<PAGE>
 
================================================================================
                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                         ------------------------------
                                    FORM 10-K

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

                   For the Fiscal Year Ended December 31, 1998

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

         For the transition period from ____________ to ______________.

                           Commission File No. 0-27600

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

                          OPTICAL SENSORS INCORPORATED
             (Exact name of registrant as specified in its charter)

                  Delaware                              41-164359
      (State or other jurisdiction of                (I.R.S. Employer
       incorporation or organization)              Identification No.)

         7615 Golden Triangle Drive
                  Suite A
           Minneapolis, Minnesota                       55344-3733
  (Address of principal executive offices)              (Zip code)


       Registrant's telephone number, including area code: (612) 944-5857

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

           Securities registered pursuant to Section 12(g) of the Act:

                          Common Stock, $.01 par value
                         Preferred Share Purchase Rights

        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 March 1, 1999, 8,841,123 shares of Common Stock of the Registrant
were outstanding, and the aggregate market value of the Common Stock of the
Registrant as of that date (based upon the last reported sale price of the
Common Stock at that date as reported by the Nasdaq National Market System),
excluding outstanding shares beneficially owned by directors and executive
officers, was $11,720,041.

                       DOCUMENTS INCORPORATED BY REFERENCE

        Part III of this Annual Report on Form 10-K incorporates by reference
information (to the extent specific sections are referred to herein) from the
Registrant's Proxy Statement for its 1999 Annual Meeting to be held May 6, 1999
(the "1999 Proxy Statement").

================================================================================
<PAGE>
 
                                     PART I

        This Form 10-K contains certain forward-looking statements. For this
purpose, any statements contained in this Form 10-K that are not statements of
historical fact may be deemed to be forward-looking statements. Without limiting
the foregoing, words such as "may," "will," "expect," "believe," "anticipate,"
"estimate" or "continue" or comparable terminology are intended to identify
forward-looking statements. These statements by their nature involve substantial
risks and uncertainties, and actual results may differ materially depending on a
variety of factors, including those set forth in the section below entitled
"Certain Important Factors."

Item 1.        BUSINESS.

General

        Optical Sensors Incorporated (the "Company") has developed the SensiCath
system, a patient-connected, on-demand arterial blood gas ("ABG") monitoring
system, which provides precise and accurate ABG results within 60 seconds
without exposure to potentially infectious blood or depleting the patient's
blood supply (the "SensiCath System"). ABG tests measure oxygen ("O2"), carbon
dioxide ("CO2") and acid-base ("pH") in a sample of blood taken from a patient's
artery. These tests, which are among the most frequently ordered and most
urgently needed tests for critically ill and unstable patients, are the foremost
indicators of the body's ability to absorb and use oxygen. Results of ABG tests
provide a basis for medical treatment and intervention and are required to
accurately regulate the patient's respiratory support system. The Company
believes that the SensiCath System is the first ABG analyzer to be integrated
into both an arterial pressure monitoring line and a critical care patient
monitoring system. The SensiCath System utilizes a disposable, fiberoptic sensor
device (the "SensiCath Sensor") connected to a small modular instrument (the
"ABG Module") that is part of the Company's OpticalCAM instrumentation
("OpticalCAM"). The SensiCath System is able to either stand alone or interface
with various monitoring platforms. Because of the need to conserve resources, in
January 1999, the Company suspended direct sales activity of the SensiCath
System and reduced associated expenses.

        In July 1998, the Company entered into a patent license agreement with
the Institute of Critical Care Medicine ("ICCM"), headed by distinguished
intensive care medicine specialist Max Harry Weil, M.D., Ph D. The license
agreement provides the Company with the exclusive, worldwide right under ICCM's
pending and issued patents to use the Company's technology to assess tissue
perfusion under the tongue (sublingually) and in the esophagus to aid in the
diagnosis and monitoring of shock. Generalized inadequacy of tissue perfusion is
the hallmark of clinical shock. Diagnosis of shock may be difficult in its early
stages when the signs and symptoms are masked by the body's natural compensatory
mechanisms that preserve blood supply to vital organs by reducing blood flow to
other organs. If treatment is delayed to the point that the body's compensatory
systems can no longer maintain adequate circulation and vital tissue perfusion,
the consequences can be disastrous for the patient. To date, there has been no
rapid, low-cost, noninvasive method to objectively determine when a patient has
inadequate tissue perfusion and is in early shock. The Company is currently
developing the CapnoProbe SL, which is a handheld device with a CO2 probe that
is slipped under the tongue like a thermometer. It non-invasively measures the
tissue CO2 of the mucous membrane in the mouth - a sensitive measure that can
indicate early clinical shock, even when traditional vital signs may still
appear relatively normal, as in compensated shock cases. According to the
Wilkerson Group, a leading market research organization, the U.S. market
potential for the CapnoProbe is more than $300 million in the emergency
department and intensive care markets alone. In December 1998, the Company filed
a 510(k) for FDA clearance of the CapnoProbe SL as a Class II medical device.
Prototype versions of the CapnoProbe system are
<PAGE>
 
currently being evaluated at clinical sites in the United States. The Company
has completed set up of one manufacturing pod for manual assembly of the
prototype probes and finished preliminary plans for automated probe assembly.
The Company projects that the product will be available for commercialization in
the first quarter of 2000.

        In October 1998, the Company implemented a strategic plan to focus its
corporate resources on development and commercialization of the CapnoProbe and
initiated a workforce reduction of approximately twenty percent. The Company
continued its plan to focus on the CapnoProbe in January 1999 by further
reducing its workforce, suspending direct sales activity of the SensiCath System
and reducing associated expenses. The Company currently has approximately 30
full-time and two part-time employees. In January 1999, the Company also
announced that it had engaged Volpe Brown Whelan & Company, LLC, to serve as
financial advisor to the Company. The Company is working with Volpe Brown Whelan
to explore strategic alternatives, including joint ventures, corporate strategic
alliances, sale of the business or product lines, or other business
combinations. The Company also exercised its right to convert Instrumentation
Laboratory Company ("IL") to a non-exclusive distributor of the SensiCath System
in January 1999. The Company does not expect meaningful sales of the SensiCath
System in the future.

        The Company was incorporated in Minnesota in May 1989 and reincorporated
in Delaware in January 1996. The Company's executive offices are located at 7615
Golden Triangle Drive, Suite A, Minneapolis, Minnesota 55344, and its telephone
number is (612) 944-5857.

SensiCath System

        The SensiCath System is able to interface with various monitoring
platforms, including monitoring systems produced and installed by Marquette
Medical Systems, Inc., SpaceLabs Medical, Inc., and the Hewlett-Packard Company.
In addition, the OpticalCam provides stand-alone instrumentation capability for
the SensiCath System, operating independently of any other monitoring equipment.
The SensiCath Sensor contains three optical fibers with fluorescent chemistries
for sensing O2, CO2 and pH. The disposable, single-patient sensor has been
designed to provide accurate ABG data for the 144-hour approved period of use.
The ABG Module is the source and receptor of optical signals, provides signal
processing and communicates with other components in the monitoring system.

        The fiberoptic sensors are located outside the patient's artery
(paracorporeal) as a part of an existing arterial pressure monitoring line which
is secured to the patient's forearm. The integration of the SensiCath Sensor
with an existing arterial line and a bedside monitoring system enables the
health care provider to provide integrated bedside management of rapid changes
in the patient's cardiopulmonary status. The closed-loop system of the SensiCath
Sensor and the arterial line eliminates blood loss and blood exposure resulting
from traditional ABG analysis.

        The SensiCath Sensor is attached to the standard arterial line already
in place on critically ill patients. A standard line includes an arterial
cannula, pressure monitoring tubing and pressure transducer. The arterial line
is constantly filled with saline or other physiologic solution as part of its
function as a pressure monitor. The SensiCath Sensor is added to the arterial
line in a flow-through configuration which does not disrupt the arterial
pressure waveform or interfere with fluid delivery. Unlike electrochemical ABG
analyzers, the SensiCath System needs to be calibrated only once at the outset
of its use. The calibration procedure takes approximately five minutes and
requires only two small pouches of initialization fluid which are included with
the SensiCath Sensor.

                                       2
<PAGE>
 
        The SensiCath System is then ready to provide ABG measurements. To take
an ABG measurement, the health care provider pushes a button on the bedside
monitor and draws blood past the sensor. A tone from the monitor signals the
health care provider to return the blood to the patient and flush the line. The
ABG results then appear on the monitor screen within 60 seconds. The
time-consuming and complicated process of removing, handling and analyzing a
blood sample, all of which can contribute to delayed and inaccurate results, is
unnecessary with the SensiCath System.

The CapnoProbe

        The CapnoProbe SL is a handheld device with a CO2 probe that is slipped
under the tongue like a thermometer that non-invasively measures the tissue CO2
of the mucous membrane in the mouth - a sensitive measure that can indicate
early clinical shock, even when traditional vital signs may still appear
relatively normal, as in compensated shock cases. According to the Wilkerson
Group, a leading market research organization, the U.S. market potential for the
CapnoProbe is more than $300 million in the emergency department and intensive
care markets alone. In December 1998, the Company filed a 510(k) for FDA
clearance of the CapnoProbe SL as a Class II medical device. The CapnoProbe SL's
disposable CO2 probe is self-calibrating and is planned to provide CO2 readings
in less than one minute. One CapnoProbe sensor will be used on one patient for a
single measurement. Multiple measurements would be made depending on the
severity of the patient's state and response to therapy. The CapnoProbe
instrument will be portable, rugged and battery operated. The Company is using
its proven designs from its existing OpticalCAM blood analyte monitor and the
CO2 component of its SensiCath blood gas sensor to reduce technical risk in the
program and to speed development to market. No new research is required for the
product and all milestones to commercialization are engineering related.
Prototype versions of the CapnoProbe system are currently being evaluated at
clinical sites in the United States.

Sales and Marketing

        During 1998, the Company's principal distribution channel for its
products was through IL. In January 1998, the Company entered into an agreement
with IL for worldwide distribution of the Company's SensiCath Sensors and
OpticalCAM instrumentation. IL was required to purchase sufficient quantities of
products from the Company that would result in preestablished annual minimum
revenues to the Company. IL failed to meet the quota requirements for 1998, and,
accordingly, the Company exercised its right to convert IL's exclusive right to
a non-exclusive right in January 1999. During 1998, the Company also maintained
a sales and marketing staff. In January 1999, the Company suspended sales
activity of the SensiCath system and reduced expenses and personnel (including
sales and marketing personnel) in order to concentrate its resources on the
CapnoProbe. The Company does not expect meaningful sales of the SensiCath System
in the future.

        The Company is currently working with Volpe Brown Whelan & Company, LLC
to explore strategic alternatives, including joint ventures, corporate strategic
alliances, sale of the business or product lines, or other business
combinations. One of the strategic alternatives could include a distribution
partner for the CapnoProbe.

Research and Development

        The Company's research and development staff is currently focusing on
the design and development of the CapnoProbe technology. There can be no
assurance that the Company will be able to successfully develop the CapnoProbe
product on a timely basis or at all. During 1998, the Company's research and
development activities related to improvements to the SensiCath System,
including

                                       3
<PAGE>
 
modifications to reduce set-up and calibration time for the system, design and
analysis of new sensors to measure additional blood analytes and design of cost
reduction programs. The Company's research and development expenses for the
fiscal years ended December 31, 1998, 1997 and 1996 were $4,248,029, $4,975,037
and $5,632,458, respectively. The Company anticipates that it will continue to
spend significant amounts on research and development activities for the
foreseeable future.

