SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                   FORM 10-QSB

 (X)    QUARTERY REPORT UNDER SECTION 13 OR 15 (d) OF THE SECURITIES 
        EXCHANGE ACT OF 1934

                  For the quarterly period ended July 4, 1998

                  Commission File Number 0-11447


                                  DATAKEY, INC.
        (Exact name of small business issuer as specified in its charter)


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

                 407 WEST TRAVELERS TRAIL, BURNSVILLE, MN 55337
                    Issuer's telephone number: (612) 890-6850


              (Former name, former address and former fiscal year,
                          if changed since last report)

         Check whether the issuer (1) filed all reports  required to be filed by
Section 13 or 15 (d) of the  Exchange Act during the past 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 ___

                      APPLICABLE ONLY TO CORPORATE ISSUERS

        The number of shares  outstanding of the issuer's common equity,  as of
August 14, 1998, is 2,949,735.

         Transitional Small Business Disclosure Format (check One):
                                Yes      No   X



<PAGE>
                          PART I. FINANCIAL INFORMATION
                          ITEM I. FINANCIAL STATEMENTS
                          DATAKEY, INC. AND SUBSIDIARY
                           CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>

                                                                   July 4,      December 31,
                                                                    1998            1997
                                                                 -----------    ------------
                                                                 (UNAUDITED)                
                   ASSETS
CURRENT ASSETS
<S>                                                              <C>            <C>
  Cash and cash equivalents                                      $ 1,748,701    $ 1,305,392
  Trade receivables, less allowance for
    doubtful accounts of $31,707 and $30,000                       1,047,562        634,267
  Inventories                                                      1,159,640      1,082,737
  Prepaid and other                                                   74,836         53,360
                                                                 -----------    ------------
                   Total current assets                            4,030,739      3,075,756
                                                                 -----------    ------------

OTHER ASSETS
  Prepaid licenses at cost less amortization                       1,000,925        996,611
   of $92,676 and $89,890
Patents at cost, less amortization
    of $112,103 and $91,911                                          112,871        107,691
                                                                 -----------    ------------
                                                                   1,113,796      1,104,302
                                                                 -----------    ------------

EQUIPMENT AND LEASEHOLD IMPROVEMENTS, at cost
  Production tooling                                               1,214,249      1,215,012
  Equipment                                                        3,004,135      2,956,269
  Furniture and fixtures                                             304,852        298,771
  Leasehold improvements                                             286,916        281,956
                                                                 -----------    ------------
                                                                   4,810,152      4,752,008
  Less accumulated depreciation                                   (3,530,877)    (3,278,760)
                                                                 -----------    ------------
                                                                   1,279,275      1,473,248
                                                                 -----------    ------------

                                                                 $ 6,423,810    $ 5,653,306
                                                                 ===========    ============


                   LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES
  Accounts payable                                               $   419,427    $   184,103
  Accrued severance obligation                                        77,400        185,672
  Accrued license fees                                               439,000        439,000
  Accrued dividends                                                   15,799              0
  Accrued expenses                                                   227,885        316,157
                                                                 -----------    ------------
                   Total current liabilities                       1,179,511      1,124,932
                                                                 -----------    ------------



SHAREHOLDERS' EQUITY
  Convertible preferred stock, voting, stated value
    $2.50 per share; authorized 400,000 shares;
    issued and outstanding 150,000 shares                            375,000        375,000
  Convertible preferred stock series A, voting, 8% cumulative,
    stated value $15.80 per share; authorized 150,000 shares;
    issued and outstanding 100,000 shares                          1,580,000              0
  Common stock, par value $.05 per share;
    authorized 10,000,000 shares; issued and
    outstanding 2,943,901 and 2,887,235                              147,195        144,361
  Additional paid-in capital                                       4,535,587      4,089,283
  Accumulated deficit                                             (1,393,483)       (80,270)
                                                                 -----------    ------------
                                                                   5,244,299      4,528,374
                                                                 -----------    ------------

                                                                 $ 6,423,810    $ 5,653,306
                                                                 ===========    ============
</TABLE>


                 See Notes to Consolidated Financial Statements

                                        2
<PAGE>

                          DATAKEY, INC. AND SUBSIDIARY
                        CONSOLIDATED STATEMENTS OF INCOME
                                   (UNAUDITED)
<TABLE>
<CAPTION>


                                                   Three Months Ended             Six Months Ended
                                                 July 4,       June 28,         July 4,      June 28,
                                                  1998           1997            1998          1997

