<PAGE>   1

                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                    FORM 10-K

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

                    FOR THE FISCAL YEAR ENDED APRIL 30, 1998

                                       OR

[ ]        TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED]

            FOR THE TRANSITION PERIOD FROM __________ TO ___________

                           COMMISSION FILE NO. 0-20488
                                 PMR CORPORATION
             (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

                DELAWARE                                23-2491707
     State or other jurisdiction of         I.R.S. Employer Identification No.
     incorporation or organization

    501 WASHINGTON STREET, 5TH FLOOR                       92103
         SAN DIEGO, CALIFORNIA                          (Zip Code)
(Address of principal executive offices)

        REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE (619) 610-4001

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

        SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE

           SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
                     COMMON STOCK, PAR VALUE $.01 PER SHARE

                     

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

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

         As of July 24, 1998, the approximate aggregate market value of the
Common Stock held by non-affiliates of the registrant was $44,582,569, based
upon the closing price of the Common Stock reported on the Nasdaq National Stock
Market of $9.3125 per share. See footnote (1) below.

         The number of shares of Common Stock outstanding as of July 24, 1998
was 6,959,810.

                       DOCUMENTS INCORPORATED BY REFERENCE

         Certain portions of the registrant's definitive Proxy Statement, to be
filed not later than 120 days after April 30, 1998 in connection with the
registrant's 1998 Annual Meeting of Stockholders, are incorporated by reference
into Part III of this Form 10-K.


-----------
(1) The information provided shall in no way be construed as an admission that
    any person whose holdings are excluded from the figure is not an affiliate
    or that any person whose holdings are included is an affiliate and any such
    admission is hereby disclaimed. The information provided is included solely
    for record keeping purposes of the Securities and Exchange Commission.
<PAGE>   2

                                     PART I

ITEM 1.  BUSINESS

GENERAL

         Except for the historical information contained herein, the following
discussion contains forward-looking statements that involve risks and
uncertainties. The Company's actual results could differ materially from those
discussed below. Factors that could cause or contribute to such differences
include without limitation, those discussed in the description of the Company's
business below and the section entitled "Risk Factors," in Item 7 "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
elsewhere in this Annual Report, as well as those discussed in documents
incorporated herein by reference.

OVERVIEW

         PMR Corporation and its subsidiaries ("PMR" or the "Company") is a
leading manager of specialized mental health care programs and disease
management services designed to treat individuals diagnosed with a serious
mental illness ("SMI"), primarily schizophrenia and bi-polar disorder (i.e.,
manic-depressive illness). PMR manages the delivery of a broad range of
outpatient and community-based psychiatric services for SMI patients, consisting
of 37 intensive outpatient programs (the "Outpatient Programs"), two case
management programs (the "Case Management Programs") and four chemical
dependency and substance abuse programs (the "Chemical Dependency Programs"). In
June 1998, the Company announced an agreement to form a new company to be called
Stadt Solutions, LLC ("Stadt Solutions") that will be jointly owned by the
Company and Stadtlander Drug Distribution Co., Inc. ("Stadtlander"). Stadt
Solutions will offer a specialty pharmacy program for individuals with an SMI,
initially serving approximately 6,000 individuals through fourteen pharmacies in
thirteen states.

         PMR, with Stadt Solutions, will operate in twenty-three states and
is expected to employ or contract with more than 400 mental health and
pharmaceutical industry professionals and currently provides services to
approximately 11,000 individuals diagnosed with SMI. PMR believes it is the only
private sector company focused on providing an integrated mental health disease
management model to the SMI population.

         A four-decade old public policy trend of de-institutionalizing the
mentally ill from long-term care hospitals into the community has resulted in a
deterioration in SMI patient care. In response to this trend, a fragmented,
community-based system of care has evolved that does not adequately provide the
patient management or coordination of benefits required by the medically complex
SMI patient population. SMI patients typically enter the health care system
through multiple, uncoordinated points of care where services are provided in
reaction to patient crises rather than proactively to manage patient care.
Multiple physicians, case workers and other care providers handle patients in
various sites across the spectrum of care with little or no coordination. This
disjointed system of care results in low levels of patient monitoring and
medication compliance among the SMI population, which increases the incidence
rate of high-cost catastrophic events. Coordination and monitoring of patient
services is essential to avoid the debilitating effects of fragmented care
delivered by diverse outpatient providers which are reimbursed by disparate,
uncoordinated funding sources. PMR's clinical philosophy focuses on improving
outcomes and lowering costs by utilizing intensive, community-based treatment of
the SMI population in outpatient settings.

         PMR's Outpatient Programs serve as a comprehensive alternative to
inpatient hospitalization and include partial hospitalization and lower
intensity outpatient services. The Case Management Programs provide an
intensive, individualized primary care service which consists of a proprietary
case management model utilizing clinical protocols for delivering care to SMI
patients. The Company also provides Chemical Dependency Programs to patients
affiliated with managed care organizations and government-funded programs.

         During fiscal 1998, the Company continued to establish the initial
infrastructure and relationships for its site management and clinical
information initiative. The Company believes that its access to a large SMI
patient base provides it with a unique opportunity to collect, process and
analyze clinical and pharmacoeconomic data on schizophrenia and bi-polar
disorder. In January 1997, PMR entered into a collaborative agreement with
United HealthCare Corporation and its Applied HealthCare Informatics division
("Applied Informatics") to assist in 


                                       2.


<PAGE>   3
developing this initiative. In November 1997, the Company established a
strategic relationship with InSite Clinical Trials to assist in the training and
development of clinical research sites. In June 1998, PMR entered into an
agreement with Stadtlander to form Stadt Solutions and to contribute the site
management and clinical information initiative to the new venture.

         PMR's objective is to be the leader in the management of cost-effective
programs which provide quality care and foster the successful recovery of
individuals from the devastating effects of SMI. The Company intends to achieve
this objective by (i) obtaining new contracts for its Outpatient and Case
Management Programs, (ii) expanding Stadt Solutions, a new specialty pharmacy
program, (iii) establishing new programs and ancillary services, and (iv)
combining its outpatient, case management and chemical dependency capabilities
into a fully-integrated mental health disease management model. PMR believes
that its proprietary mental health disease management model will position it to
accept risk for SMI benefits and directly manage the costs associated with
providing care to the SMI population.

         PMR was incorporated in the State of Delaware in 1988. The operations
of the Company include the operations of the Company's wholly owned
subsidiaries, Psychiatric Management Resources, Inc., Collaborative Care
Corporation, Collaborative Care, Inc., and PMR-CD, Inc. The principal executive
offices of the Company are located at 501 Washington Street, 5th Floor, San
Diego, California 92103. The Company's telephone number is (619) 610-4001.

THE MARKET AND INDUSTRY BACKGROUND

         According to the National Institute of Mental Health (the "NIMH") and
its National Advisory Mental Health Council (the "NAMHC"), serious mental
illnesses are neurobiological disorders of the brain and include schizophrenia,
schizoaffective disorder, manic-depressive illness and autism, as well as severe
forms of other disorders such as major depression, panic disorder and
obsessive-compulsive disorder. These diseases are chronic and represent one of
the highest cost segments of the health care system. Industry sources indicate
that approximately 2.8% of the adult population and 3.2% of children ages 9-17
are affected by SMI, for a total SMI population in the United States of
approximately 5.6 million people. According to industry sources, in 1995,
individuals diagnosed with SMI consumed $27 billion in direct medical costs
relating to the provision of mental health services and consumed more than $74
billion in total costs, including estimates of lost productivity. Based on
industry data, the Company estimates that the direct medical expenditures
associated with SMI represent in excess of 25% of total direct mental health
care costs. However, the potential costs of direct medical care may exceed these
levels due to the approximately 2.2 million Americans estimated to be suffering
from untreated SMI. Substantially all costs of treating and managing the SMI
population are borne by federal, state and local programs, including Medicare
and Medicaid. The SMI population accesses care primarily through community
mental health centers ("CMHCs") and other community-based health care facilities
such as psychiatric and acute care hospitals and nursing homes. CMHCs typically
are not-for-profit organizations which lack access to capital, sophisticated
management information and financial systems, and comprehensive programs for
treating SMI patients.

         Since 1955, the SMI population in the United States has experienced
extensive de-institutionalization resulting in the public psychiatric hospital
census declining from approximately 560,000 individuals in 1955 to approximately
72,000 individuals in 1994. The effect of de-institutionalization is exacerbated
by the fact that the general population grew 58% over this same period, while
the SMI incidence rate remained stable. Industry sources estimate that there are
approximately 763,000 individuals in the United States currently diagnosed with
SMI who otherwise would have received inpatient treatment prior to
de-institutionalization, of which 60%-75% are patients with schizophrenia or
bi-polar disorder. The result of this trend has been increased rates of
transinstitutionalism and homelessness among SMI patients. Transinstitutionalism
is a term utilized to describe the mechanism by which de-institutionalized
individuals receive care in one or more alternate settings such as nursing
homes, general hospitals, jails and prisons. Industry estimates indicate that
23% of nursing home residents have a mental disorder and that more than 98,000
acute care hospital beds are occupied by SMI patients. Furthermore,
approximately 10% of all prison and jail inmates are SMI diagnosed and 35% of
the approximately 350,000 homeless individuals in the United States are
currently suffering from SMI disorders.

         The most frequently occurring primary diagnosis of the SMI population
treated by PMR is schizophrenia, an incurable biological disorder which affects
approximately 1% of the general population. Approximately 70% of 

                                       3.

<PAGE>   4
the patients treated at the Company's programs are diagnosed with schizophrenia
or schizoaffective disorder. The remainder are afflicted with bi-polar disorder,
major depression, or other personality disorders. Industry sources indicate that
up to 50% of patients suffering from schizophrenia receive no treatment for
symptoms. In addition, due to the stigma and social constraints that accompany
schizophrenia, 25% of schizophrenics attempt to end their lives through suicide.
In general, each year a significant percentage of individuals with schizophrenia
are admitted for an inpatient hospitalization and virtually all of the diagnosed
population is prescribed a chronic medication regimen. It is not uncommon that
these individuals also suffer from a substance abuse or chemical dependency
diagnosis. Based on industry data, the Company estimates that schizophrenia
consumes approximately $20 billion in annual mental health care expenditures.
The direct medical costs of schizophrenia are consumed primarily in CMHCs,
nursing homes and acute care hospitals.

         Since the introduction of Clozaril in the United States in 1989,
several pharmaceutical products have been developed for SMI patients that have
resulted in significant improvements in treatment. Although the specific
biological causes of SMI remain unknown, the efficacy of many treatment regimens
has been found to be comparable to that in other branches of medicine. For
example, with the exception of autism, medications exist which generate medical
responses in 60%-90% of patients with SMI. For schizophrenia and schizoaffective
disorder, research has shown that standard anti-psychotic medication will reduce
psychotic symptoms in 60% of patients and in 70%-85% of those experiencing
symptoms for the first time. These newer medications, with proper compliance,
offer significant potential for recovery to individuals afflicted with SMI.

PROGRAMS AND OPERATIONS

OUTPATIENT PROGRAMS

         PMR's Outpatient Programs are operated under management or
administrative contracts with acute care hospitals, psychiatric hospitals and
CMHCs, and consist principally of intensive outpatient programs which serve as
alternatives to inpatient care. These programs target patients in crisis or
those recovering from crisis and thus provide more intensive clinical services
than those generally available in a traditional outpatient setting. The Company
currently manages 37 Outpatient Programs in Arizona, Arkansas, California,
Colorado, Hawaii, Illinois, Kentucky, Michigan, North Carolina, Ohio, Tennessee,
Texas and Washington. The Company contracts with 27 separate providers including
Scripps Health, Sutter Health System, St. Luke's Hospital of San Francisco and
the University of California, Irvine. Typically, the Company's contracts are two
to five years in length. While contract expirations occur from time to time in
the ordinary course of business, the Company vigorously attempts to extend and
renew existing contracts and to maintain its market share through the addition
of new contracts.

         The Outpatient Programs consist principally of psychiatric partial
hospitalization programs which are ambulatory in nature and provide intensive,
coordinated clinical services to patients diagnosed with SMI. In 1996, the
Company introduced its structured outpatient clinic which is a lower intensity
"step-down" outpatient service designed to continue the care, maintain the gains
achieved and prevent the relapse of patients who have completed the partial
hospitalization program. To further expand the Company's potential client
population, in August 1997, the Company broadened its structured outpatient
program to include clients who are at a lower level of clinical risk.

         Patients admitted to the Outpatient Programs undergo a complete
assessment and treatment planning process that includes psychiatric,
psycho-social, medical and other specialized evaluations. Each SMI individual is
assigned a care coordinator responsible for managing the comprehensive treatment
available to the patient, which includes specialty services for geriatric and
dually diagnosed patients. All Outpatient Programs provide programming five or
six days a week. Treatments include daily group psychotherapy and individual
therapy conducted by therapists, nurses and mental health specialists who are
supervised by the appropriate department of the hospital or CMHC and by senior
clinical managers in the programs. In Outpatient Programs where the Company
retains designated staffing responsibilities, the Company provides program
administrators, and medical directors, and may provide nurses, community
liaisons and other clinical personnel. In these cases, the program administrator
generally has a degree in psychology or social work and several years of
experience in health care administration. Typically, the medical director is a
board-eligible or certified psychiatrist and the other professionals have
various levels of training in nursing, psychology or social work.


                                       4.

<PAGE>   5

         Through its Outpatient Programs, the Company brings management
expertise to the health care provider with respect to the establishment,
development and operation of an outpatient program for SMI patients that is not
usually available on an in-house basis. Services provided under Outpatient
Program management contracts include complete program design and administration
from start-up through ongoing program operation. These programs are intended to
enhance the delivery of outpatient mental health services by introducing
proprietary clinical protocols and procedures, conducting quality assurance and
utilization reviews, advising on compliance with government regulations and
licensure requirements, supplying highly trained personnel, and expanding the
range of services provided. In addition, the programs also enhance the
management of financial and administrative services by providing support to the
providers and performing budget, financial and statistical analyses designed to
monitor facility performance. The Company believes these comprehensive features
enhance the efficiency and quality of care provided by its Outpatient Programs.

CASE MANAGEMENT PROGRAMS

         PMR's Case Management Programs were created in 1993 to treat the SMI
population in a managed care environment. The case management model was
developed in part from proprietary clinical protocols and assessment tools which
were purchased in 1993 from leading researchers in the field of psychiatric
rehabilitation. Specifically, the Company's programs provide SMI individuals
with personalized, one-on-one services designed to stabilize their daily lives
and provide early intervention in crisis situations, thereby limiting the
catastrophic events which lead to inpatient hospitalizations. The Case
Management Programs utilize comprehensive protocols based upon a specific model
of intensive service coordination in conjunction with a case manager whose
responsibilities include consumer education, the development of crisis plans,
responding to crisis events, linking patients to emergency services, assessing
patient needs, reviewing patient treatment plans, and authorizing and reviewing
services. Case management services vary by market and need of the population and
may include 24-hour case management, crisis intervention, respite services,
housing assistance, medication management and routine health screening. PMR
believes that its Case Management Programs represent the core clinical tool for
managing the SMI population in either a capitated or fee-for-service environment
and enable its patients to live more healthy, independent, productive and
satisfying lives in the community.

         PMR offers its case management services through long-term exclusive
management agreements with leading independent case management agencies or
CMHCs. Pursuant to those agreements, the Company contributes its proprietary
protocols and management expertise and, when necessary, negotiates case
management rates and contracts on behalf of the providers. The Company also
provides training, management information systems support, and accounting and
financial services. Presently, the Company has management agreements with two
case management agencies in Tennessee.

         PMR provides its Case Management services principally in Davidson
County, Tennessee, presently serving approximately 2,200 consumers located
primarily in Nashville, Tennessee. The Company is in the process of terminating
or substantially restructuring its relationship with a case management agency in
Memphis due to contractual disputes and differences in operating philosophy.
During fiscal 1998, the Company reached agreement with its CMHC providers in
Arkansas to terminate Case Management services due to the repeated delays in
transitioning the Arkansas Medicaid program to a managed care environment.

         In 1998, the Company introduced an additional service in Tennessee,
known as Urgent Care. Urgent Care is a high acuity, crisis intervention service
designed for triage and stabilization of a patient at the time of highest
clinical need. The service involves a physician intervention and thus combines a
medical model at crises and assessment with the case management model for
on-going maintenance. The Company anticipates introducing this service into
additional markets in Tennessee in fiscal 1999.

CHEMICAL DEPENDENCY PROGRAMS

         Through a wholly-owned subsidiary, the Company operates and manages
programs devoted exclusively to substance abuse and rehabilitation in ambulatory
settings, primarily to patients of managed care organizations in Southern
California. The Company's chemical dependency and substance abuse programs are
operated both as free-standing treatment services or as part of a Management
Services Agreement with health care providers. All programs have received
accreditation by the Joint Commission of American Health Organizations
("JCAHO").


                                       5.


<PAGE>   6

         The Company also offers chemical dependency programs that have been
specially developed with application to public sector clients. Public sector
clients with chemical dependency problems often are also dually diagnosed with a
mental illness. Bridging the gap between the two systems (i.e. chemical abuse
and mental health) is often difficult due to different funding streams,
treatment philosophies and regulations pertaining to Medicaid and other public
sector payors. Meeting the needs of the public sector dually diagnosed client
requires cross training of staff and development of linkage between traditional
chemical dependency providers and providers of behavioral health services.

         The Company operates four outpatient programs in southern California
under the name of Twin Town Treatment.

SITE MANAGEMENT AND CLINICAL INFORMATION

         In January 1997, the Company began the development of a site management
and clinical information division. This division seeks to participate in
clinical trials and collect clinical information related to pharmaceutical and
non-pharmaceutical clinical practice. The Company's objective is to build a
business model that contributes to the Company's revenues and earnings and to
develop an information asset that can improve and define "best practices" for
the SMI patient population. On January 24, 1997, the Company signed an agreement
with the Applied Healthcare Informatics division of United Healthcare with
respect to developing this business.

         The Company believes that its expanding service base is an excellent
platform for the development of research and clinical information business
lines. Key to that assumption is the Company's direct access to a large number
of individuals with SMI. Presently, the Company believes that it has access,
through programs it manages and through contracts providers, to more than 20,000
individuals diagnosed with SMI. In November 1997 the Company signed an agreement
with Insite Clinical Trials, Inc. for the specific development and training of
Company sites for participation in clinical trials, as well as the marketing of
those sites to sponsors of clinical trials. InSite Clinical Trials is now a
wholly owned subsidiary of United Healthcare, Inc.

         The genetic and neurobiological bases of severe mental disorders will
continue to be the focus of intensive research attention in the field.
Presently, numerous pharmaceutical companies and drug development companies have
compounds in various stages of development which are targeted for the treatment
of these disorders. The development of these compounds requires extensive
pre-clinical and clinical testing phases, many aspects of which are outsourced
to global contract research organizations ("CROs"). The Company's current
research network includes six locations with qualified investigators and study
coordinators. The Company plans to expand the network to between ten and twelve
locations by the end of fiscal 1999. The Company anticipates that the site 
management and clinical information initiative will be contributed to Stadt 
Solutions as part of the venture between the Company and Stadtlander.

STADT SOLUTIONS

         The Company and Stadtlander have entered into a binding subscription
agreement to form Stadt Solutions, a Delaware limited liability company. Stadt 
Solutions will offer specialty pharmaceutical services to individuals with SMI.
The joint venture will also offer site management and clinical information 
services to pharmaceutical companies, health care providers and public sector 
purchasers. It is expected that ownership of Stadt Solutions will be held 50.1%
by PMR and 49.9% by Stadtlander. Following formation, Stadtlander will be 
entitled to receive a priority distribution approximately equivalent to the 
operating income Stadtlander expected to be generated by Stadtlander's existing 
base of approximately 6,000 clients whom the parties expect will choose to 
receive services from the venture. The incremental operating income in excess of
this base, if any, will be distributed equally to the Company and Stadtlander.

         The venture will commence business with operations serving clients
through fourteen pharmacies in thirteen states serving approximately 6,000
clients. These individuals are presently receiving the drug clozaril, an
anti-psychotic for schizophrenia, as well as blood monitoring services. Stadt
Solutions will seek to offer patients expanded services, including dispensing of
all of the pharmaceuticals needed by these individuals and providing disease
management services to improve compliance and education for the patient, the
physician and family 

                                       6.

<PAGE>   7
members. The Company believes that Stadt Solutions will be the first specialty
pharmacy company devoted to serving the needs of individuals with an SMI.

