142 effective January
1, 2002. Pursuant to SFAS 142, the Company completed its transitional and
annual impairment test of goodwill in 2002 which resulted in no goodwill
impairment

A reconciliation of previously reported net income to the pro forma amounts
adjusted for the exclusion of goodwill amortization follows (in thousands,
except per share amounts):

|                                                     |  |                         |       |      |  |      |        |   |  |   |        |  
|---------------------------------------------------- |  | ----------------------- | ----- | ---- |  | ---- | ------ | - |  | - | ------ | -
|                                                     |  | Year ended December 31,
|                                                     |  |                        
|                                                     |  | 2002                    |       | 2001 |  | 2000
|                                                     |  |                         |       |      |  |     
|Reported net income (loss) before extraordinary item |  | $                       | 5,684 |      |  | $    | 3,815  |   |  | $ | (1,916 | )
|Extraordinary loss on extinguishment of debt         |  | $                       |      |      |  |      | (1,237 | ) |  |   |       |  
|                                                     |  |                         |       |      |  |      |        |   |  |   |        |  
|Reported net income (loss)                           |  | $                       | 5,684 |      |  | $    | 2,578  |   |  | $ | (1,916 | )
|Add: goodwill amortization                           |  |                         |      |      |  |      | 359    |   |  |   | 276    |  
|                                                     |  |                         |       |      |  |      |        |   |  |   |        |  
|Proforma adjusted net income                         |  | $                       | 5,684 |      |  | $    | 2,937  |   |  | $ | (1,640 | )
|                                                     |  |                         |       |      |  |      |        |   |  |   |        |  
|Proforma adjusted earnings per common share, basic   |  | $                       | 0.93  |      |  | $    | 0.59   |   |  | $ | (0.34  | )
|                                                     |  |                         |       |      |  |      |        |   |  |   |        |  
|Proforma adjusted earnings per common share, diluted |  | $                       | 0.86  |      |  | $    | 0.55   |   |  | $ | (0.34  | )
|                                                     |  |                         |       |      |  |      |        |   |  |   |        |  

The following table presents the changes in the carrying amount of goodwill for
the year ended December 31, 2002 (in thousands):

|                               |  |  |        | 
|------------------------------ |  |  | ------ | 
|Balance at December 31, 2001   |  |  | 15,208 | 
|Acquisition of PMR Corporation |  |  | 12,914 | 
|Acquisition of Riveredge       |  |  | 662    | 
|Other                          |  |  | 38     | 
|Balance at December 31, 2002   |  |  | 28,822 | 

Contracts

Contracts represent the fair value of management contracts and service
contracts purchased and are being amortized using the straight-line method over
five years. The amounts reported at December 31, 2002 and 2001 are net of
accumulated amortization of $927,000 and $620,000, respectively. Amortization
expense related to contracts was $307,000 and $306,000 for the years ended
December 31, 2002 and 2001, respectively. Estimated amortization expense for
the years ended December 31, 2003 and 2004 of contracts is $300,000.

When events, circumstances and operating results indicate that the carrying
values of certain long-lived assets and

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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002

the related identifiable intangible assets might be impaired, the Company
prepares projections of the undiscounted future cash flows expected to result
from the use of the assets and their eventual disposition. If the projections
indicate that the recorded amounts are not expected to be recoverable, such
amounts are reduced to estimated fair value. Fair value is estimated based upon
projections of discounted cash flows.

Other Assets

Other assets consist principally of loan costs which are deferred and amortized
over the term of the related debt. The amounts reported at December 31, 2002
and 2001 are net of accumulated amortization of $484,000 and $85,000,
respectively.

Stock-Based Compensation

In January 2003, the FASB issued SFAS 148, Accounting for Stock-Based
Compensation-Transition and Disclosure, an Amendment of FASB Statement No. 123.
SFAS 148 amends SFAS 123, Accounting for Stock-Based Compensation, to provide
alternative methods of transition for a voluntary change to the fair-value
based method of accounting for stock-based employee compensation. In addition,
SFAS 148 amends the disclosure requirements of SFAS 123 to require prominent
disclosures in both annual and interim financial statements about the method of
accounting for stock-based employee compensation and the effect of the method
used on reported results. SFAS 148 has no material impact on the Company, as
it does not plan to adopt the fair-value method of accounting for stock options
at the current time. The Company has included the required disclosures below
and in Note 10.

The Company accounts for its stock option plans in accordance with the
provisions of Accounting Principles Board (APB) Opinion No. 25, Accounting
for Stock Issued to Employees, and related interpretations as more fully
described in Note 10. As such, compensation expense would be recorded on the
date of grant only if the current market price of the underlying stock exceeded
the exercise price.

Pro forma information regarding net income and earnings per share is required
by SFAS No. 123, and has been determined as if the Company had accounted for
its employee stock options under the fair value method of that Statement.
During 2002, 2001 and 2000, the Company granted 515,000, 35,000 and 85,000
stock options, respectively. The fair value of these options was estimated
using the Black-Scholes option pricing model for 2002. For 2001 and 2000, the
Company used the minimum value option pricing model as its stock was not
publicly traded.

The following weighted-average assumptions were used in the respective pricing models:

|                        |  |      |        |      |  |      |      |   |  |  |       |   
|----------------------- |  | ---- | ------ | ---- |  | ---- | ---- | - |  |  | ----- | --
|                        |  | 2002 |        | 2001 |  | 2000
|                        |  |      |        |      |  |     
|Risk-free interest rate |  |      | 3.11   | %    |  |      | 3.69 | % |  |  | 6.27  | % 
|Volatility              |  |      | 111.70 | %    |  |      | N/A  |   |  |  | N/A   |   
|Expected life           |  |      | 4      |      |  |      | 10   |   |  |  | 10    |   
|Dividend yield          |  |      | 0.00   | %    |  |      | 0.00 | % |  |  | (0.00 | %)

The weighted-average fair value of options granted are presented in the following table:

|                                         |  |      |      |      |  |      |      |  |  |   |      | 
|---------------------------------------- |  | ---- | ---- | ---- |  | ---- | ---- |  |  | - | ---- | 
|                                         |  | 2002 |      | 2001 |  | 2000
|                                         |  |      |      |      |  |     
|Exercise Price equal to Market Price     |  | $    | 4.13 |      |  | $    | 0.05 |  |  | $ | 0.08 | 
|Exercise Price less than Market Price    |  | $    | 3.74 |      |  | $    |     |  |  | $ |     | 
|Exercise Price greater than Market Price |  | $    | 2.67 |      |  | $    |     |  |  | $ |     | 

Option valuation models require the input of highly subjective assumptions.
Because the Companys employee stock options have characteristics significantly
different from those of traded options, and because changes in the subjective
input assumptions can materially affect the fair value estimate, in
managements opinion, the existing models do not necessarily provide a reliable
single measure of the fair value of its employee stock options.

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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002

For purposes of pro forma disclosure, the estimated fair value of the options
is amortized to expense over the options vesting period. The Companys pro
forma information follows (in thousands, except per share amounts):

|                                                  |  |      |       |      |  |      |       |  |  |   |        |  
|------------------------------------------------- |  | ---- | ----- | ---- |  | ---- | ----- |  |  | - | ------ | -
|                                                  |  | 2002 |       | 2001 |  | 2000
|                                                  |  |      |       |      |  |     
|Net income (loss)                                 |  | $    | 5,684 |      |  | $    | 2,578 |  |  | $ | (1,916 | )
|Pro forma compensation expense from stock options |  |      | 92    |      |  |      | 12    |  |  |   | 19     |  
|                                                  |  |      |       |      |  |      |       |  |  |   |        |  
|Pro forma net income (loss)                       |  | $    | 5,592 |      |  | $    | 2,566 |  |  | $ | (1,935 | )
|                                                  |  |      |       |      |  |      |       |  |  |   |        |  
|Basic pro forma earnings (loss) per share         |  | $    | 0.92  |      |  | $    | 0.51  |  |  | $ | (0.40  | )
|                                                  |  |      |       |      |  |      |       |  |  |   |        |  
|Diluted pro forma earnings (loss) per share       |  | $    | 0.85  |      |  | $    | 0.48  |  |  | $ | (0.40  | )
|                                                  |  |      |       |      |  |      |       |  |  |   |        |  

Use of Estimates

Management of the Company has made certain estimates and assumptions relating
to the reporting of assets and liabilities and the disclosure of contingent
assets and liabilities to prepare these consolidated financial statements in
conformity with accounting principles generally accepted in the United States.
Actual results could differ from those estimates.

Risk Management

The Company carries general and professional liability insurance from an
unrelated commercial insurance carrier. Prior to December 6, 2002, the Company
maintained a claims-made policy under which it was insured for per occurrence
losses up to $6,000,000 with policy limits of $8,000,000 in the aggregate. On
December 6th, 2002, the Company increased its self-insured retention from
$100,000 per claim to $3 million per claim and increased its policy limit to
$10 million per occurrence and in the aggregate to mitigate the increases in
the cost of professional and general liability insurance and to increase
coverage for additional exposures due to acquisitions. The reserve for
professional and general liability risks is based on historical claims,
demographic factors, industry trends, severity factors, and other actuarial
assumptions calculated by an independent third party. This estimate is
discounted to its present value using a 5% discount rate. This estimated
accrual for professional and general liabilities could be significantly
affected should current and future occurrences differ from historical claim
trends and expectations. The Company has established a captive insurance
company to manage this additional self-insured retention. While claims are
monitored closely when estimating professional and general liability accruals,
the complexity of the claims and wide range of potential outcomes often hampers
timely adjustments to the assumptions used in these estimates. The reserve for
professional and general liability was $743,000 as of December 31, 2002. The
Company had no reserves recorded in previous years because substantially all of
the risk was insured.

The Company also carries workers compensation insurance from an unrelated
commercial insurance carrier. The Companys experience with workers
compensation claims has been insignificant. The Company believes that adequate
provision has been made for workers compensation and professional and general
liability risks.

Fair Value of Financial Instruments

The carrying amounts reported in the accompanying Consolidated Balance Sheets
for cash, accounts receivable, and accounts payable approximate their fair
value given the short-term maturity of these instruments. Based upon the
borrowing rates currently available to the Company, the carrying amounts
reported in the accompanying Consolidated Balance Sheets for long-term debt
approximate fair value.

