SECURITIES AND EXCHANGE COMMISSION

                          Washington, D.C. 20549

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

                               FORM 10-K

                               (Mark One)

|X|   Annual  Report  Pursuant to Section 13 or 15(d) of the Securities
      Exchange Act of 1934 For the fiscal year ended December 31, 1996.

|_|   Transition Report Pursuant to Section 13 or 15(d) of the Securities  
      Exchange Act of 1934 For the  transition  period from ______ to ______

                     Commission file number: 1-11144

                       Regency Health Services, Inc.
          (Exact name of Registrant as specified in its charter)

               Delaware                              33-0210226
       (State of incorporation)         (I.R.S. Employer Identification No.)

                                 2742 Dow Avenue
                            Tustin, California 92780
                    (Address of principal executive offices)

       Registrant's telephone number, including area code: (714) 544-4443

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

            Title of Securities         Name of Exchange on which Registered
       Common Stock, $.01 par value            New York Stock Exchange

        Securities registered pursuant to section 12(g) of the Act: None

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

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

         Based on the closing  price of $10 5/8 per share on February  28, 1997,
the  aggregate   market  value  of  the   registrant's   voting  stock  held  by
non-affiliates was $106,661,000.  Solely for  purposes of  this computation, the
registrant's  directors and executive  offers have been deemed to be affiliates.
Such  treatment  is not  intended to be, and should not be  construed  to be, an
admission by the  registrant  or such  directors  and officers  that any of such
persons are  "affiliates,"  as that term is defined under the  Securities Act of
1934.

The number of shares of common  stock  outstanding  as of February  28, 1997 was
15,792,157.

                      Documents Incorporated by Reference:

Portions of Regency's 1996 Annual Report to  Shareholders  are  incorporated  by
reference into Part II of this Form 10-K. 
Portions  of Regency's  Notice of  Annual  Meeting  of  Stockholders  and  Proxy
Statement  to  be  held  May 8,  1997  are  incorporated  by reference into Part
III of this Forms 10-K.

<PAGE>
                           TABLE OF CONTENTS

PART I

     ITEM 1    BUSINESS                                        1

     ITEM 2    PROPERTIES                                     16

     ITEM 3    LEGAL PROCEEDINGS                              17

     ITEM 4    SUBMISSION OF MATTERS
               TO A VOTE OF SECURITY HOLDERS                  17

PART II

     ITEM 5    MARKET FOR REGENCY HEALTH
               SERVICES, INC. COMMON STOCK
               AND RELATED STOCKHOLDER MATTERS                18

     ITEM 6    SELECTED FINANCIAL DATA                        18

     ITEM 7    MANAGEMENT'S DISCUSSION AND ANALYSIS
               OF FINANCIAL CONDITION AND RESULTS
               OF OPERATIONS                                  19

     ITEM 8    FINANCIAL STATEMENTS AND 
               SUPPLEMENTARY DATA                             30

     ITEM 9    CHANGES IN AND DISAGREEMENTS
               WITH ACCOUNTANTS ON ACCOUNTING 
               AND FINANCIAL DISCLOSURE                       55

PART III

     ITEM 10   DIRECTORS AND EXECUTIVE
               OFFICERS OF REGENCY HEALTH
               SERVICES, INC.                                 56

     ITEM 11   EXECUTIVE COMPENSATION                         56

     ITEM 12   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL
               OWNERS AND MANAGEMENT                          56

     ITEM 13   CERTAIN RELATIONSHIPS AND RELATED
               TRANSACTIONS                                   56

PART IV

     ITEM 14   EXHIBITS, FINANCIAL STATEMENT SCHEDULES
               AND REPORTS ON FORM 8-K                        57

     SIGNATURES                                               64


                                       
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                                     PART I

ITEM 1.  BUSINESS

General

   This  Annual  Report on Form  10-K of  Regency  Health  Services,  Inc. ("the
Company" or "Regency")  contains statements  which  constitute  "forward looking
statements" within the  meaning of the Private Securities  Litigation Reform Act
of 1995.  Such  statements appear in  a number of places in  this Annual  Report
including,  without  limitation, under the headings General,  Business Strategy,
Business Units, Manner of Operation, Sources of Payment, Regulation, Competition
and  Tax   Audits  of  the  Section  entitled  "Business"  and  in  Management's
Discussion and Analysis of Financial  Condition and  Results of Operations. Such
forward looking statements include  the views, opinions and expectations of  the
Company, its officers and directors with respect to the matters there discussed,
and as to the  intent,  belief  and anticipation  of such  persons  expressed in
this  Annual  Report.  Readers  are cautioned  that  any  such  forward  looking
statements involve  risks,  uncertainties and factors  that  may  impact on  the
actual results or activities of the Company. These risks and items are discussed
below in greater  detail in the portion of this Annual  Report entitled "Factors
Which May Affect the Company".

   Regency is a national provider of an array of healthcare  services from acute
rehabilitation  to  home  health  care.  As of February  28,  1997,  the Company
delivered  care  from 116 Company operated inpatient facilities  in five states.
These facilities provide a spectrum of services including acute  rehabilitation,
neurological care, subacute treatment,  basic and  intermediate  skilled nursing
care, assisted living and ancillary services such as rehabilitation and pharmacy
services.  Additionally, the Company  provides outpatient rehabilitation through
10  clinics.  It also continues  to expand its  contract rehabilitation therapy,
pharmacy  and  home health  operations.  As of February  28,  1997,  the Company
provided contract rehabilitation  therapy services in 15 states to 63 affiliated
and  116  non-affiliated facilities,  pharmacy  services  in  four  states to 70
affiliated  and 84  non-affiliated  facilities  and  home health  care  services
through 28 operating locations in California and Ohio.

   In order to meet the challenges of healthcare reform,  industry consolidation
and other  changes,  the  Company  plans to  enhance  the  continuum  of care it
provides  in defined  markets to suit the needs of those  markets.  The  Company
believes  adding  various  inpatient and  outpatient  services to the continuum,
while expanding the  availability  of current  services like subacute care, will
attract  managed  care  organizations   seeking  to  build   relationships  with
integrated  delivery  systems.  The Company  expects the more  diverse  services
offered will provide "one stop" shopping for payors and will bring patients into
the Company's delivery system sooner,  often either immediately  following or in
lieu of invasive  treatment.  The Company also sees  strategic  joint  operating
relationships with tertiary care institutions, payors and physicians as enabling
it to establish closer ties to the medical community.

   Regency  was  incorporated  in  Delaware  in 1986  and grew  rapidly  through
acquisitions. In April 1994, Regency merged with Care Enterprises, Inc. ("Care")
in a stock  transaction  accounted for as a pooling of interests ("the Merger").
The Merger more than doubled the number of  facilities  and beds operated by the
Company  and made the  Company a leading  provider of  long-term  and  specialty
healthcare services in California. It established a presence for Regency in West
Virginia, Ohio and New Mexico. Additionally,  it provided a significant base for
the  expansion of both the  ancillary  services  offered by Regency and the home
health care services offered by Care.  Following the Merger,  management focused
on  integrating   Regency  and  Care  operations.   This  included   instituting
standardized systems,  operating procedures and cost controls. The Company added
several experienced senior officers.  Others were replaced,  along with a number
of  administrators  at  under-performing  facilities.  During 1995,  the Company
exchanged  leasehold  interests in three  nursing  facilities  in New Mexico for
leasehold  interests in four nursing  facilities  in Ohio which were operated by
another  company;  opened a newly  constructed  facility;  and  acquired  SCRS &
Communicology,  Inc. ("SCRS"),  a contract  rehabilitation  therapy company.  In
1996, the Company  disposed of 7 healthcare  facilities in  California.  It also
acquired 19  healthcare  facilities in Tennessee  and North  Carolina;  pharmacy



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<PAGE>

operations in California, Tennessee and North Carolina, and entered into a joint
venture   with  a  pharmacy  in  Ohio.   To  complete  the  roster  of  contract
rehabilitation  services provided by SCRS, the subsidiary acquired a respiratory
therapy company.  In early 1997, the Company acquired four acute  rehabilitation
hospitals,   six   neurological   treatment   centers   and  eleven   outpatient
rehabilitation clinics in California.

Industry Overview

   Healthcare  is  one  of  the  largest   industries  in  the  United   States,
representing total expenditures of approximately  $884.0 billion or 13.9% of the
1993  gross   domestic   product,   according  to  the  Health  Care   Financing
Administration  ("HCFA").  This 1993 figure represents a 7.8% increase over 1992
expenditures of $820.0 billion recorded by HCFA.  Historically,  these increases
have outpaced inflation. This is due, in part, to the increased availability and
use of  high-technology  medicine and to the diverse  medical  needs of an aging
population.

   The  post-acute  care  industry  encompasses  a  broad  range  of  healthcare
services,  including basic and intermediate  skilled  nursing,  assisted living,
ambulatory  businesses,  subacute care,  rehabilitation  therapy including acute
rehabilitation,  home healthcare and pharmacy services provided to patients with
medically  complex needs who can be cared for outside of the acute care hospital
environment.  The Company's  management  believes that demand for these services
will increase substantially during the next decade, primarily due to emphasis on
healthcare cost containment and to the growing senior population.

   The senior population is growing at a faster rate than the overall population
as a result of the baby boom and  advances  in medical  technology  that  extend
life.  According to the United States Census Bureau ("the Census  Bureau"),  the
number of individuals in the United States over 64 has grown from  approximately
25.6 million in 1980, or approximately 11.3% of the population, to approximately
31.1 million in 1990, or  approximately  12.5% of the population.  Census Bureau
projections  indicate  that the  number  of  individuals  in this  age  group is
expected to increase to approximately  34.9 million,  to approximately  12.7% of
the population, by the year 2000. Additionally,  individuals 85 years of age and
older are one of the  fastest  growing  segments of the  population.  The Census
Bureau  projects that the number of  individuals in that age group will increase
from  approximately 3.0 million in 1990 to approximately 4.3 million by the year
2000.

   Cost containment  procedures that encourage  reduced lengths of stay in acute
care  hospitals  are  prevalent.  In 1983,  the federal  government  changed the
reimbursement for acute care hospitals from a retrospective cost-based system to
a prospective  reimbursement  system based upon rates  established for diagnosis
related groups  ("DRGs").  Additionally,  many private insurers limit acute care
reimbursement  to "reasonable  and customary"  charges while health  maintenance
organizations ("HMOs") and preferred-provider  organizations ("PPOs") attempt to
contain costs by  negotiating  reduced  rates for acute care hospital  services.
These factors have resulted in reduced  lengths of stay in acute care hospitals,
with many  patients  being  discharged  to lower  level  facilities  where their
skilled  needs  can be  met  more  cost-effectively.  Accordingly,  the  Company
believes that the  healthcare  industry  will  experience  increased  demand for
post-acute   care.  The  Company  is  well  positioned  to  benefit  from  these
developments due to its expanding  capability to provide post-acute and subacute
specialty services. Additionally,  industry consolidation is expected to present
the Company with  opportunities  for growth and  expansion  of its  continuum of
care.

   Although  the Company  believes  that the demand for the services it provides
will  increase over the next decade,  it  anticipates  competition  to meet this
demand. In addition, the regulatory framework in which healthcare providers will
operate,  including parameters for payment of services, is uncertain.  Depending
on the nature of such  regulation,  the  healthcare  industry  may be subject to
increased  pressure  to  lower  operating  costs  and may  face  more  stringent
requirements regarding reimbursement.

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<PAGE>

Business Strategy

   The Company's  strategy is to enhance its position as an integrated  delivery
provider  recognized  for cost-effective,  high-quality  healthcare  services in
selected geographic areas.  Implementation of this strategy means adding certain
inpatient  and  outpatient  services  along  with  growing  ancillary businesses
based  on  the needs  of  the markets  where it  currently has  operations,  and
involves certain risks. See "Factors Which May Affect Company". In addition, the
Company plans to develop the  information technology infrastructure necessary to
support  the  cost-effective  operation  of this integrated delivery system. The
fundamental elements of the Company's strategy include:

     o   expanding the continuum of care and overall scope of services  provided
         by the Company through such means as strategic alliances,  diversifying
         services in  inpatient  facilities,  increasing  outpatient  ambulatory
         business and growth of home healthcare services;

     o   in-sourcing ancillary services such as pharmacy and rehabilitation 
         services;

     o   increasing the Company's marketing of ancillary services to third party
         facilities;

     o   acquiring new businesses to complete the continuum in selected markets 
         where the Company currently operates;

     o   eengineering operating models and investment in  information technology
         to reduce  administrative and operating costs and develop an integrated
         delivery system.

    Management believes Regency has certain competitive  strengths which support
its  strategy.  Foremost  among  these  is the  Company's  market  position  and
experience  operating  long-term care  facilities in California.  The California
market is  characterized  by a high  degree  of  regulatory  oversight  and cost
controls  imposed  by  third  party  payors.  With 64% of its  revenues  in this
environment, the Company has considerable experience controlling operating costs
while  continuing to deliver  high-quality  healthcare.  The Company believes it
will be  able to  utilize  this  experience  as a  competitive  advantage  as it
broadens the  continuum of care offered to its patients in existing  markets and
expands its ancillary service businesses in new markets. The Company has reduced
revenues from Medi-Cal from 32.3% of total revenues in 1995 to 21.7%  (pro-forma
for the acquisition of four acute  rehabilitation  hospitals,  six  neurological
care centers and 10 outpatient clinics on January 1, 1997 and the disposition of
six long term care facilities in 1996 and one on January 1, 1997) for 1996.

   Expanding the Continuum of Care. A significant  component of Regency's growth
strategy  is  expanding  the  continuum  of care.  By  increasing  its  scope of
services,  the Company  believes  that it will attract  additional  managed care
payors and other insurers as participants in its regional,  integrated  delivery
systems.  Given the current  industry  consolidation,  the Company believes this
strategy  is  necessary  to  establish  a  significant  market  position  in the
geographic  areas  it  has  targeted  for  expansion.  Moreover,  expanding  the
continuum of care should increase business for higher margin ancillary  services
and attract  greater  numbers of patients whose care is reimbursed by other than
government sources.

   An important  component of this strategy is  supplementing  current  services
offered by the Company. The Company intends to do so through strategic alliances
or by  developing  new  programs.  A prime  example of a  strategic  alliance to
reinforce the continuum is the joint venture relationship the Company now enjoys
with two acute medical centers in California. Subacute services also continue to
grow.  As of February  28, 1997,  46 of the  Company's  facilities  had subacute
programs  in place,  up from 42 at the end of 1995.  Additionally,  the  Company
intends to continue to  emphasize  the growth of its home health care  division.
The   provision  of  home  health  care  services   complements   the  Company's
facility-based  services and substantially  broadens the continuum of care which
it is able to provide.  Furthermore,  the Company will  emphasize  the growth in
outpatient  services.  The Company  believes that its ability to package a broad
array of services in this manner is attractive to managed care payors.

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<PAGE>

   Another  important  industry  factor  prompting  the  Company  to expand  its
continuum is the growing  marketing  penetration  of managed care  organizations
both across the nation and in the regions where the Company operates. As managed
care market share increases,  it is important for healthcare  providers like the
Company to enter into  managed  care  contracts  in order to maintain  and build
their patient base. In  determining  which  providers to contract  with,  payors
consider,  among other factors,  quality of care, range of services,  geographic
coverage and the  cost-effectiveness  of the care.  These payors  control  costs
through stringent  utilization  review systems,  increased use of discounted and
capitated fee arrangements  and, when appropriate,  directing  patients to lower
acuity  alternatives  along the continuum of patient care. The Company  believes
that development of its integrated  delivery system in selected regions gives it
the scope of  services,  quality of care,  geographic  coverage and cost control
that will enable it to compete more effectively for managed care contracts.

   As of January 1, 1997, the Company added 4 acute rehabilitation  hospitals, 6
neurological care centers and 10 outpatient clinics to its roster of operations.
With  this,  it formed a new  division,  Regency  Rehabilitation  and  Specialty
Services,  to mark the significance of rehabilitation  services in the strategic
development of the continuum of care.

   To implement  its strategy,  the Company  intends to: (i) continue to enhance
the continuum of services it offers;  (ii) develop market  concentration for its
continuum of inpatient,  outpatient and home health  services in targeted states
and regions to parallel increasing payor consolidation; (iii) consider strategic
alliances  with managed  care  payors,  hospital  groups,  physicians  and other
healthcare  providers;  (iv) explore acquisitions which could further expand the
services  provided by the Company;  and (v) upgrade its  management  information
systems to develop  connections  between systems and geographic  locations which
will assist in integrating financial and clinical data across all business lines
in order to meet the future  information needs the managed care environment will
require.

   In-Sourcing  Patient Services.  Regency expects to continue to in-source such
patient services as pharmacy and rehabilitation services. The Company's existing
facilities  provide a ready market and could generate  additional growth for the
Company's  ancillary  service  businesses.  The Company  believes that continued
in-sourcing  of these  services  could enhance  revenues and solidify its market
position by broadening  the base of potential  patients from which it is able to
draw and by  creating  stronger  platforms  from  which it can offer  additional
services.  Moreover,  these  types of  services  should  enhance  the  Company's
profitability  by  attracting  greater  numbers of patients who pay directly for
services without the benefit of government assistance programs.  Generally,  the
profitability  of caring for these  patients is higher than for  patients  under
government  assistance programs.  Historically,  the Company has realized higher
profit margins on the ancillary services it is targeting for in-sourcing.

   The August 1996  acquisition  of Managed  Respiratory  Care  Services by SCRS
enabled the Company to insource additional  respiratory  therapy  rehabilitation
that was  previously  furnished by  non-affiliated  providers.  During 1996, the
Company  acquired Assist A Care pharmacy to expand the growth in the delivery of
pharmacy services in California.  The Company expects to complete development of
a hub and satellite  network for  distribution  within its  California  pharmacy
operations  during 1997. The acquisition of Executive  Pharmacy provided for the
in-sourcing  of pharmacy  services to the Company's  facilities in Tennessee and
North Carolina and expanded the Company's  pharmacy  services to  non-affiliated
facilities  as well.  In 1996, a strategic  alliance was  initiated  with Vrable
pharmacy  to enable the Company to  in-source  pharmacy  services  in Ohio.  The
Company  believes that continued  expansion of the pharmacy  network  outside of
California and to non-related  facilities both in California and in other states
will occur primarily through acquisitions.

   Marketing Ancillary Services. In addition to expanding the range of ancillary
services  provided  directly  to its  patients,  Regency  intends  to expand the
marketing of its ancillary  services to third party facilities.  The development
and marketing of ancillary  services  should enable the Company to serve greater
numbers of higher revenue patients.  Expansion of ancillary services marketed to
non-affiliated  facilities is an important  component of the  Company's  goal to
increase  the  quality  of its payor  mix.  Moreover,  management  believes  the


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<PAGE>

selective acquisition and marketing of ancillary services supports the continued
growth of the Company in  targeted  market  segments  and  locations  and should
produce  synergies  as the  Company  expands  both the number of  facilities  it
operates and the continuum of care it provides to its patients.

   Expanding  Through  Acquisition.  Regency  has grown  primarily  through  the
selective  acquisition of new facilities and ancillary  service  providers.  The
Company expects to continue to grow  principally  through such  acquisitions and
the  synergies  these new  facilities  and ancillary  services may provide.  The
Company intends to focus its acquisition and expansion  efforts in those markets
where the Company already has a presence that provide an attractive  opportunity
for the  expansion,  geographic  and  otherwise,  of the  continuum  of care the
Company  offers to its  patients.  By such  expansion,  the  Company  intends to
develop a significant  market  presence,  which  will enable  it  to better take
advantage of the opportunities for synergies provided by new acquisitions and to
enhance further the range of services provided to its patients. The Company will
continue to assess the viability of expansion  into other areas as  economically
attractive acquisitions become available. The Company actively seeks acquisition
opportunities in the ordinary course of its business and is currently  reviewing
prospective acquisitions.

Business Units

   The Company's business operations consist of four basic units: long-term care
facilities including subacute specialty units, rehabilitation services, pharmacy
services and home healthcare.

   Nursing Center Operations.  As of  February 28, 1997,  103  of the  Company's
healthcare  facilities  are licensed as skilled  nursing  facilities and provide
skilled nursing care for patients who do not require more extensive treatment at
an acute care hospital.  Seven of these  facilities and one additional  facility
are also approved by the  California  Department  of Health  Services to provide
mental health services. The Company's skilled nursing facilities provide 24-hour
nursing care, room and board, social services and activity programs,  as well as
special diets and other services that may be specified by a patient's physician.
Patients  at these  facilities  often  have  been  discharged  from  acute  care
hospitals  and  require  substantial  medical  attention.  In  some  cases,  the
facilities  also provide  assisted living  arrangements.  In addition to skilled
nursing   facilities,   the   Company   operates   three   facilities   for  the
developmentally   disabled, one  of which  is also licensed as a skilled nursing
facility and  is  included  above.  The  Company  believes  that its substantial
California presence,  together  with  the expansion of its continuum of services
and  greater  market  penetration  for its  ancillary  services,  will  increase
the  Company's  ability  to  obtain   contracts  and referrals from managed care
companies.  For  the  year  ended  December 31, 1996,  approximately 5.1% of the
Company's revenues  were  attributable to  managed care; management expects this
percentage to increase.

   As of February 28, 1997, 25 of the Company's skilled nursing  facilities were
accredited by the Joint Commission on Accreditation of Healthcare  Organizations
("JCAHO"),  an independent  organization  that reviews  facilities and accredits
those that achieve  certain  standards for quality  control and  assurance.  The
Company has applied for accreditation at additional facilities.

   As of February 28, 1997, 46 of the Company's  healthcare  facilities included
subacute  specialty units which serve the needs of patients of all ages who have
medically   complex   conditions  which  require  ongoing  nursing  and  medical
supervision and access to specialized equipment and services, but do not require
many of the  other  services  provided  by acute  care  hospitals.  The  Company
increased the number of its facilities containing dedicated subacute units to 46
during  1996 from 42 at the end of 1995.  The units  provide  such  services  as
respiratory  therapy,  ventilator care,  oncology  services,  infusion  therapy,
post-surgical wound management and care to patients with auto-immune  deficiency
syndrome  (AIDS).  In addition,  as of February 28, 1997,  the Company  provided
specialized  services  at three of its  facilities  to patients  diagnosed  with
Alzheimer's  disease.  Based upon its  experience  within the  industry  and its
knowledge of acute care  hospital  rates,  as  disclosed  by such  institutions,
management  believes  that  it  is  able  to  provide  subacute  care  at  rates


                                       5
<PAGE>

substantially  below the rates  typically  charged by acute care  hospitals  for
comparable  services and still earn higher average revenues per patient day than
it receives for basic nursing services.

   Rehabilitation   Services.   Ninety-six  of  the  Company's  skilled  nursing
facilities provide special rehabilitation  services including physical,  speech,
occupational, and respiratory therapy. These ancillary services are administered
by licensed therapists and rehabilitation aides.  Currently,  these services are
provided by several contract therapy providers, including SCRS.

   The  objective of these  programs is to help  patients  achieve their highest
level of functional  independence.  Rehabilitation  services are instrumental in
lowering the overall cost of care by reducing the length of a patient's stay and
improving a patient's  quality of life.  Specialized  management  staff  oversee
these rehabilitation  programs to ensure high-quality service delivery,  program
compliance and achievement of maximum outcomes for the patient.

   In August 1996,  the  Company's  rehabilitation  services  subsidiary,  SCRS,
acquired Managed  Respiratory  Care Services,  a respiratory  therapy  provider.
Beyond the  services it provides the  Company,  as of February  28,  1997,  SCRS
delivers rehabilitation services at 116 non-affiliated  healthcare facilities in
14  states  and  to  home   healthcare   patients   under  four  contracts  with
non-affiliated healthcare providers.

   As of January 1, 1997, the Company added four acute rehabilitation hospitals,
six  neurological  care centers and 10  outpatient  clinics to the  continuum of
rehabilitation  services  it  offers.  The  Company  believes  this  enhancement
increases  its appeal to managed care payors  seeking  providers who are able to
effectively manage the cost and quality of care delivered to their patients.

   Pharmacy  Services.  For the past six years, the Company has operated its own
institutional pharmacy, First Class Pharmacy, Inc. In 1996, the Company acquired
or opened four  additional  pharmacy   operations   to  expand  its  service  to
Company-operated  facilities and non-affiliated facilities in California,  Ohio,
Tennessee and North  Carolina.  As of December 31, 1996, the Company's  pharmacy
operations provided  prescription  services and basic pharmaceutical  dispensing
programs to 68  Company-operated  facilities with  approximately  7,257 licensed
beds and to 84 non-affiliated facilities with approximately 7,428 licensed beds.
In  addition,  the  Company's  pharmacy  operations  provide  certain  specialty
services such as infusion therapy,  enteral nutrition, and urological and ostomy
supply programs. The Company has also developed certain specialty consulting and
ancillary  programs  to  help  each  facility  comply  with  state  and  federal
regulations.  Additionally,  the Company is pursuing development of an automated
hub and satellite network of pharmacy operations within California to reduce the
cost of supplying pharmacy services.

