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

                                  FORM 10-K

       [X]        ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
                    OF THE SECURITIES EXCHANGE ACT OF 1934
                  FOR THE FISCAL YEAR ENDED OCTOBER 31, 1998
                                      OR
       [ ]      TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
                    OF THE SECURITIES EXCHANGE ACT OF 1934

                       COMMISSION FILE NUMBER: 0-20946

                       HEALTH MANAGEMENT SYSTEMS, INC.
            (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

                  NEW YORK                            13-2770433
            (STATE OR OTHER JURISDICTION OF         (I.R.S. EMPLOYER)
            INCORPORATION OR ORGANIZATION)         IDENTIFICATION NO.)

                   401 PARK AVENUE SOUTH                   10016
                     NEW YORK, NEW YORK                   (ZIP CODE)
        (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)

                                 (212) 685-4545
              (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
                        --------------------------------

          SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

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                                                        NAME OF EACH EXCHANGE
                TITLE OF EACH CLASS                      ON WHICH REGISTERED
                -------------------                      -------------------
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                      NONE
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           SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

                                  COMMON STOCK
                                (Title of Class)

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. [ ]

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
                            -----             -----

The aggregate market value of the registrant's common stock held by
non-affiliates as of January 11, 1999 was $127,027,607 based on the closing
price on the Nasdaq National Market System on that day.

Number of shares outstanding of the registrant's common stock, $.01 par value,
on January 11, 1999 was 17,316,671.

                      DOCUMENTS INCORPORATED BY REFERENCE:

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      DOCUMENT                                      WHERE INCORPORATED
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      PROXY STATEMENT FOR THE ANNUAL MEETING        PART III
      TO BE  HELD ON MARCH 9, 1999
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                                TABLE OF CONTENTS

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                                                                                     Page
Contents                                                                            Number
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Cover Page ........................................................................    i

PART I
   Item 1.  Business ..............................................................    1
   Item 2.  Properties ............................................................   10
   Item 3.  Legal Proceedings .....................................................   11
   Item 4.  Submission of Matters to a Vote of Security Holders ...................   12

PART II
   Item 5.  Market for Registrant's Common Equity and Related Shareholder Matters..   12
   Item 6.  Selected Financial Data ...............................................   12
   Item 7.  Management's Discussion and Analysis of Financial Condition and
            Results of Operations .................................................   13
   Item 7A. Quantitative and Qualitative Disclosures About Market Risks ...........   13
   Item 8.  Financial Statements and Supplementary Data ...........................   13
   Item 9.  Changes in and Disagreements with Accountants on Accounting and
            Financial Disclosure ..................................................   13

PART III
   Item 10. Directors and Executive Officers of the Registrant ....................   13
   Item 11. Executive Compensation ................................................   13
   Item 12. Security Ownership of Certain Beneficial Owners and Management ........   13
   Item 13. Certain Relationships and Related Transactions ........................   13

PART IV
   Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K ......   13
   Signatures .....................................................................   14
   Exhibit Index ..................................................................   15
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PART I

                SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS


      EXCEPT FOR THE HISTORICAL FINANCIAL INFORMATION CONTAINED HEREIN, THE
MATTERS DISCUSSED IN THIS ANNUAL REPORT ON FORM 10-K MAY BE CONSIDERED
"FORWARD-LOOKING" STATEMENTS WITHIN THE MEANING OF SECTION 27A OF THE SECURITIES
ACT OF 1933, AS AMENDED, AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934,
AS AMENDED. SUCH STATEMENTS INCLUDE DECLARATIONS REGARDING THE INTENT, BELIEF OR
CURRENT EXPECTATIONS OF THE COMPANY AND ITS MANAGEMENT. PROSPECTIVE INVESTORS
ARE CAUTIONED THAT ANY SUCH FORWARD-LOOKING STATEMENTS ARE NOT GUARANTEES OF
FUTURE PERFORMANCE AND INVOLVE A NUMBER OF RISKS AND UNCERTAINTIES AND THAT
ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE INDICATED BY SUCH
FORWARD-LOOKING STATEMENTS. AMONG THE IMPORTANT FACTORS THAT COULD CAUSE ACTUAL
RESULTS TO DIFFER MATERIALLY FROM THOSE INDICATED BY SUCH FORWARD-LOOKING
STATEMENTS INCLUDE THOSE RISKS IDENTIFIED IN "ITEM 7 - MANAGEMENT'S DISCUSSION
AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION - CERTAIN FACTORS
THAT MIGHT AFFECT FUTURE OPERATING RESULTS" AND OTHER RISKS IDENTIFIED FROM TIME
TO TIME IN THE COMPANY'S REPORTS AND REGISTRATION STATEMENTS FILED WITH THE
SECURITIES AND EXCHANGE COMMISSION.

ITEM 1. BUSINESS

OVERVIEW

      Health Management Systems, Inc. (the "Company" or "HMSY") furnishes
proprietary information management and data processing products and services to
healthcare providers and payors, including government health service agencies.
These services address the various types of data generated by the interaction of
the participants in the healthcare delivery process: the providers of care, the
third-party payors, and the patients. Through its product and service offerings,
the Company acts as an outsourcer of information management functions addressing
the operational, administrative, financial, and clinical data that result from
the rendering of healthcare services to patients. The Company's product and
service offerings benefit its clients by enhancing revenue (achieved through
improved reimbursability, profitability, and/or collectability), accelerating
cash flow, reducing operating and administrative costs (by supplying advanced
information analytics), and improving decision-making capabilities (via the
provision of useful information).

      Healthcare providers receive payment for services from patients,
third-party payors, or a combination thereof. Third-party payors include
commercial insurance companies, governments or their fiscal agents and
intermediaries, health maintenance organizations, preferred provider
organizations, third-party administrators for self-insured companies, and
managed care companies. Although patients generally retain primary
responsibility for payment for all healthcare services, third-party payors bear
the preponderance of the responsibility for many charges for care. Obtaining
reimbursement from third-party payors has become increasingly difficult because
of frequent changes in reimbursement formulae and contractual requirements for
pre-admission certification and utilization review, and administrative
procedures instituted by third-party payors in an effort to control costs. To be
successful in obtaining payment from third-party payors, hospitals and other
healthcare providers require regulatory knowledge and technical skills to manage
complex data collection, integration, analysis, and accounts receivable
management functions. To ensure that program costs are not greater than
necessary, third-party payors require knowledge and skills analogous to those
required by providers.

      Using the operational, financial, administrative, and clinical data
generated as part of the healthcare delivery process, the Company applies
proprietary software and other analytical tools to transform data into valuable
information that clients use to (i) minimize operating and administrative costs
while improving profitability, (ii) measure the quality of care, and (iii)
optimize the outcome of the transfer payment processes linking payors,
providers, and patients. Customers of the Company utilize the Company's products
and services to improve their decision-making and operating capabilities and to
achieve improved operational, administrative, financial, and clinical
performance. The Company believes its customers benefit from the Company's
unique understanding of the healthcare delivery and associated transfer payment
processes, from the perspective of both providers and payors.


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Company History

      A healthcare information systems and services enterprise, the Company is
organized into two divisions: Transfer Payment Services ("Transfer Payment
Division") and Software Systems and Services ("Software Division"). The Transfer
Payment Division comprises two business units: Provider Transfer Payment
Services ("Provider Transfer Payment Unit") and Payor Transfer Payment Services
("Payor Transfer Payment Unit"). The Company's Software Division also comprises
two business units: Decision Support Systems ("DSS Unit") and Managed Care
Information Systems ("MCIS Unit").

      Within the Transfer Payment Division, the Provider Transfer Payment Unit
has delivered Retroactive Claims Reprocessing ("RCR")(sm) services since 1974
and began to deliver Comprehensive Account Management Services ("CAMS")(sm) in
1986 and Electronic Data Interchange ("EDI") services with the acquisition in
1990 of Quality Medi-Cal Adjudication Incorporated ("QMA"). QMA provides
electronic billing and automated denial reprocessing services. In 1997 the
Company acquired a computerized medical record-based processing system for
managed care public health and ambulatory care facilities as part of its
purchase of substantially all the assets of Global Health Systems, Inc. and GHS
Management Services, Inc. (collectively "Global"). In 1997 the Company formed a
Business Office Outsourcing business unit and in 1998 consolidated this Business
Office Outsourcing unit with the remainder of its Provider Transfer Payment
Unit. The Payor Transfer Payment Unit began delivery of Third Party Liability
Recovery ("TPLR")(sm) services in 1985 and augmented its product line in 1996
with the acquisition of CDR Associates, Inc. ("CDR"). CDR is a provider of
hospital-based claim audits to payors, principally Blue Cross and Blue Shield
organizations.

      The Company's Software Division was referred to in the aggregate as MCIS
in 1997; in 1998, MCIS refers to one of the Software Division's two business
units, while the DSS Unit refers to the other. The Company entered the software
business in 1995 as a consequence of its merger with Health Care microsystems,
Inc. ("HCm"). HCm furnishes microcomputer-based distributed decision support
systems and services to providers of care and bearers of financial risk in the
healthcare industry and today comprises the DSS Unit of the Company. In 1996 the
DSS Unit acquired Quality Standards in Medicine, Inc. ("QSM") and integrated
QSM's clinical information systems with HCm's decision support offerings. In
1997 the Company, which had owned a 43% equity interest in Health Information
Systems Corporation ("HISCo"), acquired from Welsh, Carson, Anderson & Stowe
("WCAS") and various of its affiliates, independent investors, and from certain
of the Company's executive officers and directors, the remaining 57% of HISCo's
equity. At the time of acquisition, HISCo merged with its sole operating
subsidiary, Health Systems Architects, Inc., and was renamed HSA Managed Care
Systems, Inc ("HSA"). Today, this entity comprises the MCIS Unit and furnishes
automated business and information solutions, including software and services,
to bearers of financial risk in the healthcare industry.

      The HCm, CDR, and QSM mergers were accounted for using the pooling of
interest method, while the QMA, HISCo, and Global acquisitions were accounted
for using the purchase method.

                    HEALTHCARE REFORM AND REGULATORY MATTERS

      The healthcare reimbursement process continues to change. Federal, state,
and local governments, as well as other third-party payors, have initiated
policies to reduce the rate of increase in healthcare expenditures. Many of
these policy initiatives have contributed to the complex and time-consuming
nature of obtaining healthcare reimbursement for medical services.

      Changes occurring in the healthcare industry, most notably the evolution
of healthcare towards the present managed care model characterized by the
formation of large integrated delivery systems and capitated reimbursement, have
created an increasingly complex reimbursement environment that impacts both
providers and payors. This environment is made even more complex as the
historical distinction between providers and payors becomes less clear. The
consolidation of healthcare into integrated delivery systems has broken down
traditional organizational barriers that once supported a clear delineation
between the manner in which providers and payors utilized operational,
financial, administrative, and clinical information. Today, emphasis is placed
on improving the level of provider and payor accountability for both the
delivery and the utilization of healthcare services. Providers


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must ensure that they are properly reimbursed by third-party payors for
healthcare services rendered in accordance with pre-established contracts.
Likewise, payors must ensure that they are making payments for only those
services for which they are responsible and in the dollar amounts specified by
these pre-established contracts.

      Although the Company cannot predict the nature of future healthcare
reforms that will be adopted by federal, state, and local governments, the
Company believes that the shifting of traditional insurance risk to providers of
care, the consolidation of providers, and the resulting additional information
management requirements placed on providers and payors should increase the
demand for the Company's offerings. Moreover, the Company believes that
providers, payors, and patients--both separately and together--will benefit from
the Company's integration of cost and other financial and clinical data,
enabling identification and management by all participants (providers, payors,
and patients) of the outcomes (benefits and costs) achieved.

      The Company observes the intensification of interest in ensuring
compliance by providers and payors with the statutory, regulatory, and
contractual requirements of managed care. The Company believes that the
intensifying concern regarding compliance has increased its costs, as the
Company seeks to ensure its own compliance and that of its customers. At the
same time, the Company believes that the increased focus on compliance creates a
potential market for its products and services.

      The Company's services also are subject to regulations pertaining to
billing services, which primarily involve recordkeeping requirements and other
provisions designed to prevent fraud. The Company believes that it operates in a
manner consistent with such regulations, the enforcement of which is
increasingly more stringent.

      The Medicare program is administered by the Health Care Financing
Administration ("HCFA"), an agency of the United States Department of Health and
Human Services. HCFA currently contracts with numerous intermediaries and fiscal
agents to process regional claims for reimbursement. Although HCFA has
established the regulatory framework for Medicare claims administration,
Medicare intermediaries have the authority to develop independent procedures for
administering the claims reimbursement process. The Medicaid program is subject
to regulation by HCFA, but is administered by state governments. State
governments provide for Medicaid claims reimbursement either through the
establishment of state-owned and operated processing centers or through
contractual arrangements with third-party fiscal agents who own and operate
their own processing centers. The requirements and procedures for reimbursement
implemented by Medicaid differ from state to state. Similar to the claims
administration processes of Medicare and Medicaid, many national health
insurance companies and self-insured employers administer reimbursement of
claims through local or regional offices. Consequently, because guidelines for
the reimbursement of claims are generally established by third-party payors at
local or regional levels, hospital and other provider reimbursement managers
must remain current with the local procedures and requirements of third-party
payors.

      The ownership and operation of hospitals is subject to comprehensive
federal and state regulation, which affects hospital reimbursement. Since
adoption, the Medicare and Medicaid programs have undergone significant and
frequent changes, and it is realistic to expect additional changes in the
future. Specifically, the Balanced Budget Act of 1997 ("BBA"), which is expected
to cut Medicare and Medicare-funded Medicaid spending by more than $115 billion
over the next four years, could reduce Medicare payments received by hospitals
by as much as 10% to 15%. While the BBA could have an adverse effect on the
operations of hospitals and other providers of healthcare, and consequently
reduce the amount of the Company's revenue, the Company believes that healthcare
organizations can use the Company's products and services to reduce costs while
maintaining or improving the quality of care (thereby compensating in part or
whole losses in revenue due to the BBA).

      In addition, the Social Security Act imposes certain requirements on the
Company with regard to confidentiality and disclosure of Medicare and Medicaid
provider and beneficiary data. Specifically, the Company is prohibited from
disclosing information that is obtained by or from the Department of Health and
Human Services except as otherwise provided by regulations or other federal law.
Generally, the Company is required to maintain standards of confidentiality that
are comparable to those of an agency administering the Medicare or Medicaid
program when the Company uses data obtained from such programs.


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      Finally, the Health Insurance Portability and Accountability Act of 1996
("HIPAA") requires the Secretary of Health and Human Services to adopt national
standards for certain types of electronic health information transactions and
the data elements used in such transactions and to adopt standards to ensure the
integrity and confidentiality of health information. All providers, payors, and
clearinghouses will be mandated to use HIPAA standards when electronically
exchanging health data covered by HIPAA. Any material restriction on the ability
of healthcare providers and payors to obtain or disseminate health information
could adversely affect the Company's business, financial condition, and results
of operations.

      The Company believes that the rapidity of consolidation within the
healthcare industry will continue to create opportunities for the Company in its
role as data consolidator. Yet the rapidity of change suggests that some of the
consolidation may have been overdone and may be undone over the next several
years, as providers downsize and integrated delivery networks ("IDN's") begin to
unbundle. The Company believes these dynamics constitute both a risk to its
existing business relationship with Columbia/HCA Healthcare Corporation
("Columbia"), the Company's largest client, and an opportunity for new business
in the future.

                         PRINCIPAL PRODUCTS AND SERVICES

      The Company is organized into two divisions: the Transfer Payment
Division and the Software Division.  The Transfer Payment Division comprises
two business units: the Provider Transfer Payment Unit and the Payor Transfer
Payment Unit.  The Company's Software Division also comprises two business
units: the DSS Unit and the  MCIS Unit.

Provider Transfer Payment Unit

       The Provider Transfer Payment Unit within the Transfer Payment Division
has delivered RCR services since 1974 and began to deliver CAMS in 1986 and EDI
services with the acquisition in 1990 of QMA. In 1997 the Company acquired a
computerized medical record-based processing system for managed care public
health and ambulatory care facilities as a consequence of its purchase of
Global. In 1997 the Company formed a Business Office Outsourcing business unit
and in 1998 consolidated this Business Office Outsourcing unit with the
remainder of its Provider Transfer Payment Unit.

      The Company's Provider Transfer Payment Unit offerings are performed on
retroactive, concurrent, and prospective bases. The Company's first product,
RCR, entails the retroactive recovery of third-party payments due provider
healthcare organizations, including large public and voluntary hospitals. RCR
services are used by a hospital (most commonly for its emergency room and
outpatient clinics) to realize third-party revenue from patient accounts after
the hospital has expended its own best efforts at billing and collection, but
before the accounts are referred to a collection agency. The Company's
specialized data aggregation, data purification, data editing, and electronic
claim preparation and transmission routines are designed to facilitate the
reimbursement of accounts that remain unpaid because necessary billing
information was missing or because third-party coverage was not known. RCR
services have evolved from a strictly background process to a process frequently
concurrent and integrated with clients' internal processes, entailing onsite
support, designed to generate the maximum results through targeted review,
analysis, and opportunity identification. RCR services require the hospital to
provide the Company with copies of existing data files, demand minimal hospital
staff support, and generally involve no patient contact. Through the application
of the Company's proprietary technology, the Company's RCR services produce for
its hospital clients incremental revenue, which otherwise would remain
uncollected.

      Since 1974, RCR services have generated in excess of $1.3 billion for
hospitals from Medicaid, Medicare, and commercial insurors nationwide. Over the
last three fiscal years, such services have generated over $360 million in
incremental reimbursements.

      Using database-driven methodologies developed in connection with RCR, the
Provider Transfer Payment Unit is able to provide a range of additional
retroactive recovery services to healthcare providers. The Unit offers Cost
Report recovery services, including Medicare Bad Debt Recovery, in which the
Company assists providers in isolating coinsurance and deductible amounts that
qualify for Bad Debt reimbursement, and Disproportionate Share services, in
which the Company identifies and recalculates improperly classified claims that
are eligible for Federal


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Financial Participation. The Unit supports clients' substantiation of future
claims for Medicare Bad Debt by establishing appropriate processes. The Provider
Transfer Payment Unit furnishes Accounts Receivable Conversion Services, in
which the Company liquidates aged accounts from an outgoing patient accounting
system before a new patient accounting system is installed. In addition, the
Company performs Supplemental Security Income ("SSI") identification and
recovery services in order to generate reimbursement from Medicaid for services
rendered to recipients approved for SSI upon conclusion of the lengthy SSI
application review process.

      As a result of the technology and expertise developed in providing RCR
services, the Company is able to provide custom institutionalized data
processing, computer software, and operations support services to hospitals,
public health clinics, outpatient treatment facilities, and companies that serve
the healthcare industry. In contrast to RCR services, which retrospectively
reprocess patient accounts receivable data, CAMS delivered to healthcare
providers provides concurrent third-party claim identification, editing,
preparation, and electronic claims submission. The Company integrates data
derived from the hospital's disparate data collection systems and manages the
electronic interfaces between the hospital and the transfer payment agencies
upon which the hospital is dependent for reimbursement. CAMS is designed to
provide an integrated and comprehensive solution to a hospital's accounts
receivable liquidation requirements by combining (i) an intimate familiarity
with the principal in-house shared data collection and patient accounting
systems found in large urban hospitals with (ii) expertise in the management and
liquidation of accounts receivable, thereby offering a hospital a unique
opportunity to improve the effectiveness of its accounts receivable management
program (enhance revenue and accelerate cash flow) while decreasing its
administrative costs.

      Through its RCR and CAMS offerings, the Company has developed the
capability to submit healthcare claims data and to receive remittance data
electronically from a diverse array of third-party payors. In addition, the
Company provides electronic billing and follow-up services for claims submitted
by providers to Medi-Cal (the California Medicaid program). The Company also
provides stand-alone EDI services to clients in Illinois, New York, and
Pennsylvania. The Company's strategy includes the continued development of EDI
services as an integral component of its Business Office Outsourcing offering.

      Using its EDI capability and medical record-based processing system
acquired from Global, the Provider Transfer Payment Unit is also able to provide
products and services on a concurrent basis as part of its Business Office
Outsourcing offering. The Company created this offering in 1997 to provide a
lower-cost alternative to its CAMS offering for hospitals, physician groups,
faculty practices, public and private clinic systems, and other healthcare
organizations. As part of its Business Office Outsourcing offering, the Company
integrates its software, staff, and processes to enable providers, including
those bearing financial risk, to manage their data and transfer payment
processes. Components of the Company's Business Office Outsourcing offering
include pre-treatment patient registration and admission; treatment
authorization; claim preparation and billing; account follow-up; and reporting.
For providers at financial risk, the Company's Business Office Outsourcing
offering includes membership services, claims administration, provider services,
risk administration, and management information.

      The Company's fees are tailored to the particular configuration of service
furnished to the client, with the preponderance of the Company's remuneration
based upon contingent fee arrangements, which range from single digit fees for
full outsourcing to fees of 25% or more for more selective revenue enhancement
engagements. The Company recognizes revenue at the time the work on a particular
bill submission, claim, recovery, or cost report has been completed and accepted
by the client for purposes of initiating the revenue recovery process.

Payor Transfer Payment Unit

      The Payor Transfer Payment Unit began delivery of TPLR services in 1985
and augmented its product line in 1996 with the acquisition of CDR, a provider
of hospital-based claim audits to payors, principally Blue Cross and Blue Shield
organizations.

      In 1985, the Company began to offer TPLR services principally to state
Medicaid agencies, as a means of identifying third parties with prior liability
for Medicaid claims. As part of its TPLR offering, the Company provides
hospital-based claims audits on behalf of payors, for the purpose of recovering
credit balances and duplicate


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payments. The Company provides services to state Medicaid agencies as well as to
Medicaid HMO's and to Blue Cross/Blue Shield organizations and commercial
insurers (including managed care payors).

      The Payor Transfer Payment Unit applies its proprietary information
management and coordination of benefits methodologies used in TPLR to examine
paid claims datasets in order to identify duplicate payments, overpayments,
compliance-related erroneous payments, and other inappropriate payments on
behalf of payor organizations.