Merger with PMR Corporation

On August 5, 2002, pursuant to a definitive Merger Agreement dated May 6, 2002
and with respective stockholder and regulatory approvals, PMR Acquisition
Corporation, a newly formed, wholly-owned subsidiary of PMR Corporation, merged
with and into Psychiatric Solutions, Inc., a Delaware corporation whose name,
subsequent to

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##### Table of Contents



PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002

the merger, was changed to Psychiatric Solutions Hospitals, Inc. (PSH).
Concurrently, the name of PMR Corporation was changed to Psychiatric Solutions,
Inc. (PSI or the Company). The surviving corporation in the merger was PSH,
which has become a wholly-owned subsidiary of the Company. In exchange for
their outstanding shares of common stock or preferred stock in PSH,
stockholders of PSH received newly-issued shares of Company common stock.
Options to acquire PSH common stock were converted into options to purchase
shares of Company common stock based on the common stock exchange ratio used in
the merger. Warrants of PSH will enable the holders to exercise these
securities into shares of Company common stock. After giving effect to the
exercise of all outstanding options and warrants of PSH following the merger,
the former PSH stockholders and the Companys pre-merger stockholders received
approximately 72% and 28% of the common stock of the Company, respectively. The
headquarters of the combined company has been relocated to Franklin, Tennessee.
In addition, effective August 6, 2002, the shares of the Company were approved
for listing on the Nasdaq National Market under the ticker symbol PSYS. The
Merger Agreement is on file with the Securities and Exchange Commission (SEC)
as an exhibit to Amendment No. 1 to the Companys Registration Statement on
Form S-4 filed on June 12, 2002, as amended July 11, 2002.

Inasmuch as the former PSH stockholders own more than half of the surviving
corporations outstanding common stock pursuant to the merger, PSH has been
treated as the acquiring company for accounting purposes. The condensed
consolidated financial statements located herein relate to PSH only prior to
August 5, 2002, and to the merged company on and subsequent to August 5, 2002.
Historical financial information relating to PMR Corporation just prior to the
merger can be found in the Companys quarterly report on Form 10-Q for the
quarter ended July 31, 2002, as filed with the SEC on September 16, 2002.

Reclassifications

Certain reclassifications have been made to the prior year to conform with
current year presentation. Specifically, PSHs Series A Preferred Stock,
Series B Preferred Stock and Common Stock were converted to post merger Common
Stock on August 5, 2002 at rates pursuant to the merger agreement with PMR
Corporation of 0.246951, 0.312864 and 0.115125, respectively. All periods
prior to August 5, 2002 have been retroactively restated to reflect conversion
at the applicable conversion rates. The following table sets forth the effect
of retroactive conversion as of December 31, 2001 (in thousands):

|                                                       |  |                                           |     |                 |  |                    |        |                    |  |            |        |         |  |     |         |        |  |  |         |   |  |        |        |   |  |  |        |  
|------------------------------------------------------ |  | ----------------------------------------- | --- | --------------- |  | ------------------ | ------ | ------------------ |  | ---------- | ------ | ------- |  | --- | ------- | ------ |  |  | ------- | - |  | ------ | ------ | - |  |  | ------ | -
|                                                       |  | Effect of Conversion at December 31, 2001
|                                                       |  |                                          
|                                                       |  |                                           |     |                 |  |                    |        |                    |  | Additional |        |         |  |     |         |        |  |  |         |   |  |        |        |   |  | 
|                                                       |  | Common Stock                              |     | Paid in Capital |  | Series A Preferred |        | Series B Preferred
|                                                       |  |                                           |     |                 |  |                    |        |                   
|                                                       |  |                                           |     |                 |  | Shares             |        |                    |  |            |        |         |  |     |         | Shares |  |  |         |   |  | Shares
|                                                       |  | Balance                                   |     | O/S             |  | Balance            |        | Balance            |  | O/S        |        | Balance |  | O/S
|                                                       |  |                                           |     |                 |  |                    |        |                    |  |            |        |         |  |    
|Balances prior to conversion                           |  |                                           | 73  |                 |  |                    | 7,296  |                    |  |            | 74     |         |  |     | 10,497  |        |  |  | 10,497  |   |  |        | 8,555  |   |  |  | 4,976  |  
|Conversion of Common Stock to
post merger Common Stock |  |                                           | (65 | )               |  |                    | (6,456 | )                  |  |            | 65     |         |  |     |         |        |  |  |         |   |  |        |        |   |  |  |        |  
|Conversion of Series A Preferred
to post merger Common |  |                                           | 26  |                 |  |                    | 2,593  |                    |  |            | 10,471 |         |  |     | (10,497 | )      |  |  | (10,497 | ) |  |        |        |   |  |  |        |  
|Conversion of Series B Preferred
to post merger Common |  |                                           | 16  |                 |  |                    | 1,557  |                    |  |            | 8,539  |         |  |     |         |        |  |  |         |   |  |        | (8,555 | ) |  |  | (4,976 | )
|                                                       |  |                                           |     |                 |  |                    |        |                    |  |            |        |         |  |     |         |        |  |  |         |   |  |        |        |   |  |  |        |  
|Balances post conversion                               |  |                                           | 50  |                 |  |                    | 4,990  |                    |  |            | 19,149 |         |  |     |        |        |  |  |        |   |  |        |       |   |  |  |       |  
|                                                       |  |                                           |     |                 |  |                    |        |                    |  |            |        |         |  |     |         |        |  |  |         |   |  |        |        |   |  |  |        |  

Recent Pronouncements

In August 2001, the FASB issued Statement of Financial Accounting Standards No.
144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS
144), which supersedes SFAS 121, Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to be Disposed of, and the accounting and
reporting provisions of APB Opinion No. 30, Reporting the Effects of Disposal
of a Segment of a Business and Extraordinary, Unusual and Infrequently
Occurring Events and Transactions. SFAS 144 removes goodwill from its scope and
clarifies other implementation issues related to SFAS 121. SFAS 144 also
provides a single framework for evaluating long-lived assets to be disposed of
by sale. The Company does not expect SFAS 144 to have a material

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##### Table of Contents



PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002

effect on its results of operations or financial position.

In April 2002, the FASB issued Statement of Financial Accounting Standards No.
145, Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB
Statement No. 13, and Technical Corrections (SFAS 145). SFAS 145 prohibits
the classification of gains or losses from debt extinguishments as
extraordinary items unless the criteria outlined in APB Opinion No. 30,
Reporting the Results of Operations  Reporting the Effects of Disposal of a
Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring
Events and Transactions, are met. SFAS 145 also eliminates an inconsistency
between the required accounting for sale-leaseback transactions and the
required accounting for certain lease modifications that have economic effects
that are similar to sale-leaseback transactions. SFAS 145 is effective for
fiscal years beginning after May 15, 2002, with early adoption encouraged. The
Company intends to adopt the provisions of SFAS 145 effective January 1, 2003
and will be required to reclassify amounts previously reported as an
extraordinary item to a component of income from continuing operations.

2. Revenue

Revenue consists of the following amounts (in thousands):

|                        |  |              |         |      |  |      |        |  |  |   |        | 
|----------------------- |  | ------------ | ------- | ---- |  | ---- | ------ |  |  | - | ------ | 
|                        |  | December 31,
|                        |  |             
|                        |  | 2002         |         | 2001 |  | 2000
|                        |  |              |         |      |  |     
|Patient service revenue |  | $            | 81,929  |      |  | $    | 16,026 |  |  | $ |       | 
|Management fee revenue  |  |              | 31,983  |      |  |      | 27,973 |  |  |   | 23,502 | 
|                        |  |              |         |      |  |      |        |  |  |   |        | 
|Total revenue           |  | $            | 113,912 |      |  | $    | 43,999 |  |  | $ | 23,502 | 
|                        |  |              |         |      |  |      |        |  |  |   |        | 

Net Patient Service Revenue

Patient service revenue is reported on the accrual basis in the period in which
services are provided, at established rates, regardless of whether collection
in full is expected. Net patient service revenue includes amounts estimated by
management to be reimbursable by Medicare and Medicaid under provisions of cost
or prospective reimbursement formulas in effect. Amounts received are generally
less than the established billing rates of the facilities and the differences
(contractual allowances) are reported as deductions from patient service
revenue at the time the service is rendered. The effect of other arrangements
for providing services at less than established rates is also reported as
deductions from patient service revenue. During the year ended December 31,
2002, approximately 26% and 26% of the Companys revenues related to patients
participating in the Medicare and Medicaid programs, respectively.

The Company provides care without charge to patients who are financially unable
to pay for the health care services they receive. Because the Company does not
pursue collection of amounts determined to qualify as charity care, they are
not reported in revenues. Settlements under cost reimbursement agreements with
third party payers are estimated and recorded in the period in which the
related services are rendered and are adjusted in future periods as final
settlements are determined. Final determination of amounts earned under the
Medicare and Medicaid programs often occur in subsequent years because of
audits by the programs, rights of appeal and the application of numerous
technical provisions.

The Companys revenue is particularly sensitive to regulatory and economic
changes in the state of Texas. As of December 31, 2002 and 2001, the Company
operated three facilities in Texas. The Company generated 50% and 34% of its
revenue from its Texas operations for the years ended December 31, 2002 and
2001, respectively.

Management Fee Revenue

Revenue is recorded as management fee revenue for the Psychiatric Unit
Management division. The Psychiatric Unit Management division receives
contractually determined management fees and director fees from hospitals and
clinics for providing psychiatric management and development services.

There were no individual or group of affiliated contracts in 2002 and 2001,
which provided a significant concentration of management fee revenue.

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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002

3. Earning Per Share

Statement of Financial Accounting Standards (SFAS) No. 128, Earnings per
Share, requires dual presentation of basic and diluted earnings per share by
entities with complex capital structures. Basic earnings per share includes no
dilution and is computed by dividing net income by the weighted average number
of common shares outstanding for the period. Diluted earnings per share
reflects the potential dilution of securities that could share in the earnings
of the entity. The Company has calculated its earnings per share in accordance
with SFAS No. 128 for all periods presented.