<S>                                           <C>            <C>            <C>            <C>
Revenue                                       $ 1,742,630    $ 1,934,129    $ 3,226,185    $ 3,343,930
Cost of goods sold                              1,049,410      1,195,375      1,939,500      2,130,247
                                              -----------    -----------    -----------    -----------
                   Gross Profit                   693,220        738,754      1,286,685      1,213,683




Operating expenses:
Research, development
   and engineering                                412,839      1,047,175        811,962      2,063,527
  Marketing and sales                             502,519        393,625        978,676        788,000
  General and administrative                      210,529        217,810        422,845        429,366
                                              -----------    -----------    -----------    -----------

                   Total operating expenses     1,125,887      1,658,610      2,213,483      3,280,893
                                              -----------    -----------    -----------    -----------

                   Operating loss                (432,667)      (919,856)      (926,798)    (2,067,210)

Interest income                                    12,843         43,537         24,384        119,154
                                              -----------    -----------    -----------    -----------

                   Loss before
                   income taxes                  (419,824)      (876,319)      (902,414)    (1,948,056)
                                              -----------    -----------    -----------    -----------
Income tax expense                                      0              0              0              0

                   Net loss                   ($  419,824)   ($  876,319)   ($  902,414)   ($1,948,056)
                                              ===========    ===========    ===========    ===========



  Basic and diluted
  loss per share                              ($     0.28)   ($     0.30)   ($     0.45)   ($     0.67)
                                              ===========    ===========    ===========    ===========


Weighted average number of
  common shares outstanding                     2,921,085      2,887,235      2,903,885      2,886,023
                                              ===========    ===========    ===========    ===========


</TABLE>
                 See Notes to Consolidated Financial Statements





                                        3

<PAGE>

                          DATAKEY, INC. AND SUBSIDIARY
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                   (UNAUDITED)
<TABLE>
<CAPTION>
                                    
                                                           Three Months Ended             Six Months Ended
                                                          July 4,      June 28,        July 4,       June 28,
                                                           1998          1997           1998           1997
CASH FLOWS FROM
OPERATING ACTIVITIES
<S>                                                   <C>            <C>            <C>            <C>
  Net loss                                            ($  419,824)   ($  876,319)   ($  902,414)   ($1,948,056)
  Adjustments to reconcile net loss
  to net cash used in operating activities:
    Depreciation                                          128,766        122,575        252,117        237,637
    Amortization                                           11,543         30,827         22,978         39,788
    Change in assets and liabilities
    (Increase) decrease:
      Trade receivables                                  (152,553)      (453,579)      (413,295)      (580,757)
      Inventories                                          10,016       (166,338)       (76,903)      (671,062)
      Prepaid expenses and other                             (349)         6,399        (21,476)       (52,419)
      Prepaid license fees                                (10,000)      (103,665)        (7,100)      (183,665)
     Increase (decrease) in:
      Accounts payable                                    109,195          4,887        235,324        365,942
      Accrued expenses                                    (85,914)        (7,258)       (88,270)       237,140
      Accrued license fees                                      0       (109,750)             0       (109,750)
      Accrued severance                                   (41,500)       (47,100)      (108,272)       (88,600)
                                                      -----------    -----------    -----------    -----------

         Net cash used in
         operating activities                            (450,620)    (1,599,321)    (1,107,311)    (2,753,802)
                                                      -----------    -----------    -----------    -----------

CASH FLOWS FROM INVESTING ACTIVITIES
  Purchase of tooling and equipment                       (36,986)      (200,446)       (58,144)      (464,309)
  Purchase of held-to-maturity
    securities                                                  0        (41,192)             0       (113,999)
  Proceeds from maturity of
    held-to-maturity securities                                 0      2,502,421              0      4,517,583
  Patent  costs                                           (12,954)       (19,457)       (25,372)       (19,869)
                                                      -----------    -----------    -----------    -----------

         Net cash provided by(used in)
         investing activities                             (49,940)     2,241,326        (83,516)     3,919,406
                                                      -----------    -----------    -----------    -----------

CASH FLOWS FROM FINANCING ACTIVITIES
  Net proceeds from issuance of
    preferred stock                                     1,426,222              0      1,426,222              0
  Net proceeds from issuance of
    common stock                                          207,914              0        207,914         18,727
                                                      -----------    -----------    -----------    -----------
          Net cash provided by financing activities     1,634,136              0      1,634,136         18,727
                                                      -----------    -----------    -----------    -----------

         Increase in cash and
         cash equivalents                               1,133,576        642,005        443,309      1,184,331

CASH AND CASH EQUIVALENTS
  Beginning                                               615,125        682,356      1,305,392        140,030
                                                      -----------    -----------    -----------    -----------
  Ending                                                1,748,701      1,324,361      1,748,701      1,324,361
                                                      ===========    ===========    ===========    ===========

SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING
AND FINANCING ACTIVITIES
  Accrued preferred stock dividends                        15,799              0         15,799              0
  Obligation recorded in connection with prepaid
  license fees                                                  0        768,250              0        768,250
                                                      -----------    -----------    -----------    -----------
                                                           15,799        768,250         15,799        768,250
                                                      ===========    ===========    ===========    ===========

</TABLE>
                 See Notes to Consolidated Financial Statements

                                        4


<PAGE>


                          DATAKEY, INC. AND SUBSIDIARY
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


GENERAL

In the opinion of management,  the accompanying  unaudited financial  statements
contain all adjustments necessary to present fairly Datakey's financial position
as of July 4, 1998,  and December 31, 1997,  and results of its  operations  and
cash flows for the  three-month  and six-month  periods ended July 4, 1998,  and
June 28, 1997.  The  adjustments  that have been made are of a normal  recurring
nature.

The accounting  policies  followed by the Company are set forth in Note 1 to the
Company's  financial  statements in the 1997 Datakey,  Inc. Annual Report and in
Form 10-KSB for the year ended December 31, 1997.


PRIVATE PREFERRED STOCK FINANCING

The Company completed,  in May 1998, a $1.58 million convertible preferred stock
financing which entitles the preferred  shareholders,  for a two-year period, to
convert their  investment into common shares at 80% of the average closing price
(for a 10 day period prior to conversion)  of the Company's  common stock with a
maximum  conversion  price of $5.00 per share and a minimum  conversion price of
$2.75 per share.  This "beneficial  conversion"  feature has been interpreted by
the office of the SEC chief accountant to be an assumed preferred stock dividend
of  fourteen  cents per common  share,  which must be taken  into  account  when
computing basic and diluted loss per share.

BASIC AND DILUTED LOSS PER SHARE

Basic and diluted  loss per share,  in  accordance  with  Statement of Financial
Accounting Standards No. 128 are as follows:

<TABLE>
<CAPTION>

                                                 Three Months Ended             Six Months Ended
                                           July 4, 1998   June 28, 1997   July 4, 1998  June 28, 1997
                                            -----------    -----------    -----------    -----------

<S>                                         <C>            <C>            <C>            <C>         
Net Loss                                    $  (419,824)   $  (876,319)   $  (902,414)   $(1,948,056)

Less:
         Accrued preferred stock dividend       (15,799)             0        (15,799)             0

         Assumed preferred stock dividend      (395,000)             0       (395,000)             0
                                            -----------    -----------    -----------    -----------
Loss available to common stockholders       $  (830,623)   $  (876,319)   $(1,313,213)   $(1,948,056)
                                            ===========    ===========    ===========    ===========

Weighted average common shares                2,921,085      2,887,235      2,903,885      2,886,023

Basic and diluted loss per share            $     (0.28)   $     (0.30)   $     (0.45)   $     (0.67)
                                            ===========    ===========    ===========    ===========

</TABLE>


<PAGE>


ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
                          DATAKEY, INC. AND SUBSIDIARY
                  RESULTS OF OPERATIONS AND FINANCIAL CONDITION


RESULTS OF OPERATIONS

         REVENUE - Revenue for the three-month and six-month  periods ended July
4, 1998, decreased by $191,499 and $117,745, or 10 and 4 percent,  respectively,
compared  to the  comparable  1997  periods.  The  decrease in revenue is due to
unusually  strong revenue in the second  quarter of 1997.  The newly  introduced
information  security  products are  currently in  evaluation  or pilot  program
stages with several  companies.  If larger  quantity  orders are received in the
second half of 1998, as the Company currently anticipates,  revenue from the new
products  could exceed  revenue  from the  existing  products by the 1998 fourth
quarter,  in which case total 1998 revenue would then exceed 1997  revenue.  The
Company's ability to achieve acceptable revenue growth is primarily dependent on
the generation of significant  sales of its information  security products which
cannot at this time be assured.

         GROSS PROFIT MARGIN - Gross profit as a percentage of revenue increased
to 40 percent  in the  three-month  and  six-month  periods  ended July 4, 1998,
compared to 38 and 36 percent respectively,  in the comparable 1997 periods. The
1998  improvement in margin  percentage is due to improved  factory direct labor
utilization,  a reduction in scrap and yield loss, and a favorable  product mix.
The Company expects the gross profit margin as a percentage of revenue to remain
at about the current levels for the balance of 1998.