Manufacturing and Supply

        The Company manufactures the SensiCath Sensor at its facility in
Minneapolis, Minnesota, which includes approximately 4,000 square feet of
manufacturing space. The FDA conducted a scheduled good manufacturing practices
("GMP") inspection of the Company's manufacturing facility in November 1997, and
the Company has passed the inspection. The Company has also received ISO 9001
certification for its manufacturing facility. The SensiCath Sensors are
manufactured in a unique, reproducible process. The finished device is packaged
and sterilized prior to being shipped.

        The Company purchases components from various suppliers and relies on
single sources for the OpticalCAM monitor, as well as a few key components. To
date, the Company has qualified only single sources for certain purchased
components of the Company's unique optical platform. While the Company believes
that alternate suppliers are available and can be approved in accordance with
the Company's vendor qualification procedures, identifying and qualifying such
vendors could cause a delay in production of the Company's products. Any such
delay could have a material adverse effect on the Company. In addition, the ABG
Module is currently manufactured solely by Marquette Medical Systems, Inc.

        The Company has not yet established commercial manufacturing for the
CapnoProbe.

Competition

        Competition in the medical device industry in general and the ABG
analyzer market in particular is intense and expected to increase. The Company
believes that the principal competitive factors for ABG analyzers and monitors
are accuracy, rapid results, cost-effectiveness, integration with bedside
monitors, reduction of blood loss and exposure, and price. Several other
point-of-care or near-patient blood gas testing manufacturers have commercially
available products, including AVL Scientific Corp., i-STAT Corporation,
Diametrics Medical, Inc., SenDx Medical Inc. and VIA Medical, Inc. In addition,
some manufacturers of laboratory equipment are marketing "mobile" versions of
traditional blood gas testing equipment. The Company also expects that
manufacturers of central and satellite laboratory testing equipment will compete
to maintain their revenues and market share. Most of the Company's competitors
have significantly greater financial, technical, research, marketing, sales,
distribution and other resources than the Company. There can be no assurance
that the Company's competitors will not succeed in developing or marketing
technologies and products that are more effective or less expensive than those
developed or marketed by the Company or that would render the Company's
technology and products obsolete or noncompetitive. Furthermore, there can be no
assurance that the emergence of new products, technologies or procedures will
not reduce the need for ABG analysis.

        To the Company's knowledge, there are no commercially available products
that would be directly competitive with the CapnoProbe. Indirect competition is
seen in The Datex-Ohmeda (Instrumentarian Corporation) TONOCAP system. This
product measures CO2 in the tissue of the stomach wall as an indicator of shock
and has only recently been introduced to critical care medicine. The TONOCAP
system requires placement of a balloon catheter into the stomach and measures
air from

                                       4
<PAGE>
 
the balloon at regular intervals. However, the administration of a histamine-2
receptor (e.g., Tagamet) and a stomach free of food are required for accurate
measurements, making this a difficult product to use in emergency situations
where it is most needed. Even with its limitations, there is a growing body of
literature that reinforces the importance of measuring gastrointestinal CO2 as a
method of diagnosing shock since there is evidence that if elevated CO2 cannot
be reversed within six to twenty four hours, aggressive treatment will not be
effective.

Patents and Proprietary Rights

        The Company seeks to protect technology, inventions and improvements
that it considers important through the use of patents and trade secrets. The
Company currently holds 17 U.S. patents and has filed a number of patent
applications in the United States, Japan and key European countries. There can
be no assurance, however, that the Company's patents will provide competitive
advantages for the Company's products, or that such rights will not be
challenged or circumvented by competitors. In addition, there can be no
assurance that any pending patent applications will issue. Claims made under
patent applications may be denied or significantly narrowed and the issued
patents, if any, may not provide significant commercial protection to the
Company. The Company could incur substantial costs in proceedings before the
U.S. Patent and Trademark Office, including interference proceedings. These
proceedings could result in adverse decisions as to the priority of the
Company's inventions.

        In July 1998, the Company entered into a patent license agreement with
the ICCM, which provides the Company with the exclusive, worldwide right under
ICCM's pending and issued patents to use the Company's technology to assess
tissue perfusion under the tongue (sublingually) and in the esophagus to aid in
the diagnosis and monitoring of shock. The CapnoProbe product being developed by
the Company is expected to be subject to royalties under the license agreement.
The Company is obligated to pay ICCM a minimum annual royalty of $300,000 for
five years in order to maintain exclusivity. The Company may elect, on one
years' written notice, not to make the annual minimum royalty payment of
$300,000, but ICCM would have the right to terminate the license agreement. The
Company is obligated to pay ICCM a customary royalty equal to a percentage of
sales, which varies depending on the selling price to the customer of the
CapnoProbe. The Company is also obligated to meet certain product development
milestones under the license agreement.

        While the Company does not believe that any of its products infringe any
valid claims of patents or other proprietary rights held by third parties, there
can be no assurance that the Company does not infringe any patents or other
proprietary rights held by third parties. If an infringement claim was made, the
costs incurred to defend the claim could be substantial and adversely affect the
Company, even if the Company were ultimately successful in defending the claim.
If the Company's products were found to infringe any proprietary right of a
third party, the Company could be required to pay significant damages or license
fees to the third party or cease production. Litigation may also be necessary to
enforce patent rights held by the Company, or to protect trade secrets or
techniques owned by the Company. Any such claims or litigation could result in
substantial costs and diversion of effort by management of the Company.

        The Company also relies on trade secrets and other unpatented
proprietary technology. There can be no assurance that the Company can
meaningfully protect its rights in such unpatented proprietary technology or
that others will not independently develop substantially equivalent proprietary
products or processes or otherwise gain access to the Company's proprietary
technology. The Company seeks to protect its trade secrets and proprietary
know-how, in part, with confidentiality agreements with employees and
consultants. There can be no assurance that the agreements will not be breached,
that the

                                       5
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Company will have adequate remedies for any breach or that the Company's trade
secrets will not otherwise become known to or independently developed by
competitors.

        SensiCath(R),OpticalCAM(TM), and CapnoProbe(TM) are trademarks of the
Company.

Government Regulation

        The Company's products, development activities and manufacturing
processes are subject to regulation by numerous governmental authorities,
principally the United States Food and Drug Administration ("FDA") and
corresponding foreign agencies. In the United States, the FDA administers the
Federal Food, Drug and Cosmetics Act and amendments thereto, including the Safe
Medical Devices Act of 1990. The Company is subject to the standards and
procedures respecting manufacture and marketing of medical devices contained in
the Federal Food, Drug and Cosmetics Act and the regulations promulgated
thereunder and is subject to inspection by the FDA for compliance with such
standards and procedures. Noncompliance with applicable requirements can result
in, among other things, fines, injunctions, civil penalties, recall or seizure
of products, total or partial suspension of production, failure of the
government to grant premarket clearance or premarket approval for devices,
withdrawal of marketing approvals and criminal prosecution.

        In the United States, medical devices are classified into one of three
classes (class I, II or III), on the basis of the controls deemed necessary by
the FDA to reasonably assure their safety and effectiveness. Under FDA
regulations, class I devices are subject to general controls (e.g., labeling,
premarket notification and adherence to good manufacturing practices) and class
II devices are subject to general and special controls (e.g., performance
standards, postmarket surveillance, patient registries and FDA guidelines ). In
general, class III devices (e.g., life-sustaining, life-supporting and
implantable devices, or new devices which have not been found substantially
equivalent to a legally marketed device), in addition to being subject to
general and special controls, must receive premarket approval ("PMA") by the FDA
to ensure their safety and effectiveness.

        Before a new or significantly modified device can be introduced into the
market, the manufacturer must generally obtain marketing clearance through a
510(k) notification or approval of a PMA application. A 510(k) clearance will be
granted if the proposed device is "substantially equivalent" to a predicate
device (i.e., a legally marketed class I or class II medical device, or a class
III medical device for which the FDA has not called for the submission of a PMA
application). Commercial distribution of a device for which a 510(k)
notification is required can begin only after the FDA issues a written
determination that the device is "substantially equivalent" to a predicate
device. The process of obtaining a 510(k) clearance typically can take several
months to a year or longer. A PMA application must be filed if a proposed device
is not substantially equivalent to a legally marketed class I or class II
device, or if it is a class III device for which the FDA has called for a PMA
application. Certain class III devices that were on the market before May 28,
1976 ("preamendments class III devices"), and devices that are substantially
equivalent to them, can be brought to market through the 510(k) process until
the FDA calls for the submission of PMA applications for preamendments class III
devices. The process of obtaining a PMA can be expensive, uncertain and lengthy,
frequently requiring anywhere from one to several years from the date the PMA is
submitted to the FDA, if approval is obtained at all.

        The Company has received 510(k) clearance to market the SensiCath System
and the OpticalCAM monitor from the FDA. In December 1998, the Company submitted
a 510(k) for the

                                       6
<PAGE>
 
CapnoProbe, but has not yet received clearance to market. There can be no
assurance that this or any other future 510(k) submissions will be cleared by
the FDA on a timely basis, if at all.

        The Company is also subject to regulation in each of the foreign
countries in which it sells its products with regard to product standards,
packaging requirements, labeling requirements, import restrictions, tariff
regulations, duties and tax requirements. Many of the regulations applicable to
the Company's products in such countries are similar to those of the FDA. The
national health or social security organizations of certain of such countries
require the Company's products to be qualified before they can be marketed in
those countries. Delays in receipt of, or a failure to receive such approvals or
clearances, or the loss of any previously received approvals or clearances,
could have a material adverse effect on the Company. To date, the Company has
not experienced significant difficulty in complying with these regulations. In
February 1997, the Company received the European Medical Devices Directorate
("MDD") approval to place the "CE" mark on its products. The CE mark enables the
Company's products to be marketed, sold and used throughout the European Union,
subject to limited "safeguard" powers of member states.

        The Company is subject to periodic inspections by the FDA, which is
charged with auditing the Company's compliance with good manufacturing practices
("GMP") established by the FDA and other applicable government standards. The
Company is also subject to inspections by the MDD and other European regulatory
agencies. Strict regulatory action may be initiated in response to audit
deficiencies or to product performance problems. The Company believes that its
manufacturing and quality control procedures are in compliance with the
requirements of the FDA and MDD regulations. The Company's manufacturing
facilities and processes are also subject to periodic inspection and review by
its Notified Body in conjunction with the Company's ISO 9001 certification.
Failure to maintain GMP and ISO 9001 certifications could have a material
adverse effect on the Company.

Employees

        The Company currently has approximately 30 full-time and two part-time
employees. No employees are covered by collective bargaining agreements, and the
Company considers its relationship with its employees to be good.

Item 2.        PROPERTIES.

        The Company's facilities are located at 7615 Golden Triangle Drive,
Minneapolis, Minnesota, and consist of approximately 23,364 square feet. The
Company leases these facilities pursuant to a lease that expires on November 30,
1999. The lease provides for rent of approximately $20,800 per month, including
base rent and a pro rata share of operating expenses and real estate taxes. The
Company believes it will be able to renew this lease if necessary.

Item 3.        LEGAL PROCEEDINGS.

        There are no material pending or threatened legal, governmental,
administrative or other proceedings to which the Company is a party or of which
any of its property is subject.

Item 4.        SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

        No matter was submitted to a vote of security holders during the fourth
quarter of the fiscal year covered by this Report.

                                       7
<PAGE>
 
Item 4a.       EXECUTIVE OFFICERS OF THE COMPANY.

        The executive officers of the Company, their ages and the offices held,
as of March 1, 1999, are as follows:

        Name           Age           Title
-------------------   ----    -------------------------------------

Paulita M. LaPlante     41    President and Chief Executive Officer

Byron (Buzz) Moran      56    General Manager, Non-Invasive Systems

Wesley G. Peterson      51    Chief Financial Officer, Vice President of Finance
                              and Administration and Secretary

Victor Kimball          35    Vice President, Strategic Planning and Product
                              Development

James H. Quackenbush    40    Vice President, Manufacturing and Operations


        Information regarding the business experience of the executive officers
of the Company is set forth below.

