<PAGE>   1
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549     
                           ----------------------

                                   FORM 10-K

                       FOR ANNUAL AND TRANSITION REPORTS
                    PURSUANT TO SECTIONS 13 OR 15(d) OF THE
                        SECURITIES EXCHANGE ACT OF 1934

(MARK ONE)

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

For the fiscal year ended September 30, 1998

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

For the transition period from _________ to ___________

                        COMMISSION FILE NUMBER: 1-12238

                               MHM SERVICES, INC.
             (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

<TABLE>
<S>                                                              <C>
              DELAWARE                                           52-1223048
 (State or Other Jurisdiction of                                 (Identification I.R.S. Employer No)
 Incorporation or Organization)

 8000 TOWERS CRESCENT DRIVE, SUITE 810, VIENNA, VIRGINIA         22182
 (Address of Principal Executive Offices)                        (Zip Code)
</TABLE>

Registrant's telephone number, including area code:  (703) 749-4600

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

<TABLE>
<CAPTION>
                                        Name of Each Exchange
 Title of Each Class                    on Which Registered
 -------------------                    -------------------
<S>                                     <C> 

 COMMON STOCK, PAR VALUE $.01 PER       Over-The-Counter Bulletin
 SHARE                                  Board
</TABLE>

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
Company 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. [ ]

         The aggregate market value of the Registrant's common stock held by
nonaffiliated (based upon the closing price of $ .50 of Common Stock on the
Over-The-Counter Bulletin Board) on December 31, 1998, was approximately
$1,102,073.

         As of December 31, 1998, there were 3,538,225 shares of Common Stock,
par value $.01 per share, of the Registrant outstanding.




                                       1
<PAGE>   2
                                     PART I

ITEM 1. BUSINESS

GENERAL

         MHM Services, Inc. (hereafter, including its subsidiaries, the
"Company") which initially incorporated in 1981 in Virginia and reincorporated
in Delaware in 1994, has provided specialty healthcare services primarily in
institutional settings.  Through April 1996, the Company's principal business
was the provision of behavioral healthcare services either in free-standing
hospitals which the Company owned or through the management of behavioral
healthcare programs under contracts with acute care hospitals.  As the mental
healthcare market sought less costly alternatives to long-term inpatient
services, in 1993 the Company, principally through its subsidiary, MHM Extended
Care Services, Inc. (the "Extended Care Services Division"), began to provide
specialized medical and behavioral healthcare services primarily to the elderly
in nursing homes and to children, adolescents and adults in clinics located
throughout Massachusetts.

         As the Company transitioned its business to the Extended Care Services
Division, within several years, the Company began to appreciate that its
ability to achieve profitable operations through the Extended Care Services
Division was questionable.  Therefore, the Company pursued other opportunities.
To this end, starting in the fourth quarter of 1997, the Company, through its
subsidiary MHM Correctional Services, Inc. (the "Correctional Services
Division"), began to provide on a capitated basis mental health care services
to  all of the inmate populations of the Tennessee and Georgia Departments of
Correction.  The Company is of the opinion that the business associated with
the Correctional Services Division offers the best opportunities, in the short
and long term, to improve the Company's business prospects and achieve
profitable operations.

         In order to achieve the shifts in its business strategies, which have
evolved over the past five years, the Company has divested itself of the
business units within the divisions no longer at the core of the Company's
principal business focus.  To this end, in fiscal 1998, the Company sold the
last of its seven remaining free-standing facilities it owned.  This last sale
occurred on April 17, 1998.  In this sale, the Company sold its inpatient
psychiatric operating unit located at Mountain Crest Hospital in Ft. Collins,
Colorado.  Immediately prior to this sale, the Company acquired the physical
assets of the hospital which were previously leased to Mountain Crest and then
sold the physical assets along with the operations to Poudre Valley Hospital, a
general hospital also located in Ft. Collins, Colorado.  The assets the Company
acquired were purchased for $2,700,000.  The entire hospital along with the
psychiatric operations was sold for a cash purchase price of approximately
$6,500,000.

         Although the Company determined in fiscal 1998 to divest itself of the
Extended Care Services Division, no transactions occurred within such year.
However, in the first quarter of fiscal 1999, the Company entered into three
agreements, all of which closed in the first quarter of fiscal 1999.  See "Item
7, Management's Discussion and Analysis of Financial Conditions and Results of
Operations, RECENT DEVELOPMENTS."  As a result of these sales, the Company's
sole remaining operations in the Extended Care Services Division consist of a
capitated Medicaid contract to provide services to Medicaid beneficiaries
residing in Georgia nursing homes.

CORRECTIONAL SERVICES DIVISION

         In fiscal 1997, the Company became aware of opportunities to provide
specialized healthcare services to correctional facilities and formed the
Correctional Services Division to pursue opportunities in this market niche. In
February 1997, the Company began to provide dental services under a contract
with Prison Health Services, Inc. ("PHS") to the 5,000 inmates in the Delaware
correctional system. This contract was for a one-year term. In June 1997, the
Tennessee Department of Corrections awarded the Company a three-year contract
to provide statewide mental health services to the Tennessee prison system,
consisting of approximately 12,000 inmates in 22 facilities, for compensation
on a per capita basis. The Company began to provide services under this
contract on July 1, 1997. In September 1997, the Georgia Department of
Corrections awarded the Company a contract with the initial term being the
remaining nine months of the Department's fiscal year, with four additional one
year extensions at the option of the State of Georgia, to





                                       2
<PAGE>   3
provide statewide mental health services to the Georgia correctional system,
consisting of approximately 37,000 inmates in 40 facilities for compensation on
a per capita basis. The Company began to provide services under this contract
on October 1, 1997.

         Because outsourcing mental health services within correctional systems
is a nascent industry, the Georgia and Tennessee correctional contracts alone
make the Company, in its opinion, one of the largest providers of mental health
services to inmates in the United States. The Company is also actively pursuing
other correctional contract opportunities through its sales team that markets
directly to federal, state and county correctional programs, and private
companies, which provide general medical services to correctional institutions.
Proposals are submitted pursuant to a competitive bid process. There can be no
assurance that the Correctional Services Division will win other contracts. Net
revenues from the Correctional Services Division approximated 37% of the
Company's total net revenues for fiscal 1998.

         The Company believes that there are significant opportunities to grow
the Correctional Services Division based on the size of the market, federal and
state mandates for mental health services to prisoners, and the increasing
trend for states to outsource mental health services. Accordingly, the Company
has decided to focus its growth efforts on this division. Private contractors
provide approximately 30% of current inmate healthcare spending in the United
States. Privatization of inmate healthcare services continues to increase due
to growing acceptance, success of privatization efforts and recognition that
managed care practices are applicable in correctional system settings. In the
past, many states have hired psychologists and other mental health workers on a
contract basis to provide these same services to their inmates. However, the
Internal Revenue Service has recently been threatening to impose payroll tax
requirements on some states for these contract mental health workers.  Such a
requirement could accelerate the trend to outsource such services.

         The Company believes that there are several advantages to providing
health care services on a capitation basis including lower billing/collection
costs, more predictable cash flow, fewer bad debts, less restrictive government
regulations and fewer compliance issues. At the same time, there are financial
risks associated with entering into capitated arrangements for health care.
These include utilization levels (number of patients treated as a percentage of
the total population) exceeding projections, increasing costs and usage of
psychotropic medications, including the introduction of new or improved and
more costly medications, and the availability and cost of labor  If the Company
were unable to cover the costs of providing services under these capitated
contracts within the agreed upon capitation rates, significant losses could be
incurred. There are also risks unique to providing health care services in a
correctional setting including the high degree of litigation that is often
present in a correctional system.  To date, the Company has not been a party to
any such litigation.

EXTENDED CARE SERVICES DIVISION

         Prior to pursuing a strategy in the corrections market, the Company's
Extended Care Services Division emerged as the primary line of business the
Company determined to pursue.  For the three fiscal years ending with September
30, 1997, the Company invoked a growth strategy for the Extended Care Services
Division, primarily through acquisitions, as it sought to increase its market
share.  For fiscal 1998, this division generated approximately $15,000,000 of
revenue or 52% of the Company's total revenue.

         The purpose of the Extended Care Services Division has been primarily
to provide mental health care professionals primarily to extended care
facilities such as nursing homes.  The Company's professionals consist of
employees and independent contractors who provide services generally through
contracts, which are cancelable upon sixty days notice.  These professionals
visit the facilities at regularly scheduled intervals or on an as needed basis.
The Company only relies upon the facility for space to render the Company's
services and assistance in locating residents requiring the Company's services.
Billings for the services are made to governmental programs, such as Medicare
and Medicaid, and to the insurers covering the care being provided.

         Primarily through the Company's acquisitions, by the end of fiscal
1998, the Extended Care Services Division was providing services to residents
of 738 facilities located in Georgia, Massachusetts, New Jersey, Pennsylvania
and Tennessee. A major component of the business of this division was a
contract to provide certain capitated mental health





                                       3
<PAGE>   4
care services under the Georgia Medicaid program to nursing home patients.  In
Massachusetts, the Company generally provided mental health care services at
health care clinics to individuals of all ages.  However, in 1998, the Company
recognized that its short and long term prospects would be hindered if it
continued to operate the Extended Care Services Division primarily as a result
of the continued losses this division was incurring.  Therefore, because of the
Company's need to generate working capital and the losses being incurred in the
Extended Care Services Division, in the first quarter of 1999, the Company sold
its operations in Georgia, other than the capitated Medicaid contract and its
assets and operations in Massachusetts, Pennsylvania, and Tennessee.  These
sales along with certain other operations, which were previously discontinued,
resulted in the virtual liquidation of the Extended Care Services Division
other than services provided under services provided the Georgia Medicaid 
contract.

         The business of the Extended Care Services Division has been affected,
and will continue to be affected so long as the Company continues to operated
the Georgia Medicaid contract, by federal, state and local laws and regulations
concerning, among other matters, professional licensure and reimbursement.
Licensing, reimbursement and other applicable regulations vary by jurisdiction
and are subject to change.  Of all the laws and regulations, those under the
Medicare and Medicaid programs cause the highest level of concern.  Under these
programs, providers of services, such as the Company, are subject to audits and
to partial repayments of reimbursements received in prior periods.  Also,
companies, which participate in these programs, are subject to the federal
Fraud and Abuse Statute.  This statute prohibits individuals or entities which
participate in the Medicare or Medicaid programs from knowingly and willfully
offering, paying, soliciting or receiving payment in order to induce
referrals for items or services reimbursed under these programs.  This statute
also authorizes the promulgation of regulations to exempt certain arrangements
from the prohibitions of the statute.  In 1991, regulations were issued
creating certain "safe harbors" immunizing certain relationships between health
care providers and referral sources from the scope of the Fraud and Abuse
Statute.  Failure to satisfy a safe harbor requirement, however, does not
necessarily mean that a relationship is illegal.  Rather, the failure to fit
within a safe harbor means that a particular relationship is not immune from
scrutiny and the possibility of prosecution and sanctions.  The Company
believes that it is in compliance with the Fraud and Abuse Statute as well as
other state and federal statutes and regulations restricting patient referrals.

HOSPITAL SERVICES

         The sale in April 1998, of the Mountain Crest Hospital located in Ft.
Collins, Colorado, resulted in the total cessation of the Company's inpatient
services business.  In fiscal 1996, revenue from hospital services represented
67% of total revenues.  By fiscal 1998, this percentage had dropped to 10%.

         Although the Company is effectively out of the inpatient business, it
still remains subject to certain governmental reimbursement programs in which
it participated.  In this regard, the reimbursement under Medicare and Medicaid
has been made on a cost reimbursement tentative rate basis with final
settlement generally determined several years after submission of fiscal year
cost reports and audits by fiscal intermediaries.  These audits could expose
the Company to additional future liabilities.