PROGRAM LOCATIONS
<TABLE>
<CAPTION>
LOCATION (STATE, CITY)                   SERVICE PROVIDED
-------------------------------------    ----------------
<S>                                      <C>
California       San Diego               Outpatient, Clinical Research
                 Culver City             Outpatient
                 Santee                  Outpatient
                 San Francisco           Outpatient
                 Los Angeles             Outpatient
                 Studio City             Outpatient
                 Oakland                 Outpatient
                 Santa Ana               Outpatient
                 Vista                   Outpatient
                 Union City              Outpatient
                 Riverside               Outpatient
                 San Bernardino          Outpatient
                 Rosemead                Outpatient
                 Sacramento              Outpatient, Clinical Research
                 Orange                  Outpatient, Chemical Dependency
                 San Jose                Outpatient
                 La Jolla                Outpatient
                 Burbank                 Chemical Dependency
                 Los Alamitos            Chemical Dependency
                 Torrance                Chemical Dependency
                 Encinitas               Clinical Research

Alabama          Birmingham              Pharmacy*

Arizona          Phoenix                 Outpatient
                 Tempe                   Outpatient

Arkansas         Little Rock             Outpatient (2), Clinical Research

Colorado         Denver                  Outpatient (2)

Georgia          Atlanta                 Pharmacy*

Hawaii           Honolulu                Outpatient, Pharmacy*

Illinois         Chicago                 Outpatient, Pharmacy*

Kentucky         Frankfort               Outpatient
                 Bowling Green           Outpatient
                 Mayfield                Outpatient

Maine            Portland                Pharmacy*

Massachusetts    Boston                  Pharmacy*

Michigan         Detroit                 Outpatient (2), Clinical Research

Minnesota        Minneapolis             Pharmacy*

Missouri         St. Louis               Pharmacy*

New York         Long Island             Pharmacy*

North Carolina   Charlotte               Outpatient

Ohio             Cleveland               Outpatient

Pennsylvania     Pittsburgh              Pharmacy*
                 Philadelphia            Pharmacy*

South Carolina   Columbia                Pharmacy*

Tennessee        Kingsport               Outpatient
                 Madison                 Outpatient
                 Nashville               Outpatient, Case Management, Clinical Research
                 Memphis                 Case Management

Texas            Austin                  Outpatient

Utah             Salt Lake City          Pharmacy*

Washington       Bellevue                Outpatient
</TABLE>


                                    7.

<PAGE>   8
<TABLE>
<CAPTION>
LOCATION (STATE, CITY)                   SERVICE PROVIDED
-------------------------------------    ----------------
<S>                                      <C>

                 Seattle                 Pharmacy*
</TABLE>


----------           

     *    Anticipated service and location upon formation of Stadt Solutions.


CONTRACTS

OUTPATIENT PROGRAMS

         Each Outpatient Program is generally administered and operated pursuant
to the terms of written management or administrative contracts with providers.
These contracts generally govern the term of the program, the method by which
the program is to be managed by the Company, the responsibility of the provider
for licensure, billing, insurance and the provision of health care services, and
the methods by which the Company will be compensated. The contracts are
generally for a stated term between two and five years. Generally, contracts may
only be terminated with cause or upon the occurrence of certain material events
including changes in applicable laws, rules or regulations.

         Revenues derived by the Company under these contracts generally fit
within three types of arrangements: (i) an all-inclusive fee arrangement based
on fee-for-service rates which provides that the Company is responsible for
substantially all program costs; (ii) a fee-for-service arrangement whereby
substantially all program costs are the responsibility of the provider; and
(iii) a fixed fee arrangement. The all-inclusive arrangements were in effect at
34 of the 39 Outpatient Programs operated during fiscal 1998 and constituted
approximately 62.4% of the Company's revenues for the year ended April 30, 1998.
Typical contractual agreements with these providers, primarily acute care
hospitals or CMHCs, require the Company to provide, at its own expense, specific
management personnel for each program site. Regardless of the type of
arrangement with the provider, all medical services rendered in the programs are
provided by the provider.

         A significant number of the Company's contracts require the Company to
indemnify the provider for some or all of the management fee paid to the Company
if either third-party reimbursement for mental health services provided to
patients of the programs is denied or if the management fee paid to the Company
is not reimbursable by Medicare. See "Risk Factors -- Dependence Upon Medicare
Reimbursement," "-- Sufficiency of Existing Reserves to Cover Reimbursement
Risks," "Management's Discussion and Analysis of Financial Condition and Results
of Operations" and "Business -- Regulatory Matters."

         In February 1998, the Company announced that Scripps Health had
received a letter from an official at Region IX of HCFA, informing Scripps
Health that its partial hospitalization programs managed by the Company could no
longer be considered "provider based" for Medicare reimbursement purposes. In
July 1998, HCFA notified Scripps Health that certain of the programs are
approved as "provider based" and that certain other program locations are not
"provider based" because they did not meet HCFA's service area requirements. As
a result of HCFA's notice, the Company and Scripps Health amended their
contract, Scripps Health reconfigured certain of its partial hospitalization
programs and one of the locations was acquired by another provider who engaged
the Company to manage the program. While to the Company's knowledge, no other
Company programs have received provider based challenges to date, it is possible
that these challenges will emerge with other providers and that the Company may
not be able to amend its contracts to satisfy HCFA or its provider customers.

         As the Outpatient Programs mature and increase in number, the Company
anticipates that as a matter of normal business development, contract
terminations may occur on a periodic basis. In the past, if a contract was
terminated, the Company has been successful in contracting with another provider
in the program's geographic area. There can be no assurance that the Company
will be able to successfully replace such terminated contracts or programs in
the future.

         The Company's Outpatient Program contracts covering sites operated by
hospitals operating under Scripps Health, a San Diego provider, accounted for
approximately 13.9% and 12.6% of the Company's revenues for fiscal 

                                       8.

<PAGE>   9
1998 and fiscal 1997, respectively. No other provider accounted for more than
10% of the Company's revenues for fiscal 1998.

CASE MANAGEMENT PROGRAMS

         Each Case Management Program is generally administered pursuant to a
management and affiliation agreement with a contracting provider and operates
through a wholly owned subsidiary of the Company. The Company is responsible for
developing and implementing detailed operating protocols relating to training
procedures, management information systems, utilization review, coordination of
quality assurance, contract development and other management and administrative
services, and, under certain contracts, the provision of mental health services.
Pursuant to the terms of the management and affiliation agreements, the Company
manages and operates, on behalf of each case management provider, the delivery
of case management and other covered psychiatric services. The case management
provider is responsible for staff personnel and program facilities, and retains
final discretionary authority to approve the related policy manual, staffing
issues and overall program operations.

         The terms of the management and affiliation agreements are six years
and may only be terminated for cause upon the occurrence of such events as (i) a
loss of accreditation or other required licensing or regulatory qualifications,
(ii) material breach by either party, (iii) certain legislative or
administrative changes that may adversely affect the continued operation of the
program and (iv) failure to achieve certain performance targets after designated
notice and cure periods. In the Fall of 1995, the Company commenced the
operation of its Case Management Programs with two case management agencies in
Nashville, Tennessee and Memphis, Tennessee. In March and April of 1996, the
Company also executed management and affiliation agreements with three CMHCs in
Arkansas, which became operational in 1996. In September 1997 and in May 1998
the Company reached agreement with its CMHC providers to close its Case
Management Programs in Arkansas. The Company is engaged in arbitration with a
case management agency in Memphis regarding disputes involving the management
and affiliation agreement. The Company cannot predict the outcome of the
arbitration. The Company expects to terminate or substantially restructure the
relationship with the case management agency in fiscal 1999. See "Risk Factors
--Concentration of Revenues" and "-- Limited Operating History of Case
Management Programs."

         Commencing in July 1996, two managed care consortiums became the payors
for mental health care services under the Tennessee Tenncare Partners State
Medicaid Managed Care Program ("TennCare"). These consortiums, known as
Tennessee Behavioral Health ("TBH") and Premier Behavioral Health ("Premier"),
were fully at-risk for the approximately 1.2 million individuals who qualified
for coverage based on Medicaid eligibility or other indigency standards. The
Company has a contract for a Case Management Program with Premier. The Company
received notice of termination of its contract with TBH effective December 10,
1997. The parties were unable to negotiate a new contract, however, the Company
has continued to provide services to, and receive payments from, TBH at reduced
rates. In February 1998, Magellan Health Services, Inc. acquired Merit
Behavioral Health Care, Inc. and thus became the managing shareholder of TBH.
Magellan, through its Green Spring subsidiary, is also the managing shareholder
of Premier. The Company is presently renegotiating its rates with Premier and
anticipates that Premier will take over TBH's business, which may result in the
Company's contract with Premier applying to all the Company's case management
services in Tennessee. Some uncertainty exists as to the future structure of
TennCare. See "Risk Factors -- Potential Changes in TennCare."

         Case management contracts in Tennessee accounted for 21.6% and 23.7% of
the Company's revenues for fiscal 1998 and fiscal 1997, respectively.

MARKETING AND DEVELOPMENT

         PMR's principal marketing efforts with respect to its Outpatient and
Case Management Programs are concentrated in the identification of prospective
hospitals, CMHCs and case management agencies which may be suitable providers.
Providers that may contract for the Company's services are identified through an
analysis of market need, discussions with key individuals in the prospective
area, and an assessment of the financial and clinical profile of the provider.
The Company also markets the benefits of its Outpatient, Case Management and
Urgent Care Programs to managed care organizations and their provider networks
as public sector contracts are awarded. The development of the Chemical
Dependency Programs focuses on expanding current contractual relationships, 

                                       9.


<PAGE>   10
obtaining new provider contracts and marketing primarily to at-risk payors where
ambulatory chemical dependency services are of significant value.

         The Company's marketing efforts with providers are undertaken by its
own marketing and development personnel who focus upon the dissemination of
information about the benefits of the Company's programs. The Company believes
that its ability to secure new contracts with providers is based on its
reputation for quality and the uniqueness of its services in its market areas.

REGULATORY MATTERS

COMPLIANCE WITH MEDICARE GUIDELINES; REIMBURSEMENT FOR PARTIAL HOSPITALIZATION
PROGRAMS

         A significant component of the Company's revenues are derived from
payments made by providers to the Company for the management and administration
by the Company of Outpatient Programs managed for providers. The Company bills
its management fee to the provider as a purchased management and administrative
support service. Substantially all of the patients admitted to these programs
are eligible for Medicare coverage and thus, the providers rely upon payment
from Medicare. The providers are reimbursed their costs on an interim basis by
Medicare fiscal intermediaries and the providers submit annual cost
reimbursement reports to the fiscal intermediaries for audit and payment
reconciliation. The providers seek reimbursement of the Company's management
fees from these fiscal intermediaries as part of their overall payments from
Medicare. Under certain of the Company's contracts the Company is obligated to
indemnify the provider for all or some portion of the Company's management fees
that may be disallowed to the provider. In the event a significant amount of
such fees are disallowed for providers, there could be a material adverse effect
upon the Company's financial condition and results of operations. In addition,
to the extent that providers who contract with the Company for management
services suffer material losses in Medicare payments, there is a greater risk of
non-payment by the providers, and a risk that the providers will terminate or
not renew their contracts with the Company. Thus, even though the Company is not
paid by Medicare, it may be adversely affected by reductions in Medicare
payments or other Medicare policies. See "Risk Factors-Dependence Upon Third
Party Reimbursement" below and "Item 7. Management's Discussion And Analysis Of
Financial Condition And Results Of Operations."

         The Medicare Program is part of a federal health program created in
1965 as part of the federal social security system. It is administered by the
U.S. Department of Health and Human Services which has established Health Care
Financing Administration ("HCFA") to promulgate rules and regulations governing
the Medicare program and the benefits associated therewith.

         Medicare guidelines indicate that, subject to certain regulatory
requirements relating to reasonable costs imposed upon a Provider, contract
management services may be used in lieu of or in support of in-house staff of
the provider and are reimbursable by Medicare. As a general rule, Medicare
guidelines indicate that contract management services costs related to
furnishing services covered by Medicare are reasonable if the costs incurred are
comparable with marketplace prices for similar services. Management of the
Company believes that the value of the Company's services is comparable with
marketplace prices for similar services.

         HCFA has published criteria which partial hospitalization services must
meet in order to qualify for Medicare funding. In transmittal number 1303
(effective January 2, 1997) and in subsequent criteria published in Section
230.50 of the Medicare Coverage Manual, HCFA requires partial hospitalization
services to be: (i) incident to a physician's service; (ii) reasonable and
necessary for the diagnosis or treatment of the patient's conditions; and (iii)
provided by a physician with a reasonable expectation of improvement of the
patient from the treatment. The Medicare criteria for coverage, specifically
what is "reasonable and necessary" in particular cases is a subjective
determination on which health care professionals may disagree. Moreover, the
fiscal intermediaries which administer the Medicare program and evaluate and
process claims for payment, establish local medical review policies which may
have a material adverse effect on the Company's results of operations. How
Medicare applies its "reasonable and necessary" standard is not always
consistent, and that standard may be interpreted in the future in a manner which
is more restrictive than currently prevailing interpretations. The Company and
its providers have quality assurance and utilization review programs to monitor
partial hospitalization programs managed by the Company to ensure that such
programs operate in compliance with the Company's understanding of all Medicare
coverage requirements.



                                      10.


<PAGE>   11
         All of the partial hospitalization programs managed by the Company are
required to be "provider based" programs by HCFA, which administers the Medicare
program. This designation is important since partial hospitalization services
are covered only when furnished by or "under arrangement" with, a "provider",
i.e., a hospital or a CMHC. To the extent that partial hospitalization programs
are not operated in a manner which is deemed by HCFA to satisfy its "provider
based" criteria, there would not be Medicare coverage for the services furnished
at that site under Medicare's partial hospitalization benefit. In August 1996,
HCFA published (and in 1998 substantially reissued) criteria for determining
when programs operated in facilities separate from a hospital's or CMHC's main
premises may be deemed to be "provider based" programs. The proper
interpretation and application of these criteria are not entirely clear, and are
applied on a case by case basis, thereby creating a risk that some of the sites
managed by the Company will be found not to be "provider based." If such a
determination is made, HCFA may cease reimbursing for the services of the
provider and has not ruled out, in some situations, the possibility that it
would seek retrospective recoveries from providers. Any such cessation of
reimbursement for services or retrospective recoveries could result in
non-payment by providers and have a material adverse effect on the Company's
business, financial condition and results of operations. See "Risk Factors -
Dependence Upon Third Party Reimbursement."

         In February 1998, the Company announced that Scripps Health had
received a letter from an official at Region IX of HCFA, informing Scripps
Health that its partial hospitalization programs managed by the Company could no
longer be considered "provider based" for Medicare reimbursement purposes. In
July 1998, HCFA notified Scripps Health that certain of the programs were
approved as "provider based" and that certain other program locations are not
"provider based" because they did not meet HCFA's service area requirements. As
a result of HCFA's notice, the Company and Scripps Health amended their
contract, Scripps Health reconfigured certain of its partial hospitalization
programs and one of the locations was acquired by another provider who engaged
the Company to manage the program. While to the Company's knowledge, no other
Company programs have received provider based challenges to date, it is possible
that these challenges will emerge with other providers and that the Company may
not be able to amend its contracts to satisfy HCFA or its provider customers.
See "Business - Contracts - Outpatient Programs."

         Historically, CMHCs, unlike hospitals, were not surveyed by a Medicare
contractor before being permitted to participate in the Medicare program.
However, HCFA is now in the process of surveying all CMHCs to confirm that they
meet all applicable Medicare conditions for furnishing partial hospitalization
programs. Management believes that all the CMHCs which contract with the Company
should be found to be in compliance with the applicable requirements, but it is
possible that some CMHCs contracting with the Company will be terminated from
the Medicare program. It is also possible that the government will attempt to
recover payments made to such CMHCs for services which had been furnished by the
Company and paid for by Medicare.

CHANGES IN MEDICARE'S COST BASED REIMBURSEMENT FOR PARTIAL HOSPITALIZATION
SERVICES

         The Balanced Budget Act of 1997 requires the implementation of a
prospective payment system ("PPS") for all outpatient hospital services,
including partial hospitalization, for the calendar year beginning January 1,
1999. Under such a system, a predetermined rate would be paid to providers
regardless of the provider's reasonable costs. While the actual reimbursement
rates have not been determined and thus their effect, positive or negative, is
unknown, the Company anticipates that it may need to negotiate modifications to
its contracts with providers if the system is implemented. The initial date for
publishing the proposed PPS rates was May 1998. Recent concerns over HCFA's
compliance with year 2000 computer issues have raised the possibility of
significant delays in such implementation. The uncertainty regarding PPS has
negatively effected the Company's marketing of new programs due to provider's
uncertainty regarding the economic impact of the new rates. While the Company
cannot predict the impact of continued delays on the Company's marketing
program, it could have a material adverse effect on the Company's ability to
sign new contracts and retain existing contracts.

         The Medicare partial hospitalization benefit has a coinsurance feature,
which means that the amount paid by Medicare is the provider's reasonable cost
less "coinsurance" which is ordinarily to be paid by the patient. The
coinsurance amount is 20% of the charges for the services and must be charged to
the patient by the provider unless the patient is indigent. If the patient is
indigent or if the patient does not pay the provider the billed coinsurance
amounts after reasonable collection efforts, the Medicare program has
historically paid those amounts as "allowable Medicare bad debts." The
allowability of Medicare bad debts to providers for whom the Company manages
partial 


                                      11.

<PAGE>   12
hospitalization programs is significant since most of the patients in programs
managed by the Company are indigent or have very limited resources. The Balanced
Budget Act of 1997 reduces the amount of Medicare allowable bad debts payable to
hospital providers, as follows: 25% for provider fiscal years beginning on or
after October 1, 1997; 40% for provider fiscal years beginning on or after
October 1, 1998; and 45% for provider fiscal years beginning on or after October
1, 1999. The reduction in "allowable Medicare bad debts" could have a materially
adverse effect on Medicare reimbursement to the Company's hospital providers and
could further result in the restructuring or loss of Provider contracts with the
Company. It is also possible that the reduction in reimbursable allowable bad
debt by Medicare could be extended to CMHC providers.

COMPLIANCE WITH MEDICAID REGULATIONS AND POTENTIAL CHANGES

         Since the Company is involved with state Medicaid agencies and with
providers whose clients are covered by Medicaid, the Company must comply with
the laws and regulations governing such reimbursement. Medicaid is a joint state
and federally funded program established as part of the Social Security Act in
the mid-1960s to provide certain defined health care benefits to poor, indigent
or otherwise eligible general welfare recipients. As states consider methods to
control the cost of health care services generally, and behavioral health
services specifically, to Medicaid recipients, and because such recipients are,
as a group, heavy users of the type of services which the Company offers, the
effect of Medicaid reimbursement and regulatory compliance with its rules could
be material to the Company's financial condition and results of operations.

         Medicaid funding and the methods by which services are supplied to
recipients are changing rapidly. Many states have "carved out" behavioral health
services from the delivery of other health services to Medicaid recipients and
are separately procuring such services on a capitated basis requiring the
contractor, and permitting subcontracted providers, to assume risk.

         The Company 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 ever-increasing uncertain political pressures on such
legislatures in terms of controlling and reducing such appropriations. The
overall trend is generally to impose lower reimbursement rates and to negotiate
reduced contract rates with providers, including incentives to assume risk not
only by licensed managed care organizations with whom state Medicaid agencies
contract, but by subcontracted providers, such as the Company. Part of the
Company's strategy for growth depends upon obtaining continued and increased
contracts with managed care organizations to provide behavioral health managed
care services to Medicaid recipients. Consequently, any significant reduction in
funding for Medicaid programs could have a material adverse effect on the
Company's business, financial condition and results of operations.

         The United States Congress continues to consider legislation to
substantially alter the overall Medicaid program, to give states greater
flexibility in the design and operation of their individual Medicaid program,
and to stabilize federal spending for such benefits. Various states are also
considering 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 with respect to other individuals funded
by public resources. The reduction in other public resources could have an
impact upon the delivery of services to Medicaid recipients.

         Many of the patients served in the Outpatient Programs managed by the
Company are indigent or have very limited resources. Accordingly, many of those
patients have Medicaid coverage in addition to Medicare coverage. In some of the
states where the Company furnishes services, the state Medicaid plans have paid
the Medicare coinsurance amount. However, under the Balanced Budget Act of 1997,
states will no longer have to pay such amounts if the amount paid by Medicare
for the service equals or exceeds what Medicaid would have paid had it been the
primary insurer. To the extent that states take advantage of this new
legislation and refuse to pay the Medicare coinsurance amounts on behalf of the
Outpatient Program patients to the extent that they had in the past, it will
have an adverse effect on the providers with whom the Company contracts, and
thus, may have a material adverse effect on the Company's business, financial
condition and results of operations.

                                      12.


<PAGE>   13

COMPLIANCE WITH OTHER STATE REGULATORY CONSIDERATIONS

         The Company is also sensitive to the particular nature of the delivery
of behavioral health services and various state and federal requirements with
respect to confidentiality and patient privacy. Indeed, federal and state laws
require providers of certain behavioral health services to maintain strict
confidentiality as to treatment records and, the fact of treatment. There are
specific requirements permitting disclosure, but inadvertent or negligent
disclosure can trigger substantial criminal and other penalties.