   Home Health  Services.  The  Company  provides  home health care  services in
selected areas in California and Ohio through two operating divisions, Care Home
Health and Care At Home.  The Company  has  provided  home health care  services
since 1983. Care Home Health  primarily  serves Medicare  patients while Care At
Home provides services to private pay, managed care and Medicaid  patients.  The
services  offered include skilled  nursing,  rehabilitation  services,  infusion
therapy,  ventilator  care,  care for patients  with AIDS,  and other  specialty
services.


Manner of Operation

   Nursing Center Operations.  Each healthcare  facility operated by the Company
is supervised by a licensed  administrator who is responsible for all aspects of
facility operations.  A facility administrator  typically oversees a director of
nursing, a director of admissions and other department supervisors. The director
of nursing  supervises a staff of registered  nurses,  licensed practical nurses
and nurses'  aides.  The director of admissions is  responsible  for  developing
local marketing strategies and programs.  To supervise the medical management of
patients,  the Company also contracts with licensed physicians to act as medical
directors at each facility.  The Company's  corporate  staff provides support to
facility administrators in, among other things, quality improvement,  management


                                       6
<PAGE>

reporting, marketing, management training, legal services, human resources, risk
management, reimbursement, data processing, cash management, and accounting.

   The Company has a  professional  services  department  which  includes  field
consultants  who  represent  the  corporate   philosophy  to  each  professional
discipline  providing  patient care. The department  coordinates the development
and implementation of corporate and  administrative  policies and procedures and
authors most clinical manuals used in direct patient care. To ensure  regulatory
compliance  and  high-quality  clinical  services,  the  department  is actively
involved in location-specific  and Company-wide  quality improvement  activities
and  education  through  interdisciplinary  consulting  services  to  all of the
Company's  operational  areas.  In 1996, the department  introduced a continuous
quality  improvement  program  to the  division  that is  designed  to  identify
opportunities to improve quality before negative outcomes can occur.

   Contract   Rehabilitation   Therapy   Operations.   The  Company's   contract
rehabilitation  therapy  operations are directed by the senior vice president of
Rehabilitation and managed by two divisional executive vice presidents;  one who
oversees field operations,  clinical services,  corporate support, finance and a
recruiting  division  known  separately  as  Therapy  International  and one who
oversees  all  sales,  marketing  and the  PulsePoint  Technologies  information
service.  Field  operations  are  controlled by divisional  vice  presidents who
supervise  state  regional  directors and a team of area  clinical  managers who
typically oversee three to seven facilities each.

   Pharmacy  Operations.  The Company's  pharmacy  operations are managed by the
senior vice president of Home Health and Pharmacy Operations, who is responsible
for all aspects of home health and pharmacy operations. Each pharmacy is managed
by either a general  manager  or  pharmacy  manager,  who is a  pharmacist,  and
supported by a business  manager who oversees the billing  department  staff,  a
professional  staff  of  consulting  and  dispensing  pharmacists,   nurses  and
dietitians,  and a support  staff of  technicians  and delivery  personnel.  The
division  corporate  staff  includes  a  regional   controller,   regional  vice
presidents  of  operations,  a vice  president of business  development,  a vice
president  of  acquisitions,  and a director of pharmacy  support  services  who
provide financial accounting,  management oversight, new program implementation,
acquisitions,  marketing,  sales support, new business  assimilation,  and other
management support services to each pharmacy manager.

   Home Health  Operations.  The Company's  home health  operations  are divided
geographically into two regions, each managed by a regional vice president.  The
regional vice presidents  report to the senior vice president of Home Health and
Pharmacy   Services  and  are   supported  by  regional   directors  of  quality
improvement,  consumer  education,  finance and  Infusion.  Each of the Medicare
certified agencies is managed by a director of professional services.

Sources of Payment

   The Company receives  payment for healthcare  services from (i) the federally
assisted  Medicaid  program,  (ii) the federal Medicare  program,  (iii) private
sources,  including  HMOs and  commercial  insurance,  and (iv)  other  sources,
including  special  programs  sponsored  by local  governments  and the Veterans
Administration.  Because private and Medicare  reimbursement  rates historically
have been higher than Medicaid reimbursement rates, the Company has targeted the
private-pay market and has worked to make available  Medicare-eligible  services
in its  healthcare  facilities.  Changes  in the  mix of the  Company's  patient
population  between  Medicaid and a combination  of Medicare,  private and other
sources  can  significantly  affect  profitability.  Governmental  reimbursement
programs are subject to change, which also can affect profitability.

   As of February 28, 1997,  102 of the Company's  facilities  are certified for
participation  in  Medicaid.  Medicaid is a medical  assistance  program for the
indigent  and  is  operated  by  state  governments  with  financial  assistance
(approximately  50% of the funds available) from the federal  government under a
matching  program.  Medicaid  is  subject  to  federally  imposed  requirements.
Medi-Cal, California's version of Medicaid, currently provides for reimbursement


                                       7
<PAGE>

at established daily rates, as determined by the California Department of Health
Services,  based on median costs of nursing facilities,  classified by number of
licensed beds and  geographic  location.  Medi-Cal  primarily pays for long-term
custodial care for patients who qualify for welfare  benefits.  In Ohio and West
Virginia  Medicaid  reimbursement  is a  prospective  cost-based  system with an
adjustment  factor to account  for patient  acuity.  Medicaid  reimbursement  is
primarily  provided  under a prospective  cost-based  system in Tennessee and in
North  Carolina  is provided  under a system that has both a cost  reimbursement
component,   subject  to  limitations,  as  well  as  a  prospective  cost-based
component.  Twelve of the  Company's  home  healthcare  agencies are eligible to
participate  in the Medicare  program and all of the Company's  home  healthcare
agencies are eligible to participate in the Medicaid program.

   As of February 28, 1997, 96 of the Company's  skilled nursing  facilities are
certified for participation in Medicare.  Medicare is a health insurance program
operated by the federal government for the aged and certain chronically disabled
individuals.   Medicare   reimbursement  rates  for  the  Company's   healthcare
facilities  are  regulated by the federal  government  and  generally  utilize a
cost-based  reimbursement  system,  subject to geographic cost limits.  Medicare
pays both the  allowed  direct  costs and  allowed  overhead  costs  related  to
services provided to patients covered by the Medicare program. Medicare specific
rates  are  dependent  upon the cost and  volume  of the  services  provided  as
calculated on the cost reports that each facility is required to submit annually
to Medicare.  Reimbursement from Medicare is subject to retrospective adjustment
to reconcile  payments made to a facility on an interim basis with  subsequently
determined  allowable  costs.  Overpayments  may be recovered  directly from the
facility at the time the  adjustment is made or by reducing  future  payments to
the facility or other facilities operated by the Company.

   The  Company's  cost of care  for its  Medicare  patients  sometimes  exceeds
regional  reimbursement  limits  established  by Medicare.  The Company  submits
exception  requests for its excess costs  annually.  Exception  requests for all
cost report  periods  through  December 31, 1994 have been filed.  The Company's
final rates as approved by the Health  Care  Financing  Administration  ("HCFA")
represent, on average,  approximately 84% of the requested rates as submitted in
the exception  requests.  During 1994,  the Company  recognized  50% of the 1994
estimated  exception  requests  anticipated  to be received,  which  represented
revenues of approximately  $1,550,000.  Commencing  January 1, 1995, the Company
recognized 70% of the estimated  exception requests  anticipated to be received,
which represented  revenues of approximately  $3,563,000 and $3,001,000 for 1996
and 1995,  respectively.  Amounts  received  in  respect of  exception  requests
relating to periods  prior to December 31, 1994 will  continue to be recorded on
the cash basis.  The Company believes that it will be able to recover its excess
costs under any pending exception  requests or under any exception requests that
may be submitted in the future;  however, there can be no assurance that it will
be able to do so.

   The Company has a broad  customer  base.  There are no  customers  or related
groups of customers  that  account for a  significant  portion of the  Company's
revenue.  The loss of a single customer or group of related  customers would not
have a material  adverse  effect on the  operations  of the  Company  taken as a
whole. However, two non-affiliated  healthcare providers represented 24% of SCRS
total  revenues  during  1996.  For a detail of revenue by  business  unit,  see
"Management's  Discussion  and  Analysis of Financial  Condition  and Results of
Operations."

   Reimbursement   rates  for  HMOs  are  negotiated  by  the  Company  and  the
organization.  Charges for other  private-pay  patients are  established  by the
Company from time to time and are  determined  by market  conditions  and costs.
Veterans  Administration  contracts are generally at negotiated daily rates. The
Company  also  receives  reimbursement,  generally  at  negotiated  daily rates,
pursuant to five  contracts with county  governments  relating to certain of the
Company's  facilities which provide services to the mentally  disordered.  These
contracts  may be  terminated  by either  party  upon 60 days',  or less,  prior
notice.

                                       8
<PAGE>

   The  following  table sets forth the  Company's  percentage  of net operating
revenue provided by source of payor for the periods indicated:
<TABLE>

                                             1996         1995         1994
                                           ---------    ---------    ---------
                <S>                        <C>          <C>          <C>  
                Medicaid                     40.6%        39.9%        42.7%
                Medicare                     29.3         31.9         31.3
                Private                      11.6         13.6         15.2
                Managed care                  5.1          5.4          4.6
                Other                        13.4          9.2          6.2
                                           =========    =========    =========
                Total                       100.0%       100.0%       100.0%
                                           =========    =========    =========
</TABLE>

   As of February 28, 1997, the Company had in effect agreements with nearly all
major HMOs operating in California to provide skilled nursing care and ancillary
services to patients at its  facilities  who are enrolled as members in the HMO.
Payment by HMOs for  services  provided  by the  Company is based on  negotiated
contract  rates  that  vary by HMO.  Reimbursement  is based  upon the  level of
patient acuity, irrespective of the actual services provided. Thus, if a patient
requires a greater  level of healthcare  services than that normally  provided a
patient of the agreed acuity level,  the Company will not be reimbursed for such
additional services.

   Contract  Rehabilitation  Therapy Services to  Non-affiliates.  Revenues from
contract  rehabilitation  services  to  non-affiliates  are  generally  received
directly  from the  long-term  care  facility  where the patient  being  treated
resides,  which in turn are paid by Medicare or other payors. These revenues are
included  in other  sources of revenue.  Revenue  from  contract  rehabilitation
therapy  services  provided to Regency  operated  facilities are included in the
Medicaid,  Medicare  and private pay sources of revenues for Regency for each of
the  applicable  facilities.  Charges to  non-affiliates,  though  not  directly
regulated,  are effectively limited by regulatory reimbursement policies imposed
on the long-term care facilities that receive these therapy services, as well as
competitive market factors.

   Pharmacy  Services to  Non-affiliates.  Revenue from the  Company's  pharmacy
services  are  derived  from the  provision  of such  services  to  patients  at
long-term  care  facilities  not  operated  by Regency  and  patients at Regency
facilities   billed  directly  to  third-party   payors.   Regency  enters  into
non-exclusive  contracts with non-affiliated  facilities,  and personnel at such
facilities  submit  prescriptions  to  Regency  on  behalf of  patients  at such
facilities.  Regency is in most cases paid  directly  by  Medicare,  Medicaid or
private pay sources,  and not by the long-term care  facility.  The amounts that
can be charged for prescriptions are often limited by Medicaid regulations.

   Home Health  Operations.  Revenue from the Company's  home health  operations
come from a variety of payors  including  the Medicare  and  Medicaid  programs,
commercial  insurance,  health  maintenance  organizations,  private sources and
special county/state  programs. In January 1996, two of the Company's California
home health agencies entered the HCFA "Prospective Pay" pilot program. This is a
three year program under which  reimbursement will be determined on an "episode"
basis not on a fee for service (per visit)  basis.  An "episode" is defined as a
120 day period of home  health  benefit,  inclusive  of all  necessary  services
(including ancillary services).

   Related Party Transactions.  Medicare  regulations that apply to transactions
between related parties,  such as Regency and its subsidiaries,  are relevant to
the amount of Medicare reimbursement that the Company is entitled to receive for
contract  rehabilitation  therapy  and  pharmacy  services  that it  provides to
Regency operated facilities.  These Medicare regulations generally require that,
among other  things,  (i) the  Company's  rehabilitation  therapy  and  pharmacy
subsidiaries must each be a bona fide separate organization;  (ii) a substantial
part of the contract  rehabilitation  therapy services or pharmacy services,  as
the  case  may  be,  of  the  relevant   subsidiary   must  be  transacted  with
non-affiliated  entities,  and  there is an  open,  competitive  market  for the
relevant services;  (iii) contract  rehabilitation therapy services and pharmacy


                                       9
<PAGE>

services,  as the case may be,  are  services  that  commonly  are  obtained  by
long-term care facilities from other  organizations  and are not a basic element
of patient care ordinarily furnished directly to patients by such long-term care
facilities;  and  (iv)  the  prices  charged  to the  Company's  long-term  care
facilities by its contract  rehabilitation  therapy  operations  subsidiary  and
pharmacy operations  subsidiaries are in line with the charges for such services
in the  open  market  and no  more  than  the  prices  charged  by its  contract
rehabilitation   therapy   operations   subsidiary   and   pharmacy   operations
subsidiaries  under comparable  circumstances to  non-affiliated  long-term care
facilities.  Regency  believes  that  each  of the  foregoing  requirements  are
presently  being satisfied with respect to its contract  rehabilitation  therapy
and  pharmacy  subsidiaries,   and  therefore,  Regency  believes  it  presently
satisfies the requirements of these  regulations.  Consequently,  it has claimed
and received  reimbursement under Medicare for contract  rehabilitation  therapy
services  (since the  acquisition  of SCRS in July 1995) and  pharmacy  services
(beginning  in January  1996)  provided to patients in its own  facilities  at a
higher rate than if it did not  satisfy  these  requirements.  If the Company is
unable to satisfy these regulations,  the reimbursement the Company receives for
contract  rehabilitation  therapy  and  pharmacy  services  provided  to its own
facilities would be materially  adversely  affected.  If, upon audit by relevant
reimbursement agencies such agencies find that each of these regulations has not
been satisfied,  and if, after appeal, such findings are sustained,  the Company
could be required to refund  some or all of the  difference  between its cost of
providing  these  services and the higher amount  actually  received.  While the
Company  believes  that it has  satisfied  and will  continue  to satisfy  these
regulations,  there can be no  assurance  that its  position  would  prevail  if
contested by relevant reimbursement agencies.

Marketing

   Recognizing the growing  influence of managed care upon healthcare  delivery,
the Company's  Marketing and Managed Care departments were combined in 1996. The
integration  of these  areas  allows a  synergistic  approach to  marketing  the
Company's services to payors,  providers and patients.  Long-term strategies and
Company-wide  marketing  programs  are  developed by the  corporate  Marketing &
Managed Care staff. However,  primary marketing  responsibility rests with field
personnel for each of the Company's business lines.

   The  Company has  developed  various  marketing  and  managed  care  training
programs  and  manuals for use by staff who are  involved  in service  delivery.
Software  programs,  statistical  data,  and field  interview  responses  aid in
development  of  materials  to  support  marketing  efforts.   Recognizing  that
healthcare  decisions are made at the local level by physicians,  case managers,
discharge  planners,  family  members  and  patients,  the  Company  attempts to
identify,  develop and maintain  relationships with the primary referral sources
in each of the areas it serves.  Marketing personnel also research,  analyze and
advise the Company  concerning  opportunities in each of its local market areas.
From this, the Company's  marketing staff seeks to develop  programs to maximize
occupancy  and  financial  performance  in  each  of the  Company's  facilities.
Complementing   these   efforts,   Managed   Care  staff   identify  and  pursue
opportunities to develop relationships with managed care providers.

Quality Management

   The Company believes that an essential element of its business strategy is to
focus on the quality of service  provided.  This depends in large measure on the
existence  of a trained and  educated  work force.  The  Company  views  quality
management as a two-pronged  system:  Continuous  Quality  Improvement and Total
Quality Management.

   In 1996, the Company introduced a Continuous Quality Improvement program into
its  long-term  care  operations.  This program  places the  responsibility  for
quality  improvement in the hands of those who most greatly impact quality - the
facility staffs. It is a facility-based  system of identifying  opportunities to
improve  quality  before  negative  events can occur.  As system  weaknesses are
identified,  they are resolved through a problem-solving procedure that is based
on Total Quality Management.

                                       10
<PAGE>

   With  initial  assistance  from the Richard  Rodgers  Consulting  Group,  the
Company has, since 1993, trained over 9,000 employees in the principles of Total
Quality  Management  ("TQM").  In  addition,  certain  executive  and  mid-level
managers have been trained in the use of  Statistical  Process  Control and data
analysis in sound business decision-making.

   In  implementing  its TQM initiative,  the Company did not create  additional
layers of bureaucracy,  but instead  developed and communicated to its employees
the simple message that the Company's vision,  mission and culture are dedicated
to meeting and exceeding the expectations of its customers.

   Because the Company believes that quality planning is an important  component
of the strategic planning process and integral to the successful  realization of
its strategic objectives, TQM is results-oriented. At all levels of the Company,
rewards are tied to specific agreed-upon result statements that directly support
the Company's strategic objectives. Employee performance is evaluated based upon
achievement of stated quantitative measures. In this way, the Company's focus is
continually directed back to its strategic objectives.

Regulation

   The  healthcare  industry is subject to  extensive  federal,  state and local
statutes  and  regulations.  The  regulations  include  licensure  requirements,
reimbursement  rules and  standards  and levels of services of care.  Changes in
applicable  laws and  regulations  or new  interpretations  of existing laws and
regulations  could  have a  material  adverse  effect on  licensure  of  Company
facilities,  eligibility  for  participation  in  federal  and  state  programs,
permissible activities,  costs of doing business, or the levels of reimbursement
from governmental, private, and other sources. To date such changes have not had
a material adverse effect on the Company's  business.  However,  there can be no
assurance that regulatory  authorities will not adopt changes or interpretations
that adversely affect the Company's business.

   Licensing.  The Company's  healthcare  facilities  and pharmacy  services are
subject to licensing requirements by state and local authorities.  The Company's
healthcare facilities are licensed by each state's licensing agency. In granting
licenses,  an agency considers,  among other factors,  the physical condition of
the facility,  the  qualifications of the administrative and nursing staffs, the
quality of care, and compliance with applicable  statutes and  regulations.  The
failure to maintain or renew any required regulatory approvals or licenses could
prevent  the Company  from  offering  its  existing  services or from  obtaining
reimbursement.

   As of February 28, 1997, 96 of the Company's  skilled nursing  facilities are
certified for participation in Medicare and 102 of the Company's  facilities are
certified for participation in Medicaid.  Twelve of the home healthcare agencies
operated by the Company are eligible to participate in the Medicare  program and
all of the Companies home healthcare agencies are eligible to participate in the
Medicaid  program.  The Company,  through its  subsidiaries,  holds  licenses to
operate long-term care facilities in California,  West Virginia, Ohio, Tennessee
and North  Carolina.  Ohio does not  require  that a new  license be issued on a
yearly  basis.  The  Company,  through  its  subsidiaries,  participates  in the
Medicare and Medicaid programs in California, West Virginia, Ohio, Tennessee and
North Carolina.

   Most  states  in  which  SCRS  operates   permit  a  corporation  to  provide
rehabilitation  services provided that the individual therapist is licensed. The
Company's  rehabilitation services at facilities not operated by the Company are
offered under the individual  license of Sherri L. Medina,  the Company's Senior
Vice  President-Rehabilitation  Services and through the licenses of  individual
therapists.  In California and Indiana, services are provided either through Ms.
Medina's  professional  corporation  or through a  professional  corporation  of
another employee.  The failure by Ms. Medina to maintain her individual  license
would prevent the Company from offering such services to other  facilities until
a replacement supervising officer were employed.

                                       11
<PAGE>

   In certain  states,  statutes  require  that a state agency  approve  certain
acquisitions,   the  addition  of  beds  and   services   and  certain   capital
expenditures.  Such state approvals generally require implementation of the item
being approved  within a specified time period.  The failure to obtain the state
approval  can  result  in the  inability  to make  the  acquisition,  to add the
service,  to operate  the  facility  or complete  the  addition or other  change
requested,   and  can  result  in  the   imposition   of  sanctions  or  adverse
reimbursement action.

   The  Omnibus  Budget  Reconciliation  Act of 1987  ("OBRA")  was  implemented
effective  October 1, 1990.  Among other things,  OBRA  eliminated the different
certification standards for "skilled" and "intermediate care" nursing facilities
under the Medicaid  program in favor of a single  "nursing  facility"  standard.
OBRA also mandated an increase in the level of services nursing  facilities must
provide to participate in Medicare and Medicaid.  This change, the cost of which
was  partially  offset by  reimbursement  rate  increases  for  Medicaid  and an
increase  in the  routine  cost limits  under  Medicare,  thus far has not had a
significant impact on the Company.

   Effective July 1, 1995, new regulations  under OBRA dealing with  enforcement
policies  and  procedures  and a new  survey  process  became  operative.  These
regulations  provide for a variety of  penalties  for  noncompliance  with other
substantive  regulations  and  minimum  standards  of care,  including  required
preparation  and  submission  of  plans of  correction,  new  patient  admission
moratoriums, denial of reimbursement,  decertification of Medicare reimbursement
eligibility,  delicensing, forced facility shutdown and loss of provider status.
While the Company believes that it is in substantial compliance with the current
requirements  of OBRA, it is unable to predict how the  enforcement  regulations
will be implemented,  or how future  interpretations  of current  regulations or
future regulations promulgated under OBRA may affect it. In addition,  there can
be no assurance that the Company's  facilities and the provision of services and
supplies by the Company now or in the future will  initially meet or continue to
meet the requirements for participation in Medicare or Medicaid programs.

   The Company and its healthcare facilities are subject to routine inspections,
at any time, to monitor  compliance with government  regulations.  Based on such
inspections,  the Company receives,  from time to time in the ordinary course of
its  business,  notices of  failure to comply  with  various  requirements.  The
Company  endeavors  to take prompt  corrective  action  and, in most cases,  the
Company and the reviewing  agency agree on remedial steps.  The reviewing agency
may take action  against a facility,  which can include the imposition of fines,
recovery of Medicare  payments  paid with respect to deficient  care,  temporary
suspension  of admission of new patients to the facility,  decertification  from
participation   in  the   Medicare   or  Medicaid   programs   and,  in  extreme
circumstances,  revocation of the facility's license. In certain  circumstances,
failure of  compliance  at one facility may affect the ability of the Company to
obtain or maintain licenses or approvals under Medicare and Medicaid programs at
other Company facilities.

   Reimbursement.  Governmental  reimbursement programs are subject to statutory
and regulatory changes,  administrative rulings and interpretations,  government
funding restrictions,  and retroactive reimbursement  adjustments,  all of which
could materially  increase or decrease the services covered or the rates paid to
the Company for its services. There have been and the Company expects that there
will continue to be, a number of proposals to limit  governmental  programs such
as Medicare and Medicaid  reimbursement  for  healthcare  services.  The Company
cannot  predict at this time whether any of these  proposals will be adopted or,
if  adopted  and  implemented,  what  effect  such  proposals  would have on the
Company.  There can be no assurance  that payments under  governmental  programs
will remain at levels  comparable  to present  levels or will be  sufficient  to
cover the cost allocable to patients eligible for reimbursement pursuant to such
programs.  In  addition,  governmental  reimbursement  programs  require  strict
compliance  with both patient  eligibility and acuity  requirements,  and timely
payment  requests.  The failure to adhere to these  requirements  is a basis for
denial of  reimbursement or for a required  refund,  with interest,  of any sums
paid by the program.

   In addition,  the Company's cash flow could be adversely affected by periodic
government program funding delays,  shortfalls,  or other difficulties,  such as
that which  occurred in 1995 when the State of California  failed to adopt a new


                                       12
<PAGE>

budget prior to the end of the 1994-1995 fiscal year and, as a result,  Medi-Cal
delayed reimbursement payments for several weeks. Medi-Cal also delayed payments
and rate increases for several weeks in 1990 and 1991.  Medi-Cal has on a number
of recent occasions  delayed payments and rate increases,  including for several
weeks in each of 1990,  1991 and 1995.  The Company has mitigated the effects of
such payment  delays by  monitoring  the related  activities  of the  California
legislature,  expediting billings through its electronic billing arrangement and
agreeing  with  creditors  to  extend  the due  date for  payables.  See Item 7.
"Management's  Discussion  and  Analysis of Financial  Condition  and Results of
Operations  -  Liquidity  and  Capital  Resources."  There can be no  assurance,
however,  that the Company  will be able to  mitigate  the effects of any future
funding delays. During 1996, the Company averaged approximately $8.1 million per
month in cash receipts from the Medi-Cal program.