LIQUIDITY

         As a result of the Company's continued negative operating results, and
availability of capital, the Company has been experiencing severe difficulty
generating sufficient cash flows from operations to meet its obligations and
sustain its operations.  The report of the Company's independent auditors on
the Company's consolidated financial statements as of and for the year ended
September 30, 1998, includes an explanatory paragraph which states that such
conditions raise substantial doubt as to the Company's ability to continue as a
going concern. See "Item 7 - Management's Discussion and Analysis of Financial
Condition and Results of Operations" and Note 2 of the Notes to Consolidated
Financial Statements. In a continuing effort to improve this situation for both
the immediate future and the long-term, the Company is continuing its efforts
to reduce operating expenses, seek more profitable business opportunities,
finance its working capital requirements, raise additional capital and improve
its cash flows or find a buyer for the Company.  Nevertheless, there can be no
assurance that the Company's efforts will result in positive effects on the
Company's financial condition.





                                       4
<PAGE>   5
EMPLOYEES

         As of September 30, 1998, the Company had 72 full-time employees and
142 part-time employees engaged in the operations of the Extended Care Services
Division and 43 full-time and 11 part-time employees in the Correctional
Services Division. In addition, as of such date, the Company had 11 employees
engaged in corporate and administrative operations.

         The Company's employees include healthcare professionals, such as
psychiatrists, psychologists, social workers, nurses, counselors and
occupational and activities therapists, and employees engaged in corporate,
finance, marketing, administration and other support positions. None of the
Company's employees are covered by a collective bargaining agreement, and the
Company considers its employee relations to be good. The Company's
relationships with certain healthcare professionals are pursuant to contracts
with each professional establishing independent contractor relationships.

COMPANY HISTORY

         As noted above, the Company was incorporated in 1981 in the
Commonwealth of Virginia, and in October 1994 changed its state of
incorporation to Delaware. From 1986 to August 1993, the Company was a wholly
owned subsidiary of MEDIQ Incorporated ("MEDIQ").  In August 1993, MEDIQ
distributed the stock of the Company to MEDIQ's shareholders.

FORWARD-LOOKING STATEMENTS

         This report includes forward-looking statements based on management's
current plans and expectations relating to the proposed business activities of
the Company, estimates of amounts that are not yet determinable and the
proposed activities of the Company relating to improving its liquidity. Such
statements involve risks and uncertainties which may cause actual future
activities and results of operations to be materially different from that
suggested in this report, including, among others, lack of adequate cash flow
to continue to fund ongoing operations, retire debt obligations as they become
due the amount and timing of receipt of third party payor settlements,
government reimbursement, risks associated with industry consolidation and
acquisitions and competition.

ITEM 2. PROPERTIES

         Currently, the Company's executive offices are located in Vienna,
Virginia pursuant to a lease expiring in January 1999.  Pursuant to such lease,
the Company pays annual rent of approximately $23 per square foot on
approximately 6,600 square feet, with annual increases in an amount equal to 3%
of the prior year's base rent. On February 1, 1999, the Company's executive
offices will be relocated to McLean, Virginia pursuant to a lease expiring in
November 2000.  Pursuant to such lease, the Company will pay annual rent of
approximately $27 per square foot on approximately 3,300 square feet, with
annual increases in an amount equal to 3% of the prior year's base rent.  In
connection with its operations, the Company maintains two regional offices,
which require an annual lease commitment of approximately $70,000 per year.
The Company is in the process of relinquishing or terminating other leases it
maintained prior to the divestitures, which have occurred in the Extended Care
Services Division. The Company believes that its facilities are adequate to
carry on its business as currently structured.

ITEM 3. LEGAL PROCEEDINGS

         On July 15, 1998, the Company and MEDIQ reached a settlement of
MEDIQ's claim for $11,800,000 against the Company for which MEDIQ had obtained
a judgment against the Company for this dispute.  In return for a cash payment
of $3,000,000 by the Company, MEDIQ has vacated its claim, and released the
Company and its affiliates from any and all other liabilities; provided,
however, no bankruptcy proceedings involving the Company occur which result in
MEDIQ repaying all or part of the settlement it received.





                                       5
<PAGE>   6
         The settlement was funded by a $2,000,000 loan from Health Care
Financial Partners, the Company's principal lender, as well as from the
Company's existing lines of credit.  The $2,000,000 is collateralized by
substantially all the assets of the Company.  The loan from Health Care
Financial Partners, which has a six month term, carries interest of prime plus
two percent, a two percent commitment fee, and a completion fee of an
additional two percent.  In addition, in return for making the loan, Health
Care Financial Partners has been granted warrants for 300,000 shares of common
stock of the Company, priced at $.01 per share and exercisable at any time
before July 15, 2003.

         Additionally, Michael S. Pinkert, CEO, has extended his personal
guarantee to Health Care Financial Partners covering $800,000 of the
$2,000,000.  In return for his guarantee, Mr. Pinkert has been granted warrants
for 145,000 shares of the Company's stock, at a price of $.50 per share and
exercisable at any time before July 15, 2008.

         As a result of the settlement, the Company recognized a one-time gain
of $9,185,000 in the fourth quarter which was reported as an extraordinary
item.

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

         No matters were submitted to a vote of security holders during the
quarter ended September 30, 1998.





                                       6
      
<PAGE>   7
                                    PART II

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCK HOLDER
   MATTERS

MARKET INFORMATION

    The following table sets forth, for the periods indicated, the high and low
sales prices for the Company's common stock, par value $.01 per share (the
"Common Stock"), as listed on the American Stock Exchange ("AMEX") and the Over
the Counter Bulletin Board ("OTC"):

<TABLE>
<CAPTION>
                                             HIGH    LOW  
                                            ------  ------
            <S>                             <C>     <C>      
            Year ended September 30, 1998:                
                     First Quarter          $1.937  $.375 
                     Second Quarter           .937   .312 
                     Third Quarter            .937   .500 
                     Fourth Quarter          1.750   .438 
                                                          
            Year ended September 30, 1997:                
                     First Quarter          $1.063  $.375 
                     Second Quarter           .813   .125 
                     Third Quarter            .938   .625 
                     Fourth Quarter          1.875   .875 
</TABLE>                                       

    On June 9, 1998, the Company was notified that the American Stock Exchange
Executive Committee of the Exchange Board of Governors had denied appeal of the
February 3, 1998 determination by the Exchange to delist the Company stock.
The last day for trading the Company's stock on the American Stock Exchange was
June 16, 1998.  Effective June 17, 1998, the Company's stock has been traded on
the Electronic Bulletin Board service under the symbol "MHMM".  With respect to
information related to Over-The-Counter Bulletin Board trades, sale price
includes prices between dealers, may not reflect markups, markdowns or
commissions and may not represent the final actual transaction.

COMMON STOCKHOLDERS

    As of December 31, 1998, there were approximately 1,480 holders of record
of the Company's Common Stock.

DIVIDENDS

    The Company has never declared or paid any cash dividends and does not
expect to pay cash dividends for the foreseeable future.  The declaration of
dividends in the future will at all times be subject to the sole discretion of
the Company's Board of Directors, and will depend upon the operating results,
capital requirements and financial position, general economic conditions and
other pertinent conditions or restrictions relating to any future financing.

ITEM 6.  SELECTED CONSOLIDATED FINANCIAL DATA

    The selected consolidated financial information presented below has been
derived from the audited consolidated financial statements of the Company. This
data is qualified in its entirety by reference to, and should be read in
conjunction with the Company's Consolidated Financial Statements and Notes
thereto and Management's Discussion and Analysis of Financial Condition and
Results of Operations, included elsewhere herein.





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<PAGE>   8
STATEMENT OF OPERATIONS DATA (IN THOUSANDS EXCEPT PER SHARE DATA)

<TABLE>
<CAPTION>
                                                                YEAR ENDED SEPTEMBER 30,                   
                                            ---------------------------------------------------------------
                                              1998       1997         1996          1995(1)      1994(1)   
                                            --------  ----------   ----------    ------------  ------------
 <S>                                        <C>        <C>        <C>            <C>             <C>
 Net revenues                               $ 29,294   $ 20,851   $  34,670      $ 41,109        $ 48,286

 Costs and expenses:
   Operating                                  20,040     14,875      25,765        28,918          33,895
   General and administrative                  7,539      5,760       9,718        10,085          10,644
   Provision for bad debts                     3,326      3,467       6,320         4,467           2,009
   Depreciation and amortization                 597        369       1,034         1,603           1,617
   Gain (loss) - sale of freestanding   
     facilities (2)                           (2,465)        --       4,440            --              --
   Writedown of long-term assets (3)             430        696         461         2,228              --
   Restructuring charges (4)                      --         --          --            --             966

 Other (credits) charges:
   Equity in earnings of Joint Venture            --         --          --          (835)           (292)
   Gain on sale of Joint Venture                  --         --          --        (3,542)             --
   Interest expense - MEDIQ                      757      1,042       1,097         1,171             932
   Interest expense - other                      166         93         290           366             389
   Other (income) expense-net (5)                 --       (662)       (233)         (223)            (33)
 Income (loss) before income tax            --------   --------   ---------      --------        --------
   expense (benefit), extraordinary item  
   and cumulative effect of a change in   
   accounting principle                       (1,096)    (4,789)    (14,222)       (3,129)         (1,841)
 Income tax (benefit) expense                     93         --        (308)          894            (525)
 Extraordinary item (6)                        9,185         --        (463)           --              --
 Cumulative effect of a change in
   accounting principle (7)                       --         --          --            --            (732)
                                            --------   --------   ---------      --------        --------
 Net (loss) income                          $  7,996   $ (4,789)  $ (14,377)     $ (4,023)       $ (2,048)
                                            ========   ========   =========      ========        ========

 (Loss) earnings per share                  $   2.26   $  (1.40)  $   (4.34)     $  (1.22)       $   (.63)
                                            ========   ========   =========      ========        ========

 Weighted average shares outstanding           3,528      3,411       3,310         3,310           3,267
                                            ========   ========   =========      ========        ========
                                                                                      
                                                                                      
</TABLE>

BALANCE SHEET DATA (IN THOUSANDS)


<TABLE>
<CAPTION>
                                                     SEPTEMBER 30,
 -------------------------------------------------------------------------------------------------------------
                                                   1998       1997         1996        1995(1)      1994(1) 
                                                   ----       ----         ----        -------      ------- 
 <S>                                             <C>         <C>           <C>          <C>         <C>     
 Working capital                                 $ (2,011)   $(11,245)     $   2,566    $ 5,923     $    485
 Total assets                                       7,536      11,414         15,669     30,283       41,900
 Long term debt, less current maturities              176       1,456            257      2,422          716
 Due to MEDIQ, less current maturities (8)             --          --          9,967     10,733       11,500
 Stockholders' (deficit) equity                      (134)     (8,270)        (3,582)    10,795       14,818
</TABLE>


               SEE NOTES TO SELECTED CONSOLIDATED FINANCIAL DATA

Notes to Selected Consolidated Financial Data:

(1) Effective August 1, 1994, the Company formed a joint venture ("Joint
    Venture") to combine its contract management business with that of Horizon
    Mental Health Services, Inc. ("Horizon"). The Joint Venture, which was
    owned 27.5% by the Company and 72.5% by Horizon, managed both companies'
    hospital behavioral health care contracts. The operating results of the
    contract management business were included in the Company's results of
    operations through the commencement of the Joint Venture on August 1, 1994.
    On March 20, 1995, Horizon completed its initial public offering and, in
    accordance with the terms of the Joint Venture Agreement, acquired the
    Company's interest in the Joint Venture for approximately $9,600,000 (net
    of related expenses). The sale resulted in a pre-tax gain of  $3,542,000
    (approximately $3,000,000 net of taxes).