The following table sets forth the computation of basic and diluted earnings
per share (in thousands, except per share amounts):

|                                   |                                                                  |   |                         |       |      |   |      |       |  |   |       |        |  
|---------------------------------- | ---------------------------------------------------------------- | - | ----------------------- | ----- | ---- | - | ---- | ----- |  | - | ----- | ------ | -
|                                   |                                                                  |   | Year ended December 31,
|                                   |                                                                  |   |                        
|                                   |                                                                  |   | 2002                    |       | 2001 |   | 2000
|                                   |                                                                  |   |                         |       |      |   |     
|Numerator:                         |                                                                  |   |                         |       |      |   |      |       |  |   |       |       
|                                   | Net income available to common
stockholders                      |   | $                       | 5,684 |      |   | $    | 2,578 |  |   | $     | (1,916 | )
|                                   | Interest expense on convertible debt
outstanding                 |   |                         | 324   |      |   |      |      |  |   |       |       |  
|                                   |                                                                  |   |                         |       |      |   |      |       |  |   |       |       
|                                   | Net income used in computing diluted
earnings per common share   |   | $                       | 6,008 |      |   | $    | 2,578 |  |   | $     | (1,916 | )
|                                   |                                                                  |   |                         |       |      |   |      |       |  |   |       |       
|Denominator:                       |                                                                  |   |                         |       |      |   |      |       |  |   |       |       
|                                   | Weighted average shares outstanding
for basic earnings per share |   |                         | 6,111 |      |   |      | 5,010 |  |   |       | 4,817  |  
|                                   | Effects of dilutive stock options and
warrants outstanding       |   |                         | 453   |      |   |      | 299   |  |   |       |       |  
|                                   | Effect of dilutive convertible debt
outstanding                  |   |                         | 422   |      |   |      |      |  |   |       |       |  
|                                   | Shares used in computing diluted
earnings per common share       |   |                         | 6,986 |      |   |      | 5,309 |  |   |       | 4,817  |  
|                                   |                                                                  |   |                         |       |      |   |      |       |  |   |       |       
|Earnings per common share, basic   |                                                                  | $ | 0.93                    |       |      | $ | 0.51 |       |  | $ | (0.40 | )     
|                                   |                                                                  |   |                         |       |      |   |      |       |  |   |       |       
|Earnings per common share, diluted |                                                                  | $ | 0.86                    |       |      | $ | 0.49 |       |  | $ | (0.40 | )     
|                                   |                                                                  |   |                         |       |      |   |      |       |  |   |       |       

Diluted earnings per share for the year ended December 31, 2001, does not
include debt outstanding which was convertible into 483,000 shares, as its
effect would be antidilutive. Diluted earnings per share for the year ended
December 31, 2000, do not include the effect of stock options, warrants or
convertible debt outstanding, as the effects would be antidilutive.

4. Discontinued Operations

Included in discontinued operations are the operating results and estimated
losses on the unwind of service agreements entered into with physicians, as
well as the operating results and gain on disposal for the Employee Assistance
Program. As part of the Companys Physician Practice Management Division, the
Company had acquired certain net assets of psychiatric clinics, and had
operated the clinics and managed the physician practices under long-term
service agreements with the physicians that practiced exclusively through the
clinics. The Company had not consolidated these clinics or the physician
practices it managed, as it did not have operating control. Additionally,
discontinued operations include the operating results and estimated losses on
the closure of clinics owned by the Company. Such clinics provided group and
individual therapy sessions to patients through partial hospitalization and
intensive outpatient programs. The Company-owned clinics were all closed as of
December 31,

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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002

2000. The Companys Employee Assistance Programs division contracted with
employers to provide confidential assistance and counseling to their employees.

The Companys implementation of plans during 2000 to exit these lines of
business resulted in an estimated loss on disposal of discontinued operations
of $1,738,000 during the year ended December 31, 2000. The December 31, 2000
loss on disposal consists primarily of lease termination costs and the write
down of fixed assets and other assets directly resulting from the decision to
exit the Physician Practice Management line of business. The December 31, 2000
loss on disposal also includes an estimate of losses from operations associated
with the physician practice service agreements of approximately $359,000
through the disposal date. Such costs are recorded within net assets of
discontinued operations in the accompanying Consolidated Balance Sheet. The
December 31, 2001 income (loss) on disposal consists primarily of a gain on the
sale of the Employee Assistance Programs division of $1,170,000 (net of taxes
of $223,000), the operations of the Employee Assistance Programs division from
the measurement date through the disposal date of $246,000 and final
adjustments to the Companys 2000 loss on disposal of $84,000.

Management fee revenue earned under the service agreements and net patient
service revenue earned from the Company-owned clinics totaled $9,876,000 and
$12,814,000 for the years ended December 31, 2001 and 2000, respectively.
Management fee revenue earned under the service agreements includes
reimbursement of clinic expenses incurred on behalf of the clinic facilities.
These reimbursed clinic expenses do not include the salaries and benefits of
physicians and therapists who provide medical service.

5. Acquisitions

2000 ACQUISITIONS

During 2000, the Company acquired various entities, which provided psychiatric
management and development services and employee assistance and counseling
services. Certain assets of these entities were acquired in exchange for Common
Stock, cash, notes payable or a combination thereof. The Company issued 130,000
shares of Common Stock in connection with these acquisitions during 2000.

The following table summarizes the allocation of the aggregate purchase price
of the aforementioned acquisitions (in thousands):

|                                |                                        |         |        |       |  |       |     |     |  |   |        |        | 
|------------------------------- | -------------------------------------- | ------- | ------ | ----- |  | ----- | --- | --- |  | - | ------ | ------ | 
|2000                            |                                        | Sunrise |        | EAP   |  | Total
|                                |                                        |         |        |       |  |      
|Assets acquired:                |                                        |         |        |       |  |       |     |     |  |   |        |       
|                                | Assets receivable                      |         | $      | 4,640 |  |       | $   | 50  |  |   | $      | 4,690  | 
|                                | Other current assets                   |         |        | 81    |  |       |     |    |  |   |        | 81     | 
|                                | Fixed assets                           |         |        | 98    |  |       |     | 18  |  |   |        | 116    | 
|                                | Costs in excess of net assets acquired |         |        | 9,790 |  |       |     | 931 |  |   |        | 10,721 | 
|                                | Contracts                              |         |        | 526   |  |       |     |    |  |   |        | 526    | 
|                                |                                        |         |        |       |  |       |     |     |  |   |        |       
|                                |                                        |         | 15,135 |       |  |       | 999 |     |  |   | 16,134 |       
|                                | Liabilities assumed                    |         |        | 2,177 |  |       |     | 382 |  |   |        | 2,559  | 
|                                | Subordinated convertible notes issued  |         |        | 3,600 |  |       |     | 400 |  |   |        | 4,000  | 
|                                | Common stock issued                    |         |        |      |  |       |     | 46  |  |   |        | 46     | 
|                                |                                        |         |        |       |  |       |     |     |  |   |        |       
|Cash paid, net of cash acquired |                                        | $       | 9,358  |       |  | $     | 171 |     |  | $ | 9,529  |       
|                                |                                        |         |        |       |  |       |     |     |  |   |        |       

2001 ACQUISITIONS

During 2001, the Company acquired four free-standing psychiatric facilities,
three in Texas and one in North Carolina. All of the acquisitions were
accounted for by the purchase method. The aggregate purchase price of these
transactions was allocated to the assets acquired and liabilities assumed based
upon their respective fair values. The consolidated financial statements
include the accounts and operations of the acquired entities for periods
subsequent to the respective acquisition dates. The goodwill associated with
these acquisitions is deductible for federal income tax purposes.

F-15



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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002

The following table summarizes the allocation of the aggregate purchase price
of the aforementioned acquisitions (in thousands):

|                                |                                        |       |             |            |  |        |       |       |             |   |       |       |  |   |        |        | 
|------------------------------- | -------------------------------------- | ----- | ----------- | ---------- |  | ------ | ----- | ----- | ----------- | - | ----- | ----- |  | - | ------ | ------ | 
|                                |                                        |       | West Oaks   |            |  |        |       |       | Texas Neuro |   |       |       | 
|                                |                                        |       | and Cypress |            |  |        |       |       | Rehab       |   |       |       | 
|2001                            |                                        | Creek |             | Holly Hill |  | Center |       | Total
|                                |                                        |       |             |            |  |        |       |      
|Assets acquired:                |                                        |       |             |            |  |        |       |       |             |   |       |       |  |   |        |       
|                                | Assets receivable                      |       | $           | 7,091      |  |        | $     | 1,617 |             |   | $     | 3,400 |  |   | $      | 12,108 | 
|                                | Other current assets                   |       |             | 244        |  |        |       | 99    |             |   |       | 154   |  |   |        | 497    | 
|                                | Fixed assets                           |       |             | 6,833      |  |        |       | 6,264 |             |   |       | 4,738 |  |   |        | 17,835 | 
|                                | Costs in excess of net assets acquired |       |             |           |  |        |       | 403   |             |   |       | 135   |  |   |        | 538    | 
|                                |                                        |       |             |            |  |        |       |       |             |   |       |       |  |   |        |       
|                                |                                        |       | 14,168      |            |  |        | 8,383 |       |             |   | 8,427 |       |  |   | 30,978 |       
|                                | Liabilities assumed                    |       |             | 2,105      |  |        |       | 758   |             |   |       | 798   |  |   |        | 3,661  | 
|                                | Subordinated convertible notes issued  |       |             | 2,000      |  |        |       |      |             |   |       | 2,500 |  |   |        | 4,500  | 
|                                | Long-term debt issued                  |       |             | 9,908      |  |        |       | 7,542 |             |   |       | 5,062 |  |   |        | 22,512 | 
|                                |                                        |       |             |            |  |        |       |       |             |   |       |       |  |   |        |       
|Cash paid, net of cash acquired |                                        | $     | 155         |            |  | $      | 83    |       |             | $ | 67    |       |  | $ | 305    |       
|                                |                                        |       |             |            |  |        |       |       |             |   |       |       |  |   |        |       

2002 ACQUISITIONS

During 2002, the Company acquired one free-standing psychiatric hospital in
Illinois (Riveredge Hospital). Also during 2002, the Company merged with PMR
Corporation a developer and manager of specialized mental health programs and
disease management services designed to treat individuals diagnosed with a
serious mental illness. The acquisition of the hospital and merger with PMR
Corporation were accounted for as acquisitions by the Company using the
purchase method. The aggregate purchase price of these transactions was
allocated to the assets acquired and liabilities assumed based upon their
respective fair values. The consolidated financial statements include the
accounts and operations of the acquired entities for periods subsequent to the
respective acquisition dates. As these transactions involved the acquisition of
stock, the goodwill associated with these acquisitions is not deductible for
federal income tax purposes. The purchase of Riveredge included an escrow
arrangement whereby the Company has deposited $4.5 million of the purchase
price with an escrow agent. The escrowed funds will be released to the seller
upon satisfaction of certain earnings targets and indemnification by the seller
of certain claims and cost report settlements. Any claims by the Company on
these escrowed funds would affect the purchase price. Approximately $1.5
million of these funds were released during 2002.