   Antifraud  and  Self-Referral  Regulations.  Various  Federal  and state laws
regulate  the  relationship  between  providers  of  health  care  services  and
physicians or others able to refer  medical  services,  including  employment or
service contracts,  leases and investment relationships.  These laws include the
fraud and abuse  provisions  of the  Medicare  and  Medicaid  and similar  state
statutes  (the "Fraud and Abuse  Laws"),  which  prohibit the payment,  receipt,
solicitation  or  offering of any direct or  indirect  remuneration  intended to
induce the  referral of Medicare  and  Medicaid  patients or for the ordering or
providing  of  Medicare  or  Medicaid  covered  services,  items  or  equipment.
Violations of these provisions may result in civil and criminal penalties and/or
exclusion  from  participation  in the Medicare  and Medicaid  programs and from
state programs  containing similar provisions relating to referrals of privately
insured  patients.  The United States  Department  of Health and Human  Services
("HHS")  has  interpreted  these  provisions  broadly to include  the payment of
anything of value to influence  the  referral of Medicare or Medicaid  business.
HHS has issued regulations which set forth certain "safe harbors,"  representing
business  relationships  and  payments  that can  safely be  undertaken  without
violation of the Fraud and Abuse Laws.  In addition,  certain  Federal and state
requirements  generally  prohibit certain  providers from referring  patients to
certain  types of entities in which such provider has an ownership or investment
interest or with which such provider has a compensation  arrangement,  unless an
exception is available.  The Company  considers all applicable  laws in planning
marketing   activities  and  exercises  care  in  an  effort  to  structure  its
arrangements  with health  care  providers  to comply with these laws.  However,
because there is no procedure for obtaining  advisory  opinions from  government
officials,  the Company is unable to provide assurances that all of its existing
or future  arrangements will withstand  scrutiny under the Fraud and Abuse Laws,
safe harbor  regulations or other state or federal  legislation or  regulations,
nor  can  it  predict  the  effect  of  such  rules  and  regulations  on  these
arrangements  in  particular  or on the  Company's  operations  in general.  The
Company  systematically  reviews  its  operations  on a  periodic  basis and has
adopted  policies  intended to ensure that it complies  with the Fraud and Abuse
Laws and similar state statutes.

   Environmental  Regulations.  The  Company's  healthcare  operations  generate
medical  waste that must be disposed of in compliance  with  Federal,  state and
local  environmental laws, rules and regulations.  The Company's  operations are
also subject to compliance  with various  other  environmental  laws,  rules and
regulations.  Such  compliance does not, and the Company  anticipates  that such
compliance  will not,  materially  affect the  Company's  capital  expenditures,
earnings or competitive position.

Competition

   The Company,  and the healthcare industry in general,  faces the challenge of
continuing to provide quality  patient care while  contending with rising costs,
strong  competition for patients and a general reduction of reimbursement  rates
by both private and public payors.  As both private and public payors reduce the
scope of services  which may be reimbursed and reduce  reimbursement  levels for
covered services, national and state efforts to reform the healthcare system may
further impact reimbursement rates. Changes in medical technology,  existing and
future   legislation,   regulations,   contracting   innovations   and  industry
consolidation  may  require  changes  in the  Company's  facilities,  equipment,
personnel, rates and/or services in the future.

                                       13
<PAGE>

   The  Company  competes  with a  variety  of  other  providers  of  healthcare
services,  including  other  rehabilitation  hospitals,  other  skilled  nursing
facilities,  other home health  providers,  hospitals  offering  long-term  care
services and personal care or  residential  facilities.  Competition  has become
more  intense as  alternatives  for  nursing  and  rehabilitation  patients  has
increased.  Many  hospitals  now have  skilled  nursing  units  and home  health
agencies. Community-based programs such as assisted living and congregate living
centers also compete for residents with the Company's skilled nursing facilities
and congregate living centers. With the movement from  `institutional',  skilled
nursing  facilities to  residential  living  facilities  and  congregate  living
centers, maintaining occupancy rates becomes increasingly difficult.

   As of February  28,  1997,  the  Company  operated  83  inpatient  facilities
(including 4 acute  rehabilitation  facilities and 6 neurological  care centers)
with 7,521  licensed beds in  California.  The Company  estimates that there are
approximately 1,300  free-standing  long-term care facilities with approximately
125,000  licensed  beds in  California.  The Company also operates 33 facilities
with 3,943 beds in West  Virginia,  Ohio,  Tennessee,  and North  Carolina.  The
Company's  competitive position varies across statewide and local markets.  Some
of the significant  factors relating to individuals'  selection of the Company's
healthcare facilities include quality of care, reputation,  physical appearance,
services offered,  family  preferences,  benefit plan preferences and price. The
Company's  facilities and home health agencies  operate in communities  that are
served by similar entities. Some competing facilities,  home health agencies and
pharmacies offer services not offered by the Company.  Furthermore,  competitors
may benefit  from  greater  financial  resources,  longer  operating  histories,
charitable endowments, favorable tax status and other resources not available to
the  Company.  There can be no  assurance  that the Company  will not  encounter
increased  competition in the future that would  adversely  affect the Company's
results of operations.

   Contract therapy services,  like those offered by SCRS, are provided by other
rehabilitation  service  companies,  many of whom are  larger  and have  greater
resources than the Company. In addition,  many of SCRS's existing customers have
begun to develop the capability of directly providing such services, rather than
contracting with other providers for these services.

   The long term care  pharmacy  market is  rapidly  consolidating  and this has
resulted in numerous large institutional pharmacies. These pharmacies are larger
and have greater resources than the Company.

Employees

   As of February 28, 1997, the Company had  approximately  16,170 full-time and
part-time employees.  Of these employees,  approximately 12,080 were employed at
its  healthcare  facilities,  approximately  850 at its  home  health  agencies,
approximately   240  in  its  pharmacy   operations,   approximately   2,680  in
rehabilitation services and approximately 320 at its regional administrative and
corporate  offices.  Approximately  1,600 of the  employees  were  covered by 12
collective  bargaining  agreements.  The  Company  believes  that  it  maintains
productive  relations  with its  employees in general and with the 12 collective
bargaining  units. The Company is subject to both federal and state minimum wage
and wage and hour laws and maintains various employee benefit plans.

Tax Audits

   A State of Ohio income tax audit for the years 1991  through  1994 is ongoing
and a  California  Franchise  Tax Board  income  tax audit for 1994 is  pending.
Although  it is not  possible  to predict  with  certainty  the  outcomes of the
audits, in the opinion of the Company,  adequate provision for the matters under
review has been made,  and the results of the audits are not  expected to have a
material adverse effect on the Company's consolidated financial position.

                                       14
<PAGE>

Insurance

   The Company  maintains  general and  professional  liability  insurance  on a
claims-made  basis subject to a $100,000 per occurrence  self-insured  retention
limited to an aggregate  stop loss of  $500,000.  All-risk  property  insurance,
including earthquake and flood, is carried for all Company operations.

   The Company self-insures its workers'  compensation  programs for its nursing
facilities in California and Ohio, pharmacy  operations,  home health operations
and its  corporate  office  employees.  For all other  operations,  the  Company
purchases  insurance for this risk. The Company is required to maintain  standby
letters of credit with the state insurance  departments  for its  self-insurance
workers'  compensation  programs,  which  as of  December  31,  1996  aggregated
approximately $8.4 million. These letters of credit assure that benefits payable
by the Company to its covered employees (which estimated  benefits are reflected
as liabilities on the Company's  books and records) are paid when required.  The
Company  has  not  defaulted  in  its  workers'   compensation  benefit  payment
obligations since the Company began its self-insurance program in 1983.

Factors Which May Affect Company

   The following important factors,  among others, in the past have affected and
in the future could  affect,  the  financial  results,  business  strategy,  and
business  operations of healthcare  providers  including the Company,  and could
materially impact the various forward looking statements  contained elsewhere in
this  Annual  Report.  Readers are  cautioned  to review  such  forward  looking
statements  in the  context  of these  factors.  A number  of  these  items  are
summarized as follows:

   Dependence  on  Reimbursement  from  Medicare  and  Medicaid.  The  Company's
business is dependent upon its ability to obtain and maintain reimbursement from
Medicare and Medicaid. These government-sponsored healthcare programs are highly
regulated and are subject to budgetary and other constraints. In addition, these
government programs have instituted  cost-containment measures designed to limit
payments made to healthcare  providers.  Furthermore,  government  reimbursement
programs are subject to statutory and regulatory changes, administrative rulings
and  interpretations,   determinations  of  intermediaries,  government  funding
restrictions  and  retroactive  reimbursement  adjustments,  all of which  could
materially increase or decrease the services covered by such programs, the rates
paid to healthcare providers for their services, or the eligibility of providers
to  receive  reimbursement.  In  addition,  there can be no  assurance  that the
Company's facilities and the provisions of services by the Company in the future
will continue to meet the requirements for participation in Medicare or Medicaid
programs as presently enacted or as they may be changed.

   Governmental Regulation.  The long-term care industry is subject to extensive
federal,  state and local  licensure  and  certification  laws.  Long-term  care
facilities  and home health  agencies are subject to annual and routine  interim
inspections to monitor  compliance with governmental  regulations.  Certain laws
establish minimum healthcare  standards and provide for significant remedies for
non-compliance including fines, refunds of prior payments, new patient admission
moratoriums,   federal  or  state  monitoring  of  operations,  and  closure  of
facilities.

   The Company is also  subject to federal and state laws that govern  financial
and other arrangements involving healthcare providers. These laws often prohibit
certain  direct and  indirect  payments or  fee-splitting  arrangements  between
healthcare  providers  that are designed to induce or encourage  the referral of
patients  to,  or the  recommendation  of, a  particular  provider  for  medical
products and  services.  Possible  sanctions  for  violations of any of these or
similar restrictions or prohibitions, include loss of eligibility to participate
in reimbursement  programs, as well as civil and criminal penalties.  Changes in
interpretation  or manner of  enforcement  of these  laws or  regulations  could
adversely affect the Company.

   Dependence on California. A substantial portion of the Company's billings are
to the California Medicaid program, Medi-Cal. California has a less generous and


                                       15
<PAGE>

more heavily regulated  healthcare  reimbursement system that typically provides
for  lower  reimbursement  rates  than  do  a  majority  of  other  states. And,
California historically  has  enforced  its regulations more  strictly than most
other jurisdictions.  In addition,  California has  a higher applicable  minimum
wage and higher workers' compensation  costs than most other states. The Company
may  be  materially   and  adversely  affected   by  the  failure  of   Medi-Cal
reimbursement  rates  to  increase  in  proportion  to  cost  increases,  by any
reduction in the levels of reimbursement,  or by healthcare reform measures that
substantially increase its operating costs.  Further, there have been, and there
are  likely to continue to be, strong  legislative  pressures to avoid increases
in Medi-Cal  reimbursement levels and to impose reductions in such payments.

   Uncertainty  of  Litigation.  The Company  regularly  is made a defendant  in
lawsuits by or on behalf of patients at one or more of its facilities or to whom
healthcare services were provided seeking to recover for injuries sustained as a
result of alleged errors and  omissions.  Often these suits also allege that the
injuries resulted from intentional actions or omissions of healthcare  personnel
for whom the Company is asserted to have legal responsibility,  and consequently
seek awards of punitive damages. The Company also on a regular basis, is sued by
persons claiming that their employment by the Company was improperly terminated,
that they were denied  employment  or promotions  because of their race,  creed,
religion,  gender,  ethnic origin or sexual  orientation,  or that they suffered
sexual  harassment  or other  tortuous  conduct,  which  suits  seek  awards  of
compensatory,  incidental and punitive  damages.  Although the Company maintains
insurance  for its  professional  errors and  omissions,  it is not  insured for
damages  sustained  as a result of  intentional  torts  committed,  for punitive
damages or for awards of damages in wrongful  termination  cases.  The Company's
financial  condition and results of operations could be adversely  affected by a
significant award for damages that is not covered by insurance.

ITEM 2.  PROPERTIES

   The  following  table  sets  forth   information   regarding  the  healthcare
facilities owned or leased by the Company as of February 28, 1997:
<TABLE>
<CAPTION>
                                  Facilities                                    Beds
                   -----------------------------------------  ------------------------------------------
                    Owned     Leased     Managed     Total     Owned     Leased     Managed     Total
                   --------- --------- ------------ --------  --------- --------- ------------ ---------
<S>                <C>       <C>       <C>          <C>       <C>       <C>       <C>          <C>  
California               32        50            1       83      2,098     5,175          248     7,521
Ohio                      4         4           --        8        402       461           --       863
North Carolina            1        10           --       11         86     1,278           --     1,364
Tennessee                --         8           --        8         --     1,097           --     1,097
West Virginia             5         1           --        6        554        65           --       619
                   --------- --------- ------------ --------  --------- --------- ------------ ---------
                         42        73            1      116      3,140     8,076          248    11,464
                   ========= ========= ============ ========  ========= ========= ============ =========
</TABLE>

   Nine of the Company's healthcare facilities are encumbered by deeds of trusts
or mortgages.

   The Company's home health  subsidiaries,  Home Health Services,  Inc. and 
Americare  Homecare,  Inc. lease office space  aggregating 51,549 square feet 
for its 28 home health locations in California and Ohio.

   The Company's pharmacy subsidiaries,  First Class Pharmacy, Inc. and Assist-
A-Care,  Inc. lease approximately 51,934 square feet for its locations in 
California, North Carolina and Tennessee.

   The Company's  rehabilitation  subsidiary,  South Coast  Rehabilitation  
Services,  Inc. leases an 8,035 square foot office in Aliso Viejo, California.

                                       16
<PAGE>

   The Company  leases  office space  aggregating  65,608 square feet for its  
corporate  and regional  offices in California  and West Virginia.

   The  Company  also  leases  space  for  its  outpatient  clinics  aggregating
approximately 16,500 square feet in California.

   In the  facilities  that are leased,  subleased,  or managed,  the  Company's
rights as lessee or sublessee  could be subject to  termination if the lessor or
sublessor of a facility fails to pay its rent,  taxes, loan obligations that are
secured by the facility,  if any, or other similar obligations.  The Company has
not experienced any such lease terminations,  although there can be no assurance
that the Company's rights to operate its leased or subleased facilities will not
be so affected in the future.

   The Company's  facilities are subject to various  governmental zoning and use
restrictions.  One of the Company's  facilities  that provides  services for the
mentally  disordered is currently  operating pursuant to a deemed to be approved
conditional  use permit.  In July 1992, the facility filed an application  for a
conditional  use permit and is  currently  appealing  the recent  denial of said
application.  A mediator has been  appointed  to monitor  this matter.  Although
there can be no assurance,  the Company believes it will prevail with its appeal
and that the conditional use permit will be renewed.

ITEM 3.  LEGAL PROCEEDINGS

   In 1995, a class action  lawsuit,  captioned  Standish and Miriam Mallory and
Claire Bauman vs. Regency Health  Services,  Inc.,  which had been filed against
the Company in July 1994, was settled for $9,000,000.  The Company's  portion of
this settlement, together with related legal fees and other costs, resulted in a
pre-tax charge of $3,098,000, which is included in the consolidated statement of
operations for the year ended December 31, 1995.

   Additionally,  the Company is subject to claims and legal actions by patients
and  others in the  ordinary  course of  business.  The  Company  has  insurance
policies in varying  amounts  covering most of the  outstanding  lawsuits.  If a
judgment were awarded in excess of the insurance coverage, the burden would fall
on the  Company.  The Company  does not expect that the  ultimate  outcome of an
unfavorable  judgment  in any of the pending  legal  matters  would  result in a
material  adverse  effect on the Company's  consolidated  financial  position or
results of operations.  However,  there can be no assurances that an unfavorable
judgment in future claims and legal  actions  would not have a material  adverse
effect  on  the  Company's   consolidated   financial  position  or  results  of
operations.

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

   None.



                                       17
<PAGE>

                                     PART II

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

   The  Company's  common stock is traded under the symbol "RHS" on the New York
Stock Exchange.

   The  quarterly  price range of common stock for 1996 and 1995 are included on
page 47 of the 1996  Regency  Annual  Report under the caption "Stock Market 
Information" and are incorporated herein by reference.

   At February 28, 1997, 15,792,157 shares of Company common stock were held of
record by approximately  1,000 stockholders as reported by the Company's 
transfer agent.

   The Company has not declared or paid cash dividends on common stock since its
inception,  and does not  currently  plan to declare or pay any dividends in the
foreseeable  future.  Covenants in a note agreement  between the Company and its
lenders limit the payment of cash dividends on Company common stock.  Among such
restrictions  is a  provision  limiting  the  payment  of  dividends  and  other
restricted payments,  as defined, to no more than 50% of consolidated net income
from and after January 1, 1996, on a cumulative basis, plus $5,000,000.

ITEM 6.  SELECTED FINANCIAL DATA

   On  April 4,  1994,  Regency  and  Care  completed  their  merger  ("Merger")
accounted for as a pooling-of-interests.  Consequently, the historical financial
statements  for periods prior to the Merger are restated as though the companies
had been merged since  inception.  The  calculation of income per share for each
period  presented prior to the Merger reflects the issuance of .71 of a share of
Regency  common  stock for each share of common and common  equivalent  share of
Care common stock.

   The  following  consolidated  financial  data as of and for the  years  ended
December  31,  1996,  1995,  1994,  1993 and 1992,  have been  derived  from the
Company's audited Consolidated  Financial Statements.  The selected consolidated
financial  data set  forth  below  should  be read in  conjunction  with  Item 7
"Management's  Discussion  and  Analysis of Financial  Condition  and Results of
Operations" and with the Consolidated Financial Statements and the notes thereto
included elsewhere in this Report.
<TABLE>
<CAPTION>

                                                                  Year Ended December 31,
                                               --------------------------------------------------------------
                                                   1996 (2)   1995 (3)    1994 (4)      1993        1992 (5)
                                                   --------   --------    --------      ----        --------
                                                           (in thousands except per share data)
<S>                                                <C>        <C>         <C>         <C>           <C>     
Net operating revenue (1)....................      $558,050   $416,093    $377,336    $336,954      $295,340
Income (loss) before extraordinary item......         6,399      4,454       (800)      11,790        10,419
Net income (loss)............................         5,206      2,845       (800)      11,742        10,330
Income (loss) per common share before
   extraordinary item (fully diluted)........           .39        .27       (.05)         .69           .76
Net income (loss) per common share (fully
   diluted)..................................           .32        .17       (.05)         .69           .75
Total assets.................................       353,576    338,942     250,896     242,300       164,403
Total long-term debt.........................       184,908    183,986     101,941     103,245        53,638

------
<FN>

(1)  In 1994,  the  Company  changed  its  policy on  recognizing  revenue  from
     exception  requests  filed with the Health  Care  Financing  Administration
     ("HCFA"). Previously, no revenue was recognized until payment in respect of
     the exception  request was actually  received.  In 1994,  the Company began
     recognizing 50% of the estimated exception requests anticipated to be filed
     for the applicable  period. In 1995 and 1996, the Company recognized 70% of
     the  estimated  exception  requests  anticipated  to be  received  for  the
     applicable period.

                                       18
<PAGE>

(2)  In  1996,  the  Company  redeemed  all  $48.9  million  of its  outstanding
     Convertible  Subordinated  Debentures resulting in an extraordinary loss on
     extinguishment  of debt of $1,459,000  ($868,000 net of tax) and refinanced
     three of its Industrial Revenue Bond Issues (IRBs) with a principal balance
     of $7,560,000  resulting in an extraordinary loss of $546,000 ($325,000 net
     of tax). In addition,  the Company recorded an $11,283,000  ($6,769,000 net
     of tax) charge,  primarily related to severance,  the write-off of property
     which  will  have  no  value  under  the  Company's  new  operating  model,
     allowances for certain notes and non-patient receivables and a reduction of
     the reserve for assets held for sale recorded in 1995.

(3)  In 1995, a class action  lawsuit,  which had been filed against the Company
     in July 1994,  was settled for  $9,000,000.  The Company's  portion of this
     settlement, together with related legal fees and other costs, resulted in a
     pre-tax charge of $3,098,000  ($1,921,000 net of tax), which is included in
     the  consolidated  statement of operations  for the year ended December 31,
     1995. In addition, the Company repaid its $30 million, 8.10% Senior Secured
     Notes resulting in costs and a prepayment penalty of $2,681,000 ($1,609,000
     net of tax), classified as an extraordinary item and the Company recorded a
     $9,000,000  ($8,200,000  net  of  tax)  charge,  primarily  related  to the
     disposition   of  certain   facilities   (see  Note  14  to  the  Company's
     Consolidated Financial Statements).

(4) As required under the  pooling-of-interests  accounting method, all fees and
    expenses related to the Merger and  restructuring of the combined  companies
    were  reflected in the  Consolidated  Statement of Operations of the Company
    for the year ended  December  31,  1994,  resulting  in a pre-tax  charge of
    $14,700,000  ($10,600,000  net of  tax),  including  a  reserve  for  losses
    associated with the disposal of duplicate facilities.  Additionally, in 1994
    the Company recorded a pre-tax charge of approximately  $1,600,000 ($975,000
    net of tax) related to the closure of a facility  damaged by the Northridge,
    California earthquake in 1994.

(5) During  Care's  reorganization  period (prior to emergence  from  bankruptcy
    proceedings on December 31, 1990),  Care established a reserve for losses on
    discontinuance of certain operations.  These losses were originally included
    as part of an overall  provision/(credit)  for reorganization  items. During
    the year ended  December  31, 1992,  the Company  recognized  pre-tax  gains
    resulting from the reversal of reserves for losses on the  discontinuance of
    certain operations of $461,000 and the reversal of reserves for expenses and
    fees resulting from Care's Chapter 11 proceedings of $75,000.  Additionally,
    in 1992 the Company  recognized  a gain of  $1,000,000  on the disposal of a
    nursing facility.
</FN>
</TABLE>

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

Overview of Strategic Plan

   The healthcare  industry  continues to change as the  government,  commercial
payors and  healthcare  providers  like the Company  focus on rising  healthcare
costs.  It is the  Company's  belief,  as well as  that  of the  government  and
commercial payors, that the most effective delivery system for reducing costs is
a  regionally  oriented  market  based model  within the context of the evolving
managed  care  system.  Presently,  only  5.1%  of the  Company's  revenues  are
generated from managed care payors, however, management and other members of the
industry  believe the Medicare  system will be adopting a prospective pay system
in the coming years for skilled  nursing  facilities.  Furthermore,  the Company
believes more Medicare  participants will be entering managed care plans as they
typically offer more services at a fixed price.

   Considering the  anticipated  changes in the industry,  the Company  believes


                                       19
<PAGE>

that the most successful business strategy in the future will be to provide both
payors and patients, collectively the customers, cost effective delivery of care
with high  customer  satisfaction.  This will mean  significant  changes  in the
current  delivery  system.  The Company believes its future delivery system will
need to have the following components:

o   Focus on customers  through a fully  integrated  delivery  system which will
    allow for  "one-stop  shopping".  This means that the Company  will need  to
    provide  multiple low cost services across the continuum of care in each  of
    the regions in which it provides  care.  In the future,  acquisitions   will
    focus on  completing  the  continuum of care  within the  Company's  various
    regional markets.
o   Name  recognition as customers  must be convinced that the Company  provides
    consistent  service  throughout the continuum of care.  
o   Regionally  focus to ensure that  diverse  services  are  available  in each
    market and that those services are integrated  rather  than  the traditional
    focus on separate business lines.
o   Focus on placing the patient in the most  effective  setting with the lowest
    cost while  demonstrating  positive  outcomes from the delivery of  medicine
    and care.  Basically,  the  Company  will  strive  to provide  high  quality
    service across the continuum of care at a low cost.
o   Focus on a low overhead cost structure. Reengineering to eliminate non-value
    added services and  investments in information  technology  will be required
    in order to reduce  costs and  enable the  Company  to  provide  consistent,
    integrated,  low cost services.  The  investment in  information  technology
    will also provide  management  critical  information  in  a timely manner to
    effectively manage its business in the managed care environment.

   During 1996 the Company  developed and began to implement its strategic  plan
to address these issues. In connection with this plan, the Company acquired four
acute rehabilitation  hospitals,  ten outpatient  rehabilitation clinics and six
neurological treatment centers effective January 1, 1997. The purchase price was
$43.0  million,  made up of a cash  payment of $36.3  million and notes  payable
totaling $6.7 million.  This  acquisition was one of many steps in the Company's
plan to complete the  continuum  of care in its various  regional  markets.  The
Company has also hired two individuals with extensive experience in acquisitions
to focus on the  acquisition  of home health  agencies and  outpatient  clinics,
primarily in our existing nursing  operations  markets to complete the continuum
of care in those markets.

   During 1996, the Company  recorded a  restructuring  and other  non-recurring
charge of $11.3 million primarily related to initiatives  designed to reengineer
the operating model through which the Company manages its business and lower its
operating  costs.  Also included in the charge were amounts for  consulting  and
other obligations for which there is no future benefit, reductions in the assets
held for sale reserve  established  in 1995,  additional  reserves for notes and
non-patient  receivables  and a charge  for the  impairment  of other  long-term
assets.

   A major component of the reengineering, in terms of importance and cost, will
involve  integrating  the  Company's   information  systems  to  allow  for  the
integrated  delivery  of  patient  care  across  all  service  lines  within the
continuum of care. The Company will therefore be making a significant investment
in information  technology over the next five years. This investment will result
in cost savings in the future.  The first phase of the investment in information
technology will be investments in the  infrastructure  such as a  communications
network and servers combined with upgrades of the accounts payable software, the
acquisition  of Kronos  time  clocks and other  transaction  systems,  which are
expected to be completed  during 1997. The second phase will be the  integration
of the various computer  systems used by the different  divisions of the Company
to allow for a seamless  transfer of patient care information  across the entire
continuum of care. The  integration of the various  systems is expected to begin
during 1998.