                                       8
<PAGE>   9
(2) The Company completed the sale of six of its seven freestanding behavioral
    health facilities in 1996 and recorded a loss of $4,440,000 consisting
    primarily of the write off of intangibles related to the facilities of
    $3,184,000, loss on the sale of certain property, plant, and equipment
    aggregating $319,000, transaction expenses of $568,000, severance expenses
    of $349,000, and other expenses of $680,000, offset by estimated Medicare
    depreciation recapture income of approximately $660,000.  In April 1998,
    the Company sold its last inpatient psychiatric hospital operation and
    reported a gain on the sale of $2,465,000.

(3) In the fourth quarter of 1998, the Company decided to dispose of certain
    assets and contractual rights of its Extended Care Services Division.  In
    connection with this decision, the Company determined that goodwill and
    other intangibles related to the acquisition of HCI and Apogee were
    permanently impaired and were written down to an estimated value resulting
    in a charge of $430,000. In the fourth quarter of 1997, the Company decided
    to dispose of the Florida and North Carolina operations of its Extended
    Care Services Division and close its Atlanta, Georgia billing office. In
    connection with these decisions, the Company determined that goodwill
    relating to the acquisition of HCI was partially impaired and was written
    down to an estimated value resulting in a charge of $696,000. In the fourth
    quarter of 1996, the Company wrote off the assets related to the
    discontinued operations of Supportive Counseling Care ("SCC") including
    property, plant and equipment and goodwill resulting in a charge of
    $461,000. In the fourth quarter of 1995, the Company determined that the
    recoverability of certain of the assets, including property, plant and
    equipment and goodwill, related to one of the Company's freestanding
    facilities, were impaired, other than temporarily. Accordingly, the
    carrying value of such assets was reduced to estimated fair value,
    resulting in a charge of $2,228,000.

(4) In connection with the commencement of the Joint Venture, the Company
    recorded a restructuring charge of $966,000 related to the downsizing of
    its corporate activities.

(5) In May 1997, the Supreme Court of Delaware upheld a lower court award of
    $459,000 to the Company from Horizon relating to the rights of the Company
    to receive certain cash flows as part of the sale of its interest in the
    joint venture to Horizon resulting in additional income in fiscal 1997.

(6) The Company recorded an extraordinary item in the amount of $463,000
    consisting primarily of costs related to the early retirement of the
    Company's long-term debt and the write-off of associated loan acquisition
    costs.   In July 1998, the Company and MEDIQ settled the $11,800,000
    judgement against the Company for payment of $3,000,000 in cash. As a
    result of this transaction, the Company recorded a gain on early
    extinguishment of debt of $9,185,000.

(7) This amount represents the cumulative effect of a change in the Company's
    method of accounting for certain preopening costs and certain costs
    incurred in securing management contracts.

(8) The Company's long term debt obligations to MEDIQ were reclassified as a
    current liability in 1997.  The MEDIQ obligation was settled in July 1998.





                                       9
<PAGE>   10
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
   OF OPERATIONS

    The following discussion should be read in conjunction with the financial
statements, and notes thereto, included elsewhere in this report.

GENERAL

    The Company made significant changes in its operations in 1995, 1996, 1997
and 1998, including the sale of all of the Company's seven freestanding
behavioral healthcare facilities (see "Recent Developments"), so that the
Company could focus on its Correctional Services Division and Extended Care
Services Division.  The Company formed a Correctional Services Division in 1997
and in the fourth quarter of 1997 secured contracts with the Tennessee and
Georgia Departments of Correction to provide mental health services on a
capitated basis to the inmates of those states' correctional systems. The
Company is currently seeking additional contract awards in this industry. The
Extended Care Services Division, which commenced operations in the Fall of 1993
has experienced growth through internal development, principally from one
contract with the State of Georgia, and acquisitions. However, the Company has
experienced continuing losses in the Extended Care Services Division.  In
fiscal 1997, in an effort to improve the financial operations of this division,
the Company closed extended care operations in certain states because revenues
were insufficient to achieve profitability.  Despite management's efforts, the
profitability of this division has not improved which has resulted in
management's decision to divest itself of this line of business in favor of
growing the Correctional Services Division.

    As a result of the Company's continuing negative operating results,
increases in accounts receivable and other factors, the Company has continued
to experience difficulty generating sufficient cash flows from operations to
meet its obligations and sustain its operations. At September 30, 1998, the
Company's current liabilities exceeded its current assets by $2,011,000. The
Company's working capital deficit is primarily due to the classification as
current liabilities of a $2,000,000 loan with HealthCare Financial Partners,
the Company's principal lender, as well as the Company's existing line of
credit with NationsBank of $500,000.  The loan from HealthCare Financial
Partners and the NationsBank line of credit were used to fund a $3,000,000 cash
payment to MEDIQ as final settlement of a judgement of $11,800,000 brought
against the Company by MEDIQ.  This settlement was reached in July 1998.

    The report of the Company's independent auditors on the Company's audited
consolidated financial statements for the fiscal year ended September 30, 1998,
includes an explanatory paragraph which states that such conditions raise
substantial doubt as to the Company's ability to continue as a going concern.
In a continuing effort to improve this situation for both the immediate future
and the long-term, the Company is continuing its efforts to reduce operating
expenses, seek more profitable business opportunities, finance its working
capital requirements, raise additional capital and improve its cash flows.
Nevertheless, there can be no assurance that the Company's efforts will result
in positive effects on the Company's financial condition.

RECENT DEVELOPMENTS

    In 1996 the Company sold Oakview Treatment Center to Glass Mental Health
Foundation for $50,000 in cash and two promissory notes totaling $2,150,000.
Due to lack of payment on the promissory notes, the Company declared the notes
in default and foreclosed on the property in September 1998.  The property is
subject to a junior lien held by the Internal Revenue Service (IRS). On
November 6, 1998, the Company entered into an agreement with an investor to
purchase the real property for an amount that will substantially cover the
amount of notes receivable outstanding.

    Effective December 16, 1998, the Company entered into an agreement to
divest certain assets related to the delivery of mental health services to
patients of extended care facilities in the States of Tennessee and Georgia,
except those provided under the Company's Medicaid contract with the State of





                                       10
<PAGE>   11
Georgia Department of Medical Assistance.  No consideration was received;
however, the Company was relieved of managing the business.  Losses of
approximately $251,000 consisting of the write down of related intangible
assets were recognized in fiscal 1998 in anticipation of this transaction.

    On December 31, 1998, the Company entered into an agreement with another
organization to sell certain assets initially acquired from National
Mentor, Inc., Liberty Bay Colony Health Services, Inc. (Liberty Bay) and
Liberty Management Group, Inc.  (Liberty Management) related to the delivery of
outpatient mental health services and services to patients of extended care
facilities in the State of Massachusetts. These assets were sold for $850,000,
which will result in a gain on sale of approximately $200,000 to be recorded by
the Company in the first quarter of fiscal 1999.

    On December 31, 1998, the Company entered into an agreement to sell 
certain assets related to the delivery of mental health services to patients of
extended care facilities in the State of Pennsylvania.  The total consideration
for this transaction was $170,000 of which $20,000 was paid at closing and the
remaining $150,000 was in the form of a promissory note payable, in its
entirety, on March 30, 1999.  The assets acquired by the purchaser in this
transaction secure this note. This transaction will result in a gain on sale of
approximately $25,000 to be recorded by the Company in the first quarter of
fiscal 1999.

    These transactions and current Company efforts are consistent with
management's strategy to improve the Company's profitability through the
divestiture of certain extended care services and focus upon the corrections
business.


OPERATING STRATEGY

    Historically, the Company's principal business was the operation of
freestanding behavioral healthcare facilities and the management of behavioral
healthcare programs under contracts with acute care hospitals. The market for
behavioral healthcare has undergone dramatic changes in recent years, resulting
in pressure on providers to reduce both costs, by lowering utilization of
inpatient care, and reimbursement rates.

    In response to these market changes and their adverse impact on the
Company's operating results, the Company has changed its business dramatically
in recent years. Beginning in 1996 and concluding in 1998, the Company sold all
of its seven freestanding behavioral health facilities, deciding to focus on
the growth of its Extended Care Services Division and then its Corrections
Services Division.

    In fiscal 1996, the Company determined that it would focus its operating
strategy on growth opportunities in its Extended Care Services Division and
other specialty on-site healthcare services. During fiscal 1997, the Company
made several acquisitions in its Extended Care Services Division. See Note 5 of
Notes to Consolidated Financial Statements. Through 1998, the Extended Care
Services Division has not operated profitably despite the Company's efforts to
reduce operating expenses and focus on profitable operations.  These efforts
included the Company closing or selling, in 1997, extended care operations in
certain states where revenues have not been sufficient to operate on a
profitable scale, and selectively reducing operating, general and
administrative costs and consolidating or outsourcing billing and payroll
functions. Notwithstanding these changes, the Company determined that the
Extended Care Services Division will not operate profitably in the future and
decided to divest itself of the division.

    In fiscal 1997, the Company further refined its operating strategy by
forming a Correctional Services Division to provide specialized health services
to inmates in correctional facilities. In fiscal 1997, the Company was awarded
capitated contracts with the States of Tennessee and Georgia to provide mental
health services to inmates in their state correctional facilities. The Company
began performing under these contracts on July 1, 1997 (Tennessee) and October
1, 1997 (Georgia). The Company intends to pursue additional contract
opportunities in the correctional service area, although there can be no
assurance that it will have sufficient resources to do so.





                                       11
<PAGE>   12
SOURCES OF FINANCING

    The Company continues to seek sources of financing to fund operating costs
and expenses. Effective March 11, 1997, the Company's subsidiary, MHM Extended
Care Services, Inc., obtained a revolving credit facility in an amount up to
$4,000,000. The amount eligible for borrowings on the credit facility is
limited based on the amount of the Company's qualified accounts receivable. In
October 1997 and again in July 1998, the Company borrowed $500,000 under a line
of credit with NationsBank, N.A., which debt is guaranteed by certain officers
and directors of the Company. The line of credit permits maximum borrowings by
the Company of $500,000, and bears interest at a rate 2.6% over the EuroDollar
rate. As of September 30, 1998, the Company had drawn the full $500,000. In
July 1998, the Company borrowed $2,000,000 from HealthCare Financial Partners,
which has a six-month term and an interest rate of prime plus 2%.  In
consideration of the loan, the Company granted HealthCare Financial Partners
five year warrants for 300,000 shares exercisable at $.01 per share. Michael S.
Pinkert, President and CEO, has guaranteed $800,000 of the loan with HealthCare
Financial Partners.  For his guaranty, the Company granted Mr. Pinkert 145,000
ten year warrants exercisable at $.50 per share.  See Note 14 of Notes to
Consolidated Financial Statements. As of September 30, 1998, the Company had
cash and cash equivalents available of $54,000. The Company has continued to
experience significant negative cash flow from operations. Although the Company
continues to seek additional sources of debt and equity financing.  No
assurance can be provided that the Company's efforts will be successful.

ACQUISITIONS

    Effective March 31, 1997, the Company's Extended Care Services Division
acquired certain assets and contractual rights related to the long-term care
operations of Apogee, Inc. in Pennsylvania and Tennessee, consisting of
contracts with approximately 275 facilities. As consideration for the purchase,
the Company paid $100,000 in cash, issued a three-year promissory note in the
principal amount of $125,000 and issued 200,000 shares of common stock of MHM
Services, Inc. at $.50 per share. The purchase price was primarily allocated to
intangible assets. The note provides for interest payments on September 30,
1997 for the first two quarters and quarterly thereafter at an annual interest
rate of 7% and annual principal payments in the amount of approximately
$41,668. The agreement for the acquisition of Apogee provides for additional
consideration based on net cash collected as defined in the Apogee purchase
agreement. The annual earnout is payable for a five year period based on 20% of
net cash collected, as such term is defined in the Apogee Agreement, commencing
March 31, 1997.  Such additional consideration is calculated annually by the
Company and did not result in a liability for the year beginning March 31,
1997.  As of September 30, 1998 the Company does not anticipate any liability
for the year beginning March 31, 1998 or thereafter.