      TPLR contracts generally have one to three year terms and provide for
contingent fees that typically range from 8% to 10% or more of the amounts
recovered for the client. The Company recognizes revenue at the time the work on
a particular recovery or disallowance has been submitted to the client or its
third-party payors or intermediaries and accepted by the client for purposes of
initiating the recovery process.

      Since 1985, TPLR services (exclusive of those offered by CDR) have
generated in excess of $677 million, of which $382 million has been generated in
the last three years.

DSS UNIT

      The Company entered the software business in 1995 as a consequence of its
merger with HCm. HCm furnishes microcomputer-based distributed decision support
systems and services to providers of care and bearers of financial risk in the
healthcare industry and comprises the DSS Unit of the Company. In 1996 the DSS
Unit acquired QSM and integrated QSM's clinical information systems with HCm's
decision support offerings.

      The DSS Unit provides clients with prospective, concurrent, and
retroactive decision support applications and services, including a concurrent
managed care contract profiler and payment calculator system and data warehouse
services for a substantial number of Columbia facilities. As a consequence,
proper calculation of anticipated contractual allowances are now provided as an
integrated component of the managed care reimbursement process for a substantial
number of Columbia facilities. On a retroactive basis, the DSS Unit performs
underpayment recovery services in conjunction with its decision support
applications to assist healthcare providers in the recovery of underpayments due
from managed care payors; the Company is paid on a contingent fee basis for
these underpayment recovery services. In addition, the DSS Unit provides
Columbia with prospective DSS applications for reimbursement management.

      The growth of managed care and the consolidation of healthcare
institutions is significantly increasing the complexity of the industry and the
associated demand for decision support systems. In the managed care environment,
the Company believes decision support to be the linchpin for integrating,
analyzing, and understanding key operational, financial, administrative, and
clinical data obtained from institutions' transaction-based healthcare
information systems. As such, decision support systems and services are
increasingly being relied upon to guide the management practices of providers
(in areas ranging from managed care contracting and clinical pathways
development to physician profiling) to ensure the success and financial and
operational viability of their organizations. The current clients for the DSS
Unit include more than 500 hospitals and IDN's located primarily in the United
States. These hospitals range in size from 50 to more than 1,000 beds, and
include many of the most progressive and complex health systems in the Country,
as well as some of the largest multi-site hospital chains, managed care
organizations, and long-term care institutions.

      In development with several major healthcare organizations for the past
three years, the Company's suite of DSS products and services, called Alliance
for Decision Support(TM) ("Alliance"; formerly called HCm Alliance(TM) for
Managed Care), was released to the market in June 1998. Alliance enables
healthcare providers to perform clinical, cost, and contract management from the
perspective of the provider, payor, and/or third-party administrator. Employing
advanced systems integration, data validation, and distribution methods,
Alliance supports evolving data warehousing and information systems initiatives.
Alliance was built with an open system architecture, running on a variety of
platforms that support client server processing and world wide web applications.
In addition to purchasing the Company's software, customers have the option of
partnering with the Company or outsourcing part or all of the operation of the
Alliance system to the Company. The Company continues to integrate clinical
quality measures within Alliance.


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       In partnering relationships, the Company dedicates considerable resources
to providing a wide variety of related consulting applications, including
managed care strategic consulting, data acquisition, development and training,
contract management and compliance, clinical performance measurement, and
managed care reporting.

      Through Alliance for Financial Management(TM) ("FM"; formerly called HCm
Alliance(TM) for Financial Modeling), the DSS Unit offers hospitals and
long-term care organizations an enterprise-wide financial analysis and modeling
application, with capabilities including productivity analysis, budgeting and
forecasting, long-range planning and analysis, and provider resource management.
FM incorporates multi-dimensional, on-line analytical processing technology,
integrated with electronic mail applications and standard spreadsheet tools to
support communications and analysis. The DSS Unit also provides FM-related
application consulting services, focusing on analysis and development of cost
accounting, contract management, budgeting, business lines, and treatment
patterns.

MCIS Unit

      In 1997 the Company, which had owned a 43% equity interest in HISCo,
acquired from WCAS and various of its affiliates, independent investors, and
from certain of the Company's executive officers and directors, the remaining
57% of HISCo's equity. At the time of acquisition, HISCo merged with its
operating subsidiary, Health Systems Architects, Inc., and was renamed HSA
Managed Care Systems, Inc. Today, this entity comprises the MCIS Unit and
furnishes automated business and information solutions, including software and
services, to bearers of financial risk in the healthcare industry.

      The MCIS Unit provides large-scale transaction processing systems and
services to large and medium-sized commercial payors and managed care plans,
including some large Blue Cross/Blue Shield organizations, as well as to newly
formed managed care organizations. Through the implementation of development
partnerships with large payor organizations, the MCIS Unit has begun to provide
its products and services on an outsourcing basis. In fiscal year 1998, the
Company executed an agreement pursuant to which it will complete a full-scale
rollout in fiscal year 1999 of its pilot Service Bureau engagement on a per
member/per month basis.

      Both public and private entities are rapidly embracing managed care health
plans as a means of providing and managing healthcare services. With this
increased demand, the number of existing payors, the number of start-up
entities, and the number of IDN's seeking to offer managed care products has
greatly increased. To support their businesses, these payors require systems to:
manage patient membership, provider contracts, and networks; process and
adjudicate claims; manage risk; and perform medical management.

      The four principal offerings of the MCIS Unit are Health Enterprise
Systems ("HES"); ProAlliance(TM) (formerly called Provider Information
Management System); CapAlliance(TM) (formerly called The Capitation Facility);
and Service Bureau. HES is a risk management solution for payors seeking a
strategy to manage their own health plans and market their own products,
providing data processing for plans offering a full spectrum of products, from
traditional indemnity coverage through complete managed care programs. Comprised
of modular systems, HES automates four major areas of healthcare administration:
membership and billing; provider administration; capitation; and benefits and
claims. ProAlliance(TM) is a data repository enabling proactive management based
on integrated information such as credentialing, accreditation, and pricing
arrangements. CapAlliance(TM), the Company's stand-alone capitation offering,
manages the payment to providers of pre-negotiated per capita amounts. Through
its Service Bureau offering, the Company provides its managed care
functionality, including hardware and software, in an outsourcing mode.

      In fiscal year 1998, in conjunction with development partners and on its
own, the Company migrated various of its MCIS offerings to an open system
architecture, running on platforms that support client server and world wide web
applications.

      The Company's MCIS offerings are sold on a stand-alone basis, or can be
integrated into existing systems, the latter option enabling payors to preserve
their investments in information technology. The Company believes that these
offerings dramatically reduce the cost of processing claims through
auto-adjudication.


                                       7
<PAGE>   10
                                    CUSTOMERS

      The Company's client base includes hospitals, IDN's, multi-hospital
systems, large commercial payors, Blue Cross/Blue Shield organizations, and
state Medicaid agencies. The Company also has a limited number of clients in the
United Kingdom. Among the Company's domestic clients are the nation's three
largest public health systems. The Company works with selected development
partners in the research, development, and testing of its software products and
services.

                           MARKET TRENDS/OPPORTUNITIES

      The demands of managing the delivery of patient care with ever increasing
qualitative and quantitative rigor will continue to drive the need for increased
amounts of operational, financial, administrative, and clinical information. The
Company believes that it possesses the data content, analytic tools, technology,
and process management skills required to respond to the current and anticipated
needs of provider and payor clients for tools and services to manage this
evolving complexity.

      Cost pressures continue to drive horizontal and vertical integration of
providers and payors alike. Consolidation among healthcare organizations is
creating larger healthcare delivery systems with greater regional market power.
This phenomenon is creating a new market for the Company's products, with fewer
but larger client prospects. Despite some recent analyses suggesting that the
rapidity of this change may be undone over the next several years, as providers
are downsized and IDN's begin to unbundle, the Company believes that it has the
opportunity to leverage its products and services across larger enterprises,
making the Company's products and services more cost effective for clients. As
well, the shifting of financial risk from payors to providers creates the
opportunity for the Company to provide its MCIS offerings to providers as well
as payors.

      A certain portion of the accounts receivable against which the Company's
traditional receivables management services were focused has been capitated and
is no longer subject to recovery through the primary RCR offering. Capitation
and other forms of managed care reimbursement, however, have created an
opportunity for the Company to augment its RCR offering with underpayment
recovery services, enabling providers to ensure proper reimbursement under
capitated and other managed care contracts. In addition, providers' commercial
insurance portfolios are becoming more problematic. Providers are increasingly
seeking assistance from vendors to optimize recovery of commercial insurance
claims, which are frequently rejected erroneously as managed care claims. In
addition, the Company expects that there will be a growing trend toward
outsourcing by healthcare provider organizations in the future.


                                       8
<PAGE>   11
                                   COMPETITION

      Although the Company's products and services involve various proprietary
aspects, its business is highly competitive and competition has been
consolidating rapidly. While the Company believes that no one company competes
with all aspects of its business, several companies, some of which may be larger
and have greater financial resources than the Company, compete with the Company
in providing one or more of the Company's offerings. The Company also encounters
competition from companies attempting to expand the scope of their products and
services within or into the healthcare information management services industry.

PROVIDER TRANSFER PAYMENT UNIT

       The Company's Provider Transfer Payment Unit competes with systems
integration companies (such as Electronic Data Systems Corporation ["EDS"]),
hospital computer systems vendors (such as HBOC & Company ["HBOC"], which has
announced its intent to be acquired by McKesson Corporation, and Shared Medical
Systems Corporation ["SMS"]), EDI companies (such as National Data Corporation
["NDC"], MedE America Corporation ("MedE"), and QuadraMed Corporation ["QMDC"]),
and national public accounting firms. The Company competes on the basis of its
proprietary systems, existing relationships, long-standing reputation in the
provider market segment, and pricing. The Company's EDI offerings compete with
numerous entities, including MedE, NDC, and QMDC.

PAYOR TRANSFER PAYMENT UNIT

      The Company's Payor Transfer Payment Unit targets federal and state
healthcare agencies and large commercial payors, and competes primarily with
national public accounting firms (especially Deloitte & Touche LLP and its
frequent business partner Public Consulting Group). The Company competes on the
basis of its proprietary systems, historically high recovery rates, and pricing.

DSS UNIT

      The Company's DSS Unit competes with products provided by Transition
Systems, Inc. (recently acquired by Eclipsys Corporation), HBOC, and QMDC.
Companies that offer financial management products, including Hyperion Software
and PeopleSoft, Inc., are also competitors. The Company competes on the basis of
its proprietary software and management consulting services.

MCIS UNIT

      The Company's MCIS Unit competes against many companies, including Health
Systems Design Corporation and ERISCO, Inc. ("ERISCO"), as well as with in-house
systems development groups. The Company sells its products to large provider
organizations, and views IDN's as a potential market for its existing products
and services. In the provider market, competition comes from large hospital
computer systems vendors, such as HBOC and SMS, which also offer managed care
information systems as part of their solutions.

      In the traditional indemnity health insurance market, the Company's MCIS
offerings compete with claims adjudication and provider management products from
ERISCO, Synertech, a subsidiary of Highmark, Inc., Resource Information
Management Systems, Inc., and Rothenberg Health Systems, Inc., which was
acquired by QMDC. As the Company enters the IDN market, it will compete with
HBOC's Amisys Division and SMS. CSC Healthcare, a subsidiary of Computer
Sciences Corporation, has also been investing in and may emerge as a strong
competitor in the IDN information systems market.

      The Company's MCIS offerings compete on the basis of its proprietary
software, healthcare software development expertise, and large-scale project
management capabilities.

                                       9
<PAGE>   12
SIGNIFICANT CONTRACTS

      The Company's largest client is Columbia, a customer of the DSS Unit. This
client accounted for 10%, 12%, and 8% of the Company's total revenue in fiscal
years 1998, 1997, and 1996, respectively. The Company provides its services to
Columbia primarily principally pursuant to a series of 12-month work order
agreements. There is no assurance that any of these agreements will be renewed.
The Company's second largest client is a group of healthcare facilities under
the governance of Los Angeles County, for which the Company provides a full
range of provider business office outsourcing products and services, including
managed care services. During fiscal years 1998, 1997, and 1996, this group
accounted for 9%, 12%, and 12%, respectively, of the Company's total revenue.

      The Company's ten largest clients accounted for approximately 50% of the
Company's revenue in fiscal year 1998. Including the Company's contract with the
County of Los Angeles, six of the Company's ten largest contracts expire in
fiscal year 1999. The Company provides its services pursuant to agreements
subject to competitive re-procurement. There is no assurance that any of these
agreements will be renewed and, if renewed, that the fee rates will be equal to
those currently in effect.

                            NEW PRODUCTS AND SERVICES

      The Company's strategy is to continue to strengthen its position as a
leading provider of decision support software and services, managed care
information systems and services, and transfer payment products and services for
both providers and payors. In addition, the Company will continue to leverage
its existing software and services to enhance its outsourcing offerings. Key
components of the Company's strategy include: (i) increasing levels of
investment in product research and development, (ii) enhancing its outsourcing
capabilities, (iii) investing in its data warehousing infrastructure, (iv)
leveraging existing relationships with large clients through provision of
additional Company products and services, and (v) expanding the Company's
strategic development partnerships with provider and payor organizations for all
aspects of its business.

                            MERGERS AND ACQUISITIONS

      The Company may acquire companies that supply healthcare providers and
payors with information management software, systems, or services if the
offerings of such companies would benefit from access to the Company's
technology, software applications, or client base. The Company believes that
such acquisition opportunities exist due, in part, to competitive pressures on
local service businesses that lack adequate capital, technical, and management
resources. The Company also believes that consolidation will continue to occur
within the healthcare information services industry.

                                    EMPLOYEES

      As of October 31, 1998, the Company had 860 employees: 420 in the Software
Division and 440 in the Transfer Payment Division. No employees are covered by a
collective bargaining agreement or are represented by a labor union.

                  FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS

      Specific financial information with respect to the Company's industry
segments is provided in Note 13, Business Segment Information, of Notes to
Consolidated Financial Statements, on page F-31 on this Form 10-K.

ITEM 2. PROPERTIES

      The Company's New York City offices consist of approximately 146,000
square feet. In addition, the Company leases approximately 142,000 square feet
of office space in approximately 22 locations throughout the United States.
Information regarding the Company's leases is included in Note 14, Commitments,
of Notes to Consolidated Financial Statements, on page F-32 of this Form 10-K.


                                       10
<PAGE>   13
      The Company operates IBM CMOS processors, associated peripheral devices
from Hitachi Data Systems and EMC Corporation, communications devices, a large
number of microcomputers, and extensive local and wide area networks. These
technologies facilitate both product development and production processes.

      The Company's data processing operations afford both batch processing and
national on-line network capabilities and are controlled by multiple levels of
physical and software security. Each of the Company's critical systems is backed
up on a nightly basis. Copies of the Company's operating systems, key
applications software, and critical client data are maintained offsite to ensure
continuity of business. The Company does not rely on unique hardware or software
systems and its purchase and maintenance agreements with vendors provide for
back-up support in case of computer systems failure.

ITEM 3. LEGAL PROCEEDINGS

      In April and May 1997, five purported class action lawsuits were commenced
in the United States District Court for the Southern District of New York
against the Company and certain of its present and former officers and directors
alleging violations of the Securities Exchange Act of 1934 in connection with
certain allegedly false and misleading statements. These lawsuits, which sought
damages in an unspecified amount, were consolidated into a single proceeding
captioned In re Health Management Systems, Inc., Securities Litigation (97
CIV-1965 (HB) and a Consolidated Amended Complaint was filed. Defendants made a
motion to dismiss the Consolidated Amended Complaint, which was submitted to the
Court on December 18, 1997 following oral argument. On May 27, 1998, the
Consolidated Amended Complaint was dismissed by the Court for failure to state a
claim under the federal securities laws, with leave for the plaintiffs to
replead. On July 17, 1998, a Second Consolidated Amended Complaint was filed in
the United States District Court of the Southern District of New York, which
reiterates plaintiffs' allegations in their prior Complaint. On September 11,
1998, the Company and the other defendants filed a motion to dismiss the second
Complaint. The motion was fully briefed in late November 1998, at which time the
motion was submitted to the Court. The Company intends to continue its vigorous
defense of this lawsuit.

      On June 1, 1998, MedE America Corp. commenced a lawsuit against the
Company and others in the United States District Court for the Southern District
of New York. In its complaint, plaintiff alleges copyright infringement and
other violations of its rights relating to the Company's development and sale of
certain computer software, known as the Universal Billing Platform, which was
recently developed for the Company by certain former employees of plaintiff, who
are also defendants in the action, acting as independent contractors. Plaintiff,
among other relief, seeks (i) to restrain the Company from continuing to market
and sell the alleged infringing software, and (ii) monetary damages in excess of
$10,000,000. Over a period in excess of nine months prior to the filing of the
complaint, the parties engaged in an extensive exchange of communications, as a
result of which the Company concluded, after investigation, that plaintiff's
claims were without merit. On July 22, 1998, the Company answered the complaint,
denying the material allegations of the complaint. Discovery has commenced, and
the Company intends to vigorously contest plaintiff's claims. Pursuant to the
Rules of the Court, this matter has been referred to a court-appointed mediator,
who in the context of non-binding mediation and independent of the court
proceeding, will attempt to assist in settling the matter or narrowing the
issues between the parties. Absent a settlement of this matter through
mediation, the Company intends to continue its vigorous defense of this lawsuit.

      On June 28, 1998, eight holders of promissory notes (the "Notes") of HHL
Financial Services, Inc. ("HHL") commenced a lawsuit against the Company and
others in the Supreme Court of the State of New York, County of Nassau, alleging
various breaches of fiduciary duty on the part of the defendants against HHL.
The complaint alleges that as a result of these breaches of duty, HHL was caused
to make substantial unjustified payments to the Company, which ultimately led to
defaults on the Notes and to HHL filing for Chapter 11 bankruptcy protection. On
June 30, 1998, the same Note holders commenced a virtually identical action (the
"Adversary Proceeding") in the United States Bankruptcy Court for the District
of Delaware, where HHL's Chapter 11 proceeding is pending. The Adversary
Proceeding alleges the same wrongdoing as the New York State Court proceeding
and seeks the same damages, i.e., $2,300,000 (the unpaid amount of the Notes)
plus interest. Plaintiffs have moved in the Bankruptcy Court to have the Court
abstain from hearing the Adversary Proceeding in deference to the New York State
Court action. The Company has opposed plaintiffs' motion for abstention and on
September 15, 1998, filed a motion in the Bankruptcy Court to dismiss the
Adversary Proceeding. This motion was fully


                                       11
<PAGE>   14
briefed in mid-December 1998, at which time the motions were submitted to the
Court. The Company intends to continue its vigorous defense of this lawsuit.

      The Company is a party to several other legal proceedings. In the opinion
of the Company's management, none of these other proceedings is expected to have
a material adverse effect on the Company's financial position, results of
operations, or liquidity.

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

      None.

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS

      The Company's common stock is included in the Nasdaq-AMEX National Market
System (symbol: HMSY). As of the close of business on January 19, 1999, there
were approximately 10,000 holders of the Company's common stock, including the
individual participants in security position listings. The Company has not paid
any cash dividends on its common stock and does not anticipate paying cash
dividends in the foreseeable future. The Company's current intention is to
retain earnings to support the future growth of its business. The Company's
credit agreement with its bank contains limitations on the Company's ability to
pay cash dividends.

      The table below summarizes the high and low closing prices per share for
the Company's common stock for the fiscal year periods indicated, as reported on
the Nasdaq-AMEX National Market System.

<TABLE>
<CAPTION>
                           First         Second       Third        Fourth
                          Quarter        Quarter      Quarter      Quarter
                          -------        -------      -------      -------
<S>                       <C>            <C>          <C>           <C>
      1998:
      Market Price:
        High               $ 7.63         13.38        13.12         9.25
        Low                  5.25          7.25         7.75         3.94

      1997:
      Market Price:
         High              $27.75         12.37         7.50        10.00
         Low                13.00          4.75         4.50         5.63

      1996:
      Market Price:
        High               $26.83         31.75        37.00        31.75
        Low                 21.33         24.50        25.50        22.25
</TABLE>

ITEM 6. SELECTED FINANCIAL DATA

      The information required by Item 6 is found on page F-13 of this report.


                                       12
<PAGE>   15
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

      The information required by Item 7 is found on pages F-1 to F-12 of this
report.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS

      Not applicable.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

      The information required by Item 8 is found on pages F-16 to F-37 of this
report.

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

      The information required by Item 10 will be included in the Company's
Proxy Statement for the 1999 Annual Meeting of Shareholders (the "Proxy
Statement"), which will be mailed within 120 days after the close of the
Company's fiscal year ended October 31, 1998, and is hereby incorporated herein
by reference to such Proxy Statement.

ITEM 11. EXECUTIVE COMPENSATION

      The information required by Item 11 will be included in the Proxy
Statement, which will be mailed within 120 days after the close of the Company's
fiscal year ended October 31, 1998, and is hereby incorporated herein by
reference to such Proxy Statement.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

      The information required by Item 12 will be included in the Proxy
Statement, which will be mailed within 120 days after the close of the Company's
fiscal year ended October 31, 1998, and is hereby incorporated herein by
reference to such Proxy Statement.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

      The information required by Item 13 will be included in the Proxy
Statement, which will be mailed within 120 days after the close of the Company's
fiscal year ended October 31, 1998, and is hereby incorporated herein by
reference to such Proxy Statement.

PART IV

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

      A.    Financial Statements - See Index to Consolidated Financial
            Statements on page F-14.

      B.    Schedule
            Schedule II - Valuation and Qualifying Accounts

      C.    Reports on Form 8-K
            None

      D.    Exhibits - See Exhibit Index


                                       13
<PAGE>   16
                                   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.