         OPERATING  EXPENSES - Operating  expense  decreased by $532,723,  or 32
percent, in the three-month period and $1,067,410 or 33 percent in the six-month
period ended July 4, 1998, compared to the comparable 1997 periods. The decrease
is  attributable  to a  substantial  reduction  in  research,  development,  and
engineering (R&D) expense,  offset in part by an increase in marketing and sales
expense.  R&D expense  declined  substantially  because  the  initial  major new
product  development  phase was  completed in late 1997,  and the Company is now
able  to  concentrate  on  product   enhancements   and  upgrades  during  1998.
Consequently, the Company expects to invest about 45 percent less on R&D in 1998
than in 1997.  Marketing and sales expense  increased  $108,894 or 28 percent in
the three-month  period and $190,676 or 24 percent in the six-month period ended
July 4, 1998,  compared to the comparable 1997 periods as the Company  increased
its advertising and promotional  activities for the newly introduced information
security  products.  Marketing  and sales  expenses  are expected to continue at
about a 30 to 40 percent higher level than was incurred in 1997.

         INTEREST INCOME - Interest income declined $30,694,  or 71 percent,  in
the  three-month  period  ended  July 4, 1998 and  $94,770  or 80 percent in the
six-month period ended July 4, 1998,  compared to the comparable 1997 periods as
proceeds  from  interest  bearing  accounts  were  utilized  to fund new product
development  and product  promotion  activities.  Interest income is expected to
remain lower than the comparable 1997 periods for the balance of 1998.


<PAGE>

         FINANCIAL  CONDITION - During the  three-month  and  six-month  periods
ended July 4, 1998,  the Company had a net increase of  $1,133,576  and $443,309
respectively,  in cash  and cash  equivalents  as  compared  to an  increase  of
$642,005 and $1,184,331  respectively,  in the comparable 1997 periods. The 1997
increases were primarily due to realization of proceeds from maturing marketable
debt  securities  during  the  periods.  Net cash used in  operating  activities
decreased  to $450,620  and  $1,107,311  respectively,  in the  three-month  and
six-month  periods  ended July 4, 1998,  compared to $1,599,321  and  $2,753,802
respectively,  in the  comparable  1997 periods.  The reduced use of cash in the
1998 periods is directly  attributable  to a reduction in the operating  loss to
$419,824 and $902,414 in the three-month and six-month periods respectively,  in
1998, from $1,599,321 and $2,753,802 in 1997.

         Datakey's  balance sheet reflects  $2,851,228 in working  capital as of
July 4, 1998,  and a current assets to current  liabilities  ratio of 3.42 to 1.
The Company expects to continue  spending on R&D at a reduced amount compared to
1997, and on marketing and sales  activities at an increased  amount compared to
1997.  Inventory and accounts  receivable levels are expected to increase during
the  balance  of 1998 to  support  the  expected  ramp-up  in  revenue  from the
Company's new information  security products.  The Company believes that it will
have adequate  financial  resources to fund its operations and R&D and marketing
activities  during  1998  through  utilization  of its $1  million  bank line of
credit, proceeds from the private preferred stock financing described above, and
positive cash flow from  operations  later in the year if the Company returns to
profitability  as it currently  expects.  If market  acceptance of the Company's
information  security  products  is  slow to  develop  or does  not  develop  as
currently  anticipated  the  Company may need funds in addition to its bank line
and recent private preferred stock financing. In such circumstances, there is no
assurance that the necessary funding would be available upon acceptable terms.

         The Company has  evaluated the impact,  if any, from the  changeover of
various  computer  systems during the year 2000. Based upon its current internal
analysis and results of questions posed to major software and service suppliers,
the  Company  feels  that  year  2000  will  have no  significant  financial  or
operational impact.


                              CAUTIONARY STATEMENTS

The  Management's  Discussion  and  Analysis  contains  certain  forward-looking
statements  relating  primarily  to  the  introduction  and  acceptance  of  the
Company's   information  security  products,   the  anticipated   generation  of
significant  revenue  from  such  products  in 1998 and the  impact of year 2000
issues  on its  business.  The  statements  are  subject  to  certain  risks and
uncertainties,  which could cause results to differ from those projected.  These
risks and uncertainties,  in addition to those discussed above, include: (i) the
ability of the Company to  successfully  develop all of the new  products  under
development  and to control costs as necessary;  (ii) the  capability of the new
products to function as currently anticipated;  (iii) the potential introduction
of  competitive  products by companies  with greater  resources than that of the
Company;  (iv) market  acceptance of the new products,  and (v) the accuracy and
reliability  of the Company's and its suppliers'  assessment and  remediation of
year 2000 issues.