    Effective December 1, 1996, the Company's Extended Care Services Division
acquired, pursuant to an agreement (the "Liberty Bay Agreement") by and among
the Company, MHM Extended Care Services, Inc., Liberty Bay Colony Health
Services, Inc. ("Liberty Bay") and Liberty Management Group, Inc. ("Liberty
Management"), certain assets and contractual rights from Liberty Bay which
constitute Liberty Bay's geropsychiatric management services operations in
Massachusetts. The Company has integrated these operations under the name
"MHM/Bay Colony Counseling Services." As a result of this acquisition and the
continued development of MHM/Bay Colony Counseling Services, as of September
30, 1998, the Company served approximately 115 extended care facilities in
Massachusetts.

    As consideration for the purchase, the Company paid Liberty Bay $150,000 in
cash and issued a promissory note in the principal amount of $150,000 (the
"Liberty Bay Note"). The purchase price was primarily allocated to intangible
assets. The Liberty Bay Note provides for quarterly interest payments at an
annual rate of 9% and the payment of the principal amount in one
installment on December 1, 1999. The agreement for the acquisition of Liberty
Bay Colony provides for additional consideration based on cash flows. Amounts
payable are calculated annually for a five-year period at twenty percent of the
aggregate cash flows from all contracts (net of expenses). The agreement
stipulates limitations on the





                                       12
<PAGE>   13
amount of bad debt expense and regional overhead that may be charged against
cash flow. The agreement also stipulates that the calculation will be made on a
contract by contract basis with no adjustment for contracts in a loss position,
except that in the first annual earnout period a one-time adjustment to
regional overhead is made for losses on fifteen specific contracts. Such
additional consideration is calculated, paid, and expensed, annually by the
Company and totaled approximately $37,000 and $3,000 for years beginning
December 1, 1997 and 1996, respectively.  The payment for December 1, 1998 was
estimated at $40,000.  After December 1, 1998, given the recent sale of the
Liberty Bay business, no future earn-out liability will exist except for
certain modest amounts from receivable collections occurring after the sale.

OVERVIEW OF REVENUE SOURCES

    In the Extended Care Services Division, the Company is paid primarily by
third-party payors based on fee-for-service basis. In certain instances, the
Company also is paid by the patient for all or a portion of the services. The
Company recognizes net revenues from extended care services at the estimated
net realizable amounts from third-party payors, principally state and federal
health insurers (including Medicare and Medicaid).  Estimated amounts
recognized by the Company are reconciled at the time the payment for the
services provided is actually received.

    The Company's Extended Care Services Division has generated revenues from
clinical services for physicians and other healthcare professionals providing
care to residents of extended care facilities. Such revenues represented
approximately 52%, 66%, and 33% of total net revenues in 1998, 1997 and 1996,
respectively. The decreased percentage of revenues in 1998 compared to 1997
resulted from the Company's decision in 1997 to close certain extended care
operations in certain states where revenues had not been sufficient to operate
on a profitable scale and from the increased revenues generated from the
Correctional Services Division.

    The Company's Correctional Services Division generates revenues from the
provision of specialty health care services to the inmates of correctional
systems primarily at capitated rates based on inmate census. These revenues
represented approximately 37% of total 1998 net revenues. The Company is based
under its Correction Service contracts on a monthly basis.  Net revenues in
this division are reported on an accrual basis at the capitated rate applied to
the number of inmates.

    In the Hospital Division the Company was primarily paid at a fixed-rate for
services provided based on the allowable cost of such services. Such payments
were generally made by third-party payors, principally Medicare, but also
including Medicaid and other health-care insurers. The Company had agreements
with third-party payors that provide for payments for patient services at
amounts that differ from its established rates. For Medicare, the Company was
reimbursed for cost reimbursable items at a tentative rate with final
settlement determined after submission of annual cost reports by the Company
and audits thereof by the Medicare fiscal intermediary. The Company is in the
process of negotiating final settlements for prior reporting periods relating
to filed costs reports for two of the six freestanding facilities sold in 1996
and its Mountain Crest facility sold in 1998.

    Patient service revenues from the Company's freestanding facilities were
based on covered charges billed primarily to third-party payors, including
Medicare, Medicaid and other government-sponsored programs. These accounted for
10%, 31%, and 67% of the Company's total net revenues in 1998, 1997 and 1996,
respectively. Such revenues can be significantly affected by changes in
utilization and reimbursement rates. Typically, payments from such payors are
made at amounts less than the amounts charged, based on existing contractual
relationships or reimbursement methodologies. The Company records net patient
service revenues based upon expected reimbursement. Certain
government-sponsored programs pay primarily on a cost reimbursement basis. The
Company is reimbursed for cost reimbursable items at a tentative rate, with
final settlement generally determined several years after submission of fiscal
year cost reports and audits thereof by the fiscal intermediary. Differences
between amounts recorded as tentative settlements and final audited amounts are
reflected as adjustments to contractual allowances in the year in which
settlement is determined. The Company also receives patient service revenues
under





                                       13
<PAGE>   14
payment agreements with commercial insurance carriers, health maintenance
organizations and preferred provider organizations.

RESULTS OF OPERATIONS

    The following table sets forth, for the periods indicated, the percentage
relationship that components of the Company's results of operations bear to net
revenues.

<TABLE>
<CAPTION>
                                                                      YEAR ENDED SEPTEMBER 30,        
                                                            ------------------------------------------
                                                                1998            1997           1996
                                                            ------------    ------------   -----------
 <S>                                                         <C>             <C>              <C>
 Net revenues                                                   100.0%         100.0%           100.0%
 Costs and expenses:
   Operating                                                     68.4           71.4             74.3
   General and administrative                                    25.7           27.7             28.0
   Provision for bad debts                                       11.4           16.6             18.2
   Depreciation and amortization                                  2.0            1.8              3.0
   (Gain) loss on sale of freestanding facilities                (8.4)            --             12.8
   Writedown of long-term assets                                  1.5            3.3              1.3
 Other (credits) charges:
   Interest expense - MEDIQ                                       2.6            5.0              3.2
   Interest expense - other                                        .6             .4               .8
   Other (income) expense - net                                   ---           (3.2)             (.6)
                                                             --------        -------          ------- 

 Loss before income taxes and extraordinary item                 (3.7)         (23.0)           (41.0)

 Income tax (benefit) expense                                      .3            ---              (.9)
                                                             --------        -------          -------

 Loss before extraordinary item                                  (4.0)         (23.0)           (40.1)

 Extraordinary item - loss on early extinguishment of debt       31.4            ---            ( 1.3)
                                                             --------        -------          -------

 Net Income (Loss)                                               27.4%         (23.0)%          (41.4)%
                                                             ========        =======          =======  
</TABLE>


Fiscal Year 1998 Compared to Fiscal Year 1997

    Net revenues for the year ended September 30, 1998, were $29,294,000 as
compared to $20,851,000 for the prior year, an increase of $8,443,000 or 40%,
primarily reflecting the revenue growth from the Correctional Services Division
in 1998. Net revenues from the Correctional Services Division were $10,888,000
in 1998 compared to $632,000 in 1997. The Correctional Services Division
commenced operations in February 1997. Net revenues from the Extended Care
Services Division were $15,326,000 in 1998 as compared to $13,737,000 in 1997,
an increase of $1,589,000 or 12%. This increase is due principally to the
revenues related to two acquisitions made by the Company in its Extended Care
Services Division during fiscal 1997; Liberty Bay (December 1996) and Apogee
(March 1997).  In April 1998, the Company sold it last freestanding facility,
Mountain Crest Hospital. As a result, net revenues from freestanding facilities
were $2,793,000 for 1998 compared to $6,482,000 for 1997. Net revenues from
favorable settlements on third-party costs reports were $762,000 in 1998.

    Operating expenses for the year ended September 30, 1998, were $20,040,000,
as compared to $14,875,000 in the prior year, an increase of $5,165,000 or 35%.
This increase was attributable primarily to increased costs in the Correctional
Services Division, which commenced operations in fiscal 1997.

    General and administrative expenses for the year ended September 30, 1998,
were $7,539,000 as compared to $5,760,000, an increase of $1,779,000 or 31%.
Again, this increase was attributable primarily to increased costs in the
Correctional Services Division.

    The provision for bad debts for 1998 decreased to $3,326,000 as compared to
$3,467,000 for 1997. As a percentage of net revenues, bad debt expense was 11%
in 1998 and 17% in 1997. Increased revenues from the Correctional Service's
Division primarily caused this reduction. Because these revenues





                                       14
<PAGE>   15
are paid on a capitated basis, there are no bad debts associated with these
revenues.  The 1998 bad debt provision relates to the estimated net realizable
value of receivables generated in the Extended Care Services Division and
reserves on receivables remaining after the sale of the freestanding
facilities. The decline for the 1998 bad debt provision reflects an overall
reduction in accounts receivable remaining after the sale of the freestanding
facilities and the Extended Care Services Division.

    Depreciation and amortization increased to $597,000 in 1998 from $369,000
in the prior year. The Company accelerated its amortization of goodwill and
other intangibles related to the Liberty and Apogee acquisitions, beginning
October 1, 1997.  Amortization costs in 1998 were $406,000 as compared to
$184,000 in 1997.

    In preparation for the divestiture of certain operations of the Extended
Care Services Division, the Company took a write down of $430,000 of goodwill
and capitialized start-up costs from its acquisition of the extended care
operations of Apogee and HCI.

    In April 1998, the Company sold its last remaining freestanding psychiatric
hospital operation, Mountain Crest Hospital in Fort Collins, Colorado for a
cash price of approximately $6,500,000. As a result of the transaction, the
Company reported a one-time gain of $2,465,000.

    Interest expense - other increased in 1998 to $166,000 from $93,000 in
1997, an increase of 78%. This increase is primarily caused by interest costs
for the revolving line of credit with HealthCare Financial Partners, the line
of credit with NationsBank and the six-month loan with HealthCare Financial
Partners.

    In July 1998, in return for a $3,000,000 payment, the Company and MEDIQ
settled the $11,800,000 judgement MEDIQ had obtained against the Company.  As a
result of this settlement, the Company recognized a one-time gain of $9,185,000
related to early extinguishment of debt.

    Net income for 1998 was $7,996,000 as compared to a net loss for 1997 of
$4,789,000. The net income for 1998 was primarily derived from the sale of the
Company's last freestanding hospital and the recorded gain from the MEDIQ
settlement.  The gain from sale of the freestanding hospital and the operation
of the Correctional Services Division in Georgia and Tennessee generated
taxable income in certain states resulting in an estimated state tax provision
of $93,000 in 1998.

Fiscal Year 1997 Compared to Fiscal Year 1996

    Net revenues for the year ended September 30, 1997, were $20,851,000 as
compared to $34,670,000 for the prior year, a decrease of $13,819,000 or 40%,
primarily reflecting the reduction in net revenues due to the 1996 sales of the
Company's freestanding inpatient facilities. The Company sold Oakview Treatment
Center on April 5, 1996, and sold five other freestanding facilities on May 31,
1996. The Company continued to operate one facility, the Mountain Crest
facility. As a result, net revenues from freestanding facilities were
$6,482,000 for 1997 compared to $23,255,000 for 1996. Net revenues from the
Extended Care Services Division were $13,737,000 in 1997 as compared to
$11,415,000 in 1996, an increase of 20%. This increase is due principally to
the revenues related to two acquisitions made by the Company in its Extended
Care Services Division during fiscal 1997; Liberty Bay (December 1996) and
Apogee (March 1997). In the fourth quarter of 1997, the Company decided to
dispose of its extended care operations in Florida and North Carolina. As a
result, approximately $595,000 of net revenues reported in 1997 were not
generated in fiscal 1998. Net revenues for 1997 also included $632,000 relating
to the Correctional Services Division, which commenced operations in February
1997.