                                    HEALTH MANAGEMENT SYSTEMS, INC.
                                    ------------------------------
                                              (REGISTRANT)


                                    BY:   /S/   PAUL J. KERZ
                                          ------------------------------
                                          Paul J. Kerz
                                          President and Chief Executive Officer


                                    DATE: January 11, 1999

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


<TABLE>
<CAPTION>
Signatures                  Title                           Date
----------                  -----                           ----
<S>                         <C>                             <C>
/S/ PAUL J. KERZ            Chairman, President,            January 11, 1999
-------------------------   Chief Executive Officer,
Paul J. Kerz                Chief Financial Officer,
                            and Director



/S/ ROBERT V. NAGELHOUT     Executive Vice President,       January 11, 1999
-------------------------   Chief Operating Officer, and
Robert V. Nagelhout         Director



/S/ DONALD J. STAFFA        Senior Vice President and       January 11, 1999
------------------------    Director
Donald J. Staffa


/S/ RANDOLPH G. BROWN       Director                        January 11, 1999
------------------------
Randolph G. Brown


/S/ WILLIAM W. NEAL         Director                        January 11, 1999
-------------------------
William W. Neal


/S/ GALEN D. POWERS         Director                        January 11, 1999
-------------------------
Galen D. Powers


/S/ ELLEN A. RUDNICK        Director                        January 11, 1999
-------------------------
Ellen A Rudnick


/S/ RICHARD H. STOWE        Director                        January 11, 1999
-------------------------
Richard H. Stowe
</TABLE>


                                       14
<PAGE>   17
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                                 EXHIBIT INDEX

<TABLE>
<CAPTION>
EXHIBIT
NUMBER
------
<S>       <C>
2.1       Agreement and Plan of Merger dated as of January 18, 1995 among Health
          Management Systems, Inc., HCm Acquisition Corp., and all the
          shareholders of Health Care microsystems, Inc., as amended
          (Incorporated by reference to Exhibit 10.18 to the Company's Annual
          Report on Form 10-K for the year ended October 31, 1994 and to Exhibit
          10.2 to the Company's Registration Statement on Form S-3, file no.
          33-91518)

2.2       Agreement and Plan of Merger, dated as of April 29, 1996 among Health
          Management Systems, Inc., CDR Acquisition Corp., CDR Associates, Inc.,
          and all the shareholders of CDR Associates, Inc. (Incorporated by
          reference to Exhibit 10.1 to the Company's Current Report on Form 8-K
          dated April 29, 1996)

2.2(i)    First Amendment to Agreement and Plan of Merger, dated as of April 29,
          1996, among Health Management Systems, Inc., CDR Acquisition Corp.,
          CDR Associates, Inc., and all the shareholders of CDR Associates, Inc.
          (Incorporated by reference to Exhibit 2.2(i) to the Company's Annual
          Report on Form 10-K for the year ended October 31, 1996 [the 1996 Form
          10-K].)

2.3       Agreement and Plan of Merger, dated as of September 3, 1996, by and
          among Health Management Systems, Inc., QSM Acquisition Corporation and
          Quality Standards in Medicine, Inc. (Incorporated by reference to
          Exhibit 2.1 to the Company's Registration Statement on Form S-4, File
          No. 333-13513 [the S-4])

2.3(i)    Amendment to Agreement and Plan of Merger, dated as of November 20,
          1996, by and among Health Management Systems, Inc., QSM Acquisition
          Corporation, and Quality Standards in Medicine, Inc. (Incorporated by
          reference to Exhibit 10.1 to Post-Effective Amendment No. 1 to the
          S-4)

2.4       Agreement and Plan of Merger, dated as of March 18, 1997, by and among
          Health Management Systems, Inc., HISCo Acquisition Corp., Health
          Information Systems Corporation and HSA Managed Care Systems, Inc.
          (Incorporated by reference to Exhibit 2.1 to the Company's Quarterly
          Report on Form 10-Q for the quarter ended April 30, 1997 [the April
          1997 Form 10-Q])

2.5       Asset Purchase Agreement, dated as of March 10, 1997, by and among
          GHS, Inc., Global Health Systems, Inc. GHS Management Services, Inc.,
          Health Management Systems, Inc. and Global Health Acquisition Inc.
          (Incorporated by reference to Exhibit 2.1 to the Company's Quarterly
          Report on Form 10-Q for the quarter ended July 31, 1997 [the July 1997
          Form 10-Q].)

2.5(i)    Assignment and Assumption Agreement, dated as of July 15, 1997,
          between Global Health Acquisition Corp. and HSA Managed Care Systems,
          Inc. (Incorporated by reference to Exhibit 2.2 to the July 1997 Form
          10-Q.)

3.1       Amended and Restated Certificate of Incorporation of Health
          Management Systems, Inc. (Incorporated by reference to Exhibit 3.1
          to Amendment No. 1 [Amendment No. 1] to the Company's Registration
          Statement on Form S-1, File No. 33-4644 [the Registration
          Statement] and Exhibit 3(i) to the Company's Quarterly Report on
          Form 10-Q for the quarter ended January 31, 1996 [the January 1996
          Form 10-Q])
</TABLE>


                                       15
<PAGE>   18
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                                 EXHIBIT INDEX

<TABLE>
<CAPTION>
EXHIBIT
NUMBER
------
<S>       <C>
3.2       By-Laws of Health Management Systems, Inc. (Incorporated by
          reference to Exhibit 3.2 to Amendment No. 1)


10.1      Financial Management Services Agreement, dated August 1, 1989,
          between Health Management Systems, Inc. and the County of Los
          Angeles (Incorporated by reference to Exhibit 10.2 to the
          Registration Statement)

10.2(i)   Master Software License Agreement, dated June 29, 1992, by and
          between Health Care microsystems, Inc. and Healthtrust, Inc. - The
          Hospital Company.

10.2(ii)  Amendment, dated as of September 1, 1995, to Master Software License,
          dated June 29, 1992, by and between Health Care microsystems, Inc. and
          Columbia/HCA. (Incorporated by reference to Exhibit 10.2(ii) to the
          1997 Form 10-K)

10.3(i)   Health Management Systems, Inc. Stock Option and Restricted Stock
          Purchase Plan, as amended (Incorporated by reference to Exhibit 10.3
          to the Registration Statement, to Exhibit 10.3 to Amendment No. 2
          [Amendment No. 2] to the Registration Statement, Exhibit 10.1 to the
          Company's Quarterly Report on Form 10-Q for the quarter ended January
          31, 1994 [the January 1994 Form 10-Q] and Exhibit to the January 1996
          Form 10-Q.)

10.3(ii)  Amendment No. 6, dated as of December 2, 1997, to the Health
          Management Systems, Inc., Stock Option and Restricted Stock
          Purchase Plan. (Incorporated by reference to Exhibit 10.3(iii) to
          the 1997 Form 10K)

10.3(iii) Health Management Systems, Inc. Employee Stock Purchase Plan, as
          amended (Incorporated by reference to Exhibit 10.2 to the January 1994
          Form 10-Q and to Exhibit 10.1 to the Company's Quarterly Report on
          Form 10-Q for the quarter ended January 31, 1995 [the January 1995
          Form 10-Q])

10.3(iv)  Health Management Systems, Inc. 1995 Non-Employee Director Stock
          Option Plan (Incorporated by reference to Exhibit 10.2 to the
          January 1995 Form 10-Q)

10.3(v)   Health Management Systems, Inc. Profit Sharing Plan (Incorporated by
          reference to Exhibit 10.3(iv) to the Company's Annual Report on Form
          10-K for the year ended October 31, 1995 [the 1995 Form 10-K])

10.3(vi)  Health Management Systems, Inc. Profit Sharing Plan, as amended
          (Incorporated by reference to Exhibit 10.3(vi) to the 1995 Form
          10-K)

10.4(i)   Credit Agreement and Guaranty Among Health Management Systems, Inc.,
          as Borrower, Accelerated Claims Processing, Inc., Quality Medi-Cal
          Adjudication, Incorporated, Health Care microsystems, Inc., and CDR
          Associates, Inc., as Guarantors, and The Chase Manhattan Bank, as Bank
          (Incorporated by reference to Exhibit 10.1 to the Company's Quarterly
          Report on Form 10-Q for the quarter ended July 31, 1996 [the July 1996
          Form 10-Q])

10.4(ii)  First Amendment to Credit Agreement and Guaranty and Waiver
          (Incorporated by reference to Exhibit 10.1(i) to the July 1996 Form
          10-Q)
</TABLE>


                                       16
<PAGE>   19
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                                 EXHIBIT INDEX

<TABLE>
<CAPTION>
EXHIBIT
NUMBER
------
<S>       <C>
10.4(iii) Guaranty Agreement, dated as of April 16, 1997, between Health
          Management Systems, Inc. and The Chase Manhattan Bank (Incorporated by
          reference to Exhibit 10.1 to the April 1997 Form 10-Q)

10.4(iv)  Second Amendment to Credit Agreement and Guaranty, dated as of April
          16, 1997, among Health Management Systems, Inc., Accelerated Claims
          Processing, Inc., Quality Medical Adjudication, Incorporated, Health
          Care microsystems, Inc., CDR Associates, Inc., and The Chase Manhattan
          Bank (Incorporated by reference to Exhibit 10.1 to the July 1997 Form
          10-Q)


10.4(v)   Third Amendment to Credit Agreement and Guaranty, dated as of June 30,
          1997, among Health Management Systems, Inc., Accelerated Claims
          Processing, Inc., Quality Medical Adjudication, Incorporated, Health
          Care Microsystems, Inc., CDR Associate, Inc., HSA Managed Care
          Systems, Inc., Quality Standards in Medicine, Inc. and The Chase
          Manhattan Bank (Incorporated by reference to Exhibit 10.1 to the July
          1997 Form 10-Q)

10.5(i)   Leases, dated February 1, 1980, September 24, 1981, September 24,
          1982, and January 6, 1986, as amended, between 401 Park Avenue South
          Associates and Health Management Systems, Inc. (Incorporated by
          reference to Exhibit 10.13 to the Registration Statement and to
          Exhibit 10.5 to the Company's Quarterly Report on Form 10-Q for the
          quarter ended January 31, 1994)

10.5(ii)  Lease, dated as of March 15, 1996, by and between 387 PAS Enterprises,
          as Landlord, and Health Management Systems, Inc., as Tenant
          (Incorporated by reference to Exhibit 10.2 to the July 1996 Form 10-Q)

10.6      Lease, dated September 1996, by and between Pacific Corporate Towers
          LLC, Health Management Systems, Inc., and Health Care microsystems,
          Inc. (Incorporated by reference to Exhibit 10.13 to the 1996 Form
          10-K)

10.7      Services Agreement, dated as of October 31, 1995, between Health
          Information Systems Corporation and Health Management Systems, Inc.
          (Incorporated by reference to Exhibit 10.19(iv) to the 1995 Form 10-K)

10.8      Agreement and Release of Claims dated as of October 29, 1996, by and
          among HHL Financial Services, Inc., Health Management Systems, Inc.,
          and the First National Bank of Chicago (Incorporated by reference to
          Exhibit 10.12 to the 1996 Form 10-K)

10.9      Security Agreement, dated as of April 16, 1997, by and between
          Robert V. Nagelhout and Health Management Systems, Inc.
          (Incorporated by reference to Exhibit 10.3 to the April 1997 Form
          10-Q)

10.10     Promissory note, dated as of April 16, 1997, by and between
          Robert V. Nagelhout and The Chase Manhattan Bank. (Incorporated
          by reference to Exhibit 10.4 to the April 1997 Form 10-Q)

10.11     Consulting Service Agreement, dated as of May 1, 1997, by and
          between Improved Funding Techniques, Inc. and Health Management
          Systems, Inc. (Incorporated by reference to Exhibit 10.2 to the
          July 1997 Form 10-Q)
</TABLE>


                                       17
<PAGE>   20
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                                 EXHIBIT INDEX

<TABLE>
<CAPTION>
EXHIBIT
NUMBER
------
<S>       <C>
10.12     Employment Agreement, as of May 1, 1997, by and between Joseph H.
          Czajkowski and CDR Associates, Inc., a wholly-owned subsidiary of
          Health Management Systems, Inc. (Incorporated by reference to Exhibit
          10.3 to the July 1997 Form 10-Q)

10.13     Employment Agreement, as of May 1, 1997, by and between Jeffrey R.
          Donnelly and CDR Associates, Inc., a wholly-owned subsidiary of Health
          Management Systems, Inc. (Incorporated by reference to Exhibit 10.4 to
          the July 1997 Form 10-Q)

10.14     Sublease Agreement, dated December 23, 1997, between Health Management
          Systems, Inc. and Shandwick USA, Inc. (Incorporated by reference to
          Exhibit 10.1 to the company's Quarterly Report on Form 10-Q for the
          quarter ended January 31, 1998 [the January 1998 Form 10-Q])

10.15     Consent to Sublease, dated December 23, 1997, by 387 P.A.S.
          Enterprises to the subletting by Health Management Systems, Inc.
          to Shandwick USA, Inc. (Incorporated by reference to Exhibit 10.2
          to the January 1998 Form 10-Q)

*10.16    Promissory note, dated as of October 15, 1998, in the principal
          amount of $500,000 between Paul J. Kerz and HSA Managed Care
          Systems, Inc.

*10.17    Promissory note, dated as of October 15, 1998, in the principal
          amount of $250,000 between Paul J. Kerz and HSA Managed Care
          Systems, Inc.

*10.18    Security Agreement, dated as of October 15, 1998, between Paul J.
          Kerz and HSA Managed Care Systems, Inc.

*11.0     Computation of Earnings per Share

*21.1     List of subsidiaries of Health Management Systems, Inc.

*23.1     Consent of KPMG LLP, independent certified public accountants

24.2      Consent of Ernst & Young LLP, independent certified public accountant.
          (Incorporated by reference to Exhibit 24.2 to the 1996 Form 10-K)

24.3      Report of independent certified public accountants on the financial
          statements of Health Information Systems Corporation as of and for the
          period ended October 31, 1996 (Incorporated by reference to Exhibit
          24.3 to the 1996 Form 10-K)

*27.1     Financial Data Schedule, which is submitted electronically to the
          Securities and Exchange Commission for informational purposes only
</TABLE>


* Filed herewith


                                       18
<PAGE>   21
               MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF
                       OPERATIONS AND FINANCIAL CONDITION

      This Annual Report on Form 10-K contains forward-looking statements which
involve risks and uncertainties. The Company's actual results may differ
significantly from the results discussed in the forward-looking statements.
Factors that might cause such a difference include, but are not limited to,
those discussed in "Risk Factors" beginning on page F-7.

OVERVIEW

      A healthcare information systems and services enterprise, the Company is
organized into two divisions: Transfer Payment Division and Software Division.
The Transfer Payment Division comprises two business units: Provider Transfer
Payment Unit and Payor Transfer Payment Unit. The Company's Software Division
also comprises two business units: DSS Unit and MCIS Unit.

      Within the Transfer Payment Division, the Provider Transfer Payment Unit
has delivered RCR services since 1974 and began to deliver CAMS in 1986 and EDI
services with the acquisition in 1990 of QMA. QMA provides electronic billing
and automated denial reprocessing services. In 1997 the Company acquired a
computerized medical record-based processing system for managed care public
health and ambulatory care facilities as part of its purchase of substantially
all the Global assets. In 1997 the Company formed a Business Office Outsourcing
unit and in 1998 consolidated this Business Office Outsourcing unit with the
remainder of its Provider Transfer Payment Unit. The Payor Transfer Payment Unit
began delivery of TPLR services in 1985 and augmented its product line in 1996
with the acquisition of CDR. CDR is a provider of hospital-based claim audits to
payors, principally Blue Cross and Blue Shield organizations.

      The Company's Software Division was referred to in the aggregate as MCIS
in 1997; in 1998, the MCIS Unit refers to one of the Software Division's two
business units, while the DSS Unit refers to the other. The Company entered the
software business in 1995 as a consequence of its merger with HCm. HCm furnishes
microcomputer-based distributed decision support systems and services to
providers of care in the healthcare industry and today comprises the DSS Unit of
the Company. In 1996 the DSS Unit acquired QSM and integrated QSM's clinical
information systems with HCm's decision support offerings. In 1997 the Company,
which had owned a 43% equity interest in HISCo, acquired from WCAS and various
of its affiliates, independent investors, and from certain of the Company's
executive officers and directors, the remaining 57% of HISCo's equity. At the
time of acquisition, HISCo merged with its sole operating subsidiary, Health
Systems Architects, Inc., and was renamed HSA Managed Care Systems, Inc.("HSA").
Today, this entity comprises the MCIS Unit and furnishes automated business and
information solutions, including software and services, to bearers of financial
risk in the healthcare industry.

      The HCm, CDR, and QSM mergers were accounted for using the pooling of
interest method, while the QMA, HISCo, and Global acquisitions were accounted
for using the purchase method.


                                      F-1
<PAGE>   22
RESULTS OF OPERATIONS

      The table below summarizes the Company's results of operations and the
percentage of total revenue of selected line items for the last three fiscal
years.

<TABLE>
<CAPTION>
Years Ended October 31,                             1998                         1997(a)                          1996
($ In Thousands)
---------------------------------------------------------------------------------------------------------------------------------
                                               Amount    %                      Amount    %                   Amount    %
                                        -------------------------       -------------------------       -------------------------
<S>                                     <C>             <C>             <C>            <C>              <C>             <C>
Revenue:
        Transfer Payment Division
         Provider                       $  34,987              33%      $  39,007              44%      $  55,410              55%
         Payor                             22,251              21%         16,849              19%         26,406              26%
                                        ---------       ---------       ---------       ---------       ---------       ---------
                                           57,238              54%         55,856              62%         81,816              81%
        Software Division
         Provider (DSS)                    25,499              24%         24,873              28%         19,510              19%
         Payor (MCIS)                      22,515              21%          8,788               9%              0               0%
                                        ---------       ---------       ---------       ---------       ---------       ---------
                                           48,014              46%         33,661              38%         19,510              19%

---------------------------------------------------------------------------------------------------------------------------------
                                          105,252             100%         89,517             100%        101,326             100%
Cost of services:
        Compensation                       59,288              56%         52,361              58%         49,370              49%
        Data processing                     8,771               9%          7,593               9%         10,282              10%
        Occupancy                           9,663               9%         10,383              12%          8,001               8%
        Other                              17,906              17%         18,018              20%         20,220              20%
---------------------------------------------------------------------------------------------------------------------------------
                                           95,628              91%         88,355              99%         87,873              87%
         Operating margin before
           amortization of intangibles      9,624               9%          1,162               1%         13,453              13%
         Amortization of intangibles        1,964               2%          1,331               1%            204               0%
---------------------------------------------------------------------------------------------------------------------------------
           Operating  income (loss)         7,660               7%           (169)             (0)%        13,249              13%
Net interest and net other income           1,700               2%          2,755               3%            987               1%
Gain (loss) on investment                     597               1%             (9)             (0)%          (927)             (1)%
Merger related costs                            0               0%           (537)             (1)%          (494)             (0)%
Equity in (loss) earnings of affiliate          0               0%           (310)             (0)%            50               0%
---------------------------------------------------------------------------------------------------------------------------------
        Income before income taxes          9,957               9%          1,730               2%         12,865              13%
Income tax (expense) benefit               (3,869)             (4)%           351               0%         (5,574)             (6)%
---------------------------------------------------------------------------------------------------------------------------------
        Net income                      $   6,088               6%      $   2,081               2%      $   7,291               7%
---------------------------------------------------------------------------------------------------------------------------------
</TABLE>


 (a)  The fiscal year 1997 operating results have been reclassified to include
      Global in the Transfer Payment Division.


                                      F-2
<PAGE>   23
YEARS ENDED OCTOBER 31, 1998 AND 1997

      Consolidated revenue for the fiscal year ended October 31, 1998 was
$105,252,000, an increase of $15,735,000 or 18% from prior year revenue of
$89,517,000. Revenue from the Transfer Payment Division was $57,238,000, an
increase of $1,382,000 or 2% from the prior year. Revenue from the Software
Division was $48,014,000, an increase of $14,353,000 or 43% over the prior year;
this increase is primarily attributable to the inclusion of the MCIS Unit
results for the entirety of the fiscal year in 1998 but for only two-thirds of
the year (March 18 through October 31) in 1997.

      Cost of services for the fiscal year ended October 31, 1998 was
$95,628,000, an increase of $7,273,000 or 8% from the prior year, which included
only partial year costs for the MCIS Unit in fiscal year 1997 and partial year
costs for the Global acquisition consummated by the Company in July 1997 and
reported as part of the Provider Transfer Payment Unit in fiscal year 1998. In
summary, increased costs in the Software Division of $11,045,000 (of which
$8,962,000 are attributable to the MCIS Unit) were offset by diminished costs of
approximately $3,772,000 in the Transfer Payment Division.

      Compensation expense for the fiscal year ended October 31, 1998 was
$59,288,000 or 62% of total cost of services, an increase of $6,927,000 or 13%
over the prior year, when compensation cost was 59% of total cost of services.
Increased compensation expense was attributable in large part to the addition of
full year compensation costs for the MCIS Unit and the full year effect of the
Global acquisition, offset by lower compensation expense in the Transfer Payment
Division due to reduction in average headcount and decreased deferred
compensation benefits. Headcount, the principal driver of compensation expense,
for the entire Company increased by 48 or 6% from 812 at the end of October 1997
to 860 at the end of October 1998. Headcount for the DSS Unit decreased from 248
at the end of 1997 to 229 at the end of 1998, while headcount for the MCIS Unit
increased from 142 to 191; thus, headcount for the Software Division increased
by 30, from 390 to 420. Headcount for the Transfer Payment Division increased by
18, from 422 to 440.

      Data processing expense for the fiscal year ended October 31, 1998 was
$8,771,000, an increase of $1,178,000 or 16% from the prior year. The increase
is due primarily to full year costs of operations in fiscal year 1998 associated
with acquisitions completed during the course of fiscal year 1997.

      Occupancy expense for the fiscal year ended October 31, 1998 was
$9,663,000, a decrease of $720,000 or 7% from the prior year. The decrease is
attributable to the subletting of two floors at the Company's New York City
offices, offset by increases associated with acquisitions completed during the
course of fiscal year 1997.