   The Company incurs certain costs and operating  inefficiencies  in connection
with  acquisitions  following such  acquisition,  relating to the integration of
such facility's financial and administrative  systems,  physical plant and other
aspects  of  its  operations  into  those  of  the  Company.  In  addition,  the
introduction of a substantial  portion of the Company's contract  rehabilitation
therapy,  pharmacy and other  ancillary  services to a new operation may take as
long as 12 months to fully implement. There can be no assurance that each of the


                                       20
<PAGE>

service providers the Company may acquire will be profitable. In addition, there
can be no assurance that new acquisitions that result in significant integration
costs and inefficiencies will not adversely affect the Company's profitability.

General

   In connection with the strategy and acquisitions discussed above, the Company
has created the Regency  Rehabilitation  and Specialty  Services  Division which
includes the Acute Rehabilitation  Hospitals (and related outpatient clinics and
neurological treatment centers), the Contract  Rehabilitation Therapy Operations
and future outpatient clinic acquisitions.

   The following table sets forth certain  operating data for the Company on the
dates indicated:
<TABLE>
<CAPTION>

                                          February 28,       December 31,
                                             1997      1996     1995       1994
<S>                                         <C>       <C>      <C>        <C>
Nursing center operations
     Facilities............................    106       107      94         93
     Licensed beds......................... 11,119    11,200   9,178      9,134
     Subacute beds.........................  1,108     1,108   1,040        879
     Subacute units........................     46        46      42         35

Regency rehabilitation and specialty services
division

  Acute rehabilitation operations
     Rehabilitation hospitals..............      4        --      --         --
     Neurological centers..................      6        --      --         --
     Licensed beds.........................    345        --      --         --
     Outpatient clinics....................     10        --      --         --

  Contract rehabilitation therapy operations
     Non-affiliated facilities served......    116       114      79         --
     Regency operated facilities served....     63        57      27         --
                                            =======   =======  =======   =======  
      Total................................    179       171     106         --
                                            =======   =======  =======   =======

Pharmacy operations
     Non-affiliated facilities served.......    84        84       5          5
     Regency operated facilities served.....    70        68      36         34
                                            =======   =======  =======   =======
      Total.................................   154       152      41         39
                                            =======   =======  =======   =======

Home health agencies........................    28        29      29         28
</TABLE>

Nursing Center Operations

         The Company's nursing center  operations  derive  net operating revenue
from  the  performance  of  routine  and  ancillary  services  at  the Company's
facilities.  Revenue from  routine services is comprised of charges for room and
board and basic nursing  services for  the care of patients, including  those in
the  Company's  subacute  specialty  units. Revenue  from  ancillary services is
comprised  of  charges for rehabilitative services, subacute specialty services,
and pharmaceutical  products and services provided to patients at the  Company's
facilities.  Nursing  center  operations  derive most of its ancillary  services
revenue from  Medicare- and  HMO-eligible  patients.  The Company has classified
revenue from nursing  center  operations as either basic nursing care revenue or
subacute revenue. Basic nursing care revenue includes charges for room and board


                                       21
<PAGE>

for non-Medicare and non-HMO patients.  Subacute revenue includes room and board
and basic  nursing  services for Medicare and HMO patients and revenues from all
ancillary services provided to patients at the Company's facilities.

   Effective  July 1, 1994,  the  Company  elected to dispose of two  healthcare
facilities due to excess  capacity in certain  markets caused by the Regency and
Care merger (the "Merger") and to dispose of a residential  facility operated by
Care (the  "Dispositions").  The Company  established a $2.7 million  reserve in
1994 related to these  dispositions,  which  consisted  of a  write-down  of the
assets  to  estimated  fair  value,  transaction  costs,  and  a  provision  for
anticipated operating losses to the time the transactions were completed.  These
facilities  were  disposed  of in 1995 and the  results of  operations  of these
facilities  since  July 1,  1994  are not  reflected  in the  operations  of the
Company.

   During 1995 the Company  exchanged  leasehold  interests in three  healthcare
facilities  with  360  beds  in New  Mexico  for  leasehold  interests  in  four
healthcare  facilities  with 461 beds in Ohio  previously  operated  by  another
company.  In 1995,  the Company  also opened a newly  constructed  facility  and
disposed of one additional facility.

   Effective  December  31,  1995,  the  Company  determined  to  dispose  of 13
facilities  located in California as part of its strategic plan of  diversifying
from California Medicaid. The results of operations of these facilities continue
to be reflected in the Company's financial  statements until each disposition is
completed.  During 1996 the  Company  disposed  of six of these  facilities.  On
January 1, 1997 the Company disposed of one additional facility.

   Effective  February 1, 1996,  the  Company  acquired 18 healthcare facilities
with 2,375  beds in  Tennessee  and  North  Carolina,  accounted  for  under the
purchase method of accounting.

   Effective April 1, 1996, the Company  acquired a healthcare  facility with 64
nursing beds and 22 assisted  living beds located in Lexington,  North Carolina,
accounted for under the purchase method of accounting.

Ancillary Businesses Operations

   In July 1995,  the  Company  acquired  SCRS &  Communicology,  Inc.  ("SCRS")
accounted  for  under  the  purchase   method  of   accounting.   SCRS  provides
rehabilitation   services  to  Company   operated  and  third  party  healthcare
facilities  in 12 states  in the  West,  Midwest,  and  Southeast.  From July to
December  1995,  79% of SCRS  revenues were derived from  providing  services to
non-affiliated  healthcare  providers.  Two non-affiliated  healthcare providers
represented  approximately 38% of SCRS total revenues from July to December 1995
and  approximately  24% in 1996. In 1996, 70% of SCRS revenues were derived from
providing services to non-affiliated healthcare providers.

   The Company's  pharmacy  operations provide  prescription  services and basic
pharmaceutical  dispensing  programs  to  Company  and  third  party  healthcare
facilities.  During 1995, 55% of revenues from pharmacy  operations were derived
from providing services to non-affiliated  healthcare  providers and patients at
Regency  facilities  billed  directly  to  third-party  payors.  In January  and
February of 1996, the Company  acquired  three  additional  pharmacy  operations
accounted for under the purchase  method of accounting.  During 1996, 65% of the
revenues  of  pharmacy  operations  were  derived  from  providing  services  to
non-affiliated  healthcare  providers and patients at Regency  facilities billed
directly to third party payors.

   The Company's home health operations provide skilled nursing,  rehabilitation
and other  services in selected  areas in California  and Ohio.  The Company has
positioned its home healthcare capabilities to serve its facilities' home health
needs.   During  January  1997,  two  of  the  home  healthcare   agencies  were
consolidated resulting in a reduction of one agency.

                                       22
<PAGE>

Results of Operations

   The  following  table sets  forth the  amounts  of  certain  elements  of net
operating  revenue and the  percentage  of total net  operating  revenue for the
periods presented:
<TABLE>

                                                            Year ended December 31,
                                              1996                    1995                   1994
                                      ----------------------  ---------------------  ---------------------
                                      (Dollars in thousands)
<S>                                      <C>         <C>        <C>         <C>        <C>         <C> 
Basic nursing care.................      $285,819     51%       $227,243     55%       $216,623     58%
Subacute...........................       169,664     31         134,601     32         129,663     34
                                      ------------  --------  -----------  --------  -----------  --------
    Total nursing center operations       455,483     82         361,844     87         346,286     92
Contract rehabilitation therapy
  operations to non-affiliates (1).        42,577      8          12,240      3              --     --
Pharmacy operations to                     21,994      4           7,157      2           4,697      1
  non-affiliates (2)...............
Home healthcare operations.........        35,302      6          31,792      7          24,456      6
Interest...........................         2,694     --           3,060      1           1,897      1
                                      ============  ========  ===========  ========  ===========  ========
     Total.........................      $558,050    100%       $416,093    100%       $377,336    100%
                                      ============  ========  ===========  ========  ===========  ========
<FN>

(1) Net of  intercompany  billings of  $18,004,000  and $3,267,000 for the years
ended December 31, 1996 and 1995, respectively.

(2) Net of intercompany  billings of  $11,912,000,  $5,971,000,  and $5,107,000,
for the years ended December 31, 1996, 1995 and 1994,
    respectively.
</FN>
</TABLE>

   The following table sets forth certain operating data for the Company for the
periods presented:

<TABLE>
<CAPTION>
                                                    Year ended December 31,
                                                1996         1995         1994
                                             ---------    --------    ----------
<S>                                         <C>          <C>          <C>
     Patient Days by Payor:
        Medicare...........................   307,313      244,729      239,003
        Private/Other......................   760,992      678,310      708,477
        Managed Care.......................   116,508       94,072       72,065
        Medicaid........................... 2,476,530    1,905,571    1,926,451
                                            =========    =========    ==========
           Total........................... 3,661,343    2,922,682    2,945,996
                                            =========    =========    ==========

     Home Health Visits....................   253,855      260,526      217,662
     Home Health Hours (1).................   448,717      395,871           --

     Revenue Mix:
        Medicare...........................     29.3%        31.9%        31.3%
        Private/Other......................     25.0%        22.8%        21.4%
        Managed Care.......................      5.1%         5.4%         4.6%
        Medicaid...........................     40.6%        39.9%        42.7%
<FN>

      (1) Information not compiled in 1994.
</FN>
</TABLE>






                                       23
<PAGE>

   The  following  table  presents  the  percentage  of  net  operating  revenue
represented by certain items reflected in the Company's Consolidated  Statements
of Operations for the periods indicated:
<TABLE>
<CAPTION>

                                                For the year ended December 31,
                                                   1996       1995        1994
                                                  ------     ------      ------

<S>                                               <C>        <C>         <C>   
Net operating revenue.............................100.0%     100.0%      100.0%
                                                  ------     ------      ------
Costs and expenses:
   Operating expenses............................. 81.2       80.7        81.6
   Corporate general and administrative...........  4.4        4.8         5.1
   Rent expense...................................  4.5        4.0         4.1
   Depreciation and amortization..................  2.7        2.4         2.5
   Interest expense...............................  3.2        2.3         2.1
   Merger and restructuring expenses..............   --         --         3.9
   Class action lawsuit settlement................   --        0.8          --
   Restructuring and other non-recurring charges..  2.0        2.2         0.4
                                                  ------     ------      ------

                   Total costs and expenses....... 98.0       97.2        99.7
                                                  ======     ======      ======
   Income before provision for income taxes and
      extraordinary item..........................  2.0%       2.8%        0.3%
                                                  ======     ======      ======
</TABLE>
Fiscal Year  Comparison 1996 to 1995

Net Operating Revenue

   The Company's net  operating  revenue for the fiscal year ended  December 31,
1996  ("Fiscal  1996") was $558.1  million  compared  to $416.1  million for the
fiscal year ended  December  31,  1995  ("Fiscal  1995"),  an increase of $142.0
million or 34.1%.

   Net operating revenue from nursing center operations  increased $93.7 million
or 25.9% to $455.5  million  from $361.8  million  primarily  due to revenues of
$78.8 million from the 1996 acquisition of 19 nursing facilities and an increase
in same  store  revenues  (including  the  impact  of sold  buildings)  of $14.9
million.  The increase in same store  revenues  (excluding  sold  buildings) was
primarily  due to an increase in patient days of 3.9% and an increase in average
rates  per  patient  day of  5.7%,  on a  same  store  basis.  The  increase  in
reimbursement  rates per  patient  day of 5.7% was  primarily  due to  providing
services to higher acuity  patients,  an increase in the Medi-Cal  reimbursement
rates beginning in August 1996 and the Company  recognizing  revenues associated
with the  elimination  of the  Medicare  Routine  Cost Limit (RCL)  inflationary
freeze.  The  increase  in  services  provided  to  higher  acuity  patients  is
demonstrated  by the  shift in payor mix on a same  store  basis  from  Medicaid
(43.2% to 42.3%) and  private and other  (20.4% to 19.5%) to Medicare  (30.1% to
31.1%) and managed care (6.2% to 7.0%).  The Medi-Cal  rate  increases in August
1996 resulted in approximately $1.0 million in revenues.  The revenue associated
with the elimination of the RCL inflationary freeze totaled $1.5 million.

   Net operating  revenue from  contract  rehabilitation  therapy  operations to
non-affiliates increased $30.3 million or 247.8% in 1996 over 1995 primarily due
to the operations of SCRS being included for the full year in 1996 versus a half
year in 1995 and an increase in the number of  non-affiliated  facilities served
to 114 in 1996 from 79 in 1995. Net operating  revenue from pharmacy  operations
to  non-affiliates  and services to patients in the Company's  facilities billed
directly to third parties  increased  $14.8 million or 207.3% in 1996 over 1995,
primarily due to the acquisitions of Assist-A-Care  pharmacy in January 1996 and
Executive Pharmacy in February 1996 (collectively, the "Pharmacy Acquisitions").
Net operating  revenue from the pharmacy  acquisitions was  approximately  $12.0
million in 1996. Net operating revenue from home healthcare operations grew $3.5
million or 11.0% in 1996 over 1995  primarily  due to an increase  in  treatment
hours from  395,871 in 1995 to 448,717 in 1996 and an  increase  in revenue  per
visit.

                                       24
<PAGE>

Costs and Expenses

   Total costs  and  expenses  increased  $142.7  million  or  35.3%  to  $547.0
million (98.0% of net operating  revenue) in 1996 from $404.3  million (97.2% of
net operating revenue) in 1995.

   Operating  expenses as a percentage of net operating  revenue  increased from
80.7% in 1995 to 81.2% in 1996.  The increase  resulted  from the  incurrence of
increased labor costs in the nursing center operations while reimbursement rates
per  patient day for room and board  charges  remained  relatively  flat for the
Medi-Cal and Medicare  systems during the first and second  quarters of 1996. In
addition, the home health agencies participating in the Medicare Prospective Pay
System pilot project  beginning in 1996 did not  adequately  reduce costs at the
outset of this  program  in the first  quarter  of 1996.  The  Company  made the
necessary cost reductions  during the second and third quarters and realized the
benefits of the Medi-Cal rate  increases and the  elimination  of the RCL freeze
discussed  above in the third and fourth  quarters.  For the  fourth  quarter of
1996, operating costs as a percentage of revenue were 80.3%.

   Corporate general and  administrative  expense is the corporate  overhead and
regional costs related to the supervision of operations.  The expense  increased
from  $19.8  million  in 1995 to  $24.3  million  in 1996 due  primarily  to the
acquisition  of  18  healthcare  facilities  effective  February  1,  1996,  the
acquisition of one healthcare  facility effective April 1, 1996 and the Pharmacy
Acquisitions  (collectively,  the "1996  Acquisitions").  However,  this expense
decreased  as a  percentage  of revenue  from 4.8% in 1995 to 4.4% in 1996.  The
decrease as a percentage  of revenue is  attributed  to  achieving  economies of
scale through  acquisition,  the reduction of certain  corporate office expenses
and same store growth.

   Rent  expense as a  percentage  of  revenue  increased  from  4.0% in 1995 to
4.5% in 1996  primarily  due to the  assumption  of lease obligations  from  the
1996 Acquisitions.

   Depreciation  and  amortization  expense  as a  percentage  of net  operating
revenue  increased to 2.7% in 1996 from 2.4% in 1995  primarily  due to goodwill
amortization  related  to the  purchase  of  SCRS  in July  1995  and  the  1996
Acquisitions.

   Interest expense  increased as a percentage of net operating  revenue to 3.2%
in 1996 from 2.3% in 1995 primarily due to the Company issuing the 9 7/8% Senior
Subordinated Notes (the "Senior  Subordinated  Notes") in October 1995 partially
offset by the repayment of the 8.1% Senior Secured Notes in that month,  as well
as the issuance of the 12 (0)% Subordinated  Notes in June 1996 partially offset
by the repayment of the 6 (OMEGA)% Convertible  Subordinated  Debentures in July
1996.

   In Fiscal 1995,  the Company  settled its class action  lawsuit  resulting in
a pre-tax  charge of $3.1 million ($1.9 million net of taxes).

   As discussed  above,  the Company  began  the  transition from development to
the implementation of its strategic  plan  to  achieve lower operating costs and
offer an integrated delivery system during Fiscal 1996.  Initiatives  associated
with the restructuring  include:  making a significant investment in information
technology;   integrating   divisional   operations   within  regional  markets;
consolidating   and   automating   the   pharmacy   operations;   reducing   the
administrative  costs  within the home  healthcare  operations;  automating  and
streamlining  certain functions within the nursing operations;  and streamlining
the corporate support structure.  As a result of these  initiatives,  during the
fourth  quarter  of 1996 the  Company  recorded a  restructuring  charge of $6.6
million  ($4.0  million  after tax).  The Company  also  recorded  non-recurring
charges  related to consulting  fees owed for which there is no future  benefit,
the  establishment  of  additional  reserves for certain  notes and  non-patient
receivables, the impairment of certain other long-term assets and a reduction of
the assets held for sale reserve  established in 1995 in an aggregate  amount of
$4.7 million ($2.8 million after tax).

   In Fiscal 1996, the Company recorded an extraordinary charge of $1.2 million,
net  of  tax,  resulting  from  the  redemption  of  all  $48.9  million  of the
outstanding  Convertible  Subordinated  Debentures  and the  refinancing  of the


                                       25
<PAGE>

Industrial  Revenue  Bond  Issues  (IRBs).  The  redemption  of the  Convertible
Subordinated Debentures produced an extraordinary loss on extinguishment of debt
of  $868,000,   net  of  tax,  resulting  from  the  write  off  of  unamortized
underwriting  costs and the refinancing of the IRBs resulted in an extraordinary
loss on extinguishment of debt of $325,000 net of tax,  resulting from the write
off of unamortized  underwriting  costs and a call premium paid. In Fiscal 1995,
the Company repaid its $30.0 million  Senior  Secured Notes,  resulting in costs
and a prepayment  penalty  totaling  $2.7 million  ($1.6  million net of taxes),
classified as an extraordinary item.

Fiscal Year Comparison 1995 to 1994

Net Operating Revenue

   The  Company's  net  operating  revenue  for Fiscal  1995 was $416.1  million
compared to $377.3  million for the fiscal year ended December 31, 1994 ("Fiscal
1994"), an increase of $38.8 million or 10.3%.

   Net operating revenue from nursing operations increased $15.6 million or 4.5%
due to increased levels of reimbursement  and a shift in payor mix from Medicaid
to Medicare and managed  care,  partially  offset by a slight  decrease in total
patient days.  The average  increase in  reimbursement  rates for all payors was
5.3% and was primarily due to providing services to higher acuity patients.  The
Company  experienced  a 0.8% net  decrease in total  patient days in Fiscal 1995
from Fiscal 1994,  consisting  of a decrease of 20,880 and 30,167 from  Medicaid
and private and other sources, respectively, and an increase of 5,726 and 22,007
from Medicare and managed care, respectively.

   Net operating  revenue from home health operations grew $7.3 million or 30.0%
in Fiscal 1995 over Fiscal 1994, primarily reflecting additional patient visits.
Pharmacy operations revenues increased $2.5 million or 52.4% in Fiscal 1995 over
Fiscal 1994,  primarily as a result of increased  pharmacy  services provided to
patients  serviced  in the  Company's  facilities  and  billed  directly  to the
appropriate  payors and not the facility.  Net  operating  revenue from contract
rehabilitation  therapy  operations are a result of the purchase of SCRS in July
1995.

   Interest income increased $1.2 million in Fiscal 1995 over Fiscal 1994 due to
investment of proceeds from the issuance of the Senior  Subordinated Notes in an
aggregate amount of $110.0 million in October 1995.

Costs and Expenses

   Total costs and expenses for Fiscal 1995 increased $28.2 million, or 7.5%, to
$404.3  million  (97.2% of net operating  revenue) from $376.1 million (99.7% of
net  operating  revenue)  for Fiscal  1994.  This  decrease  in total  costs and
expenses as a percentage  of revenues  was  primarily a result of the merger and
restructuring  expenses  incurred in Fiscal 1994,  partially offset by the class
action  lawsuit  settlement  and the  additional  disposition  of assets  charge
recorded in Fiscal 1995. Excluding these non-recurring expenses, total costs and
expenses  increased to $392.2 million (94.3% of net operating revenue) in Fiscal
1995 from  $359.9  million  (95.4% of net  operating  revenue)  in Fiscal  1994,
primarily as a result of providing more services to patients.

   Operating  expenses as a percentage  of net  operating  revenue  decreased to
80.7% for Fiscal 1995,  from 81.6% for Fiscal 1994.  This decline was  primarily
attributable  to  growth  in the  Company's  higher  margin  businesses  such as
subacute care, contract  rehabilitation  therapy and pharmacy services in Fiscal
1995.

   Corporate general and administrative  expense increased $0.4 million, or 2.2%
from  Fiscal  1994 to Fiscal  1995,  while  decreasing  as a  percentage  of net
operating  revenue  to 4.8% for Fiscal  1995,  from 5.1% for  Fiscal  1994.  The
decrease as a percentage of revenues was attributable to the Company's achieving
12 months of economies of scale in 1995 by eliminating duplicate costs after the
Merger in 1994.

                                       26
<PAGE>

   Interest expense as a percentage of net operating  revenue  increased to 2.3%
in Fiscal 1995 from 2.1% in Fiscal 1994,  primarily as a  result of the issuance
of the Senior Subordinated Notes  in October 1995.

   As a result of the Merger,  in Fiscal 1994, the Company accrued $14.7 million
($10.6  million  net of taxes) of  estimated  fees and  expenses  related to the
transaction as required under the  pooling-of-interests  accounting  method.  No
comparable fees and expenses were incurred during Fiscal 1995.

   In Fiscal 1995,  the Company  settled its class action  lawsuit  resulting in
a pre-tax  charge of $3.1 million ($1.9 million net of taxes).

   In  Fiscal  1995,  the  Company   completed  the  disposition  of  previously
identified  facilities  and  determined  to dispose of an  additional 13 nursing
facilities  located in California,  resulting in an additional pre-tax charge of
$9.0 million ($8.2 million net of taxes). In Fiscal 1994, the Company incurred a
loss of $1.6 million ($1.0 million net of taxes)  resulting  from closure of one
facility  which  was  substantially  damaged  in the  January  1994  Northridge,
California earthquake, and the abandonment of its leasehold interest.

   In Fiscal 1995,  the Company  repaid its $30.0 million  Senior Secured Notes,
resulting in costs and a prepayment  penalty totaling $2.7 million ($1.6 million
net of taxes), classified as an extraordinary item.

Liquidity and Capital Resources

   Working capital at December 31, 1996 decreased $50.0 million to $67.2 million
(including  cash and cash  equivalents  of $22.9  million)  from $117.2  million
(including  cash and cash  equivalents of $104.2  million) at December 31, 1995.
The  decrease  was  primarily  attributable  to  funding  the 1996  Acquisitions
(including funding of working capital), funding of a workers' compensation trust
and the purchase of treasury stock. The Company established a revocable workers'
compensation  claims  payment  trust  to  pre-fund  its  workers'   compensation
obligations  which was funded for Fiscal  1995 in March 1996 with  approximately
$10.6 million from available cash. The Company anticipates funding an additional
$5 million to $6 million in March of 1997.  During  Fiscal 1996,  the  Company's
receivables increased  approximately $29.7 million primarily related to the 1996
Acquisitions  and growth in  ancillary  businesses.  The  estimated  third party
settlements increased by $9.4 million partially due to recording revenue related
to RCL exceptions  and the  elimination of the RCL  inflationary  freeze.  As of
December 31, 1996 and 1995,  the Company had RCL exception  request  receivables
totaling $8.1 million and $4.5 million, respectively.

   The Company's  major  requirements  for liquidity  relate to funding  working
capital,  capital improvements,  and debt service obligations.  The Company must
also  provide  funding  to  cover  potential  delays,  temporary  cessations  or
interruption  in payments by  third-party  payors due to  political or budgetary
constraints. In addition, as part of its strategic plan, the Company anticipates
investing approximately $40 million in information technology over the next five
years.  A  significant  portion  of this  investment  will be  financed  through
operating leases. Management believes that these liquidity needs can be met from
available cash, internally generated funds and existing borrowing capacity under
the NationsBank credit agreement (discussed below).

   The  Company's   healthcare   facilities  require  capital  improvements  for
renovations and improvements in physical appearance. Future capital improvements
may be required as a result of routine regulatory inspections.  In addition, the
Company is and will continue to invest in improving its information systems. The
Company's  capital  expenditures  for the years ended December 31, 1996 and 1995
were approximately $12.6 million and $14.2 million, respectively.  These capital
expenditures  have been financed  through a combination of internally  generated
funds and debt. The Company expects to spend approximately an aggregate of $14.0
million for capital  expenditures  during 1997 to be financed through borrowings
under the NationsBank  credit  agreement  (discussed  below) and funds generated
from operations.

                                       27
<PAGE>

   The Company has financed its  acquisitions  from a combination  of borrowings
and funds  generated  by  operations.  The  Company  expects to  finance  future
acquisitions  from a  combination  of  existing  cash,  the  NationsBank  credit
agreement  (discussed  below)  and  alternative  sources  such  as  real  estate
investment  trusts.  Depending  on the  numbers,  size  and  timing  of any such
transactions,  the Company may in the future  require  additional  financing  in
order to continue to make acquisitions.

   During 1996, the Company  purchased 862,000 shares of Company common stock at
an average price of $9.56 per share. The  transactions,  accounted for using the
cost method, reduced stockholders' equity by $8.3 million.