    Operating expenses for the year ended September 30, 1997, were $14,875,000,
as compared to $25,765,000 in the prior year, a decrease of $10,890,000 or 42%.
This decrease was attributable primarily to the sale of six of the Company's
seven freestanding behavioral healthcare facilities, offset in part by
increased costs in the Company's Extended Care Services Division and
Correctional Services Division which commenced operations in fiscal 1997.





                                       15
<PAGE>   16
    General and administrative expenses for the year ended September 30, 1997,
were $5,760,000 as compared to $9,718,000 in fiscal 1996, a decrease of
$3,958,000 or 41%. This decrease was attributable primarily to the sale of six
of the Company's seven freestanding behavioral healthcare facilities, offset by
increases in costs in the Company's Extended Care Services Division and
Correctional Services Division.

    The provision for bad debts for 1997 decreased to $3,467,000 from
$6,320,000 for 1996. As a percentage of net revenues, bad debt expense was 17%
in 1997 and 18% in 1996. The 1996 bad debt expense was high due to the
provision for bad debts relating to Supportive Counseling Care (SCC). The 1997
bad debt expense was high due to reserves against receivables remaining after
the sale of freestanding facilities and bad debt reserves against Extended Care
Services Division receivables in the Company's Georgia billing office. In the
fourth quarter of 1997, the Company shut down its Georgia billing office and
outsourced all of its billing and collection efforts to minimize further bad
debts.

    Depreciation and amortization decreased to $369,000 in 1997 from $1,034,000
in the prior year. This decrease of 64% was due to the sale of the freestanding
facilities, which had a much higher base of depreciable fixed assets than
ongoing operations.

    Loss on sale of freestanding facilities was from transactions occurring
solely in 1996.

    Interest expense - other decreased in 1997 to $93,000 from $290,000 in
1996, a decrease of 68%. This decrease is primarily attributable to the
retirement of debt relating to the freestanding facilities sold in 1996.

    Other income for 1997 increased by $429,000 due to the May 1997 award to
the Company of certain cash flows due it from the sale of its interest in the
joint venture to Horizon.

    The total net loss for 1997 was $4,789,000 as compared to a loss of
$14,377,000 for 1996. The 1996 loss was higher than 1997 due to operating
losses from the freestanding facilities through the date of sale and the loss
recorded from the sale of freestanding facilities.

MAJOR CUSTOMER

    The Company has two contracts with the State of Georgia. The Extended Care
Services Division provides behavioral healthcare services to approximately
2,400 Medicaid patients residing in nursing homes under the Pre-Admission
Screening and Annual Resident Review (PASARR) contract with the State of
Georgia, the so-called Georgia Medicaid contract. The PASSAR contract expires
June 1999.  For the year ended September 30, 1998, the PASARR contract
accounted for 12% of net revenues. MHM Correctional Services was awarded a
multi-year contract (single year with four optional extension years) with the
State of Georgia to provide mental health services to the inmates of the
state's correctional facilities on a capitated basis. This contract began on
October 1, 1997. This contract is projected to provide approximately $9,000,000
of annual revenue. Both of these contracts are subject to the procurement
process of the State of Georgia, and there is no assurance as to the
expectation of future revenues earned under these contracts.

    MHM Correctional Services was awarded a three-year contract with the State
of Tennessee to provide mental health services to the inmates of the state's
correctional facilities on a capitated basis. This contract began on July 1,
1997. This contract is projected to provide approximately $2,000,000 of annual
revenue.  This contract is subject to the procurement process of the State of
Tennessee, and there is no assurance as to the expectation of future revenues
earned under these contracts.





                                       16
<PAGE>   17
IMPACT OF INFLATION

    Behavioral health programs are labor intensive. As wages and employee
benefit costs increase during inflationary periods, and outside suppliers pass
cost increases through to the Company, costs rise proportionately. The Company
has implemented systems to monitor and control increases in expenses.
Government-sponsored programs, including Medicare and Medicaid, which represent
a substantial portion of the Company's revenues, and contractual arrangements
with other third party payors, may limit the Company's ability to obtain
corresponding revenue increases. Additionally, the Company's capitated
contracts with the correctional systems of Georgia and Tennessee are subject to
an inflation risk if psychotropic drug costs exceed the contracted increase in
the capitation rate the Company receives.

YEAR 2000 ISSUES

    The Year 2000 issue is the result of computer programs being written using
two digits rather than four to define the applicable year. Any of the Company's
computer programs that have date sensitive software may recognize a date using
"00" as the year 1900 rather than the year 2000. This could result in a system
failure or miscalculations causing disruptions of operations, including, among
other things, a temporary inability to process transactions, send invoices or
engage in similar normal business activities.

    Specific application programs that the Company uses and which this issue
may impact include billing related software and payroll.  The Company's Chief
Financial Officer is in charge of investigating the potential impact of the
Year 2000 issue. The Company has not completed its evaluation of the impact of
the Year 2000 issue, and therefore, there can be no assurance that this issue
will not materially affect future financial results, or cause reported
financial information to be necessarily indicative of future operating results
or future financial condition.

    The Company has a material relationship with a third-party vendor that
performs billing and collections on behalf of the Extended Care Services
Division.  The vendor has represented to the Company that this billing system
is Year 2000 compliant.  In fiscal 1998, the Company's management did not
perform a formal review of this system because of the anticipated divestiture
of the Extended Care Services Division in fiscal year 1999 thus, eliminating
the need to continue the vendor's service.

    The Company has outsourced its payroll processing to an independent payroll
company.  That vendor has represented to the Company that their payroll
processing systems are year 2000 compliant.  The Company's management has not
performed any reviews over that system, though the vendor is a major supplier
of payroll services.  If their systems were to fail, the Company would manually
prepare payroll for its employees.

    The Company's information systems are resident on personal computers.  The
Company plans to take the appropriate steps to make these systems Year 2000
compliant during fiscal 1999.  The costs of addressing the Company's year 2000
issues have not been estimated.

LIQUIDITY AND CAPITAL RESOURCES

    On September 30, 1998, the Company had cash and cash equivalents of
$54,000, compared to $108,000 at September 30, 1997. The decrease in available
cash is the result of the Company using cash to fund continued operating
losses.

    Cash used in operating activities was $2,344,000 for 1998, as compared to
$3,151,000 for the prior year. Cash was primarily used in 1998 to reduce debt
and fund operating losses. The Company has continued to experience significant
operating losses, and is continuing to seek opportunities to restructure its
business to more profitable lines and to reduce operating expenses.





                                       17
<PAGE>   18
    Net cash provided by investing activities in 1998 of $3,722,000 was
primarily from the sale of the Company's last freestanding facility, Mountain
Crest Hospital.

    In March 1997, the Company's wholly owned subsidiary, MHM Extended Care
Services, Inc., obtained a revolving credit facility in an amount up to
$4,000,000. The amount eligible for borrowings on the credit facility is
limited based on the amount of the Company's qualified accounts receivable. At
September 30, 1998, the Company had outstanding borrowings of $344,000 which
was approximately equal to what the Company was eligible to borrow at that
date. See Note 10 of Notes to Consolidated Financial Statements.

    In July 1998 and October 1997, the Company borrowed $500,000 under a line
of credit with NationsBank, N.A., which debt is guaranteed by certain officers
and directors of the Company. The line of credit permits maximum borrowings by
the Company of $500,000, and bears interest at a rate 2.6% above the EuroDollar
rate. As of September 30, 1998, the Company had drawn the full $500,000. See
Note 10 of Notes to Consolidated Financial Statements.

    In July 1998, the Company settled its dispute with MEDIQ Inc.  The Company
funded the $3,000,000 settlement payment to MEDIQ by fully drawing on the
NationsBank line of credit in the amount of, $500,000, drawing on a portion of
the revolving line of credit with HealthCare Financial Partners, amounting to
$275,000, and receiving a loan from HealthCare Financial Partners of
$2,000,000.  The Company's Directors and Officers liability insurance paid the
remaining $225,000 of this settlement.

    The loan from HealthCare Financial Partners has a six-month term and an
interest rate of prime plus 2%.  In consideration of the loan, the Company
granted HealthCare Financial Partners five year warrants for 300,000 shares of
stock exercisable at $.01 per share.  Michael S. Pinkert has also guaranteed
$800,000 of the $2,000,000 HealthCare Financial Partners loan.  For his
guaranty, the Company granted Mr. Pinkert ten year warrants for 145,000 share
of stock excerisable at $.50 per share. See Note 10 of Notes to Consolidated
Financial Statements.

    The Company expects to repay the $2,000,000 loan with HealthCare Financial
Partners and the $500,000 line of credit with NationsBank from the proceeds of
the sale of real property owned by the Company and proceeds from cost report
settlements outstanding from the sale of the freestanding hospital facilities
in 1996.

    As a result of the Company's continued negative operating results and
reduced collections of accounts receivable from certain government-funded
payors, as well as other administrative delays by third party payors, the
Company has been experiencing difficulty generating sufficient cash flows from
operations to meet its obligations and sustain its operations. In an effort to
improve this situation, the Company sold all of its freestanding facilities,
has taken steps to reduce operating expenses, is attempting to raise additional
capital, and is working to improve its cash flows. See "Recent Developments."
With respect to its efforts to reduce operating expenses, in 1997 the Company
ceased providing extended care services in the States of North Carolina and
Florida, and made a decision to sell, and has sold, substantially all of its
Extended Care Services Division in the first quarter of fiscal 1999.  Although
the Company continues to seek additional sources of debt and equity financing,
given the Company's financial condition it is unlikely that the Company's
efforts will be successful unless the Company is able to significantly reduce
its operating losses and raise additional working capital.  The Company's
liquidity could also be improved by (i) the collection of additional
outstanding receivables; (ii) significant reductions in overhead; and (iii)
obtaining additional capital and/or financing sources.  However, to date, the
Company's efforts to improve liquidity through these means have not been
successful. There can be no assurance that any of such events will occur or, if
they do occur, that the impact on cash flows will be sufficient to enable the
Company to continue its operations.






                                       18
<PAGE>   19
    This report includes forward-looking statements based on management's
current plans and expectations, relating to the proposed business activities of
the Company, and the proposed activities of the Company relating to improving
its liquidity. Such statements involve risks and uncertainties which may cause
actual future activities and results of operations to be materially different
from that suggested in this report, including, among others, the use of
available cash resources to fund continued operating losses, the risks
associated with industry consolidation and acquisitions, and the need to manage
growth.