        Paulita M. LaPlante has been the President and a Director of the Company
since September 1998 and Chief Executive Officer of the Company since December
1998. From June 1994 to September 1998, Ms. LaPlante served as the Company's
Vice President of Worldwide Sales, Marketing and Business Development and was
Director of Marketing and Business Development from April 1992 to June 1994. She
also served as the Company's interim Vice President of Research and Development
from January 1994 to September 1994. From 1986 to April 1992, Ms. LaPlante held
a variety of positions with American Medical Systems, Inc., including Manager
for Prostate Products, Manager of New Business Development and Manager of
Worldwide Technical Training.

        Byron (Buzz) Moran has been the Company's General Manager, Non-Invasive
Systems since December 1998 and from September 1994 to December 1998 was the
Company's Vice President of Research and Development and Operations. From
January 1985 to August 1994, Mr. Moran held several management positions,
including Vice President and General Manager and Vice President of Research and
Development, for Spectramed Incorporated, a medical device manufacturer which is
a subsidiary of British Oxygen Corporation.

        Wesley G. Peterson has been the Company's Chief Financial Officer since
January 1992, Vice President of Finance and Administration since June 1994 and
Secretary since July 1992. He was also Director of Finance and Administration
from January 1992 to June 1994. From December 1986 to December 1991, Mr.
Peterson was the Vice President of Finance and Administration for CIMA Labs,
Inc., a manufacturer and distributor of pharmaceuticals based in Minneapolis,
Minnesota.

        Victor Kimball has been the Company's Vice President, Strategic Planning
and Product Development since December 1998. From June 1997 to October 1998, Mr.
Kimball was Director of Engineering and Business Development and from January
1995 to June 1997, he was Director of

                                       8
<PAGE>
 
Engineering. From June 1992 to January 1995 he was Engineering Manager of the
Company. From June 1983 to June 1992, Mr. Kimball was an Engineer for TSI Inc.
but most recently an Engineer Manager.

        James H. Quackenbush has been the Company's Vice President since June
1998. From October 1992 to June 1998, Mr. Quackenbush was Director a
Manufacturing and Operations of the Company. From 1989 to October 1992, he
served as Senior Manufacturing Engineer and Manager of Stent Operations of
Schneider (USA), Inc., a former subsidiary of Pfizer, Inc.
which develops and manufactures cardiology products.

                                     PART II

Item 5.        MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
               MATTERS.

        The common stock of Optical Sensors Incorporated has been traded on The
Nasdaq National Market, under the symbol OPSI, since the Company's initial
public offering on February 14, 1996. The following table sets forth the high
and low closing prices for the Company's common stock, as reported by the Nasdaq
National Market, for the periods indicated:

                  Quarter Ended          High          Low
                --------------         -------        ------

                March 31, 1998          $6.000        $4.625
                June 30, 1998            5.125         3.500
                September 30, 1998       4.125         1.000
                December 31, 1998        1.875          .906

                March 31, 1997         $11.500        $7.500
                June 30, 1997            8.750         4.500
                September 30, 1997       7.375         4.500
                December 31, 1997        8.000         4.500

        The foregoing prices reflect inter-dealer prices, without dealer markup,
mark-down or commissions, and may not represent actual transactions.

        As of March 22, 1999, the Company had 238 stockholders of record of its
common stock and an estimated 2,700 beneficial holders whose shares were
registered in the names of nominees.

        Optical Sensors Incorporated has never paid any cash dividends on its
common stock, and does not anticipate paying any cash dividends on its common
stock in the foreseeable future.

                                       9
<PAGE>
 
Item 6.        SELECTED FINANCIAL DATA.

<TABLE>
<CAPTION>
                                             Years Ended December 31,
                             --------------------------------------------------------
                               1998        1997        1996        1995        1994
                             --------    --------    --------    --------    --------
                                       (in thousands, except per share data)
                             ---------------------------------------------------------
STATEMENTS OF OPERATIONS DATA
<S>                          <C>         <C>         <C>         <C>         <C>   
Net sales                    $  1,019    $    141    $    163    $   --      $   --
Operating expenses             10,533      10,472       9,734       8,249       6,463
Loss from operations          (12,420)    (12,527)    (10,941)     (8,249)     (6,463)
Interest income, net              628       1,193       1,555         118         183
Net loss                     $(11,817)   $(11,333)   $ (9,385)   $ (8,131)   $ (6,280)
Net loss per common share,
  basic and diluted          $  (1.34)   $  (1.35)   $  (1.30)   $ (19.27)   $ (21.88)

<CAPTION>
                                                    December 31,
                             --------------------------------------------------------
                               1998        1997        1996        1995        1994
                             --------    --------    --------    --------    --------
                                                  (in thousands)
                             --------------------------------------------------------
BALANCE SHEET DATA
<S>                          <C>         <C>         <C>         <C>         <C>     
Cash and cash equivalents    $  8,080    $ 17,101    $ 30,135    $  5,395    $  2,851
Working capital                 9,103      18,220      30,039       5,242       2,363
Total assets                   12,565      21,626      32,369       6,367       3,582
Long-term obligations             495         472        --          --          --
Total shareholders' equity     10,984      20,157      31,050       5,778       2,987

</TABLE>

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

Result of Operations

Fiscal Years Ended December 31, 1998 and 1997

        Net sales were $1,018,864 and $140,936 for 1998 and 1997, respectively.
Sales in 1997 were adversely affected by a recall of the SensiCath initiated by
the Company in May 1997 because of an interference problem with a certain
portion of the critical care patient population. In December 1997, the Company
introduced an enhanced version of its SensiCath Sensor that solved the inference
problems, accounting for the sales increase in 1998. In 1998, approximately 26%
of net sales were from the sale of SensiCath Sensors, and approximately 74% of
net sales were from the placement of OpticalCAM instrumentation. In January
1999, the Company discontinued direct sales activities of the SensiCath System
in order to focus its resources on development of the CapnoProbe product.
Accordingly, the Company does not expect meaningful sales of the SensiCath
System in the future.

        Costs of products sold were $2,905,506 and $2,195,714 in 1998 and 1997,
respectively, an increase of $709,792 in 1998. The increase in 1998 is the
result of higher sales and manufacturing

                                       10
<PAGE>
 
levels. A total of $446,000 in 1997 represented a write-down of OpticalCAM
inventories to estimated market value. The amount of the write-down reflected
the difference between the Company's estimated net realizable value based on the
future selling price to its customers of the OpticalCAM System and the cost of
inventories on hand or on order at the end of 1997. Under the agreement between
the Company and IL, the Company has agreed to sell OpticalCAM instrumentation to
IL at the lower of the Company's direct cost of manufacturing or previously
scheduled amounts. Accordingly, the Company does not expect to generate any
gross margin from the sale of OpticalCAM instrumentation in future periods. The
Company expects that spending in this area in 1999 will be reduced by
approximately one third due to the decline in sales activities. The remaining
anticipated costs consist of fixed overhead expenses and personnel and other
resources will be re-directed towards development of the CapnoProbe product.

        Research and development expenses were $4,248,029 and $4,975,037 in 1998
and 1997, respectively, a decrease of $727,008, or 15% in 1998. Research and
development expenses in 1997 included a $500,000 payment to Marquette Medical
Systems, Inc. under a previously disclosed technology purchase agreement. No
comparable payments occurred in 1998. In 1998 the Company's research and
development efforts were directed primarily towards SensiCath System
improvements. Towards the end of 1998, research and development efforts were
directed increasingly towards development of the CapnoProbe product. The Company
anticipates that research and development expenses will continue to decline in
1999 by approximately an additional 15%, primarily due to a reduction in
personnel. Under the July 1998 license agreement with ICCM, the Company expects
to pay $300,000 in minimum royalties in 1999. The minimum royalty payments will
be recorded as research and development expenses because no CapnoProbe sales are
anticipated in 1999. The Company is obligated to pay ICCM a customary royalty
equal to a percentage of sales, which varies depending on the selling price to
the customer of the CapnoProbe. However, the Company does not currently expect
to have any commercial sales of the CapnoProbe in 1999. Under the previously
disclosed agreement with Marquette Medical Systems, the Company is obligated to
make a final payment of $500,000 if Marquette sells certain minimum quantities
of ABG Modules. Based on past performance, the Company does not expect Marquette
to accomplish these sales in the foreseeable future.

        Selling, general and administrative expenses were $6,284,904 and
$5,496,772 in 1998 and 1997, respectively, an increase of $788,132, or 14%, in
1998. The increase is attributable primarily to increased sales activities in
1998. The Company's administrative expenses were essentially unchanged in 1998
from the prior year. In January 1999, the Company discontinued direct sales
activities. Accordingly, the Company expects selling, general and administrative
expenses to decrease by up to 50% in 1999, not including expenses which might
result from its activities in securing a corporate merger, distribution partner
or sale of a portion or all of the Company.

        Net interest income decreased $618,318 to $628,344 in 1998 from
$1,246,662 in 1997, due to declining cash reserves resulting from negative cash
flows.

        The Company incurred a net loss of $11,817,330 in 1998 compared to a net
loss of $11,333,358 in 1997. Since inception, the Company has incurred a
cumulative net loss of $58,366,050. The increase in net loss in 1998 was
primarily due to the decrease in net interest income described above. Increased
spending in selling expenses were offset by reductions in other areas. The
Company anticipates that its operating losses will continue for the foreseeable
future.

                                       11
<PAGE>
 
Fiscal Years Ended December 31, 1997 and 1996

        Net sales were $140,936 and $163,068 for 1997 and 1996, respectively.
Sales in 1997 were adversely affected by the Company's action in May of 1997 to
voluntarily recall the SensiCath. The Company completed a number of significant
product enhancements in the second half of 1997 and began commercial
distribution of the enhanced sensor in December 1997. In 1997, approximately 64%
of net sales were from the sale of SensiCath Sensors, and approximately 36% of
net sales were from the placement of OpticalCAM instrumentation. Sales in 1996
were primarily from sensors purchased by customers and third parties for
evaluation purposes. The Company did not have any instrument sales in 1996.

        Costs of products sold were $2,195,714 and $1,369,221 in 1997 and 1996,
respectively, an increase of $826,493. A total of $446,000 of the increase for
1997 represented a write-down of OpticalCAM inventories to estimated market
value. The major component of cost of products sold for 1997 and the primary
reason for the increase from 1996 to 1997, excluding the inventory write-down,
was manufacturing infrastructure costs necessary for anticipated future sales
levels, which was established to its current level in the latter part of 1996.

        Research and development expenses were $4,975,037 and $5,632,458 in 1997
and 1996, respectively, a decrease of $657,421, or 12% in 1997. The Company
completed development of the OpticalCAM in late 1996, which was a significant
component of research and development expense in 1996 that did not recur in
1997, and the Company spent less on clinical research activities during 1997 as
the SensiCath System reached development maturity. These two factors accounted
for the majority of the decrease in research and development expenses. Research
and development expenses also included payments to Marquette Medical Systems
under a previously disclosed technology purchase agreement of $500,000 and
$553,250 in 1997 and 1996, respectively.

        Selling, general and administrative expenses were $5,496,772 and
$4,102,147 in 1997 and 1996, respectively, an increase of $1,394,625, or 34%, in
1997. The increase is attributable primarily to organizational expansion of
sales and marketing and product positioning activities beginning the latter half
of 1996. During late 1996, the Company completed the initial hiring of its sales
and marketing staff to support product positioning and initial product launch
activities. Salaries and benefits for the expanded sales and marketing staff and
travel expenses related to their activities and depreciation for OpticalCAM
demonstration units accounted for a significant portion of the increase in
selling, general and administrative expenses in 1997. The Company's
administrative expenses decreased slightly in 1997 from the prior year.