   On June 28, 1996 the Company issued 12(0)% Junior Subordinated Notes ("Junior
Subordinated  Notes") in an  aggregate  amount of $50  million.  Interest on the
Notes  will be  payable  semi-annually  on  January 15 and July 15 of each year,
commencing  January 15, 1997. The Junior  Subordinated Notes will mature on July
15, 2003,  unless  previously  redeemed.  Net  proceeds  received by the Company
totaled  approximately  $48.4 million and funded the redemption of the Company's
outstanding 6(OMEGA)% Convertible  Subordinated  Debentures due 2003 on July 29,
1996 (see Note 3 to the Consolidated Financial Statements).

   Effective  September 30, 1996, the Company refinanced three of its Industrial
Revenue Bond Issues (IRBs) with an aggregate  outstanding  principal  balance of
$7,560,000 with three new issues of tax exempt IRBs maturing  through  September
2012.  One of the new issues bears  interest at rates  ranging from 4.2% to 6.0%
based on the maturity  dates of the  individual  bonds.  The other two IRBs bear
interest at a variable rate initially set at 4.0%, which is capped at 12.0% (see
Note 3 to the Consolidated  Financial  Statements).  The IRBs are now secured by
irrevocable letters of credit rather than mortgages on the specific facilities.

   In Fiscal 1996, the Company recorded an extraordinary  charge of $1.2 million
resulting  from  the  redemption  of  all  $48.9  million  of  the   outstanding
Convertible  Subordinated  Debentures  and  the  refinancing  of the  IRBs.  The
redemption of the Convertible  Subordinated Debentures produced an extraordinary
loss on extinguishment of debt of $868,000, net of tax, resulting from the write
off of unamortized  underwriting  costs and the refinancing of the IRBs resulted
in an  extraordinary  loss on  extinguishment  of debt of  $325,000  net of tax,
resulting  from the  write  off of  unamortized  underwriting  costs  and a call
premium paid.

   On  December  28,  1995 the  Company  entered  into a  revolving  credit loan
agreement  ("Credit  Agreement") with NationsBank of Texas,  N.A. as agent for a
group of banks,  which  provided up to $50 million in a revolving line of credit
and  letters of credit.  No  borrowings  were drawn on the Credit  Agreement  at
December  31, 1995 and  throughout  1996.  On  December  20,  1996,  the Company
increased the available  financing to $100 million and revised certain terms and
covenants  through the Amended and Restated Credit  Agreement  ("Amended  Credit
Agreement"). Borrowings bear interest at either the Base Rate plus up to .50% or
the Adjusted  Eurodollar  Rate plus .75% to 2.00%,  depending  on the  Company's
Consolidated  Adjusted  Leverage  Ratio,  all as defined in the  Amended  Credit
Agreement.  The Amended Credit Agreement has scheduled commitment  reductions of
$25 million each on January 2, 1999 and 2000 and expires on January 2, 2001. The
Amended Credit Agreement is  collateralized by accounts  receivable,  all of the
common stock of each of the  Company's  subsidiaries  and certain  other current
assets of the Company and its subsidiaries.  The Amended Credit Agreement, among
other things, (a) requires the Company to maintain certain financial ratios, and
(b) restricts the Company's  ability to incur debt and liens,  make investments,
pay dividends,  purchase  treasury  stock,  prepay or modify certain debt of the
Company,  liquidate or dispose of assets,  merge with another  corporation,  and
create or acquire  subsidiaries.  As of  December  31,  1996,  $16.2  million of
standby  letters  of  credit  were  issued  in  connection  with  the  Company's
self-insured  workers'  compensation  programs and refinanced Industrial Revenue
Bonds (discussed  above) out of a total available of $35 million.  On January 2,
1997 the  Company  borrowed  $40  million  under the  Amended  Credit  Agreement
principally to fund the acquisition of four acute rehabilitation  hospitals, ten
outpatient  rehabilitation  clinics and six neurological  treatment  centers for
$36.3 million in cash and notes payable totaling $6.7 million.

                                       28
<PAGE>

   In October 1995,  the Company issued the  Subordinated  Notes in an aggregate
amount of $110  million.  Interest  on the  Subordinated  Notes  will be payable
semi-annually  commencing  April 15,  1996.  The  Subordinated  Notes  mature on
October 15, 2002,  unless previously  redeemed.  The net proceeds to the Company
were approximately  $106.7 million,  of which  approximately  $31.5 million were
used to repay the principal and  prepayment  penalty on the 8.1% Senior  Secured
Notes and $47.4  million was used for  acquisitions  subsequent  to December 31,
1995 (see Notes 3 and 13 to the Company's Consolidated Financial Statements).

Seasonality

   The  Company's  income  from  operations   before  fixed  charges   generally
fluctuates  from  quarter  to  quarter.  The  fluctuation  is related to several
factors: the timing of Medicaid rate increases,  seasonal census cycles, and the
number of calendar days in a given quarter.  As a result,  the Company's  income
from operations  before fixed charges tends to be higher in its third and fourth
quarters when compared to the first and second quarters.

Impact of Inflation

   The healthcare  industry is labor intensive.  Wages and other labor costs are
especially sensitive to inflation. Increases in wages and other labor costs as a
result of  inflation,  or increases in federal or state  minimum wages without a
corresponding  increase in Medicare  and  Medicaid  reimbursement  rates,  could
adversely impact the Company.

Reimbursement

   The majority of the Company's net operating  revenue is derived from services
provided under the Medicare and Medicaid  programs.  Numerous proposals relating
to  healthcare  reform  have  been or may be  introduced  in the  United  States
Congress,  state  legislatures  or by  governmental  agencies  who  regulate the
Medicare and Medicaid  programs.  It is uncertain what reform will ultimately be
enacted by the federal government, any state government or governmental agencies
and therefore, the Company cannot predict at this time the impact on the Company
of any proposed reforms.

   As discussed above, the Company provides contract rehabilitation and pharmacy
services to both Regency operated and non-affiliated  facilities.  Under current
Medicare  regulations,  reimbursement  for these  services  provided to Medicare
eligible patients in Regency  facilities is based upon the related entity's cost
to provide the services  unless a  significant  portion of the related  entity's
revenues are derived from non-affiliated facilities. If a significant portion of
the related  entity's  revenues  are  derived  from  non-affiliated  facilities,
Medicare will reimburse the facility's cost, which includes a profit paid to the
related  entity.  During 1995 and prior  years,  the Company was  reimbursed  by
Medicare  based  on  its  pharmacy   operation  costs  on  billings  to  Regency
facilities,  as it did not meet the  significant  portion  criteria.  After  the
acquisition  of  Assist-A-Care  Pharmacy  and  Executive  Pharmacy in 1996,  the
Company  believes it meets the significant  portion  criteria and is recording a
profit on billings for pharmacy  services provided to Medicare eligible patients
in Regency  facilities.  The Company  believes it meets the significant  portion
criteria for its contract  rehabilitation  therapy operations  provided by SCRS,
and therefore has recorded a profit on billings to Regency  facilities since the
acquisition of SCRS. Medicare regulations do not define a "significant portion,"
therefore,  the Company's and  Medicare's  interpretations  could differ,  which
could  result in  retroactive  adjustments  related to the profit on billings to
Regency facilities for pharmacy and contract rehabilitation services.

   In the federal budget deficit reduction bill, various reimbursement rules and
regulations were adopted by the federal  government that pertain to the Company.
The changes to  regulations  promulgated  under OBRA,  some of which  expand the
remedies   available  to  enforce   regulations   mandating  minimum  healthcare
standards,  may have an adverse effect on the Company's operations.  The Company
is unable to predict the  particular  effect on the Company  until the manner in
which these regulations are implemented becomes known.

                                       29
<PAGE>

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Index to Financial Statements and Supplementary Data

    Report of Independent Public Accountants.............................. 31

    Consolidated Balance Sheets as of December 31, 1996 and 1995.......... 32

    Consolidated Statements of Operations for the Years Ended
       December 31, 1996, 1995 and 1994................................... 34

    Consolidated Statements of Stockholders' Equity for the Years Ended
       December 31, 1996, 1995 and 1994................................... 35

    Consolidated Statements of Cash Flows for the Years Ended
       December 31, 1996, 1995 and 1994................................... 36

    Notes to Consolidated Financial Statements............................ 38

















































                                       30
<PAGE>

                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS


To the Shareholders of Regency Health Services, Inc.:

   We have  audited  the  accompanying  consolidated  balance  sheets of REGENCY
HEALTH SERVICES,  INC. (a Delaware  corporation) and subsidiaries as of December
31,  1996  and 1995  and the  related  consolidated  statements  of  operations,
stockholders'  equity  and cash flows for the three  years in the  period  ended
December 31, 1996.  These  financial  statements are the  responsibility  of the
Company's  management.  Our  responsibility  is to  express  an opinion on these
financial statements based on our audits.

   We  conducted  our audits in  accordance  with  generally  accepted  auditing
standards.  Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement.  An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements.  An audit also includes
assessing the  accounting  principles  used and  significant  estimates  made by
management,  as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

   In our opinion, the financial statements referred to above present fairly, in
all material respects,  the financial position of Regency Health Services,  Inc.
and  subsidiaries  as of December  31,  1996 and 1995,  and the results of their
operations  and their cash flows for each of the three years in the period ended
December 31, 1996, in conformity with generally accepted accounting principles.

   Our  audits  were made for the  purpose  of  forming  an opinion on the basic
financial  statements  taken as a whole.  The  schedule  listed  in the index of
financial  statements is presented for purposes of complying with the Securities
and  Exchange  Commission's  rules  and  is not a  required  part  of the  basic
financial  statements.   This  schedule  has  been  subjected  to  the  auditing
procedures  applied in our audits of the basic financial  statements and, in our
opinion,  fairly states in all material respects, the financial data required to
be set forth therein in relation to the basic  financial  statements  taken as a
whole.



Orange County, California
February 14, 1997                                       ARTHUR ANDERSEN LLP



























                                       31
<PAGE>




<TABLE>

                          REGENCY HEALTH SERVICES, INC.
                           CONSOLIDATED BALANCE SHEETS
                                 (In thousands)

                                     ASSETS
<CAPTION>

                                                                                December 31,
                                                                            1996            1995
                                                                            ----            ----

<S>                                                                       <C>             <C>
CURRENT ASSETS:
   Cash and cash equivalents...........................................   $  22,875       $104,238
   Restricted cash.....................................................       4,425             --
   Accounts receivable, net of allowances of $4,723 and $3,757 at
     December 31, 1996 and 1995, respectively..........................      80,949         51,203
   Estimated third party settlements...................................      10,180            800
   Notes and other receivables.........................................       1,355          2,182
   Deferred income taxes...............................................       6,898          5,447
   Assets held for sale................................................       6,915          8,970
   Other current assets................................................       7,819          6,396
                                                                        ------------   ------------
           Total current assets........................................     141,416        179,236
                                                                        ------------   ------------

PROPERTY AND EQUIPMENT:
   Land................................................................      21,207         21,249
   Buildings and improvements..........................................     100,120         96,396
   Leasehold interests - other.........................................      17,640         17,556
   Leasehold interests - related party.................................       1,989          2,075
   Equipment...........................................................      38,054         24,610
                                                                        ------------   ------------
                                                                            179,010        161,886
   Less accumulated depreciation and amortization......................    (43,938)       (34,679)
                                                                        ------------   ------------
           Total property and equipment................................     135,072        127,207
                                                                        ------------   ------------
  OTHER ASSETS:
   Mortgage notes receivable, net of allowances of $1,352 and $951 at
      December 31, 1996 and 1995, respectively.........................       1,014          5,163
   Goodwill, net of accumulated amortization of $3,700 and $563 at
      December 31, 1996 and 1995, respectively.........................      53,753         13,621
   Other assets, net of accumulated amortization of $3,736 and $2,206
      at December 31, 1996 and 1995, respectively......................      22,321         13,715
                                                                        ------------   ------------
           Total other assets..........................................      77,088         32,499
                                                                        ============   ============
                                                                           $353,576       $338,942
                                                                        ============   ============


        The  accompanying  notes  are an  integral  part of these consolidated statements.
</TABLE>

                                       32
<PAGE>

<TABLE>


                          REGENCY HEALTH SERVICES, INC.
                     CONSOLIDATED BALANCE SHEETS (Continued)
                        (In thousands, except par value)

                      LIABILITIES AND STOCKHOLDERS' EQUITY
<CAPTION>



                                                                                December 31,
                                                                             1996          1995
                                                                             ----          ----

<S>                                                                       <C>           <C>
CURRENT LIABILITIES:
   Current portion of long-term debt...................................   $   2,418     $   4,371
   Accounts payable....................................................      24,958        22,285
   Accrued expenses....................................................       8,290         5,946
   Accrued compensation................................................      26,253        18,051
   Accrued workers' compensation.......................................       4,338         5,377
   Deferred revenue....................................................       2,407         1,743
   Accrued interest....................................................       5,578         4,231
                                                                        ------------   -----------
           Total current liabilities...................................      74,242        62,004

LONG-TERM DEBT, NET OF CURRENT PORTION.................................     182,490       179,615
OTHER LIABILITIES AND NONCURRENT RESERVES..............................      10,878         8,988
DEFERRED INCOME TAXES..................................................       5,018         7,946
                                                                        ------------   -----------
           Total liabilities...........................................     272,628       258,553
                                                                        ------------   -----------

COMMITMENTS AND CONTINGENCIES

STOCKHOLDERS' EQUITY:
   Common stock, $.01 par value;  authorized - 35,000 shares;  
      15,919 and 16,670 shares issued and outstanding at December 31,
      1996 and 1995, respectively, net of 862 shares held in treasury 
      in 1996..........................................................         168           167
   Additional paid-in capital..........................................      52,031        56,679
   Retained earnings...................................................      28,749        23,543
                                                                        ------------   -----------
           Total stockholders' equity..................................      80,948        80,389
                                                                        ============   ===========
                                                                           $353,576      $338,942
                                                                        ============   ===========


         The  accompanying  notes  are an  integral  part of these consolidated statements.
</TABLE>

                                       33
<PAGE>


<TABLE>

                          REGENCY HEALTH SERVICES, INC.
                      CONSOLIDATED STATEMENTS OF OPERATIONS
                    (In thousands, except per share amounts)
<CAPTION>



                                                                       Year Ended December 31,
                                                                  1996           1995           1994
                                                                  ----           ----           ----

<S>                                                              <C>            <C>            <C>     
NET OPERATING REVENUE.....................................       $558,050       $416,093       $377,336
                                                              ------------   -------------   ------------
COSTS AND EXPENSES:
   Operating expenses.....................................        453,131        335,849        307,807
   Corporate general and administrative...................         24,292         19,811         19,392
   Rent expense...........................................         24,956         16,767         15,555
   Depreciation and amortization..........................         15,317         10,122          9,295
   Interest expense.......................................         18,060          9,676          7,844
   Merger and restructuring expenses......................             --             --         14,650
   Class action lawsuit settlement........................             --          3,098             --
   Restructuring and other non-recurring charges..........         11,283          9,000          1,600
                                                              ------------   ------------    -----------
      Total costs and expenses............................        547,039        404,323        376,143
                                                              ------------   ------------    -----------
INCOME BEFORE PROVISION FOR INCOME TAXES AND EXTRAORDINARY
   ITEM...................................................         11,011         11,770          1,193
PROVISION FOR INCOME TAXES................................          4,612          7,316          1,993
                                                              -----------    -----------     ----------
INCOME (LOSS) BEFORE EXTRAORDINARY ITEM                             6,399          4,454          (800)
EXTRAORDINARY ITEM - Loss on extinguishment of debt, net of
   applicable income taxes of $812 and $1,072 in 1996 and
   1995, respectively.....................................        (1,193)        (1,609)             --
                                                              -----------    -----------     ----------

NET INCOME (LOSS).........................................    $     5,206      $   2,845     $    (800)
                                                              ===========    ===========     ==========

INCOME (LOSS) PER SHARE:
Income (loss) before extraordinary item...................    $       .39    $       .27     $    (.05)
Extraordinary item........................................          (.07)          (.10)             --
                                                              ------------   ------------    -----------
Net income (loss) per share...............................    $       .32    $       .17     $    (.05)
                                                              ============   ============    ===========

Weighted average shares of common stock and equivalents...         16,476         16,654         16,545
                                                              ============   ============    ===========



         The  accompanying  notes  are an  integral  part of these consolidated statements.

</TABLE>



                                       34
<PAGE>


<TABLE>

                          REGENCY HEALTH SERVICES, INC.
                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                                 (In thousands)
<CAPTION>
                                                                                      

                                                                       Additional
                                                    Common Stock        Paid-In      Retained
                                                 Shares      Amount     Capital      Earnings       Total
                                                 ------      ------    ----------    --------       ----- 

<S>                                              <C>           <C>       <C>          <C>          <C>    
  BALANCE, December 31, 1993.................    16,220        $162      $45,355      $21,498      $67,015
     Exercise of stock options...............        95           1          475           --          476
     Conversion of Convertible Subordinated
        Debentures...........................        87           1        1,031           --        1,032
     Charge in lieu of income taxes (1994)...        --          --        2,636           --        2,636
     Retroactive charge in lieu of income
        taxes (1993).........................        --          --        2,608           --        2,608
     Net loss................................        --          --           --        (800)        (800)
                                               ---------   ---------  -----------  -----------  -----------

  BALANCE, December 31, 1994.................    16,402         164       52,105       20,698       72,967
     Exercise of stock options...............       211           2        1,254           --        1,256
     Exercise of share appreciation rights...        55           1          614           --          615
     Conversion of Convertible Subordinated
        Debentures...........................         2          --           20           --           20
     Charge in lieu of income taxes..........        --          --        2,686           --        2,686
     Net income..............................        --          --           --        2,845        2,845
                                               ---------   ---------  -----------  -----------  -----------

  BALANCE, December 31, 1995.................    16,670         167       56,679       23,543       80,389
     Exercise of stock options..............         99           1          680           --          681
     Restricted Stock Distribution...........        12          --          144           --          144
     Charge in lieu of income taxes..........        --          --        2,814           --        2,814
     Repurchase of common stock .............     (862)          --      (8,286)           --      (8,286)
     Net income .............................        --          --           --        5,206        5,206
                                               ---------   ---------  -----------  -----------  -----------

  BALANCE, December 31, 1996.................    15,919        $168      $52,031      $28,749      $80,948
                                               =========   =========  ===========  ===========  ===========


        The  accompanying  notes  are an  integral  part of these consolidated statements.
</TABLE>



                                       35
<PAGE>


<TABLE>

                          REGENCY HEALTH SERVICES, INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (In thousands)
<CAPTION>

                                                                       1996         1995          1994
                                                                       ----         ----          ----

<S>                                                                  <C>          <C>           <C>
    CASH FLOWS FROM OPERATING ACTIVITIES:
       Net income (loss)..........................................   $   5,206    $    2,845    $   (800)
                                                                    -----------  ------------  -----------
       Adjustments  to  reconcile  net  income  (loss) to net cash  
          provided  by operating activities:
          Extraordinary loss on extinguishment of debt............       2,005         2,681           --
          Depreciation and amortization...........................      15,317        10,122        9,295
          Deferred income taxes and charge in lieu of taxes.......     (1,317)         4,506          408
          Restructuring and other non-recurring charges...........       9,749         9,000        6,052
          Other, net..............................................         122           649         (94)
          Change in cash from  changes  in  assets  and  liabilities,
          excluding effects of acquisitions and dispositions:
            Accounts receivable...................................    (28,537)         1,481      (4,640)
            Estimated third party settlements.....................     (9,380)       (3,569)        1,645
            Other current assets..................................       (270)         6,748      (1,582)
            Current and other liabilities.........................      11,308       (4,003)          814
                                                                    -----------  ------------  -----------

            Net cash provided by operating activities.............       4,203        30,460       11,098
                                                                    -----------  ------------  -----------

    CASH FLOWS FROM INVESTING ACTIVITIES:
       Acquisitions...............................................    (50,800)      (13,225)           --
       Proceeds from disposition of facilities....................       3,682            --        2,239
       Purchases of property and equipment........................    (12,575)      (14,223)     (12,576)
       Collection on mortgage notes receivable....................         695           349          410
       Changes in other assets, net...............................     (1,623)       (1,278)      (2,585)
                                                                    -----------  ------------  -----------

            Net cash used in investing activities.................    (60,621)      (28,377)     (12,512)
                                                                    -----------  ------------  -----------

    CASH FLOWS FROM FINANCING ACTIVITIES:
       Payments on long-term debt.................................    (62,598)      (31,940)      (2,705)
       Proceeds from issuance of long-term debt...................      56,143       107,162        2,996
       Workers compensation trust funding.........................    (10,637)            --           --
       Purchase of treasury stock.................................     (8,286)            --           --
       Proceeds from exercise of options..........................         433         1,256          476
                                                                    -----------  ------------  -----------

            Net cash provided by (used in) financing activities...    (24,945)        76,478          767
                                                                    -----------  ------------  -----------

    NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS..........    (81,363)        78,561        (647)

    CASH AND CASH EQUIVALENTS, beginning of period................     104,238        25,677       26,324
                                                                    -----------  ------------  -----------

    CASH AND CASH EQUIVALENTS, end of period......................    $ 22,875      $104,238      $25,677
                                                                    ===========  ============  ===========

    SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
       Cash paid during the year for interest.....................    $ 16,713     $   8,334      $ 6,788
                                                                    ===========  ============  ===========

       Cash paid during the year for income taxes.................   $   3,750     $   2,152      $ 2,651
                                                                    ===========  ============  ===========


          The  accompanying  notes  are an  integral  part of these consolidated statements.
</TABLE>



                                       36
<PAGE>


                          REGENCY HEALTH SERVICES, INC.
                CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)


SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES:

         During the year ended December 31, 1996:

             The  Company  acquired  Assist-A-Care  Pharmacy  in San Diego,
             California and issued a promissory  note in the amount of $2.6
             million as part of the purchase price.

             The  Company  issued a  promissory  note in the  amount of $2.2  
             million in  connection  with the  acquisition  of 18 healthcare 
             facilities in Tennessee and North Carolina.

             The  Company   acquired   Executive   Pharmacy  and  issued  a
             promissory note in the amount of $763,000.

         During the year ended December 31, 1995:

             $20,000 of the Company's Convertible  Subordinated  Debentures 
             were converted into 1,616 shares of common stock.

             The  Company  issued  a  promissory   note  of  $3,400,000  in
             connection with the acquisition of SCRS and Communicology, Inc.

         During the year ended December 31, 1994:

             $1,076,000   of   the   Company's   Convertible   Subordinated
             Debentures  were converted into 86,946 shares of common stock.
             Unamortized  debenture  fees of $44,000  were  offset  against
             additional paid-in capital.












 The accompanying notes are an integral part of these consolidated statements.



                                       37
<PAGE>



                          REGENCY HEALTH SERVICES, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS




1.        MERGER AND BASIS OF PRESENTATION

         On April 4, 1994,  Regency  Health  Services,  Inc.  ("Regency"  or the
"Company")  and Care  Enterprises,  Inc.  ("Care")  completed  the  merger  (the
"Merger").  Pursuant to the Agreement  and Plan of Merger,  dated as of December
20,  1993,  as amended,  Care Merger Sub,  Inc., a wholly  owned  subsidiary  of
Regency,  was  merged  with  and into  Care,  and  Care  became  a wholly  owned
subsidiary  of Regency.  Each share of common stock of Care was  converted  into
0.71 of a share of common stock of Regency.  Approximately  9,400,000  shares of
common stock were issued in this transaction. At the time of the Merger, Regency
operated 43 healthcare  facilities with 4,215 licensed beds and Care operated 51
healthcare facilities with 5,040 licensed beds.

         The  Merger  qualified  as  a  pooling-of-interests  transaction  under
generally accepted accounting  principles.  The  pooling-of-interests  method of
accounting  is  intended  to present  as a single  interest  two or more  common
stockholder interests that were previously independent. The pooling-of-interests
method of accounting assumes that the combining  companies have been merged from
inception.  Consequently,  the historical financial statements for periods prior
to the  consummation of the combination are restated as though the companies had
been  merged  since  inception.  The  calculation  of income  per share for 1994
presented  reflects the  issuance of .71 of a share of Regency  Common Stock for
each share of common and  common  equivalent  share of Care  Common  Stock.  The
restated financial statements are adjusted to conform the accounting policies of
the separate companies.

2.       SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

         Nature of Business As of December  31, 1996,  the Company  operated 107
healthcare   facilities  with  11,200   licensed  beds  that  provide   nursing,
rehabilitative,  subacute and other  specialized  medical services  primarily in
California and in Ohio, West Virginia, North Carolina and Tennessee. Through its
wholly  owned home health  subsidiaries,  the  Company  provides  patients  with
technical medical support at home such as infusion therapy,  ventilator care and
respite  services.   The  Company  also  provides  ancillary  services  such  as
rehabilitation programs and pharmaceutical services at certain of its healthcare
facilities as well as at non-affiliated facilities.

         Principles  of  Consolidation  The  consolidated  financial  statements
include the  accounts of the Company and all of its wholly  owned  subsidiaries.
All significant intercompany accounts and transactions have been eliminated.

         Cash and Cash Equivalents For financial reporting purposes, the Company
considers  all highly  liquid  instruments  purchased  with a maturity  of three
months or less to be cash equivalents.