                                       19
<PAGE>   20
ITEM 8 FINANCIAL STATEMENTS

<TABLE>
                  <S>                                              <C>
                  Independent Auditors' Report                      21
                  - 1998 and 1997


                  Independent Auditors' Report -                    22
                  1996


                  Consolidated Statements of
                  Operations -
                  Three Years Ended                                 23
                  September 30, 1998


                  Consolidated Balance Sheets -
                  September 30, 1998 and 1997                       24


                  Consolidated Statements of
                  Stockholders' Deficit -
                  Three Years Ended                                 25
                  September 30, 1998


                  Consolidated Statements of
                  Cash Flows -
                  Three Years Ended September                      26-
                  30, 1998                                         27


                  Notes to Consolidated                            28-
                  Financial Statements                             50


                  Schedule II- Valuation and
                  Qualifying Accounts and
                  Reserves                                         51
</TABLE>





                                       20

<PAGE>   21
INDEPENDENT AUDITORS' REPORT

Board of Directors and Stockholders
MHM Services, Inc.:

We have audited the accompanying consolidated balance sheets of MHM Services,
Inc. and subsidiaries as of September 30, 1998 and 1997, and the related
consolidated statements of operations, stockholders' deficit, and cash flows
for the years then ended.  Our audits also included the financial statement
schedule listed in the Index at Item 14.  These consolidated financial
statements and the financial statement schedule are the responsibility of the
Company's management.  Our responsibility is to express an opinion on the
consolidated financial statements and the financial statement schedule based on
our audits.  The accompanying consolidated financial statements of MHM
Services, Inc. as of September 30, 1996, were audited by other auditors whose
report thereon dated December 30, 1996, expressed an unqualified opinion with
an explanatory paragraph describing an uncertainty about the Company's ability
to continue as a going concern.

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 consolidated 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 1998 and 1997 consolidated financial statements referred to
above present fairly, in all material respects, the financial position of MHM
Services, Inc. and subsidiaries as of September 30, 1998 and 1997, and the
results of their operations and their cash flows for the years then ended in
conformity with generally accepted accounting principles.  Also, in our
opinion, the financial statement schedule for 1998 and 1997, when considered in
relation to the basic consolidated financial statements taken as a whole
presents fairly in all material respects the information set forth therein.

The accompanying consolidated financial statements have been prepared assuming
that the Company will continue as a going concern.  The Company has incurred
aggregated losses before extraordinary items of $19,892,000 for the three years
ended September 30, 1998, has a working capital deficiency of $2,011,000 as of
September 30, 1998 and is experiencing difficulty in generating sufficient cash
flows to meet its obligations and sustaining its operations, as discussed in
Note 2 to the consolidated financial statements. Such conditions raise
substantial doubt as to the Company's ability to continue as a going concern.
Management's plans concerning these matters are also described in Note 2 to the
consolidated financial statements.  The consolidated financial statements do
not include any adjustments that might result from the outcome of this
uncertainty.



KPMG LLP

McLean, Virginia

December 31, 1998





                                       21

<PAGE>   22
                          INDEPENDENT AUDITORS' REPORT


Board of Directors and Stockholders
MHM Services, Inc.
Vienna, Virginia

We have audited the accompanying consolidated statements of operations, 
stockholders' deficit, and cash flows of MHM Services, Inc. and subsidiaries 
for the year ended September 30, 1996.  Our audit also included the financial 
statement schedule for the year ended September 30, 1996 listed in the Index at 
Item 14.  These financial statements and the financial statement schedule are 
the responsibility of the Company's management.  Our responsibility is to 
express an opinion on the financial statements and the financial statement 
schedule based on our audit.

We conducted our audit 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 audit provides a reasonable basis 
for our opinion.

In our opinion, such consolidated financial statements present fairly, in all 
material respects, the results of operations and cash flows of MHM Services,
Inc.  and subsidiaries for the year ended September 30, 1996 in conformity with 
generally accepted accounting principles.  Also, in our opinion, the financial 
statement schedule for the year ended September 30, 1996, when considered in 
relation to the basic consolidated financial statements taken as a whole,
presents  fairly in all material respects the information set forth therein.

The accompanying consolidated financial statements have been prepared assuming 
that the Company will continue as a going concern.  The Company has incurred 
aggregated net losses of $20,448,000 for the three years ended September 30, 
1996 and has stockholders' deficency of of $3,582,000 as of September 30, 1996
and is experiencing difficulty in generating sufficient cash flows to meet 
its obligations and sustain its operations.  Such conditions raise substantial 
doubt as to the Company's ability to continue as a going concern.  The 
consolidated financial statements do not include any adjustments that might 
result from the outcome of this uncertainty.



/s/ DELOITTE & TOUCHE LLP

DELOITTE & TOUCHE LLP
Washington, D.C.
December 30, 1996





                                      22
<PAGE>   23
MHM SERVICES, INC. AND SUBSIDIARIES

Consolidated Statements of Operations

Years ended September 30, 1998, 1997, and 1996

<TABLE>
<CAPTION>
                                                                                   1998                1997              1996
------------------------------------------------------------------------------------------------------------------------------
<S>                                                                      <C>                     <C>              <C>
Revenues:
      Net patient service revenue                                        $   14,864,000          16,986,000        31,400,000
      Premium revenue                                                        14,430,000           3,865,000         3,270,000
------------------------------------------------------------------------------------------------------------------------------

                                                                             29,294,000          20,851,000        34,670,000
------------------------------------------------------------------------------------------------------------------------------

Costs and expenses:
      Operating                                                              20,040,000          14,875,000        25,765,000
      General and administrative                                              7,539,000           5,760,000         9,718,000
      Provision for bad debts                                                 3,326,000           3,467,000         6,320,000
      Depreciation and amortization                                             597,000             369,000         1,034,000
      (Gain) loss on sale of freestanding facilities (note 4)                (2,465,000)         -                  4,440,000
      Writedown of long-term assets (note 6)                                    430,000             696,000           461,000
      Other (credits) charges:
           Interest expense - MEDIQ (note 10)                                   757,000           1,042,000         1,097,000
           Interest expense - other                                             166,000              93,000           290,000
           Other income, net (note 3)                                        -                     (662,000)         (233,000)
------------------------------------------------------------------------------------------------------------------------------

                                                                             30,390,000          25,640,000        48,892,000
------------------------------------------------------------------------------------------------------------------------------

Loss before income taxes and extraordinary item                              (1,096,000)         (4,789,000)      (14,222,000)
Income tax (benefit) expense (note 12)                                           93,000          -                   (308,000)
------------------------------------------------------------------------------------------------------------------------------

Loss before extraordinary item                                               (1,189,000)         (4,789,000)      (13,914,000)

Extraordinary item - gain (loss) on early extinguishment
      of debt (note 10)                                                       9,185,000          -                   (463,000)
------------------------------------------------------------------------------------------------------------------------------

Net income (loss)                                                        $    7,996,000          (4,789,000)      (14,377,000)
------------------------------------------------------------------------------------------------------------------------------

Earnings (loss) per share-basic and diluted:
      Loss before extraordinary item                                     $        (0.34)              (1.40)            (4.20)
      Extraordinary item                                                           2.60          -                       (.14)
------------------------------------------------------------------------------------------------------------------------------

Net income (loss)                                                        $         2.26               (1.40)            (4.34)
------------------------------------------------------------------------------------------------------------------------------

Weighted average shares outstanding                                           3,528,000           3,411,000         3,310,000
------------------------------------------------------------------------------------------------------------------------------
</TABLE>

See accompanying notes to consolidated financial statements.



                                                                     (Continued)


                                       23
<PAGE>   24
MHM SERVICES, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

September 30, 1998 and 1997

<TABLE>
<CAPTION>
=================================================================================================================================
ASSETS (NOTE 10)                                                                                          1998              1997
---------------------------------------------------------------------------------------------------------------------------------
<S>                                                                                           <C>                   <C>
Current assets:
     Cash and cash equivalents                                                                $         54,000           108,000
     Accounts receivable, less allowances of $4,438,000 and $5,514,000
          in 1998 and 1997, respectively                                                             2,706,000         4,491,000
     Prepaid expenses                                                                                  134,000              ,000
     Estimated third-party payor settlements (note 7)                                                1,409,000           103,000

     Repossessed property under contract for sale (note 4)                                           1,172,000         1,910,000
     Other current assets                                                                                8,000           133,000
---------------------------------------------------------------------------------------------------------------------------------

Total current assets                                                                                 5,483,000         6,964,000

Property, plant, and equipment, net (note 8)                                                           335,000           531,000
Restricted cash                                                                                        526,000           537,000
Notes receivable, net (note 4)                                                                       -                 1,039,000
Other intangibles, net of accumulated amortization of $395,000
     and $144,000 in 1998 and 1997, respectively (notes 5 and 6)                                       431,000           873,000
Deferred rent                                                                                        -                   416,000
Other assets                                                                                           223,000           288,000
Goodwill, net of accumulated amortization of $419,000 and $266,000
      in 1998 and 1997, respectively (notes 5 and 6)                                                   538,000           766,000
---------------------------------------------------------------------------------------------------------------------------------

                                                                                              $      7,536,000        11,414,000
---------------------------------------------------------------------------------------------------------------------------------
LIABILITIES AND STOCKHOLDERS' DEFICIT
---------------------------------------------------------------------------------------------------------------------------------

Current liabilities:
     Accounts payable                                                                         $        444,000           975,000
     Accrued payroll and related expenses                                                              746,000           908,000
     Accrued expenses - MEDIQ (note 10)                                                              -                 1,019,000
     Estimated third-party payor settlements (note 7)                                                  967,000         2,187,000
     Other accrued expenses (note 9)                                                                 2,258,000         2,400,000
     Note payable (note 10)                                                                          2,000,000          -
     Line of credit (note 10)                                                                          500,000          -
     Current maturities of long-term debt (note 10)                                                    579,000        10,720,000
---------------------------------------------------------------------------------------------------------------------------------

Total current liabilities                                                                            7,494,000        18,209,000

Long-term debt (note 10)                                                                               176,000         1,456,000

Other liabilities                                                                                    -                    19,000
---------------------------------------------------------------------------------------------------------------------------------

                                                                                                     7,670,000        19,684,000
---------------------------------------------------------------------------------------------------------------------------------
Stockholders' deficit:
     Preferred stock ($.01 par value; authorized: 5,000,000; issued and outstanding: none)           -                  -
     Common stock ($.01 par value; authorized: 15,000,000; issued and outstanding:
          3,538,000 and 3,513,000 in 1998 and 1997, respectively)                                       35,000            35,000
     Additional paid-in capital                                                                     41,938,000        41,798,000
     Accumulated deficit                                                                           (42,107,000)      (50,103,000)
---------------------------------------------------------------------------------------------------------------------------------

Total stockholders' deficit                                                                           (134,000)       (8,270,000)
---------------------------------------------------------------------------------------------------------------------------------
Commitments and contingencies (note 11)
                                                                                              $      7,536,000        11,414,000
=================================================================================================================================

</TABLE>

See accompanying notes to consolidated financial statements.




                                                                     (Continued)

                                       24


<PAGE>   25
MHM SERVICES, INC. AND SUBSIDIARIES

Consolidated Statements of Stockholders' Deficit

Years ended September 30, 1998, 1997, and 1996

<TABLE>
<CAPTION>
===============================================================================================================================

                                                         Common stock
                                                   --------------------------        Additional
                                                          Shares                        paid-in     Accumulated
                                                          issued       Amount           capital         deficit            Total
--------------------------------------------------------------------------------------------------------------------------------
<S>                                                    <C>           <C>             <C>           <C>             <C>
Balance, September 30, 1995                            3,310,000     $ 33,000        41,699,000     (30,937,000)     10,795,000

      Net loss                                            -              -              -           (14,377,000)    (14,377,000)
--------------------------------------------------------------------------------------------------------------------------------

Balance, September 30, 1996                            3,310,000       33,000        41,699,000     (45,314,000)     (3,582,000)

      Issuance of common stock in connection
          With Apogee acquisition (note 5)               200,000        2,000            98,000        -                100,000
      Exercise of stock options                            3,000         -                1,000        -                  1,000
      Net loss                                            -              -              -            (4,789,000)     (4,789,000)
--------------------------------------------------------------------------------------------------------------------------------

Balance, September 30, 1997                            3,513,000       35,000        41,798,000     (50,103,000)     (8,270,000)

      Exercise of stock options                           25,000         -               12,000        -                 12,000
      Issuance of stock warrants in connection
          With Mediq settlement (note 14)                 -              -              128,000        -                128,000
      Net income                                          -              -              -             7,996,000       7,996,000
--------------------------------------------------------------------------------------------------------------------------------

Balance, September 30, 1998                            3,538,000     $ 35,000        41,938,000     (42,107,000)       (134,000)
================================================================================================================================
</TABLE>


See accompanying notes to consolidated financial statements.