SPECIFIC LICENSING OF PROGRAMS

         The Company's Outpatient Programs are operated as outpatient
departments of hospitals or CMHCs, thus subjecting such programs to regulation
by federal, state and local agencies. These regulations govern licensure and
conduct of operations at the facilities, review of construction plans, addition
of services and facilities and audit of cost allocations, cost reporting and
capital expenditures. The facilities occupied by the programs must comply with
the requirements of municipal building, health and fire codes. Inclusion of
hospital space where the Outpatient Programs are furnished within the hospitals'
license, when required under applicable state laws, is a prerequisite to
participation in the Medicare programs. Additionally, the Provider's premises
and programs are subject to periodic inspection and recertification.

FALSE CLAIMS INVESTIGATIONS AND ENFORCEMENT OF HEALTH CARE FRAUD LAWS

         The Office of the Inspector General within the U.S. Department of
Health and Human Services, as well as other federal, state, and private
organizations, are aggressively enforcing their interpretation of Medicare and
Medicaid laws and policies, and other applicable standards. Often in such
enforcement efforts, the government has relied on the Federal False Claims Act.
Under that law, if the government prevails in a case, it is entitled to treble
damages plus not less than $5,000 nor more than $10,000 per claim, plus
reasonable attorney fees and costs. In addition, a person found to have
submitted false claims can be excluded from governmental health care programs
including Medicare and Medicaid. If a provider contracting with the Company were
excluded from governmental health programs, no services furnished by that
provider would be covered by any governmental health program. Some of the
providers contracting with the Company are reported to be under active
investigation for health care fraud, although the Company is not aware of those
investigations relating to programs with which the Company is involved. If the
Company were excluded from governmental health programs, providers contracting
with the Company could not be reimbursed for amounts paid to the Company.

         To prevail in a False Claims Act case, the government need show only
that incorrect claims were submitted with "reckless disregard" or in "deliberate
ignorance" of the applicable Medicare law. The government does not have to prove
that the claims were submitted with the intent to defraud a governmental or
private health care payor. The qui tam provisions of the Federal False Claims
Act permit individuals also to bring suits under the False Claims Act. The
incentive for an individual to do so is that he or she will usually be entitled
to approximately 15% to 30% of any ultimate recovery. Under the Federal False
Claims Act, the Office of the Inspector General, in conjunction with the
Department of Justice, have successfully made demands on thousands of providers
to settle alleged improper billing disputes at double damages or more. Although
the Company does not bill governmental programs directly, it could possibly be
liable under the False Claims Act to the extent that it is found to have
"caused" false claims to have been presented.

         In February 1998, the Company announced that an Outpatient Program that
it formerly managed in Dallas, Texas was the subject of a civil investigation
conducted by the U.S. Department of Health and Human Services' Office of
Inspector General and the U.S. Attorney's office in Dallas, Texas. See "Item 3.
Legal Proceedings."

         In addition, the Company was informed on July 20, 1998 that a qui tam
suit had been filed by a former employee of the Company against a subsidiary of
the Company. See "Item 3. Legal Proceedings."

         There are many other civil and criminal statutes at the federal and
state levels that may penalize conduct related to submitting false claims for
health care services or for offering or receiving anything of value in exchange
for the referral of patients. The penalties under many of those statutes are
severe, and the government often need not 

                                      13.

<PAGE>   14
prove intent to defraud in order to prevail. Management believes that the
Company is in material compliance with applicable regulatory and industry
standards. However, in light of the complexity of the policies governing
governmental health care programs together with changing and uncertain
interpretations of those policies, it is impossible to be absolutely assured
that the government (or a qui tam relator in the name of the government) will
not assert that some conduct by the Company has given rise to potentially a
large liability.

         In the past, there have been occasions when Medicare fiscal
intermediaries have denied coverage for all or substantially all of the claims
submitted by the providers where the Company had a management contract. Such
denials have occurred even though a physician has certified that the Outpatient
Program services were medically necessary. Notwithstanding the Company's ongoing
efforts to assure that the Outpatient Program services furnished by it under
contract are consistent with its understanding of the Medicare coverage
criteria, it is possible that there will be future occasions when a substantial
number of services furnished at a site managed by the Company will be denied
coverage. The Health Insurance Portability and Accountability Act of 1996 grants
the U.S. Department of Health and Human Services broad authority to impose civil
monetary penalties on providers for certain activities. Among those activities
are the repeated submission of claims for services which are not medically
necessary. If there were again to be occasions when a Medicare fiscal
intermediary denied a large number of claims for a site managed by the Company,
it is possible that the government would seek sanctions from the provider and
possibly from the Company. While the Company believes that it would be
inappropriate for the government to seek such sanctions for services for which
the coverage criteria are interpreted differently at different times and which
have been ordered by a physician, it is not clear at this time how the
government will apply this new authority.

COMPETITION

         In general, the operation of psychiatric programs is characterized by
intense competition. General, community and specialty hospitals, including
national companies and their subsidiaries, provide many different health care
programs and services. The Company anticipates that competition will become more
intense as pressure to contain the rising costs of health care continues to
intensify, particularly as programs such as those operated by the Company are
perceived to help contain mental health care costs. Many other companies engaged
in the management of outpatient psychiatric programs compete with the Company
for the establishment of affiliations with acute care hospitals. Furthermore,
while the Company's existing competitors in the case management business are
predominantly not-for-profit CMHCs and case management agencies, the Company
anticipates that other health care management companies will eventually compete
for this business. Many of these present and future competitors are
substantially more established and have greater financial and other resources
than the Company. In addition, the Company's current and potential providers may
choose to operate mental health programs themselves rather than contract with
the Company. There can be no assurance that the Company will be able to compete
effectively with its present or future competitors, and any such inability could
have a material adverse effect on the Company's business, financial condition
and results of operations.

         The Company believes that the proprietary nature of its policy and
procedures manuals as well as the level of service it provides and the expertise
of its management and field personnel provides it with a leading position in the
development and management of Outpatient Programs. The Company believes that the
Case Management Programs provide the means to effectively control costs in a
managed, public-sector mental health system by reducing the costs for the
population that consumes the largest portion of the treatment dollars, the SMI
population. In addition, the Company believes that the Company's case management
model provides state-of-the-art treatment and rehabilitation services which
serve to upgrade the existing provider network in a community. The Company
believes the benefits of its case management model are recognized as a
distinguishing feature for public-sector managed care efforts.

         The Company's primary existing competitors in the case management
business are predominantly not for profit CMHCs and case management agencies.
The Company anticipates that mental health managed care companies will
eventually compete for this business. There can be no assurances that the
Company will be able to compete successfully with its present or future
competitors.

         The specialty pharmacy business is intensely competitive. There are
numerous local, regional and national companies which can dispense
pharmaceuticals locally or through the mail. There are also numerous companies
which provide lab work and analysis services necessary for blood monitoring.
Many of these companies have 
                                      14.


<PAGE>   15
substantially greater resources than Stadt Solutions. While the Company believes
that Stadt Solutions will be the first specialty pharmacy company to focus on
SMI and further believes that Stadt Solutions will offer value added disease
management services not typically provided by competitors, there can be no
assurance that Stadt Solutions will be able to compete successfully with its
present or future competitors.

EMPLOYEES

         As of July 15, 1998, PMR employed approximately 818 employees, of which
397 are full-time employees. Approximately 713 employees staff clinical programs
and approximately 105 are in corporate management including finance, accounting,
development, utilization review, training and education, information systems,
human resources and legal areas. None of the Company's employees are subject to
a collective bargaining agreement and the Company believes that its employee
relations are good.


RISK FACTORS

         The Company's business is subject to a number of risks, including the
risks described in this section and elsewhere in this Annual Report on Form
10-K. The Company's actual results could differ materially from the results
projected in this Report or in any other forward-looking statements presented by
management from time to time, due to some or all of such risks.

         Dependence Upon Medicare Reimbursement. A significant component of the
Company's revenues is derived from payments made by providers to the Company for
managing and administering Outpatient Programs for providers. Substantially all
of the patients admitted to the Outpatient Programs are eligible for Medicare
coverage. A provider's Medicare payments can be adversely affected by actions of
HCFA or fiscal intermediaries in several ways including: (i) denials of coverage
on claims for services furnished to Medicare eligible patients; (ii)
disallowances of costs claimed on the annual cost report on the grounds that
such costs are unreasonable, relate to uncovered services or are otherwise
non-allowable; or (iii) changes in the law or interpretation of the law
governing Medicare coverage and payment. Providers generally seek reimbursement
of the Company's management fees from the fiscal intermediaries as part of their
overall payments from Medicare, and payment of the Company's management fee may
be directly affected by the reimbursement experience of the provider.

         In certain instances, providers are not obligated to pay the Company's
management fee if coverage for claims submitted by the provider related to
services furnished by the Company are denied by Medicare's fiscal intermediary.
In other instances, the Company may be obligated to indemnify a provider to the
extent the Company's management fee charged to the provider is disallowed by
Medicare's fiscal intermediary for reimbursement. The occurrence of either of
these events with respect to a significant number of providers or a significant
amount of fees could have a material adverse effect upon the Company's business,
financial condition and results of operations. See "Business -- Regulatory
Matters -- Compliance With Medicare Guidelines; Reimbursement For Partial
Hospitalization Programs."

         The Company's programs have in the past, and may in the future, from
time to time, be subject to Focused Medical Reviews. A "Focused Medical Review"
consists of an intensive review by fiscal intermediaries of HCFA, on an
industry-wide basis, of certain targeted claims. Focused Medical Reviews may
occur for a number of reasons including, without limitation, an intermediary's
concern about coverage for claims at a specific site or because HCFA has
identified certain services as being at risk of inappropriate program payment.
This generally occurs when HCFA identifies significant industry-wide increases
in payments for certain types of services, as had been the case with partial
hospitalization benefits.

         During 1997 and 1998, HCFA has increased its scrutiny of outpatient
psychiatric services due to a significant increase in charges to Medicare for
outpatient partial hospitalization and other mental health services. The Company
believes that Focused Medical Reviews and related denials are increasing
throughout the industry, including at programs managed by the Company. Any
denied claims resulting from future Focused Medical Reviews could have a
material adverse effect on the Company's business, financial condition and
results of operations. See "Business --Regulatory Matters -- Compliance With
Medicare Guidelines; Reimbursement For Partial Hospitalization Programs."


                                      15.

<PAGE>   16
         All of the partial hospitalization programs managed by the Company are
required under HCFA's current interpretation of the Medicare regulations, to be
"provider based" programs by HCFA. This designation is important since partial
hospitalization services are covered only when furnished by or "under
arrangement" with, a "provider", i.e., a hospital or a CMHC. To the extent that
partial hospitalization programs are not deemed by HCFA to be "provider based"
under HCFA's current interpretation of the Medicare regulations, there would not
be Medicare coverage for the services furnished at that site under Medicare's
partial hospitalization benefit. HCFA has published criteria for determining
when programs operated in facilities separate from a hospital's or CMHC's main
premises may be deemed to be "provider based" programs. The proper
interpretation and application of these criteria are not entirely clear, and
there is a risk that some of the sites managed by the Company will be found not
to be "provider based". If such a determination is made, HCFA may cease
reimbursing for the services at the provider, and HCFA has not ruled out the
possibility that, in some situations, it would seek retrospective recoveries
from providers. Any such cessation of reimbursement for services or
retrospective recoveries could result in non-payment by providers and have a
material adverse effect on the Company's business, financial condition and
results of operations.

         In February 1998, the Company announced that Scripps Health had
received a letter from an official at Region IX of HCFA, informing Scripps
Health that its partial hospitalization programs managed by the Company could no
longer be considered "provider based" for Medicare reimbursement purposes. In
July 1998, HCFA notified Scripps Health that certain of the programs are
approved as "provider based" and that certain other program locations were not
"provider based" because they did not meet HCFA's service area requirements. As
a result of HCFA's notice, the Company and Scripps Health amended their
contract, Scripps Health reconfigured certain of its partial hospitalization
programs and one of the locations was acquired by another provider who engaged
the Company to manage the program. While to the Company's knowledge, no other
Company programs have received provider based challenges to date, it is possible
that these challenges will emerge with other providers and that the Company may
not be able to amend its contracts to satisfy HCFA or its provider customers. In
addition, there can be no assurance that HCFA will not challenge the "provider
based" status of the Scripps Health program in the future. If the Company is
unable to amend its contracts to satisfy any "provider based" challenge in the
future, the potential termination of any such contracts could have a material
adverse effect upon the Company's business, financial condition and results of
operations.

         See "Business -- Contracts -- Outpatient Programs," "-- Regulatory
Matters -- Compliance with Medicare Guidelines; Reimbursement for Partial
Hospitalization Programs."

         Impact of Health Care Reform and the Balanced Budget Act of 1997.
Political, economic and regulatory influences are subjecting the health care
industry in the United States to fundamental change. Changes in the law, new
interpretations of existing laws, or changes in payment methodology or amounts
may have a dramatic effect on the relative costs associated with doing business
and the amount of reimbursement provided by government or other third-party
payors. In addition to specific health care legislation, both the Clinton
Administration and various federal legislators have considered health care
reform proposals intended to control health care costs and to improve access to
medical services for uninsured individuals. These proposals have included
cutbacks to the Medicare and Medicaid programs and steps to permit greater
flexibility in the administration of the Medicaid program. In addition, some
states in which the Company operates are considering various health care reform
proposals. The Company anticipates that federal and state governments will
continue to review and assess alternative health care delivery systems and
payment methodologies, and that public debate on these issues will likely
continue in the future. Due to uncertainties regarding the ultimate features of
reform initiatives and their enactment, implementation and interpretation, the
Company cannot predict which, if any, of such reform proposals will be adopted,
when they may be adopted or what impact they may have on the Company.
Accordingly, 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 effect on the Company's business,
financial condition and results of operations.

         The Balanced Budget Act of 1997 could adversely affect reimbursements
to certain providers and payments to the Company. The Medicare partial
hospitalization benefit has a coinsurance feature, which means that the amount
paid by Medicare is the provider's reasonable cost less "coinsurance" which is
ordinarily to be paid by the patient. The Medicare program has historically paid
amounts designated as the patient's coinsurance obligation where the patient is
indigent or if the patient does not pay the provider the billed coinsurance
amounts after reasonable collection efforts. Those amounts are characterized as
"allowable Medicare bad debts." The allowability of bad debts to providers is
significant because most of the patients in programs managed by the Company are


                                      16.
<PAGE>   17
indigent or have very limited resources. The Balanced Budget Act of 1997 reduces
the amount of allowable Medicare bad debts payable to hospital providers, as
follows: 25% for provider fiscal years beginning on or after October 1, 1997;
40% for provider fiscal years beginning on or after October 1, 1998; and 45% for
provider fiscal years beginning on or after October 1, 1999. The reduction in
"allowable Medicare bad debts" could have a material adverse impact on Medicare
reimbursement to the Company's hospital Providers and could further result in
the restructuring or loss of provider contracts with the Company. It is also
possible that the reduction in reimbursable allowable bad debt by Medicare could
be expanded to CMHC providers. An adverse effect on Medicare reimbursement to
the Company's hospital providers, and if so expanded, on reimbursement to CMHC
providers, could have a material adverse effect upon the Company's business,
financial condition and results of operations. See "Business -- Regulatory
Matters -- Compliance With Medicare Guidelines; Reimbursement For Partial
Hospitalization Programs."

         In addition, under the Balanced Budget Act of 1997, state Medicaid
plans that have historically paid the Medicare coinsurance amount will no longer
have to pay such amounts if the amount paid by Medicare for the service equals
or exceeds what Medicaid would have paid had it been the primary insurer. To the
extent that states take advantage of this new legislation and refuse to pay the
Medicare coinsurance amounts on behalf of the Outpatient Program patients to the
degree that they had in the past, it will have an adverse impact on the
providers with whom the Company contracts, and thus may have a material adverse
effect on the Company's business, financial condition and results of operations.
See "Business -- Regulatory Matters -- Changes In Medicare's Cost Based
Reimbursement For Partial Hospitalization Services" and "-- Compliance With
Medicaid Regulations and Potential Changes."

         The PPS to be implemented under the Balanced Budget Act of 1997 could
have an adverse effect on the business of certain providers and the Company.
While the actual reimbursement rates and methodology for the PPS have not been
determined and thus their effect is unknown, the Company may need to negotiate
modifications to its contracts with providers, which could have a material
adverse effect on the Company's business, financial condition and results of
operations. Recent concerns over HCFA's compliance with year 2000 computer
issues have raised the possibility of significant delays in the implementation
of PPS. The uncertainty regarding PPS has negatively effected the Company's
marketing of new programs due to provider's uncertainty regarding the economic
impact of the new rates. While, the Company cannot predict the impact of
continued delays on the Company's marketing program, it could have a material
adverse impact on the Company's ability to sign new contracts and retain
existing contracts. See "Business -- Regulatory Matters -- Changes in Medicare's
Cost Based Reimbursement For Partial Hospitalization Services."

         Sufficiency of Existing Reserves to Cover Reimbursement Risks. The
Company maintains significant reserves to cover the potential impact of two
primary uncertainties: (i) the Company may have an obligation to indemnify
certain providers for some portions of its management fee which may be subject
to disallowance upon audit of a provider's cost report by fiscal intermediaries;
and (ii) the Company may not receive full payment of the management fees owed to
it by a provider during the periodic review of the provider's claims by the
fiscal intermediaries. The Company has been advised by HCFA that certain
program-related costs are not allowable for reimbursement. The Company may be
responsible for reimbursement of the amounts previously paid to the Company that
are disallowed pursuant to obligations that exist with certain providers.
Although the Company believes that its potential liability to satisfy such
requirements has been adequately reserved in its financial statements, there can
be no assurance that such reserves will be adequate. The obligation to pay the
amounts estimated within the Company's financial statements (or such greater
amounts as are due), if and when they become due, could have a material adverse
effect upon the Company's business, financial condition and results of
operations. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations," "Business - Regulatory Matters - Compliance with
Medicare Guidelines; Reimbursement for Partial Hospitalization Programs.

         Continuity of Management Contracts. Substantially all of the revenues
of the Company are derived from contracts with providers, behavioral health
organizations and case management agencies. The continued success of the Company
is subject to its ability to maintain, renew, extend or replace existing
management contracts and obtain new management contracts. These contracts
generally have defined terms of duration and many have automatic renewal
provisions. The contracts often provide for early termination either by the
provider if specified performance criteria are not satisfied or by the Company
under various other circumstances.

                                      17.


<PAGE>   18
         Contract renewals and extensions are likely to be subject to competing
proposals from other contract management companies as well as consideration by
certain providers to terminate their mental health programs or convert their
mental health programs from independently managed programs to programs operated
internally. There can be no assurance that any provider or case management
agency will continue to do business with the Company following expiration of its
management contract or that such management contracts will not be terminated
prior to expiration. In addition, any changes in the Medicare or Medicaid
program which have the effect of limiting or reducing reimbursement levels for
mental health services provided by programs managed by the Company could result
in the early termination of existing management contracts and could adversely
affect the ability of the Company to renew or extend existing management
contracts and to obtain new management contracts. The termination or non-renewal
of a significant number of management contracts could result in a significant
decrease in the Company's net revenues and could have a material adverse effect
on the Company's business, financial condition and results of operations. See
"Business -- Contracts."

         Potential Changes in TennCare. The Company has a contract for a Case
Management Program with Premier. In addition, the Company is presently
renegotiating its rates with Premier. The Company previously received a notice
of termination of its contract with TBH. The Company anticipates that Premier
may take over TBH's business, possibly resulting in the Company's contract with
Premier applying to all of the Company's case management services in Tennessee.
However, there can be no assurance that the Company's relationship with Premier
and TBH will be resolved as currently anticipated by the Company, and there can
be no assurance that the ultimate resolution of such matters will not have a
material adverse effect on the Company's business, financial condition and
results of operations. The TennCare program has been subjected to substantial
criticism which could result in structural changes which the Company cannot
predict with any degree of certainty, and which could have a material adverse
effect on the Company's business, financial condition and results of operations.

         In addition, the Company is in the process of arbitrating its agreement
with a case management agency in Memphis and anticipates terminating or
substantially restructuring the agreement. See "Business -- Contracts -- Case
Management Programs." While the Company does not anticipate that
the outcome of this arbitration will have a material adverse effect on the
Company's business, the Company cannot predict the outcome of this matter or
other potential related changes or outcomes, with any degree of certainty, and
such results could individually or in the aggregate have a material adverse
effect on the Company's business, financial condition and results of operations.

         Concentration of Revenues. For fiscal 1998, only one provider accounted
for more than 10% of the Company's revenue. In addition, although not attributed
to a particular "customer," the Case Management Programs accounted for 22.4% of
the Company's revenue for fiscal 1998. These programs were largely operated
under contracts with two managed care consortiums in the State of Tennessee and
management agreements with two case management agencies. A termination or
non-renewal of any of these contracts could have a material adverse effect on
the Company's business, financial condition and results of operations. See " --
Potential Changes in TennCare," "Management's Discussion and Analysis of
Financial Condition and Results of Operations," "Business --Programs and
Operations" -- Case Management Programs" and "Contracts -- Case Management
Programs."