The following table summarizes the allocation of the aggregate purchase price
of the aforementioned acquisitions (in thousands):

|                                |                                        |           |        |        |  |       |        |        |  |   |        |        | 
|------------------------------- | -------------------------------------- | --------- | ------ | ------ |  | ----- | ------ | ------ |  | - | ------ | ------ | 
|2002                            |                                        | Riveredge |        | PMR    |  | Total
|                                |                                        |           |        |        |  |      
|Assets acquired:                |                                        |           |        |        |  |       |        |        |  |   |        |       
|                                | Accounts receivable                    |           | $      | 4,208  |  |       | $      | 121    |  |   | $      | 4,329  | 
|                                | Other current assets                   |           |        | 833    |  |       |        | 168    |  |   |        | 1,001  | 
|                                | Fixed assets                           |           |        | 15,350 |  |       |        | 155    |  |   |        | 15,505 | 
|                                | Costs in excess of net assets acquired |           |        | 662    |  |       |        | 12,914 |  |   |        | 13,576 | 
|                                | Other assets                           |           |        | 100    |  |       |        | 357    |  |   |        | 457    | 
|                                |                                        |           |        |        |  |       |        |        |  |   |        |       
|                                |                                        |           | 21,153 |        |  |       | 13,715 |        |  |   | 34,868 |       
|                                | Liabilities assumed                    |           |        | 4,289  |  |       |        | 4,573  |  |   |        | 8,862  | 
|                                | Subordinated notes issued              |           |        | 10,000 |  |       |        |       |  |   |        | 10,000 | 
|                                | Long-term debt issued                  |           |        | 6,864  |  |       |        |       |  |   |        | 6,864  | 
|                                | Common stock issued                    |           |        |       |  |       |        | 15,385 |  |   |        | 15,385 | 
|                                |                                        |           |        |        |  |       |        |        |  |   |        |       
|Cash acquired, net of cash paid |                                        | $         |       |        |  | $     | (6,243 | )      |  | $ | (6,243 | )     
|                                |                                        |           |        |        |  |       |        |        |  |   |        |       

The purchase price allocation for PMR is preliminary as of December 31, 2002 as
the Company has not yet
F-16Table of Contents

PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002

completed its valuation of identifiable intangible assets acquired in the
merger.

Other Information

The following represents the unaudited pro forma results of consolidated
operations as if the aforementioned acquisitions had occurred at the beginning
of the immediate preceding period, after giving effect to certain adjustments,
including the depreciation and amortization of the assets acquired based upon
their fair values and changes in interest expense resulting from changes in
consolidated debt:

|                                  |  |      |         |      |  |      |         |  |  |   |        |  
|--------------------------------- |  | ---- | ------- | ---- |  | ---- | ------- |  |  | - | ------ | -
|                                  |  | 2002 |         | 2001 |  | 2000
|                                  |  |      |         |      |  |     
|Revenues                          |  | $    | 141,075 |      |  | $    | 134,735 |  |  | $ | 87,600 |  
|Income before extraordinary items |  |      | 9,671   |      |  |      | 5,272   |  |  |   | (2,671 | )
|Net income                        |  |      | 9,671   |      |  |      | 4,035   |  |  |   | (2,671 | )
|Earnings per common share, basic  |  | $    | 1.58    |      |  | $    | 0.81    |  |  | $ | (0.55  | )

The pro forma information given does not purport to be indicative of what the
Companys results of operations would have been if the acquisitions had in fact
occurred at the beginning of the periods presented, and is not intended to be a
projection of the impact on future results or trends.

6. Long-term debt

Long-term debt consists of the following (in thousands):

|                                                                                                   |                                                                                                                                     |   |              |        |      |   |        |        | 
|-------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------- | - | ------------ | ------ | ---- | - | ------ | ------ | 
|                                                                                                   |                                                                                                                                     |   | December 31,
|                                                                                                   |                                                                                                                                     |   |             
|                                                                                                   |                                                                                                                                     |   | 2002         |        | 2001
|                                                                                                   |                                                                                                                                     |   |              |        |     
|Debt payable to banks:                                                                             |                                                                                                                                     |   |              |        |      |   |        |       
|                                                                                                   | Revolving line of credit, expiring on November 30, 2004
and bearing interest at the prime rate plus 2% (7.25%
at December 31, 2002) |   | $            | 5,383  |      |   | $      | 11,150 | 
|                                                                                                   | Non-revolving line of credit, due on November 30, 2003
and bearing interest at the prime rate plus 4.75%
(10% at December 31, 2002) |   |              | 17,275 |      |   |        | 15,656 | 
|Mortgage loan on facility, maturing on December 1, 2037 and
bearing a fixed interest rate of 5.95% |                                                                                                                                     |   | 4,928        |        |      |   |       |       
|Related party bridge loan (liquidation preference value of
$1,000,000)                             |                                                                                                                                     |   |             |        |      |   | 1,000  |       
|Subordinated convertible notes                                                                     |                                                                                                                                     |   | 3,600        |        |      |   | 3,600  |       
|Subordinated promissory notes                                                                      |                                                                                                                                     |   | 12,538       |        |      |   | 4,880  |       
|Other                                                                                              |                                                                                                                                     |   | 98           |        |      |   | 52     |       
|                                                                                                   |                                                                                                                                     |   |              |        |      |   |        |       
|                                                                                                   |                                                                                                                                     |   | 43,822       |        |      |   | 36,338 |       
|Less current portion                                                                               |                                                                                                                                     |   | 7,070        |        |      |   | 15,387 |       
|                                                                                                   |                                                                                                                                     |   |              |        |      |   |        |       
|Long-term debt                                                                                     |                                                                                                                                     | $ | 36,752       |        |      | $ | 20,951 |       
|                                                                                                   |                                                                                                                                     |   |              |        |      |   |        |       

2000 Senior Credit Facility

In conjunction with an acquisition in May 2000, the Amended Loan Agreement and
the amounts outstanding thereunder were replaced with a $17,500,000 senior
credit facility (2000 Senior Credit Facility). The 2000 Senior Credit Facility
included two lines of credit: a $5,500,000 non-revolving term loan (2000 Term
Loan) and a $12,000,000 revolving working capital line of credit (2000
Revolver). Both lines of credit were collateralized by the Companys assets and
stock of the Companys subsidiaries.

F-17



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##### Table of Contents



PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002

Until the maturity date of the 2000 Revolver, the Company could borrow, repay
and re-borrow an amount not to exceed the lesser of $12,000,000 or the
Borrowing Base (the estimated net value of eligible accounts receivable, as
defined in the 2000 Senior Credit Facility, multiplied by 85%). The 2000
Revolver was due in full at maturity in May 2005, with the exception of an
Interim Availability Balance (as defined in the 2000 Senior Credit Facility) of
approximately $385,000, which was paid during 2001.

Under the 2000 Revolver, all of the Companys collections, except for Medicare
and Medicaid, were deposited into lockbox accounts controlled by the lender.
The funds deposited into the lockbox accounts were applied to outstanding
borrowings with the lender on a daily basis.

The Company was required to pay an unused fee in the amount of .375% per year
of the unused portion of the 2000 Senior Credit Facility. This fee was payable
monthly in arrears on the first day of each calendar month.

In conjunction with the amendment dated August 31, 2001, the Company borrowed
an additional $3,500,000 under the 2000 Term Loan and $1,500,000 under a new
Term Loan B. The 2000 Term Loan was to be repaid in twenty equal quarterly
installments commencing as of January 1, 2002. Prior to the amendment, the 2000
Term Loan was payable in twenty quarterly installments of $275,000 beginning on
June 30, 2000. In addition to the quarterly principal payments of the 2000 Term
Loan, the Company was required to make additional principal payments on the
2000 Term Loan in the amount of 30% of the Excess Cash Flow (as defined in the
2000 Senior Credit Facility) within ninety days of each fiscal year end. The
Term Loan B was to be repaid in equal monthly installments commencing as of
March 1, 2002, with final payment on August 1, 2003. Interest accrued on the
2000 Revolver was payable weekly. Interest accrued on the 2000 Term Loan and
Term Loan B was payable monthly.

2001 Senior Credit Facility

In conjunction with an acquisition in November 2001, the 2000 Senior Credit
Facility was replaced with a $33,156,305 senior credit facility (2001 Senior
Credit Facility). The 2001 Senior Credit Facility includes two lines of credit:
a $15,656,305 non-revolving term loan (2001 Term Loan) and a $17,500,000
revolving working capital line of credit (2001 Revolver). Both lines of credit
are collateralized by the Companys assets and stock of the Companys
subsidiaries.

Until the maturity date of the 2001 Revolver, the Company may borrow, repay and
re-borrow an amount not to exceed the lesser of $17,500,000 or the Borrowing
Base (the estimated net collectible value of eligible receivables, as defined
in the 2001 Senior Credit Facility, multiplied by 85%). The 2001 Revolver is
due in full at maturity in November 2004. The available borrowings under the
2001 Revolver were $7,135,000 at December 31, 2002. The 2001 Term Loan is due
in monthly installments of principal and interest, as well as an additional
principle payment equal to 50% of the Companys excess cash flows for the year
that is due within 30 days after preparation of the Companys audited financial
statements, but in no event later than 145 days after year-end. Although the
2001 Term Loan is due November 30, 2003, the terms of the agreement provide the
Company with the option to extend the maturity date by two years. Management
intends to either exercise the option to extend the maturity date or to
refinance the amount outstanding prior to maturity. Accordingly, amounts due
under the 2001 Term Loan have been included in long-term debt on the
accompanying consolidated balance sheet.

Under the 2001 Revolver, all of the Companys collections, except for Medicare
and Medicaid, are deposited into lockbox accounts controlled by the lender. The
funds deposited into the lockbox accounts are applied to outstanding borrowings
with the lender on a daily basis. As such, the outstanding borrowings under the
2001 Revolver are classified as short term at December 31, 2002 and 2001.