                                                                     (Continued)



                                       25

<PAGE>   26
MHM SERVICES, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

Years ended September 30, 1998, 1997, and 1996

<TABLE>
<CAPTION>
                                                                                     1998              1997                1996
--------------------------------------------------------------------------------------------------------------------------------
<S>                                                                           <C>               <C>                <C>
Cash flows from operating activities:
  Net income (loss)                                                           $ 7,996,000        (4,789,000)        (14,377,000)
  Adjustments to reconcile net income (loss) to net cash used in operating
       activities:
           Depreciation and amortization                                          597,000           369,000           1,034,000
           Provision for bad debts                                              3,326,000         3,467,000           6,320,000
           Provision (benefit) for deferred income taxes                         -                  -                   500,000
           (Gain) loss on sale of freestanding facilities                      (2,465,000)          -                 4,440,000
           Gain on early extinguishment of debt                                (9,185,000)          -                  -
           Loss on disposal of fixed assets                                        28,000           -                  -
           Writedown of long-term assets                                          430,000           696,000             461,000
           Increase (decrease) in cash from changes in:
                Accounts receivable and estimated third-party payor
                  settlements, net                                             (2,997,000)       (5,000,000)           (723,000)
                Income taxes refundable                                          -                  662,000            (662,000)
                Prepaid expenses and other                                        141,000          (118,000)             10,000
                Deferred rent                                                     (31,000)         (198,000)            (52,000)
                Accounts payable                                                 (531,000)          170,000            (867,000)
                Accrued payroll and related expenses                             (162,000)          325,000            (283,000)
                Accrued expenses - MEDIQ                                          817,000           698,000             (56,000)
                Other accrued expenses                                           (380,000)          567,000            (627,000)
--------------------------------------------------------------------------------------------------------------------------------

Net cash used in operating activities                                          (2,344,000)       (3,151,000)         (4,882,000)
--------------------------------------------------------------------------------------------------------------------------------

Cash flows from investing activities:
  Proceeds from sale of freestanding facilities and Joint Venture               3,688,000           -                 9,099,000
  Capital expenditures for property, plant and equipment                          (23,000)         (178,000)           (273,000)
  Collections on notes receivable                                                -                  190,000            -
  Acquisitions of businesses                                                     -                 (427,000)           (150,000)
  Deferred costs                                                                 -                  -                    69,000
  Restricted cash                                                                  11,000          (231,000)           (306,000)
  Other assets                                                                     65,000           (82,000)            (30,000)
  Other liabilities                                                               (19,000)           (6,000)             (6,000)
--------------------------------------------------------------------------------------------------------------------------------

Net cash provided by (used in) investing activities                             3,722,000          (734,000)          8,403,000
--------------------------------------------------------------------------------------------------------------------------------

Cash flows from financing activities:
  Borrowings                                                                   12,651,000         4,110,000            -
  Debt repayments                                                             (14,095,000)       (3,393,000)         (3,280,000)
  Other                                                                            12,000           (29,000)            (20,000)
--------------------------------------------------------------------------------------------------------------------------------

Net cash provided by (used in) financing activities                            (1,432,000)          688,000          (3,300,000)
--------------------------------------------------------------------------------------------------------------------------------

Increase (decrease) in cash and cash equivalents                                  (54,000)       (3,197,000)            221,000

Cash and cash equivalents:
  Beginning of year                                                               108,000         3,305,000           3,084,000
--------------------------------------------------------------------------------------------------------------------------------

  End of year                                                                    $ 54,000           108,000           3,305,000
================================================================================================================================
</TABLE>




                                                                     (Continued)


                                       26
<PAGE>   27

MHM SERVICES, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows, Continued

<TABLE>
<CAPTION>

                                                                                            1998          1997             1996
--------------------------------------------------------------------------------------------------------------------------------
<S>                                                                                 <S>                <C>            <C>
Supplemental disclosure of cash flow information:
      Interest paid                                                                 $    292,000       358,000        1,398,000
      Income taxes refunded, net of payments                                               -           662,000           71,000
--------------------------------------------------------------------------------------------------------------------------------

Supplemental disclosure of non-cash investing and financing activities:
      Property and equipment and other assets financed with capital leases
           and long-term debt                                                       $      -             -               63,000
      Acquisition - portion financed with long-term debt                                   -           275,000          338,000
      Notes received from sale of freestanding facility                                    -             -            1,400,000
      Liabilities assumed - BHC                                                            -             -            1,160,000
      Issuance of stock warrants - to obtain financing from HCFP                         128,000         -               -
      Issuance of stock - acquisition of Apogee                                            -           100,000           -
--------------------------------------------------------------------------------------------------------------------------------
</TABLE>


See accompanying notes to consolidated financial statements.



                                                                     (Continued)


                                       27
<PAGE>   28
MHM SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

September 30, 1998, 1997, and 1996

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

   (1)   ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

         ORGANIZATION

         MHM Services, Inc., through its wholly-owned subsidiaries, MHM Extended
         Care Services, Inc. (Extended Care Services Division), MHM Correctional
         Services, Inc. (Correctional Services Division), and MHM of Colorado,
         Inc., (collectively the Company), is a provider of on-site specialty
         health care services. The Company provides subacute medical and
         behavioral health services to residents of long-term care facilities as
         well as to inmates of state correctional facilities. The Company
         primarily operates in four states. The Company's premium revenue is
         derived from two contracts with the state of Georgia and one contract
         with the state of Tennessee.

         CONSOLIDATION

         The accompanying consolidated financial statements include the accounts
         of MHM Services, Inc. and its subsidiaries. All significant
         inter-company accounts and transactions have been eliminated in
         consolidation.

         CASH EQUIVALENTS

         Cash equivalents include all liquid investments with purchased
         maturities of three months or less.

         ACCOUNTS RECEIVABLE

         The Company's accounts receivable from its Extended Care Services
         Division are due from its patients (primarily in Massachusetts,
         Pennsylvania, Tennessee and Georgia) and other third-party payors,
         primarily Medicare (50 percent), Medicaid (20 percent), Blue Cross (5
         percent) and various commercial insurance companies and other (20
         percent). The Company's accounts receivable from its Correctional
         Services Division (5 percent) are due from the states with which MHM
         has contracted. The Company maintains an allowance for potential losses
         from uncollectible accounts.

         PROPERTY, PLANT AND EQUIPMENT

         Property, plant, and equipment are stated at cost. Capital leases are
         recorded at the present value of future lease payments. The Company
         provides for depreciation and amortization on a straight-line basis as
         follows:

               Buildings and improvements                     30 years
               Furniture, fixtures, and equipment             5-8 years
               Equipment under capital lease                  5-8 years
               Leasehold improvements                         life of lease



                                                                    (Continued)
                                       28
<PAGE>   29
MHM SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements


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

   (1)   CONTINUED

         RESTRICTED CASH

         Restricted cash consists of certificates of deposit, which secure
         performance bonds obtained as required by a correctional contract with
         the state of Tennessee and an extended care contract with the state of
         Georgia. It also includes lockbox accounts restricted to pay down a
         certain revolving credit facility (see note 10).

         OTHER INTANGIBLE ASSETS

         Other intangible assets consist primarily of contractual rights and
         covenants not to compete. These assets are amortized on a straight-line
         basis over three to five years (see note 6).

         GOODWILL

         Goodwill represents the excess of the purchase price over the fair
         value of net assets acquired and is amortized on a straight-line basis
         over three to five years (see note 6).

         CARRYING VALUE OF LONG-TERM ASSETS

         At September 30, 1996, 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
         Company evaluates the carrying value of long-term assets, including
         property, plant, and equipment, goodwill and other intangible assets,
         based upon current and anticipated net income and undiscounted cash
         flows, and recognizes an impairment when it is probable that such
         estimated future net income and/or cash flows will be less than the
         carrying value of the asset. Measurement of the amount of impairment,
         if any, is based upon the difference between carrying value and fair
         value (see note 6).

         PATIENT SERVICE REVENUE RECOGNITION

         Net patient service revenues are reported at the estimated net
         realizable amounts from patients and third-party payors for services
         rendered, including estimated retroactive adjustments under
         reimbursement agreements with third-party payors. Retroactive
         adjustments are accrued on an estimated basis in the period in which
         the related services are rendered and adjusted in future periods as
         final settlements are determined.


                                                                     (Continued)
                                       29
<PAGE>   30
MHM SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements


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

(1)    CONTINUED

         PREMIUM REVENUE RECOGNITION

         The Company has agreements with two states to provide mental health
         services to prison inmates and nursing home residents. Under these
         agreements, the Company receives monthly capitated payments based on
         the number of participants, regardless of services actually performed
         by the Company.

         CHARITY CARE

         The Company has a policy of providing charity care at its behavioral
         health facilities to patients who are unable to pay. Such patients are
         identified based on financial information obtained from the patient and
         subsequent analysis. Since the Company does not expect payment,
         estimated charges for charity care are not included in revenues. The
         amounts of charity care provided, at established rates, were $14,000,
         $12,000, and $682,000 for 1998, 1997, and 1996, respectively.

         MALPRACTICE INSURANCE COVERAGE

         Medical malpractice claims are covered by a medical malpractice
         insurance policy, which is a claims-made policy with a prepaid
         five-year extended reporting period included.

         EARNINGS (LOSS) PER SHARE

         The Company adopted SFAS No. 128 (Statement 128), Earnings Per Share,
         in 1998. Under this statement, earnings (loss) per common share is
         computed by dividing net income (loss) by the weighted average number
         of common shares outstanding during the year. Common stock equivalents
         such as stock options and warrants are excluded from the earnings
         (loss) per share calculation because the effect would be antidilutive.

         FAIR VALUE OF FINANCIAL INSTRUMENTS

         The fair value of cash and cash equivalents, restricted cash, accounts
         receivable, estimated third-party payor settlements receivable and
         payable, accounts payable and accrued expenses are equivalent to their
         carrying value because of the short-term maturity of those instruments.
         The fair values of the Company's long-term debt (see note 10) are
         considered to be equivalent to their carrying values based upon
         consideration of borrowings with similar credit ratings, collateral and
         maturities. The fair value of the Company's notes receivable is
         equivalent to its carrying value which was estimated at net realizable
         value (see note 4).


                                                                     (Continued)
                                       30
<PAGE>   31
MHM SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements


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

(1)      CONTINUED

         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. Estimates also effect the reported
         amounts of revenues and expenses during the reporting period. Actual
         results could differ from those estimates. The most significant
         estimates include the allowance for potential losses from uncollectible
         accounts receivable, estimates of assets and liabilities due from/to
         third-party payors, the estimated net realizable value of notes
         receivable, and the estimated impairment of goodwill and other
         intangible assets.

         INCOME TAXES

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

         STOCK OPTION PLAN

         Prior to October 1, 1996, the Company accounted for its stock option
         plan in accordance with the provisions of Accounting Principles Board
         (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and
         related interpretations. As such, compensation expense would be
         recorded on the date of grant only if the current market price of the
         underlying stock exceeded the exercise price. On October 1, 1996, the
         Company adopted SFAS No. 123, Accounting for Stock-Based Compensation,
         which permits entities to recognize as expense over the vesting period
         the fair value of all stock-based awards on the date of grant.
         Alternatively, SFAS No. 123 allows entities to continue to apply the
         provisions of APB Opinion No. 25 and provide pro forma net income and
         pro forma earnings per share disclosures for employee stock option
         grants made in 1996 and future years as if the fair-value-based method
         defined in SFAS No. 123 had been applied. The Company has elected to
         continue to apply the provisions of APB Opinion No. 25 and provide the
         pro forma disclosure provisions of SFAS No. 123.