         Limited Operating History of Case Management Programs. The operations
of the Company's Case Management Programs are subject to limited operating
history. Thus, the success of these programs will be dependent upon the
Company's ability to manage and expand operations effectively, control costs and
recognize operating efficiencies. By virtue of the lack of operating history,
there can be no assurance that the Company will be able to maintain these
operations at their current level or expand these programs in the future. See
"Risk Factors -- Potential Changes in TennCare," "-- Concentration of Revenues"
and "Business -- Programs and Operations" "-- Case Management Programs" and
"Contracts -- Case Management Programs."

          Government Regulation. Mental health care is an area subject to
extensive regulation and frequent changes in those regulations. Changes in the
laws or new interpretations of existing laws can have a significant effect on
the methods of doing business, costs of doing business and amounts of
reimbursement available from governmental and other payors. In addition, a
number of factors, including changes in the healthcare industry and the
availability of investigatory resources, have resulted in increased scrutiny,
inquiry and investigations by various federal and state regulatory agencies
relating to the operation of healthcare companies, including the Company. The
Company is and will continue to be subject to varying degrees of regulation, 
licensing, inquiry and investigation by 

                                      18.


<PAGE>   19
health or social service agencies and other regulatory and enforcement
authorities in the various states and localities in which it operates or intends
to operate. The Company's business is subject to a broad range of federal, state
and local requirements including, but not limited to, fraud and abuse laws,
licensing and certification standards, and regulations governing the scope and
quality of care. Violations of these requirements may result in civil and
criminal penalties and exclusions from participation in federal and state-funded
programs. The Company at all times attempts to comply with all such laws
including applicable Medicare and Medicaid regulations; however, there can be no
assurance that the expansion or interpretation of existing laws or regulations,
or the imposition of new laws or regulations, will not have a material adverse
effect on the Company's provider relationships or the Company's business,
financial condition and results of operations.

         The U.S. Department of Health and Human Services has established HCFA
to administer and interpret the rules and regulations governing the Medicare
program and the benefits associated therewith. Applicable Medicare guidelines
permit the reimbursement of contracted management services provided that, among
other things, the associated fees are "reasonable." As a general rule, Medicare
guidelines indicate that the costs incurred by a provider for contract
management services relating to furnishing Medicare-covered services are deemed
"reasonable" if the costs incurred are comparable with marketplace prices for
similar services. Although management believes that the Company's charges for
its services are comparable with marketplace prices for similar services, the
determination of reasonableness may be interpreted by HCFA or a fiscal
intermediary in a manner inconsistent with the Company's belief. Notwithstanding
the Company's belief, a determination that the Company's management fees may not
be "reasonable" may have a material adverse effect on the Company's business,
financial condition and results of operations.

         HCFA requires that partial hospitalization programs must meet certain
published criteria to qualify for Medicare funding, including that the partial
hospitalization services be reasonable and necessary for the diagnosis or
treatment of the patient's condition. The Medicare criteria for coverage,
specifically what is "reasonable and necessary" in particular cases, is a
subjective determination on which health care professionals may disagree.
Moreover, the fiscal intermediaries which administer the Medicare program and
evaluate and process claims for payment, establish local medical review policies
which may have a material adverse effect on the Company's results of operations.
Medicare does not always apply its "reasonable and necessary" standard
consistently, and that standard may be interpreted in the future in a manner
which is more restrictive than currently prevailing interpretations. Although
the Company and its providers have quality assurance and utilization review
programs to ensure that the partial hospitalization programs managed by the
Company are operating in compliance with the Company's understanding of all
Medicare coverage requirements, there can be no assurance that in the future
certain aspects of the Company's programs will not be found to have failed to
satisfy all applicable criteria for Medicare eligibility. See "Business --
Regulatory Matters -- Compliance With Medicare Guidelines; Reimbursement For
Partial Hospitalization Programs."

         In February 1998, the Company announced that an Outpatient Program that
it formerly managed in Dallas, Texas was the subject of a civil investigation
conducted by the U.S. Department of Health and Human Services' Office of
Inspector General and the U.S. Attorney's office in Dallas, Texas. The
investigation resulted from a HCFA review of certain partial hospitalization
services rendered by the program. As of July 27, 1998, no formal complaint,
demand, or additional request for information has been made by the investigating
agencies. The Company is unable to predict the impact, if any, on the Company's
business, financial condition or results of operations, which may result from
the investigation or any claim or demand which may arise therefrom. See
"Business -- Regulatory Matters -- False Claims Investigations And Enforcement
Of Health Care Fraud Laws."

         The Company was informed that a qui tam suit had been filed by a former
employee of the Company against a subsidiary of the Company. The Company is
unable to predict the impact, if any, that the claim and ultimate resolution
thereof may have on the Company's business, financial condition or results of
operations. See "Item 3. Legal Proceedings."

         Historically, CMHCs, unlike hospitals, were not surveyed by a Medicare
contractor before being permitted to participate in the Medicare program.
However, HCFA is now in the process of surveying all CMHCs to confirm that they
meet all applicable Medicare conditions for furnishing partial hospitalization
programs. Management believes that all the CMHCs that contract with the Company
should be found in compliance with the applicable requirements. However, there
can be no assurance that some CMHCs contracting with the Company will not be


                                      19.


<PAGE>   20
terminated from the Medicare program or that the government will not attempt to
recover payments made to such CMHCs for services, including payments relating to
the Company's services, which had been furnished and paid for by Medicare. See
"Business -- Regulatory Matters."

         Risks Associated with Acquisitions. The Company currently intends as
part of its business strategy to pursue acquisitions of complementary businesses
as it seeks to compete in the rapidly changing healthcare industry. Acquisitions
involve numerous risks, including difficulties in assimilation of the operations
and personnel of the acquired business, the integration of management
information and accounting systems of the acquired business, the diversion of
management's attention from other business concerns, risks of entering markets
in which the Company has no direct prior experience, and the potential loss of
key employees of the acquired business. The Company's management will be
required to devote substantial time and attention to the integration of any such
businesses and to any material operational or financial problems arising as a
result of any such acquisitions. There can be no assurance that operation or
financial problems will not occur as a result of any such acquisitions. Failure
to effectively integrate acquired businesses could have a material adverse
effect on the Company's business, financial condition and results of operations.

         The Company intends to continue to evaluate potential acquisitions of,
or investments in, companies which the Company believes will complement or
enhance its existing business. Future acquisitions by the Company may result in
potentially dilutive issuances of equity securities, the incurrence of
additional debt and amortization expenses related to goodwill and other
intangible assets which could adversely affect the Company's business, financial
condition and results of operations. There can be no assurance that the Company
will consummate any acquisition in the future or if consummated, that any such
acquisition will ultimately be beneficial to the Company.


         Management of Rapid Growth. The Company expects that its outpatient
psychiatric management services business and the number of its Outpatient, Case
Management and Chemical Dependency Programs may increase significantly as it
pursues its growth strategy. If it materializes, this rapid growth will place
significant demands on the Company's management resources. The Company's ability
to manage its growth effectively will require it to continue to expand its
operational, financial and management information systems, and to continue to
attract, train, motivate, manage and retain key employees. If the Company is
unable to manage its growth effectively, its business, financial condition and
results of operations could be adversely affected.

         Dependence on Key Personnel. The Company depends, and will continue to
depend, upon the services of its current senior management for the management of
the Company's operations and the implementation of its business strategy. In
addition, the Company's success is also dependent upon its ability to attract
and retain additional qualified management personnel to support the Company's
growth. The loss of the services of any or all such individuals or the Company's
inability to attract additional management personnel in the future may have a
material adverse effect on the Company's business, financial condition and
results of operations. The Company presently has no employment agreements with
any of its senior executive officers.

         The Company's success and growth strategy also will depend on its
ability to attract and retain qualified clinical, marketing and other personnel.
The Company competes with general acute care hospitals and other health care
providers for the services of psychiatrists, psychologists, social workers,
therapists and other clinical personnel. Demand for such clinical personnel is
high and they are often subject to competing offers. There can be no assurance
that the Company will be able to attract and retain the qualified personnel
necessary to support its business in the future. Any such inability may have a
material adverse effect on the Company's business, financial condition and
results of operations.

         Competition. In general, the operation of psychiatric programs is
characterized by intense competition. General, community and specialty
hospitals, including national companies and their subsidiaries, provide many
different health care programs and services. The Company anticipates that
competition will become more intense as pressure to contain the rising costs of
health care continues to intensify, particularly as programs such as those
operated by the Company are perceived to help contain mental health care costs.
Many other companies engaged in the management of outpatient psychiatric
programs compete with the Company for the establishment of affiliations with
acute care hospitals. Furthermore, while the Company's existing competitors in
the case management business are predominantly not-for-profit CMHCs and case
management agencies, the Company anticipates that other health care management
companies will eventually compete for this business. Many of these present and
future 

                                      20.

<PAGE>   21
competitors are substantially more established and have greater financial
and other resources than the Company. In addition, the Company's current and
potential providers may choose to operate mental health programs themselves
rather than contract with the Company. There can be no assurance that the
Company will be able to compete effectively with its present or future
competitors, and any such inability could have a material adverse effect on the
Company's business, financial condition and results of operations.

         The specialty pharmacy business is intensely competitive. There are
numerous local, regional and national companies which can dispense
pharmaceuticals locally or through the mail. There are also numerous companies
which provide lab work and analysis services necessary for blood monitoring.
Many of these companies have substantially greater resources than Stadt
Solutions. While the Company believes that Stadt Solutions will be the first
specialty pharmacy company to focus on SMI and further believes that Stadt 
Solutions will offer value added disease management services not typically 
provided by competitors, there can be no assurance that Stadt Solutions will 
be able to compete successfully with its present or future competitors.

         Availability and Adequacy of Insurance. The provision of mental health
care services entails an inherent risk of liability. In recent years,
participants in the industry have become subject to an increasing number of
lawsuits alleging malpractice or related legal theories, many of which involve
large claims and significant defense costs. The Company currently maintains
annually renewable liability insurance intended to cover such claims and the
Company believes that its insurance is in conformity with industry standards.
There can be no assurance, however, that claims in excess of the Company's
insurance coverage or claims not covered by the Company's insurance coverage
(e.g., claims for punitive damages) will not arise. A successful claim against
the Company not covered by, or in excess of, the Company's insurance coverage
could have a material adverse effect upon the Company's business, financial
condition and results of operations. In addition, claims asserted against the
Company, regardless of their merit or eventual outcome, could have a material
adverse effect upon the Company's reputation and ability to expand its business,
and could require management to devote time to matters unrelated to the
operation of the Company's business. There can be no assurance that the Company
will be able to obtain liability insurance coverage on commercially reasonable
terms in the future or that such insurance will provide adequate coverage
against potential claims.

          Shares Eligible For Sale. Sales by holders of substantial amounts of
Common Stock could adversely affect the prevailing market price of the Common
Stock. The number of shares of Common Stock available for sale in the public
market is limited by restrictions under the Securities Act of 1933, as amended
(the "Securities Act"), including Rule 144 ("Rule 144") under the Securities
Act. As of July 24, 1998, the Company had 6,959,810 shares of Common Stock
outstanding. Of these shares, the officers and directors of the Company and
their affiliates own 2,172,420 shares and may acquire up to 768,175 shares that
may be issued upon the exercise of outstanding stock options and warrants. These
outstanding shares and shares issued upon the exercise of the options and
warrants are considered "restricted securities" and may be sold, subject to the
volume limitations under Rule 144.

         Possible Volatility of Stock Price. The market price of the Common
Stock could be subject to significant fluctuations in response to various
factors and events, including, but not limited to, the liquidity of the market
for the Common Stock, variations in the Company's quarterly results of
operations, revisions to existing earnings estimates by research analysts and
new statutes or regulations or changes in the interpretation of existing
statutes or regulations affecting the health care industry generally or mental
health services in particular, some of which are unrelated to the Company's
operating performance. In addition, the stock market in recent years has
generally experienced significant price and volume fluctuations that often have
been unrelated to the operating performance of particular companies. These
market fluctuations also may adversely affect the market price of the Common
Stock.

         Concentration of Ownership, Anti-Takeover Provisions. The officers and
directors of the Company and their affiliates own over 20% of the Company's
issued and outstanding Common Stock (and over 30% including shares issuable upon
currently exercisable stock options and warrants). Although the officers and
directors do not have any arrangements or understandings among themselves with
respect to the voting of the shares of Common Stock beneficially owned by such
persons, such persons acting together could elect a majority of the Company's
Board of Directors and control the Company's policies and day-to-day management.
The Company's Board of Directors has the authority, without action by the
stockholders, to issue shares of preferred stock and to fix the rights and
preferences of such shares. The ability to issue shares of preferred stock,
together with certain provisions of Delaware law and certain provisions of the
Company's Restated Certificate of Incorporation, such as staggered 

                                      21.
<PAGE>   22
terms for directors, limitations on the stockholders' ability to call a meeting
or remove directors and the requirement of a two-thirds vote of stockholders for
amendment of certain provisions of the Restated Certificate of Incorporation or
approval of certain business combinations, may delay, deter or prevent a change
in control of the Company, may discourage bids for the Common Stock at a premium
over the market price of the Common Stock and may adversely affect the market
price of, and the voting and other rights of the holders of, the Common Stock.

         Year 2000 Compliance. The year 2000 issue is the result of computer
applications being written using two digits rather than four to define the
applicable year. Computer applications may recognize a date using "00" as the
year 1900 rather than the year 2000, resulting in system failures or
miscalculations causing disruption of operations. The Company has reviewed its
material computer applications for year 2000 compliance and is working with
vendors and suppliers to make its computer applications year 2000 compliant.
However, if any such corrections cannot be completed on a timely basis, the year
2000 issue could have a material adverse impact on the Company's business,
financial condition and results of operations. Because of the many uncertainties
associated with year 2000 compliance issues, and because the Company's
assessment is necessarily based on information from third party vendors and
suppliers, there can be no assurance that the Company's assessment is correct or
as to the materiality or effect of any failure of such assessment to be correct.

         The Company has not determined whether and to what extent computer
applications of contract providers and Medicare and other payors will be year
2000 compliant. In addition, the Company has not determined the extent to which
any disruption in the billing practices of providers or the payment practices of
Medicare or other payors caused by the year 2000 issues will affect the
Company's operations. However, any such disruption in the billing or
reimbursement process could have a substantial adverse impact on Medicare or
Medicaid payments to providers and, in turn, payments to the Company. Any such
disruption could have a material adverse effect upon the Company's business,
financial condition and results of operations. See "Management's Discussion And
Analysis of Financial Condition And Results of Operations -- Impact of Year 2000
Computer Issues."

ITEM 2.  PROPERTIES

         The Company owns no real property, but currently leases and subleases
approximately 205,000 square feet comprised of (i) a lease for the Company's
corporate headquarters expiring on April 3, 2002, (ii) two leases for regional
administration offices expiring in July 2001 and September 2001, respectively,
and (iii) thirty (30) leases for program sites, averaging three years duration,
none of which extend beyond 2002. The Company carries property and liability
insurance where required by lessors and sublessors. The Company believes that
its facilities are adequate for its short term needs. Leases and sub-leases,
other than the short-term and month-to-month leases, generally provide for
annual rental adjustments which are either indexed to inflation or have been
agreed upon, and typically provide for termination on not less than ninety (90)
days' written notice.

ITEM 3.  LEGAL PROCEEDINGS

         In February 1998, the Company announced that it had been informed that
the Outpatient Program that it formerly managed in Dallas, Texas is the subject
of a civil investigation being conducted by the U.S. Department of Health and
Human Services' Office of inspector General and the U.S. Attorney's office in
Dallas, Texas (collectively the "Agencies").  The investigation resulted from a
HCFA review of the eligibility for payment under Medicare's coverage guidelines
of certain partial hospitalization services rendered by the program. As of July
27, 1998, no formal complaint, demand, or additional request for information has
been made by the investigating agencies.

         A representative of the Agencies has indicated that the investigation
is civil in nature and focuses on eligibility of patients for partial
hospitalization services. The eligibility determinations for participation at
the Dallas program were made by board certified or board eligible psychiatrists.
The Company is cooperating fully with the Agencies.

         Due to the preliminary nature of the investigation, the Company is
unable to predict the ultimate outcome of the investigation, or the material
impact, if any, on the Company's business, financial condition or results of
operations. See "Risk Factors -- Government Regulation."


                                      22.


<PAGE>   23
         The Company is engaged in disputes with TBH regarding certain payments
made to the Company for case management services provided by the case management
agencies. TBH has made a claim based on a sample audit, for approximately $4.2
million relating to payments made to the Company for case management services.
The Company believes that the claim is without merit and is in the process of
discussing the issue with TBH. The matter may be referred to arbitration if the
parties do not resolve the dispute.

         The Company is engaged in arbitration with a case management agency in
Memphis regarding disputes involving the management and affiliation agreement.
The Company cannot predict the outcome of the arbitration. The Company expects
to terminate or restructure substantially the relationship with the case
management agency in fiscal 1999. See "Risk Factors -- Potential Changes in
TennCare."

         A qui tam suit has been filed by Anastasios Giorgiadis, a former
employee of the Company, against a subsidiary of the Company in Federal District
Court in the Southern District of California. This suit was filed under seal and
the Company was first informed of it on July 20, 1998. The suit alleges a broad
range of improper conduct relating to the quality of services furnished by the
Company, the medical necessity of the services furnished by the Company, and the
accuracy of billing for services furnished by the Company and by physicians who
admit patients to the programs managed by the Company, and other matters. The
suit was filed by a former employee who previously had filed a separate action
for wrongful termination. The Company prevailed in that wrongful termination
case when the court dismissed the case by granting the Company's motion for
summary judgment. The allegations in the wrongful termination case were very
similar to the allegations in the pending qui tam case. Notwithstanding the
similarity between the allegations in the wrongful termination case and the qui
tam case, the Company cannot give any assurances with respect to the ultimate
outcome of the qui tam case or its effect on the Company's business, financial
condition or results of operations. 

         Under the False Claims Act, the Department of Justice must inform the
court whether it will intervene and take control of the qui tam suit. In this
case, the Department of Justice has not yet made that decision, but rather is
conducting an investigation. The Company has met with the Assistant United
States Attorney who is coordinating the government's investigation of this case,
and the Company has agreed to furnish certain documentation to the government.
The Company is unable to predict the impact, if any, on the Company's business,
financial condition, or results of operations which may result from the
investigation, or any claims which may arise therefrom. See "Risk Factors --
Government Regulation."

         The Company is not a party to any other material legal proceedings
required to be reported hereunder.

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

         The Company held a special meeting of the stockholders on March 5, 1998
to approve an amendment to the Company's Restated Certificate of Incorporation
(the "Restated Certificate") to increase the authorized number of shares of
Common Stock and to clarify certain provisions of the Restated Certificate
relating to the Board of Directors' authority to issue preferred stock, the
limitation of directors' personal liability under the Delaware General
Corporation Law and indemnification of officers, directors, employees and agents
of the Company (collectively the "Amendment").

         The Amendment was approved with 4,927,085 votes in favor, 93,335 votes
against and 32,448 abstentions.


                                      23.
<PAGE>   24


ITEM 4A. EXECUTIVE OFFICERS OF THE COMPANY

         The executive officers of the Company and their ages and positions at
April 30, 1998, are as follows:
<TABLE>
<CAPTION>
NAME                                  AGE          POSITION
----                                  ---          --------
<S>                                   <C>    <C>                       
Allen Tepper....................      50     Chief Executive Officer

Fred D. Furman..................      50     President

Mark P. Clein...................      39     Executive Vice President and Chief
                                             Financial Officer

Susan D. Erskine................      46     Executive Vice President-
                                             Development, Secretary and 
                                             Director

Daniel L. Frank.................      41     President of Disease Management 
                                             Division

Charles E. Galetto..............      47     Senior Vice President - Finance and
                                             Treasurer 
</TABLE>

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

         Allen Tepper co-founded the Company in 1988, has served as Chairman and
Chief Executive Officer of the Company since October 1989 and previously served
as President from October 1989 to April 1997. Mr. Tepper co-founded Consolidated
Medical Corp., which was engaged in out-patient clinic management for acute care
hospitals in the Philadelphia area. The company was subsequently sold to the
Berwind Corporation in 1984 and Mr. Tepper remained with the company until
December 1986 as Senior Vice President. Mr. Tepper holds a Masters of Business
Administration degree from Northwestern University and a Bachelors degree from
Temple University.

         Fred D. Furman has served as President of the Company since April 1997.
Previously, he held the position of Executive Vice President -- Administration
and General Counsel from March 1995 to April 1997. Prior to joining the Company,
Mr. Furman was a partner at Kleinbard, Bell and Brecker, a Philadelphia law firm
from 1980 to March 1995. Mr. Furman is a member of the National Health Lawyers
Association. He holds a Juris Doctor degree and a Bachelors degree from Temple
University.