        Net interest income decreased $308,824 to $1,246,662 in 1997 from
$1,555,486 in 1996, due to declining cash reserves resulting from negative cash
flows.

        The Company incurred a net loss of $11,333,358 in 1997 compared to a net
loss of $9,385,272 in 1996. Since inception, the Company has incurred a
cumulative net loss of $46,548,720. The increase in net loss in 1997 was
primarily due to the increase in operating expenses described above. The Company
anticipates that its operating losses will continue for the foreseeable future.

                                       12
<PAGE>
 
Liquidity and Capital Resources

        To date, the Company has financed its operations primarily through the
sale of equity securities. From inception through December 31, 1995, the Company
raised net proceeds of $30,400,000 from private equity financings and stock
option exercises. In the first quarter of 1996, the Company completed an initial
public offering of 2,875,000 shares of Common Stock. The net proceeds to the
Company from the public offering were approximately $33,916,000. In January
1998, the Company sold 441,203 shares of Common Stock to IL, which represented
4.99% of the Company's outstanding Common Stock following completion of the
transaction, at a price of $5.00 per share (which is equal to the closing market
price on the date before signing of the agreement) for a total price of
$2,206,015. The proceeds from the sales of stock have been used to fund costs of
producing products and for the operating expenses described above and capital
expenditures described below. The Company's Common Stock is quoted on the Nasdaq
National Market under the symbol "OPSI."

        The Company granted IL and its affiliates certain pre-emptive rights to
participate in future sales of equity securities by the Company, and certain
demand and incidental registration rights under a registration rights agreement
previously entered into by the Company and shareholders that purchased shares of
stock in private transactions prior to the Company's initial public offering in
February 1996. IL is prohibited from selling or otherwise transferring its
shares of Common Stock for a period of one year, except to an affiliate or
pursuant to the exercise of its registration rights. IL and its affiliates are
also subject to certain standstill provisions for a period of five years that
prohibit them from (a) acquiring more than 5.0% of the Company's outstanding
Common Stock, (b) entering into a voting agreement with respect to the shares IL
purchased from the Company, (c) participating in any proxy solicitation or
becoming a participant in an election contest, or (d) joining a group for the
purpose of acquiring, holding, voting or disposing of shares of Common Stock.

        The Company's cash and cash equivalents were $8,079,871 and $17,101,130
at December 31, 1998 and 1997, respectively. The decrease in the Company's cash
balance is due to the operating losses described above. The Company incurred
cash expenditures of $10,782,956 for operations and $491,929 for capital
expenditures in 1998. In addition, the Company acquired equipment and tooling
under capital leases for a total of $338,061 in 1998. The capital equipment
expenditures were principally for the acquisition of manufacturing, research and
development and marketing promotional equipment. A substantial portion of the
inventory level at December 31, 1998 consisted of key components and ABG Modules
and OpticalCAM monitors for which the Company relies on sole suppliers.

        As of December 31, 1998, the Company had no material commitments
outstanding for tooling and equipment. The Company has contracts to purchase
minimum quantities of instrumentation and other sole source inventory items with
an outstanding aggregate commitment of approximately $900,000 in 1999 and 2000.

        The Company believes that sufficient liquidity is available to satisfy
its operating needs through 1999. However, the Company anticipates that
additional funding will be necessary to continue operations past 1999.

                                       13
<PAGE>
 
Year 2000 Software Performance Exposure

        The Company has determined that the software embedded in the ABG Modules
is Year 2000 compliant and that its major internal information technology
systems are Year 2000 compliant. The Company has ancillary software programs
which may not be Year 2000 compliant. Should any of these programs require
replacement, the Company anticipates that the total cost will not exceed
$50,000. The Company does not believe this amount nor any impact on ongoing
information technology projects will have any material affect on its ongoing
operations. The Company has initiated discussions with its significant
suppliers, large customers and financial institutions to ensure that those
parties have appropriate plans to remediate Year 2000 issues where their systems
interface with the Company's systems or otherwise impact its operations. The
Company is assessing the extent to which its operations are vulnerable should
those organizations fail to properly remediate their computer systems. For those
vendors that have not yet certified year 2000 compliance and which are sole
suppliers of critical product components, the Company plans to have sufficient
inventories on hand at the end of 1999 to support its needs for at least six
months. For the Company's distributor, the Company has the ability to ship
product directly to the end customer and to invoice and collect receivables
should it be necessary to do so. The Company's Year 2000 initiative is being
managed by an internal staff. While the Company believes its planning efforts
are adequate to address its Year 2000 concerns, there can be no assurance that
the systems of other companies which may impact the Company's operations will be
converted on a timely basis and will not have a material effect on the Company.
The cost of the Year 2000 initiatives is not expected to be material to the
Company's results of operations or financial position.

Certain Important Factors

        In addition to the factors identified above, there are several important
factors that could cause the Company's actual results to differ materially from
those anticipated by the Company or which are reflected in any forward-looking
statements of the Company. These factors, and their impact on the success of the
Company's operations and its ability to achieve its goals, include the
following:

o       Development and Commercialization of CapnoProbe. The Company's future
        success will depend, in part, on successful development and
        commercialization of the CapnoProbe product. Although this product is
        based on the Company's existing technology, the Company is in the later
        stages of developing and testing prototypes and is currently engaged
        human clinical trials of the CapnoProbe product. The Company has set up
        one manufacturing pod for manual assembly of the prototype probes and
        finished preliminary plans for automated probe assembly. The Company
        projects that the product will be available for commercialization in the
        first quarter of 2000. The Company has not yet established commercial
        manufacturing for the CapnoProbe. Accordingly, there can be no assurance
        that the Company will successfully develop a commercial CapnoProbe
        product.

o       Completion of Corporate Alliance or Business Combination. In January
        1999, the Company announced that it had engaged Volpe Brown Whelan &
        Company, LLC, to serve as financial advisor to the Company. The Company
        is working with Volpe Brown Whelan to explore strategic alternatives,
        including joint ventures, corporate strategic alliances, sale of the
        business or product lines, or other business combinations. The Company's
        future success will depend on its ability to complete such a strategic
        transaction.

o       Competition. Competition among medical device companies is intense and
        increasing. There can be no assurance that the Company's competitors
        will not succeed in developing or marketing

                                       14
<PAGE>
 
        technologies and products that are more effective or less expensive than
        the Company's products or that would render the Company's products
        obsolete or non-competitive.

o       Regulatory Approvals. The Company's ability to market its current
        products and any products that it may develop in the future requires
        clearances or approvals from the FDA and other governmental agencies,
        including, in some instances, foreign and state agencies. The process
        for maintaining and obtaining necessary regulatory clearances and
        approvals can be expensive and time consuming. There can be no assurance
        that the Company will be able to maintain or obtain necessary regulatory
        approvals and clearances in the future.

Item 7A.       QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK.

        Not Applicable.

Item 8.        FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

        The Company's Financial Statements and Independent Auditors' Report
thereon on pages 18 to 37 of this Report are incorporated herein by reference.

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

        None.


                                    PART III

Item 10.       DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.

        (a)    Directors, Executive Officers, Promoters and Control Persons

        The information under the captions "Election of Directors -- Information
About Nominees" and "Election of Directors -- Other Information About Nominees"
in the Company's 1999 Proxy Statement is incorporated herein by reference. The
information concerning executive officers of the Company is included in this
Report under Item 4a, "Executive Officers of the Company."

        (b)    Section 16(a) Beneficial Ownership Reporting Compliance

        The information under the caption "Section 16(a) Beneficial Ownership
Reporting Compliance" in the Company's 1999 Proxy Statement is incorporated
herein by reference.

Item 11.       EXECUTIVE COMPENSATION.

        The information under the captions "Election of Directors -- Director
Compensation" and "Executive Compensation and Other Benefits" in the Company's
1999 Proxy Statement is incorporated herein by reference.

                                       15
<PAGE>
 
Item 12.       SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
               MANAGEMENT.

        The information under the caption "Principal Shareholders and Beneficial
Ownership of Management" in the Company's 1999 Proxy Statement is incorporated
herein by reference.

Item 13.       CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

        The information under the caption "Certain Transactions" in the
Company's 1999 Proxy Statement is incorporated herein by reference.


                                     PART IV

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

        (a)    1.     Financial Statements.

               The following Financial Statements of the Company are set forth
        herein:

               Financial Statements:                                     Page:
               ---------------------                                     -----

               Report of Independent Auditors.........................    18

               Balance Sheets as of December 31, 1998 and 1997........    19

               Statements of Operations for the years ended
               December 31, 1998, 1997 and 1996.......................    20

               Statement of Shareholders' Equity for the years ended
               December 31, 1998, 1997 and 1996....................... 21-22

               Statements of Cash Flows for the years ended
               December 31, 1998, 1997 and 1996.......................    23

               Notes to Financial Statements.......................... 24-37

               2.     Financial Statement Schedules.

               All schedules are omitted as the required information is
        inapplicable or the information is presented in the financial statements
        or related notes thereto.

               3.     Exhibits

               The exhibits to this Report are listed in the Exhibit Index on
        pages 39 to 43 below.

                                       16
<PAGE>
 
                A copy of the exhibits referred to above will be furnished at a
        reasonable cost to any person who was a stockholder of the Company as of
        March 22, 1999, upon receipt from any such person of a written request
        for any such exhibit. Such request should be sent to: Optical Sensors
        Incorporated, 7615 Golden Triangle Drive, Suite A, Minneapolis,
        Minnesota 55344; Attn: Stockholder Information.

                The following is a list of each management contract or
        compensatory plan or arrangement required to be filed as an exhibit to
        this Annual Report on Form 10-K pursuant to Item 13(a):

                A. 1989 Omnibus Stock Option Plan, as amended.

                B. 1991 Stock Option Plan, as amended.

                C. 1993 Stock Option Plan, as amended.

                D. Form of Non-Statutory Stock Option Agreement for Nonemployees
                   pursuant to 1993 Stock Option Plan.

                E. Form of Non-Statutory Stock Option Agreement for Nonemployee
                   Directors pursuant to 1993 Stock Option Plan.

                F. Form of Incentive Stock Option Agreement for Employees
                   pursuant to 1993 Stock Option Plan.

                G. Employee Stock Purchase Plan.

                H. Executive Management Change in Control Severance Pay Plan.

                I. Amendment No. 1 to Executive Management Change in Control
                   Severance Pay Plan.

                J. Key Employee Change in Control Severance Pay Plan.

                K. Board Advisory Agreement between the Company and Sam B.
                   Humphries.

                L. Letter Agreement between the Company and Sam B. Humphries.

        (b)     Reports on Form 8-K

        The Company did not file any Current Reports on Form 8-K during the
quarter ended December 31, 1998.

                                       17
<PAGE>
 
                         Report of Independent Auditors


Board of Directors
Optical Sensors Incorporated

We have audited the accompanying balance sheets of Optical Sensors Incorporated
as of December 31, 1998 and 1997, and the related statements of operations,
shareholders' equity and cash flows for each of the three years in the period
ended December 31, 1998. 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 financial position of Optical Sensors Incorporated at
December 31, 1998 and 1997, and the results of its operations and its cash flows
for each of the three years in the period ended December 31, 1998, in conformity
with generally accepted accounting principles.