      Other operating expense for the fiscal year ended October 31, 1998 was
$17,906,000, a decrease of $112,000 or 1% from the prior year. This decrease was
attributable to cost reductions in the Transfer Payment Division, offset in part
by full year costs in fiscal year 1998 for acquisitions completed during the
course of fiscal year 1997.

      Operating margin before amortization of intangible assets for the fiscal
year ended October 31, 1998 was $9,624,000, an increase of $8,462,000 or 728%
from the $1,162,000 realized in fiscal year 1997. The Company's operating margin
rate before amortization of intangible assets was 9.1%, compared to 1.3% in the
prior year.

      Amortization of intangible assets for the fiscal year ended October 31,
1998 was $1,964,000, an increase of $633,000 from the prior year. This increase
was attributable to a full year of amortization of intangibles for both the
Global and HSA acquisitions.

      Net interest and other income for the fiscal year ended October 31, 1998
was $2,297,000, an increase of $398,000 over the prior year. Fiscal year 1998
other income included $597,000 in capital gains compared to a loss of $9,000 in
the prior year. The prior year also included $877,000 in interest expense
reversal resulting from a favorable Internal Revenue Service audit resolution,
merger expense of $537,000 and equity losses in


                                      F-3
<PAGE>   24
HISCo of $310,000, none of which events occurred in fiscal year 1998. Finally,
fiscal year 1998 interest income declined by $178,000 from the prior year due to
lower interest rates and lower cash balances.

      The Company's income tax expense for the fiscal year ended October 31,
1998 was $3,869,000, resulting in an effective tax rate of approximately 38.9%.
This compared to an income tax benefit of $351,000 for fiscal year 1997. The
fiscal year 1998 tax rate of 38.9% is lower than the Company's normal rate of
slightly under 42% and is attributable to available capital losses carried
forward which sheltered the entirety of a $593,000 long term capital gain, both
for tax and financial statement purposes. The effective tax rate for fiscal year
1998 exclusive of the benefit of the tax-sheltered capital gain was 41.3%,
compared to an equivalent effective tax rate of 42.9% in fiscal year 1997. The
tax benefit in fiscal year 1997 was primarily due to a reversal of $1,093,000 in
accrued taxes arising from the favorable resolution of an Internal Revenue
Service audit.

      Net income for the fiscal year ended October 31, 1998 was $6,088,000, an
increase of $4,007,000 or 193% from the prior year. Diluted earnings per share
were $0.34 in fiscal year 1998, compared to $0.12 in fiscal year 1997. Included
in the fiscal year 1998 earnings per share are $0.03 resulting from $593,000 in
fully sheltered long-term capital gains; included in fiscal year 1997 earnings
per share were $0.06 attributable to non-recurring events, which were a $310,000
loss in earnings due to the Company's [then] equity interest in HISCo, $537,000
in merger related costs, offset by a one-time benefit from the reversal of a
$877,000 reserve for interest expense and $1,093,000 in accrued taxes resulting
from a favorable resolution of an Internal Revenue Service audit concluded
fiscal year 1997. Earnings per share without the one-time and unusual events
increased from $0.06 in Fiscal Year 1997 to $0.31 in fiscal year 1998, an
increase of $0.25 per share.


YEARS ENDED OCTOBER 31, 1997 AND 1996

      Consolidated revenue for the fiscal year ended October 31, 1997 was
$89,517,000, a decrease of $11,809,000 or 12% from the prior year. Consolidated
revenue during fiscal year 1996 gave effect to a charge during the third quarter
occasioned by the default of HHL Financial Services, Inc. ("HHL") on its
obligations under a data processing agreement with the Company. Before the HHL
revenue reversal of $2,180,000 in the third quarter of fiscal year 1996,
consolidated revenue decreased $13,989,000 or 14%. Revenue from the Transfer
Payment Division was $55,855,000, a decrease of $25,960,000 or 32% from the
prior year. Before the HHL revenue reversal, Transfer Payment Division revenue
decreased $23,780,000 or 29% from the prior year due to the non-recurrence in
1997 of one-time projects in 1996, a contract hiatus with a major client, lower
billing volumes and fee rates, and contract expirations. Revenue by division
during fiscal year 1997 has been reclassified to transfer Global revenue from
the Software Division to the Transfer Payment Division.

      Revenue from the Software Division during the fiscal year ended October
31, 1997 was $33,661,000, an increase of $14,151,000 or 73% from the prior year
period. Revenue from DSS services was $24,873,000, an increase of $5,363,000 or
28% over the prior year due to the continued growth of software consulting fees
and maintenance contract revenue. Revenue from MCIS for fiscal year 1997 was
$8,788,000. There was no comparable prior year revenue for MCIS because HSA was
acquired during fiscal year 1997 in a transaction accounted for under the
purchase method.

      Cost of services for the fiscal year ended October 31, 1997 was
$88,355,000, an increase of $482,000 or less than 1% from the prior year. Prior
to the effect of the one-time HHL charge of $6,704,000 in the third quarter of
1996, comprised of $1,362,000 of compensation costs, $2,199,000 of data
processing costs, and $3,143,000 of other operating costs (including $2,881,000
of bad debt expense related to HHL receivables and $262,000 of net other
operating expenses), cost of services increased $7,186,000 or 9% over the prior
year. This increase was due primarily to the added cost of services resulting
from the HSA and Global acquisitions, which added costs of services by
$9,249,000, and increased operating costs of DSS services of $3,228,000, which
increases were offset by certain cost reductions in the Transfer Payment
Division.

      Compensation expense for the fiscal year ended October 31, 1997 was
$52,361,000 or 59% of total cost of services, an increase of $2,991,000 or 6%
from the prior year. Compensation expense in 1997 compared


                                      F-4
<PAGE>   25
to 1996 prior to the HHL one-time charge of $1,362,000 in the third quarter of
1996 increased $4,353,000 or 9%. The increased compensation expense was
primarily attributable to operating costs resulting from the HSA and Global
acquisitions, which increased compensation expense by $6,395,000, and increased
compensation cost from DSS services of $2,642,000. Included in compensation
expense in 1997 was severance cost of $568,000 in connection with two reductions
in force in the Transfer Payment Division. These cost increases were partially
offset by lower compensation expenses, including bonus and profit sharing
expenses, in the Transfer Payment Division.

      Data processing expense for the fiscal year ended October 31, 1997 was
$7,593,000, a decrease of $2,689,000 or 26% from the prior year. Prior to the
effect of the HHL one-time charge in the third quarter of 1996 of $2,199,000,
data processing expense decreased $490,000 or 6%. The decrease in cost was due
to certain cost reductions and lower Transfer Payment Division revenue, which
more than offset the $1,087,000 increase in operating costs from the HSA and
Global acquisitions.

      Occupancy expense for the fiscal year ended October 31, 1997 was
$10,383,000, an increase of $2,382,000 or 30% over the prior year. This increase
was primarily due to the expansion of the Company's facilities, including
additional floors at the Company's New York City offices, and $813,000 in
additional operating expense from the HSA and Global acquisitions.

      Other operating expense for the fiscal year ended October 31, 1997 was
$18,018,000, a decrease of $2,202,000 or 11% from the prior year. Prior to the
effect of the HHL one-time charge of $3,143,000 in the third quarter of 1996,
other operating expenses increased $941,000 or 6%. The increase was due to an
additional $954,000 in other operating expenses attributable to HSA and Global.

      Operating margin before amortization of intangible assets for the fiscal
year ended October 31, 1997 was $1,162,000, a decrease of $12,291,000 or 91%
from the prior year. The Company's operating margin rate before amortization of
intangible assets was 1.3%, compared to 13.3% in the prior year. Prior to the
effect of the HHL one-time charge and revenue reversal in 1996, operating margin
before amortization decreased $21,175,000 or 95%.

      Amortization of intangible assets for the fiscal year ended October 31,
1997 was $1,331,000, an increase of $1,127,000 from the prior year. The increase
resulted primarily from the amortization of software and goodwill acquired in
the HSA and Global acquisitions.

      Net interest and net other income for the fiscal year ended October 31,
1997 was $2,746,000, an increase of $1,759,000. The increase was partially due
to a reversal of $877,000 in accrued interest expense resulting from a favorable
resolution of an Internal Revenue Service audit during fiscal year 1997. In
addition, the Company wrote off its investment in HHL of $927,000 in 1996 as
part of the one-time charge. Merger related costs of $537,000 were incurred in
the fiscal year ended October 31, 1997 related to the Company's merger with QSM
in November 1996. Merger related costs of $494,000 were incurred in the fiscal
year end October 31, 1996 related to the Company's merger with CDR in April
1996. The Company recognized a loss of $310,000 through March 18, 1997 (the date
on which the Company acquired the remaining 57% of HISCo's equity which it did
not already own) from its equity investment in HISCo, compared to earnings of
$50,000 in the prior year.

      The Company's income tax benefit for the fiscal year ended October 31,
1997 was $351,000. The tax benefit was primarily due to a reversal of $1,093,000
in accrued taxes arising from the favorable Internal Revenue Service audit
resolution in 1997. Exclusive of the Internal Revenue Service audit resolution,
the effective tax rate was 42.9%. This compares to income tax expense of
$5,574,000 and an effective tax rate of 43.3% for fiscal year 1996.

      Net income for the fiscal year ended October 31, 1997 was $2,081,000, a
decrease of $5,210,000 or 71% from the prior year. Earnings per share were $0.12
in 1997 compared to $0.39 in 1996. Earnings per share excluding all one-time
events were $0.06 in 1997 compared to $0.72 in 1996.


                                      F-5
<PAGE>   26
LIQUIDITY AND CAPITAL RESOURCES

      At October 31, 1998, the Company had $56,709,000 in net working capital,
an increase of $2,910,000 or 5% from the level at October 31, 1997. The
Company's principal sources of liquidity at October 31, 1998 consisted of cash,
cash equivalents, and short-term investments aggregating $28,402,000, net
accounts receivable of $54,993,000, and an available balance of $30,000,000
under its bank line of credit. On June 11, 1998, an officer and director of the
Company repaid a loan guaranteed by the Company to the bank and the available
balance under the Company's line of credit with the bank increased by $1,600,000
from $28,400,000 to $30,000,000. See Note 16(c) of the Notes to Consolidated
Financial Statements. Accounts receivable at October 31, 1998 reflected an
increase of $15,474,000 or 39% from the October 31, 1997 balance. The increase
in accounts receivable results primarily from revenue increases in the Payor
Transfer Payment Unit and its elongated receivables liquidation cycle.

      The Company's bank line of credit expires on July 15, 1999. Although the
Company intends to secure a new line of credit at that time, there can be no
assurance that the Company will be able to do so on terms which are acceptable
to it.

      On May 28, 1997, the Board of Directors authorized the Company to
repurchase such number of shares of its common stock that have an aggregate
purchase price not in excess of $10,000,000. The Company is authorized to
repurchase these shares from time to time on the open market or in negotiated
transactions at prices deemed appropriate by the Company. Repurchased shares are
deposited in the Company's treasury and used for general corporate purposes. In
the fourth quarter of fiscal year 1998, the Company repurchased 185,000 shares
of common stock at an average price of $6.97 per share, for an aggregate
purchase price of $1,290,000. In fiscal year 1998, the Company repurchased a
total of 734,500 shares of common stock at an average price of $8.01 per share,
for an aggregate purchase price of $5,887,000. Since the inception of the
repurchase program in June 1997, the Company has repurchased in the open market
1,049,000 shares of common stock at an average price of $7.39 per share, for an
aggregate purchase price of $7,750,000.

INFLATION

      The Company's business is labor intensive. Wages and other
employee-related expenses increase during periods of inflation and when
shortages in the skilled labor market occur. Although the moderate inflation
rates of the past several years have not imposed significant problems for the
Company, the Company implemented selective wage increases in fiscal year 1998 to
assure retention of qualified personnel in key areas of its operations.


RISK FACTORS

      This Annual Report on Form 10-K and other statements issued or made from
time to time by the Company or its representatives contain statements which may
constitute "forward-looking statements" within the meaning of the Securities Act
of 1933, as amended, and the Securities Exchange Act of 1934, as amended by the
Private Securities Litigation Reform Act of 1995. Those statements include
statements regarding the intent, belief or current expectations of the Company
and members of its management, as well as the assumptions on which such
statements are based. Prospective investors are cautioned that any such
forward-looking statements are not guarantees of future performance and involve
risks and uncertainties, and that actual results may differ materially from
those contemplated by such forward-looking statements. Important factors
currently known to management that could cause actual results to differ
materially from those in forward-looking statements are set forth in the safe
harbor compliance statement for forward-looking statements set forth below. The
Company undertakes no obligation to update or revise forward-looking statements
to reflect changed assumptions, the occurrence of unanticipated events or
changes to future operating results over time.


                                      F-6
<PAGE>   27
                PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
                        SAFE HARBOR COMPLIANCE STATEMENT
                         FOR FORWARD-LOOKING STATEMENTS

      In passing the Private Securities Litigation Reform Act of 1995 (the
"Reform Act"), Congress encouraged public companies to make "forward-looking
statements" by creating a safe harbor to protect companies from securities law
liability in connection with forward-looking statements. The Company intends to
qualify both its written and oral forward-looking statements for protection
under the Reform Act and any other similar safe harbor provisions.

      "Forward-looking statements" are defined by the Reform Act. Generally,
forward-looking statements include expressed expectations of future events and
the assumptions on which the expressed expectations are based. All
forward-looking statements are inherently uncertain as they are based on various
expectations and assumptions concerning future events and they are subject to
numerous known and unknown risks and uncertainties which could cause actual
events or results to differ materially from those projected. Due to those
uncertainties and risks, prospective investors are urged not to place undue
reliance on written or oral forward-looking statements of the Company. The
Company undertakes no obligation to update or revise this safe harbor compliance
statement for forward-looking statements to reflect future developments. In
addition, the Company undertakes no obligation to update or revise
forward-looking statements to reflect changed assumptions, the occurrence of
unanticipated events or changes to future operating results over time.

      The Company provides the following risk factor disclosure in connection
with its continuing effort to qualify its written and oral forward-looking
statements for the safe harbor protection of the Reform Act and any other
similar safe harbor provisions. Important factors currently known to management
that could cause actual results to differ materially from those in
forward-looking statements include the following:

VARIABILITY OF OPERATING RESULTS;  LENGTH OF SALES CYCLES; TERMINABILITY OF
CUSTOMER CONTRACTS.

      The Company's revenue and operating results may vary significantly from
quarter to quarter as a result of a number of factors, including the number and
timing of systems sales; the termination of, or a reduction in, offerings of the
Company's products and services; the loss of customers due to consolidation in
the healthcare industry; the length of the sales cycles and delays in the
implementation process; and general economic conditions. The Company experiences
sales cycles of three to eighteen months. As a result, the Company's results of
operations are subject to significant fluctuations and its results of operations
for any particular quarter or fiscal year may not be indicative of results of
operations for future periods. A significant portion of the Company's operating
expenses are fixed, and planned expenditures are based primarily on sales
forecasts. Any inability of the Company to reduce spending or to compensate for
any failure to meet sales forecasts or receive anticipated revenues could
magnify the adverse impact of such events on the Company's operating results.
Further, the commencement of one or more major implementations could generate a
large increase in revenue and net income for any given quarter or fiscal year,
which increase may prove anomalous when compared to changes in revenues and net
income in other periods, and which may not provide a valid basis for future
projections. The Company's ability to complete implementation of its systems and
recognize revenue is dependent on certain factors outside the control of the
Company, including its customers' ability to allocate internal resources to the
implementation process and, with respect to certain customers, the need to
obtain necessary approvals upon completion of work but prior to customer
acceptance. In addition, many of the Company's agreements with its customers may
be terminated under certain circumstances upon 30 to 90 days notice. The
termination of customer agreements could have a material adverse effect on the
Company's business, financial condition and results of operations.


                                      F-7
<PAGE>   28
NEW PRODUCT DEVELOPMENT AND SYSTEM ENHANCEMENT

      The Company's future performance will depend in large part upon the
Company's ability to provide the increasing functionality required by its
customers through the timely development and successful introduction of new
products and enhancements to its existing suite of products. The Company has
historically devoted significant resources to product enhancements and research
and development and believes that significant continuing development efforts
will be required to adapt to changing marketplace requirements, to sustain its
operations and integrate the products and technologies of acquired businesses.
There can be no assurance that the Company will successfully or in a timely
manner develop, acquire, integrate, introduce and market new product
enhancements or products, or that product enhancements or new products developed
by the Company will meet the requirements of hospitals or other healthcare
providers and payors and achieve or sustain market acceptance.

LIMITED PROPRIETARY RIGHTS; RISK OF INFRINGEMENT

      The Company's success is dependent to a significant extent on its ability
to maintain the proprietary and confidential aspects of its data processing and
computer software technology. The Company relies on a combination of trade
secrets, copyright and trademark laws, nondisclosure and other contractual
provisions to protect its proprietary rights. There can be no assurance that the
measures taken by the Company to protect its intellectual property will be
adequate or that the Company's competitors will not independently develop
products and services that are substantially equivalent or superior to those of
the Company.

      Substantial litigation regarding intellectual property rights exists in
the software industry, and the Company expects that software products may be
increasingly subject to third-party infringement claims as the number of
competitors in the Company's industry segment grows and the functionality of
products overlaps. Although the Company believes that its products do not
infringe upon the proprietary rights of third parties, a lawsuit alleging
copyright infringement has been filed against the Company, and there can be no
assurance that other third parties will not assert infringement claims against
the Company in the future or that a license or similar agreement will be
available on reasonable terms in the event of an unfavorable ruling on any such
claim. In addition, any claim may require the Company to incur substantial
litigation expenses or subject the Company to significant liabilities and could
have a material adverse effect on the Company's business, financial condition
and results of operations. There can be no assurance that the Company will be
successful in its defense of any such claims. See "Item 3, Legal Proceedings"
for additional information regarding the copyright infringement claim pending
against the Company.

RISK OF PRODUCT DEFECTS; FAILURE TO MEET PERFORMANCE CRITERIA

      Products and services such as those offered by the Company at times
contain errors or failures, especially when initially introduced or when new
versions are released or processes implemented. Although the Company conducts
extensive testing, software errors have been discovered in certain enhancements
and products and services after their introduction. There can be no assurance
that, despite testing by the Company and by current and potential customers,
errors or performance failures will not occur in these products and services
under development or in other enhancements or products after commencement of
commercial shipments or implementations, resulting in loss of revenue and
customers, delay in market acceptance, diversion of development resources,
damage to the Company's reputation or increased service and warranty costs, any
of which could have a material adverse effect upon the Company's business,
financial condition and results of operations.


                                      F-8
<PAGE>   29
ACQUISITIONS AND EXPANSION

      The Company's strategy includes the expansion of its business through
selective acquisitions. In pursuing such acquisitions, the Company competes with
other prospective acquirors, some of which may have greater financial resources
than the Company. There can be no assurance that suitable acquisition
opportunities will be identified or that acquisitions can be consummated or
integrated successfully into the Company's operations. In addition, future
acquisitions by the Company could result in potentially dilutive issuances of
equity securities, the incurrence of debt and contingent liabilities and
amortization expenses related to goodwill and other tangible assets, any of
which could materially adversely affect the Company's operating results and
financial position.

      Growth through acquisition entails certain risks in that acquired
operations could be subject to unanticipated business uncertainties or legal
liabilities. The Company seeks to minimize these risks through investigation and
evaluation of the operations proposed to be acquired and through transaction
structure and indemnification. The various risks associated with the
acquisitions and operational integration of future acquisitions and the
subsequent performance of such acquired operations may adversely affect the
Company's results of operations. The ability of the Company to acquire
additional operations may depend upon its ability to obtain appropriate
financing and personnel.

COMPETITION

      The business of providing information management and data processing
products and services to hospitals and other healthcare providers and to
government health service agencies and other healthcare payors is highly
competitive. The Company's competitors vary in the size, scope and breadth of
the products and services they offer. There can be no assurance that competitors
will not develop or offer products with superior functionality, or that other
features of competitive products will not be preferred by the Company's
customers. Several of the Company's competitors have significantly greater
financial, technical, product development and marketing resources than the
Company. In the future, additional competitors could enter the market, including
providers of information systems to other segments of the healthcare industry,
and compete with the Company. A substantial amount of the Company's sales are
derived from competitive procurement processes managed directly by sophisticated
clients or consultants that require specific, highly detailed presentations from
several qualified vendors. There can be no assurance that future competition
will not have a material adverse effect on the Company's business, financial
condition and results of operations.

HEALTHCARE PAYMENT COMPLEXITY

      The complexity of the healthcare transfer payment process, and the
experience of the Company in offering services that improve the ability of its
customers to recover incremental revenue through that process, have been
contributing factors to the success of the Company's service offerings.
Complexities of the healthcare transfer payment process include multiple payors,
the coordination and utilization of clinical, operational, financial and/or
administrative review instituted by third-party payors in an effort to control
costs and manage care. If the payment processes associated with the healthcare
industry are simplified, the need for services such as those offered by the
Company could be reduced, and there could be a resulting adverse effect on the
Company's business, results of operations or financial condition.


                                      F-9
<PAGE>   30
HEALTHCARE REGULATION AND REFORM

      The healthcare industry in the United States is subject to changing
political, economic and regulatory influences that may affect the procurement
practices and operations of healthcare organizations. The Company's products are
designed to function within the structure of the healthcare financing and
reimbursement system currently being used in the United States. During the past
several years, the healthcare industry has been subject to increasing levels of
governmental regulation of, among other things, reimbursement rates and certain
capital expenditures. From time to time, certain proposals to reform the
healthcare system have been considered by Congress. These proposals, if enacted,
may increase government involvement in healthcare, lower reimbursement rates and
otherwise change the operating environment for the Company's clients. Healthcare
organizations may react to these proposals and the uncertainty surrounding such
proposals by curtailing or deferring investments, including those for the
Company's products and services. The Company cannot predict with any certainty
what impact, if any, such proposals or healthcare reforms might have on its
results of operations, financial condition or business.