         Mark P. Clein has served as Executive Vice President and Chief
Financial Officer of the Company since May 1996. Prior to joining the Company,
Mr. Clein was a Managing Director of Health Care Investment Banking for
Jefferies & Co., an investment banking firm, from August 1995 to May 1996, a
Managing Director of Rodman & Renshaw, Inc., an investment banking firm, from
March 1995 to August 1995, a Managing Director of Mabon Securities Corp., an
investment banking firm, from March 1993 to March 1995, a Vice President with
Sprout Group, an affiliate of Donaldson, Lufkin and Jenrette, Inc., from May
1991 to March 1993, and a Vice President and partner with Merrill Lynch Venture
Capital, Inc. from 1982 to February 1990 and from August 1990 to February 1991.
Mr. Clein holds a Masters of Business Administration degree from Columbia
University and a Bachelors degree from the University of North Carolina.

         Susan D. Erskine co-founded the Company in 1988 and has served as
Executive Vice President, Secretary and a director of the Company since October
1989. Ms. Erskine previously served in several operational and marketing
management positions with acute care hospitals and health care management
organizations. Ms. Erskine holds a Masters in Health Science degree and
completed post-graduate work at Stanford University in Education and Psychology,
and she holds a Bachelors degree from the University of Miami.

         Daniel L. Frank has served as President of the Disease Management
division of the Company since April 1998. This division is responsible for the
development of Stadt Solutions and its integrated managed care initiative. Mr.
Frank has also served as a director of the Company since 1992. Previously, Mr.
Frank was President of Coram Healthcare's Lithotripsy division from 1996 until
its sale in 1997. Prior to that, Mr. Frank was Chief Executive Officer of
Western Medical Center - Anaheim and Santa Ana Health, Inc. from 1993 to 1996.
From 1991 to 1993, he was President of Summit Ambulatory Network.

                                      24.
<PAGE>   25

         Charles E. Galetto has served as Senior Vice President-Finance and
Treasurer of the Company since August 1997. Prior to joining the Company, Mr.
Galetto was Vice President-Corporate Controller of Medtrans, a medical
transportation company, from June 1996 to July 1997 and Vice President, Chief
Financial Officer, Treasurer and Secretary of Data/Ware Development, Inc., a
computer hardware and software developer, from 1989 to May 1996. Mr.
Galetto holds a Bachelors degree from Wayne State University.

                                     PART II

ITEM 5. MARKET PRICE OF AND DIVIDENDS ON THE COMPANY'S COMMON EQUITY AND RELATED
        STOCKHOLDER MATTERS

(a)     MARKET INFORMATION

         The Company's Common Stock (NASDAQ symbol "PMRP") is traded publicly
through the NASDAQ National Market System. The following table represents
quarterly information on the price range of the Company's Common Stock. This
information indicates the high and low sale prices reported by the NASDAQ
National Market System. These prices do not include retail markups, markdowns or
commissions:
<TABLE>
<CAPTION>
QUARTERS FOR THE YEAR ENDED APRIL 30, 1998                  HIGH              LOW
                                                            ----              ---
<S>                                                         <C>              <C>   
         FIRST QUARTER                                      $24.13           $16.88
         SECOND QUARTER                                     $24.50           $19.13
         THIRD QUARTER                                      $23.63           $17.00
         FOURTH QUARTER                                     $19.50           $10.50

QUARTERS FOR THE YEAR ENDED APRIL 30, 1997

         FIRST QUARTER                                      $15.50           $8.50
         SECOND QUARTER                                     $35.25           $14.13
         THIRD QUARTER                                      $31.44           $20.25
         FOURTH QUARTER                                     $29.75           $16.75
</TABLE>


(b)       HOLDERS

         As of July 23, 1998 there were 89 holders of record of the Company's
Common Stock.

(c)      DIVIDENDS

         It is the policy of the Company's Board of Directors to retain earnings
to support operations and to finance continued growth of the Company rather than
to pay dividends. The Company has never paid or declared any cash dividends on
its Common Stock and does not anticipate paying any cash dividends in the
foreseeable future. The Company's credit facility contains certain restrictions
and limitations, including the prohibition against payment of dividends on
Common Stock.

(d)      RECENT SALES OF UNREGISTERED SECURITIES

         From May 1, 1997 to April 30, 1998, the Company has sold and issued
(without payment of any selling commission to any person) the following
unregistered securities:

         On May 1, 1997, the Company issued a Warrant to purchase up to 5,000
shares of Common Stock to each of Case Management, Inc. and Mental Health
Cooperative, Inc. in connection with Management and Affiliation Agreements with
each of them. The Warrants were issued in connection with services provided
under Management and Affiliation Agreements, based on the program's satisfaction
of certain revenue-based threshold requirements. Each Warrant is exercisable for
5 years at an exercise price equal to the average closing price of the
Company's common

                                      25.


<PAGE>   26

stock on the Nasdaq National Market for the 10 trading days prior to April 30,
1997 (subject to adjustment upon certain events as described in the Warrants.)
The proceeds to be received, if any, upon exercise of the warrant are
anticipated to be used for operating capital. The issuance of the Warrants were
deemed to be exempt from registration under the Securities Act by virtue of
Section 4(2) thereunder.

ITEM 6.  SELECTED FINANCIAL DATA

         The following selected financial data should be read in conjunction
with the Company's consolidated financial statements and the accompanying notes
included elsewhere herein.
<TABLE>
<CAPTION>

                                                        YEARS ENDED APRIL 30
                                   ----------------------------------------------------------------
                                     1998          1997         1996          1995           1994
                                   -------      --------      -------       --------       --------
                                              (in thousands, except per share amounts)

<S>                               <C>           <C>           <C>           <C>            <C>     
INCOME STATEMENT INFORMATION
Revenues                          $ 67,524      $ 56,637      $ 36,315      $ 21,747       $ 22,786
Net Income (loss)                    1,458         3,107           918        (2,352)           825
Net Income (loss) per share
  Basic                                .24           .66           .26          (.71)           .25
  Diluted                              .22           .55           .23          (.71)           .25

WEIGHTED SHARES OUTSTANDING
  Basic                              6,053         4,727         3,484         3,336          3,228
  Diluted                            6,695         5,646         4,471         3,336          3,347
</TABLE>


<TABLE>
<CAPTION>
                                                            AS OF APRIL 30
                                   ----------------------------------------------------------------
                                     1998          1997         1996          1995           1994
                                   -------      --------      -------       --------       --------
<S>                               <C>           <C>           <C>           <C>            <C>     
BALANCE SHEET INFORMATION
Working Capital                   $ 51,820      $ 17,036      $ 10,911      $  8,790       $  7,705
Total Assets                        70,449        32,450        21,182        14,811         13,671
Long Term Debt                         392             0             0           126            320
Total Liabilities                   16,903        16,202        12,070         7,749          5,972
Stockholders' Equity                53,546        16,248         9,112         7,062          7,699

</TABLE>
<TABLE>
<CAPTION>

                                                        QUARTERS FOR THE YEARS ENDED
                         ------------------------------------------------------------------------------------------------------
                                        APRIL 30, 1998                                          APRIL 30, 1997
                         ------------------------------------------------       -----------------------------------------------
                           7/31/97      10/31/97      1/31/98     4/30/98        7/31/96     10/31/96      1/31/97      4/30/97
                         ---------      --------      -------     -------        -------     --------      -------      -------
                                                  (in thousands, except per share amounts)

<S>                       <C>           <C>          <C>          <C>           <C>          <C>          <C>          <C>   
REVENUES                    16,177       17,561       16,522       17,264        13,028       14,293       14,190       15,126
NET INCOME (LOSS)              970        1,162        1,327       (2,001)          583          799          831          894
NET INCOME (LOSS) PER
SHARE
  Basic                        .19          .22          .19         (.29)          .14          .16          .17          .19
  Diluted                      .17          .19          .18         (.29)          .12          .14          .14          .15
</TABLE>


                                      26.
<PAGE>   27


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
        OF OPERATIONS

         The following discussion should be read in conjunction with the more
detailed information and consolidated financial statements and accompanying
notes, as well as the other financial information appearing elsewhere in this
document. Except for historical information, the following discussion contains
forward-looking statements that involve risks and uncertainties. The Company's
actual results could differ materially from those discussed herein. Factors that
could cause or contribute to such differences include, but are not limited to,
those discussed in "Risk Factors," as well as those discussed elsewhere in this
document.

OVERVIEW

         PMR is a leading manager of specialized mental health care programs and
disease management services designed to treat individuals diagnosed with SMI.
PMR manages the delivery of a broad range of outpatient and community-based
psychiatric services for SMI patients, consisting of 37 Outpatient Programs, two
Case Management Programs and four Chemical Dependency Programs. Stadt Solutions,
upon formation, will offer a specialty pharmacy program for individuals with
SMI, initially serving approximately 6,000 individuals through fourteen
pharmacies in thirteen states. Stadt Solutions will also receive the Company's
clinical research and information business upon formation. Including Stadt
Solutions, PMR will operate in approximately twenty-three states and is expected
to employ or contract with more than 400 mental health and pharmaceutical
professionals and provide services to approximately 11,000 individuals diagnosed
with SMI. PMR believes it is the only private sector company focused on 
providing an integrated mental health disease management model to the SMI 
population.

         PMR's Outpatient Programs serve as a comprehensive alternative to
inpatient hospitalization and include partial hospitalization and lower
intensity outpatient services. The Case Management Programs provide an
intensive, individualized primary care service which consists of a proprietary
case management model utilizing clinical protocols for delivering care to SMI
patients. The Company also provides Chemical Dependency Programs to patients
affiliated with managed care organizations and government-funded programs.

SOURCES OF REVENUE

         Outpatient Programs. Outpatient Programs operated by PMR are the
Company's primary source of revenue. Revenue under these programs is derived
primarily from services provided under three types of agreements: (i) an
all-inclusive fee arrangement based on fee-for-service rates which provides that
the Company is responsible for substantially all program costs; (ii) a
fee-for-service arrangement under which substantially all program costs are the
responsibility of the provider; and (iii) a fixed fee arrangement. The
all-inclusive arrangements are in effect at 34 of the 39 Outpatient Programs
operated during fiscal 1998 and constituted 62.4% of the Company's revenue for
the year ended April 30, 1998. Typical contractual agreements with these
providers, primarily acute care hospitals or CMHCs, require the Company to
provide, at its own expense, specific management personnel for each program
site. Patients served by the Outpatient Programs typically are covered by
Medicare.

         Revenue under the Outpatient Program is recognized at estimated net
realizable amounts when services are rendered based upon contractual
arrangements with providers. Under certain of the Company's contracts, the
Company is obligated to indemnify the provider for all or some portion of the
Company's management fees that may not be deemed reimbursable to the provider by
Medicare's fiscal intermediaries. As of April 30, 1998, the Company had recorded
$7.5 million in contract settlement reserves to provide for possible amounts
ultimately owed to its provider customers resulting from disallowance of costs
by Medicare and Medicare cost report settlement adjustments. Such reserves are
classified as non-current liabilities because ultimate determination of
substantially all of the potential contract disallowances is not anticipated to
occur during fiscal 1998. See "Risk Factors -- Dependence Upon Medicare
Reimbursement" and "-- Sufficiency of Existing Reserves to Cover Reimbursement
Risks."

         Case Management Programs. For its Case Management Programs in
Tennessee, the Company receives a monthly case rate payment from the managed
care consortiums responsible for managing the TennCare program and is
responsible for planning, coordinating and managing psychiatric case management
services for its consumers who are eligible to participate in the TennCare
program. The Company also is responsible for providing a portion of the 

                                      27.


<PAGE>   28
related outpatient clinical care under certain of the agreements. Revenue under
the TennCare program is recognized in the period in which the related service is
to be provided. These revenues represent substantially all of the Company's case
management revenues. The urgent care program receives interim payments which are
adjusted based on inpatient utilization statistics which are compared to a
baseline. Revenues are recognized based on the quarterly calculation of the
statistical trends. See "Risk Factors -- Potential Changes in TennCare," "--
Concentration of Revenues" and "-- Limited Operating History of Case Management
Programs."

         Chemical Dependency Programs. In Southern California, the Company
contracts primarily with managed care companies and commercial insurers to
provide its outpatient chemical dependency services. The contracts are
structured as fee-for-service or case rate reimbursement and revenue is
recognized in the period in which the related service is delivered. In Arkansas,
the Company managed detoxification and dual diagnosis programs for individuals
eligible for public sector reimbursement. The Company generated revenue based on
a combination of state-funded grants and Medicaid fee-for-service reimbursement.
Revenue was recognized in the period in which the related service was delivered.
The Arkansas programs were terminated as of June 30, 1998.

RESULTS OF OPERATIONS

         The following table sets forth, for the periods indicated, the
percentage of revenue represented by the respective financial items:
<TABLE>
<CAPTION>

                                                   YEAR ENDED APRIL 30,
                                             -------------------------------
                                             1998         1997          1996
                                             ----         ----         -----
<S>                                          <C>          <C>          <C>   
Revenue..................................... 100.0%       100.0%       100.0%
Operating expenses..........................  71.5         73.7         78.4
Marketing, general and administrative.......  13.6         10.7         11.1
Provision for bad debts.....................   7.6          5.4          4.0
Depreciation and amortization...............   1.6          1.2          1.6
Special Charge                                 3.8          -            -
Interest (income), expense..................  (1.8)        (0.4)         0.0
                                             ----          ----         ----
Total expenses..............................  96.3         90.6         95.1
                                             -----         ----         ----
Income before income taxes                     3.7%         9.4%         4.9%
                                             =====         ====         ====
</TABLE>

YEAR ENDED APRIL 30, 1998 COMPARED TO YEAR ENDED APRIL 30, 1997

         REVENUE. Revenue increased from $56.6 million for the year ended April
30, 1997 to $67.5 million for the year ended April 30, 1998, an increase of
$10.9 million, or 19.2%. The Outpatient Programs recorded revenue of $49.4
million, an increase of 23.5% as compared to fiscal 1997. The growth in
Outpatient Programs was the result of the addition of nine new programs in
fiscal 1998 and increases in "same-site" revenues of 11.7% compared to fiscal
1997. The remainder of the increase in revenue came from the growth in Case
Management Programs in Tennessee and Arkansas, which recorded revenue of $15.1
million, an increase of $1.4 million or 10.4% as compared to fiscal 1997.
Revenue from the Chemical Dependency Programs was $3.0 million, an increase of
1.0% as compared to fiscal 1997. The Company is currently in the process of
terminating or restructuring its relationship with a Tennessee case management
agency and during fiscal 1998 terminated its Arkansas Case Management Programs.
See "Business -- Programs and Operations -- Case Management Programs."

         OPERATING EXPENSES. Operating expenses consist of costs incurred at the
program sites and costs associated with the field management responsible for the
administering the programs. Operating expenses increased from $41.7 million for
the year ended April 30, 1997 to $48.2 million for the year ended April 30,
1998, an increase of $6.5 million, or 15.6%. As a percentage of revenue,
operating expenses were 71.5%, down from 73.7% for the year ended April 30,
1997. The improvement in the operating expense ratio was due to reductions in
certain 

                                      28.
<PAGE>   29
expenses as well as operating leverage realized as a result of revenue growth in
the Outpatient and Case Management Programs which was spread across existing
fixed and semi-variable cost structures.

         MARKETING, GENERAL AND ADMINISTRATIVE. Marketing, general and
administrative expenses increased from $6.0 million for the year ended April 30,
1997 to $9.2 million for the year ended April 30, 1998, an increase of $3.2
million, or 53.3%. The increase was due to investment in both the regional and
home offices to support existing and anticipated programs. As a percentage of
revenue, marketing, general and administrative expenses were 13.6% for the year
ended April 30, 1998, as compared to 10.7% for the year ended April 30, 1997.

         PROVISION FOR BAD DEBTS. Provision for bad debt expense increased from
$3.1 million for the year ended April 30, 1997 to $5.1 million for the year
ended April 30, 1998, an increase of $2.0 million, or 64.5%. The increase was
due to anticipated difficulties associated with collection of receivables
relating to program locations closed in the fourth quarter of fiscal 1998. As
part of a special charge in the fourth quarter of fiscal 1998, the Company
recorded approximately $2.4 million in additional bad debt expenses associated
with the closed programs.

         SPECIAL CHARGE. A Special Charge of $5.0 million was recorded in the
fourth quarter to provide for costs associated with closing several programs,
resolving the provider based status associated with the Scripps Health programs
and resolving other regulatory matters. Included in this charge is a $2.4
million bad debt expense which was recorded in provision for bad debts. The
remaining $2.6 million was allocated to program closing costs which were $1.4
million and costs associated with noncancelable contract obligations which were
$1.2 million.

         DEPRECIATION AND AMORTIZATION. Depreciation and amortization expense
increased from $701,000 for the year ended April 30, 1997 to $1,065,000 for the
year ended April 30, 1998, an increase of $364,000 or 51.9%. The increase was
due to additional capital expenditures associated with the start-up of new
programs during fiscal 1998 and as well as equipment and leasehold improvements
associated with the Company's corporate office.

         INTEREST (INCOME), EXPENSE. Interest income increased from $217,000 for
the year ended April 30, 1997 to $1,187,000 for the year ended April 30, 1998,
an increase of $970,000 or 447.0%. This increase resulted from higher cash and
cash equivalent and short-term investment balances resulting from the completion
of the Company's common stock offering in October 1997.

         INCOME BEFORE INCOME TAXES. Income before income taxes decreased from
$5.3 million for the year ended April 30, 1997 to $2.5 million for the year
ended April 30, 1998, a decrease of $2.8 million, or 52.8%. Income before income
taxes as a percentage of revenue decreased from 9.4% to 3.7% over this period of
time.

YEAR ENDED APRIL 30, 1997 COMPARED TO YEAR ENDED APRIL 30, 1996

         REVENUE. Revenue increased from $36.3 million for the year ended April
30, 1996 to $56.6 million for the year ended April 30, 1997, an increase of
$20.3 million, or 56.0%. The Outpatient Programs recorded revenue of $40.0
million, an increase of 49.3% as compared to fiscal 1996. This increase was the
result of same-site increases in revenue of 40.0% compared to fiscal 1996 and
the gross addition of eight new programs in fiscal 1997. The remainder of the
increase in revenue came predominantly from the growth in Case Management
Programs in Tennessee and the introduction of Case Management Programs in
Arkansas, which recorded revenue of $13.7 million, an increase of 80.3% as
compared to fiscal 1996. Revenue from the Chemical Dependency Programs was $2.9
million, an increase of 54.4% as compared to fiscal 1996. This increase was
attributable to a full year of operation of the Little Rock public sector
program in Arkansas and to growth in the managed care business in California.

         OPERATING EXPENSES. Operating expenses increased from $28.5 million for
the year ended April 30, 1996 to $41.7 million for the year ended April 30,
1997, an increase of $13.2 million, or 46.3%. Of this increase, $5.4 million, or
40.9%, resulted from the effect of a full year of operations of the Case
Management Programs in Tennessee and the launch of the Case Management Programs
in Arkansas. The remainder of the increase in operating expenses was associated
primarily with increased costs to support the revenue growth at existing
Outpatient Programs and the net addition of six Outpatient Programs during
fiscal 1997.

                                      29.
<PAGE>   30


         MARKETING, GENERAL AND ADMINISTRATIVE. Marketing, general and
administrative expenses increased from $4.0 million for the year ended April 30,
1996 to $6.0 million for the year ended April 30, 1997, an increase of $2.0
million, or 50.0%. The increase was related to the following factors: (i) the
reorganization of the Company into three regions; (ii) the significant
investment in the Mid-America region to prepare for anticipated growth
associated with an enabling agreement with Columbia/HCA Healthcare Corporation;
(iii) the start-up of the site management and clinical information initiative;
and (iv) increases in personnel associated with information systems, development
and utilization review.

         PROVISION FOR BAD DEBTS. Provision for bad debt expense increased from
$1.4 million for the year ended April 30, 1996 to $3.1 million for the year
ended April 30, 1997, an increase of $1.7 million, or 121.4%. This increase was
due to an increase in the percentage for bad debt from 4.0% in fiscal 1996 to
5.4% in fiscal 1997, which resulted in part from higher rates of indigent
clients in the Case Management Programs, limited collection experience in the
Case Management Programs and in the Chemical Dependency Programs in Arkansas,
and a more conservative percentage for denials by third-party payors.

         DEPRECIATION AND AMORTIZATION. Depreciation and amortization expense
increased from $596,000 for the year ended April 30, 1996 to $701,000 for the
year ended April 30, 1997, an increase of $105,000, or 17.6%. The increase was
due to additional capital expenditures associated with the start-up of eight new
Outpatient Programs and increased capital expenditures for information systems.

         INTEREST (INCOME), EXPENSE. Interest expense decreased from $2,000 for
the year ended April 30, 1996 to interest income of $217,000 for the year ended
April 30, 1997, an increase of $219,000. The improvement was due to higher cash
and cash equivalent balances and the absence of bank debt in fiscal 1997.