The Company must pay an unused fee in the amount of 0.05% per month of the
monthly unused portion of the 2001 Senior Credit Facility. This fee is payable
monthly is arrears on the first day of each calendar month. Such fees were
approximately $50,000 for the year ended December 31, 2002.

The 2001 Senior Credit Facility contains customary covenants which include (i)
a specified monthly census required for any owned, operated or leased
facilities of the Company, (ii) a limitation on capital expenditures, sales of
assets,
F-18Table of ContentsPSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002mergers, changes of ownership and management, new lines of business and
dividends, and (iii) various financial covenants.At December 31, 2002, the Company was in compliance with all applicable debt
covenant requirements.Extraordinary ItemCommensurate with the refinancing of the 2000 Senior Credit Facility, the
Company expensed the remaining deferred loan costs associated with this debt of
$419,000 and incurred early termination penalties of $818,000, resulting in an
extraordinary loss on extinguishment of debt of $1,237,000 at December 31,
2001.Mortgage LoanOn November 25, 2002, the Company entered into a mortgage loan agreement to
borrow $4,928,000 from the U.S. Department of Housing and Urban Development
(HUD), secured by real estate located at Holly Hill Hospital in Raleigh, NC.
Interest accrues on the HUD loan at 5.95% and principal and interest are
payable in 420 monthly installments through December 2037. The Company used
proceeds from the loan to repay $4,385,000 of its 2001 Term Loan, pay certain
refinancing costs, and fund required escrow amounts for future improvements to
the property. The carrying amount of assets held as collateral approximated
$5,911,000 as of December 31, 2002.Related Party Bridge LoanIn October 2000, the Company entered into subordinated notes totaling
$1,000,000 with certain stockholders of the Company (collectively referred to
as the Bridge Loan). The Bridge loan bore interest at 10% payable monthly. The
proceeds were used to fund short-term working capital requirements. In April
2002, the Company refinanced the Bridge loan with funds available under its
2001 Senior Credit Facility.As consideration for the issuance of the Bridge Loan, the Company granted
warrants (Bridge Loan Warrants) to purchase 228,069 shares of the Companys
common stock at $0.03 per share. The carrying value of the Bridge Loan was
reduced by the fair market value of the Bridge Loan Warrants issued. The
carrying value of the Bridge Loan was accreted to its face value over the term
of the Bridge Loan. Accretion of the Bridge Loan was $521,000, $704,000 and
$166,000 for the years ended December 31, 2002, 2001 and 2000, respectively.Subordinated Convertible NotesIn connection with an acquisition during May 2000, the Company issued
subordinated convertible notes payable (Subordinated Convertible Notes). The
Subordinated Convertible Notes mature and become immediately due and payable
upon the earlier of (i) sale of the Company (ii) any change of control as
defined in the Subordinated Convertible Notes, or (iii) the Companys initial
public offering of common stock. Interest accrues on the Subordinated
Convertible Notes at 9% and is payable May 1, 2005. As of December 31, 2002 and
2001, the Company has accrued $864,000 and $540,000 of interest, respectively,
which is included in other liabilities on the accompanying consolidated balance
sheets.Any time until April 30, 2004, holders of the Subordinated Convertible Notes
may convert the unpaid principal balance, in increments of $1,000, into shares
of the Companys common stock based upon the following conversion prices:

|                             |  |                  |  | 
|---------------------------- |  | ---------------- |  | 
|Conversion Date              |  | Conversion Price
|                             |  |                 
|May 1, 2000 - April 30, 2001 |  | $6.39 per share 
|May 1, 2001 - April 30, 2002 |  | $7.45 per share 
|May 1, 2002 - April 30, 2003 |  | $8.53 per share 
|May 1, 2003 - April 30, 2004 |  | $9.59 per share 

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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002

Subordinated Promissory Note

In connection with an acquisition in 2000, the Company issued a promissory note
payable (Subordinated Promissory Note) in the amount of $400,000 bearing
interest at 9% for the year ended December 31, 2000. The Subordinated
Promissory Note matures in five equal annual installments beginning April 1,
2001. Accrued interest is due and payable on the first day of each calendar
quarter beginning July 1, 2000.

In connection with two acquisitions in 2001, the Company issued promissory
notes (Subordinated Promissory Notes) totaling $4,500,000. A $2,500,000
Subordinated Promissory Note bore interest at 9% per annum and matured June 30,
2002, with periodic interest payments due beginning December 31, 2001. The
$2,000,000 Subordinated Promissory Note bears interest at 9% per annum and
matures June 30, 2005, with periodic principal and interest payments due
beginning September 30, 2002. The $2,500,000 Subordinated Promissory Note was
repaid with proceeds from debt issued in July 2002.

These Subordinated Promissory Notes contain customary covenants which include a
cross default covenant with the occurrence of a default of any indebtedness of
at least $1,000,000 held by any creditor of the Company. As of December 31,
2002, the Company was in compliance with these covenants.

Senior Subordinated Notes

On June 28, 2002, the Company entered into a securities purchase agreement with
1818 Mezzanine Fund II, L.P. (1818 Fund) to issue up to $20 million of senior
subordinated notes with detachable nominal warrants. At the closing on June 28,
2002, a total of $10 million of the senior subordinated notes were issued. The
notes have a term of seven years and bear interest at 12% annually, payable
quarterly. The notes provide for a prepayment penalty of 6%, 3% and 1% if the
notes are prepaid prior to the first anniversary, second anniversary and third
anniversary of the closing date, respectively. The notes grant the holders the
right to require prepayment in the event of a change of control of the Company,
subject to a prepayment penalty of 1% if redeemed on or before the third
anniversary of the closing date. The notes also contain customary covenants
which include: (i) a specified monthly patient census for any owned, operated
or leased facilities, (ii) limitations on sales of assets (iii) maintenance of
minimum interest coverage, leverage and fixed charge ratios.

In connection with the issuance of the senior subordinated notes, the Company
issued detachable stock purchase warrants for the purchase of 372,412 shares of
the Companys stock at an exercise price of $.01 per share which provide the
holder with the ability to require the Company to repurchase their warrants or
stock acquired upon exercise of the warrants at fair market value for cash.
The agreement provides the holder of the warrant to exercise the warrant by
payment of cash or delivery of shares. The warrants are exercisable over ten
years from the effective date. The initial value of the warrants of
approximately $2,000,000 is being amortized to interest expense over the term
of the senior subordinated notes. As of December 31, 2002, the fair value of
the warrants totaled approximately $2.0 million and are included as a component
of long term debt. Because the holder of the warrants has the ability to
require the Company to repurchase the warrants for cash, the warrants
constitute a derivative which requires changes in value of the warrants to be
recorded as an increase or decrease to earnings. For each $1 increase in stock
price, the Company will be required to record non cash expense of approximately
$372,500. The stock purchase warrants contain provisions that allow the issuer
to put their warrants, or stock after exercise, back to the Company at fair
market value for cash or for the deliverance of shares. The put price under
the agreement would approximate $2 million or require the deliverance of
371,841 shares as of December 31, 2002.

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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002

Other

The aggregate maturities of long-term debt, are as follows (in thousands):

|                    |  |       |  |   |        |   |        | 
|------------------- |  | ----- |  | - | ------ | - | ------ | 
|2003                |  |       |  |   |        | $ | 7,070  | 
|2004                |  |       |  |   |        |   | 2,094  | 
|2005                |  |       |  |   |        |   | 19,723 | 
|2006                |  |       |  |   |        |   | 52     | 
|2007 and thereafter |  |       |  |   |        |   | 14,883 | 
|                    |  |       |  |   |        |   |        | 
|                    |  | Total |  | $ | 43,822 |  
|                    |  |       |  |   |        |   |        | 

7. Preferred Stock

Upon the merger with PMR Corporation on August 5, 2002, the Companys Preferred
Stock converted to post merger Common Stock at rates of 0.246951 and 0.312864
for Series A Preferred Stock and Series B Preferred Stock, respectively. All
periods prior to August 5, 2002 have been retroactively restated to reflect
conversion at the applicable conversion rates. The Company had outstanding
10,497,000 shares of Series A Preferred Stock and 4,975,736 shares of Series B
Preferred Stock at December 31, 2001.

8. Leases

At December 31, 2002, future minimum lease payments under non-cancelable leases
are as follows (in thousands):

|     |  |       |  |   |       |   |     | 
|---- |  | ----- |  | - | ----- | - | --- | 
|2003 |  |       |  |   |       | $ | 862 | 
|2004 |  |       |  |   |       |   | 648 | 
|2005 |  |       |  |   |       |   | 332 | 
|2006 |  |       |  |   |       |   | 281 | 
|2007 |  |       |  |   |       |   | 180 | 
|     |  |       |  |   |       |   |     | 
|     |  | Total |  | $ | 2,303 |  
|     |  |       |  |   |       |   |     | 

Rent expense totaled $870,000 and $536,000 for December 31, 2002 and 2001,
respectively.