DEPENDENCE UPON KEY PERSONNEL

      As the Company's success depends upon the continued contributions of its
senior management, the loss of services of certain of the Company's executive
officers could have an adverse effect on the Company's business. Accordingly,
although the Company does not have long term service agreements with most of its
executive officers, the Company does have confidentiality, non-compete and
non-solicitation agreements with most of its management and certain other key
employees. In general, such agreements (i) require the employee to protect the
confidential and proprietary information of the Company and (ii) preclude the
employee from soliciting other employees of the Company or competing with the
Company for periods of up to three years following termination of employment. In
addition, the Company believes that its continued success also will depend in
large part on its ability to attract and retain highly-skilled management,
technology, marketing, and sales personnel. Competition for such personnel is
intense, and there can be no assurance that the Company will be successful in
attracting and retaining such personnel as necessary. Furthermore, the Company's
ability to manage change and growth successfully will require the Company to
continue to improve its management expertise as well as its financial systems
and controls. Additions of new personnel, and departures of existing skilled
employees, can be disruptive and could have a material adverse effect on the
Company's business, financial condition and results of operations.

POSSIBLE VOLATILITY OF STOCK PRICES

      The market price of the Company's common stock has been subject in the
past and could be subject in the future to significant fluctuations in response
to variations in the Company's quarterly operating results and other factors,
such as announcements of technological innovations or new products by the
Company or by the Company's competitors, adoption of new or amended government
regulations, challenges to or changes in patent or other proprietary rights, and
developments in the Company's relationships with its customers. In addition, the
stock market has in recent years experienced and continues to experience
significant price fluctuations. These fluctuations often have been unrelated to
the operating performance of the specific companies whose stock is traded. Broad
market fluctuations, as well as fluctuating economic conditions generally, may
adversely affect the market price of the Company's common stock.


                                      F-10
<PAGE>   31
CERTAIN ANTI-TAKEOVER PROVISIONS

      The Company's certificate of incorporation, as amended, authorizes the
issuance of up to 5,000,000 shares of "blank check" preferred stock with such
designations, rights and preferences as may be determined by the Company's Board
of Directors. Accordingly, the Company's Board of Directors is empowered,
without shareholder approval, to issue preferred stock with dividend,
liquidation, conversion, voting or other rights which could adversely affect the
voting power or other rights of holders of the Company's common stock. In the
event of issuance, preferred stock could be utilized, under certain
circumstances, as a method of discouraging, delaying or preventing a change in
control of the Company. Although the Company has no present intention to issue
any shares of preferred stock, there can be no assurance that the Company will
not do so in the future. In addition, the Company's by-laws provide for a
classified Board of Directors, which provision could also have the effect of
discouraging a change of control of the Company.

LITIGATION

      The Company is a party to various proceedings as described under Item 3,
"Legal Proceedings," of this Report, which description is incorporated herein by
reference. Although the Company believes that it has meritorious defenses to the
claims of liability or for damages in the actions against the Company, there can
be no assurance that an outcome favorable to the Company will be reached in any
of these litigations or that additional lawsuits will not be filed against the
Company. Further, there can be no assurance that these lawsuits will not have a
disruptive effect upon the operations of the business, that the defense of the
lawsuits will not consume the time and attention of the senior management of the
Company, or that the resolution of the lawsuits will not have a material adverse
effect upon the Company, including without limitation, the Company's results of
operations, financial position and cash flow.

      The Company is a party to several other legal proceedings. In the opinion
of the Company's management, none of these other proceedings is expected to have
a material adverse effect on the Company's financial position, results of
operations, or liquidity.

YEAR 2000

      In common with many other companies, the "Year 2000 ("Y2K") computer
issue" creates risks for the Company. To address these Y2K issues, the Company
formulated a plan and began work at the end of 1997. The plan has assessment and
remediation proceeding in tandem with completion and testing of critical systems
by mid-1999. The Company has put in place a working committee and continues to
track to plan and original costs estimates. Activities included in this plan are
intended to encompass all major categories of systems in use by the Company,
including product development, operations, sales, finance, and human resources.
Interactions with major suppliers of products and services have been identified
and the Company is working to ensure uninterrupted delivery of those products
and services. Contingency plans for all potential single points of disruption
have been or are being developed. It is expected that assessment and remediation
will be completed by mid-1999, and contingency planning activities will be
completed by the autumn of 1999.

      The Company is working closely with, and has developed and delivered
correspondence to, all of its clients potentially affected by the Y2K problem as
to the status of the Company's plans. The Company continues to work with its
clients to ensure a smooth transition to the next millennium. The Company also
responded to the passage of the Y2K Information and Disclosure Act ("Y2K Act")
enacted on October 19, 1998. The purpose of the Y2K Act is to encourage and
promote disclosure regarding Y2K issues and to provide limitations for claims on
tort liability.

      The Company has designed and tested the most current versions of its
products for Y2K Compliance. A significant number of the Company's customers are
running product versions that are not Y2K compliant. While the Company has been
encouraging such customers to migrate to current versions, it is possible that
the Company may experience increased expenses in addressing migration issues and
may lose customers. Moreover, the revenue stream and financial stability of
existing customers may be adversely impacted by Y2K problems, which could


                                      F-11
<PAGE>   32
cause fluctuations in the Company's revenue. In addition, there can be no
assurances that the Company's current products do not contain undetected errors
or defects associated with Y2K date functions that may result in the material
costs to the Company. Moreover, the assessment of whether a complete system will
operate correctly depends on the hardware capability of the system and software
design and integration, and for most end-users this will include hardware and
software provided by companies other than the Company. Except as specifically
provided for in the limited warranty accompanying the current versions of its
products, the Company does not believe it is legally responsible for costs
incurred by customers related to ensuring their Y2K capability. Nevertheless,
the Company is incurring various costs to provide customer support and customer
satisfaction services regarding Y2K issues, and it is anticipated that these
expenditures will continue through 1999 and thereafter.

      The costs incurred to date related to these programs are estimated at less
than $1,000,000. The Company currently expects that the total cost of these
programs, including both incremental spending and redeployed resources, will not
exceed $2,000,000. The total cost estimate does not include potential costs
related to any customer or other claims or the cost of internal software and
hardware replaced in the normal course of business. In some instances, the
installation schedule of new software and hardware in the normal course of
business is being accelerated to afford a timely solution to Y2K capability
issues. The total cost estimate is based on the current assessment of relevant
projects and is subject to change as the projects progress.

      The expenses incurred by the Company to identify and address the Y2K
matters discussed above, or the expenses or liabilities to which the Company may
become subject as a result of such matters, could have a material adverse effect
on the Company's business, financial condition and results of operation. In
addition, there can be no assurance that the failure to ensure Y2K capability by
a supplier or another third party would not have a material adverse effect on
the Company.


                                      F-12
<PAGE>   33
SELECTED CONSOLIDATED FINANCIAL DATA

<TABLE>
<CAPTION>
Years Ended October 31,                                   1998       1997 (a)         1996 (b)         1995 (b)        1994 (b)
  ($ In Thousands, Except Per Common Share Data)
--------------------------------------------------------------------------------------------------------------------------------
<S>                                                    <C>             <C>              <C>              <C>             <C>
STATEMENT OF OPERATIONS DATA:
Revenue                                                $ 105,252         89,517          101,326          90,495          73,940
Cost of services                                          95,628         88,355           87,873          73,035          61,094
--------------------------------------------------------------------------------------------------------------------------------
    Operating margin before amortization of                9,624          1,162           13,453          17,460          12,846
    intangibles
Amortization of intangibles (c)                            1,964          1,331              204             243             190
--------------------------------------------------------------------------------------------------------------------------------
    Operating income (loss)                                7,660           (169)          13,249          17,217          12,656
Net interest and net other income                          1,700          2,746              987             942             464
Gain (loss) on investment                                    597              0             (927)              0               0
Merger related costs                                           0           (537)(d)         (494)(e)      (1,045)(f)         (59)(f)
Equity in (loss) earnings of affiliate (g)                     0           (310)              50               0               0
--------------------------------------------------------------------------------------------------------------------------------
    Income before income taxes                             9,957          1,730           12,865          17,114          13,061
Income tax (expense) benefit                              (3,869)           351           (5,574)         (8,152)         (6,353)
--------------------------------------------------------------------------------------------------------------------------------
    Net income                                             6,088          2,081            7,291           8,962           6,708
--------------------------------------------------------------------------------------------------------------------------------
PER COMMON SHARE DATA:
Diluted net income attributable to common              $    0.34       $   0.12         $   0.39         $  0.51         $  0.40
shareholders
Weighted average common shares and
    common share equivalents                              17,833         17,979           18,494          17,579          16,674
--------------------------------------------------------------------------------------------------------------------------------
SELECTED OPERATING DATA:
Operating margin as a percentage of revenue                    9%             1%              13%             19%             17%
Operating income (loss) as a percentage of revenue             7%            (0)%             13%             19%             17%
--------------------------------------------------------------------------------------------------------------------------------
</TABLE>

<TABLE>
<CAPTION>
                                                                                         October 31,
                                                            --------------------------------------------------------------------
                                                            1998           1997             1996            1995            1994
--------------------------------------------------------------------------------------------------------------------------------
BALANCE SHEET DATA:
<S>                                                    <C>              <C>              <C>             <C>             <C>
Cash and short-term investments                        $  28,402         39,080           39,521          30,112          27,827
Working capital                                           56,709         53,799           54,753          41,413          35,732
Total assets                                             117,802        109,694          109,643          88,101          70,689
Common shareholders' equity                               83,269         79,806           74,612          58,203          46,662
--------------------------------------------------------------------------------------------------------------------------------
</TABLE>


                  NOTES TO SELECTED CONSOLIDATED FINANCIAL DATA

(a)   Includes the revenue and costs associated with the Company's HSA and
      Global acquisitions. See Notes 2(a) and 2(b) of Notes to Consolidated
      Financial Statements.

(b)   Financial data for the years 1994 through 1996 has been restated to
      reflect the merger with QSM in 1997. See Note 2(c) of Notes to
      Consolidated Financial Statements.

(c)   Intangible assets were principally recorded in connection with the
      Company's 1989 recapitalization, its acquisition of QMA in 1990, and its
      HSA and Global acquisitions in 1997. See Notes 1(e) and 6 of Notes to
      Consolidated Financial Statements.

(d)   Includes costs associated with the Company's merger with QSM. See Note
      2(c) of Notes to Consolidated Financial Statements.

(e)   Includes costs associated with the Company's merger with CDR. See Note
      2(d) of Notes to Consolidated Financial Statements.

(f)   Includes costs associated with the Company's merger with HCm.

(g)   In March 1997, the Company acquired the remaining outstanding shares of
      HISCo not already owned by the Company. The acquisition was accounted for
      using the purchase method. See Note 2(b) of Notes to Consolidated
      Financial Statements.


                                      F-13
<PAGE>   34
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
                                                                                      PAGE
CONSOLIDATED FINANCIAL STATEMENTS                                                     NUMBER
---------------------------------                                                     ------
<S>                                                                                   <C>
Report of Independent Certified Public Accountants                                     F-15

Consolidated Statements of Operations for the Years Ended October 31, 1998,
1997, and 1996                                                                         F-16

Consolidated Balance Sheets as of October 31, 1998 and 1997                            F-17

Consolidated Statements of Shareholders' Equity for the Years Ended
  October 31, 1998, 1997, and 1996                                                     F-18

Consolidated Statements of Cash Flows for the Years Ended October 31, 1998,
1997, and 1996                                                                         F-19

Notes to Consolidated Financial Statements                                             F-20


FINANCIAL STATEMENT SCHEDULE:

Schedule II - Valuation and Qualifying Accounts                                        F-37
</TABLE>


                                      F-14
<PAGE>   35
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS


The Board of Directors and Shareholders
Health Management Systems, Inc.:

      We have audited the accompanying consolidated financial statements of
Health Management Systems, Inc. and subsidiaries as listed in the accompanying
index. In connection with our audits of the consolidated financial statements,
we also have audited the financial statement schedule as listed in the
accompanying index. These consolidated financial statements and financial
statement schedule are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements and financial statement schedule 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 consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Health
Management Systems, Inc. and subsidiaries as of October 31, 1998 and 1997, and
the results of their operations and their cash flows for each of the years in
the three-year period ended October 31, 1998 in conformity with generally
accepted accounting principles. Also, in our opinion, the related financial
statement schedule, when considered in relation to the basic consolidated
financial statements taken as a whole, presents fairly, in all material
respects, the information set forth therein.


New York, New York
November 24, 1998


                                      F-15
<PAGE>   36
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                     CONSOLIDATED STATEMENTS OF OPERATIONS
                   ($ In Thousands, Except Per Share Amounts)


<TABLE>
<CAPTION>
                                                                                  Years ended
                                                                                  October 31,
                                                                      -------------------------------
                                                                         1998        1997       1996
                                                                         ----        ----       ----
<S>                                                                   <C>         <C>          <C>
Revenue:
  Trade                                                               $105,252    $89,186      $ 95,719
  Affiliates                                                                 0        331         5,607
                                                                      --------    -------      --------
                                                                       105,252     89,517       101,326  
Cost of services:
  Compensation                                                          59,288     52,361        49,370
  Data processing                                                        8,771      7,593        10,282
  Occupancy                                                              9,663     10,383         8,001
  Other                                                                 17,906     18,018        20,220
                                                                      --------    -------      --------
                                                                        95,628     88,355        87,873
                                                                      --------    -------      --------
    Operating margin before amortization of intangibles                  9,624      1,162        13,453

  Amortization of intangibles                                            1,964      1,331           204
                                                                      --------    -------      --------

    Operating income (loss)                                              7,660       (169)       13,249

Other income (expense):
  Net interest and net other income                                      1,700      2,755           987
  Gain (loss) on investment                                                597         (9)         (927)
  Merger related costs                                                       0       (537)         (494)
  Equity in (loss) earnings of affiliate                                     0       (310)           50
                                                                      --------    -------      --------
                                                                         2,297      1,899          (384)

    Income before income taxes                                           9,957      1,730        12,865

Income tax (expense) benefit                                            (3,869)       351        (5,574)
                                                                      --------    -------      --------

    Net income                                                        $  6,088    $ 2,081      $  7,291
                                                                      ========    =======      ========

Earnings per share data:
  Basic:
    Basic earnings per share                                          $   0.35    $  0.12      $   0.42
                                                                      ========    =======      ========
 
    Weighted average common shares outstanding                          17,366     17,611        17,166
                                                                      ========    =======      ========
  Diluted:
    Diluted earnings per share                                        $   0.34    $  0.12      $   0.39
                                                                      ========    =======      ========

    Weighted average common shares and common share equivalents         17,833     17,979        18,494
                                                                      ========    =======      ========

</TABLE>

See accompanying notes to consolidated financial statements.

                                      F-16
<PAGE>   37
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                          CONSOLIDATED BALANCE SHEETS
                   ($ In Thousands, Except Per Share Amounts)


<TABLE>
<CAPTION>
                                            October 31,              October 31,
                                               1998                     1997 
                                            -----------              -----------
<S>                                       <C>                      <C> 
                                     ASSETS
Current assets:                                                        
   Cash and cash equivalents                $    13,883              $    20,694
   Short-term investments                        14,519                   18,386
   Accounts receivable, billed, net              28,792                   22,593
   Accounts receivable, unbilled, net            26,201                   16,926
   Income tax receivable                          2,340                      510
   Other current assets                           4,021                    2,874
                                            -----------              -----------
      Total current assets                       89,756                   81,983

Property and equipment, net                       6,687                    7,988
Goodwill, net                                    11,742                   12,316
Capitalized software costs, net                   4,203                    2,020
Deferred income taxes                             3,303                    2,721
Other assets                                      2,111                    2,666
                                            -----------              -----------
      Total assets                          $   117,802              $   109,694
                                            ===========              ===========

                      LIABILITIES AND SHAREHOLDERS' EQUITY

Current liabilities:
   Accounts payable and accrued expenses    $    15,864              $    16,153
   Deferred revenue                               5,876                    5,122
   Deferred income taxes                         11,307                    6,909
                                            -----------              -----------
      Total current liabilities                  33,047                   28,184     

Other liabilities                                 1,486                    1,704
                                            -----------              -----------
   Total liabilities                             34,533                   29,888

Shareholders' equity:
  Preferred stock - $.01 par value; 
   5,000,000 shares authorized; none 
   issued and outstanding                             0                        0

  Common stock - $.01 par value; 
   45,000,000 shares authorized; 
   18,332,367 shares issued and 
   17,283,367 shares outstanding at 
   October 31, 1998; 17,773,653 shares 
   issued and 17,459,153 shares 
   outstanding at October 31, 1997                  183                      178

  Capital in excess of par value                 71,134                   67,304
  Retained earnings                              19,595                   13,506
  Unrealized appreciation on short-term
   investments                                      107                      681
                                            -----------              -----------
                                                 91,019                   81,669

  Less treasury stock, at cost     
   1,049,000 shares at October 31, 1998
   and 314,500 shares at October 31, 1997        (7,750)                  (1,863)
                                            -----------              -----------
   Total shareholders' equity                    83,269                   79,806
   Total liabilities and shareholders' 
    equity                                  $   117,802              $   109,694
                                            ===========              ===========

See accompanying notes to consolidated financial statements.
</TABLE>

                                      F-17
<PAGE>   38
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
                                ($ In Thousands)

<TABLE>
<CAPTION>
                                                                                               Unrealized
                                                 Common Stock                                Appreciation
                                             --------------------   Capital In                     (Loss)                     Total
                                                              Par    Excess Of   Retained   on Short-term   Treasury   Shareholders'
                                                  Shares    Value    Par Value   Earnings     Investments      Stock         Equity
                                                  ------    -----   ----------   --------     -----------      -----         ------
<S>                                          <C>            <C>     <C>          <C>        <C>             <C>         <C>
Balance at October 31, 1995                   16,562,912    $165        53,439      4,135             464          0         58,203
  
  Net income                                           0       0             0      7,290               0          0          7,290
  Stock option activity                          794,994       8         5,629          0               0          0          5,637
  Employee stock purchase plan activity          163,085       2         2,330          0               0          0          2,332
  Disqualifying dispositions                           0       0         1,143          0               0          0          1,143
  Appreciation on short-term investments               0       0             0          0               7          0              7
                                              ----------    ----        ------     ------            ----     ------          ------
Balance at October 31, 1996                   17,520,991    $175        62,541     11,425             471          0         74,612

  Net income                                           0       0             0      2,081               0          0          2,081
  Stock option activity                           69,480       1           333          0               0          0            334
  Employee stock purchase plan activity           95,332       1           708          0               0          0            709
  Stock issued to retire QSM debt                 87,850       1         1,434          0               0          0          1,435
  Stock issued to non-employees                        0       0            98          0               0          0             98
  Disqualifying dispositions                           0       0         2,190          0               0          0          2,190
  Treasury stock acquisition                    (314,500)      0             0          0               0     (1,863)        (1,863)
  Appreciation on short-term investments               0       0             0          0             210          0            210
                                              ----------    ----        ------     ------            ----     ------          ------
Balance at October 31, 1997                   17,459,153    $178        67,304     13,506             681     (1,863)        79,806

  Net income                                           0       0             0      6,088               0          0          6,088
  Stock option activity                          440,316       4         2,713          0               0          0          2,717
  Employee stock purchase plan activity          118,398       0           515          0               0          0            515
  Treasury stock acquisition                    (734,500)      1             0          0               0     (5,887)        (5,886)
  Disqualifying dispositions                           0       0           602          0               0          0            602
  Depreciation on short-term investments               0       0             0          0            (574)         0           (574)
                                              ----------    ----        ------     ------            ----     ------          ------
Balance at October 31, 1998                   17,283,367    $183        71,134     19,595             107     (7,750)         83,269
                                              ==========    ====        ======     ======            ====     ======          ======

</TABLE>

See accompanying notes to consolidated financial statements.



                                      F-18
<PAGE>   39
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                ($ In Thousands)

<TABLE>
<CAPTION>
                                                                                                           Years ended
                                                                                                           October 31,
                                                                                              ------------------------------------
                                                                                                1998          1997          1996
                                                                                              --------      --------      --------
<S>                                                                                           <C>           <C>           <C>
Operating activities:
  Net income                                                                                  $  6,088      $  2,081      $  7,291
    Adjustments to reconcile net income to net cash provided by (used in)
      operating activities:
        Loss on investment                                                                           0             0           927
        Depreciation and amortization                                                            3,520         3,811         3,117
        Amortization of intangibles                                                              1,964         1,331           204
        Provision for doubtful accounts                                                            838           538         4,485
        Loss on disposal of assets                                                                   0            17             0
        Deferred tax expense (benefit)                                                           4,022        (1,635)         (424)
        Equity in loss (earnings) of affiliate                                                       0           310           (50)
        Stock options issued to non-employees                                                        0            98             0
        Changes in assets and liabilities:         
          (Increase) decrease in accounts receivable                                           (15,474)        5,008       (15,188)
          (Increase) decrease in other current assets                                           (2,977)        4,137          (793)
          Increase (decrease) in accounts payable and accrued expenses                            (289)       (2,910)        3,196
          Increase (decrease) in amounts payable to affiliates                                       0          (747)          902
          Increase (decrease) in deferred revenue                                                  754          (575)          881
          Increase (decrease) in other assets and liabilities, net                              (1,497)       (1,531)        2,187
              Net cash (used in) provided by operating activities                             --------      --------      --------
                                                                                                (3,051)        9,933         6,735
                                                                                              --------      --------      --------

Investing activities:
  Capital asset expenditures                                                                    (1,263)       (2,462)       (4,456)
  Acquisition of assets of subsidiaries of GHS, Inc.                                                 0        (2,146)            0
  Software capitalization                                                                       (3,138)       (1,498)       (1,151)
  Investment in affiliates                                                                           0             0           (28)
  Acquisition of remainder of Health Information Systems Corporation, net of cash acquired           0        (3,689)            0
  Net proceeds (purchases) in short-term investments                                             3,295          (964)        2,106
                                                                                              --------      --------      --------
              Net cash used in investing activities                                             (1,106)      (10,759)       (3,529)
                                                                                              --------      --------      --------

Financing activities:
  Proceeds from issuance of common stock                                                           515           709         2,332
  Proceeds from exercise of stock options                                                        2,717           334         5,637
  Common stock repurchases                                                                      (5,886)       (1,863)            0
  Proceeds from notes payable                                                                        0             0           340
                                                                                              --------      --------      --------
              Net cash (used in) provided by financing activities                               (2,654)         (820)        8,309
                                                                                              --------      --------      --------
              Net (decrease) increase in cash and cash equivalents                              (6,811)       (1,646)       11,515
Cash and cash equivalents at beginning of period                                                20,694        22,340        10,825
                                                                                              --------      --------      --------
Cash and cash equivalents at end of period                                                    $ 13,883      $ 20,694      $ 22,340
                                                                                              ========      ========      ========
</TABLE>


See accompanying notes to consolidated financial statements.