         INCOME BEFORE INCOME TAXES. Income before income taxes increased from
$1.8 million for the year ended April 30, 1996 to $5.3 million for the year
ended April 30, 1997, an increase of $3.5 million, or 194.4%. Income before
income taxes as a percentage of revenue increased from 4.9% to 9.4% over this
period of time.

LIQUIDITY AND CAPITAL RESOURCES

         For the year ended April 30, 1998, net cash used in operating
activities was $3.0 million. Working capital at April 30, 1998 was $51.8
million, an increase of $34.8 million, or 204.2%, as compared to working capital
at April 30, 1997. Cash and cash equivalents and short-term investments at April
30, 1998 were $38.8 million, an increase of $28.7 million, or 286.0% as compared
to April 30, 1997. The increase in working capital, cash and cash equivalents
and short-term investments was due to the completion of a public offering of
shares of common stock of the Company during October 1997, which resulted in net
proceeds of $33.1 million, which was offset by cash used to finance operating
activities.

         The use of cash for operating activities during the year ended April
30, 1998 was due to delayed collections of accounts receivable. Accounts
receivable growth was a result of significant revenue increases combined with an
increase in days revenue outstanding to 88 at April 30, 1998 (versus 67 at April
30, 1997). The increase in days revenue outstanding was due to focused reviews
of claims by fiscal intermediaries at several Outpatient Programs. The other
significant use of cash was the purchase of equipment and leasehold improvements
associated with recently opened sites and investment in information technology.

         During fiscal 1999, working capital is expected to be realized
principally from operations, as well as from a $10 million line of credit from
Sanwa Bank which became effective November 1, 1996. Interest is payable under
this line of credit at a rate of either the bank's reference rate or the
Eurodollar rate plus 2%. As of April 30, 1998 no balance was outstanding under
the line of credit. Working capital is anticipated to be utilized during fiscal
1999, to continue expansion of the Company's Outpatient and Case Management 
Programs, for expansion of Stadt Solutions and the site management and clinical
information business, and for the development of a risk based managed care 
project. The Company also anticipates using working capital and, if necessary,
incurring indebtedness in connection with, selective acquisitions.

         The opening of a new Outpatient Program site typically requires $45,000
to $150,000 for office equipment, supplies, lease deposits, leasehold
improvements and the hiring and training of personnel prior to opening. These

                                      30.


<PAGE>   31

programs generally experience operating losses through an average of the first
four months of operation. The Company expects to provide cash for the start up
of the site management and clinical information business as part of the
formation of Stadt Solutions. The Company also is in the process of refining the
specifications for the purchase and development of a new care management
information system which will be a state of the art data collection and
repository system for the Company's clinical information. The Company
anticipates investing approximately $1,000,000 in this system during fiscal
1999.

         From time to time, the Company recognizes charges to operations as a
result of particular uncertainties associated with the health care reimbursement
rules as they apply to the Outpatient Programs. During fiscal 1997 and fiscal
1998, a substantial majority of the Company's revenue was derived from the
management of the Outpatient Programs. Since substantially all of the patients
of the Outpatient Programs are eligible for Medicare, collection of a
significant component of the Company's management fees is dependent upon
reimbursement of claims submitted to fiscal intermediaries by the hospitals or
Community Mental Health Centers on whose behalf these programs are managed.
Under the Company's contracts with its providers, the Company may be responsible
to indemnify providers for the portion of the Company's management fee
disallowed for reimbursement pursuant to warranty obligations that exist with
certain providers. Although the Company believes that its potential liability to
satisfy such requirements has been adequately reserved in its financial
statements, the obligation to pay such amounts, if and when they become due,
could have a material adverse effect on the Company's short term liquidity.
Certain factors are, in management's view, likely to lessen the impact of any
such effect, including the expectation that, if claims arise, they will arise on
a periodic basis over several years and that any disallowance will merely be
offset against obligations already owed by the provider to the Company.

         The Company maintains significant reserves to cover the potential
impact of two primary uncertainties: (i) the Company may have an obligation to
indemnify certain providers for some portions of its management fee which may be
subject to disallowance upon audit of a provider's cost report by fiscal
intermediaries; and (ii) the Company may not receive full payment of the
management fees owed to it by a provider during the periodic review of the
provider's claims by the fiscal intermediaries.

         The Company has been advised by HCFA that certain program-related costs
are not allowable for reimbursement. The Company may be responsible for
reimbursement of the amounts previously paid to the Company that are disallowed
pursuant to obligations that exist with certain providers. Although the Company
believes that its potential liability to satisfy such requirements has been
adequately reserved in its financial statements, there can be no assurance that
such reserves will be adequate. The obligation to pay the amounts estimated
within the Company's financial statements (or such greater amounts as are due),
if and when they become due, could have a material adverse effect upon the
Company's business, financial condition and results of operations. See "Risk
Factors -- Sufficiency of Existing Reserves to Cover Reimbursement Risks,"
"Business -- Contracts" and "-- Regulatory Matters."

IMPACT OF INFLATION

         A substantial portion of the Company's revenue is subject to
reimbursement rates that are regulated by the federal and state governments and
that do not automatically adjust for inflation. As a result, increased operating
costs due to inflation, such as labor and supply costs, without a corresponding
increase in reimbursement rates, may adversely affect the Company's earnings in
the future.

IMPACT OF YEAR 2000 COMPUTER ISSUES

         The year 2000 issue is the result of computer applications being
written using two digits rather than four to define the applicable year. The
Company's computer applications (and computer applications used by any of the
Company's customers, vendors, payors or other business partners) may recognize
a date using "00" as the year 1900 rather than the year 2000. This could result
in system failures or miscalculations causing disruption of operations.

         The Company has completed a thorough review of its material computer
applications and has identified and scheduled necessary corrections for its
computer applications. Corrections are currently being made and are expected to
be substantially implemented by the third quarter of fiscal 1999. The Company
expects that the total cost associated with these revisions will not be
material. These costs will be primarily incurred during fiscal 1999 

                                      31.

<PAGE>   32
and be charged to expense as incurred. For externally maintained systems, the
Company has begun working with vendors to ensure that each system is currently
year 2000 compliant or will be made year 2000 compliant during 1998 or 1999. The
cost to be incurred by the Company related to externally maintained systems is
expected to be minimal. The Company believes that by completing its planned
corrections to its computer applications, the year 2000 issue with respect to
the Company's systems can be mitigated. However, if such corrections cannot be
completed on a timely basis, the year 2000 issue could have a material adverse
impact on the Company's business, financial condition and results of operations.
Because of the many uncertainties associated with year 2000 compliance issues,
and because the Company's assessment is necessarily based on information from
third party vendors and suppliers, there can be no assurance that the Company's
assessment is correct or as to the materiality or effect of any failure of such
assessment to be correct.

         The Company has initiated a program to determine whether the computer
applications of its significant payors and contract providers will be upgraded
in a timely manner. The Company has not completed this review and it is unknown
whether computer applications of contract providers and Medicare and other
payors will be year 2000 compliant. The Company has not determined the extent to
which any disruption in the billing practices of providers or the payment
practices of Medicare or other payors caused by the year 2000 issues will affect
the Company's operations. However, any such disruption in the billing or
reimbursement process could have a substantial adverse impact on Medicare or
Medicaid payments to providers and, in turn, payments to the Company. Any such
disruption could have a material adverse effect upon the Company's business,
financial condition and results of operations.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

         Financial Statements and supplementary data of the Company are provided
at the pages indicated in Item 14(a).

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURE

         There has not been any change of accountants or any disagreements with
the Company's accountants on any matter of accounting practice or financial
disclosure during the reporting periods.

                                    PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS

         The information required by this item with respect to Directors is
incorporated by reference from the information under the caption "Election of
Directors" contained in the Company's definitive proxy statement in connection
with the solicitation of proxies for the Company's 1998 Annual Meeting of
Stockholders to be held on October 15, 1998 (the "Proxy Statement"). See "Item
4A. Executive Officers of the Company" with regard to Executive Officers.

ITEM 11. EXECUTIVE COMPENSATION

         The information required by this item is incorporated by reference from
the information under the caption "Executive Compensation" contained in the
Proxy Statement.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

         The information required by this item is incorporated by reference from
the information under the caption "Security Ownership of Certain Beneficial
Owners and Management" contained in the Proxy Statement.


                                      32.
<PAGE>   33
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

         The information required by this item is incorporated by reference from
the information under the caption "Certain Relationships and Related
Transactions" contained in the Proxy Statement.

                                     PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(a) The following documents are filed as part of this Annual Report on Form
10-K:

         1.       Financial Statements: The financial statements of PMR are
                  included as Appendix F of this report. See Table of Contents
                  to Financial Statements in Appendix F.

         2.       Financial Statement Schedules: Schedule II - PMR Corporation
                  Valuation and Qualifying Accounts is included in Appendix F of
                  this report. See Table of Contents to Financial Statements in
                  Appendix F.

         3.       The exhibits which are filed with this Report or which are
                  incorporated herein by reference are set forth in the Exhibit
                  Index on page 33.

(b)      Reports on Form 8-K:

         During the fourth quarter of fiscal 1998, the Company filed the
following report on Form 8-K:

         1. Report on Form 8-K dated February 19, 1998, and filed on or about
February 25, 1998, announcing the third quarter results, regulatory challenges
and the signing of a letter of intent to acquire the provider division of
American Psych Systems.

         2. Report on Form 8-K dated May 12, 1998, and filed on or about May 13,
1998, announcing the Company's plan to take a special change and preliminary
estimates of fourth quarter results.

         3. Report on Form 8-K dated June 9, 1998 and filed on or about June 11,
1998 announcing a preliminary resolution of the provider-based challenge and a
proposed joint venture with Stadtlander.

(c)      Exhibits:
<TABLE>
<CAPTION>
        EXHIBIT
         NUMBER                        DESCRIPTION
         ------        ---------------------------------------------------------
 
<S>                    <C>
           3.1         The Company's Restated Certificate of Incorporation,
                       filed with the Delaware Secretary of State on March 9,
                       1998.
        
           3.2         The Company's Amended and Restated Bylaws.*
        
           4.1         Common Stock Specimen Certificate.**
        
          10.1         The Company's 1997 Equity Incentive Plan (filed as
                       Exhibit 10.1).*
        
          10.2         Form of Incentive Stock Option Agreement under the 1997
                       Plan (filed as Exhibit 10.2).*
        
          10.3         Form of Nonstatutory Stock Option Agreement under the
                       1997 Plan (filed as Exhibit 10.).*
        
          10.4         Outside Directors' Non-Qualified Stock Option Plan of
                       1992 (the "1992 Plan") (filed as Exhibit 10.4).*
        
          10.5         Form of Outside Directors' Non-Qualified Stock Option
                       Agreement (filed as Exhibit 10.5).*
        
          10.6         Amended and Restated Stock Option Agreement dated April
                       30, 1996, evidencing award to Allen Tepper (filed as
                       Exhibit 10.6).*
        
</TABLE>


                                      33.

<PAGE>   34
<TABLE>
<CAPTION>
        EXHIBIT
         NUMBER                        DESCRIPTION
         ------        ---------------------------------------------------------
 
<S>                    <C>
          10.7         Amended and Restated Stock Option Agreement dated April
                       30, 1996, evidencing award to Susan Erskine (filed as
                       Exhibit 10.7).*
        
          10.8         Amended and Restated Stock Option Agreement dated
                       February 1, 1996, evidencing award to Mark Clein (filed
                       as Exhibit 10.8).*

          10.9         Amended and Restated Stock Option Agreement dated
                       February 1, 1996, evidencing award to Mark Clein (filed
                       as Exhibit 10.9).*
        
          10.10        Amended and Restated Warrant dated July 9, 1997,
                       evidencing award to Fred Furman (filed as Exhibit
                       10.11).*
        
          10.11        Restated Management Agreement dated April 11, 1997 with
                       Scripps Health (filed as Exhibit 10.12).*
        
          10.12        Amendment to Restated Management Agreement dated July
                       15, 1998 with Scripps Health.
        
          10.13        Sublease dated April 1, 1997 with CMS Development and
                       Management Company, Inc. (filed as Exhibit 10.13).*
        
          10.14        Management and Affiliation Agreement dated April 13,
                       1995, between Mental Health Cooperative, Inc. and
                       Tennessee Mental Health Cooperative, Inc. with Addendum
                       (filed as Exhibit 10.14). (Tennessee Mental Health
                       Cooperative, Inc. subsequently changed its name to
                       Collaborative Care Corporation.)*
        
          10.15        Second Addendum to Management and Affiliation Agreement
                       dated November 1, 1996 between Mental Health Cooperative,
                       Inc. and Collaborative Care Corporation (filed as Exhibit
                       10.15).***
        
          10.16        Provider Services Agreement dated April 13, 1995, between
                       Tennessee Mental Health Cooperative, Inc. and Mental
                       Health Cooperative, Inc. (filed as Exhibit 10.15).
                       (Tennessee Mental Health Cooperative, Inc. subsequently
                       changed its name to Collaborative Care Corporation.)*
        
          10.17        Management and Affiliation Agreement dated April 13,
                       1995, between Case Management, Inc. and Tennessee Mental
                       Health Cooperative, Inc. with Addendum (filed as Exhibit
                       10.16). (Tennessee Mental Health Cooperative, Inc.
                       subsequently changed its name to Collaborative Care
                       Corporation.)*
        
          10.18        Provider Services Agreement dated April 13, 1995, between
                       Tennessee Mental Health Cooperative, Inc. and Case
                       Management, Inc. (filed as Exhibit 10.17). (Tennessee
                       Mental Health, Cooperative, Inc. subsequently changed its
                       name to Collaborative Care Corporation.)*
        
          10.19        Provider Agreement dated December 4, 1995, between
                       Tennessee Behavioral Health, Inc. and Tennessee Mental
                       Health Corporations, Inc.
        
          10.20        Addendum No. 1 to Provider Agreement dated December 4,
                       1995, between Tennessee Behavioral Health, Inc. and
                       Tennessee Mental Health Cooperative, Inc.
        
          10.21        Addendum No. 2 to Provider Agreement dated February 4,
                       1996, between Tennessee Behavioral Health, Inc. and
                       Tennessee Mental Health Cooperative, Inc.

          10.22        Provider Participation Agreement dated December 1, 1995,
                       among Green Spring Health Services, Inc., AdvoCare, Inc.
                       and Tennessee Mental Health Cooperative, Inc.
        
          10.23        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.

</TABLE>

                                      34.
<PAGE>   35
<TABLE>
          <S>          <C>
          10.24        Subscription Agreement dated June 8, 1998, between the
                       Company and Stadtlander Drug Distribution Co., Inc.

          10.25        Sanwa Bank California Credit Agreement dated February 2,
                       1996, as amended on October 31, 1996.***
        
          21.1         List of Subsidiaries.
        
          23.1         Consent of Ernst & Young LLP.
        
          27.1         Financial Data Schedule. 
</TABLE>

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

*        Incorporated by reference to exhibits filed with the SEC in the
         Company's Annual Report on Form 10-K for the year ended April 30, 1997.

**       Incorporated by reference to the Company's Registration Statement on
         Form S-18 (Reg. No. 23-20095-A).

***      Incorporated by reference to exhibits filed with the SEC in the
         Company's Registration Statement on Form S-2 (Reg. No. 333-36313).



                                   SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Company has duly caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized, on July 27, 1998.

                           PMR CORPORATION



                           By:   /s/  Allen Tepper
                                 -------------------------------------------
                                 Allen Tepper
                                 Chief Executive Officer
                                 (Principal Executive Officer)

Pursuant to the requirements of the Securities Act of 1934, this Form 10-K has
been signed by the following persons in the capacities and on the dates
indicated.
<TABLE>
<CAPTION>
SIGNATURE                          TITLE                             DATE
---------                          -----                             ----

<S>                             <C>                               <C>
/s/ Allen Tepper                Chairman, Chief Executive         July 27, 1998
-------------------------       Officer and Director
Allen Tepper              

/s/ Susan D. Erskine            Secretary, Treasurer and          July 27, 1998
-------------------------       Director
Susan D. Erskine              

/s/ Daniel L. Frank             President of Disease Management   July 27, 1998
-------------------------       Division and Director
Daniel L. Frank              

/s/ Charles McGettigan          Director                          July 27, 1998
-------------------------
Charles C. McGettigan

/s/ Richard A. Niglio           Director                          July 27, 1998
-------------------------
Richard A. Niglio

/s/ Eugene D. Hill              Director                          July 27, 1998
-------------------------
Eugene D. Hill
</TABLE>


                                      35.


<PAGE>   36


                                 PMR Corporation

                        Consolidated Financial Statements
                                  and Schedules

                       Years ended April 30, 1998 and 1997


<TABLE>
<CAPTION>

                                                     CONTENTS

<S>                                                                                                    <C>
Report of Independent Auditors..........................................................................F-1

Consolidated Financial Statements

Consolidated Balance Sheets.............................................................................F-2
Consolidated Income Statements..........................................................................F-3
Consolidated Statements of Shareholders' Equity.........................................................F-4
Consolidated Statements of Cash Flows...................................................................F-5
Notes to Financial Statements...........................................................................F-6


Schedules

Schedule II - Valuation and Qualifying Accounts........................................................S-1

</TABLE>


                                      36.
<PAGE>   37
               Report of Ernst & Young LLP, Independent Auditors

The Board of Directors and Stockholders
PMR Corporation

We have audited the accompanying consolidated balance sheets of PMR Corporation
as of April 30, 1998 and 1997, and the related consolidated statements of
income, stockholders' equity and cash flows for each of the three years in the
period ended April 30, 1998. Our audits also included the financial statement
schedule listed in the index at item 14(a). These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit 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 PMR Corporation
at April 30, 1998 and 1997, and the consolidated results of its operations and
its cash flows for each of the three years in the period ended April 30, 1998,
in conformity with generally accepted accounting principles. Also, in our
opinion, the related financial statement schedule, when considered in relation
to the basic financial statements taken as a whole, presents fairly in all
material respects the information set forth therein.


San Diego, California
June 12, 1998
except for paragraph four of Note 13, as to which the date is
July 24, 1998
 

                                      F-1
<PAGE>   38


                                 PMR Corporation

                           Consolidated Balance Sheets

<TABLE>
<CAPTION>

                                                                                              APRIL 30,
                                                                                       1998              1997
                                                                                     -----------       -----------
<S>                                                                                  <C>               <C>        
ASSETS
Current assets:
   Cash and cash equivalents                                                         $18,522,859       $10,048,203
   Short-term investments, available for sale                                         20,257,045                --
   Accounts receivable, net of allowance for uncollectible amounts of
     $9,081,610 in 1998 and $5,081,177 in 1997                                        16,655,759        11,268,962
   Prepaid expenses and other current assets                                           1,192,144           572,136
   Deferred income tax benefits                                                        4,136,000         2,464,000
                                                                                     -----------       -----------
Total current assets                                                                  60,763,807        24,353,301

Furniture and office equipment, net of accumulated depreciation of
   $1,727,040 in 1998 and $1,175,980 in 1997                                           3,492,449         1,263,743
Long-term receivables                                                                  2,976,918         2,360,872
Deferred income tax benefit                                                            2,080,000         2,970,000
Other assets                                                                           1,135,880         1,501,622
                                                                                     -----------       -----------
Total assets                                                                         $70,449,054       $32,449,538
                                                                                     ===========       ===========

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
   Accounts payable                                                                  $   469,462       $   753,660
   Accrued expenses                                                                    3,534,400           981,998
   Accrued compensation and employee benefits                                          2,178,693         2,951,867
   Advances from case management agencies                                              1,686,477           926,712
   Income taxes payable                                                                1,074,360         1,703,000
                                                                                     -----------       -----------
Total current liabilities                                                              8,943,392         7,317,237

Note payable                                                                             392,024                --
Deferred rent expense                                                                     87,566            92,822
Contract settlement reserve                                                            7,479,993         8,791,928

Commitments

Stockholders' equity:
   Convertible preferred stock, $.01 par value, authorized shares - 1,000,000;
     Series C - issued and outstanding shares - none in 1998 and 1997
   Common Stock, $.01 par value, authorized shares - 19,000,000; issued and
     outstanding shares - 6,949,650 in 1998 and 5,033,507
     in 1997                                                                              69,496            50,334
   Additional paid-in capital                                                         47,959,557        12,138,569
   Retained earnings                                                                   5,517,026         4,058,648
                                                                                     -----------       -----------
Total stockholders' equity                                                            53,546,079        16,247,551
                                                                                     -----------       -----------
                                                                                     $70,449,054       $32,449,538
                                                                                     ===========       ===========
</TABLE>

See accompanying notes. 