9. Income Taxes

The provision for income taxes consists of the following (in thousands):

|                           |         |   |        |        |      |   |   |   | 
|-------------------------- | ------- | - | ------ | ------ | ---- | - | - | - | 
|                           |         |   | 2002   |        | 2001
|                           |         |   |        |        |     
|Current:                   |         |   |        |        |      |   |   |  
|                           | Federal |   | $      |       |      |   | $ |  | 
|                           | State   |   |        | 323    |      |   |   |  | 
|                           |         |   |        |        |      |   |   |  
|                           |         |   | 323    |        |      |   |  |  
|Deferred:                  |         |   |        |        |      |   |   |  
|                           | Federal |   |        | (1,192 | )    |   |   |  | 
|                           | State   |   |        | (138   | )    |   |   |  | 
|                           |         |   |        |        |      |   |   |  
|                           |         |   | (1,330 | )      |      |   |  |  
|                           |         |   |        |        |      |   |   |  
|Provision for income taxes |         | $ | (1,007 | )      |      | $ |  |  
|                           |         |   |        |        |      |   |   |  

The reconciliation of income tax computed by applying the U.S. federal
statutory rate to the actual income tax (benefit) expense attributable to
continuing operations is as follows (in thousands):

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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002

|                                    |  |      |        |      |  |   |        |  
|----------------------------------- |  | ---- | ------ | ---- |  | - | ------ | -
|                                    |  | 2002 |        | 2001
|                                    |  |      |        |     
|Federal tax                         |  | $    | 1,590  |      |  | $ | 842    |  
|State income taxes (net of federal) |  |      | 179    |      |  |   | 98     |  
|Nondeductible goodwill amortization |  |      |       |      |  |   | 87     |  
|Change in valuation allowance       |  |      | (2,809 | )    |  |   | (1,043 | )
|Other                               |  |      | 33     |      |  |   | 16     |  
|                                    |  |      |        |      |  |   |        |  
|Total tax expense (benefit)         |  | $    | (1,007 | )    |  | $ |       |  
|                                    |  |      |        |      |  |   |        |  

Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. The tax effects of
significant items comprising the Companys temporary differences are as follows
(in thousands):

|                                   |                                  |   |       |        |      |   |       |        |  
|---------------------------------- | -------------------------------- | - | ----- | ------ | ---- | - | ----- | ------ | -
|                                   |                                  |   | 2002  |        | 2001
|                                   |                                  |   |       |        |     
|Deferred tax assets:               |                                  |   |       |        |      |   |       |       
|                                   | Net operating loss carryforwards |   | $     | 6,296  |      |   | $     | 2,656  |  
|                                   | Allowance for doubtful accounts  |   |       | 904    |      |   |       | 1,045  |  
|                                   | Accrued Liabilities              |   |       | 1,176  |      |   |       | 419    |  
|                                   |                                  |   |       |        |      |   |       |       
|Total gross deferred tax assets    |                                  |   | 8,376 |        |      |   | 4,120 |       
|                                   | Less: Valuation allowance        |   |       | (5,860 | )    |   |       | (3,890 | )
|                                   |                                  |   |       |        |      |   |       |       
|Total deferred tax assets          |                                  |   | 2,516 |        |      |   | 230   |       
|Deferred tax liabilities:          |                                  |   |       |        |      |   |       |       
|                                   | Amortization                     |   |       | (611   | )    |   |       | (438   | )
|                                   | Depreciation                     |   |       | (2,111 | )    |   |       | (81    | )
|                                   | Other                            |   |       | (52    | )    |   |       | (94    | )
|                                   |                                  |   |       |        |      |   |       |       
|Net deferred tax asset (liability) |                                  | $ | (258  | )      |      | $ | (383  | )     
|                                   |                                  |   |       |        |      |   |       |       

Management has evaluated the need for a valuation allowance for deferred tax
assets and believes that certain deferred tax assets will more likely than not
be realized through the future reversal of existing taxable temporary
differences and future earnings of the Company. In the fourth quarter of the
year ending December 31, 2002, the valuation allowance was reduced by $1.3
million, resulting in a corresponding credit to deferred income tax expense.
This adjustment reflected a change in circumstances which resulted in a
judgment that a corresponding amount of the Companys deferred tax assets will
be realized in future years. The valuation allowance increased by
approximately $2 million during the year ending December 31, 2002 as a result
of the following items (in thousands):

|                                                                           |  |   |        |  
|-------------------------------------------------------------------------- |  | - | ------ | -
|Valuation allowance at December 31, 2001                                   |  | $ | (3,890 | )
|Current year temporary differences                                         |  |   | 1,478  |  
|Valuation allowance recorded against acquired PMR net deferred tax asset   |  |   | (5,860 | )
|Release of valuation allowance recorded as purchase accounting adjustments |  |   | 1,081  |  
|Release of valuation allowance recorded as a deferred tax benefit          |  |   | 1,331  |  
|                                                                           |  |   |        |  
|Valuation allowance at December 31, 2002                                   |  | $ | (5,860 | )
|                                                                           |  |   |        |  

As of December 31, 2002 the Company had federal net operating loss
carryforwards of $15.7 million expiring in the years 2012 through 2022.

10. Stock Option Plans

During 1997, the Company and its stockholders adopted the 1997 Incentive and
Nonqualified Stock Option Plan for Key Personnel (the 1997 Key Personnel
Plan). The maximum aggregate number of shares of Common Stock to be issued
under the 1997 Key Personnel Plan shall not exceed 331,712. Shares issued under
the 1997 Key Personnel
F-22Table of ContentsPSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002Plan may be in the form of incentive stock options or non-qualified options to
officers, employers and directors. The exercise price per share determined by
the Compensation Committee of the Board of Directors (the Committee)
generally is not less than fair market value of the Common Stock on the date of
grant. Stock options shall become exercisable in whole or in part on such date
or dates as determined by the Committee at the date of grant. Options granted
generally vest and are exercisable ratably by the respective grantee over a
four-year period beginning on the date of grant. Each option shall generally
expire ten years from the grant date.Upon the merger with PMR Corporation on August 5, 2002, the Company acquired
PMR Corporations 1997 Equity Incentive Plan, as amended (the 1997 Equity
Incentive Plan). The 1997 Equity Incentive Plan provides for the granting of
options to purchase up to 1,333,333 shares of common stock to eligible
employees. Under the 1997 Equity Incentive Plan, options may be granted for
terms of up to ten years and are generally exercisable in cumulative annual
increments of 25% each year, commencing one year after the date of grant.
Option prices must equal or exceed the fair market value of the common shares
on the date of grant.Also upon the merger with PMR Corporation on August 5, 2002, the Company
acquired PMR Corporations Outside Directors Non-qualified Stock Option Plan
of 1992 (the 1992 Directors Plan). The 1992 Directors Plan provides for the
Company to grant each outside director options to purchase 5,000 shares of the
Companys common stock annually at the fair market value at the date of grant.
As amended, options for a maximum of 341,666 shares may be granted under this
plan. The options vest 33% immediately and in ratable annual increments over
the three-year period following the date of grant.During 2002, the Company recognized $118,000 compensation expense related to
stock options issued to certain officers and employees with exercise prices
below fair market value.Stock option activity, including options granted for acquisitions, is as
follows (number of options in thousands):

|                             |                        |  |         |     |                |                 |                 |      |         |       |          |      | 
|---------------------------- | ---------------------- |  | ------- | --- | -------------- | --------------- | --------------- | ---- | ------- | ----- | -------- | ---- | 
|                             |                        |  |         |     |                |                 |                 |      |         |       | Weighted
|                             |                        |  | Number  |     |                |                 |                 |      | Average
|                             |                        |  | of      |     | Option         |                 | Exercise       
|                             |                        |  | Options |     | Exercise Price |                 | Price          
|                             |                        |  |         |     |                |                 |                
|Balance at December 31, 1999 |                        |  | 202     |     |                | $0.87 to $3.04  |                 | $    | 1.56    |      
|                             | Granted                |  |         | 85  |                |                 | $               | 3.04 |         |       | $        | 3.04 | 
|                             | Canceled               |  |         | (47 | )              |                 | $0.87 to $3.04  |      | $       | 2.26  |         
|                             | Exercised              |  |         | (3  | )              |                 | $0.87 to $3.04  |      | $       | 1.74  |         
|                             |                        |  |         |     |                |                 |                 |      |         |      
|Balance at December 31, 2000 |                        |  | 237     |     |                | $0.87 to $3.04  |                 | $    | 2.00    |      
|                             | Granted                |  |         | 35  |                |                 | $               | 3.04 |         |       | $        | 3.04 | 
|                             | Canceled               |  |         | (54 | )              |                 | $0.87 to $3.04  |      | $       | 2.61  |         
|                             | Exercised              |  |         | (4  | )              |                 | $0.87 to $3.04  |      | $       | 1.04  |         
|                             |                        |  |         |     |                |                 |                 |      |         |      
|Balance at December 31, 2001 |                        |  | 214     |     |                | $0.87 to $3.04  |                 | $    | 2.08    |      
|                             | Granted                |  |         | 515 |                |                 | $0.87 to $5.50  |      | $       | 5.07  |         
|                             | Stock options acquired |  |         | 408 |                |                 | $4.50 to $30.00 |      | $       | 17.10 |         
|                             | Canceled               |  |         | (26 | )              |                 | $0.87 to $29.25 |      | $       | 4.28  |         
|                             | Exercised              |  |         | (38 | )              |                 | $0.87 to $3.04  |      | $       | 1.14  |         
|                             |                        |  |         |     |                |                 |                 |      |         |      
|Balance at December 31, 2002 |                        |  | 1,073   |     |                | $0.87 to $30.00 |                 | $    | 9.21    |      

The following table summarizes information concerning outstanding and
exercisable options at December 31, 2002 (number of options in thousands).

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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002

|                 |  |                     |       |                     |  |          |      |             |  |   |       |  |  |  |     | 
|---------------- |  | ------------------- | ----- | ------------------- |  | -------- | ---- | ----------- |  | - | ----- |  |  |  | --- | 
|                 |  | Options Outstanding |       | Options Exercisable
|                 |  |                     |       |                    
|                 |  | Number              |       | Weighted Avg.       |  | Weighted |      | Number     
|                 |  | Outstanding at      |       | Remaining           |  | Average  |      | Exercisable
|                 |  | December 31,        |       | Contractual         |  | Exercise |      | at December
|Exercise Prices  |  | 2002                |       | Life                |  | Price    |      | 31, 2002   
|                 |  |                     |       |                     |  |          |      |            
|$0.87 to $3.03   |  |                     | 97    |                     |  |          | 6.48 |             |  | $ | 0.87  |  |  |  | 80  | 
|$3.04 to $4.50   |  |                     | 123   |                     |  |          | 7.81 |             |  | $ | 3.31  |  |  |  | 64  | 
|$4.51 to $5.50   |  |                     | 496   |                     |  |          | 9.54 |             |  | $ | 5.00  |  |  |  | 45  | 
|$5.51 to $11.63  |  |                     | 70    |                     |  |          | 6.80 |             |  | $ | 9.18  |  |  |  | 70  | 
|$11.64 to $21.38 |  |                     | 205   |                     |  |          | 4.99 |             |  | $ | 18.73 |  |  |  | 205 | 
|$21.39 to $30.00 |  |                     | 82    |                     |  |          | 5.96 |             |  | $ | 26.98 |  |  |  | 82  | 
|                 |  |                     |       |                     |  |          |      |             |  |   |       |  |  |  |     | 
|$0.87 to $30.00  |  |                     | 1,073 |                     |  |          |      |             |  | $ | 13.20 |  |  |  | 546 | 
|                 |  |                     |       |                     |  |          |      |             |  |   |       |  |  |  |     | 

11. Employee Benefit Plan

The Company adopted the Psychiatric Solutions, Inc., Retirement Savings Plan
(the Plan). The Plan is a tax-qualified profit sharing plan with a cash or
deferred arrangement whereby employees who have completed two months of service
and are age 21 or older are eligible to participate. The plan allows eligible
employees to make contributions of 1% to 15% of their annual compensation. The
plan includes a discretionary company matching contribution not to exceed 15%
of eligible employee compensation. Employer contributions vest 20% after two
years of service and continue vesting at 20% per year until fully vested. At
December 31, 2002 the Company has accrued an employer matching contribution of
$164,000, which was paid during the first quarter of 2003. There were no
employer contributions to the plan during 2001.