<PAGE>



                           PART II. OTHER INFORMATION

ITEM 2.  CHANGES IN SECURITIES AND USE OF PROCEEDS

On May 15, 1998,  the Company  issued an aggregate of 100,000 shares of Series A
Convertible  Cumulative  Preferred  Stock and five-year  warrants to purchase an
aggregate of 188,095  shares of Common Stock for gross  proceeds of  $1,580,000.
The  shares  were  sold  with  the  assistance  of  Miller,   Johnson  &  Kuehn,
Incorporated (MJK) to 12 accredited investors. MJK received commissions equal to
$110,600 as part of the  offering,  and  ten-year  warrants  to purchase  37,890
shares of Common Stock,  with an exercise price of $6.60 per share.  Because the
offering was not a public offering and was offered only to accredited investors,
the  Company  relied  upon  Section  4 (6) and Rule 506 of  Regulation  D of the
Securities  Act of 1933,  as  amended,  for  exemptions  from  the  registration
requirements  of such  Act.  The  shares  of  Series  A  Convertible  Cumulative
Preferred Stock have 8 percent  dividend rights and are convertible  into shares
of Common Stock at any time on or before May 15, 2000. The  conversion  price is
equal to 80 percent of the market price (equal to average  closing bid price for
the 10-day period prior to the  conversion  date),  with the minimum and maximum
conversion price of $2.75 and $5.00,  respectively.  Investor warrants were also
granted and are  exercisable at $6.30 per share for five years.  The Company has
filed a Registration  Statement on Form S-3 covering the resale of the shares of
Company  Common  Stock:  (i)  underlying  the Series A  preferred  shares;  (ii)
issuable upon exercise of the agent and investor warrants; and (iii) issuable in
connection with the payment of any dividends paid in Company Common Stock on the
Series A preferred shares.


ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY SHAREHOLDERS
        DATAKEY, INC. AND SUBSIDIARY

The Company held its Annual Meeting on Tuesday, June 2, 1998.

Proxies for the Annual  Meeting were  solicited  pursuant to Regulation 14 under
the Securities  Exchange Act of 1934. There was no solicitation in opposition to
management's  nominees  as  listed in the  Company's  proxy  statement,  and all
nominees were elected.

By a vote of 2,810,986 shares in favor,  with 3,425 shares opposed and 50 shares
abstaining,  the  shareholders  set the number of directors to be elected at six
(6).

The following persons were elected to serve as directors of the Company,  by the
votes indicated, until the next annual meeting of shareholders:

                                     NUMBER OF               NUMBER OF VOTES
               NOMINEE               VOTES FOR                  WITHHELD
              ---------              ---------               ---------------
John H. Underwood                    2,800,311                      14,150
Terrence W. Glarner                  2,805,261                       9,200
Thomas R. King                       2,805,261                       9,200
Gary R. Holland                      2,805,261                       9,200
Eugene W. Courtney                   2,804,761                       9,700
Carl P. Boecher                      2,804,761                       9,700



<PAGE>

The shareholders  approved,  by a vote of 1,300,162 for, 629,458 against,  5,673
abstaining and 879,168 broker non-votes,  an increase of shares, from 500,000 to
800,000 in the Company's 1997 Stock Option Plan.

The shareholders also ratified the appointment of McGladrey and Pullen,  LLP, as
independent  auditors  for the Company for the fiscal year ending  December  31,
1998,  by a vote of  2,810,286  shares in favor,  850 shares  opposing and 3,325
shares abstaining.

                           PART II. OTHER INFORMATION

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K


         Exhibits

(a)      Exhibit 27    Financial Data Schedule (only filed with electronic copy)


(b)      Reports on Form 8-K:

                    The  Company  filed a Form 8-K on May 20,  1998,  that fully
                    described  the  details  of  the  private   preferred  stock
                    financing which was completed on May 15, 1998.



<PAGE>




                                   SIGNATURES


In accordance with the requirements of the Exchange Act, the Registrant has duly
caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized.

Dated August 14, 1998                Datakey, Inc.

                                     By:      /s/ Carl P. Boecher
                                              Carl P. Boecher
                                              President & Chief Executive
                                              Officer
                                              (Principal Executive Officer)


                                     By:      /s/ Alan G. Shuler
                                              Alan G. Shuler
                                              Vice President & Chief Financial
                                              Officer
                                              (Principal Financial and
                                               Accounting Officer)



<PAGE>

                                  Datakey, Inc.
                          EXHIBIT INDEX TO FORM 10-QSB
                         FOR QUARTER ENDED JULY 4, 1998


EXHIBIT NO.              DESCRIPTION


27       Financial Data Schedule