                                      F-2
<PAGE>   39


                                 PMR Corporation

                        Consolidated Statements of Income


<TABLE>
<CAPTION>

                                                                  YEAR ENDED APRIL 30,
                                                      1998                1997                1996
                                                  ------------        ------------        ------------

<S>                                               <C>                 <C>                 <C>         
Revenue                                           $ 67,523,950        $ 56,636,902        $ 36,315,921

Expenses:
   Operating expenses                               48,255,459          41,738,298          28,471,644
   Marketing, general and administrative             9,186,401           6,034,960           4,018,685
   Provision for bad debts                           5,148,580           3,084,166           1,447,983
   Depreciation and amortization                     1,064,873             700,734             595,896
   Special charge                                    2,582,896                  --                  --
   Interest (income) expense                        (1,186,637)           (217,297)              2,174
   Minority interest in loss of subsidiary                  --                  --                (524)
                                                  ------------        ------------        ------------
                                                    65,051,572          51,340,861          34,535,858
                                                  ------------        ------------        ------------

Income before income taxes                           2,472,378           5,296,041           1,780,063
Income tax expense                                   1,014,000           2,172,000             730,000
                                                  ------------        ------------        ------------
Net income                                           1,458,378           3,124,041           1,050,063
Less dividends on:
   Series C Convertible Preferred Stock                     --              17,342             131,686
                                                  ------------        ------------        ------------
Net income available to common stockholders       $  1,458,378        $  3,106,699        $    918,377
                                                  ============        ============        ============

Earnings per common share
   Basic                                          $        .24        $        .66        $        .26
                                                  ============        ============        ============
   Diluted                                        $        .22        $        .55        $        .23
                                                  ============        ============        ============

Shares used in computing earnings per share
   Basic                                             6,053,243           4,727,124           3,484,172
                                                  ============        ============        ============
   Diluted                                           6,695,321           5,645,947           4,470,980
                                                  ============        ============        ============
</TABLE>

See accompanying notes.


                                      F-3

<PAGE>   40


4

                                 PMR Corporation

                 Consolidated Statements of Stockholders' Equity

<TABLE>
<CAPTION>

                                                    SERIES C                      
                                                   CONVERTIBLE                                      
                                                 PREFERRED STOCK                COMMON STOCK                     
                                          ---------------------------------------------------------    PAID-IN   
                                              SHARES         AMOUNT          SHARES       AMOUNT       CAPITAL   
                                           ------------   ------------   ------------  ------------  ------------

<S>                                       <C>             <C>              <C>         <C>           <C>         
Balance at April 30, 1995                       700,000   $      7,000      3,338,656  $     33,385  $  7,050,262
   Issuance of common stock under stock
     option plans                                    --             --         17,174           172        61,202
   Issuance of common stock for
     non-compete agreements and       
     acquisition of minority interest                --             --        197,087         1,971     1,029,279
   Issuance of common stock for a note
     receivable                                      --             --         25,000           250       118,500
   Accrued interest on stockholder notes             --             --             --            --            --
   Dividend payable on Series C preferred
     stock                                           --             --             --            --            --
   Proceeds from payment of stockholder
     notes                                           --             --             --            --            --
   Net income                                        --             --             --            --            --
                                           ------------   ------------   ------------  ------------  ------------
Balance at April 30, 1996                       700,000          7,000      3,577,917        35,778     8,259,243
   Issuance of common stock under stock
     option plans including realization
     of income tax benefit of $369,000               --             --         96,016           960       729,189
   Dividend payable on Series C preferred
     stock                                           --             --             --            --            --
   Proceeds from payment of stockholder
     notes                                           --             --             --            --            --
   Exercise of warrants to purchase
     common stock                                    --             --        657,524         6,575     3,104,801
   Issuance of common stock for
     consulting services                             --             --          2,050            21        45,336
   Conversion of Series C convertible
     preferred stock                           (700,000)        (7,000)       700,000         7,000            --
   Net income                                        --             --             --          
                                           ------------   ------------   ------------  ------------  ------------
Balance at April 30, 1997                            --             --      5,033,507        50,334    12,138,569
   Issuance of common stock under stock
     option plans including realization
     of income tax benefit of $1,687,355             --             --        226,143         2,262     2,717,694
   Issuance of common stock in secondary
     offering, net of offering costs of
     $637,556                                        --             --      1,690,000        16,900    33,103,294
   Net income                                        --             --             --            --            --
                                           ------------   ------------   ------------  ------------  ------------
Balance at April 30, 1998                            --   $         --      6,949,650  $     69,496  $ 47,959,557
                                           ============   ============   ============  ============  ============
</TABLE>


<TABLE>
<CAPTION>

                                              
                                           
                                           NOTES RECEIVABLE                   TOTAL
                                                 FROM         RETAINED    STOCKHOLDERS'
                                             STOCKHOLDERS     EARNINGS        EQUITY
                                             ------------   ------------   ------------

<S>                                         <C>            <C>            <C>         
Balance at April 30, 1995                    $    (62,626)  $     33,572   $  7,061,593
   Issuance of common stock under stock
     option plans                                   1,184             --         62,558
   Issuance of common stock for
     non-compete agreements and
     acquisition of minority interest                  --             --      1,031,250
   Issuance of common stock for a note
     receivable                                  (118,750)            --             --
   Accrued interest on stockholder notes           (4,507)            --         (4,507)
   Dividend payable on Series C preferred
     stock                                             --       (131,686)      (131,686)
   Proceeds from payment of stockholder
     notes                                         43,152             --         43,152
   Net income                                          --      1,050,063      1,050,063
                                             ------------   ------------   ------------
Balance at April 30, 1996                        (141,547)       951,949      9,112,423
   Issuance of common stock under stock
     option plans including realization
     of income tax benefit of $369,000                 --             --        730,149
   Dividend payable on Series C preferred
     stock                                             --        (17,342)       (17,342)
   Proceeds from payment of stockholder
     notes                                        141,547             --        141,547
   Exercise of warrants to purchase
     common stock                                      --             --      3,111,376
   Issuance of common stock for
     consulting services                               --             --         45,357
   Conversion of Series C convertible
     preferred stock                                   --             --             --
   Net income                                          --      3,124,041      3,124,041
                                             ------------   ------------   ------------
Balance at April 30, 1997                              --      4,058,648     16,247,551
   Issuance of common stock under stock
     option plans including realization
     of income tax benefit of $1,687,355               --             --      2,719,956
   Issuance of common stock in secondary
     offering, net of offering costs of
     $637,556                                          --             --     33,120,194
   Net income                                          --      1,458,378      1,458,378
                                             ------------   ------------   ------------
Balance at April 30, 1998                    $         --   $  5,517,026   $ 53,546,079
                                             ============   ============   ============
</TABLE>

See accompanying notes.


                                      F-4
<PAGE>   41


                                 PMR Corporation

                      Consolidated Statements of Cash Flows
<TABLE>
<CAPTION>

                                                                                   YEARS ENDED APRIL 30,
                                                                       1998                1997                1996
                                                                   ------------        ------------        ------------
<S>                                                                <C>                 <C>                 <C>         
OPERATING ACTIVITIES
Net income                                                         $  1,458,378        $  3,124,041        $  1,050,063
Adjustments to reconcile net income to net cash provided by
   (used in) operating activities:
     Special charge                                                   2,582,896                  --                  --
     Depreciation and amortization                                    1,064,873             700,734             595,896
     Issuance of stock for consulting services                               --              45,357                  --
     Provision for bad debts                                          5,148,580           3,084,166           1,447,983
     Accrued interest income on notes receivable from
       stockholders                                                          --                  --              (4,507)
     Deferred income taxes                                             (782,000)         (3,834,000)           (841,000)
     Minority interest in loss of joint venture                              --                  --                (524)
     Changes in operating assets and liabilities:
       Accounts and notes receivable                                (11,151,423)         (4,980,050)         (3,778,660)
       Refundable income tax                                                 --                  --             817,165
       Prepaid expenses and other assets                               (620,008)           (250,630)            (88,487)
       Accounts payable and accrued expenses                           (404,697)            212,937             474,124
       Accrued compensation and employee benefits                      (773,174)            675,058           1,415,780
       Advances from case management agencies                           759,765             (86,135)          1,012,847
       Other liabilities                                                     --            (127,213)           (205,034)
       Contract settlement reserve                                   (1,311,935)          3,292,908           1,975,797
       Income taxes payable                                           1,058,715           1,394,511             308,489
       Deferred rent expense                                             (5,256)            (56,709)            (60,331)
                                                                   ------------        ------------        ------------
Net cash (used in) provided by operating activities                  (2,975,286)          3,194,975           4,119,601

INVESTING ACTIVITIES
Purchases of short-term investments, available-for-sale             (20,257,045)                 --                  --
Purchases of furniture and office equipment                          (2,927,837)           (958,685)           (179,281)
Acquisition of Twin Town minority interest                                   --                  --            (185,000)
                                                                   ------------        ------------        ------------
Net cash used in investing activities                               (23,184,882)           (958,685)           (364,281)

FINANCING ACTIVITIES
Proceeds from secondary offering, net of offering costs              33,120,194                  --                  --
Proceeds from sale of common stock and notes receivable from
   stockholders                                                       1,032,601           3,983,072             105,710
Proceeds from note payable to bank                                      517,397                  --             800,000
Payments on note payable to bank                                        (35,368)                 --          (2,000,000)
Cash dividend paid                                                           --             (89,081)           (125,484)
                                                                   ------------        ------------        ------------
Net cash provided by (used in) financing activities                  34,634,824           3,893,991          (1,219,774)
                                                                   ------------        ------------        ------------

Net increase (decrease) in cash                                       8,474,656           6,130,281           2,535,546

Cash at beginning of year                                            10,048,203           3,917,922           1,382,376
                                                                   ------------        ------------        ------------

Cash at end of year                                                $ 18,522,859        $ 10,048,203        $  3,917,922
                                                                   ============        ============        ============
SUPPLEMENTAL INFORMATION:
Taxes paid                                                         $  1,330,725        $  4,611,489        $    380,735
                                                                   ============        ============        ============
Interest paid                                                      $     20,936        $     17,612        $    129,108
                                                                   ============        ============        ============
</TABLE>

See accompanying notes. 

                                      F-5
<PAGE>   42


                                 PMR Corporation

                   Notes to Consolidated Financial Statements

                                 April 30, 1998



                                       
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES

ORGANIZATION, BUSINESS AND PRINCIPLES OF CONSOLIDATION

PMR Corporation ("the Company") develops, manages and markets acute outpatient
psychiatric programs, psychiatric case management programs and substance abuse
treatment programs. The Company operates in the healthcare industry segment. The
consolidated financial statements include the accounts of the Company and its
wholly owned subsidiaries, Psychiatric Management Resources, Inc., Collaborative
Care Corporation, PMR-CD, Inc., Aldine - CD, Inc. and Twin Town Outpatient.

LEGISLATION, REGULATIONS AND MARKET CONDITIONS

The Company is subject to extensive federal, state and local government
regulation relating to licensure, conduct of operations, ownership of
facilities, expansion of facilities and services and reimbursement for services.
As such, in the ordinary course of business, the Company's operations are
continuously subject to state and federal regulator scrutiny, supervision and
control. Such regulatory scrutiny often includes inquires, investigations,
examinations, audits, site visits and surveys, come of which may be non-routine.
The Company believes that it is in substantial compliance with the applicable
laws and regulations. However, if the Company is ever found to have engaged in
improper practices, it could be subjected to civil, administrative or criminal
fines, penalties or restitutionary relief.

CASH AND CASH EQUIVALENTS

Cash and cash equivalents consist of highly liquid investments with maturities,
when acquired, of three months or less. Investments with original maturities of
three months or less that were classified as cash equivalents totaled $7,816,828
and $58,342 as of April 30, 1998 and 1997, respectively.

SHORT-TERM INVESTMENTS

Marketable equity securities and debt securities are classified as
available-for-sale. Available-for-sale securities are carried at fair value with
unrealized gains and losses reported in a separate component of stockholders'
equity. The costs of debt securities in this category is adjusted for
amortization of premiums and accretion of discounts to maturity. Such
amortization along with realized gains and losses, interest and dividends are
included in interest income. The cost of securities sold is based on the
specific identification method.

                                      F-6
<PAGE>   43

                                PMR Corporation

             Notes to Consolidated Financial Statements (continued)



1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

CONCENTRATION OF CREDIT RISK

The Company grants credit to contracting providers in various states without
collateral. Losses resulting from bad debts have traditionally not exceeded
management's estimates. The Company has receivables, aggregating $10,258,000 at
April 30, 1998, from four providers, each of which comprise more than 10% of
total receivables. The Company monitors the credit worthiness of these customers
and believes the balances outstanding, net of allowance at April 30, 1998, are
fully collectible.

Substantially all of the Company's cash and cash equivalents is deposited in two
banks. The Company monitors the financial status of these banks and does not
believe the deposits are subject to a significant degree of risk.

USE OF ESTIMATES

The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and related disclosures at
the date of the financial statements and the amounts of revenues and expenses
reported during the period. Actual results could differ from those estimates.
The Company's significant accounting estimates are the allowance for
uncollectible accounts and the contract settlement reserve.

FURNITURE AND OFFICE EQUIPMENT

Furniture and office equipment are stated at cost and are depreciated over their
estimated useful lives using the straight-line method. Depreciation expense for
each of the three years ended April 30, 1998 was $709,932, $344,254 and
$320,212, respectively.

OTHER ASSETS

Other assets are comprised of the following at April 30:
<TABLE>
<CAPTION>

                                                              1998             1997
                                                           ----------       ----------

<S>                                                        <C>              <C>       
Proprietary information and covenants not to compete       $1,118,753       $1,118,753
Goodwill                                                      978,858          978,858
Other                                                         282,176          282,176
                                                           ----------       ----------
                                                            2,379,787        2,379,787
Less accumulated amortization                               1,243,907          878,165
                                                           ----------       ----------
                                                           $1,135,880       $1,501,622
                                                           ==========       ==========
</TABLE>


                                      F-7
<PAGE>   44

                                PMR Corporation

             Notes to Consolidated Financial Statements (continued)



1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Other assets are being amortized using the straight-line method over their
estimated useful lives. The estimated useful life of proprietary information and
covenants not to compete is five to nine years and goodwill is 15 years.

EARNINGS PER SHARE

In February 1997, the Financial Accounting Standards Board issued SFAS No. 128,
Earnings per Share. SFAS No. 128 is effective for financial statements issued
for periods ending after December 15, 1997 and replaces APB Opinion 15, Earnings
per Share ("EPS"). SFAS No. 128 requires dual presentation of basic and diluted
earnings per share by entities with complex capital structures. Basic EPS
includes no dilution and is computed by dividing net income by the weighted
average number of common shares outstanding for the period. Diluted EPS reflects
the potential dilution of securities that could share in the earnings of the
entity. The Company has adopted SFAS No. 128 in the third fiscal quarter ending
January 31, 1998 and has calculated its earnings per share in accordance with
SFAS No. 128 for all periods presented. As required by SFAS 128, all prior
periods presented have been restated.

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

                                                                        YEARS ENDED APRIL 30,
                                                           --------------------------------------------
                                                              1998             1997             1996
                                                           ----------       ----------       ----------
<S>                                                        <C>              <C>              <C>       
Numerator:
   Net income available to common stockholders             $1,458,378       $3,106,699       $  918,377
   Preferred stock dividends                                       --           17,342          131,686
                                                           ==========       ==========       ==========
   Net income available to common stockholders after
     assumed conversion of preferred stock                 $1,458,378       $3,124,041       $1,050,063
                                                           ==========       ==========       ==========

Denominator:
   Weighted average shares outstanding for basic
     earning per share                                      6,053,243        4,727,124        3,484,172
                                                           ----------       ----------       ----------
   Effects of dilutive securities:
     Employee stock  options                                  596,008          707,368          158,317
     Warrants                                                  46,070          119,825          128,491
     Convertible preferred stock                                   --           91,630          700,000
                                                           ----------       ----------       ----------
   Dilutive potential common shares                           642,078          918,823          986,808
   Shares used in computing diluted net income per
     common share                                           6,695,321        5,645,947        4,470,980
                                                           ==========       ==========       ==========

Earnings per common share, basic                           $      .24       $      .66       $      .26
                                                           ==========       ==========       ==========
Earnings per common share, diluted                         $      .22       $      .55       $      .23
                                                           ==========       ==========       ==========
</TABLE>

                                      F-8
<PAGE>   45

                                PMR Corporation

             Notes to Consolidated Financial Statements (continued)



1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

REVENUE RECOGNITION AND CONTRACT SETTLEMENT RESERVE

The Company's acute outpatient psychiatric program customers are primarily acute
care hospitals or community mental health centers ("Providers"). Typical
contractual agreements with providers require the Company to provide, at its own
expense, specific management personnel for each program site. Revenue under
these programs is primarily derived from services provided under three types of
agreements: 1) an all inclusive fee arrangement based on fee-for-service rates
which provide that the Company is responsible for substantially all program
costs, 2) a fee-for-service arrangement whereby substantially all of the program
costs are the responsibility of the Provider, and 3) a fixed fee arrangement. In
all cases, the Company provides on-site managerial personnel.
Patients served by the acute outpatient psychiatric programs typically are
covered by the Medicare program.

The Company has been retained to manage and provide the outpatient psychiatric
portion of a managed health care program funded by the State of Tennessee
("TennCare"). Under the terms of its agreements, the Company receives a monthly
case rate payment from the managed care consortium responsible for managing the
TennCare program, and is responsible for planning, coordinating and managing
psychiatric case management to residents of Tennessee who are eligible to
participate in the TennCare program using the proprietary treatment programs
developed by the Company. The Company is also responsible for providing the
related clinical care under the agreements. The Company has signed six-year
contracts with two case management agencies to provide the clinical network
necessary for the Company to meet its obligations under the TennCare program.
Revenue under this program was approximately $14,607,000, $13,429,000, and
$7,600,000 for the years ended April 30, 1998, 1997 and 1996, respectively.

The Company also operates chemical dependency rehabilitation programs. Revenue
from these programs for the years ended April 30, 1998, 1997 and 1996 was
$2,828,000, $1,673,000 and $1,898,000, respectively.

Revenue under the Acute Outpatient Psychiatric Programs is recognized when
services are rendered based upon contractual arrangements with Providers at the
estimated net realizable amounts. Under certain management contracts, the
Company is obligated under warranty provisions to indemnify the Providers for
all or some portions of the Company's management fees that may be disallowed as
reimbursable to the Providers by Medicare's fiscal intermediaries. The Company
has recorded contract settlement reserves


                                      F-9
<PAGE>   46

                                PMR Corporation

             Notes to Consolidated Financial Statements (continued)




1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

to provide for possible amounts ultimately owed to its Providers resulting from
disallowance of costs by Medicare and Medicare cost report settlement
adjustments. Such reserve is classified as a non-current liability as ultimate
resolution of substantially all of these issues is not expected to occur during
fiscal 1999.

Revenue under the TennCare managed care program is recognized in the period in
which the related service is to be provided.

INSURANCE

The Company carries "occurrence basis" insurance to cover general liability,
property damage and workers' compensation risks. Medical professional liability
risk is covered by a "claims made" insurance policy that provides for guaranteed
tail coverage.

STOCK OPTIONS

Financial Accounting Standards Board Statement No. 123, Accounting for
Stock-Based Compensation (SFAS No. 123), establishes the use of the fair value
based method of accounting for stock-based compensation arrangements, under
which compensation cost is determined using the fair value of stock-based
compensation determined as of the grant date, and is recognized over the periods
in which the related services are rendered. In accordance with the provisions of
SFAS No. 123, the Company has elected to follow Accounting Principles Board
Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) and related
Interpretations in accounting for its employee stock options. Under APB 25, when
the purchase price of restricted stock or the exercise price of the Company's
employee stock options equals or exceeds the fair value of the underlying stock
on the date of issuance or grant, no compensation expense is recognized. In
accordance with SFAS No. 123, the Company will present pro forma disclosures of
net income and earnings per share as if SFAS No. 123 had been applied.

LONG-LIVED ASSETS

Effective May 1, 1996, the Company adopted Financial Accounting Standards Board
Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed Of (SFAS No. 121) which requires impairment
losses to be recorded on long-lived assets used in operations when indicators of
impairment are present and the undiscounted cash flows estimated to be generated
by those assets are less

                                      F-10
<PAGE>   47

                                PMR Corporation

             Notes to Consolidated Financial Statements (continued)



1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

than the assets' carrying amount. Statement 121 also addresses the accounting
for long-lived assets that are expected to be disposed of. Any impairment losses
identified will be measured by comparing the fair value of the asset to its
carrying amount. The Company has recognized all known material impairment losses
on long-lived assets used in operations.

RECENTLY ISSUED ACCOUNTING STANDARDS

In June 1997, the Financial Accounting Standards Board issued SFAS 130,
Reporting Comprehensive Income and SFAS 131, Segment Information. Both of these
standards are effective for the fiscal years beginning after December 15, 1997.
SFAS 130 requires that all components of comprehensive income, including net
income, be reported in the financial statements in the period in which they are
recognized. SFAS 131 amends the requirements for public enterprise to report
financial and descriptive information about its reportable operating segments.
The Company currently operates in one business and three operating segments. The
adoption of this standard will require the Company to disclose additional
financial and descriptive information about the operating segments.