                                         /s/ Ernst & Young LLP

Minneapolis, Minnesota
February 12, 1999


                                       18
<PAGE>
 
                          Optical Sensors Incorporated

                                 Balance Sheets

<TABLE>
<CAPTION>
                                                                    December 31
                                                                1998            1997
                                                            ----------------------------
<S>                                                         <C>             <C>         
Assets
Current assets:
   Cash and cash equivalents                                $  8,079,871    $ 17,101,130
   Accounts receivable                                           162,858          27,100
   Inventories                                                 1,846,294       2,017,497
   Prepaid expenses and other current assets                      99,610          70,491
                                                            ----------------------------
Total current assets                                          10,188,633      19,216,218

Property and equipment:
   Leased equipment                                            1,017,953         679,892
   Research and development equipment                            740,444         594,542
   Leasehold improvements                                        339,614         259,172
   Furniture and equipment                                       148,621         109,214
   Marketing equipment                                         1,004,840         986,483
   Production equipment                                          460,118         259,363
                                                            ----------------------------
                                                               3,711,590       2,888,666
   Less accumulated depreciation                              (1,866,074)       (974,887)
                                                            ----------------------------
                                                               1,845,516       1,913,779
Other assets:
   Patents, net                                                  513,547         434,752
   Other assets                                                   16,833          60,785
                                                            ----------------------------
                                                                 530,380         495,537
                                                            ----------------------------
Total assets                                                $ 12,564,529    $ 21,625,534
                                                            ============================

Liabilities and shareholders' equity Current liabilities:
   Accounts payable                                         $    353,563    $    437,039
   Employee compensation                                         441,917         404,513
   Other liabilities and accrued expenses                         29,714           2,154
   Obligations under capital lease, current portion              260,319         152,756
                                                            ----------------------------
Total current liabilities                                      1,085,513         996,462

Obligations under capital lease, less current portion            494,909         472,206

Shareholders' equity:
   Preferred Stock, par value $.01 per share
     Authorized shares - 5,000,000                                  --              --
   Common Stock, par value $.01 per share:
     Authorized shares - 30,000,000
     Issued and outstanding shares - 1998--8,829,401;
       1997--8,400,554                                            88,294          84,006
   Additional paid-in capital                                 69,317,467      67,088,370
   Accumulated deficit                                       (58,366,050)    (46,548,720)
   Deferred compensation                                         (55,604)       (221,790)
   Note receivable from officer                                     --          (245,000)
                                                            ----------------------------
Total shareholders' equity                                    10,984,107      20,156,866
                                                            ----------------------------
Total liabilities and shareholders' equity                  $ 12,564,529    $ 21,625,534
                                                            ============================
</TABLE>

See accompanying notes.

                                       19
<PAGE>
 
                          Optical Sensors Incorporated

                            Statements of Operations

<TABLE>
<CAPTION>
                                                                Year ended December 31
                                                         1998            1997            1996
                                                    --------------------------------------------
<S>                                                 <C>              <C>             <C>        
Net sales                                           $  1,018,864     $   140,936     $   163,068
Cost of goods sold                                    (2,905,566)     (2,195,714)     (1,369,221)
                                                    --------------------------------------------
Gross margin                                          (1,886,702)     (2,054,778)     (1,206,153)

Operating expenses:
   Research and development                            4,248,029       4,975,037       5,632,458
   Selling, general and administrative                 6,284,904       5,496,772       4,102,147
                                                    --------------------------------------------
Total operating expenses                              10,532,933      10,471,809       9,734,605
                                                    --------------------------------------------

Operating loss                                       (12,419,635)    (12,526,587)    (10,940,758)

Interest expense                                         (95,043)        (21,143)           --
Interest income                                          723,387       1,267,805       1,555,486
Other expense                                            (26,039)        (53,433)           --
                                                    --------------------------------------------
                                                         602,305       1,193,229       1,555,486
                                                    --------------------------------------------
Net loss                                            $(11,817,330)   $(11,333,358)    $(9,385,272)
                                                    ============================================

Net loss per common share:
   Basic and diluted                                $      (1.34)   $      (1.35)    $     (1.30)

Shares used in calculation of net loss per share:
     Basic and diluted                                 8,819,000       8,375,000       7,222,000

</TABLE>

See accompanying notes.

                                       20
<PAGE>
 
                          Optical Sensors Incorporated

                        Statement of Shareholders' Equity

                          Year ended December 31, 1998

<TABLE>
<CAPTION>
                                        Series A               Series B                Series C              Series D    
                                       Convertible            Convertible            Convertible            Convertible  
                                     Preferred Stock        Preferred Stock        Preferred Stock        Preferred Stock
                                  -------------------------------------------------------------------------------------------
                                    Shares      Amount     Shares      Amount     Shares     Amount      Shares     Amount
                                  -------------------------------------------------------------------------------------------
<S>                                 <C>        <C>         <C>         <C>        <C>        <C>       <C>          <C>     
Balance at December 31, 1995         113,223   $ 1,133     656,577     $ 6,566    1,416,008  $ 14,159   2,210,828   $ 22,109
Issuance of Common Stock in
   conjunction with public
   offering, net of expenses of 
   $3,459,218                              -         -            -          -            -         -           -          -
Conversion of Preferred Stock in
   conjunction with public 
   offering                         (113,223)   (1,133)    (656,577)    (6,566)  (1,416,008)  (14,159) (2,210,828)   (22,109)
Issuance of Common Stock upon
   exercise of options and
   warrants                                -         -            -          -            -         -           -          -
Value assigned to warrants in
   connection with debt and lease
   financing                               -         -            -          -            -         -           -          -
Amortization of deferred
   compensation                            -         -            -          -            -         -           -          -
Net loss                                   -         -            -          -            -         -           -          -
                                  --------------------------------------------------------------------------------------------
Balance at December 31, 1996               -         -            -          -            -         -           -          -
Issuance of Common Stock upon
   exercise of options and
   warrants and employee stock
   purchase plan                           -         -            -          -            -         -           -          -
Value assigned to warrants in
   connection with debt and lease
   financing                               -         -            -          -            -         -           -          -
Amortization of deferred
   compensation                            -         -            -          -            -         -           -          -
Net loss                                   -         -            -          -            -         -           -          -
                                  --------------------------------------------------------------------------------------------
Balance at December 31, 1997               -         -            -          -            -         -           -          -
Issuance of Common Stock in
   connection with private 
   placement                               -         -            -          -            -         -           -          -
Issuance of Common Stock upon
   exercise of options and
   warrants and employee stock
   purchase plan                           -         -            -          -            -         -           -          -
Value assigned to warrants in
   connection with debt and lease
   financing                               -         -            -          -            -         -           -          -
Forfeiture of Common Stock                 -         -            -          -            -         -           -          -
Payment on note receivable                 -         -            -          -            -         -           -          -
Amortization of deferred
   compensation                            -         -            -          -            -         -           -          -
Net loss                                   -         -            -          -            -         -           -          -
                                  --------------------------------------------------------------------------------------------
Balance at December 31, 1998               -   $     -            -    $     -            -  $       -          -   $       -
                                  ============================================================================================
</TABLE>

See accompanying notes.

                                       21
<PAGE>
 
<TABLE>
<CAPTION>
          Series E
         Convertible                                                                                    Note                  
       Preferred Stock               Common Stock          Additional                                Receivable               
----------------------------------------------------------  Paid-in      Accumulated     Deferred       from                  
    Shares         Amount        Shares        Amount       Capital        Deficit     Compensation    Officer       Total
------------------------------------------------------------------------------------------------------------------------------
<S> <C>             <C>           <C>         <C>         <C>            <C>            <C>            <C>        <C>         
    370,338         $3,703        610,443     $  6,105    $32,970,358    $(25,830,090)  $(1,171,226)   $(245,000) $  5,777,817


          -              -      2,875,000       28,750     33,887,032               -             -            -    33,915,782

   (370,338)        (3,703)     4,766,974       47,670              -               -             -            -             -

          -              -         89,080          890         98,856               -             -            -        99,746


          -              -              -            -         18,099               -                          -        18,099

          -              -              -            -              -               -       623,452            -       623,452
          -              -              -            -              -      (9,385,272)            -            -    (9,385,272)
------------------------------------------------------------------------------------------------------------------------------
          -              -      8,341,497       83,415     66,974,345     (35,215,362)     (547,774)    (245,000)   31,049,624


          -              -         59,057          591         97,093               -             -            -        97,684


          -              -              -            -         16,932               -             -            -        16,932

          -              -              -            -              -               -       325,984            -       325,984
          -              -              -            -              -     (11,333,358)            -            -   (11,333,358)
------------------------------------------------------------------------------------------------------------------------------
          -              -      8,400,554       84,006     67,088,370     (46,548,720)     (221,790)    (245,000)   20,156,866

          -              -        441,203        4,412      2,192,779               -             -            -     2,197,191


          -              -         28,477          284         55,696               -             -            -        55,980


          -              -              -            -         16,964               -             -            -        16,964
          -              -        (40,833)        (408)       (36,342)              -             -       36,750             -
          -              -              -            -              -               -             -      208,250       208,250

          -              -              -            -              -               -       166,186            -       166,186
          -              -              -            -              -     (11,817,330)            -            -   (11,817,330)
------------------------------------------------------------------------------------------------------------------------------
          -      $       -      8,829,401      $88,294    $69,317,467    $(58,366,050)  $   (55,604)   $       -  $ 10,984,107
==============================================================================================================================
</TABLE>

                                       22
<PAGE>
 
                          Optical Sensors Incorporated

                            Statements of Cash Flows

<TABLE>
<CAPTION>
                                                                   Year ended December 31
                                                            1998            1997            1996
                                                        --------------------------------------------
<S>                                                     <C>             <C>             <C>          
OPERATING ACTIVITIES
Net loss                                                $(11,817,330)   $(11,333,358)   $ (9,385,272)
Adjustments to reconcile net loss to net cash used in
   operating activities:
Depreciation and amortization                              1,059,306         510,537         124,452
Deferred compensation amortization                           166,186         325,984         623,452
Writedown of inventories                                        --           445,706            --
Amortization of warrants in connection with debt and
   lease financing                                            16,964          16,932          18,099
Changes in operating assets and liabilities:
   Receivables                                              (135,758)         63,940         (91,040)
   Inventories                                                62,253      (1,531,286)       (931,917)
   Prepaid expenses and other assets                        (116,065)         28,085         132,602
   Accounts payable and accrued expenses                     (18,512)       (475,867)        730,259
                                                        --------------------------------------------
Net cash used in operating activities                    (10,782,956)    (11,949,327)     (8,779,365)

INVESTING ACTIVITIES
Purchases of property, plant and equipment (net)            (491,929)     (1,127,097)       (496,084)
                                                        --------------------------------------------
Net cash used in investing activities                       (491,929)     (1,127,097)       (496,084)

FINANCING ACTIVITIES
Net proceeds from issuance of Common Stock                 2,253,171          97,684      34,015,528
Proceeds from note receivable                                208,250            --              --
Payments on obligations under capital leases                (207,795)        (54,930)           --
                                                        --------------------------------------------
Net cash provided by financing activities                  2,253,626          42,754      34,015,528
                                                        --------------------------------------------

Increase (decrease) in cash and cash equivalents          (9,021,259)    (13,033,670)     24,740,079
Cash and cash equivalents at beginning of year            17,101,130      30,134,800       5,394,721
                                                        --------------------------------------------
Cash and cash equivalents at end of year                $  8,079,871    $ 17,101,130    $ 30,134,800
                                                        ============================================
</TABLE>

Supplementary Disclosure of Non-Cash Transactions: In 1998, the Company received
40,833 forfeited shares of Common Stock and forgave $36,750 on the note
receivable from officer. The Company also acquired property and equipment of
$338,061 and $679,892 under capital lease obligations during the year ended
December 31, 1998 and 1997, respectively.

See accompanying notes.