         At December 31,  1996 and 1995,  the  Company  held  personal funds  in
trust for  patients  approximating  $1,505,000 and $690,000, respectively, which
are not reflected on the accompanying balance sheets.

         Restricted  Cash  Restricted  cash of  $4,425,000  at December 31, 1996
represents  the  portion  of the  cash  in  the  Company's  pre-funded  workers'
compensation claims payment trust expected to be paid during 1997.

         Accounts  Receivable  Accounts  receivable  are  recorded  at  the  net


                                       38
<PAGE>

realizable  value  expected to be  received  from  federal and state  assistance
programs or from private sources including managed care  organizations and third
party  insurers.   Receivables  from  government  agencies  represent  the  only
concentrated  group of credit risk for the Company.  Management does not believe
that there are any credit risks associated with these government  agencies other
than possible  funding  delays.  Non-government  agency  receivables  consist of
receivables  from  various  payors  that  are  subject  to  differing   economic
conditions  and do not represent any  concentrated  credit risks to the Company.
Furthermore,  management  continually  monitors  and  adjusts its  reserves  and
allowances associated with these receivables.

         Property and Equipment At the time of Care's  emergence from bankruptcy
on December 31, 1990, property and equipment owned by Care and certain leasehold
interests  were  adjusted to current fair market value.  All other  property and
equipment is recorded at cost. The assets are  depreciated  over their estimated
useful lives using the straight-line method as follows:

Buildings and improvements....................................... 7-40 years
Leasehold interests and improvements............................. Life of leases
Equipment........................................................ 5-10 years

         Betterments,  renewals,  and extraordinary repairs that extend the life
of the asset are  capitalized;  other repairs and maintenance are expensed.  The
cost and accumulated  depreciation applicable to assets retired are removed from
the accounts and any gain or loss on disposition is recognized in income.

         Assets Held for Sale During  1995,  the Company  adopted  Statement  of
Financial  Accounting  Standards ("SFAS") No. 121 "Accounting for the Impairment
of Long-Lived  Assets and for Long-Lived Assets to Be Disposed Of." The adoption
of SFAS No.  121 did not  have a  material  effect  on the  Company's  financial
statements.  At December 31, 1995, assets held for sale represents the assets of
13  facilities  which the Company  determined to dispose of in 1995. At December
31, 1996, it represents the assets of the seven remaining  facilities  which the
Company  intends to  dispose  of during  1997 (see Note 14).  Such  amounts  are
carried at estimated fair value less selling costs.

         Goodwill  The  excess of the  purchase  price over the value of the net
assets  of the  businesses  acquired  by the  Company  is  amortized  using  the
straight-line  method  over  periods  ranging  from 15 to 22 years.  The Company
periodically  evaluates  the  carrying  value of  goodwill  in  relation  to the
operating  performance  and future  undiscounted  cash  flows of the  underlying
business to assess  recoverability.  Adjustments are made if the sum of expected
future net cash flows is less than book value of goodwill and other  depreciable
or amortizable assets.

         Asset Impairment The carrying values of long-lived  assets are reviewed
if the facts and  circumstances  suggest that an item may be  impaired.  If this
review indicates that a long-lived asset will not be recoverable,  as determined
based on the future undiscounted cash flows of the asset, the Company's carrying
value of the long-lived asset is reduced to fair value.

         Other Long-Term Assets Costs incurred to obtain long-term financing are
amortized using the effective  interest method.  Costs to initiate and implement
subacute specialty units are amortized on a straight-line basis over 36 months.

         Deferred Revenue Deferred revenue consists of patient billings recorded
in advance of services rendered.

         Workers' Compensation The Company maintains self-insurance programs for
workers'  compensation  for its  nursing  facilities  in  California  and  Ohio,
pharmacy operations,  home health operations and its corporate office employees.
For all other  operations,  the Company  purchases  insurance for this risk. The
self-insurance  liability  under  these  programs  is based on claims  filed and
actuarial estimates of claims incurred but not reported. Differences between the
amounts  accrued and  subsequent  settlements  are recorded in operations in the
year of settlement.

                                       39
<PAGE>

         Net  Operating  Revenue  Revenues  are derived  from the  operation  of
healthcare  facilities,  which are  subject  to  federal  and state  regulation.
Approximately  69.9%,  71.8%,  and 74.0%,  percent of revenues were derived from
services  provided  under  federal   (Medicare)  and  state  (Medicaid)  medical
assistance  programs  for the years  ended  December  31,  1996,  1995 and 1994,
respectively.  Revenues  from Medicaid are recorded at the  prescribed  contract
rate.  Revenues from Medicare are recorded based on an estimate of the Company's
reimbursable  cost.  Limitations  on Medicare  and  Medicaid  reimbursement  for
healthcare  services are  continually  proposed.  Changes in applicable laws and
regulations  could have an adverse  effect on the levels of  reimbursement  from
governmental,  private, and other sources. These revenues are based, in part, on
cost reimbursement principles and are subject to audit. Provisions for estimated
third-party  payor  settlements are provided in the period the related  services
are rendered. Differences between the amounts accrued and subsequent settlements
are recorded in operations in the year of settlement.

         Additionally,  the  Company's  cost of care for its  Medicare  patients
sometimes exceeds regional  reimbursement  limits  established by Medicare.  The
Company has submitted exception requests for 156 cost reports, covering all cost
report periods through  December 31, 1994. To date,  final action has been taken
by the Health Care Financing  Administration ("HCFA") on 105 exception requests.
The Company's final rates as approved by HCFA represent approximately 84% of the
requested rates as submitted in the exception requests. During 1994, the Company
recognized  50% of the  1994  estimated  exception  requests  anticipated  to be
received,  which represented  revenues of approximately  $1,550,000.  Commencing
January 1, 1995, the Company recognized 70% of the estimated  exception requests
anticipated  to  be  received,   which  represents   revenues  of  approximately
$3,563,000 and $3,001,000 in 1996 and 1995,  respectively.  Management  believes
that the  Company  will be able to recover  its excess  costs  under any pending
exception  requests or under any exception requests that may be submitted in the
future, however there can be no assurance that it will be able to do so.

         Stock  Based  Compensation.  Effective  January  1, 1996,  the  Company
adopted  the  disclosure  provisions  of SFAS No. 123,   "Accounting for  Stock-
Based  Compensation."  SFAS No. 123 requires  the Company  to disclose  proforma
net income  and  earnings  per share as  if the  fair  value   based  accounting
method of SFAS  No. 123 had been used to  account for stock based  compensation.
These disclosures are included in Note 9.

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

         Corporate General and Administrative  Expenses During 1995, the Company
changed its classification of general and administrative  expenses.  Previously,
the Company  classified  all corporate  overhead,  regional costs related to the
supervision of operations, the administrative costs at the Company's facilities,
pharmacies, and home care operations as administrative and general expenses. The
Company now classifies  corporate overhead and the regional costs related to the
supervision of operations as corporate general and administrative  expenses. All
other  costs  which  relate to the daily  operations  have  been  classified  as
operating  expenses  for the  periods  presented.  These costs in 1994 have been
reclassified to conform to the 1996 and 1995 presentation.

         Financial  Statement  Presentation  Estimated  third party  settlements
classified  in  accounts  receivable,  other  assets and other  liabilities  and
non-current  reserves in the 1995 financial statements have been reclassified to
estimated  third  party  settlements  in  current  assets to conform to the 1996
presentation.  Certain other amounts have been reclassified in the 1995 and 1994
financial statements to conform to the 1996 presentation.

                                       40
<PAGE>

3.       LONG-TERM DEBT
<TABLE>

         Long-term debt consists of the following (dollars in thousands):
                                                                                      December 31,
<CAPTION>

                                                                                    1996           1995
                                                                                    ----           ----
<S>                                                                               <C>            <C>           
Senior Subordinated Notes, interest at 9.875 percent, due October 2002. Interest
   is payable semi-annually on October 15 and April 15, commencing
   April 15, 1996; redeemable beginning October 15, 1999....................      $110,000       $110,000
Junior Subordinated Notes, interest at 12.25 percent, due July 2003, interest
   payable semi-annually on January 15 and July 15, commencing January 1997;
   redeemable beginning July 15, 2000.......................................        50,000             --
Industrial revenue bonds ("IRBs"), interest at rates from 4.0 to 8.25
   percent, due through September 2012 in varying amounts...................         9,675          9,800
Note payable, collateralized by a deed of trust, interest at 8.75 percent;
   interest and principal payable monthly through September 2033............         4,697          4,714
Note payable, secured, interest at 9.0 percent, interest and principal
   payable monthly, balance due November 2013...............................         4,276          4,308
Convertible Subordinated Debentures, interest at 6.5 percent, due March 2003,
   redeemed in 1996.........................................................            --         48,904
Note payable, interest at 6.0 percent. Interest payable quarterly commencing
   October 1, 1995; fully repaid in 1996....................................            --          3,400
Other unsecured indebtedness, interest rates up to 13.0 percent, payable in
   varying installments through August 2017.................................           646          1,014
Other secured long-term debt, interest rates up to 10.25 percent, payable in
   varying installments through August 2014.................................         5,614          1,846
                                                                               ------------  -------------
                                                                                   184,908        183,986
Less current portion........................................................         2,418          4,371
                                                                               ------------  -------------
                                                                                  $182,490       $179,615
                                                                               ============  =============
</TABLE>

         On June 28, 1996, the Company issued 12.25% Junior  Subordinated  Notes
(the "Junior  Subordinated  Notes") in an aggregate  amount of $50 million.  The
Junior  Subordinated  Notes  will  mature on July 15,  2003,  unless  previously
redeemed.  Net  proceeds  received by the Company  totaled  approximately  $48.4
million and funded the redemption of the Company's  outstanding 6.5% Convertible
Subordinated Debentures due 2003 (the "Convertible  Subordinated Debentures") on
July 29, 1996. The Junior  Subordinated Notes contain certain  covenants,  which
are similar to the 9.875%  Senior  Subordinated  Notes  ("Subordinated  Notes"),
including  limitations on the ability of the Company to, among other things, (a)
incur additional  indebtedness  and issue  redeemable  preferred stock, (b) sell
equity  interests  in  subsidiaries,  (c) make certain  restricted  payments (as
defined),  (d)  create  liens,  and (e)  engage in  mergers,  consolidations  or
transfers of substantially all of the assets of the Company to another party.

         Effective  September  30,  1996,  the Company  refinanced  three of its
Industrial  Revenue Bond Issues (IRBs) with an aggregate  outstanding  principal
balance of $7,560,000 with three new issues of tax exempt IRBs maturing  through
September 2012. One of the new issues has a principal  balance of $2,830,000 and
bears interest at rates ranging from 4.2% to 6.0% based on the maturity dates of
the  individual  bonds.  The other two IRBs bear  interest  at a  variable  rate
initially set at 4.0% which is capped at 12.0%.  The refinancing  resulted in an
extraordinary  loss on extinguishment of debt of $325,000,  net of tax resulting
from the  write-off  of  unamortized  underwriting  costs and  payment of a call
premium.  The IRBs are secured by irrevocable  standby  letters of credit issued
against the Company's Amended Credit Agreement.

         On December 28, 1995 the Company  entered into a revolving  credit loan
agreement  ("Credit  Agreement") with NationsBank of Texas,  N.A. as agent for a
group of banks,  which  provided up to $50 million in a revolving line of credit
and  letters of credit.  No  borrowings  were drawn on the Credit  Agreement  at


                                       41
<PAGE>

December  31, 1995 and  throughout  1996.  On  December  20,  1996,  the Company
increased the available  financing to $100 million and revised certain terms and
covenants  through the Amended and Restated Credit  Agreement  ("Amended  Credit
Agreement"). Borrowings bear interest at either the Base Rate plus up to .50% or
the Adjusted  Eurodollar  Rate plus .75% to 2.00%,  depending  on the  Company's
Consolidated  Adjusted  Leverage  Ratio,  all as defined in the  Amended  Credit
Agreement.  The Amended Credit Agreement has scheduled commitment  reductions of
$25 million each on January 2, 1999 and 2000 and expires on January 2, 2001. The
Amended Credit Agreement is  collateralized by accounts  receivable,  all of the
common stock of each of the  Company's  subsidiaries  and certain  other current
assets of the Company and its subsidiaries.  The Amended Credit Agreement, among
other things, (a) requires the Company to maintain certain financial ratios, and
(b) restricts the Company's  ability to incur debt and liens,  make investments,
pay dividends,  purchase  treasury  stock,  prepay or modify certain debt of the
Company,  liquidate or dispose of assets,  merge with another  corporation,  and
create or acquire  subsidiaries.  As of  December  31,  1996,  $16.2  million of
standby  letters  of  credit  were  issued  in  connection  with  the  Company's
self-insured  workers'  compensation  programs and refinanced Industrial Revenue
Bonds (discussed  above) out of a total available of $35 million.  On January 2,
1997 the Company borrowed $40 million under the Amended Credit Agreement.

         On October  12,  1995,  the  Company  issued  Subordinated  Notes in an
aggregate amount of $110 million.  Net proceeds  received by the Company totaled
approximately  $106.7 million of which  approximately  $31.5 million was used to
repay the  principal  and a  prepayment  penalty on the  Company's  8.10% Senior
Secured  Notes  (which  resulted  in  a  loss  on   extinguishment  of  debt  of
approximately  $1.6  million,  net of  tax)  and  $47.4  million  was  used  for
acquisitions  in 1996 (see Note 13).  The  Subordinated  Notes  contain  certain
covenants,  including  limitations on the ability of the Company to, among other
things,  (a) incur  additional  indebtedness and issue preferred stock, (b) sell
equity  interests  in  subsidiaries,  (c) make certain  restricted  payments (as
defined),  (d) create liens,  and (e) engage in mergers,  consolidations  or the
transfer of substantially all of the assets of the Company to another party.

         In March  1993,  the Company  issued  $50,000,000  aggregate  principal
amount of its Convertible  Subordinated  Debentures resulting in net proceeds to
the Company of  approximately  $47,800,000.  During the years ended December 31,
1995 and 1994, $20,000 and $1,076,000 of the Convertible Subordinated Debentures
were  converted into 1,616 and 86,946 shares of common stock,  respectively.  On
July 29, 1996, the Company  completed the redemption of all $48.9 million of its
outstanding Convertible Subordinated Debentures for cash at such amount from the
proceeds of the Junior  Subordinated  Notes and available  cash.  The redemption
reduces fully diluted shares by 3.9 million and produces an  extraordinary  loss
on extinguishment of debt of $868,000,  net of tax, resulting from the write-off
of unamortized underwriting costs.

         Each of the mortgage notes and certain IRBs are secured by a first deed
of trust on the related  facility.  Certain IRBs require the maintenance of debt
service  reserve  funds and all of the IRBs  contain  affirmative  and  negative
covenants.

Principal maturities on long-term debt are as follows (in thousands):
<TABLE>

Year Ending December 31,
<S>                                                                    <C>       
1997................................................................   $  2,418
1998................................................................      3,079
1999................................................................        497
2000................................................................        505
2001................................................................        802
Thereafter..........................................................    177,607
                                                                     ----------
Total...............................................................   $184,908
                                                                     ==========
</TABLE>

                                       42
<PAGE>

4.        INCOME TAXES

         The Company and its subsidiaries  file  consolidated  federal and state
income tax returns and account for income taxes under the provisions of SFAS No.
109.

         As a result of the Care bankruptcy proceedings, a "change in ownership"
occurred.  Prior to the Merger,  the Company had  substantial net operating loss
carryforwards for tax purposes ("Tax NOL") and income tax credit  carryforwards.
In March 1994, the Internal  Revenue  Service  ("IRS") issued final  regulations
relative  to Tax  NOL  utilization  when  a  "change  in  ownership"  occurs  in
bankruptcy  proceedings.   These  regulations  reduced  the  aggregate  Tax  NOL
available to the Company but did not limit its annual use.

         As a result of the Merger,  another "change in ownership"  occurred and
the Company's Tax NOL and credit  carryforward  utilization  became subject to a
combined annual limitation of approximately $7.9 million (on a pre-tax basis) in
periods after the Merger.

         After  considering the  adjustments  resulting from the IRS examination
for the years 1987 through 1990, the Company has a federal Tax NOL of $2,929,000
and income tax credit  carryforwards of $5,503,000 available for use at December
31, 1996. As a result of Fresh Start Reporting,  the tax benefits  realized from
the pre-bankruptcy  Tax NOL and income tax credit  carryforwards are recorded as
an increase in additional  paid-in capital and are not recorded in the statement
of operations.

         The provision for income taxes is as follows (in thousands):
<TABLE>
<CAPTION>

                                            1996        1995         1994
                                            ----        ----         ----

<S>                                        <C>        <C>           <C>
Current provision:
   Federal...........................      $4,950     $   722       $   597
   State.............................       1,315       1,016           988
                                         ---------    --------    ----------
                                            6,265       1,738         1,585
Deferred provision:
   Federal...........................      (3,797)      2,459        (1,971)
   State.............................        (670)        433          (257)
                                         ---------    --------    ----------
                                           (4,467)      2,892        (2,228)

Charge in lieu of income taxes.......       2,814       2,686         2,636
                                         =========    ========    ==========
                                           $4,612      $7,316       $ 1,993
                                         =========    ========    ==========
</TABLE>

         A  reconciliation  of the  federal  statutory  income tax rate with the
Company's effective tax rate follows:
<TABLE>
<CAPTION>

                                                   1996        1995       1994
                                                   ----        ----       ----

  <S>                                             <C>          <C>       <C>  
  Federal statutory rate......................    34.0%        34.0%      34.0%
  State income taxes, net of federal benefit..     6.0          6.0        6.0
  Disposition of assets charges...............      --         19.6         --
  Other non-deductible items..................      --           --       21.4
  Non-deductible merger related expenses......      --           --      101.4
  Goodwill amortization.......................     3.1          1.7        4.4
  Other, net..................................    (1.2)         0.8         --
                                                  ======       =====     =====
                                                  41.9%        62.1%     167.2%
                                                  =====        =====     ======
</TABLE>

                                       43
<PAGE>

         Deferred   income  taxes  arise  from  temporary   differences  in  the
recognition of certain  expenses for financial and tax reporting  purposes.  The
following  is a  summary  of these  differences  and the tax  effect of each (in
thousands):
<TABLE>
<CAPTION>

                                                            1996          1995
                                                            ----          ----

<S>                                                      <C>           <C>
Deferred income tax assets:
   Allowance for doubtful accounts.................      $  1,057      $  1,054
   Net operating loss carryforward.................           996         3,789
   Loss contingencies and legal settlements........           416           734
   Workers' compensation claims....................         5,370         4,827
   Covenant not to compete.........................           901            --
   Disposition of assets charges...................         4,166         2,844
   Accrued interest................................            --           598
   Other reserves..................................         3,389         1,035
   Credit carryforwards............................         5,519         4,883
   Other...........................................           243           613
   Valuation allowance.............................        (5,207)      (10,100)
                                                         ---------     --------
Total deferred income tax assets...................        16,850        10,277
                                                         ---------     --------

Deferred income tax liabilities:
   Depreciation....................................        (9,417)       (9,109)
   Other...........................................        (5,553)       (3,667)
                                                         ---------     --------
Total deferred income tax liabilities..............       (14,970)      (12,776)
                                                         ---------     --------

Net deferred income tax asset (liability)..........      $  1,880      $ (2,499)
                                                         ===========   ========
</TABLE>


         The valuation allowance primarily relates to the net operating loss and
income  tax  credit  carryforwards  of the  Company  for  periods  prior  to its
emergence from  bankruptcy.  If and when such  carryforwards  are realized,  the
offset will be to  additional  paid-in  capital not to the  provision for income
taxes.

5.        DEFERRED RENT

         Several of the Company's facilities and a home health office are leased
under long-term  operating leases that specify scheduled rent increases over the
lease terms.  Deferred rent of approximately  $986,000 and $932,000, at December
31,  1996  and  1995,  respectively,  has  been  established  to  recognize  the
difference  between the rent expense paid and the  straight-line  recognition of
minimum  rental  expense and is classified in other  liabilities  and noncurrent
reserves.

6.       COMMITMENTS AND CONTINGENCIES

         Letters of Credit
         The Company is  contingently  liable under letters of credit related to
deposit  requirements on its self-insured  workers'  compensation  plans and the
IRBs discussed in Note 3. State regulations  require the maintenance of deposits
at  specified  percentages  of  estimated  future  workers'  compensation  claim
payments that can be satisfied  through a combination of cash  deposits,  surety
bonds and letters of credit.  The total amount of letters of credit  outstanding
at December 31, 1996 and 1995, were $16,202,000 and  $16,050,000,  respectively.
At December 31, 1995,  the letters of credit were  collateralized  by cash.  The
cash  collateral  was  subsequently  released in  connection  with the Company's
Credit Agreement discussed in Note 3.

                                       44
<PAGE>

         Leases
         The Company leases certain  facilities and offices under cancelable and
noncancelable  agreements expiring at various dates through 2047. The leases are
generally  triple-net  leases and provide for the Company's  payment of property
taxes, insurance,  and repairs.  Certain leases contain renewal options and rent
escalation  clauses.  Rent escalation  clauses require either fixed increases or
increases tied to the Consumer Price Index ("CPI").  Six leases include purchase
options at fixed or market prices at various dates.

         Future minimum lease payments for operating leases at December 31, 1996
are as follows (in thousands):
<TABLE>

Year Ending December 31,
<S>                                                       <C>      
1997.........................................             $ 24,402
1998.........................................               23,005
1999.........................................               22,358
2000.........................................               21,460
2001.........................................               20,127
Thereafter...................................              110,805
                                                         ==========
                                                          $222,157
                                                         ==========
</TABLE>

         Guarantee of Leases
         The Company is contingently liable for certain operating leases assumed
by the purchasers of the Company's leasehold  interests in facilities.  With the
exception of a single  facility  re-entered  on October 1, 1994,  following  the
filing of bankruptcy by the Company's sublessee,  which has been operated by the
Company since  November 1, 1994,  the Company is not aware of any failure on the
part of these  purchasers to meet the terms of their  obligations,  and does not
anticipate any expenditures to be incurred in connection with its guarantees. If
a  default  were to  occur,  the  Company  generally  would  be  able to  assume
operations  of the  facility  and use the net  revenues  thereof  to defray  the
Company's expenditures on these guarantees.

         The  following  is a  schedule  of future  minimum  lease  payments  at
December 31, 1996 for the operating leases for which the Company is contingently
liable (in thousands):
<TABLE>

Year Ending December 31,
<S>                                                      <C>     
1997.........................................            $ 3,165
1998.........................................              1,125
1999.........................................              1,128
2000.........................................              1,136
2001.........................................              1,023
Thereafter...................................              4,617
                                                        =========
                                                         $12,194
                                                        =========
</TABLE>

         Litigation
         In 1995,  a class  action  lawsuit,  which had been filed  against  the
Company in July 1994, was settled for $9,000,000.  The Company's portion of this
settlement,  together  with related  legal fees and other  costs,  resulted in a
pre-tax charge of $3,098,000, which is included in the consolidated statement of
operations for the year ended December 31, 1995.

         The  Company is subject to claims  and legal  actions by  patients  and
others in the  ordinary  course  of its  business.  The  Company  has  insurance
policies  related  to  patient  care  claims  and  legal  actions.  In the event
judgments  were awarded for  non-patient  care legal actions or in excess of the
insurance coverage for patient care legal actions,  the burden would fall on the
Company. The Company does not expect that the ultimate outcome of an unfavorable
judgment in any pending legal matters would result in a material  adverse effect
on the Company's consolidated financial position or results of operations.

                                       45
<PAGE>

         Employment Agreements
         At December 31, 1996,  the Company had employment  agreements  with its
president,  and certain executive and senior vice presidents,  which provide for
annual base salaries in the aggregate of $1,212,000.  The  agreements  expire at
various dates through 1999.

         Insurance
         The Company maintains general and professional liability insurance on a
claims made basis, subject to a $100,000 self-insurance  retention. In addition,
all-risk property insurance,  including  earthquake and flood, is maintained for
all Company locations.

         The Company estimates its liability under the above described programs,
including potential legal fees and settlement amounts,  with respect to incurred
but  not  reported  claims  on  a  monthly  basis,  based  upon  its  historical
experience.

7.        RELATED PARTY TRANSACTIONS

         In February 1988,  the Company  entered into a 20-year lease with three
five-year option periods for its Heritage (Torrance) facility that is owned by a
former  director  of the  Company.  The lease  provides  for  monthly  payments,
currently  $35,000,  which are adjusted annually based on the CPI. Lease expense
for the  years  ended  December  31,  1996,  1995 and  1994,  was  approximately
$419,000, $415,000, and $409,000, respectively.

         In June  1990,  the  Company  entered  into a ten year  lease with four
five-year option periods for its Glendora facility that is directly owned by one
former director and indirectly owned by another director. The lease provides for
equal  monthly  payments  for three  years,  after which the monthly  payment is
adjusted  annually  based on increases in the CPI.  Lease  expense for the years
ended December 31, 1996, 1995 and 1994, was  approximately  $446,000,  $437,000,
and $420,000, respectively.