In April 1998, the Accounting Standards Executive Committee issued Statement of
Position 98-5 Reporting on Costs of Start-Up Activities, (SOP 98-5) which is
effective for fiscal years beginning after December 15, 1998. SOP 98-5 requires
costs of start-up activities and organization costs to be expensed as incurred.
In addition, all start-up costs and organization costs previously capitalized
must be written off. Initial application of this SOP 98-5 will be reported as
the cumulative effect of a change in accounting principle. The Company plans to
adopt this change in accounting principle in the first quarter of fiscal 1999,
and anticipates writing off approximately $1,000,000 in previously capitalized
start-up costs.

RECLASSIFICATION

Certain classifications of accounts in the prior year have been reclassified to
reflect current year classifications.


                                      F-11
<PAGE>   48

                                PMR Corporation

             Notes to Consolidated Financial Statements (continued)




2. OTHER AFFILIATIONS

In October 1995, the Company entered into exclusive affiliation agreements with
two case management agencies in Tennessee (see Note 1). As part of these
agreements, the Company issued 50,000 shares each of the Company's common stock
for an aggregate value of $481,250. The agreements also provide for the Company
to grant warrants to the two agencies for the purchase of up to an aggregate
550,000 shares of common stock at fair value over a six year period if certain
performance criteria are met. During fiscal 1997, warrants for the purchase of
30,000 shares of the Company's common stock at the fair market value at the date
of grant were earned by the case management agencies.

3. INVESTMENTS

At April 30, 1998, the fair market value of the marketable securities
approximates cost. The following is a summary of available-for-sale securities:
<TABLE>
<CAPTION>

                                                                  APRIL 30, 1998
                                                                  --------------
<S>                                                               <C>        
U.S. government securities                                           $16,752,478
U. S. corporate securities                                             2,005,187
Commercial paper                                                       1,000,000
Certificate of Deposit                                                   499,380
                                                                     -----------
Total debt securities                                                $20,257,045
                                                                     ===========
</TABLE>

At April 30, 1998, all short-term investments mature in one year or less.

4. LONG-TERM RECEIVABLES

Long-term receivables at April 30, 1998 consist primarily of amounts due from
contracting Providers for which the Company has established specific payment
terms for receivable amounts which were past due or for which payment, due to
contract terms, is expected to exceed one year. Management expects to receive
payment on the long-term receivables as contract terms are met, none of which
are expected to exceed two years.


                                      F-12
<PAGE>   49

                                PMR Corporation

             Notes to Consolidated Financial Statements (continued)




5. PROPERTY AND EQUIPMENT

Property and equipment consisted of the following at April 30:
<TABLE>
<CAPTION>

                                                1998                     1997
                                             -----------            ------------
<S>                                          <C>                    <C>        
Furniture and fixtures                       $ 1,975,766            $   847,863
Leasehold improvements                         1,133,641                532,966
Software                                         365,625                 54,987
Start-up costs                                 1,744,457              1,003,907
                                             -----------            -----------
                                               5,219,489              2,439,723
Accumulated depreciation                      (1,727,040)            (1,175,980)
                                             -----------            -----------
                                             $ 3,492,449            $ 1,263,743
                                             ===========            ===========
</TABLE>

6. LINE OF CREDIT

The Company has a credit agreement with a bank that permits borrowings of up to
the lesser of 50% of the aggregate amount of eligible accounts receivable of the
Company or $10,000,000 for working capital needs. The credit agreement expires
on August 30, 1999 and is collateralized by substantially all of the Company's
assets. Interest on borrowings is payable monthly at either the Bank's reference
rate or at the Bank's Eurodollar rate plus 2%. There were no borrowings
outstanding at April 30, 1998.

EQUIPMENT LINE OF CREDIT

The Company has a credit agreement with a bank that permits borrowings for the
purchase of equipment for up to $3,000,000. The credit agreement expires on
September 30, 1998, and is collateralized by the assets acquired with the
proceeds from the loan. Interest at 8.36% and principle payments on borrowings
are payable monthly over five years from the time of purchase. There was
$482,028 outstanding under this credit agreement at April 30, 1998.

7. STOCKHOLDERS' EQUITY

In June 1996, the Company called for redemption of all outstanding shares of
Series C Convertible Preferred Stock. Holders of all the Series C shares
exercised their options to convert such shares to Common Stock and accordingly,
in July 1996, the Company issued 700,000 shares of Common Stock. In conjunction
with the conversion, the Series C shareholders also exercised warrants to
purchase 525,000 shares of the Company's Common Stock for net proceeds of
$2,362,500.



                                      F-13
<PAGE>   50

                                PMR Corporation

             Notes to Consolidated Financial Statements (continued)




8. STOCK OPTIONS AND WARRANTS

During 1997, the Company amended its Employees' Incentive Stock Option Plan of
1990 which was renamed as the 1997 Equity Incentive Plan (the "1997 Plan") that
provides for the granting of options to purchase up to 2,000,000 shares of
common stock to eligible employees. Under the 1997 plan, options may be granted
for terms of up to ten years and are generally exercisable in cumulative annual
increments of 20 percent each year, commencing one year after the date of grant.
The 1997 Plan also provides for the full vesting of all outstanding options
under certain change of control events. Option prices must equal or exceed the
fair market value of the common shares on the date of grant.

The Company has a non qualified stock option plan for its outside directors
("the 1992 Plan"). The 1992 Plan provides for the Company to grant each outside
directors options to purchase 15,000 shares of the Company's common stock
annually, at the fair market value at the date of grant. Options for a maximum
of 525,000 shares may be granted under this plan. The options vest 30%
immediately and in ratable annual increments over the three year period
following the date of grant. In 1997, the board of directors amended the 1992
Plan to provide for full vesting of all outstanding options under certain change
of control events.

Warrants to purchase shares of the Company's common stock were issued in each of
the two years in the period ended April 30, 1997 to brokers in connection with
financing transactions (see Note 8). No warrants were issued in the year ended
April 30, 1998. As of April 30, 1998, broker warrants to purchase 53,000 shares
of the Company's common stock at $2.50 per share were outstanding. These
warrants expire on October 31, 1999.


                                      F-14
<PAGE>   51

                                PMR Corporation

             Notes to Consolidated Financial Statements (continued)




8. STOCK OPTIONS AND WARRANTS (CONTINUED)

A summary of the Company's stock option activity and related information is as
follows:
<TABLE>
<CAPTION>
                                                        WEIGHTED-AVERAGE                                                         
                                          SHARES         EXERCISE PRICE
                                        ----------      ---------------
<S>                                     <C>             <C>      
Outstanding April 30, 1995                 707,124            $    4.41
   Granted                                 897,526                 7.57
   Exercised                               (17,174)                3.40
   Forfeited                               (32,423)                4.11
                                        ----------            ---------
Outstanding April 30, 1996               1,555,053                 6.63
   Granted                                 486,837                20.50
   Exercised                               (96,016)                5.17
   Forfeited                              (160,268)                8.44
                                        ----------            ---------
Outstanding April 30, 1997               1,785,606                14.72
   Granted                                 105,000                19.78
   Exercised                              (226,143)                4.42
   Forfeited                               (60,855)               13.00
                                        ----------            ---------
Outstanding April 30, 1998               1,603,608            $   10.86
                                        ==========            =========
</TABLE>

At April 30, 1998 options and warrants to purchase 929,859 and 53,000 shares of
common stock, respectively, were exercisable and 899,181 shares and 165,000
shares were available for future grant under 1997 Plan and the 1992 Plan,
respectively.

The weighted-average fair value of options granted was $12.37, $15.21 and $4.48
in fiscal years 1998, 1997 and 1996, respectively.

A summary of options outstanding and exercisable as of April 30, 1998 follows:
<TABLE>
<CAPTION>

                                                          WEIGHTED-
                                          WEIGHTED-         AVERAGE                           WEIGHTED
     OPTIONS                               AVERAGE         REMAINING       OPTIONS            -AVERAGE
 OUTSTANDING (IN    EXERCISE PRICE        EXERCISE        CONTRACTUAL  EXERCISABLE (IN         EXERCISE 
    THOUSANDS)          RANGE               PRICE            LIFE         THOUSANDS)            PRICE
 ---------------    --------------        ---------       -----------      -------            ---------
<S>                 <C>                   <C>             <C>           <C>                  <C>      
    156,247          $2.37 - $3.50        $    3.13           5.0          103,247            $    3.13
    595,129          $3.75 - $6.00        $    4.38           4.2          488,262            $    4.44
    300,091         $9.75 - $11.38        $    9.86           7.2          156,593            $    9.90
    552,141         $18.88 - $28.50       $   20.57           7.7          181,757            $   20.61
</TABLE>

                                      F-15
<PAGE>   52

                                PMR Corporation

             Notes to Consolidated Financial Statements (continued)


9. STOCK OPTIONS AND WARRANTS (CONTINUED)

Adjusted pro forma information regarding net income and net income per share is
required by SFAS 123, and has been determined as if the Company had accounted
for its employee stock options and stock purchase plan under the fair value
method of SFAS 123. The fair value for these options was estimated at the date
of grant using the "Black-Scholes" method for option pricing with the following
weighted-average assumptions for fiscal 1998, 1997 and 1996:
<TABLE>
<CAPTION>

                                       1998            1997             1996
                                      -----            ----             ----
<S>                                   <C>              <C>              <C>
Expected life (years)                  5.0              6.0              6.0
Risk-free interest rate                6.34%            6.5%             6.5%
Annual dividend yield                 --               --               --
Volatility                            69%              88%              88%
</TABLE>

For purposes of pro forma disclosures, the estimated fair value of the options
granted is amortized to expense over the options' vesting period. The Company's
pro forma information for the years ended April 30, 1998, 1997 and 1996,
follows:
<TABLE>
<CAPTION>

                                                   1998                  1997              1996
                                                 -------            -------------        ----------

<S>                                              <C>                <C>                   <C>      
Pro forma net income (in thousands)              $24,335            $   1,967,939         $  98,037
Pro forma earnings per share, basic              $    --            $         .34         $     .02
Pro forma earnings per share, diluted            $    --            $         .34         $     .02
</TABLE>

10. INCOME TAXES

Income tax expense (benefit) consists of the following:
<TABLE>
<CAPTION>

                                     YEAR ENDED APRIL 30
                        1998                 1997                 1996
                    -----------          -----------          -----------
<S>                 <C>                  <C>                  <C>        
Federal:
   Current          $ 1,404,000          $ 4,868,000          $ 1,220,000
   Deferred            (612,000)          (3,009,000)            (685,000)
                    -----------          -----------          -----------
                        792,000            1,859,000              535,000

State:
   Current              392,000            1,138,000              351,000
   Deferred            (170,000)            (825,000)            (156,000)
                    -----------          -----------          -----------
                        222,000              313,000              195,000
                    -----------          -----------          -----------
                    $ 1,014,000          $ 2,172,000          $   730,000
                    ===========          ===========          ===========
</TABLE>

                                      F-16
<PAGE>   53

                                PMR Corporation

             Notes to Consolidated Financial Statements (continued)



10. INCOME TAXES (CONTINUED)

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.
<TABLE>
<CAPTION>

                                                               APRIL 30,
                                                        1998              1997
                                                      ----------         ----------
<S>                                                   <C>                <C>       
Deferred tax assets:
   Contract settlement reserve                        $3,048,000         $3,609,000
   Accrued compensation and employee benefits            405,000            531,000
   Allowance for bad debts                             3,704,000          1,979,000
   State income taxes                                     55,000            280,000
   Depreciation and amortization                         254,000            163,000
   Special Charge                                        885,000                 --
   Other                                                 179,000            159,000
                                                      ----------         ----------
Total deferred tax assets                              8,530,000          6,721,000

Deferred tax liabilities:
   Non-accrual experience method                         913,000            326,000
   Contractual retainers                               1,401,000            961,000
                                                      ----------         ----------
Total deferred tax liabilities                         2,314,000          1,287,000
                                                      ----------         ----------
Net deferred tax assets                               $6,216,000         $5,434,000
                                                      ==========         ==========
</TABLE>

A reconciliation between the federal income tax rate and the effective income
tax rate is as follows:
<TABLE>
<CAPTION>

                                                                       YEAR ENDED APRIL 30,
                                                                 1998        1997        1996
                                                                 ----        ----        ----
<S>                                                                <C>         <C>         <C>
Statutory federal income tax rate                                  35%         35%         34%
State income taxes, net of federal tax benefit                      6           6           7
                                                                   --          --          --
Effective income tax rate                                          41%         41%         41%
                                                                   ==          ==          ==
</TABLE>


                                      F-17
<PAGE>   54


                                PMR Corporation

             Notes to Consolidated Financial Statements (continued)


11. CUSTOMERS

Approximately 47% of the Company's revenues are derived from contracts with
providers in the State of California. The remainder of the Company's revenue is
derived from contracts with providers in Arizona, Arkansas, Colorado, Hawaii,
Indiana, Michigan, Tennessee, and Texas. The following table summarizes the
percent of revenue earned from any individual or agency which was responsible
for ten percent or more of the Company's consolidated revenues. There is more
than one program site for some providers.
<TABLE>
<CAPTION>

                                     YEAR ENDED APRIL 30
     Provider            1998              1997               1996
     --------            ----              ----               ----
<S>                     <C>               <C>               <C>
        A                 22%               23%               21%
        B                 14                13                11

</TABLE>
12. EMPLOYEE BENEFITS

The Company maintains a tax deferred retirement plan under Section 401(k) of the
Internal Revenue Code for the benefit of all employees meeting minimum
eligibility requirements. Under the plan, each employee may defer up to 15% of
pre-tax earnings, subject to certain limitations. The Company will match 50% of
an employee's deferral to a maximum of 3% of the employee's gross salary. The
Company's matching contributions vest over a five year period. For the years
ended April 30, 1998, 1997 and 1996, the Company contributed $265,000, $186,000
and, $138,000, respectively, to match employee deferrals.

13. COMMITMENTS AND CONTINGENCIES

The Company leases its administrative facilities and certain program site
facilities under both cancelable and non-cancelable leasing arrangements.
Certain non-cancelable lease agreements call for annual rental increases based
on the consumer price index or as otherwise provided in the lease. The Company
also leases certain equipment under operating lease agreements. Future minimum
lease payments for all leases with initial terms of one year or more at April
30, 1998 are as follows: 1999 - $3,000,348; 2000 - $2,029,999; 2001 -
$1,540,147; 2002 - $887,277 and 2003 - $162,009.

Rent expense totaled $3,140,000, $2,690,800 and $1,950,000 for the years ended
April 30, 1998, 1997 and 1996, respectively.

                                      F-18
<PAGE>   55

                                PMR Corporation

             Notes to Consolidated Financial Statements (continued)



13. COMMITMENTS AND CONTINGENCIES (CONTINUED)

LITIGATION

The Company is a party to various legal proceedings arising in the normal course
of business. In management's opinion, except as otherwise noted below, the
outcome of these proceedings will not have a material adverse effect on the
Company's consolidated financial position, results of operations or cash flows.

In February 1998, the Company announced that the outpatient program that it
formerly managed in Dallas, Texas is subject to a civil investigation being
conducted by the U.S. Department of Health and Human Services' Office of
Inspector General and the U.S. Attorney's office in Dallas, Texas (collectively,
the "Agencies"). The investigation is a result of a Health Care Financing
Administration (""HCFA") review of partial hospitalization services rendered to
63 patients at this location. The Dallas program was operational from January
1996 to February 6, 1998. A representative of the Agencies has indicated that
the investigation is civil in nature and focuses on eligibility of patients for
partial hospitalization services. The eligibility determinations for
participation at the Dallas program were made by board certified or board
eligible psychiatrists. The Company is cooperating fully with the Agencies and,
to date, no formal complaint or demand has been made by the Agencies.

On July 20, 1998, the Company was informed that a qui tam suit had been filed
against a subsidiary of the Company. The suit alleges a broad range of improper
conduct relating to the quality of services furnished by the Company, the
medical necessity of such services furnished by the Company and by physicians
who admit patients to the program managed by the Company, and other matters. The
suit was filed by a former employee who previously had filed a separate action
for wrongful termination. The Company prevailed in that wrongful termination
case when the court dismissed the case granting the Company's motion for summary
judgment. Notwithstanding the similarity between the allegations in the wrongful
termination case and the qui tam case, the Company cannot give any assurances
with respect to the ultimate outcome of the qui tam case or its effect on the
Company's business, financial condition or results of operations. Under the
False Claims Act, the Department of Justice must inform the court whether it
will intervene and take control of the qui tam suit. In this case, the
Department of Justice has not yet made that decision, but rather is conducting
an investigation. The Company has met with the Assistant United States Attorney
who is coordinating the government's investigation of this case, and the Company
has agreed to furnish certain documentation to the government.

Due to the preliminary nature of these investigations, the Company is unable to
predict the ultimate outcome of the investigations, or the material impact, if
any, on the Company's business, financial condition or results of operations.

14.  SPECIAL CHARGE

During the fourth quarter of fiscal 1998, the Company recorded a special charge
of $4,991,588. The charge resulted from management's decision to close ten
program locations in the Mid-America Region, and costs to be incurred in
connection with noncancelable operating commitments resulting from the HCFA
withdrawal of provider status for the Company's largest partial hospitalization
program.

The components of the impairment and exit costs resulting from closing program
locations consist of severance, noncancelable facility lease commitments,
related legal costs, write-off of furniture and office equipment and intangible
assets, other related costs, and additional allowances or uncollectible accounts
due to anticipated difficulties associated with collection of receivables from
closed locations.

                                      F-19
<PAGE>   56

                                PMR Corporation

             Notes to Consolidated Financial Statements (continued)



14.  SPECIAL CHARGE (CONTINUED)

In February 1998, HCFA notified Scripps Health that the "provider based" status
of its programs would be withdrawn on March 1, 1998. As a result of the notice
of withdrawal of the provider based status, the Company recorded a charge for
the costs to be incurred by the Company under the noncancelable operating
commitment provision of its management contract with Scripps Health. Subsequent
to the withdrawal, HCFA granted an extension to the program through April 15,
1998 and in June 1998, granted an additional extension of provider based status
to July 15, 1998 in order for Scripps Health and the Company to implement
certain agreed upon changes. However, there is no assurance that Scripps Health
and the Company will be able to implement the agreed upon changes required by
HCFA or that HCFA will grant additional extensions.

Following is a summary of the components of the special charge by income
statement line item:
<TABLE>

<S>                                       <C>       
Provision for bad debts                   $2,408,692

Special charge:
   Location closure related costs          1,402,896
   Contract losses                         1,180,000
                                          ----------
                                           2,582,896
                                          ----------
                                          $4,991,588
                                          ==========
</TABLE>

At April 30, 1998, special charges totaling $2,229,741 are included in accrued
liabilities in the consolidated balance sheet.

15.  SUBSEQUENT EVENT

On June 10, 1998, the Company signed a subscription agreement with Stadtlander
Drug Distribution Co., Inc. to form a new disease management company to provide
pharmaceutical care for individuals with serious mental illness. The joint
venture is expected to begin operations in July 1998.


                                      F-20
<PAGE>   57
                                   Schedule II

                                 PMR Corporation

                        Valuation and Qualifying Accounts

<TABLE>
<CAPTION>
------------------------------------------------- ---------------- ----------------- -------------------- ----------------
                   COL. A                             COL. B            COL. C             COL. D             COL. E
------------------------------------------------- ---------------- ----------------- -------------------- ----------------
                                                                      ADDITIONS
                                                                   -----------------
                 DESCRIPTION                        BALANCE AT        CHARGED TO                          BALANCE AT END
                                                   BEGINNING OF       COSTS AND         DEDUCTIONS -         OF PERIOD
                                                      PERIOD           EXPENSES           DESCRIBE
------------------------------------------------- ---------------- ----------------- -------------------- ----------------
<S>                                               <C>                <C>              <C>         <C>         <C>        
Year ended April 30, 1998
Allowance for doubtful accounts                   $5,081,177         $5,148,580       $ 1,148,147 (1)         $ 9,081,610
Contract settlement reserve                       $8,791,928         $2,349,382       $ 3,661,317 (2)         $ 7,479,993

Year ended April 30, 1997
Allowance for doubtful accounts                   $1,759,182         $3,084,166       $ (237,829) (1)         $ 5,081,177
Contract settlement reserve                       $5,499,020         $3,927,371       $  634,463  (2)         $ 8,791,928

Year ended April 30, 1996
Allowance for doubtful accounts                   $1,423,054         $1,447,983       $ 1,111,855 (1)         $ 1,759,182
Contract settlement reserve                       $3,523,223         $2,390,196       $   414,399 (2)         $ 5,499,020
</TABLE>

(1)      Uncollectible accounts written off, net of recoveries

(2)      Write off of hospital receivables based on disallowance of the
         Company's management fee on Provider's cost reimbursement report and
         the Company's indemnity obligation


                                      S-1