                                       23
<PAGE>
 
                          Optical Sensors Incorporated

                          Notes to Financial Statements

                                December 31, 1998

1. Business Activity

Optical Sensors Incorporated (the Company) is engaged in developing,
manufacturing and marketing fiberoptic chemical sensors used in the monitoring
of key physiologic parameters for medically unstable patients. The Company was
incorporated on May 23, 1989 and reincorporated in Delaware on January 4, 1996.
Prior to 1998 the Company was considered a development stage company.

2. Summary of Significant Accounting Policies

Cash Equivalents

The Company considers all highly liquid investments with a maturity of three
months or less when purchased to be cash equivalents. Investments classified as
cash equivalents consist primarily of commercial paper and municipal bonds. The
market value of investments is based on quoted market prices and approximates
cost.

Inventories

Inventories, consisting principally of finished goods, are recorded at the lower
of cost (first-in, first-out basis) or market.

Property and Equipment

Property and equipment are stated at cost. Depreciation is provided on a
straight-line basis over three to five years. Leasehold improvements are
amortized over the shorter of the term of the lease or the estimated life of the
asset. Equipment under capital leases is depreciated over the lease term.

Patents

Patents are stated at cost and are amortized upon issuance of a patent on a
straight-line basis over 60 months. The carrying value of a patent will be
reviewed if the facts and circumstances suggest that it may be impaired. If this
review indicates that patent cost will not be recoverable, as determined based
on the undiscounted cash flows over the remaining amortization period, the
Company's carrying value of the patent will be reduced by the estimated
shortfall of cash flows.

                                       24
<PAGE>
 
                          Optical Sensors Incorporated

                    Notes to Financial Statements (continued)


2. Summary of Significant Accounting Policies (continued)

Income Taxes

The Company accounts for income taxes using the liability method. Deferred
income taxes are provided for temporary differences between the financial
reporting and tax bases of assets and liabilities.

Stock-Based Compensation

The Company follows Accounting Principles Board Opinion No. 25, Accounting for
Stock Issued to Employees ("APB 25"), and related interpretations in accounting
for its stock options. Under APB 25, when the exercise price of stock options
equals the market price of the underlying stock on the date of grant, no
compensation expense is recognized.

The Company has adopted the disclosure only provisions of the Statement of
Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation
("Statement 123"). Accordingly, the Company has made pro forma disclosures of
what net loss and net loss per share would have been had the

provisions of Statement 123 been applied to the Company's stock options.

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 amounts reported in the financial statements and accompanying notes.
Actual results could differ from the estimates.

Accounting for Long-Lived Assets

The Company records losses 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 than the assets' carrying amount.

                                       25
<PAGE>
 
                          Optical Sensors Incorporated

                    Notes to Financial Statements (continued)


2. Summary of Significant Accounting Policies (continued)

Advertising

Advertising costs are charged to operations in the year incurred. The amounts in
1998, 1997 and 1996 were not material.

Net Loss Per Share

The net loss per share has been computed in accordance with the provisions of
the Financial Accounting Standards Board Statement No. 128, Earnings Per Share.
The basic and diluted per share amounts are the same.

Reclassifications

Certain reclassifications of previously reported amounts have been made to
conform with the current year presentation.

3. Private Label Reseller Agreement

In January 1998, the Company entered into an agreement with Instrumentation
Laboratory Company (IL) for worldwide distribution of the Company's SensiCath
Sensors and OpticalCAM Instruments. IL would market and distribute the Company's
products throughout the world under the names GEM SensiCath and GEM OpticalCAM.
The Company agreed to supply IL with SensiCath Sensors, on an exclusive basis,
through 2004 and on a non-exclusive basis through 2007. The Company also agreed
to supply IL with OpticalCAM Instruments, on a semi-exclusive basis, through
2004. The Company retained the right to sell OpticalCAM Instruments to
manufacturers of physiological monitoring, ventilator and anesthesia delivery
systems. IL is required to purchase sufficient quantities of products from the
Company under the agreement that will result in preestablished annual minimum
revenues to the Company. During 1998, IL did not achieve the quota requirements
and the Company has exercised its right to convert IL's exclusive right to a
non-exclusive right.

                                       26
<PAGE>
 
                          Optical Sensors Incorporated

                    Notes to Financial Statements (continued)


4. Common Stock

In January 1998, the Company sold 441,203 shares of Common Stock to
Instrumentation Laboratory Company (IL) at a price of $5.00 per share that
resulted in proceeds of $2,197,191, net of expenses related to the sale. The
Company granted IL and its affiliates certain preemptive rights to participate
in future sales of equity securities by the Company, and certain demand and
incidental registration rights under a registration rights agreement previously
entered into by the Company and shareholders that purchased shares of stock in
private transactions prior to the Company's initial public offering in February
1996. IL was prohibited from selling or otherwise transferring its shares of
Common Stock for a period of one year, except to an affiliate or pursuant to the
exercise of its registration rights. IL and its affiliates are also subject to
certain stand still provisions for a period of five years that prohibit them
from (a) acquiring more than 5.0% of the Company's outstanding Common Stock, (b)
entering into a voting agreement with respect to the shares IL purchased from
the Company, (c) participating in any proxy solicitation or becoming a
participant in an election contest, or (d) joining a group for the purpose of
acquiring, holding, voting or disposing of shares of Common Stock.

In February 1996, the Company completed an initial public offering of Common
Stock in which it sold 2,875,000 shares of Common Stock, resulting in net
proceeds of $33,915,782. Upon completion of the Company's initial public
offering of Common Stock, all shares of outstanding Convertible Preferred Stock
were converted into 4,766,974 shares of Common Stock.

Shareholder Rights Plan

In December 1996, the Company's Board of Directors adopted a Shareholder Rights
Plan by declaring a dividend of one preferred share purchase right (the "Right")
for each outstanding share of Common Stock. Under certain circumstances, a Right
may be exercised to purchase one one-thousandth of a share of Series A Junior
Preferred Stock for $90. The rights become exercisable if a person or group
acquires 15 percent or more of the Company's outstanding Common Stock, subject
to certain exceptions. If a person or group acquires 15 percent or more of the
Company's outstanding Common Stock, subject to certain exceptions, each right
will entitle its holder to buy Common Stock of the Company having a market value
of twice the exercise price of the Right. The Rights expire in December 2006 and
may be redeemed by the Company for $.001 per Right at any time before, or, in
certain circumstances, within 10 days (subject to extension)

                                       27
<PAGE>
 
                          Optical Sensors Incorporated

                    Notes to Financial Statements (continued)


4. Common Stock (continued)

following the announcement that a person has acquired 15 percent or more of the
Company's outstanding Common Stock. Until a Right is exercised, the holder of a
Right, as such, has no rights as a shareholder of the Company.

In connection with the adoption of the Shareholder Rights Plan, the Company
authorized 250,000 shares of Series A Junior Preferred Stock (the "Preferred
Stock"). Subject to the rights of holders of any Senior Securities, if any,
holders of the Preferred Stock are entitled to quarterly dividends, when, as and
if declared by the Board of Directors, in the amount of one thousand times the
aggregate per share amount of dividends paid to Common Stock shareholders. Each
Preferred Stock share is entitled to one thousand votes on all matters submitted
to a vote of the shareholders of the Company. The Preferred Stock has
liquidation preference over the Company's Common Stock. The liquidation rate on
the Preferred Stock is the greater of (a) $1,000 per share plus accrued
dividends, whether or not earned or declared, or (b) an amount equal to one
thousand times the amount distributed to the Common Stock shareholders.

5. Convertible Preferred Stock

The Company had sold certain Series (A through E) of Convertible Preferred Stock
beginning in 1991 and going through 1995. Upon completion of the Company's
initial public offering of Common Stock, all shares of outstanding Convertible
Preferred Stock were converted into 4,766,974 shares of Common Stock.

In conjunction with the sale of the Series C of Convertible Preferred Stock in
1993, the Company had issued warrants to a placement agent to purchase 79,869
shares of Common Stock at $7.38 per share. These warrants were exercised in 1997
resulting in 14,376 shares of Common Stock being issued in a "cashless"
transaction.

Upon completion of the sale of the Series B Convertible Preferred Stock in 1992,
the Series C Convertible Preferred Stock in 1993 and the Series D Convertible
Preferred Stock in 1995, certain working capital bridge loans were canceled as
payment for some of the shares. In consideration for making the loans, the
Company issued warrants to the investors to purchase 24,076 shares of Common
Stock at $9.00 per share (relating to the Series B), 26,871 shares of Common
Stock at $12.60 per share (relating to the Series C) and 61,429 shares of Common
Stock at $3.15 per share (relating to the Series D).

                                       28
<PAGE>
 
                          Optical Sensors Incorporated

                    Notes to Financial Statements (continued)


5. Convertible Preferred Stock (continued)

At December 31, 1998, warrants to purchase 19,160 shares of Common Stock at
$9.00 per share and 59,567 shares of Common Stock at $3.15 per share remain
outstanding. All other warrants have expired or been exercised. The remaining
warrants expire in 1999 and 2000.

6. Leases

Operating Leases

The Company leases its office and research and development facility under an
operating lease that expires on November 30, 1999. Operating expenses, including
maintenance, utilities, real estate taxes and insurance, are paid by the
Company. The Company also leases certain office equipment under operating
leases.

Total rent expense under operating leases was $677,000, $870,000 and $921,000
for the years ended December 31, 1998, 1997 and 1996, respectively.

Future minimum lease payments under noncancelable operating leases with initial
or remaining terms of one year or more as of December 31, 1998 are as follows:

   Year ending December 31:

     1999                                                   $516,000
     2000                                                     54,000
     2001                                                     14,000
     2002                                                      8,000
                                                            --------
                                                            $592,000
                                                            ========

Certain of the operating leases contain end of the lease purchase options which
have historically averaged 23% of the original cost of the equipment. Should the
Company not be able to return assets under existing operating leases, the end of
the lease purchase options could reach a total of approximately $190,000.

                                       29
<PAGE>
 
                          Optical Sensors Incorporated

                    Notes to Financial Statements (continued)


6. Leases (continued)

In connection with the operating lease agreements, the Company has issued
warrants to the leasing company to purchase 12,222 shares of Common Stock at
$9.00 per share and 11,904 shares of Common Stock at $3.15 per share. These
warrants expire in 2002 and 2005, respectively.

Capital Leases

In June 1997, the Company entered into an equipment lease agreement. Under the
lease agreement, the Company is allowed to lease up to $2,000,000 of equipment
between June 15, 1997 and June 30, 1999. Assets leased under the agreement at
December 31, 1998 and 1997 were approximately $1,018,000 and $680,000,
respectively, with a related obligation of $755,228 and $624,962 at December 31,
1998 and 1997, respectively. The term of each lease schedule under the agreement
is 42 months with payments due the first of each month.

Future payments under capital leases are as follows:

   1999                                                $ 339,829
   2000                                                  372,366
   2001                                                  171,501
   Thereafter                                              4,949
                                                       ---------
                                                         888,645
   Less amount representing payment of interest         (133,417)
                                                       ---------
                                                         755,228

   Less current portion                                 (260,319)
                                                       ---------
   Long-term capital lease obligations                 $ 494,909
                                                       =========

The equipment lease agreement contains an "advance pay" provision that requires
the Company to prepay an amount equal to soft costs (tooling, software, etc.)
that exceed 25% of the total drawdown. If the Company makes no further draws
under the lease, the prepayments required by the Company would be approximately
$238,000.

                                       30
<PAGE>
 
                          Optical Sensors Incorporated

                    Notes to Financial Statements (continued)


7. Income Taxes

At December 31, 1998, the Company has cumulative net operating loss
carryforwards for tax purposes of approximately $53,538,000 plus research and
development tax credit carryforwards of approximately $1,556,000. These
carryforwards are available to offset future taxable income through 2013.