12. Contingencies and Healthcare Regulation

Contingencies

The Company is subject to various claims and legal actions which arise in the
ordinary course of business. The Company has professional liability insurance
to protect against such claims or legal actions. In the opinion of management,
the ultimate resolution of such matters will be adequately covered by insurance
and will not have a material adverse effect on the Companys financial position
or results of operations.

Employment Agreements

Effective January 1, 2002, and amended and restated effective August 6, 2002,
the Company entered into an Amended and Restated Employment Agreement with Joey
Jacobs, Chief Executive Officer. Mr Jacobs agreement provides for an annual
base salary and an annual cash incentive compensation award tied to objective
criteria as established by the board of directors. The employment agreement
has an initial term of one year and is subject to automatic annual renewals
absent prior notice from either party.

Mr. Jacobs employment agreement provides for various payments to Mr. Jacobs
upon cessation of employment, depending on the circumstances. If the Company
terminates Mr. Jacobss employment without cause or if he resigns pursuant to
a constructive discharge, then (i) all options scheduled to vest during the
succeeding 24 month period will immediately vest, (ii) any restricted stock
will immediately vest, (iii) Mr. Jacobs will receive a cash payment equal to
200% of his base salary and bonus earned during the twelve months prior to
termination, and (iv) all benefits and perquisites will continue for 18 months.
In the event of a change in control, his employment agreement requires that
the Company pay him 200% of his base salary and bonus earned in the twelve
months prior to termination and to continue all benefits and perquisites for 18
months.

Effective October 1, 2002, the Company entered into an employment agreement
with Jack Salberg, Chief Operating Officer. Mr. Salbergs agreement provides
for an annual base salary and an annual cash incentive compensation

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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002

award tied to objective criteria established by the board of directors. The
employment agreement had an initial term of 15 months, subject to automatic
annual renewals absent prior notice from either party.

Mr. Salbergs employment agreement provides for various payments to Mr. Salberg
upon cessation of employment, depending upon the circumstances. If the Company
terminates Mr. Salbergs employment without cause or if he resigns pursuant to
a constructive discharge, then (i) all options scheduled to vest during the
succeeding 18 months will immediately vest, (ii) any restricted stock will
immediately vest, (iii) Mr. Salberg will receive a cash payment equal to 150%
of his base salary and bonus earned in 12 months prior to termination, and (iv)
all benefits and perquisites will continue for 18 months. If Mr. Salberg is
terminated after a change in control of the Company, his employment agreement
requires the Company to pay him a cash amount equal to 150% of his base salary
and bonus earned during the 12 months prior to termination and to continue all
benefits and perquisites for 18 months.

Capital projects

The Company is currently under contract with a software provider to replace
certain information systems at owned facilities. The amount committed under
the contract is approximately $504,000 as of December 31, 2002.

Current Operations

Final determination of amounts earned under prospective payment and
cost-reimbursement activities is subject to review by appropriate governmental
authorities or their agents. In the opinion of the Companys management,
adequate provision has been made for any adjustments that may result from such
reviews.

Laws and regulations governing the Medicare and Medicaid programs are complex
and subject to interpretation. The Company believes that it is in compliance
with all applicable laws and regulations and is not aware of any pending or
threatened investigations involving allegations of potential wrongdoing. While
no such regulatory inquiries have been made, compliance with such laws and
regulations can be subject to future government review and interpretation as
well as significant regulatory action including fines, penalties, and exclusion
from the Medicare and Medicaid programs.

The Company has acquired and may continue to acquire professional corporations
with prior operating histories. Acquired corporations may have unknown or
contingent liabilities for failure to comply with health care laws and
regulations, such as billing and reimbursement, fraud and abuse and similar
anti-referral laws. Although the Company attempts to assure itself that no such
liabilities exist and obtains indemnification from prospective sellers covering
such matters, there can be no assurance that any such matter will be covered by
indemnification or, if covered, that the liability sustained will not exceed
contractual limits or the financial capacity of the indemnifying party.

13. Related Party Transactions

During 2001 and 2000, the Company leased office space from a company whose
chief executive officer is Dr. Richard Treadway, the former chairman of the
Companys board of directors. The term of the lease was from May 16, 1999 to
July 2002 and was terminated on December 7, 2001. Rent expense for this space
totaled $142,154 for the year ended December 31, 2001. The Company believes the
terms of this lease were at fair market value.

Currently the Company leases 7,745 square feet of office space for its
executive offices from a company in which Dr. Treadway is a minority investor.
The lease was entered into in October 2001 and has a term of approximately six
years. The annual rent under this lease is approximately $492,000. The Company
believes the terms of this lease are at fair market value.

Joey Jacobs, the Companys Chief Executive Officer, serves as a member of the
board of directors of Stones River Hospital, a hospital in which the Company
manages a unit pursuant to a management agreement. The term of the third
amendment to the management agreement is two years, and automatically renews
for one year terms unless terminated by either party. Total revenue from this
management agreement was $808,000 for the year ended December 31, 2002. The
Company believes the terms of the management agreement are consistent with
F-25Table of Contents

PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002

management agreements negotiated at arms-length.

Jack Salberg, the Companys Chief Operating Officer, served as a minority owner
and member of the board of directors of the entity which owned Riveredge
Hospital prior to its acquisition by the Company during 2002. Mr Salberg
disclosed his interest to the board of directors and was not directly involved
in the negotiations to acquire the hospital . The Company believes that the
purchase price it paid for the Riveredge acquisition constituted its best
estimate of fair value. All terms were negotiated on an arms-length basis.

Edward Wissing, a director of the Company, occasionally provides advisory and
consulting services during 2002 to Brentwood Capital Advisors, the Companys
financial advisor. Mr. Wissing also is a party to a consulting arrangement
with Brentwood Capital pursuant to which he provides certain consulting
services. According to the terms of this consulting arrangement, Mr. Wissing
received a fixed consulting fee of $5,000 per month beginning in August 2002
and ending in May 2003.

14. Segment Information

The Companys facilities and management contracts comprising the Freestanding
Specialty Hospitals and Psychiatric Unit Management divisions, respectively are
each similar in their activities and the economic environments in which they
operate. Accordingly, the Companys reportable operating segments consist of
(1) Freestanding Specialty Hospitals and (2), Psychiatric Unit Management.
Prior to the acquisitions of the Companys facilities in the third and fourth
quarters of 2001 and third quarter of 2002, management had determined that the
Company did not have separately reportable segments as defined under Statement
of Financial Accounting Standards No. 131, Disclosures about Segments of an
Enterprise and Related Information.

The following is a financial summary by business segment for the periods
indicated. EBITDA represents income from continuing operations before interest
expense (net of interest income), income taxes, depreciation, amortization.
EBITDA is commonly used as an analytical indicator within the healthcare
industry and serves as a measure of leverage capacity and debt service ability.
EBITDA should not be considered as a measure of financial performance under
accounting principles generally accepted in the United States, and the items
excluded in determining EBITDA are significant components in understanding and
assessing financial performance. Because neither is a measurement determined in
accordance with accounting principles generally accepted in the United States,
it is susceptible to varying calculations, and as a result our calculation of
EBITDA as presented may not be comparable to EBITDA or other similarly titled
measures used by the companies (in thousands):

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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002

Year ended December 31, 2002

|                                                             |  |              |        |             |  |           |        |              |  |   |        |   |  |   |         | 
|------------------------------------------------------------ |  | ------------ | ------ | ----------- |  | --------- | ------ | ------------ |  | - | ------ | - |  | - | ------- | 
|                                                             |  | Freestanding |        | Psychiatric |  |           |        |              |  |   |        |  
|                                                             |  | Specialty    |        | Unit        |  | Corporate |        |              |  |  
|                                                             |  | Hospitals    |        | Management  |  | and Other |        | Consolidated
|                                                             |  |              |        |             |  |           |        |             
|Revenue                                                      |  | $            | 81,929 |             |  | $         | 31,983 |              |  | $ |       |   |  | $ | 113,912 | 
|Salaries, wages and employee benefits                        |  |              | 47,050 |             |  |           | 13,184 |              |  |   | 2,092  |   |  |   | 62,326  | 
|Professional fees                                            |  |              | 10,267 |             |  |           | 3,543  |              |  |   | 563    |   |  |   | 14,373  | 
|Other operating expenses                                     |  |              | 11,754 |             |  |           | 8,050  |              |  |   | 1,717  |   |  |   | 21,521  | 
|Provision for bad debts                                      |  |              | 3,467  |             |  |           | 214    |              |  |   |       |   |  |   | 3,681   | 
|                                                             |  |              |        |             |  |           |        |              |  |   |        |   |  |   |         | 
|EBITDA                                                       |  |              | 9,391  |             |  |           | 6,992  |              |  |   | (4,372 | ) |  |   | 12,011  | 
|Depreciation and amortization                                |  |              | 1,286  |             |  |           | 379    |              |  |   | 105    |   |  |   | 1,770   | 
|Interest expense                                             |  |              | 3,375  |             |  |           | 325    |              |  |   | 1,864  |   |  |   | 5,564   | 
|Inter-segment expenses                                       |  |              | 3,149  |             |  |           | 902    |              |  |   | (4,051 | ) |  |   |        | 
|                                                             |  |              |        |             |  |           |        |              |  |   |        |   |  |   |         | 
|Income (loss) from continuing operations before income taxes |  | $            | 1,581  |             |  | $         | 5,386  |              |  | $ | (2,290 | ) |  | $ | 4,677   | 
|                                                             |  |              |        |             |  |           |        |              |  |   |        |   |  |   |         | 
|Segment assets                                               |  | $            | 51,004 |             |  | $         | 33,012 |              |  | $ | 6,122  |   |  | $ | 90,138  | 
|                                                             |  |              |        |             |  |           |        |              |  |   |        |   |  |   |         | 
|Capital expenditures                                         |  | $            | 16,092 |             |  | $         | 171    |              |  | $ | 622    |   |  | $ | 16,885  | 
|                                                             |  |              |        |             |  |           |        |              |  |   |        |   |  |   |         | 
|Cost in excess of net assets acquired                        |  | $            | 1,238  |             |  | $         | 27,580 |              |  | $ | 4      |   |  | $ | 28,822  | 
|                                                             |  |              |        |             |  |           |        |              |  |   |        |   |  |   |         | 