                                      F-19
<PAGE>   40
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.    SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

      Founded in 1974, Health Management Systems, Inc. (the "Company")
provides information management software, systems and  services to healthcare
providers and payors.

      (a)   Principles of Consolidation

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

      (b)   Cash and Cash Equivalents

      For purposes of financial reporting, the Company considers all highly
liquid investments purchased with an original maturity of three months or less
(including money market instruments of $6,231,000 and $6,283,000 at October 31,
1998 and 1997, respectively) to be cash equivalents.

      (c)   Short-Term Investments

      Short-term investments are recorded at fair value. Included in short-term
investments are investments classified as available for sale and carried at fair
value. Debt securities that the Company does not have the intent and ability to
hold to maturity are classified either as "available for sale" or as "trading"
and are carried at fair value. Unrealized gains and losses on securities
classified as available for sale are carried as a separate component of
shareholders' equity. Unrealized gains and losses on securities classified as
trading are reported in earnings. Management determines the appropriate
classification of its investments in debt and equity securities at the time of
purchase and reevaluates such determination at each balance sheet date.

      At October 31, 1998 and 1997, the Company recorded cumulative unrealized
appreciation of $107,000 and $681,000, respectively, on these short-term
investments.

      (d)   Depreciation and Amortization of Property and Equipment

      Property and equipment are recorded at cost. Depreciation is provided
over the estimated useful lives of the property and equipment utilizing the
straight-line method. Amortization of leasehold improvements is provided over
the estimated useful lives of the assets or the terms of the leases, whichever
is shorter, utilizing the straight-line method. The estimated useful lives are
as follows:

            Equipment                     3-5 years
            Leasehold improvements        5-8 years
            Furniture and fixtures        5-7 years

      (e)   Intangible Assets

      Intangible assets have been recorded primarily as a result of the
recapitalization of the Company in 1989, the acquisition of Quality Medi-Cal
Adjudication, Incorporated ("QMA") in 1990, the acquisition of the remaining
shares of Health Information Systems Corporation ("HISCo") in March 1997, and
the acquisition of the assets of Global Health Systems, Inc. and GHS Management
Services, Inc. (collectively "Global"), subsidiaries of GHS, Inc., in July 1997.
Intangible assets consist of software, customer lists, and goodwill, which are
being amortized on a straight-line basis over three years, three years and
between ten and forty years, respectively.


                                      F-20
<PAGE>   41
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


      (f)   Software Development Costs

      The Company capitalizes software development costs (related to software
developed for resale) incurred subsequent to the establishment of technological
feasibility of the product, including costs incurred to develop upgrades
subsequent to the commercial release of the product. Amortization of software
development costs is determined on a product-by-product basis to be the greater
of the amount computed on a straight-line basis over the expected economic life
of the product, generally estimated to be 36-48 months, or using the ratio of
current gross revenue to total current and anticipated future gross revenue,
whichever is greater. Software development costs are stated at original cost of
$6,893,000 and $3,755,000 less accumulated amortization of $2,690,000 and
$1,735,000 at October 31, 1998 and 1997, respectively. Amortization expense for
the years ended October 31, 1998, 1997, and 1996 was $956,000, $992,000, and
$543,000, respectively.

      (g)   Revenue Recognition

      The Company generally recognizes revenue for financial reporting purposes
when billings are submitted to clients or their third-party payors or
intermediaries as a consequence of services performed by the Company for a
client. Accounts receivable, unbilled, net, represents amounts recognized for
services rendered but not yet invoiced and is based on the Company's estimate of
the fees that will be invoiced upon receipt of remittance data. Accounts
receivable, billed, net, represents amounts invoiced to clients. Several client
contracts contain periodic fee limitations that the Company believes will be
exceeded in the normal course of business. As a result, the fees allowable under
these contracts are recognized on a straight-line basis over the fee limitation
period as services are performed, and amounts billed in excess of revenue
recognized are deferred. Other contracts have sliding fee scales for which
revenue is fairly predictable. For these, the Company recognizes revenue, at the
estimated effective fee rate, ratably over the client's contract year. Finally,
certain contracts are subject to fixed-fee arrangements covering specified
periods, which the Company realizes on a straight-line basis over the
corresponding periods.

      The Company recognizes revenue from consulting services as the services
are provided. Revenue from software products sold to customers under license
agreements is deferred and recognized as revenue upon software installation and
satisfaction of significant Company obligations, if any, and collection of the
resulting receivable is reasonably assured. Revenue from ongoing maintenance
agreements is deferred and recognized as revenue on a straight-line basis over
the periods of the respective maintenance agreements.

      (h)   Income Taxes

      Income taxes are accounted for under the asset and liability method. Under
the asset and liability method, deferred tax assets and liabilities are
recognized for the future tax consequences attributable to differences between
the financial statement carrying amounts of existing assets and liabilities and
their respective tax bases. Deferred tax assets and liabilities are measured
using enacted tax rates expected to apply to taxable income in the years in
which those temporary differences are expected to be recovered or settled. The
effect on deferred tax assets and liabilities of a change in tax rates is
recognized as income in the period that includes the enactment date.

      (i)   New Accounting Pronouncements

      On June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive
Income." SFAS No. 130 establishes standards for reporting and display of
comprehensive income and its components (revenues, expenses, gains, and losses)
in a full set of general purpose financial statements. SFAS No. 130 requires
that all items that are required to be recognized under accounting standards as
components of comprehensive income be reported in a financial statement that is
displayed with the same prominence as other financial statements. SFAS No. 130
is effective for fiscal years beginning after December 15, 1997.
Reclassification of financial statements for earlier periods provided for
comparative purposes is required. The Company will adopt SFAS No. 130 for the
fiscal year ended October 31, 1999.


                                      F-21
<PAGE>   42
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


      In June 1997, the FASB issued SFAS No. 131, "Disclosures About Segments of
An Enterprise and Related Information." SFAS No. 131 established standards for
reporting information about operating segments in annual financial statements
and in interim financial reports issued to stockholders. It also establishes
standards for related disclosures about products and services, geographic areas
and major customers. In general, such information must be reported for
externally in the same manner used for internal management purposes. SFAS No.
131 is effective for financial statements issued for periods beginning after
December 15, 1997. In the initial year of adoption, comparative information for
earlier years must be restated. The Company will adopt SFAS No. 131 for fiscal
year ended October 31, 1999.

      In October 1997, the American Institute of Certified Public Accountants
issued Statement of Position 97-2 "Software Revenue Recognition" ("SOP 97-2").
SOP 97-2 is effective for transactions entered into in fiscal years beginning
after December 15, 1997. The Company does not believe the adoption of the
provisions of SOP 97-2 will have an impact on the revenue recognition of
software products.

      (j)   Net Income Per Common Share

      In February 1997, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 128, "Earnings per Share" ("FSAS
128"). The Company adopted SFAS 128 during the quarter ended January 31, 1998,
and earnings per share amounts for all periods presented in the accompanying
consolidated statement of operations are calculated and presented in accordance
with SFAS 128. The statement specifies new standards for the computation and
presentation of earnings per share, requiring the presentation of both "basic"
and "diluted" earnings per share.

      Basic earnings per share is based on the net income for the relevant
period divided by the weighted average number of common shares outstanding
during the period. Diluted earnings per share is based on the net income for the
relevant period divided by the weighted average number of common shares and
common stock equivalents outstanding during the period. The Company had weighted
average common shares and common stock equivalents outstanding during fiscal
years 1998, 1997, and 1996 of 17,366,000, 17,611,000 and 17,166,000 and of
467,000, 368,000, and 1,328,000, respectively. The Company's common stock
equivalents consist principally of stock options. As of October 31, 1998, the
Company had 1,802,102 potentially dilutive common shares outstanding that could
have an effect on future calculations of fully diluted earnings per share.

      (k)   Use of Estimates

      The preparation of the consolidated financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the consolidated financial statements and the reported amounts of revenue and
expenses during the reported period. The actual results could differ from those
estimates.

      (l)   Reclassifications

      Certain reclassifications were made to prior year amounts to conform to
the 1998 presentation.

      (m)   Fair Value of Financial Instruments

      The fair value of a financial instrument is the amount at which the
instrument could be exchanged in a current transaction between willing parties.
With the exception of short-term investments (see Note 1(c)), the carrying
amounts of the Company's financial instruments included in the accompanying
consolidated balance sheets approximate estimated fair value as of October 31,
1998 and 1997.

      (n) Stock-Based Compensation

      The Company accounts for its stock option plan in accordance with the
provisions of Accounting Principles Board ("APB") Opinion No. 25, "Accounting
for Stock Issued to Employees", and related


                                      F-22
<PAGE>   43
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


interpretations. As such, compensation expense would be recorded on the date of
grant only if the current market price of the underlying stock exceeded the
exercise price. On October 31, 1997, the Company adopted SFAS No. 123,
"Accounting for Stock-Based Compensation", which permits entities to recognize
as expense over the vesting period the fair value of all stock-based awards on
the date of grant. Alternatively, SFAS No. 123 also allows entities to continue
to apply the provisions of APB Opinion No. 25 and provide pro-forma net income
and pro-forma earnings per share disclosures for employee stock option grants
made in fiscal 1996 and future years as if the fair-value based method defined
in SFAS No. 123 had been applied. The Company has elected to continue to apply
the provisions of APB Opinion No. 25 and provide the pro-forma disclosure
provisions of SFAS No. 123.

      (o) Accounting for the Impairment of Long-Lived Assets The

      Company reviews its long-lived assets, certain identifiable intangibles,
and goodwill for impairment whenever events or changes in circumstances indicate
that the carrying amount of an asset may not be recoverable. Recoverability of
assets to be held and used is measured by a comparison of the carrying amount of
an asset to future net cash flows expected to be generated by the asset. If such
assets are considered to be impaired, the impairment to be recognized is
measured by the amount by which the carrying amount of the assets exceed the
fair value of the assets.

2.    BUSINESS COMBINATIONS

      (a)   Acquisition of the Assets of Global Health Systems Inc. and GHS
Management Services, Inc.

      In July 1997, the Company acquired substantially all the assets of Global
for $2,146,000. Global provides computerized record-based processing systems and
services for managed care, public health and ambulatory care facilities.

      The acquisition was accounted for using the purchase method and
accordingly the results of operations for Global from the date of acquisition
through October 31, 1998 are included in the accompanying consolidated financial
statements. The $1,701,000 excess of the purchase price over the fair market
value of the identifiable assets acquired was recorded as goodwill and is being
amortized over a period not to exceed 20 years.

      (b) Acquisition of Health Information Systems Corporation

      In March 1997, the Company, which owned 43% of the equity of Health
Information Systems Corporation ("HISCo"), acquired the remaining 57% of HISCo's
equity for $3,689,000, net of cash acquired from Welsh, Carson, Anderson & Stowe
("WCAS"), a limited partnership affiliated with WCAS, other affiliates of WCAS,
independent investors, and certain of the Company's executive officers and
directors. HISCo has been renamed HSA Managed Care Systems, Inc.("HSA") HSA
provides automated business and information solutions, including software and
services, to the bearers of risk in the healthcare industry. At the end of
fiscal year 1997, HSA became the MCIS segment of the Company's Software Systems
and Services Division ("Software Division").

      The acquisition was accounted for using the purchase method and
accordingly the results of operations of HSA from the date of acquisition
through October 31, 1998 are included in the accompanying consolidated financial
statements. The $2,309,000 excess of the purchase price over the fair market
value of the identifiable net assets acquired was recorded as goodwill and is
being amortized over a period not to exceed 20 years.

      The following unaudited pro forma financial information presents the
combined results of operations of the Company and HSA as if the acquisition had
occurred as of the beginning of fiscal years 1997 and 1996, after giving effect
to certain adjustments. The pro forma financial information does not necessarily
reflect the results of operations that would have occurred had the Company and
HSA constituted a single entity during such periods.


                                      F-23
<PAGE>   44
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


<TABLE>
<CAPTION>
                                                    (Unaudited)
                                                Year ended October 31,
                                               1997               1996
-----------------------------------------------------------------------------
<S>                                       <C>                <C>
Revenue                                   $ 94,582,000       116,892,000
Net Income                                $  1,671,000         7,358,000
-----------------------------------------------------------------------------
Earnings per share                        $       0.09              0.40
-----------------------------------------------------------------------------
</TABLE>

      (c)   Merger with Quality Standards in Medicine, Inc.

      In November 1996, the Company completed the acquisition of Quality
Standards in Medicine, Inc. ("QSM"), a Boston-based company providing clinical
quality management systems, for 260,000 shares of the Company's common stock.
This transaction was accounted for using the pooling of interests method.
Accordingly, the accompanying consolidated financial statements have been
retroactively restated through 1994 for periods presented to include the
financial position, results of operations, and cash flows of QSM. Founded in
1986, QSM provides hospitals with sophisticated systems and consulting services
to help define and measure the quality of care. QSM has clients located
primarily in 13 states and the District of Columbia. Operationally, QSM has been
combined with the Company's Health Care microsystems, Inc. ("HCm") subsidiary,
providing Decision Support Software ("DSS") as part of the Company's Software
Division.

      (d)   Merger with CDR Associates, Inc.

      In April 1996, the Company acquired all the outstanding capital stock of
CDR Associates, Inc. ("CDR") in exchange for 460,000 shares of the Company's
stock in a merger transaction which was accounted for using the pooling of
interests method. Accordingly, the accompanying consolidated financial
statements have been retroactively restated for all periods presented to include
the financial position, results of operations, and cash flows of CDR. The CDR
product makes up part of the Company's Third Party Liability Recovery ("TPLR")
Services in the Company's Transfer Payment Services Division ("Transfer Payment
Division").

3. ACCOUNTS RECEIVABLE BILLED, NET AND UNBILLED, NET

      Accounts receivable billed, net and unbilled, net as of October 31,
1998 and 1997 were $28,792,000 and $26,201,000, and $22,593,000, and
$16,926,000, respectively. Accounts receivable are reflected net of an allowance
for doubtful accounts of $1,853,000 and $1,428,000 at October 31, 1998 and 1997,
respectively.

4. FEES HELD IN ESCROW

      The Company is obligated to maintain a portion of fees received from two
clients in escrow accounts. The Company's obligation to maintain such fees in
escrow terminates at either: (a) the earlier of six years from the dates of
service associated with fees generated and settlement of the client's Medicaid
and/or Medicare audits for each applicable year, and/or (b) termination of the
contract. Due to the 1994 renewal of one client contract that eliminated future
escrow requirements and the Company's fulfillment of its maximum escrow deposit
for the second client, the Company completed its obligation to make escrow
deposits as of October 31, 1994. As of October 31, 1998 and 1997, fees held in
escrow were $457,000 and $772,000, respectively.

5. PROPERTY AND EQUIPMENT

      Property and equipment as of October 31, 1998 and 1997 consisted of the
following:

<TABLE>
<CAPTION>
                                                                   1998               1997
----------------------------------------------------------------------------------------------
<S>                                                             <C>               <C>
Equipment                                                       $15,411,000        14,697,000
Leasehold improvements                                            6,035,000         5,728,000
Furniture and fixtures                                            5,119,000         4,877,000
----------------------------------------------------------------------------------------------
                                                                 26,565,000        25,302,000
Less accumulated depreciation and amortization                  (19,878,000)      (17,314,000)
----------------------------------------------------------------------------------------------
                                                                 $6,687,000         7,988,000
----------------------------------------------------------------------------------------------
</TABLE>


                                      F-24
<PAGE>   45
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


      Depreciation and amortization expense related to property and equipment
charged to operations for the years ended October 31, 1998, 1997, and 1996 was
$2,592,000, $2,819,000, and $2,574,000, respectively.

6. GOODWILL AND OTHER INTANGIBLE ASSETS

      Goodwill and other intangible assets as of October 31, 1998 and 1997
consisted of the following:

<TABLE>
<CAPTION>
                                                      1998          1997
------------------------------------------------------------------------------
<S>                                                <C>           <C>
Goodwill                                           14,298,000    14,298,000
   Less accumulated amortization                   (2,556,000)   (1,982,000)
------------------------------------------------------------------------------
                                                   11,742,000    12,316,000
------------------------------------------------------------------------------

Other intangible assets                             7,036,000     7,036,000
   Less accumulated amortization                   (6,325,000)   (4,935,000)
------------------------------------------------------------------------------
                                                      711,000     2,101,000
------------------------------------------------------------------------------
</TABLE>

      Amortization expense related to intangible assets charged to operations
for the years ended October 31, 1998, 1997, and 1996, was $1,964,000,
$1,331,000, and $204,000, respectively.

7. ACCOUNTS PAYABLE AND ACCRUED EXPENSES

      Accounts payable and accrued expenses as of October 31, 1998 and 1997
consisted of the following:

<TABLE>
<CAPTION>
                                                   1998          1997
---------------------------------------------------------------------------
<S>                                           <C>             <C>
Accrued compensation                          $  5,802,000     4,633,000
Accrued direct project costs                     1,763,000     3,282,000
Accrued HHL one-time charges                       519,000       719,000
Accounts payable and other accrued expenses      7,719,000     7,519,000
---------------------------------------------------------------------------
                                              $ 15,803,000    16,153,000
---------------------------------------------------------------------------
</TABLE>

8. CREDIT FACILITY

      On June 30, 1997, the Company amended its unsecured revolving credit
facility with a major money center financial institution in order to remain in
compliance with one of the financial covenants of the credit agreement. The
credit facility has a term of three years, carries an unused commitment fee of
20 basis points, and bears interest at the institution's prime lending rate, or
LIBOR plus 5/8%, at the Company's option. The revolving credit facility
contains, among other things, restrictions on additional borrowings, capital
expenditures, leases, sales of assets, and payments of dividends. The revolving
credit facility also contains covenants that require the Company to maintain
minimum tangible consolidated shareholders' equity and limit debt-to-equity and
debt-to-asset relationships as defined in the agreement. The Company's plans to
repurchase up to $10,000,000 in common stock would have brought the Company
below the minimum consolidated tangible net worth test in fiscal year 1998. The
amended credit agreement reduced the credit facility to $30,000,000 and lowered
the minimum consolidated tangible net worth test for fiscal years 1998 and 1999.
The Company had an available balance under this credit facility of $30,000,000
at October 31, 1998 and $28,400,000 at October 31, 1997. See Note 16(c) -
Related Party Transactions. The Company's bank line of credit expires on July
15, 1999. Although the Company intends to obtain a new line of credit at that
time, there can be no assurance that the Company will be able to do so on terms
which are acceptable to it.

      Cash interest payments including bank charges attributable to the
aforementioned credit facility for the years ended October 31, 1998, 1997, and
1996 were $59,000, $0, and $68,000, respectively.