As a result of the sales of Preferred Stock and additional shares of Common
Stock, the Company has experienced a change in ownership under the net operating
loss limitation rules. The use of losses, incurred through the change in
ownership date, to offset future taxable income, will be limited during the
carryforward period. The credits will also be subject to limitations under these
same rules.

Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amount of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components of
the Company's deferred tax assets and liabilities are as follows:

                                                   December 31
                                               1998           1997
                                           ----------------------------
Deferred tax assets:
  Net operating loss carryforwards         $ 18,800,000    $ 15,900,000
  Tax credit carryforwards                    1,556,000       1,000,000
  Deferred compensation on stock options        788,000         724,000
  Vacation accrual                               86,000          86,000
  Book over tax depreciation                    293,000         239,000
                                           ----------------------------
Total deferred tax assets                    21,523,000      17,949,000

Deferred tax liabilities:
  Other                                          33,000          33,000
                                           ----------------------------
Total deferred tax liabilities                   33,000          33,000
                                           ----------------------------
Net deferred tax assets                      21,490,000      17,916,000
Valuation allowance                         (21,490,000)    (17,916,000)
                                           ----------------------------
                                           $          -    $          -
                                           ============================

                                       31
<PAGE>
 
                          Optical Sensors Incorporated

                    Notes to Financial Statements (continued)

8. Stock Options

The Company has three stock option plans that include both incentive and
non-statutory stock options to be granted to directors, officers, employees and
consultants of the Company. Option activity is summarized as follows:

                                                      Options       Weighted  
                                                    Outstanding      Average  
                                        Shares      -----------     Exercise  
                                       Available       Total       Price Per  
                                       for Grant       Shares        Share    
                                     -----------------------------------------

Balance at December 31, 1995            308,674       704,798       $1.80
  Granted--incentive stock options     (151,650)      151,650        8.42
  Options canceled                       36,140       (36,140)       4.62
  Options exercised                        --         (86,300)        .94
                                     --------------------------
Balance at December 31, 1996            193,164       734,008        3.11
  Granted--incentive stock options     (148,205)      148,205        5.22
  Options canceled                       24,986       (24,986)       5.71
  Options exercised                        --         (40,032)       1.28
                                     --------------------------
Balance at December 31, 1997             69,945       817,195        3.50
  Additional shares reserved            699,464          --            --
  Granted--incentive stock options   (1,383,870)    1,383,870        2.75
  Options canceled                      695,573      (695,573)       5.57
  Options exercised                        --         (16,423)       1.39
                                     --------------------------
Balance at December 31, 1998             81,112     1,489,069       $1.84
                                     ==========================

The weighted average fair value of options granted is summarized as follows:

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

Stock price equals exercise price              $2.20      $3.02      $5.26
Stock price is greater than exercise price         -          -       5.41

                                       32
<PAGE>
 
                          Optical Sensors Incorporated

                    Notes to Financial Statements (continued)


8. Stock Options (continued)

The exercise price of options outstanding at December 31, 1998 ranged from $.90
to $13.00 per share, as summarized in the following table:

<TABLE>
<CAPTION>
                          Options Outstanding                                  Options Exercisable
----------------------------------------------------------------------------------------------------------
                                    Weighted Average     Weighted Average                 Weighted Average
   Range of                          Exercise Price         Remaining                      Exercise Price 
Exercise Price        Number           Per Share        Contractual Life      Number         Per Share
----------------------------------------------------------------------------------------------------------
<S>                 <C>             <C>                 <C>                  <C>          <C>             
$ .00 to   .90         388,258            $ .90             6.4 years         305,218          $ .90
 1.69 to  1.80         964,775             1.69             9.4 years           8,333           1.80
 2.70 to 13.00         136,036             5.64             6.0 years          96,790           6.07
                     ---------                              -------------------------             
      Total          1,489,069            $1.84             8.3 years         410,341          $2.14
                     =========                              =========================             
</TABLE>

The number of options exercisable at December 31, 1998, 1997 and 1996 was
410,341, 349,646 and 239,784, respectively, at a weighted average exercise price
per share of $2.14, $3.50 and $3.06, respectively.

Pro forma information regarding net loss and net loss per share is required by
Statement 123, and has been determined as if the Company had accounted for its
employee stock options under the fair value method of Statement 123. The fair
value for these options was estimated at the date of grant using a Black-Scholes
option pricing model with the following weighted-average assumptions:

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

Expected stock price volatility          86%           75%          78%
Risk-free interest rate                  5.5%         6.5%          5.5%
Expected life of options              7.25 years     7 years      7 years

The Black-Scholes option valuation model was developed for use in estimating the
fair value of traded options which have no vesting restrictions and are fully
transferable. In addition, option valuation models require the input of highly
subjective assumptions. Because the Company's employee stock options have
characteristics significantly different from those of traded options, and
because changes in the subjective input

                                       33
<PAGE>
 
                          Optical Sensors Incorporated

                    Notes to Financial Statements (continued)


8. Stock Options (continued)

assumptions can materially affect the fair value estimate, in management's
opinion, the existing models do not necessarily provide a reliable single
measure of the fair value of its employee stock options.

For purposes of pro forma disclosures, the estimated fair value of the options
is amortized to expense over the options' vesting period. The Company's pro
forma information is as follows:

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

Pro forma net loss                $12,597,330   $11,714,634   $9,451,264
Pro forma, basic and diluted 
  net loss per common share             $1.43         $1.40        $1.31

These pro forma amounts may not be indicative of future years' amounts since the
Statement provides for a phase-in of option values beginning with those granted
in 1995.

Deferred Compensation

In August 1995, the Company recognized deferred compensation of $2,179,693. The
amount represented the excess of the deemed value for accounting purposes of the
Common Stock issuable upon exercise of certain options over the aggregate
exercise price of such options. The related options were those granted during
the period June 17, 1995 through October 3, 1995 to purchase a total of 971,640
shares of Common Stock at exercises prices ranging from $.90 to $2.70 per share.
The remaining unamortized deferred compensation of $55,605 is expected to be
charged to operations in 1999.

9. Technology Agreements

In July 1998, the Company entered into a patent license agreement with the
Institute of Critical Care Medicine ("ICCM") which provides the Company with the
exclusive, worldwide right under ICCM's pending and issued patents. In
consideration for the technology, the Company is obligated to pay ICCM minimum
annual royalties of $300,000 (quarterly payments of $75,000 beginning with the
quarter ended September 1998) for five years in order to maintain exclusivity.
The Company may elect, on one

                                       34
<PAGE>
 
                          Optical Sensors Incorporated

                    Notes to Financial Statements (continued)


9. Technology Agreements (continued)

year's written notice, not to make the annual minimum payment of $300,000 but
ICCM would then have the right to terminate the license agreement. The Company
is obligated to pay ICCM a customary royalty equal to a percentage of sales,
which varies depending on the selling price to the customer. The Company is also
obligated to meet certain product development milestones under the license
agreement.

In September 1995, the Company entered into an agreement with Marquette Medical
Systems, Inc. ("Marquette") to acquire exclusive ownership of certain technology
that had been jointly developed by the Company and Marquette. In consideration
for the technology, the Company agreed to pay $2,000,000 payable as follows:
$500,000 upon execution of the agreement, $500,000 upon completion of the
technology, $500,000 once the product has been sold and installed in 20
hospitals and $500,000 once the product has been sold and installed in an
additional 50 hospitals. The Company also agreed to pay $50,000 per month for
engineering and technical support from August 1, 1995 through January 31, 1998.
As of December 31, 1998, the Company has a remaining obligation of $500,000
under this agreement which will become payable if Marquette meets the product
sales requirements.

In August 1991, the Company entered into an agreement to purchase certain
fiberoptic chemical sensor technology for $10,000. In addition, the Company
issued 2,778 shares of Common Stock to the licensor upon assignment of the
technology. The Company has agreed to pay royalties on sales of industrial and
environmental products for which the technology purchased is a significant part.
The royalties shall be 5%, 4% and 3% on the first, second and third $10 million
sales increments and 2% on sales in excess of $40 million. For sales of such
products by any future licensees of the Company, the Company shall pay 25% of
all licensing fees received up to $500,000 and 10% thereafter. The Company has
made all payments for the technology. The Company does not intend to use the
technology in the future and, therefore, does not anticipate paying any
royalties under the agreement.

                                       35
<PAGE>
 
                          Optical Sensors Incorporated

                    Notes to Financial Statements (continued)


10. Purchase Commitments

The Company has entered into various purchase agreements under which it is
obligated at December 31, 1998. The Company has a $199,915 purchase order
outstanding for a sterilizer. A down payment of $56,659 was made in September
1998. The purchase order was placed on hold in January 1999 with final
resolution pending the outcome of the Company's plans as explained in Note 14.

The Company has entered into purchase commitments with two companies for the
purchase of SensiCath instrumentation inventory. Under the terms of the
agreements, the Company has agreed to purchase, under a specified pricing
structure, a fixed number of units. As of December 31, 1998, the Company is
committed to purchase approximately $900,000 of inventory during 1999 and 2000.

11. Employment Agreement

The Company had an employment agreement (the agreement) with the former
President and Chief Executive Officer of the Company. In connection with the
agreement, the Company granted the President options to purchase 121,162 shares
of Common Stock at a price of $9.00 per share. In August of 1995, these options
were canceled, and the Board of Directors granted the President a non-statutory
option to purchase 272,222 shares of Common stock at a price of $.90 per share.

In September 1995, the President exercised this option. The right to retain
certain of the shares was subject to the President's continued employment
through August 2, 1999. As payment for the shares, the President executed a
$245,000 promissory note, payable in full on August 1, 1998, at an interest rate
of 5.91%. The note was secured by the shares of Common Stock and proceeds of any
dividend or other distribution attributable to the shares. During 1998, the
President made a $208,250 principal payment on the note plus accrued interest,
and the Company forgave the remaining principal balance of $36,750. The Company
also entered into a board advisory agreement with the former President and Chief
Executive Officer that provides for a payment of $50,000 payable in April 1999.

                                       36
<PAGE>
 
                          Optical Sensors Incorporated

                    Notes to Financial Statements (continued)


12. Employee Benefit Plans

The Company has a 401(k) savings plan under which employees are eligible to
participate after six months of service and attaining the age of 21. Employees
may contribute up to the maximum amount which will not violate provisions of the
Plan or cause the Plan to exceed the maximum amount allowable as a deduction to
the employer. The Company, at its discretion, may make matching contributions
equal to a percentage of the employee's contribution. The Company did not
contribute to the Plan in 1998, 1997 and 1996.

13. Employee Stock Purchase Plan

In December 1996, the Company adopted an Employee Stock Purchase Plan. Eligible
employees can authorize payroll withholdings in each pay period to be designated
for stock purchase. Payroll deductions cannot exceed 10% of total compensation
and no more than 1,500 shares may be purchased by any one employee in one
offering period. There are four three-month offering periods in each year.
Employees may purchase shares of Common Stock at the end of each three-month
offering period at a price equal to 85% of the market price on the first or last
day of the offering period, whichever is lower. Shares issued under the plan
during the years ended December 31, 1998 and 1997 were 12,054 and 8,711,
respectively.

14. Subsequent Event

In January 1999, the Company announced that it had engaged Volpe Brown Whelan &
Company, LLC, investment bankers, to explore on behalf of the Company strategic
alternatives, including joint ventures, corporate strategic alliances, sale of
the business or product lines, or other business combinations. In January 1999,
the Company suspended direct sales activity of the SensiCath System and reduced
associated expenses and personnel to focus its resources on the Capro Probe
SL(TM). This reduction resulted in severance costs of approximately $304,000.