         The Company  leases  from  Newport  Harbor  Investments  Limited,  Inc.
("Newport  Harbor"),  a  corporation  wholly-owned  by a former  director of the
Company,  two nursing facilities located in Beaumont and Riverside,  California.
The leases provide for monthly rent payments of $7,083 and $5,142, respectively,
subject  to  periodic  adjustments  based  on  certain  increases  in the CPI or
Medi-Cal reimbursement rates. The Riverside facility lease contains an option to
purchase the facility for $675,000,  subject to adjustment based on increases in
the CPI from March 1992. In 1992,  the Company paid Newport  Harbor  $120,000 as
consideration for the extension of the purchase option on the Riverside facility
for a  five-year  period.  During  1996 the  Company  exercised  the  option and
acquired the  facility  for  approximately  $700,000,  net of the  consideration
already paid. Lease expense paid by the Company for the years ended December 31,
1996,  1995  and  1994,  was  approximately  $133,000,  $147,000  and  $147,000,
respectively.

         The Company  had a 26%  interest  in a pharmacy  partnership  formed in
April  1992,  which  provided  products  and  services  to  several   healthcare
facilities  operated by the Company.  For the year ended December 31, 1994 these
purchases totaled approximately $7,525,000. In August 1994, the Company sold its
interest in the pharmacy  partnership to the other partner. The Company received
its net equity in the  partnership  plus $200,000 for  goodwill.  The total cash
received by the Company was $2,239,000.

8.        INCOME (LOSS) PER SHARE

         For the years ended December 31, 1996, 1995 and 1994, income (loss) per
share was calculated  based on the weighted  average number of common and common
equivalent shares outstanding during the periods of 16,476,000,  16,654,000, and
16,545,000,  respectively.  Fully diluted  income (loss) per share for the years
ended  December 31, 1996,  1995 and 1994 is not presented  because the effect of
the  assumed   conversion  of  the  Convertible   Subordinated   Debentures  was
anti-dilutive.

                                       46
<PAGE>

         The 1994  income  per share  calculation  does not  include  the shares
reserved for issuance in connection with the Company's Share Appreciation Rights
Plan,  which  provides for  settlement  of the rights in cash or stock.  Through
December  31,  1994,  all Share  Appreciation  Rights that had been settled were
settled for cash.  During  1995,  the Board of Directors  settled all  remaining
outstanding  rights and issued shares which are included in the weighted average
share calculation for 1996 and 1995. (See Note 10.)

9.        STOCK OPTIONS

         Pursuant  to the  Merger,  Care  became a wholly  owned  subsidiary  of
Regency.  Stockholders  of Care received 0.71 of a share of Regency common stock
for  each  share of Care  common  stock  outstanding.  Pursuant  to the  Merger,
Regency's  stock  option plan was  amended to  increase  the number of shares of
Regency common stock available for grant to 1,937,991  shares.  This amount does
not include the  assumption of the Care stock option plan or share  appreciation
rights plan.

         The  Company  has a  Director  Stock  Plan  whereby  each  non-employee
director of the Company receives on July 1 of each year 2,000 restricted  shares
of Company  Common Stock and options to purchase an  additional  6,000 shares of
Company  Common  Stock.  The period of  restriction  for each award of shares of
restricted  stock  expires  on the last to occur  of:  the end of the six  month
period  following  the grant date;  participant's  direct or indirect  pecuniary
ownership of shares not subject to restrictions for at least 12 months, provided
that the  restrictions  shall lapse with respect to one restricted share granted
for every two shares of unrestricted shares; and participants  attendance at 75%
of the scheduled board meetings during the 12 month period immediately preceding
the grant date. Any shares which remain restricted when a director's  service on
the Company's Board terminates, will be forfeited. The stock options are granted
at fair market value on the date of grant and the  participants  are entitled to
exercise  such options  beginning  six months and one day after grant and ending
ten years after grant.  During the years ended December 31, 1996, 1995 and 1994,
the Company  awarded  12,000,  14,000,  and 12,000 shares of  restricted  stock,
respectively,  and during the year ended  December  31,  1994,  6,000  shares of
restricted stock were forfeited.  At December 31, 1996 restrictions  remained on
12,000 shares of stock.  In January 1997,  the period of  restriction  lapsed on
12,000 shares.

         The  following  is a summary of options  granted  pursuant to Regency's
Employee and Director stock option plans (such amounts do not include restricted
stock awards):
<TABLE>
<CAPTION>

                                             For the year ended December 31,
                           1996                           1995                           1994
                 --------------------------    ---------------------------    ----------------------------
                                Weighted                       Weighted                        Weighted
                                Average                        Average                          Average
                                Exercise                       Exercise                        Exercise
                   Shares         Price          Shares          Price          Shares           Price
                   ------         -----          ------          -----          ------           -----
<S>               <C>             <C>          <C>               <C>         <C>                 <C>
Options
outstanding at
the beginning
of the year..     1,226,214       $11.94       1,773,436         $12.37        659,058            $5.63
Granted......       911,000        10.34         262,641          11.42      1,461,015            15.08
Exercised....      (99,491)         4.28       (210,004)           5.90       (94,736)             5.27
Canceled.....     (288,612)        13.28       (599,859)          15.11      (251,901)            13.28
                 ===========      ======       =========         =======     =========           ======
Options
outstanding at
the end of the
year.........     1,749,111       $11.32       1,226,214         $11.94      1,773,436           $12.37
                 ===========    ========       =========         ======      =========           ======

Options
Exercisable..       493,008                      527,284                       701,563
                 ===========                   =========                     =========
</TABLE>

                                       47
<PAGE>

         During 1996, 1995 and 1994, no compensation cost was recognized related
to the above stock options.  The following outlines the significant  assumptions
used  to  calculate  the  fair  value   information   presented   utilizing  the
Black-Scholes Single Option approach with ratable amortization.
<TABLE>
<CAPTION>
                                                            1996          1995
                                                            ----          ----
<S>                                                         <C>           <C>  
Risk-free interest rate.................................... 5.90%         6.14%
Expected life..............................................  7.65          6.50
Expected volatility........................................   41%           41%
Expected dividends.........................................     -             -
Weighted average grant date fair value of options granted.. $5.61         $5.95
</TABLE>

         A detail of the options  outstanding and exercisable as of December 31,
1996 is presented below:
<TABLE>
<CAPTION>
                           Options outstanding                                     Options exercisable
--------------------------------------------------------------------------    ------------------------------
                                            Weighted
                                             average           Weighted                          Weighted
                                            remaining           average                           average
Range of exercise         Number           contractual         exercise          Number          exercise
      prices            outstanding       life in years          price        exercisable          price
-------------------    --------------    ----------------     ------------    -------------     ------------
<C>       <C>              <C>                      <C>           <C>              <C>              <C>    
$3.17  -  $6.98              105,561                 .84          $  3.95          100,235          $  3.94
9.15   -  10.75              821,112                8.83            10.04           86,796            10.15
11.00  -  12.88              389,000                8.72            11.69           71,250            11.68
15.00  -  15.38              433,438                7.34            15.22          234,727            15.21
-------------------        ----------               ----          -------          -------          -------

$3.17  - $15.38            1,749,111                7.96           $11.32          493,008           $11.52
===============            ==========               ====          =======          =======          =======
</TABLE>

         As the Company has adopted the disclosure  requirement of SFAS No. 123,
the following  table shows pro-forma net income and earnings per share as if the
fair value  based  accounting  method had been used to account  for  stock-based
compensation cost.
<TABLE>
<CAPTION>
         (in thousands, except earnings per share)         1996         1995
                                                           ----         ----
         <S>                                              <C>          <C>   
         Net income as reported......................     $5,206       $2,845
         Pro forma compensation expense..............      (774)        (235)
                                                          ======       ======
         Pro forma net income........................     $4,432       $2,610
                                                          ======       ======

         Pro forma earnings per share................       $.27         $.16
                                                          ======       ======
</TABLE>

         The effects of applying SFAS 123 in this pro forma  disclosure  are not
indicative of future amounts.  At December 31, 1996, 2,123,897 shares of  common
stock have been reserved for issuance under the Company's stock option plans.

10.       SHARE APPRECIATION RIGHTS PLAN

         In January 1991, Care's Board of Directors adopted a Share Appreciation
Rights Plan  (the "SAR Plan"),  which provided  for the award  of up  to 710,000
units to certain key  executives.  The SAR Plan was amended by the Care Board of
Directors and  stockholders  in May 1992, and assumed by Regency  at the time of
the Merger.

         The SAR Plan  provides  that upon award,  25% of the units vest on each
of the first four   anniversaries  of  the award date  and vested units  must be
exercised  before  the fifth anniversary  of the award.  All  outstanding  units
fully  vested on  January 1,  1995. Upon exercise,  the  awardee  is entitled to
receive  the  difference  between  the  base value and the  market  value on the


                                       48
<PAGE>

date the units are exercised, in cash or stock, at the Company's option.  During
1995, the  Company  discontinued the SAR Plan and settled all  outstanding units
for $1,628,000 cash and 55,310 shares.  This resulted  in  a charge to income of
$534,000 during 1995.

         The following is a summary of the SAR Plan (as adjusted by the Exchange
Ratio due to the Merger):

<TABLE>

                                                    Year ended December 31,
                                                     1995          1994
                                                     ----          ----
<S>                                                 <C>            <C>    
Units outstanding at beginning of the year......      236,430      236,430
Granted.........................................           --           --
Settled.........................................    (236,430)           --
Canceled........................................           --           --
                                                 =============  ===========
Units outstanding at end of the year............           --      236,430
                                                 =============  ===========

Units exercisable at end of the year............           --      177,322
                                                 =============  ===========

Unit price of outstanding units.................           --        $1.41
                                                 =============  ===========

Unit price of settled units.....................        $1.41           --
                                                 =============  ===========
</TABLE>


11.       RETIREMENT SAVINGS PLAN

         Regency  sponsors an employee  retirement  savings  plan under  Section
401(k) of the Internal  Revenue Code. All employees who are regularly  scheduled
to work 20 hours or more per week,  and complete 90 days of service are eligible
to participate.  Participants  can contribute,  on a pre-tax basis, up to 15% of
their  earnings  to the plan  (subject  to certain  limitations),  for which the
Company matched 15% of the first 3% of contributions  made for persons with less
than  three  years  of  service  and 25% of the  first  5% for all  others.  The
Company's  contributions  are subject to a four-year  vesting  period.  Matching
contributions  made by the Company for the years ended  December 31, 1996,  1995
and 1994 were approximately $697,000, $471,000, and $279,000, respectively.

12.       MERGER AND RESTRUCTURING EXPENSES

         All fees and  expenses  related to the Merger and to the  consolidation
and restructuring of the combining  companies during the year ended December 31,
1994,  were  expensed  as  required  under the  pooling-of-interests  accounting
method.

                                       49
<PAGE>

         The  following is a summary of the merger and  restructuring  expenses,
separated into cash and non-cash items (in thousands):
<TABLE>
<CAPTION>

                                                                       Cash       Non-Cash        Total
                                                                       ----       --------        -----
<S>                                                                   <C>            <C>         <C>     
Severance.....................................................        $ 4,394        $   --      $ 4,394
Management information, accounting,
   and operational integration................................          2,373            --        2,373
Investment banking fees.......................................          1,400            --        1,400
Value of assets written off...................................             --           777          777
Legal fees....................................................            612            --          612
Mailing and printing costs....................................            501            --          501
Merger bonuses................................................            500            --          500
Accounting fees...............................................            440            --          440
Former Care director and officer liability insurance..........            550            --          550
Miscellaneous.................................................            453            --          453
                                                                      -------     ---------     --------
                                                                       11,223           777       12,000
                                                                      -------     ---------     --------
Duplicate facility disposals:
   Operating losses...........................................            581            --          581
   Value of assets written off................................             --         1,569        1,569
   Loss on disposals..........................................            500            --          500
                                                                      -------     ---------     --------
                                                                        1,081         1,569        2,650
                                                                     ========     =========     ========
Total.........................................................        $12,304        $2,346      $14,650
                                                                     ========     =========     ========
</TABLE>

         As of December 31, 1994, the remaining  accrual  relating to merger and
restructuring  expenses was  $4,452,000  including  cash and  non-cash  items of
$2,800,000 and $1,700,000,  respectively.  The remaining  accrual consisted of a
provision for duplicate facility  disposals of $2.3 million,  severance costs of
$1.5  million,  investment  banking fees of $126,000,  and other costs  totaling
$545,000. All remaining costs were utilized during 1995.  (See Note 14.)

13.      ACQUISITIONS

         Effective January 2, 1996, the Company completed the acquisition of the
assets of  Assist-A-Care,  a  pharmacy  located in San  Diego,  California.  The
purchase  price  was $5.8  million,  composed  of $3.2  million  cash and a $2.6
million note payable.

         Effective February 1, 1996, the Company acquired leasehold interests in
18 health care  facilities in Tennessee and North  Carolina with 2,375 beds from
Liberty Healthcare Limited Partnership ("Liberty") through an asset purchase for
$39.3  million  cash and a note  payable  for $2.2  million.  The  Company  also
acquired  Executive  Pharmacy  (consisting of one pharmacy in North Carolina and
one in Tennessee) with a $763,000 note payable and an enteral  feeding  business
for $1.5 million cash from businesses affiliated with Liberty. In addition,  the
Company  paid  $400,000  cash for the  inventory  of  Liberty.  A portion of the
purchase  was  funded  with notes  payable,  which may be reduced as a result of
certain seller liabilities and audit adjustments. Escrow accounts established at
the time of purchase  were  funded  with $2.96  million for payment on the notes
payable  and are  included  in other  assets  on the  accompanying  consolidated
balance sheet as of December 31, 1996.

         On April 1, 1996, the Company  completed the  acquisition of the assets
of Buena Vista Nursing  Center ("Buena  Vista"),  a health care facility with 64
skilled  nursing beds and 22 assisted living beds,  located in Lexington,  North
Carolina. The purchase price was $2.875 million, consisting of $2.675 million in
cash and a $200,000  note payable.  Payment of the note is dependent  upon Buena
Vista attaining certain financial targets.

                                       50
<PAGE>

         On July 6,  1995,  the  Company  acquired  all of the  stock  of SCRS &
Communicology,  Inc.  ("SCRS") for a total purchase  price of $13.5 million,  of
which $3.4 million is represented by a promissory note which was paid in January
1996. SCRS provides  contract  rehabilitation  services to Company  operated and
third party healthcare facilities.

         All acquisitions during  1995 and 1996  were  accounted  for under  the
purchase method of accounting

         The following unaudited pro forma condensed consolidated  statements of
earnings  present  the  summarized  consolidated  results of  operations  of the
Company   after   giving   effect   to   the   acquisitions   of   Liberty   and
Liberty-affiliated businesses for the years ended December 31, 1996 and 1995, as
if such  acquisitions  had been  consummated  on January 1, 1995 (in  thousands,
except per share data):
<TABLE>
<CAPTION>

                                                               Year ended 
                                                               December 31,
                                                             -------------------
                                                               1996      1995
                                                               ----      ----
                                                                  (Unaudited)
       <S>                                                   <C>       <C>     
       Net operating revenue...............................  $564,856  $495,690
       Total costs and expenses............................   553,264   483,020
                                                              -------  --------

       Income before provision for income taxes............    11,592    12,670
       Provision for income taxes..........................     4,856     7,676
                                                             --------  --------

       Net income before extraordinary item................  $  6,736  $  4,994
                                                             ========  ========

       Income before extraordinary item per common share...  $   0.41  $   0.30
                                                             ========  ========
</TABLE>

         The pro forma results are presented for informational purposes only and
are not necessarily indicative of what results of operations actually would have
been had such  acquisitions  been consummated at the beginning of such period or
of future  operations  or  results.  The  effect of the  other  acquisitions  is
immaterial.

14.      RESTRUCTURING AND OTHER NON-RECURRING CHARGES

         During  1996 the  Company  developed  a  comprehensive  strategic  plan
impacting all of its operating divisions. In connection with this strategic plan
the Company has  undertaken  initiatives  designed to  reengineer  the operating
model  through  which it manages  its  business.  This  reengineering  effort is
focused on identifying and  implementing  the most effective and efficient model
for managing the delivery of products and services to the Company's  patients on
a local market by market basis. The plan includes  consolidating  and automating
the Pharmacy  operations,  consolidating the Home Health operations,  automating
and  streamlining  certain  functions  in the  nursing  center  operations,  and
streamlining the corporate support  structure.  Through this process the Company
identified  approximately  350  non-direct  patient  care  positions  across all
divisions,  including the Corporate  Office,  which will be  eliminated.  Of the
positions identified,  approximately 30 were eliminated during 1996. The Company
began the implementation phase of this plan during the fourth quarter of 1996.

         Additionally,   the  Company  has  identified  the   implementation  of
significant  management  information  system  (MIS)  enhancements  as a critical
component of its overall strategic plan. Implementing these MIS initiatives will
be an integral part of the realization of an effective and efficient  management
model, through which the Company can monitor its patients,  from both a cost and
a clinical  perspective,  seamlessly throughout the continuum of care and across
all divisions of the Company.  Furthermore,  these MIS initiatives  will provide
management with complete patient information within each local market,  which is
vital  in the  managed  care  environment  of  today  and in  the  future.  This
implementation is expected to continue during 1997 and into 1998. Several of the


                                       51
<PAGE>

Company's current management  information systems will be replaced in connection
with the MIS  initiatives.  The Company  has also  identified  certain  impaired
property and equipment and intangible assets and future contractual  obligations
that will have no value to the  Company  under  the new  operating  model due to
obsolescence,   consolidation  of  locations,  and  streamlining  of  processes.
Accordingly,  the Company has written off certain  long-term  assets and accrued
certain obligations, including obligations related to leases.

         The  Company has  evaluated  the  reserve  established  in 1995 for the
disposition  of  13  facilities  located  in  California   discussed  below  and
allowances  established  for certain  notes and other  non-patient  receivables.
Based on the actual sale of six of the 13  facilities,  and the estimated  sales
prices for the remaining seven  facilities,  the Company has reduced the reserve
for the  disposition of 13 facilities as of December 31, 1996.  Earnings  before
income taxes for the remaining  seven  facilities  were  $940,000,  $765,000 and
$316,000 for 1996, 1995 and 1994,  respectively.  In addition,  an allowance was
established  for certain notes and non-patient  receivables  that arose in prior
years,  which were not  collected  as  anticipated  by the  Company  and certain
long-term assets were written down to net realizable value.

         The following summarizes the impact of the above items on the Company's
results of operations for 1996:
<TABLE>
<CAPTION>

                                                                              Non-
                                                      Restructuring        recurring            Total
                                                     -----------------    -------------     ---------------
<S>                                                        <C>              <C>               <C>
MIS and other property and equipment written off
                                                           $2,057,000       $2,320,000        $  4,377,000
Goodwill and other assets written off...........            2,300,000        1,255,000           3,555,000
Future lease and other obligations..............              325,000        1,891,000           2,216,000
Severance (including $711,000 paid during 1996).
                                                            1,377,000               --           1,377,000
Allowance for notes and other receivables.......                   --        1,010,000           1,010,000
Reengineering costs incurred....................              511,000               --             511,000
Reduction of reserve for assets held for sale...                   --       (1,763,000)         (1,763,000)
                                                          -----------      -----------        -------------

                                                           $6,570,000       $4,713,000         $11,283,000
                                                          ===========      ===========        ============
</TABLE>

         In 1995,  the Company  determined  to dispose of 13 facilities  located
in  California.  In addition,  during 1995 the Company completed the disposition
of  duplicate  facilities  identified  during 1994  as  part  of the  merger and
restructuring  costs,  the  Simi  Valley  healthcare  facility  damaged  in  the
Southern  California  (Northridge)  earthquake   and  one  other  facility,  and
exchanged leasehold  interests  in  three  nursing  centers  in  New  Mexico for
leasehold  interest in four nursing centers in Ohio. These transactions resulted
in  a  net  charge  of  $9,000,000  during  1995.  This  charge was  based  upon
management's  best estimates  of the amounts expected to be estimated fair value
less selling costs.

15.       FAIR VALUE OF FINANCIAL INSTRUMENTS

         The estimated fair  values of  the Company's  financial  instruments at
December 31, 1996 are as follows (in thousands):
<TABLE>
<CAPTION>

                                                     Carrying
                                                      Amount       Fair Value
                                                     --------      ----------

   <S>                                               <C>            <C>      
   Cash and cash equivalents..................       $ 22,875       $ 22,875
                                                     ========       ========

   Mortgage notes receivable..................       $  1,937       $  1,937
                                                     ========       ========

   Long-term debt, including current portion..       $184,908       $190,139
                                                     ========       ========
</TABLE>

                                       52
<PAGE>

         The  carrying  amount   approximates  fair  value  for  cash  and  cash
equivalents  because of the short maturity of these instruments.  The fair value
of mortgage notes  receivable was estimated based on the present value of future
cash flows using  current  rates the Company  could obtain on notes with similar
characteristics and maturities.  The fair value for the Company's long-term debt
was estimated  based on the quoted market prices for the same or similar  issues
or on the present  value of future cash flows  using  current  rates the Company
could obtain on debt with similar characteristics and maturities.

16.      SUBSEQUENT EVENTS

         Effective   January  1,  1997,   the   Company   acquired   four  acute
rehabilitation  hospitals,  eleven  outpatient  rehabilitation  clinics  and six
neurological  treatment centers from Horizon/CMS Healthcare Corporation ("CMS").
The purchase price was $43.0 million, made up of a cash payment of $36.3 million
and notes payable totaling $6.7 million.

17.       QUARTERLY FINANCIAL DATA (UNAUDITED):
<TABLE>
<CAPTION>

                                                          Year Ended December 31, 1996
                                          First        Second         Third         Fourth
                                         Quarter       Quarter       Quarter        Quarter        Total
                                         -------       -------       -------        -------        -----
                                                   (in thousands, except per share amounts)

<S>                                      <C>           <C>           <C>            <C>           <C>     
Net operating revenue..............      $129,963      $137,632      $144,103       $146,352      $558,050
                                         ========      ========      ========       ========      ========

Income (loss) before extraordinary
   item............................        $2,737        $3,065        $3,641       $(3,044)        $6,399
                                         ========      ========      ========       ========      ========

Net income (loss)..................        $2,737        $3,065        $2,448       $(3,044)        $5,206
                                         ========      ========      ========       ========      ========

Income (loss) per share - Primary:
   Income (loss) before
      extraordinary item...........          $.16          $.19          $.22         $(.19)          $.39
                                         ========      ========      ========       ========      ========

   Net income (loss)...............          $.16          $.19          $.15         $(.19)          $.32
                                         ========      ========      ========       ========      ========

Income (loss) per share -
   Fully Diluted:
   Income (loss) before
      extraordinary item...........          $.16          $.18          $.22         $(.19)          $.39
                                         ========      ========      ========       ========      ========

   Net income (loss)...............          $.16          $.18          $.15         $(.19)          $.32
                                          ========     ========      ========       ========      ========
</TABLE>

         Effective January 2, 1996, the Company completed the acquisition of the
assets of  Assist-A-Care,  a  pharmacy  located in San  Diego,  California.  The
purchase  price was $5.8  million,  composed of $3.2  million in cash and a $2.6
million note payable.

         Effective February 1, 1996, the Company acquired leasehold interests in
18 health care  facilities in Tennessee and North  Carolina with 2,375 beds from
Liberty Healthcare Limited Partnership ("Liberty") through an asset purchase for
$39.3  million  cash and a note  payable  for $2.2  million.  The  Company  also
acquired  Executive  Pharmacy  (consisting of one pharmacy in North Carolina and
one in Tennessee) with a $763,000 note payable and an enteral  feeding  business
for $1.5 million cash from businesses affiliated with Liberty. In addition,  the
Company paid $400,000 cash for the inventory of Liberty.

                                       53
<PAGE>

         On April 1, 1996, the Company  completed the  acquisition of the assets
of Buena Vista Nursing Center in Lexington,  North Carolina.  The purchase price
was $2.875 million,  consisting of $2.675 million in cash and a note payable for
$200,000.

         On July 29, 1996,  the Company  completed  the  redemption of all $48.9
million of its outstanding Convertible  Subordinated Debentures for cash at such
amount.  The  redemption  reduces fully diluted shares by 3.9 million shares and
results in an extraordinary  loss on extinguishment of debt of $868,000,  net of
tax, resulting from the write-off of unamortized underwriting costs.

         Effective  September 30, 1996, the Company refinanced three of its IRBs
with an aggregate  outstanding  principal  balance of $7,560,000  with three new
issues of tax exempt IRBs. The refinancing  resulted in an extraordinary loss on
extinguishment of debt of $325,000,  net of tax, resulting from the write-off of
unamortized underwriting costs and a call premium paid.