                                      F-25
<PAGE>   46
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


9.    INCOME TAXES

      Income tax benefit (expense) for the years ended October 31, 1998, 1997,
and 1996 was comprised of the following:

<TABLE>
<CAPTION>
                                                    1998                 1997              1996
--------------------------------------------------------------------------------------------------
Current tax (expense) benefit:
<S>                                           <C>                   <C>               <C>
   Federal                                    $     577,000           (716,000)       (4,264,000)
   State and local                                 (423,000)          (568,000)       (1,734,000)
--------------------------------------------------------------------------------------------------
                                                    154,000         (1,284,000)       (5,998,000)
--------------------------------------------------------------------------------------------------

Deferred tax (expense) benefit:
   Federal                                       (3,505,000)         1,136,000           448,000
   State and local                                 (518,000)           499,000           (24,000)
--------------------------------------------------------------------------------------------------
                                                 (4,022,000)         1,635,000           424,000
--------------------------------------------------------------------------------------------------
Income tax (expense) benefit, net             $  (3,869,000)           351,000        (5,574,000)
--------------------------------------------------------------------------------------------------
</TABLE>


                                      F-26
<PAGE>   47
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


      A reconciliation of the income tax benefit (expense) to the federal
statutory rate of 34% follows:

<TABLE>
<CAPTION>
                                                                1998                      1997                        1996
----------------------------------------------------------------------------------------------------------------------------------
<S>                                                 <C>             <C>         <C>            <C>          <C>             <C>
Income tax (expense) benefit:
Computed at federal statutory rate                  $(3,386,000)    (34.0)%      (588,000)     (34.0)%      (4,374,000)     (34.0)%
State and local tax expense, net of federal            (621,000)     (6.2)%       (46,000)      (2.7)%      (1,160,000)      (9.0)%
 benefit
Amortization of goodwill                                (83,000)     (0.8)%       (70,000)      (4.0)%         (55,000)      (0.4)%
Merger related costs                                          0       0.0%       (183,000)     (10.6)%        (157,000)      (1.2)%
Equity loss in affiliate                                      0       0.0%        (88,000)      (5.1)%               0        0.0%
Municipal interest                                      181,000       1.8%        258,000       14.9%          233,000        1.8%
IRS audit resolution                                          0       0.0%      1,093,000       63.2%                0        0.0%
Amortization of software                               (104,000)     (1.0)%       (24,000)      (1.4)%               0        0.0%
Tax contingency                                         261,000       2.6%              0        0.0%                0        0.0%
Other, net                                             (117,000)     (1.3)%        (1,000)       0.0%          (61,000)      (0.6)%
----------------------------------------------------------------------------------------------------------------------------------
Total income tax (expense) benefit                  $(3,869,000)    (38.9)%       351,000       20.3%       (5,574,000)     (43.4)%
==================================================================================================================================
</TABLE>

Deferred income taxes are recognized for the future tax consequences of
temporary differences between the financial statement and tax bases of assets
and liabilities. The types of temporary differences that give rise to the
deferred tax liability, and the effect on the deferred income tax benefit
(expense) of changes in those temporary differences, are as follows:

<TABLE>
<CAPTION>
                                                        1998                   1997                   1996
-------------------------------------------------------------------------------------------------------------
<S>                                              <C>                       <C>                    <C>
Accounts receivable                              $   (3,466,000)             3,298,000            (3,294,000)
Fees held in escrow                                      141,000               188,000                108,000
Depreciable and amortizable assets                     (314,000)                12,000                397,000
Allowance for doubtful accounts                          132,000             (206,000)                653,000
Unbilled costs                                          (12,000)               259,000              (156,000)
Accounts payable and other accrued expenses            (124,000)           (1,273,000)              (170,000)
Deferred revenue                                       (157,000)             (196,000)                275,000
Deferred rent                                           (55,000)                14,000                237,000
Contract termination contingency                               0             1,093,000                479,000
HHL one-time charges                                           0           (1,434,000)              2,070,000
Other                                                  (167,000)             (120,000)              (175,000)
-------------------------------------------------------------------------------------------------------------
Deferred income tax (expense) benefit            $   (4,022,000)             1,635,000                424,000
=============================================================================================================
</TABLE>


                                      F-27
<PAGE>   48
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


      The tax effect of temporary differences that give rise to a significant
portion of the deferred tax assets and deferred tax liabilities at October 31,
1998 and 1997 were as follows:

<TABLE>
<CAPTION>
                                                                               1998                    1997
--------------------------------------------------------------------------------------------------------------
<S>                                                                       <C>                      <C>
Deferred tax assets:
    Accounts receivable/deferred items                                    $    343,000             $ 1,061,000
    Property and equipment                                                   3,354,000               2,838,000
    HHL one-time charges                                                       335,000                 689,000
    Allowance for doubtful accounts                                            705,000                 573,000
    Accounts payable and accrued expenses                                      170,000                 367,000
    Net operating loss carryforward                                          1,396,000               1,396,000
    Other                                                                      637,000                 692,000
--------------------------------------------------------------------------------------------------------------
                   Total deferred tax assets before valuation                6,940,000               7,616,000
    Less: Valuation allowances                                              (1,396,000)             (1,396,000)
--------------------------------------------------------------------------------------------------------------
                   Total deferred tax assets after valuation               $ 5,544,000             $ 6,220,000
==============================================================================================================

    Deferred tax liabilities:
    Accounts receivable/deferred items                                    $ 10,200,000             $ 7,436,000
    Property and equipment                                                   1,722,000                 892,000
    Other                                                                    1,626,000               2,080,000
--------------------------------------------------------------------------------------------------------------
                   Total deferred tax liabilities                         $ 13,548,000             $10,408,000
==============================================================================================================

Net current deferred tax liabilities                                      $(11,307,000)            $(6,909,000)
Net noncurrent deferred tax assets                                           3,303,000               2,721,000
--------------------------------------------------------------------------------------------------------------
                   Total net deferred tax liabilities                     $ (8,004,000)            $(4,188,000)
==============================================================================================================
</TABLE>

      The valuation allowances for the fiscal years ended October 31, 1998,
1997, and 1996 were $1,396,000, $1,396,000 and $0, respectively. At October 31,
1998, the Company had a net operating loss carryforward for federal income tax
purposes of $3,988,000, which is available to offset future federal taxable
income of the Company's QSM subsidiary through 2012. The Company's management
believes that the utilization of such net operating loss carryforward is in
doubt.

      Cash payments attributable to income taxes for the years ended October 31,
1998, 1997, and 1996 were $2,412,000, $1,263,000, and $5,896,000, respectively.

      The Company has had significant disqualifying disposition transactions
during the three years ended October 31, 1998. Disqualifying dispositions are
non-cash transactions and are excluded from the statements of cash flows. The
tax benefit derived from disqualifying dispositions increased shareholders'
equity by $602,000, $2,190,000, and $1,143,000 during the fiscal years ended
October 31, 1998, 1997, and 1996.

10.   EQUITY

      On May 28, 1997, the Board of Directors authorized the Company to
repurchase such number of shares of its common stock that have an aggregate
purchase price not in excess of $10,000,000. The Company is authorized to
repurchase these shares from time to time on the open market or in negotiated
transactions at prices deemed appropriate by the Company. Repurchased shares are
deposited in the Company's treasury and used for general corporate purposes. In
the fourth quarter of fiscal year 1998, the Company repurchased 185,000 shares
of common stock at an average price of $6.97 per share, using $1,290,000. In
fiscal year 1998, the Company repurchased a total of 734,500 shares of common
stock at an average price of $8.01 per share, for an aggregate purchase price of
$5,887,000. Since the inception of the repurchase program in June 1997, the
Company has repurchased in the open


                                      F-28
<PAGE>   49
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


market 1,049,000 shares of common stock at an average price of $7.39 per share
having an aggregate purchase price of $7,750,000.

      The Company's certificate of incorporation, as amended, authorizes the
issuance of up to 5,000,000 shares of "blank check" preferred stock with such
designations, rights and preferences as may be determined by the Company's Board
of Directors.

11. PROFIT SHARING AND 401(k) PLAN

      The Company had a discretionary defined contribution profit sharing plan
in which a substantial number of its employees participated. For the years ended
October 31, 1998, 1997, and 1996, profit sharing expense was $0, $197,000, and
$944,000 respectively.

      Effective January 1, 1992, the Company amended its profit sharing plan to
include a 401(k) plan, which permits an employee to contribute a portion of the
employee's compensation, subject to certain limitations. At its discretion, the
Company may make annual contributions to the 401(k) plan for the benefit of
participating employees. For the years ended October 31, 1998, 1997, and 1996,
401(k) plan expense was $959,000, $804,000, and $611,000, respectively.

      Effective October 31, 1997, the Company terminated its profit sharing
plan, including the 401(k) plan. A replacement, but identical, 401(k) plan was
established as of November 1, 1997. Having obtained approval by the Internal
Revenue Service, an initial distribution of the assets of the terminated profit
sharing plan was completed on December 18, 1998, with the balance to be
distributed in March 1999.

12. STOCK-BASED COMPENSATION PLANS

      At October 31, 1998, the Company had three stock-based compensation plans,
which are described below. The Company has adopted the disclosure-only
provisions of SFAS 123 and applies APB Opinion No. 25 and related
Interpretations in accounting for its plans. Accordingly, no employee
compensation costs have been recognized for its stock purchase plan and stock
option plans. Had compensation costs for the Company's three stock-based
compensation plans been determined consistent with fair value method prescribed
by SFAS 123, the Company's net income and earnings per share would have been
adjusted to the pro forma amounts indicated below:

<TABLE>
<CAPTION>
                                                                         1998          1997             1996
---------------------------------------------------------------------------------------------------------------
<S>                                          <C>                      <C>           <C>             <C>
Net income                                   As reported              $ 6,088       $ 2,081         $  7,291
                                             Pro forma                  2,189           837            6,630
                                                                        

Net income per diluted share                 As reported                 0.34          0.12             0.39
                                             Pro forma                   0.12          0.05             0.36
---------------------------------------------------------------------------------------------------------------
</TABLE>

      The effect noted above by applying the disclosure-only provisions of SFAS
123 may not be representative of the pro forma effect in future years.

      The fair value of the stock options granted in 1998, 1997, and 1996 is
estimated at the grant date using the Black-Scholes option-pricing model with
the following assumptions: dividend yield of 0% (the Company does not pay
dividends); expected volatility of 48.9%, 51.4%, and 51.4%; a risk-free interest
rate of 5.7%, 5.8%, and 5.8%; and expected lives of 4.91, 4.90, and 4.90 years,
respectively.


                                      F-29
<PAGE>   50
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


      Effective May 31, 1989, the Company adopted the Health Management Systems,
Inc. Stock Option and Restricted Stock Purchase Plan (the "Plan") under which:
(a) options can be granted to purchase shares of the Company's common stock at
an exercise price equal to (incentive stock options) or less than (non-qualified
stock options) the estimated fair market value of the Company's common stock, or
(b) rights can be granted in the form of an award to purchase shares of the
Company's common stock at a price equal to, more than, or less than the
estimated fair market value of the Company's common stock. Subsequent amendments
to the Plan, which have been approved by shareholders, have increased the number
of shares available to be issued under the Plan to 6,750,000 shares. The Plan
expires in May 1999.

      The stock options become exercisable and expire at various dates through
November 2008. As of October 31, 1998, no stock appreciation rights or stock
purchase awards had been granted. Effective November 13, 1998, the Company
awarded 1,655,850 stock options. Of the total options, 1,418,500 options are
subject to a performance based accelerated vesting schedule. These options are
to vest 100 percent on October 31, 2003, subject to accelerated vesting of all
or a portion of the total options upon realization of certain annual performance
measures. All options whose vesting has not otherwise been accelerated pursuant
to the foregoing will vest on October 31, 2003, subject only to the continued
employment by the Company of the optionee.

      The Company's 1995 Non-Employee Director Stock Option Plan (the "NEDP")
was adopted by the Board of Directors on November 30, 1994, which action was
subsequently approved by shareholders at the Annual Meeting of Shareholders held
on March 7, 1995. Under the NEDP, directors of the Company who are not employees
of the Company or its subsidiaries are granted options to purchase 1,500 shares
of common stock of the Company during the fourth fiscal quarter of each year
commencing with fiscal year 1995. Options for the purchase of up to 112,500
shares of common stock may be granted under the NEDP and the Company will
reserve the same number of shares for issuance. The options available for grant
are automatically increased to the extent any granted options expire or
terminate unexercised.

      Presented below is a summary of the stock option plans for the years ended
October 31, 1998, 1997, and 1996:

<TABLE>
<CAPTION>
                                      1998                         1997                       1996
----------------------------------------------------------------------------------------------------------------
                                            Weighted                     Weighted                   Weighted
                                        average exercise             average exercise           average exercise
                                Shares       price           Shares       price         Shares        price
----------------------------------------------------------------------------------------------------------------
<S>                           <C>            <C>          <C>            <C>           <C>           <C>
Options outstanding at        1,926,870      $ 7.82        1,962,752     $12.47        2,778,584     $ 10.51
   beginning of year

Granted
                                541,504        6.57        1,573,294       9.09          135,828       27.63
Exercised
                               (440,316)       6.17          (69,424)      3.90         (794,688)       7.10
Cancelled
                               (225,956)      10.61       (1,539,752)     15.22         (156,972)      17.48
----------------------------------------------------------------------------------------------------------------
Options outstanding at
   end of year                1,802,102      $ 7.50        1,926,870     $ 7.82        1,962,752     $ 12.47   
================================================================================================================
Weighted average
   grant-date fair value
   of options granted
(Black-Scholes)                              $ 3.17                      $ 4.63                      $ 13.28
----------------------------------------------------------------------------------------------------------------
</TABLE>


                                      F-30
<PAGE>   51
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


      The following table summarizes information for stock options outstanding
at October 31, 1998:

<TABLE>
<CAPTION>
                                             Weighted                                                   Weighted
     Range of               Number            average             Weighted                              average
     exercise            outstanding         remaining             average             Number           exercise
      prices            as of 10/31/98     contractual life     exercise price       exercisable          price
-----------------------------------------------------------------------------------------------------------------
<S>                    <C>                 <C>                  <C>                  <C>                <C>
     $0.43 - 4.04           59,659               2.63               $ 2.05              59,659             $ 2.05

      5.88 - 6.03          683,467               8.59                 5.88             401,971               5.88

      6.32 - 7.00          596,152               7.65                 6.48             286,202               6.63

      8.16 - 10.06         311,970               5.96                 9.30             271,970               9.26

     15.31 - 23.00         150,570               7.20                17.18             136,011              17.31

     70.51 - 70.51             284               7.18                70.51                 116              70.51
------------------------------------------------------------------------------------------------------------------
    $ 0.43 - 70.51       1,802,102               7.51               $ 7.50           1,155,929             $ 8.02
------------------------------------------------------------------------------------------------------------------
</TABLE>

      On May 28, 1997, the Board of Directors authorized a stock option exchange
program for employee participants in the Plan. Eligible employees who held stock
options ("Old Options") with exercise prices in excess of $10.00 per share were
able to exchange them for stock options ("New Options") exercisable for a lesser
number of shares with an exercise price of $5.88 per share, the average price of
the Company's common stock on the Nasdaq-Amex National Market System on June 2,
1997 ("Grant Date"). Approximately 1,600,000 Old Options were eligible to be
exchanged for 900,000 New Options. At the end of the exchange program, 1,288,000
Old Options were exchanged for 609,000 New Options. The New Options received in
the exchange entailed a new vesting schedule where one quarter vested
immediately on the Grant Date, with an additional quarter vesting on each of
November 1, 1998, 1999, and 2000, respectively. To the extent that the fair
market value of the Company's common stock exceeded $12.50 on each day for ten
consecutive trading days, the vesting of all New Options not otherwise vested
would become accelerated and 100% fully vested. On March 30, 1998, these New
Options became fully vested as a consequence of the fair market value of the
Company's common stock having exceeded $12.50 for the requisite ten consecutive
trading day period.

      On May 28, 1993, the Board of Directors adopted the Health Management
Systems, Inc. Employee Stock Purchase Plan (the "ESPP"), which was subsequently
approved by shareholders at the Annual Meeting of Shareholders held on February
28, 1994. The Company has reserved for issuance up to 1,125,000 shares of common
stock pursuant to the ESPP, which is intended to qualify as an "employee stock
purchase plan" within the meaning of Section 423 of the Internal Revenue Code of
1986. The ESPP provides that all full-time employees of the Company and its
subsidiaries may elect to participate in the ESPP without regard to length of
service if their customary employment is a minimum of 20 hours per week. For the
years ended October 31, 1998, 1997, and 1996, the Company had sold 118,531,
95,332, and 163,426 shares, respectively, of common stock pursuant to the ESPP
for aggregate consideration of $516,000, $709,000, and $2,332,000, respectively,
which activity is reflected in the accompanying consolidated financial
statements. The weighted-average fair value of those purchase rights granted in
1998, 1997 and 1996, respectively, based on the Black-Scholes model was $3.52,
$10.68, and $7.77 respectively.

13. BUSINESS SEGMENT INFORMATION

      A healthcare information systems and services enterprise, the Company is
organized into two divisions: Transfer Payment Division and Software Division.
The Transfer Payment Division comprises two business units: Provider Transfer
Payment Services and Payor Transfer Payment Services. The Company's Software
Division also comprises two units: DSS Unit and MCIS Unit.


                                      F-31
<PAGE>   52
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


<TABLE>
<CAPTION>
                                                Transfer           Software
                                            Payment Division        Division       Consolidated
-----------------------------------------------------------------------------------------------
<S>                                         <C>                   <C>             <C>
1998
Revenue                                        $  57,238,000       48,014,000      105,252,000
Operating income                                     955,000        6,705,000        7,660,000
Total assets                                      89,176,000       28,626,000      117,802,000
Depreciation and amortization                      2,365,000        3,119,000        5,484,000
Capital expenditures                                 999,000          830,000        1,829,000
-----------------------------------------------------------------------------------------------
1997
Revenue                                        $  55,856,000       33,661,000       89,517,000
Operating (loss) income                           (4,008,000)       3,839,000         (169,000)
Total assets                                      82,061,000       27,633,000      109,694,000
Depreciation and amortization                      2,651,000        2,491,000        5,142,000
Capital expenditures                                 970,000        2,990,000        3,960,000
-----------------------------------------------------------------------------------------------
1996
Revenue                                        $  81,816,000       19,510,000      101,326,000
Operating income                                  10,752,000        2,497,000       13,249,000
Total assets                                      97,133,000       12,510,000      109,643,000
Depreciation and amortization                      2,585,000          736,000        3,321,000
Capital expenditures                               4,072,000        1,535,000        5,607,000
-----------------------------------------------------------------------------------------------
</TABLE>


14. COMMITMENTS

      The Company leases office space and equipment under operating leases which
expire at various dates through 2006. The lease agreements provide for rent
escalations. Total rent expense for the years ended October 31, 1998, 1997, and
1996, including escalations, was $7,552,000, $7,634,000, and $6,313,000,
respectively.

      Minimum annual lease payments for each of the next five years ending
October 31 and thereafter are as follows:

<TABLE>
<CAPTION>
               Year                               PAYMENTS
               ---------------------------------------------
<S>                                            <C>
               1999                            $   5,481,000
               2000                                4,015,000
               2001                                3,820,000
               2002                                3,628,000
               2003                                2,794,000
               Thereafter                          1,953,000
               ---------------------------------------------
               Total                           $  21,691,000
               =============================================
</TABLE>


                                      F-32
<PAGE>   53
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


15.   SIGNIFICANT CONTRACTS

      The Company's largest client is Columbia, a customer of the DSS Unit. This
client accounted for 10%, 12%, and 8% of the Company's total revenue in 1998,
1997, and 1996, respectively. The Company provides its services to Columbia
primarily pursuant to a series of 12-month work order agreements, each expiring
at different times. There is no assurance that any of these agreements will be
renewed. The Company's second largest client is a group of healthcare facilities
under the governance of the County of Los Angeles, for which the Company
provides a full range of provider business office outsourcing products and
services, including managed care services. During the fiscal years ended October
31, 1998, 1997, and 1996, this group accounted for 9%, 12%, and 12%,
respectively, of the Company's total revenue.

      The Company's ten largest clients accounted for approximately 50% of the
Company's revenue in fiscal year 1998. Including the Company's contract with the
County of Los Angeles, six of the Company's ten largest contracts expire in
fiscal year 1999. The Company provides its services pursuant to agreements which
are subject to competitive reprocurement. There is no assurance that any of
these agreements will be renewed, and if renewed, that the fee rates will be
equal to those now in effect.

16.   RELATED PARTY TRANSACTIONS

      (a)  HHL Financial Services, Inc.

      Effective January 31, 1992, the Company entered into a management and data
processing services agreement ("Management Agreement") with HHL Financial
Services, Inc. ("HHL"). Under the Management Agreement, the Company provided HHL
with executive management, data processing, and technical support services
through June 30, 1996, subject to certain termination and renewal provisions.

      Effective July 1, 1993, the Management Agreement was amended ("Outsourcing
Amendment") to include the Company's provision of comprehensive data processing
and information management services to HHL. The five-year term of the
Outsourcing Amendment called for fixed annual fees that range from $6,700,000 to
$9,500,000, subject to upward adjustment in the event of material changes in the
scope of service and/or growth in HHL revenue in excess of 7% annually.

      On August 21, 1996, the Company announced a one-time charge and revenue
reversal pertaining to its relationship with HHL, which was in default of the
Outsourcing Amendment. The Company's one-time charge related to (i) the full
reservation of prior period accounts receivable of $2,881,000, (ii) accrual of
net costs to be incurred in excess of anticipated revenue relating to the
Company's continued contractual obligation with HHL of $3,823,000, and (iii) the
write-off of its investment in HHL of $927,000, resulting in a total one-time
charge of $7,631,000. Additionally, revenue of $2,180,000 earned and initially
recorded in the third quarter was reversed. The result of the total write-off
and revenue reversal recognized in the third quarter of $9,811,000 translated to
an after-tax impact of $5,563,000, or $0.30 per share.

      On October 29, 1996, the Company entered into an agreement with HHL and
HHL's primary financial creditor providing for mutual general releases and the
cessation of all claims. The Company also settled its liabilities due to HHL of
$1,950,000 for a payment of $870,000 resulting in the reversal of $1,080,000 in
liabilities as an offset to other operating expenses. In addition, the Company
agreed to provide, for a period of up to 18 months, a reduced level of service
to HHL in exchange for payment in advance. During this 18 month period, HHL has
the right to lower the level of service requested and therefore lower the amount
paid in advance. Also, HHL has the right to cancel the service completely on 30
days prior written notice.

      As of October 31, 1996, the Company had incurred and offset $165,000 in
net expenses for its contractual obligations with HHL. During 1997, the Company
had incurred and offset $2,739,000 in net expenses for its contractual
obligations with HHL. The remaining accrual of $519,000 at October 31, 1998, is
scheduled to be offset over the next four years against a contractual obligation
of the Company to a third party.


                                      F-33
<PAGE>   54
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


      During the years ended October 31, 1998, 1997, and 1996, the Company
received approximately $0, $1,849,000, and $5,446,000 in fees from HHL related
to these agreements and in connection with jointly executed client projects.
During the same periods, HHL charged the Company expenses for services totaling
$0, $250,000, and $1,557,000, respectively, in connection with work done on
jointly executed client projects.

      (b)  HISCo

      The Company and HISCo entered into an agreement, dated as of October 31,
1995 (the "HISCo Agreement"), pursuant to which the Company was to provide HISCo
with certain services ("Basic Services"), including executive, acquisition
support, and corporate support services. For these Basic Services, the Company
was entitled to receive a fee, payable monthly, calculated at the Company's then
current standard hourly rates established for internal allocations plus 20%. The
term of the HISCo Agreement was to continue until the later of (i) June 30, 2000
or (ii) the expiration of any outstanding work order related to additional
services. The Company believes that the terms of the HISCo Agreement were fair
and reasonable and were no less favorable to the Company than those that could
have been obtained with respect to comparable engagements with independent third
parties. In fiscal years 1997 and 1996, the Company received approximately
$331,000 and $161,000 in fees from HISCo for services provided pursuant to the
HISCo Agreement. In fiscal years 1997 and 1996, HISCo received $0 and $569,000
in fees for software development services provided to the Company pursuant to
the HISCo agreement. These software development fees were expensed by the
Company.