The Company has also implemented officer and key employee change of control
severance plans.
                                       37 
<PAGE>
 
                                   SIGNATURES

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

                                OPTICAL SENSORS INCORPORATED


Dated:  March 23, 1999        By:   /s/ Paulita M. LaPlante
                                   ---------------------------------------------
                                          Paulita M. LaPlante
                                          President and Chief Executive Officer

        Pursuant to the requirements of the Securities Exchange Act of 1934,
this Report has been signed below on March 23, 1999 by the following persons
on behalf of the Registrant and in the capacities and on the dates indicated.

Name                             Title
----                             -----


/s/ Paulita M. LaPlante          President, Chief Executive Officer and Director
-----------------------------    (principal executive officer)
Paulita M. LaPlante


/s/ Wesley G. Peterson           Chief Financial Officer, Vice President of
-----------------------------    Finance and Administration and Secretary
Wesley G. Peterson               (principal financial and accounting officer)


/s/ Richard B. Egen              Director
-----------------------------
Richard B. Egen


/s/ Sam B. Humphries             Director
-----------------------------
Sam B. Humphries


/s/ Richard J. Meelia            Director
-----------------------------
Richard J. Meelia


                                 Director
-----------------------------
Demetre M. Nicoloff, M.D.


                                 Director
-----------------------------
Gary A. Peterson

                                       38
<PAGE>
 
                          OPTICAL SENSORS INCORPORATED
                   EXHIBIT INDEX TO ANNUAL REPORT ON FORM 10-K
                      FOR THE YEAR ENDED DECEMBER 31, 1998

<TABLE>
<CAPTION>

Item No.           Item                                Method of Filing
--------           ----                                ----------------
<S>      <C>                                         <C>
3.1      Restated Certificate of Incorporation       Incorporated by reference to Exhibit 3.3
         of the Company.                             contained in the Company's Registration 
                                                     Statement on Form S-1 (File No.         
                                                     33-99904).                              

3.2      Certificate of Designation, Preferences     Incorporated by reference to Exhibit 3.2
         and Rights of Series A Junior Preferred     contained in the Company's Annual Report
         Stock.                                      on Form 10-K for the year ended December
                                                     31, 1996 (File No. 0-27600).            

3.3      Bylaws of the Company, as amended.          Filed herewith.                         

4.1      Specimen Common Stock Certificate           Incorporated by reference to Exhibit 4.1
                                                     contained in the Company's Registration 
                                                     Statement on Form S-1 (File No.         
                                                     33-99904).                              

4.2      Form of Warrant issued in connection        Incorporated by reference to Exhibit 4.4 
         with the Convertible Bridge Loan            contained in the Company's Registration  
         Agreement dated November 22, 1991           Statement on Form S-1 (File No.          
                                                     33-99904).                               

4.3      Form of Warrant issued in connection        Incorporated by reference to Exhibit 4.5 
         with the On-Call Bridge Loan Agreement      contained in the Company's Registration  
         dated December 6, 1991                      Statement on Form S-1 (File No.          
                                                     33-99904).                               

4.4      Form of Warrant issued in connection        Incorporated by reference to Exhibit 4.6 
         with the Convertible Bridge Loan            contained in the Company's Registration  
         Agreement dated May 4, 1993                 Statement on Form S-1 (File No.          
                                                     33-99904).                               

4.5      Form of Warrant issued in connection        Incorporated by reference to Exhibit 4.7 
         with the Bridge Loan Agreement dated        contained in the Company's Registration  
         June 1, 1995                                Statement on Form S-1 (File No.          
                                                     33-99904).                               

4.6      Warrant dated November 6, 1992 issued       Incorporated by reference to Exhibit 4.8 
         to Comdisco, Inc.                           contained in the Company's Registration  
                                                     Statement on Form S-1 (File No.          
                                                     33-99904).                               
</TABLE>

                                       39
<PAGE>
 
<TABLE>
<CAPTION>
<S>      <C>                                         <C>
4.7      Warrant Dated August 31, 1995 issued to     Incorporated by reference to Exhibit 4.9 
         Comdisco, Inc.                              contained in the Company's Registration  
                                                     Statement on Form S-1 (File No.          
                                                     33-99904).                               

4.8      Rights Agreement dated as of                Incorporated by reference to Exhibit 4.1 
         December 3, 1996 between the Company        contained in the Company's Current Report
         and Norwest Bank Minnesota, N.A.            on Form 8-K dated December 3, 1996 (File 
                                                     No. 0-27600).                            

10.1     Lease dated October 7, 1991 between         Incorporated by reference to Exhibit 10.1
         Registrant and First Industrial L.P.        contained in the Company's Registration  
         (successor to MIG Kappa III Companies)      Statement on Form S-1 (File No.          
                                                     33-99904).                               

10.2     Equipment Lease dated November 6, 1992,     Incorporated by reference to Exhibit 10.2
         as amended, between the Company and         contained in the Company's Registration  
         Comdisco, Inc.                              Statement on Form S-1 (File No.          
                                                     33-99904).                               

10.3     Letter Agreement dated October 1, 1995      Incorporated by reference to Exhibit 10.3
         between the Company and Marquette           contained in the Company's Registration  
         Electronics, Inc.                           Statement on Form S-1 (File No.          
                                                     33-99904).                               

10.4     Registration Rights Agreement, dated        Incorporated by reference to Exhibit 10.9
         April 28, 1992, as amended                  contained in the Company's Registration  
                                                     Statement on Form S-1 (File No.          
                                                     33-99904).                               

10.5     1989 Omnibus Stock Option Plan, as          Incorporated by reference to Exhibit     
         amended                                     10.11 contained in the Company's         
                                                     Registration Statement on Form S-1 (File 
                                                     No. 33-99904).                           

10.6     1991 Stock Option Plan, as amended          Incorporated by reference to Exhibit     
                                                     10.12 contained in the Company's         
                                                     Registration Statement on Form S-1 (File 
                                                     No. 33-99904).                           

10.7     1993 Stock Option Plan, as amended          Filed herewith.                          

10.8     Form of Non-Statutory Stock Option          Incorporated by reference to Exhibit     
         Agreement for Nonemployees pursuant to      10.21 contained in the Company's         
         1993 Stock Option Plan                      Registration Statement on Form S-1 (File 
                                                     No. 33-99904).                           
</TABLE>

                                       40
<PAGE>
 
<TABLE>
<CAPTION>
<S>      <C>                                         <C>
10.9     Form of Non-Statutory Stock Option          Incorporated by reference to Exhibit    
         Agreement for Nonemployee Directors         10.18 contained in the Company's        
         pursuant to 1993 Stock Option Plan          Registration Statement on Form S-1 (File
                                                     No. 33-99904).                          

10.10    Form of Incentive Stock Option              Incorporated by reference to Exhibit    
         Agreement for Employees pursuant to         10.19 contained in the Company's        
         1993 Stock Option Plan                      Registration Statement on Form S-1 (File
                                                     No. 33-99904).                          

10.11    Employee Stock Purchase Plan                Incorporated by reference to Exhibit 99.1
                                                     contained in the Company's Registration 
                                                     Statement on Form S-8 (File No.         
                                                     333-17493).                             

10.12    First Amendment to Lease Agreement          Incorporated by reference to Exhibit    
         dated April 26, 1996 between First          10.21 contained in the Company's Annual 
         Industrial Financing Partnership, L.P.      Report on Form 10-K for the year ended  
         and the Company.                            December 31, 1996 (File No. 0-27600).   

10.13    Supply Agreement dated August 22, 1996      Incorporated by reference to Exhibit    
         between the Company and Marquette           10.22 contained in the Company's Annual 
         Electronics, Inc.  (1)                      Report on Form 10-K for the year ended  
                                                     December 31, 1996 (File No. 0-27600).   

10.14    Manufacturing Supply Agreement dated        Incorporated by reference to Exhibit    
         September 10, 1996 between the Company      10.23 contained in the Company's Annual 
         and SpecTran Specialty Optics Company.      Report on Form 10-K for the year ended  
         (1)                                         December 31, 1996 (File No. 0-27600).   

10.15    Purchase Order dated February 21, 1997      Incorporated by reference to Exhibit    
         between the Company and SeaMED              10.24 contained in the Company's Annual 
         Corporation.  (1)                           Report on Form 10-K for the year ended  
                                                     December 31, 1996 (File No. 0-27600).   

10.16    Second Amendment to Lease Agreement,        Incorporated by reference to Exhibit    
         dated April 14, 1997, between First         10.21 contained in the Company's Annual 
         Industrial Financing Partnership, L.P.      Report on Form 10-K for the year ended  
         and the Company.                            December 31, 1997 (File No. 0-27600)    
</TABLE>

                                       41
<PAGE>
 
<TABLE>
<CAPTION>
<S>      <C>                                         <C>
10.17    Master Equipment Lease dated June 15,       Incorporated by reference to Exhibit     
         1997 between Phoenix Leasing                10.22 contained in the Company's Annual  
         Incorporated and the Company                Report on Form 10-K for the year ended   
                                                     December 31, 1997 (File No. 0-27600)     

10.18    Amendment No. 1 to Master Equipment         Incorporated by reference to Exhibit     
         Lease dated August 15, 1997 between         10.23 contained in the Company's Annual  
         Phoenix Leasing Incorporated and the        Report on Form 10-K for the year ended   
         Company                                     December 31, 1997 (File No. 0-27600)     

10.19    Private Label Reseller Agreement dated      Incorporated by reference to Exhibit 10.1
         as of January 7, 1998 between the           contained in the Company's Current Report
         Company and Instrumentation Laboratory      on Form 8-K, dated January 7, 1998 (File 
         Company.  (1)                               No. 0-27600).                            

10.20    Stock Purchase Agreement dated as of        Incorporated by reference to Exhibit 10.2
         January 7, 1998 between the Company and     contained in the Company's Current Report
         Grupo CH Werfen, S.A.                       on Form 8-K, dated January 7, 1998 (File 
                                                     No. 0-27600).                            

10.21    OEM Agreement dated February 5, 1998        Incorporated by reference to Exhibit     
         between the Company and Marquette           10.26 contained in the Company's Annual  
         Medical Systems, Inc. (1)                   Report on Form 10-K for the year ended   
                                                     December 31, 1997 (File No. 0-27600)     

10.22    Patent License Agreement dated July 20,     Incorporated by reference to Exhibit 10.1
         1998 between the Company and the            contained in the Company's Quarterly     
         Institute of Critical Care Medicine (1)     Report on Form 10-Q for the quarter ended
                                                     September 30, 1998 (File No. 0-27600)    

10.23    Board Advisory Agreement dated              Filed herewith electronically.
         September 11, 1998 between the Company
         and Sam B. Humphries

10.24    Letter Agreement dated September 14,        Filed herewith electronically.
         1998 between the Company and Sam B.
         Humphries

10.25    Executive Management Change in Control      Filed herewith electronically.
         Severance Pay Plan

10.26    Amendment No. 1 to Executive Management     Filed herewith electronically.
         Change in Control Severance Pay Plan
</TABLE>

                                       42
<PAGE>
 
<TABLE>
<CAPTION>
<S>      <C>                                         <C>
10.27    Key Employee Change in Control              Filed herewith electronically.
         Severance Pay Plan

23.1     Independent Auditors' Consent               Filed herewith electronically.

27.1     Financial Data Schedule                     Filed herewith electronically.

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

(1) Confidential treatment has been granted by the Commission with respect to
designated portions contained within document. Such portions have been omitted
and filed separately with the Commission pursuant to Rule 24b-2 of the
Securities and Exchange Act of 1934, as amended.


                                       43