         During  the fourth  quarter  of 1996,  the  Company  recorded  an $11.3
million  charge  related  to  restructuring  and  other  non-recurring  items as
discussed in Note 14.
<TABLE>
<CAPTION>

                                                          Year Ended December 31, 1995
                                          First         Second        Third         Fourth
                                         Quarter        Quarter      Quarter        Quarter        Total
                                         -------        -------      -------        -------        -----
                                                    (in thousands, except per share amounts)

<S>                                       <C>           <C>          <C>            <C>           <C>     
Net operating revenue..............       $97,548       $99,766      $107,492       $111,287      $416,093
                                          =======       =======      ========       ========      ========

Income (loss) before extraordinary
   item............................        $3,087        $1,780        $4,042       $(4,455)        $4,454
                                          =======       =======      ========       ========      ========

Net income (loss)..................        $3,087        $1,780        $4,042       $(6,064)        $2,845
                                          =======       =======      ========       ========      ========

Income (loss) per share - Primary:
   Income (loss) before
      extraordinary item...........          $.19          $.11          $.24         $(.27)          $.27
                                          =======       =======      ========       ========      ========

   Net income (loss)...............          $.19          $.11          $.24         $(.36)          $.17
                                          =======       =======      ========       ========      ========

Income (loss) per share -
   Fully Diluted:
   Income (loss) before
      extraordinary item...........          $.18          $.11          $.22         $(.27)          $.27
                                          =======       =======      ========       ========      ========

   Net income (loss)...............          $.18          $.11          $.22         $(.36)          $.17
                                          ========      =======      ========       ========      ========

</TABLE>

         Effective July 6, 1995, the Company acquired all of the stock of SCRS &
Communicology,  Inc.  ("SCRS") for a total purchase  price of $13.5 million,  of
which $3.4 million is represented by a promissory note which was paid in January
1996. The acquisition was accounted for under the purchase method of accounting.
SCRS  provides  rehabilitation  services  to Company  operated  and third  party
healthcare facilities.

                                       54
<PAGE>

         In May 1995, a class action  lawsuit  which had been filed  against the
Company in July 1994, was settled for $9,000,000.  The Company's portion of this
settlement,  together  with related  legal fees and other  costs,  resulted in a
pre-tax charge of $3,098,000, which is included in the consolidated statement of
operations for the quarter ended June 30, 1995.

         In October  1995,  the Company  repaid its $30  million,  8.10%  Senior
Secured  Notes  resulting  in  costs  and  prepayment  penalties  of  $2,681,000
($1,609,000  net of tax),  classified  as an  extraordinary  item in the quarter
ended December 31, 1995.

         In December 1995, the Company recorded a $9,000,000  charge,  primarily
related to the disposition of certain  facilities (See Note 14).

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

         None.

                                       55
<PAGE>

                                    PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

         Information  required  by this  item for the  Company's  directors  and
executive  officers will be contained in Regency's  Notice of Annual  Meeting of
Stockholders and Proxy  Statement,  pursuant to Regulation 14A, to be filed with
the  Securities  and Exchange  Commission  on or before  April 14, 1997,  and is
incorporated herein by reference.

ITEM 11.  EXECUTIVE COMPENSATION

         Information required by this item will be contained in Regency's Notice
of Annual Meeting of Stockholders  and Proxy  Statement,  pursuant to Regulation
14A, to be filed with the Securities and Exchange  Commission on or before April
14, 1997, and is incorporated herein by reference.

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

         Information required by this item will be contained in Regency's Notice
of Annual Meeting of Stockholders  and Proxy  Statement,  pursuant to Regulation
14A, to be filed with the Securities and Exchange  Commission on or before April
14, 1997 and is incorporated herein by reference.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

         Information required by this item will be contained in Regency's Notice
of Annual Meeting of Stockholders  and Proxy  Statement,  pursuant to Regulation
14A, to be filed with the Securities and Exchange  Commission on or before April
14, 1997, and is incorporated herein by reference.

                                       56
<PAGE>

                                     PART IV

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

The following are filed as part of this Report.

(a)(1) FINANCIAL STATEMENTS

Report of Independent Public Accountants.......................... 31
Consolidated Balance Sheets as of December 31, 1996 and 1995...... 32
Consolidated Statements of Operations for the Years Ended 
  December 31, 1996, 1995 and 1994................................ 34
Consolidated Statements of Stockholders' Equity for the Years
  Ended December 31, 1996, 1995 and 1994.......................... 35
Consolidated Statements of Cash Flows for the Years Ended
  December 31, 1996, 1995 and 1994................................ 36
Notes to Consolidated Financial Statements........................ 38

(a)(2) FINANCIAL STATEMENT SCHEDULES

         Schedule II - Valuation and Qualifying Accounts
         All other  Financial  Statement  schedules  have been omitted from this
Item  14(a)(2)  because they are not  applicable  or not required or because the
information  is included  elsewhere  in the  financial  statements  or the notes
thereto.

(a)(3) EXHIBITS

     Number                   Description

       3.1          Restated Certificate of Incorporation of the Company. (7)

       3.2          Restated Bylaws of the Company, and Amendment  thereto dated
                    June 8, 1995 (11).

       4.1          Restated Certificate of  Incorporation and  Restated  Bylaws
                    filed as Exhibits 3.1 and 3.2. (7)(11)

       4.2          Specimen of Common Stock Certificate. (1)

       4.3          Indenture,  dated as of October 12, 1995, for 9-7/8%  Senior
                    Subordinated   Notes   due  2002,   among  Registrant,   the
                    Subsidiary Guarantors named therein and U.S.  Trust  Company
                    of  California,   N.A.,  as  Trustee.  (originally filed  as
                    Exhibit number 4.4) (12)

       4.4          Form of 9 7/8% Senior Subordinated Note due 2003 of  Regency
                    Health Services, Inc. (included in Exhibit 4.3)

       4.5          Second  Amended and Restated  Registration Rights Agreement,
                    dated as of January 31, 1994, among Regency Health Services,
                    Inc., Care  Enterprises,  Inc. and  the  stockholders  named
                    therein. (originally  filed as Exhibit number 4.7) (7)

                                       57
<PAGE>

       4.6*         Registrant's Long-Term Incentive  Plan. (originally filed as
                    Exhibit number 4.8) (4)

       4.7*         Amendment  to  Regency   Health  Services,   Inc.  Long-Term
                    Incentive Plan. (originally filed as Exhibit number 4.9)(7)

       4.8*         Regency   Health   Services,   Inc.   Director  Stock  Plan.
                    (originally filed as Exhibit number 4.10) (4)

       4.9*         Indenture, dated as of June 28, 1996, between Regency Health
                    Services,  Inc. As Issuer, the Guarantors named  therein and
                    U.S.  Trust  Company   of  California,   N.A.,  as  Trustee.
                    (originally  filed as Exhibit number 4.11) (16)

       4.10*        Form of 12-1/4% Subordinated Note due 2003 of Regency Health
                    Services,  Inc. (included in Exhibit 4.9). (originally filed
                    as Exhibit number 4.12) (16)

      10.1*         Registrant's  401  (K)  Employee  Retirement  Savings  Plan.
                    (originally filed as Exhibit number 10.1) (1)

      10.2*         Form of Indemnity  Agreement  between the Registrant and its
                    Directors.  (originally  filed as Exhibit number 10.3) (1)

      10.3          Master  Contract  for  Non-Public,   Non-Secretarian  School
                    Agency Services,  dated September 16, 1991,  between Regency
                    High   School   and  Long  Beach  Unified  School  District.
                    (originally filed as Exhibit number 10.4) (1)

      10.4          Mental Health Services  Agreement for adolescent  center for
                    1993,  1994 and 1995,  between the  County  of  Los Angeles,
                    Department  of  Mental Health  and  Harbor   View,  formerly
                    Harbor  View  Rehabilitation   Center. (originally  filed as
                    Exhibit number 10.5) (2)

      10.5          Building  Loan  Agreement,  dated  November 20, 1992, by and
                    between   Carmichael    Convalescent    Hospital   and   PFC
                    Corporation. (originally filed as Exhibit number 10.6) (3)

      10.6          Security Agreement, dated as of  November 20,  1992, between
                    Carmichael  Convalescent   Hospital  and  PFC   Corporation.
                    (originally filed as Exhibit number 10.7) (3)

      10.7*         Employment Agreement between Regency Health  Services,  Inc.
                    and Richard K. Matros dated April 4, 1994. (originally filed
                    as Exhibit number 10.10) (7)

      10.8*         Letter agreement  between  the  Registrant  and  Cecil  Mays
                    (originally filed as Exhibit number 10.14) (9)

      10.9*         Employment agreement between Regency  Health Services,  Inc.
                    and  Stephen  W.  Carlton dated January 9, 1995. (originally
                    filed as Exhibit number 10.17) (10)

      10.10*        Indemnification  Agreement  dated  January 1, 1994,  between
                    the Company and Brad L. Kerby. (originally filed as  Exhibit
                    number 10.18) (10)

                                       58
<PAGE>

      10.11         Stock Purchase Agreement dated as of July 5,  1995 among the
                    Company,  Sherri Medina,  Jamison Ashby,  Daniel Larson  and
                    Vivra  Incorporated. (originally  filed  as  Exhibit  number
                    10.19) (11)

      10.12         Promissory Note dated as of July 6, 1995 by  the Company  in
                    favor of Vivra Incorporated.  (originally  filed as  Exhibit
                    number 10.20) (11)

      10.13         Indemnification  Escrow  Agreement dated as of July 6,  1995
                    among the Company, Vivra Incorporated, SCRS & Communicology,
                    Inc., of Ohio  and  Mellon Bank,  N.A.  (originally filed as
                    Exhibit number 10.21) (11)

      10.14         Form of Non-Competition  and Non-Disclosure  Agreement dated
                    as of July 6,  1995 between the  Company and each of  Sherri
                    Medina, Jamison Ashby  and Daniel  Larson. (originally filed
                    as Exhibit number 10.22) (11)

      10.15         Non-Competition  and  Non-Disclosure  Agreement  dated as of
                    July 6,  1995  between  the Company  and Vivra Incorporated.
                    (originally filed as Exhibit number 10.23) (11)

      10.16         Inducement  Agreement  dated  as of  July 6,  1995 among the
                    Company,  Sherri Medina  and SCRS &  Communicology, Inc., of
                    Ohio. (originally filed as Exhibit number 10.24) (11)

      10.17         Management  Services Agreement dated January 1, 1995 between
                    SCRS   &   Communicology,   Inc.,   of  Ohio   and   SCRS  &
                    Communicology,  Inc.  (originally  filed  as Exhibit  number
                    10.25) (11)

      10.18*        Employment  Agreement dated as of July 6,  1995  between the
                    Company  and  Sherri Medina.  (originally filed  as  Exhibit
                    number 10.26) (11)

      10.19*        Employment  Agreement dated as  of June 8, 1995  between the
                    Company and  David A. Grant.  (originally  filed as  Exhibit
                    number 10.27) (11)

      10.20*        Severance Agreement  and Release of Claims dated as of March
                    31, 1995 between the Company and Brad L. Kerby. (originally 
                    filed as Exhibit number 10.29) (11)

      10.21*        Credit  Agreement,  dated  as  of  December  28,1995,  among
                    Registrant,  the financial institutions  listed  therein  as
                    Lenders,  Nations Bank Capital  Markets,  Inc.,  as Arranger
                    and   NationsBank   of  Texas,  N.A.,  as Agent. (originally
                    filed as Exhibit number 10.31) (13)

      10.22*        Settlement  Agreement and Release of All Claims  dated as of
                    October 18, 1995  between  the Company  and  James R. Wodach
                    (originally filed as Exhibit number 10.32) (14)

      10.23*        Employment  Agreement  dated as of December 15, 1995 between
                    the Company  and  Bruce D.  Broussard  (originally  filed as
                    Exhibit number 10.33) (14)

      10.24         Non-Qualified   Stock  Option  Agreement   between   Regency
                    Health   Services,   Inc.   and  Richard  K.  Matros   dated
                    January 2, 1996.

      10.25         Non-Qualified  Stock  Option   Agreement   between   Regency
                    Health   Services,   Inc.  and   Bruce  D.  Broussard  dated
                    January 2, 1996.

                                       59
<PAGE>

      10.26*        Severance Letter  Agreement  dated as  of  February 22, 1996
                    between the Company and Barbara Garner  (originally filed as
                    Exhibit number 10.34) (14)

      10.27         Purchase  and Sale  Agreement, dated as of January 12, 1996,
                    between   Registrant    and    Liberty   Healthcare  Limited
                    Partnership and  Liberty  Assisted  Living  Centers  Limited
                    Partnership. (originally  filed as Exhibit number 10.35)(15)

      10.28         Stock Purchase and Sale  Agreement  dated  February 1, 1996,
                    between   First   Class  Pharmacy,  Inc.,   a   wholly-owned
                    subsidiary  of the  Registrant,  and the  owners  of  Common
                    Stock   of  Executive  Pharmacy  Services,  Inc. (originally
                    filed as Exhibit number 10.36) (15)

     10.29          Purchase and Sale Agreement - Fresno,  dated as of  November
                    19, 1996, between Regency Rehab Hospitals,  Inc., a  wholly-
                    owned  subsidiary of the Registrant and  Continental Medical
                    Systems, Inc. (originally  filed as Exhibit number 2.1) (17)

     10.30          Purchase  and  Sale  Agreement  -  Kentfield,  dated  as  of
                    November 19, 1996  between  Regency  Rehab  Hospitals, Inc.,
                    a wholly-owned  subsidiary of the Registrant  and  Kentfield
                    Hospital  Corporation.  (originally filed as Exhibit  number
                    2.2) (17)

     10.31          Stock   Purchase   and   Sale   Agreement  -  Rehabworks  of
                    California,  dated as of November 19, 1996, between Regency
                    Rehab  Hospitals,  Inc., a  wholly-owned subsidiary  of  the
                    Registrant and  CMS  Therapies,  Inc. (originally  filed  as
                    Exhibit number 2.3) (17)

     10.32          Purchase  and Sale  Agreement  - San  Bernardino,  dated  as
                    of  November  19,  1996,  between  Regency  Rehab Hospitals,
                    Inc.,  a  wholly-owned  subsidiary  of  the  Registrant  and
                    Continental  Medical  Systems,  Inc.  (originally  filed  as
                    Exhibit number 2.4) (17)

     10.33          Purchase and Sale  Agreement - San  Bernardino  Real Estate,
                    dated  as  of  November  19, 1996,  between   Regency  Rehab
                    Properties,    Inc.,   a   wholly-owned  subsidiary  of  the
                    Registrant and  Rehab Concepts Corp.  (originally  filed  as
                    Exhibit number 2.5) (17)

     10.34          Purchase   and  Sale  Agreement - San Diego,   dated  as  of
                    November 19, 1996,  between  Regency Rehab  Hospitals, Inc.,
                    a  wholly-owned  subsidiary of  the Registrant and San Diego
                    Rehab Limited  Partnership.  (originally  filed  as  Exhibit
                    number 2.6) (17)

     10.35          Purchase and Sale  Agreement - San Diego Real Estate,  dated
                    as of November 19, 1996,  between  Regency Rehab Properties,
                    Inc.,  a  wholly-owned  subsidiary  of the   Registrant  and
                    San   Diego   Health    Associates   Limited    Partnership.
                    (originally filed as Exhibit number 2.7) (17)

     10.36          Purchase and Sale Agreement - Western Neurologic Residential
                    Centers, dated  as  of November  10, 1996,  between  Regency
                    Rehab  Hospitals,  Inc.,  a  wholly-owned  subsidiary of the
                    Registrant  and   Western  Neurologic  Residential  Centers.
                    (originally filed as Exhibit number 2.8) (17)

                                       60
<PAGE>

     10.37          First Amendment  to  Purchase  and Sale  Agreement - Western
                    Neurologic  Residential  Centers,  Dated as of  November 19,
                    1996,  between  Regency  Rehab  Hospitals,  Inc., a  wholly-
                    owned  subsidiary of the Registrant and  Western  Neurologic
                    Residential  Centers.  (originally  filed  as Exhibit number
                    2.9) (17)

     10.38          Regional Office  Agreement, dated November 19, 1996, between
                    Regency Rehab Hospitals,  Inc., a wholly-owned subsidiary of
                    the  Registrant  and  Continental   Medical   Systems,  Inc.
                    (originally filed as Exhibit number 2.10)(17)

     10.39          Amended and Restated Credit Agreement  dated as of  December
                    20, 1996 among Regency Health  Services, Inc., as  borrower,
                    the Lenders listed,  Nationsbanc  Capital  Markets, Inc., as
                    arranger,  and Nationsbank of Texas, N.A., as agent. 
                    (originally filed as Exhibit number 2.11) (17)

     10.40          Amendment and confirmation of Collateral  Account Agreement,
                    Company  Pledge  Agreement  and  Company Security Agreement.
                    (originally filed as Exhibit number 2.12) (17)

     10.41          Amendment   and   Confirmation   of   Subsidiary   Guaranty,
                    Subsidiary   Pledge   Agreement  and   Subsidiary   Security
                    Agreement. (originally filed as Exhibit number 2.13) (17)

     10.42          Asset Purchase  Agreement  among  Managed  Respiratory  Care
                    Services, Inc. (MRCS), and Arizona corporation, Jean Mathews
                    and  Joe  Salazar  (the  sole  stockholders,  directors  and
                    officers of MRCS) and SCRS  & Communicology, Inc. of Ohio, a
                    wholly owned subsidiary of the Registrant.

     10.43          Financing Agreement by and between the City of Beckley, West
                    Virginia  and Beckley  Health Care Corp. ("Beckley Financing
                    Agreement"),  a wholly  owned  subsidiary of the Registrant,
                    dated as of September 1, 1996.

     10.44          Indenture of Trust  relating to $2,830,000  Nursing Facility
                    Refunding  Revenue  Bonds,  Series  1996  by and between The
                    City  of  Beckley,   West  Virginia  and  One  Valley  Bank,
                    National Association,  as Trustee,  dated as of September 1,
                    1996  issued  in  connection  with   the  Beckley  Financing
                    Agreement.

     10.45          Financing   Agreement   by  and   between   the   Board   of
                    Commissioners of the County of Perry, Ohio, by and on behalf
                    of  the  County of  Perry,  Ohio  and New  Lexington  Health
                    Care  Corp. ("New Lexington Financing Agreement"),  a wholly
                    owned subsidiary of the Registrant, dated as of September 1,
                    1996.

     10.46          Indenture of Trust  relating to $2,545,000  Nursing Facility
                    Refunding  Revenue  Bonds, Series 1996 by and between County
                    of Perry, Ohio and SunTrust Bank, Central  Florida, National
                    Association,  as  Trustee,  dated  as  of  September 1, 1996
                    issued  in  connection  with  the  New  Lexington  Financing
                    Agreement.

     10.47          Financing  Agreement  by and between the County  Commission 
                    of Harrison County by and on behalf of Harrison County, West
                    Virginia  and  Salem  Health  Care  Corp. ("Salem  Financing
                    Agreement"), a wholly owned subsidiary  of  the  Registrant,
                    dated as of September 1, 1996.

     10.48          Indenture of Trust  relating to $2,185,000  Nursing Facility
                    Refunding  Revenue  Bonds,  Series  1996  by and between the
                    County  Commission of Harrison  County by and  on  behalf of
                    Harrison County, West Virginia and One Valley Bank, National
                    Association,  as  Trustee,  dated  as  of  September 1, 1996
                    issued in connection with the Salem Financing Agreement.

      13            1996 Annual Report to Security Holders

      21            List of Subsidiaries of the Registrant

                                       61
<PAGE>

      23            Consent of Independent Public Accountants

      27            Financial Data Schedule

*    Management or compensatory plan, contract or arrangement
(1)  Incorporated by reference to Regency  Health Services,  Inc.'s Registration
     Statement  on Form S-1 (No. 33-45591).
(2)  Incorporated by reference to Regency  Health  Services,  Inc.'s 1992 Annual
     Report on Form 10-K (File No. 1-11144).
(3)  Incorporated by reference to Regency Health  Services,  Inc.'s Registration
     Statement  on Form S-1 (No. 33-53590).
(4)  Incorporated  by reference to Regency Health  Services,  Inc.'s 1993 Proxy 
     Statement dated December 10, 1993 (File No. 1-11144).
(5)  Incorporated by reference to Regency  Health  Services,  Inc.'s 1993 Annual
     Report on Form 10-K (File No. 1-11144).
(6)  Incorporated by reference  to Regency  Health  Services,  Inc.'s  Report on
     Form 10-Q for the Quarter  Ended September 30, 1993  (File No. 1-11144).
(7)  Incorporated  by  reference  to Regency  Health  Services,  Inc.'s and Care
     Enterprises,  Inc.'s Joint Proxy Statement dated March 7, 1994.
(8)  Incorporated by reference to Care Enterprises, Inc.'s 1993 Annual Report on
     Form 10-K (File No. 1-9310).
(9)  Incorporated  by  reference  to Regency  Health  Services,  Inc.'s  
     Transition  Report on Form 10-K (File No. 1-11144).
(10) Incorporated by reference to Regency Health Services, Inc.'s 1994 Annual 
     Report on Form 10-K (File No. 1-11144).
(11) Incorporated by reference to Regency Health Services, Inc.'s Report on Form
     10-Q for the Quarter Ended June 30, 1995 (File No. 1-11144).
(12) Incorporated by reference to Regency Health Services, Inc.'s Report on Form
     8-K dated August 24, 1995 (File No. 1-11144).
(13) Incorporated by reference to Regency Health Services, Inc.'s Report on Form
     8-K dated December 28, 1995 (File No. 1-11144).
(14) Incorporated by reference to Regency Health Services, Inc.'s 1995 Annual 
     Report on Form 10-K (File No. 1-11144).
(15) Incorporated by reference to Regency Health Services, Inc.'s Report on Form
     8-K dated February 15, 1996 (File No. 1-11144).
(16) Incorporated by reference to Regency Health Services, Inc.'s Report on Form
     10-Q for the Quarter Ended June 30, 1996 (File No. 1-11144).
(17) Incorporated by reference to Regency Health Services, Inc.'s Report on Form
     8-K dated January 15, 1997.


(b) REPORTS ON FORM 8-K

         None.

                                       62
<PAGE>


                                                                     SCHEDULE II
<TABLE>


                          REGENCY HEALTH SERVICES, INC.

                        VALUATION AND QUALIFYING ACCOUNTS
                                 (in thousands)
<CAPTION>


                                Balance         Charged           Charged
                                  at              to                 to                              Balance
                               Beginning        Costs &            Other                             at End
        Description            of Period       Expenses           Accounts         Deductions       of Period
--------------------------    ------------     ----------        -----------      ------------     -----------

<S>                                <C>            <C>               <C>               <C>            <C>
FOR THE YEAR ENDED
DECEMBER 31, 1996
Allowance for doubtful
accounts.............              $3,757         $2,890            $410  (a)         $2,334         $4,723
Allowance for mortgage
loan losses..........                 951            689              --                 288          1,352
                                   ------         ------            -----             ------         ------

                                   $4,708         $3,579            $410              $2,622         $6,075
                                   ======         ======            =====             ======         ======

FOR THE YEAR ENDED
DECEMBER 31, 1995
Allowance for doubtful
accounts.............              $4,189         $1,922            $734  (b)         $3,088         $3,757
Allowance for mortgage
loan losses..........                 951             --              --                  --            951
                                   ------         ------            -----             ------         ------

                                   $5,140         $1,922            $734              $3,088         $4,708
                                   ======         ======            =====             ======         ======

FOR THE YEAR ENDED
DECEMBER 31, 1994
Allowance for doubtful
accounts.............              $2,970         $1,344            $687  (c)         $  812         $4,189
Allowance for mortgage
loan losses..........               1,664             --              --                 713            951
                                   ------         ------            ----              ------         ------

                                   $4,634         $1,344            $687              $1,525         $5,140
                                   ======         ======            ====              ======         ======


<FN>

(a)  Includes (i) Executive Pharmacy acquired reserves and (ii) recoveries

(b)  Includes  (i) the  reclassification  of  accruals  established  in 1994 for
     receivables  related to duplicate  facility  disposals,  (ii) SCRS acquired
     reserves, and (iii) recoveries

(c)  Reclassification of reserve established against note received by Care

</FN>
</TABLE>

                                       63
<PAGE>


                                   SIGNATURES

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

                                           REGENCY HEALTH SERVICES, INC.


Date: March 24, 1997                       By /s/ Richard K. Matros
                                           ---------------------
                                           Richard K. Matros
                                           President and Chief Executive Officer

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

          Name and Signature                  Title                   Date
By   /s/ Richard K. Matros           President and Chief          March 24, 1997
    -----------------------------    Executive Officer(Principal
             Richard K. Matros       executive officer)
                                                                 
                                      
By   /s/ Bruce D. Broussard          Executive Vice President,    March 24, 1997
    -----------------------------    and Chief Financial Officer
            Bruce D. Broussard       (Principal financial and      
                                     accounting officer)

By   /s/ John W. Adams               Chairman of the Board        March 24, 1997
    -----------------------------    of Directors
               John W. Adams                                      

By   /s/ Gregory S. Anderson         Director                     March 24, 1997
    -----------------------------
            Gregory S. Anderson                                   

By   /s/ Tony Astorga                Director                     March 24, 1997
    -----------------------------
               Tony Astorga                                      

By   /s/ Robert G. Coo               Director                     March 24, 1997
    -----------------------------
               Robert G. Coo                                     

By   /s/ Richard K. Matros           Director                     March 24, 1997
    -----------------------------
             Richard K. Matros                                   

By   /s/ John F. Nickoll             Director                     March 24, 1997
    -----------------------------
              John F. Nickoll                                    

By   /s/ Arthur J. Pasmas            Director                     March 24, 1997
    -----------------------------
             Arthur J. Pasmas                                     


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