      In March 1997, the Company, which owned 43% of HISCo's equity, acquired
the remaining 57% of HISCo's equity for $3,689,000, net of cash acquired. In
connection with this acquisition, the HISCo agreement was terminated and HISCo
merged with its sole operating subsidiary, Health Systems Architects, Inc. and
was renamed HSA Managed Care Systems, Inc. HSA provides automated business and
information solutions, including software and services, to the bearers of risk
in the healthcare industry. The acquisition was accounted for using the purchase
method and accordingly the results of operations of HSA from the date of
acquisition through October 31, 1998 are included in the accompanying financial
statements. The $2,309,000 excess of the purchase price over fair market value
of the identifiable net assets acquired was recorded as goodwill and is being
amortized over a period of 20 years.

      In connection with the sale of their respective equity interests in HISCo
to the Company, certain of the Company's current and former officers and
directors derived gross proceeds as follows: Paul J. Kerz, $101,000; Laurence B.
Simon, $62,000; Donald J. Staffa, $31,000; Russell L. Carson, $79,000; and
Richard H. Stowe, $30,000.

      The Company's total revenue from related parties was $0, $331,000, and
$5,607,000 in fiscal years 1998, 1997, and 1996, respectively.

      (c) Robert V. Nagelhout

      In April 1997, the Company guaranteed a loan by The Chase Manhattan Bank
(the "Bank") in the original principal amount of $1,600,000 to Robert V.
Nagelhout, the Chief Operating Officer and a director of the Company. Mr.
Nagelhout granted the Company a security interest in 500,000 shares of the
Company's common stock as collateral for its guarantee. On June 11, 1998, Mr.
Nagelhout repaid the loan in its entirety, the Bank released the Company's
guaranty, and the available balance under the Company's line of credit with the
Bank was restored by $1,600,000 to $30,000,000.

      (d) Paul J. Kerz

      During October 1998, the Company's HSA subsidiary, a Delaware corporation,
made two loans to Paul J. Kerz, an officer and director of HSA, who is also the
Company's Chairman and Chief Executive Officer. One loan, in the principal
amount of $500,000, is secured by a pledge of 162,666 shares of the Company's
common stock owned by Mr. Kerz, while the other loan, in the principal amount of
$250,000, is unsecured. Both loans bear interest at the rate of 5.3125% per
annum, payable semi-annually commencing April 30, 1999, and are due as to


                                      F-34
<PAGE>   55
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


principal and all then accrued but unpaid interest on October 31, 2000. The
loans were unanimously approved by the Board of Directors of HSA and the Company
as the sole stockholder of HSA, following the recommendation of the Compensation
Committee of the Company's Board of Directors that the loans were in the best
interest of HSA and the Company, and the unanimous approval of the loans by the
independent members of the Company's Board of Directors.

17. QUARTERLY FINANCIAL DATA (UNAUDITED)

      The table below summarizes the Company's unaudited quarterly operating
results for its last three fiscal years.

<TABLE>
<CAPTION>
                                                                   First         Second           Third          Fourth
($ In Thousands, Except Earnings Per Common Share)                Quarter        Quarter         Quarter        Quarter
-----------------------------------------------------------------------------------------------------------------------
<S>                                                               <C>             <C>             <C>            <C>
1998:
Revenue                                                           $25,037         25,636          26,736         27,843
Cost of services                                                   23,504         23,523          24,267         24,334
-----------------------------------------------------------------------------------------------------------------------
Operating margin before amortization of intangibles                 1,533          2,113           2,469          3,509
Operating income                                                    1,010          1,609           1,960          3,081
Net income                                                            879          1,185           1,388          2,636
Basic earnings per common share                                      0.05           0.07            0.08           0.15
Diluted earnings per common share                                 $  0.05           0.07            0.08           0.15
-----------------------------------------------------------------------------------------------------------------------
1997:
Revenue                                                           $22,272         20,108          22,103         25,034
Cost of services                                                   18,945         22,319          23,063         24,028
-----------------------------------------------------------------------------------------------------------------------
Operating margin (loss) before amortization of intangibles          3,327         (2,211)           (960)         1,006
Operating income (loss)                                             3,281         (2,450)         (1,472)           472
Net income (loss)                                                   1,803            281            (603)           600
Basic earnings per common share                                      0.10           0.02           (0.03)          0.03
Diluted earnings per common share                                 $  0.10           0.02           (0.03)          0.03
-----------------------------------------------------------------------------------------------------------------------
1996:
Revenue                                                           $25,619         25,707          25,935         24,065
Cost of services                                                   19,920         20,238          28,555         19,160
-----------------------------------------------------------------------------------------------------------------------
Operating margin (loss) before amortization of intangibles          5,699          5,469          (2,620)         4,905
Operating income (loss)                                             5,644          5,414          (2,671)         4,862
Net income (loss)                                                   3,610          3,102          (2,097)         2,676
Basic earnings per common share                                      0.22           0.18           (0.12)          0.15
Diluted earnings per common share                                 $  0.20           0.17           (0.12)          0.14
-----------------------------------------------------------------------------------------------------------------------
</TABLE>



                                      F-35
<PAGE>   56
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


18. Legal

      In April and May 1997, five purported class action lawsuits were
commenced in the United States District Court for the Southern District of New
York against the Company and certain of its present and former officers and
directors alleging violations of the Securities Exchange Act of 1934 in
connection with certain allegedly false and misleading statements. These
lawsuits, which sought damages in an unspecified amount, were consolidated into
a single proceeding captioned In re Health Management Systems, Inc., Securities
Litigation (97 CIV-1965 (HB) and a Consolidated Amended Complaint was filed.
Defendants made a motion to dismiss the Consolidated Amended Complaint, which
was submitted to the Court on December 18, 1997 following oral argument. On May
27, 1998, the Consolidated Amended Complaint was dismissed by the Court for
failure to state a claim under the federal securities laws, with leave for the
plaintiffs to replead. On July 17, 1998, a Second Consolidated Amended Complaint
was filed in the United States District Court of the Southern District of New
York, which reiterates plaintiffs' allegations in their prior Complaint. On
September 11, 1998, the Company and the other defendants filed a motion to
dismiss the second Complaint. The motion was fully briefed in late November
1998, at which time the motion was submitted to the Court. The Company intends
to continue its vigorous defense of this lawsuit.

      On June 1, 1998, MedE America Corp. commenced a lawsuit against the
Company and others in the United States District Court for the Southern District
of New York. In its complaint, plaintiff alleges copyright infringement and
other violations of its rights relating to the Company's development and sale of
certain computer software, known as the Universal Billing Platform, which was
recently developed for the Company by certain former employees of plaintiff, who
are also defendants in the action, acting as independent contractors. Plaintiff,
among other relief, seeks (i) to restrain the Company from continuing to market
and sell the alleged infringing software, and (ii) monetary damages in excess of
$10,000,000. Over a period of in excess of nine months prior to the filing of
the complaint, the parties engaged in an extensive exchange of communications,
as a result of which the Company concluded, after investigation, that
plaintiff's claims were without merit. On July 22, 1998, the Company answered
the complaint, denying the material allegations of the complaint. Discovery has
commenced, and the Company intends to vigorously contest plaintiff's claims.
Pursuant to the Rules of the Court, this matter has been referred to a
court-appointed mediator, who in the context of non-binding mediation and
independent of the Court proceeding, will attempt to assist in settling the
matter or narrowing the issues between the parties. Absent a settlement of this
matter through mediation, the Company intends to continue its vigorous defense
of this lawsuit.

      On June 28, 1998, eight holders of promissory notes (the "Notes") of HHL
commenced a lawsuit against the Company and others in the Supreme Court of the
State of New York, County of Nassau, alleging various breaches of fiduciary duty
on the part of the defendants against HHL. The complaint alleges that as a
result of these breaches of duty, HHL was caused to make substantial unjustified
payments to the Company which, ultimately, led to defaults on the Notes and to
HHL's filing for Chapter 11 bankruptcy protection. On June 30, 1998, the same
Note holders commenced a virtually identical action (the "Adversary Proceeding")
in the United States Bankruptcy Court for the District of Delaware, where HHL's
Chapter 11 proceeding is pending. The Adversary Proceeding alleges the same
wrongdoing as the New York State Court proceeding and seeks the same damages,
i.e., $2,300,000 (the unpaid amount of the Notes) plus interest. Plaintiffs have
moved in the Bankruptcy Court to have the Court abstain from hearing the
Adversary Proceeding in deference to the New York State Court action. The
Company has opposed plaintiffs' motion for abstention and on September 15, 1998,
filed a motion in the Bankruptcy Court to dismiss the Adversary Proceeding. This
motion was briefed by mid-December 1998, at which time the motions will be
submitted to the Court. The Company intends to continue its vigorous defense of
this lawsuit.

      The Company is a party to several other legal proceedings. In the opinion
of the Company's management, none of these other proceedings is expected to have
a material adverse effect on the Company's financial position, results of
operations or liquidity.


                                      F-36
<PAGE>   57
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS


Allowance for doubtful accounts:


<TABLE>
<S>                             <C>
Balance, October 31, 1995        $   296,000
      Provision                    4,485,000
      Recoveries                          --
      Charge-offs                 (3,099,000)
                                 -----------
Balance, October 31, 1996          1,682,000
      Provision                      538,000
      Recoveries                          --
      Charge-offs                   (792,000)
                                 -----------
Balance, October 31, 1997          1,428,000
      Provision                      838,000
      Recoveries                          --
      Charge-offs                   (413,000)
                                 -----------
BALANCE, OCTOBER 31, 1998        $ 1,853,000
                                 ===========
</TABLE>


                                      F-37
<PAGE>   58
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                                 EXHIBIT INDEX

<TABLE>
<CAPTION>
EXHIBIT
NUMBER
------
<S>       <C>
2.1       Agreement and Plan of Merger dated as of January 18, 1995 among Health
          Management Systems, Inc., HCm Acquisition Corp., and all the
          shareholders of Health Care microsystems, Inc., as amended
          (Incorporated by reference to Exhibit 10.18 to the Company's Annual
          Report on Form 10-K for the year ended October 31, 1994 and to Exhibit
          10.2 to the Company's Registration Statement on Form S-3, file no.
          33-91518)

2.2       Agreement and Plan of Merger, dated as of April 29, 1996 among Health
          Management Systems, Inc., CDR Acquisition Corp., CDR Associates, Inc.,
          and all the shareholders of CDR Associates, Inc. (Incorporated by
          reference to Exhibit 10.1 to the Company's Current Report on Form 8-K
          dated April 29, 1996)

2.2(i)    First Amendment to Agreement and Plan of Merger, dated as of April 29,
          1996, among Health Management Systems, Inc., CDR Acquisition Corp.,
          CDR Associates, Inc., and all the shareholders of CDR Associates, Inc.
          (Incorporated by reference to Exhibit 2.2(i) to the Company's Annual
          Report on Form 10-K for the year ended October 31, 1996 [the 1996 Form
          10-K].)

2.3       Agreement and Plan of Merger, dated as of September 3, 1996, by and
          among Health Management Systems, Inc., QSM Acquisition Corporation and
          Quality Standards in Medicine, Inc. (Incorporated by reference to
          Exhibit 2.1 to the Company's Registration Statement on Form S-4, File
          No. 333-13513 [the S-4])

2.3(i)    Amendment to Agreement and Plan of Merger, dated as of November 20,
          1996, by and among Health Management Systems, Inc., QSM Acquisition
          Corporation, and Quality Standards in Medicine, Inc. (Incorporated by
          reference to Exhibit 10.1 to Post-Effective Amendment No. 1 to the
          S-4)

2.4       Agreement and Plan of Merger, dated as of March 18, 1997, by and among
          Health Management Systems, Inc., HISCo Acquisition Corp., Health
          Information Systems Corporation and HSA Managed Care Systems, Inc.
          (Incorporated by reference to Exhibit 2.1 to the Company's Quarterly
          Report on Form 10-Q for the quarter ended April 30, 1997 [the April
          1997 Form 10-Q])

2.5       Asset Purchase Agreement, dated as of March 10, 1997, by and among
          GHS, Inc., Global Health Systems, Inc. GHS Management Services, Inc.,
          Health Management Systems, Inc. and Global Health Acquisition Inc.
          (Incorporated by reference to Exhibit 2.1 to the Company's Quarterly
          Report on Form 10-Q for the quarter ended July 31, 1997 [the July 1997
          Form 10-Q].)

2.5(i)    Assignment and Assumption Agreement, dated as of July 15, 1997,
          between Global Health Acquisition Corp. and HSA Managed Care Systems,
          Inc. (Incorporated by reference to Exhibit 2.2 to the July 1997 Form
          10-Q.)

3.1       Amended and Restated Certificate of Incorporation of Health
          Management Systems, Inc. (Incorporated by reference to Exhibit 3.1
          to Amendment No. 1 [Amendment No. 1] to the Company's Registration
          Statement on Form S-1, File No. 33-4644 [the Registration
          Statement] and Exhibit 3(i) to the Company's Quarterly Report on
          Form 10-Q for the quarter ended January 31, 1996 [the January 1996
          Form 10-Q])
</TABLE>


                                
<PAGE>   59
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                                 EXHIBIT INDEX

<TABLE>
<CAPTION>
EXHIBIT
NUMBER
------
<S>       <C>
3.2       By-Laws of Health Management Systems, Inc. (Incorporated by
          reference to Exhibit 3.2 to Amendment No. 1)


10.1      Financial Management Services Agreement, dated August 1, 1989,
          between Health Management Systems, Inc. and the County of Los
          Angeles (Incorporated by reference to Exhibit 10.2 to the
          Registration Statement)

10.2(i)   Master Software License Agreement, dated June 29, 1992, by and
          between Health Care microsystems, Inc. and Healthtrust, Inc. - The
          Hospital Company.

10.2(ii)  Amendment, dated as of September 1, 1995, to Master Software License,
          dated June 29, 1992, by and between Health Care microsystems, Inc. and
          Columbia/HCA. (Incorporated by reference to Exhibit 10.2(ii) to the
          1997 Form 10-K)

10.3(i)   Health Management Systems, Inc. Stock Option and Restricted Stock
          Purchase Plan, as amended (Incorporated by reference to Exhibit 10.3
          to the Registration Statement, to Exhibit 10.3 to Amendment No. 2
          [Amendment No. 2] to the Registration Statement, Exhibit 10.1 to the
          Company's Quarterly Report on Form 10-Q for the quarter ended January
          31, 1994 [the January 1994 Form 10-Q] and Exhibit to the January 1996
          Form 10-Q.)

10.3(ii)  Amendment No. 6, dated as of December 2, 1997, to the Health
          Management Systems, Inc., Stock Option and Restricted Stock
          Purchase Plan. (Incorporated by reference to Exhibit 10.3(iii) to
          the 1997 Form 10K)

10.3(iii) Health Management Systems, Inc. Employee Stock Purchase Plan, as
          amended (Incorporated by reference to Exhibit 10.2 to the January 1994
          Form 10-Q and to Exhibit 10.1 to the Company's Quarterly Report on
          Form 10-Q for the quarter ended January 31, 1995 [the January 1995
          Form 10-Q])

10.3(iv)  Health Management Systems, Inc. 1995 Non-Employee Director Stock
          Option Plan (Incorporated by reference to Exhibit 10.2 to the
          January 1995 Form 10-Q)

10.3(v)   Health Management Systems, Inc. Profit Sharing Plan (Incorporated by
          reference to Exhibit 10.3(iv) to the Company's Annual Report on Form
          10-K for the year ended October 31, 1995 [the 1995 Form 10-K])

10.3(vi)  Health Management Systems, Inc. Profit Sharing Plan, as amended
          (Incorporated by reference to Exhibit 10.3(vi) to the 1995 Form
          10-K)

10.4(i)   Credit Agreement and Guaranty Among Health Management Systems, Inc.,
          as Borrower, Accelerated Claims Processing, Inc., Quality Medi-Cal
          Adjudication, Incorporated, Health Care microsystems, Inc., and CDR
          Associates, Inc., as Guarantors, and The Chase Manhattan Bank, as Bank
          (Incorporated by reference to Exhibit 10.1 to the Company's Quarterly
          Report on Form 10-Q for the quarter ended July 31, 1996 [the July 1996
          Form 10-Q])

10.4(ii)  First Amendment to Credit Agreement and Guaranty and Waiver
          (Incorporated by reference to Exhibit 10.1(i) to the July 1996 Form
          10-Q)
</TABLE>


                             
<PAGE>   60
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                                 EXHIBIT INDEX

<TABLE>
<CAPTION>
EXHIBIT
NUMBER
------
<S>       <C>
10.4(iii) Guaranty Agreement, dated as of April 16, 1997, between Health
          Management Systems, Inc. and The Chase Manhattan Bank (Incorporated by
          reference to Exhibit 10.1 to the April 1997 Form 10-Q)

10.4(iv)  Second Amendment to Credit Agreement and Guaranty, dated as of April
          16, 1997, among Health Management Systems, Inc., Accelerated Claims
          Processing, Inc., Quality Medical Adjudication, Incorporated, Health
          Care microsystems, Inc., CDR Associates, Inc., and The Chase Manhattan
          Bank (Incorporated by reference to Exhibit 10.1 to the July 1997 Form
          10-Q)


10.4(v)   Third Amendment to Credit Agreement and Guaranty, dated as of June 30,
          1997, among Health Management Systems, Inc., Accelerated Claims
          Processing, Inc., Quality Medical Adjudication, Incorporated, Health
          Care Microsystems, Inc., CDR Associate, Inc., HSA Managed Care
          Systems, Inc., Quality Standards in Medicine, Inc. and The Chase
          Manhattan Bank (Incorporated by reference to Exhibit 10.1 to the July
          1997 Form 10-Q)

10.5(i)   Leases, dated February 1, 1980, September 24, 1981, September 24,
          1982, and January 6, 1986, as amended, between 401 Park Avenue South
          Associates and Health Management Systems, Inc. (Incorporated by
          reference to Exhibit 10.13 to the Registration Statement and to
          Exhibit 10.5 to the Company's Quarterly Report on Form 10-Q for the
          quarter ended January 31, 1994)

10.5(ii)  Lease, dated as of March 15, 1996, by and between 387 PAS Enterprises,
          as Landlord, and Health Management Systems, Inc., as Tenant
          (Incorporated by reference to Exhibit 10.2 to the July 1996 Form 10-Q)

10.6      Lease, dated September 1996, by and between Pacific Corporate Towers
          LLC, Health Management Systems, Inc., and Health Care microsystems,
          Inc. (Incorporated by reference to Exhibit 10.13 to the 1996 Form
          10-K)

10.7      Services Agreement, dated as of October 31, 1995, between Health
          Information Systems Corporation and Health Management Systems, Inc.
          (Incorporated by reference to Exhibit 10.19(iv) to the 1995 Form 10-K)

10.8      Agreement and Release of Claims dated as of October 29, 1996, by and
          among HHL Financial Services, Inc., Health Management Systems, Inc.,
          and the First National Bank of Chicago (Incorporated by reference to
          Exhibit 10.12 to the 1996 Form 10-K)

10.9      Security Agreement, dated as of April 16, 1997, by and between
          Robert V. Nagelhout and Health Management Systems, Inc.
          (Incorporated by reference to Exhibit 10.3 to the April 1997 Form
          10-Q)

10.10     Promissory note, dated as of April 16, 1997, by and between
          Robert V. Nagelhout and The Chase Manhattan Bank. (Incorporated
          by reference to Exhibit 10.4 to the April 1997 Form 10-Q)

10.11     Consulting Service Agreement, dated as of May 1, 1997, by and
          between Improved Funding Techniques, Inc. and Health Management
          Systems, Inc. (Incorporated by reference to Exhibit 10.2 to the
          July 1997 Form 10-Q)
</TABLE>


                            
<PAGE>   61
                HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES
                                 EXHIBIT INDEX

<TABLE>
<CAPTION>
EXHIBIT
NUMBER
------
<S>       <C>
10.12     Employment Agreement, as of May 1, 1997, by and between Joseph H.
          Czajkowski and CDR Associates, Inc., a wholly-owned subsidiary of
          Health Management Systems, Inc. (Incorporated by reference to Exhibit
          10.3 to the July 1997 Form 10-Q)

10.13     Employment Agreement, as of May 1, 1997, by and between Jeffrey R.
          Donnelly and CDR Associates, Inc., a wholly-owned subsidiary of Health
          Management Systems, Inc. (Incorporated by reference to Exhibit 10.4 to
          the July 1997 Form 10-Q)

10.14     Sublease Agreement, dated December 23, 1997, between Health Management
          Systems, Inc. and Shandwick USA, Inc. (Incorporated by reference to
          Exhibit 10.1 to the company's Quarterly Report on Form 10-Q for the
          quarter ended January 31, 1998 [the January 1998 Form 10-Q])

10.15     Consent to Sublease, dated December 23, 1997, by 387 P.A.S.
          Enterprises to the subletting by Health Management Systems, Inc.
          to Shandwick USA, Inc. (Incorporated by reference to Exhibit 10.2
          to the January 1998 Form 10-Q)

*10.16    Promissory note, dated as of October 15, 1998, in the principal
          amount of $500,000 between Paul J. Kerz and HSA Managed Care
          Systems, Inc.

*10.17    Promissory note, dated as of October 15, 1998, in the principal
          amount of $250,000 between Paul J. Kerz and HSA Managed Care
          Systems, Inc.

*10.18    Security Agreement, dated as of October 15, 1998, between Paul J.
          Kerz and HSA Managed Care Systems, Inc.

*11.0     Computation of Earnings per Share

*21.1     List of subsidiaries of Health Management Systems, Inc.

*23.1     Consent of KPMG LLP, independent certified public accountants

24.2      Consent of Ernst & Young LLP, independent certified public accountant.
          (Incorporated by reference to Exhibit 24.2 to the 1996 Form 10-K)

24.3      Report of independent certified public accountants on the financial
          statements of Health Information Systems Corporation as of and for the
          period ended October 31, 1996 (Incorporated by reference to Exhibit
          24.3 to the 1996 Form 10-K)

*27.1     Financial Data Schedule, which is submitted electronically to the
          Securities and Exchange Commission for informational purposes only
</TABLE>


* Filed herewith