Year ended December 31, 2001

|                                                           |  |              |        |             |  |           |        |              |  |   |        |   |  |   |        | 
|---------------------------------------------------------- |  | ------------ | ------ | ----------- |  | --------- | ------ | ------------ |  | - | ------ | - |  | - | ------ | 
|                                                           |  | Freestanding |        | Psychiatric |  |           |        |              |  |   |        |  
|                                                           |  | Specialty    |        | Unit        |  | Corporate |        |              |  |  
|                                                           |  | Hospitals    |        | Management  |  | and Other |        | Consolidated
|                                                           |  |              |        |             |  |           |        |             
|Revenue                                                    |  | $            | 16,020 |             |  | $         | 27,979 |              |  | $ |       |   |  | $ | 43,999 | 
|Salaries, wages and employee benefits                      |  |              | 9,463  |             |  |           | 15,462 |              |  |   | 1,258  |   |  |   | 26,183 | 
|Professional fees                                          |  |              | 2,610  |             |  |           | 4,115  |              |  |   | 315    |   |  |   | 7,040  | 
|Other operating expenses                                   |  |              | 2,171  |             |  |           | 1,656  |              |  |   | 456    |   |  |   | 4,283  | 
|Provision for bad debts                                    |  |              | 385    |             |  |           | 277    |              |  |   |       |   |  |   | 662    | 
|                                                           |  |              |        |             |  |           |        |              |  |   |        |   |  |   |        | 
|EBITDA                                                     |  |              | 1,391  |             |  |           | 6,469  |              |  |   | (2,029 | ) |  |   | 5,831  | 
|Depreciation and amortization                              |  |              | 170    |             |  |           | 718    |              |  |   | 56     |   |  |   | 944    | 
|Interest expense                                           |  |              | 533    |             |  |           | 324    |              |  |   | 1,803  |   |  |   | 2,660  | 
|Inter-segment expenses                                     |  |              | 448    |             |  |           | 1,773  |              |  | $ | (2,221 | ) |  |   |       | 
|                                                           |  |              |        |             |  |           |        |              |  |   |        |   |  |   |        | 
|Income (loss) from continuing operations before income tax |  | $            | 240    |             |  | $         | 3,654  |              |  | $ | (1,667 | ) |  | $ | 2,227  | 
|                                                           |  |              |        |             |  |           |        |              |  |   |        |   |  |   |        | 
|Segment assets                                             |  | $            | 31,471 |             |  | $         | 20,394 |              |  | $ | 2,429  |   |  | $ | 54,294 | 
|                                                           |  |              |        |             |  |           |        |              |  |   |        |   |  |   |        | 
|Capital expenditures                                       |  | $            | 18,373 |             |  | $         |       |              |  | $ | 116    |   |  | $ | 18,489 | 
|                                                           |  |              |        |             |  |           |        |              |  |   |        |   |  |   |        | 
|Cost in excess of net assets acquired                      |  | $            | 538    |             |  | $         | 14,666 |              |  | $ | 4      |   |  | $ | 15,208 | 
|                                                           |  |              |        |             |  |           |        |              |  |   |        |   |  |   |        | 

15. Other Information

A summary of activity in the Companys allowance for bad debts follows (in
thousands):

|                             |  |              |       |                  |  |                    |       |                  |          |           |       |  |  |  |       |  |  |   |       | 
|---------------------------- |  | ------------ | ----- | ---------------- |  | ------------------ | ----- | ---------------- | -------- | --------- | ----- |  |  |  | ----- |  |  | - | ----- | 
|                             |  | Balances     |       | Additions        |  | Additions          |       | Accounts written | Balances
|                             |  | at beginning |       | charged to costs |  | charged to         |       | off, net of      |          | at end   
|                             |  | of period    |       | and expenses     |  | other accounts (1) |       | recoveries       |          | of period
|                             |  |              |       |                  |  |                    |       |                  |          |          
|Allowance for bad debts:     |  |              |       |                  |  |                    |       |                  |          |           |       |  |  |  |       |  |  |   |       | 
|Year ended December 31, 2000 |  | $            | 367   |                  |  |                    | 467   |                  |          |           | 1,818 |  |  |  | 209   |  |  | $ | 2,443 | 
|Year ended December 31, 2001 |  |              | 2,443 |                  |  |                    | 662   |                  |          |           | 921   |  |  |  | 86    |  |  |   | 3,940 | 
|Year ended December 31, 2002 |  |              | 3,940 |                  |  |                    | 3,681 |                  |          |           | 461   |  |  |  | 2,798 |  |  |   | 5,284 | 



---

|(1) |  | Allowances as a result of acquisition.
|--- |  | --------------------------------------

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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002

16. Quarterly Information (Unaudited)

Summarized results for each quarter in the years ended December 31, 2002 and
2001 are as follows (in thousands, except per share data):

|     |                                             |  |             |        |             |  |             |        |             |  |   |        |  |  |   |        |  
|---- | ------------------------------------------- |  | ----------- | ------ | ----------- |  | ----------- | ------ | ----------- |  | - | ------ |  |  | - | ------ | -
|     |                                             |  | 1st Quarter |        | 2nd Quarter |  | 3rd Quarter |        | 4th Quarter
|     |                                             |  |             |        |             |  |             |        |            
|2002 |                                             |  |             |        |             |  |             |        |             |  |   |        |  |  |   |       
|     | Revenue                                     |  | $           | 23,188 |             |  | $           | 22,622 |             |  | $ | 32,280 |  |  | $ | 35,822 |  
|     | Net income                                  |  | $           | 755    |             |  | $           | 857    |             |  | $ | 1,606  |  |  | $ | 2,466  |  
|     | Net income per share:                       |  |             |        |             |  |             |        |             |  |   |        |  |  |   |        |  
|     | Basic                                       |  | $           | 0.15   |             |  | $           | 0.17   |             |  | $ | 0.24   |  |  | $ | 0.32   |  
|     | Diluted                                     |  | $           | 0.14   |             |  | $           | 0.16   |             |  | $ | 0.22   |  |  | $ | 0.30   |  
|2001 |                                             |  |             |        |             |  |             |        |             |  |   |        |  |  |   |       
|     | Revenue                                     |  | $           | 7,218  |             |  | $           | 7,176  |             |  | $ | 9,944  |  |  | $ | 19,661 |  
|     | Income from continuing operations           |  | $           | 583    |             |  | $           | 567    |             |  | $ | 380    |  |  | $ | 697    |  
|     | Income (loss) from discontinued operations  |  | $           | (57    | )           |  | $           | 273    |             |  | $ | 1,429  |  |  | $ | (57    | )
|     | Income before extraordinary item            |  | $           | 526    |             |  | $           | 840    |             |  | $ | 1,809  |  |  | $ | 640    |  
|     | Loss from early retirement of debt          |  | $           |       |             |  | $           |       |             |  | $ |       |  |  | $ | (1,237 | )
|     | Net income (loss)                           |  | $           | 526    |             |  | $           | 840    |             |  | $ | 1,809  |  |  | $ | (597   | )
|     | Income before extraordinary item per share: |  |             |        |             |  |             |        |             |  |   |        |  |  |   |        |  
|     | Basic                                       |  | $           | 0.10   |             |  | $           | 0.17   |             |  | $ | 0.36   |  |  | $ | 0.13   |  
|     | Diluted                                     |  | $           | 0.10   |             |  | $           | 0.16   |             |  | $ | 0.32   |  |  | $ | 0.12   |  

17. Subsequent Events (Unaudited)

The Brown Schools Acquisition. On February 13, 2003, Psychiatric Solutions
signed a definitive agreement for the purchase of six psychiatric facilities
from The Brown Schools, Inc. for $63 million in cash. The six facilities,
which have an aggregate of 790 beds, are located in Austin, San Antonio and San
Marcos, Texas; Charlottesville, Virginia; Colorado Springs, Colorado; and
Tulsa, Oklahoma. For 2002, the facilities produced combined revenues of $76
million. Psychiatric Solutions expects to consummate the transaction, which is
subject to customary closing conditions, on April 1, 2003.

$25 Million Private Placement Of Convertible Preferred Stock. On February 4,
2003 Psychiatric Solutions stockholders approved the private placement of $25
million of our Series A Convertible Preferred Stock (the preferred stock)
with affiliates of Oak Investment Partners and Salix Ventures and with Brown
Brothers Harriman & Co.s The 1818 Mezzanine Fund II, L.P. The investors are
current investors in Psychiatric Solutions, with Oak Investment Partners and
Salix Ventures (or related entities) being among the co-founders of Psychiatric
Solutions. Representatives of Salix Ventures and Brown Brothers Harriman
currently serve on our Board of Directors. A representative of Oak Investment
is expected to be named to the Companys Board of Directors during the first
quarter of 2003. We intend to use the net proceeds from the preferred stock
primarily to fund acquisitions of freestanding psychiatric patient facilities.
The preferred stock will be issued in two phases: One half will be issued on
April 1, 2003, and one-half will be issued on July 1, 2003.

HUD Refinancing. Psychiatric Solutions is in the process of refinancing a
portion of its senior credit facility with various loans guaranteed by the U.S.
Department of Housing and Urban Development (HUD). These loans are expected to
be in the aggregate amount of approximately $25.0 million and will be secured
by real estate and other fixed assets of West Oaks Hospital, Cypress Creek
Hospital, Riveredge Hospital and Texas NeuroRehab Center. This refinancing is
expected to close in four installments (one per hospital). The first
installment, Holly Hill

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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002

Hospital, closed November 25, 2002. Management anticipates that this
refinancing will result in annual interest expense savings of approximately
$420,000.

F-29