                                                                     (Continued)
                                       31
<PAGE>   32
MHM SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements


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

(1)      CONTINUED

         RECLASSIFICATIONS

         Certain items in the prior years' financial statements have been
         reclassified to conform to the 1998 presentation.

(2)      LIQUIDITY

         The accompanying consolidated financial statements have been prepared
         on a going concern basis that contemplates the continuation of
         operations, realization of assets and liquidation of liabilities in the
         ordinary course of business. The Company has incurred aggregated net
         losses of $11,170,000 for the three years ended September 30, 1998, has
         an accumulated deficit of $42,107,000 as of September 30, 1998, and has
         a stockholders' deficit of $134,000 as of September 30, 1998. As of
         September 30, 1998, the Company is in default on one of its notes
         payable (see note 10) and is experiencing difficulty in generating
         sufficient cash flows to meet its other obligations and to sustain its
         operations. At September 30, 1998, current liabilities exceed current
         assets by $2,011,000. Such conditions raise substantial doubt about the
         Company's ability to continue as a going concern. The consolidated
         financial statements do not include any adjustments that might result
         should the Company be unable to continue as a going concern.

         In May 1996, the Company sold six of its seven freestanding behavioral
         health facilities that represented approximately 51 percent of net
         revenues for fiscal 1996. These facilities were sold due to the
         expectation of more profitable opportunities to grow the Extended Care
         Services Division and other specialty on-site healthcare services. The
         Company sold its one remaining freestanding behavioral health facility
         (Mountain Crest) on April 17, 1998. Mountain Crest represented
         approximately 10 percent of net revenues for fiscal 1998.

         The Company has made several acquisitions in its Extended Care Services
         Division through fiscal 1997 (see note 5). However, to date, this
         division has operated unprofitably overall. As a result, the Company is
         in the process of closing or selling extended care operations in states
         where revenues have not been sufficient to operate profitably, as well
         as making selective reductions in operating and general and
         administrative costs.

         Effective March 11, 1997, the Extended Care Services Division obtained
         a $4,000,000 revolving credit facility to finance its receivables.
         Borrowings on the credit facility are limited to qualified accounts
         receivable. Also, the Company borrowed $500,000 in October 1997 and
         again in July 1998 on a line of credit guaranteed by certain officers
         and directors of the Company. In July 1998, the Company borrowed
         $2,000,000 to finance a settlement with MEDIQ (note 10).


                                                                     (Continued)
                                       32

<PAGE>   33
MHM SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements


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

(2)      CONTINUED

         In a continuing effort to improve the Company's financial condition for
         both the immediate future and the long term, the Company is seeking
         more profitable business opportunities through its Correctional
         Services Division while divesting of its Extended Care Services
         Division. Also, the Company is continuing its efforts to finance its
         working capital requirements, raise additional capital and improve its
         cash flows. Nevertheless, there can be no assurance that the Company's
         efforts will result in positive effects on the Company's financial
         condition.

(3)      JOINT VENTURE

         In August 1994, the Company formed a joint venture (Joint Venture) to
         combine its contract management business with that of Horizon Mental
         Health Services, Inc. (Horizon) of Denton, Texas. The Joint Venture,
         which was owned 27.5 percent by the Company and 72.5 percent by
         Horizon, managed both companies' hospital behavioral health care
         contracts. The terms of the Joint Venture provided for the Company's
         continued ownership of its management contracts and the assignment to
         the Joint Venture of the operating responsibilities and revenues
         related to such contracts.

         In March 1995, Horizon completed its initial public offering, and, in
         accordance with the terms of the Joint Venture Agreement, acquired the
         Company's interest in the Joint Venture for approximately $9,600,000
         (net of related expenses). The sale resulted in a gain of approximately
         $500,000 (net of income taxes of $3,000,000). In connection with the
         sale, the Company assigned to Horizon all of its rights and interest in
         its management contracts, including related accounts receivable.

         The Company was involved in litigation with Horizon involving the
         Company's right to certain cash flows as part of the sale of its
         interest in the Joint Venture. In May 1997, the Supreme Court of
         Delaware upheld a court award in the Company's favor for approximately
         $459,000. This amount is reported in other income in 1997.

(4)     SALE OF FREESTANDING FACILITIES

         On April 5, 1996, the Company sold Oakview Treatment Center to a
         non-profit corporation affiliated with a privately owned operator of
         two psychiatric hospitals for $50,000 in cash and $2,150,000, evidenced
         by two promissory notes payable to the Company. For financial statement
         purposes, the notes were recorded using the cost recovery method of
         accounting at an estimated net realizable value of $1,400,000. This was
         equal to the net book value of the Oakview Treatment Center immediately
         prior to the sale. The notes were collaterialized by the real property
         sold. On July 31, 1998, due to lack of payment on the promissory notes,
         MHM declared the notes to be in default. As a result, the Company
         reacquired Oakview Treatment Center in a foreclosure sale on


                                                                     (Continued)
                                       33
<PAGE>   34
MHM SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements


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

(4)      CONTINUED

         September 11, 1998. The property was reacquired subject to a junior
         lien held by the Internal Revenue Service (IRS). At September 30,1998,
         the notes receivable due from the purchaser totaled $1,172,000 and are
         reported as repossessed property in the accompanying balance sheets.
         The Company has entered into an agreement to resell the property at an
         amount that will substantially cover the amount of notes receivable
         outstanding. Any sale of the property is contingent upon IRS approval
         up until the IRS's right of redemption expires on January 11, 1999.

         On May 31, 1996, the Company sold certain assets, consisting
         principally of five of its freestanding behavioral healthcare
         facilities, to Behavioral Healthcare Corporation (BHC), pursuant to an
         Asset Purchase Agreement (the BHC Agreement), dated as of January 24,
         1996, and amended as of April 11, 1996, by and between the Company and
         BHC (the BHC Sale). The facilities were sold to BHC for approximately
         $10,209,000, consisting of $9,049,000 in cash and $1,160,000 in assumed
         liabilities of the freestanding facilities (reflecting post-closing
         adjustments by both parties).

         The Company used a portion of the proceeds from the BHC Sale for: (i)
         the repayment of the principal amount outstanding under the Company's
         revolving credit facility ($2,515,000, including related early
         termination fees of $174,000); (ii) the extinguishment of a portion of
         the indebtedness not assumed by BHC at the closing of the sale
         ($692,000, including early termination fees of $139,000), which
         consisted primarily of indebtedness secured by certain of the assets
         (particularly a facility and certain equipment) acquired by BHC; and
         (iii) the funding of the Company's obligation to complete repairs to
         two of the freestanding facilities sold to BHC in the amount of
         $284,000. During 1997, the Company used the remainder of the proceeds
         to fund operating losses, Extended Care Services Division acquisitions
         and increases in receivables primarily relating to growth in the
         Extended Care Services Division.

         The pretax loss on the sale of these six freestanding behavioral health
         facilities in 1996 was $4,440,000 consisting primarily of the write off
         of intangibles related to the facilities of $3,184,000, loss on the
         sale of certain property, plant, and equipment aggregating $319,000,
         transaction expenses of $568,000, severance expenses of $349,000, and
         other expenses of $680,000, offset by estimated Medicare depreciation
         recapture income of approximately $660,000.

         The Company sold its last freestanding behavioral health facility,
         Mountain Crest Hospital, on April 17, 1998. The hospital operations,
         together with certain assets previously leased by the Hospital, were
         sold to Poudre Valley Hospital for a cash purchase price of
         approximately $6,500,000. In connection with the sale to Poudre Valley,
         the Company acquired the previously leased assets for a purchase price
         of $2,700,000. As a result of this sale, the Company reported a pretax
         gain of approximately $2,400,000.



                                                                     (Continued)
                                       34
<PAGE>   35
MHM SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements


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

(5)      ACQUISITIONS

         HCI SERVICES

         In November 1993, the Company acquired substantially all of the assets
         and assumed certain liabilities of Atlanta-based ICH Services, L.L.C.
         (ICH) (successor to HCI Services, Inc.), which provided behavioral
         health and other specialized medical services under annual contracts
         with extended care facilities. The operating results are included in
         the Company's consolidated results of operations from the date of
         acquisition. The purchase price consisted of 330,000 shares of the
         Company's common stock, as well as certain additional consideration
         payable in cash or additional shares of the Company's common stock at
         the option of the former ICH members, after the third anniversary of
         the acquisition (November 18, 1996) in an amount equal to approximately
         20 percent of the appraised fair market value of the acquired
         operations.

         To date, neither the Company nor ICH has requested an appraisal of the
         acquired operations as provided for in the purchase agreement. Both
         parties have negotiated to modify the terms of the additional
         consideration without reaching any definitive agreements. The progress
         of future negotiations is uncertain.

         If no agreement is reached, the Company will be required to comply with
         the terms of the original agreement. The Company believes that the
         value of the acquired assets has significantly declined since the
         acquisition date based on prior and ongoing operational losses as well
         as increasing regulatory and economic pressures inherent in the
         extended care services business. The Company estimates that the amount
         payable under the terms of the original agreement approximates $337,000
         which has been accrued and expensed as of September 30, 1998, in the
         consolidated financial statements. However, if an appraisal results in
         a value significantly in excess of the Company's expectation and ICH
         members demand payment in cash, the Company could be forced into a
         bankruptcy filing as a result of insufficient funding. In any event,
         the issuance of additional stock to satisfy the Company's obligation
         could have a dilutive effect on the Company's outstanding common
         stockholders.

         On December 16, 1998, the Company entered into an agreement with
         another organization to divest certain of the assets acquired from ICH
         related to the delivery of mental health services to patients of
         extended care facilities in the state of Georgia. No consideration was
         received; however, the Company was relieved of managing the business.
         Losses of approximately $75,000 consisting of the writedown of related
         intangible assets were recognized in fiscal 1998 in anticipation of
         this transaction. The Company's PASARR contract with the State of
         Georgia Department of Medical Assistance was not a part of this
         transaction.


                                                                     (Continued)
                                       35
<PAGE>   36
MHM SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements


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

(5)      CONTINUED

         SUPPORTIVE COUNSELING CARE

         In July 1995, the Company acquired certain assets of Supportive
         Counseling Care (SCC) of Manhattan Beach, California, a provider of
         behavioral healthcare services to extended care facilities, for
         $500,000, and entered into a 40 year management contract to provide
         administrative services to SCC. The operating results of the acquired
         business are included in the Company's consolidated results of
         operations from the date of acquisition. This business was discontinued
         in December 1996 (see note 6).

         MHM COUNSELING SERVICES

         In December 1995, the Company's Extended Care Services Division
         acquired the behavioral healthcare clinic operations of National
         Mentor, Inc. located in Charlestown and Taunton, Massachusetts. The
         Company changed the name of the clinics to MHM Counseling Services and
         relocated the Charlestown clinic to Cambridge. The purchase price
         included cash of $150,000 and a $338,000 term loan payable in 36
         monthly installments. The purchase price was allocated primarily to
         intangible assets. The operating results of the acquired business are
         included in the Company's consolidated results of operations from the
         date of acquisition.

         LIBERTY BAY

         Effective as of December 1, 1996, the Company's Extended Care Services
         Division acquired, pursuant to an Agreement (the Liberty Bay Agreement)
         by and among the Company, MHM Extended Care Services, Inc., Liberty Bay
         Colony Health Services, Inc. (Liberty Bay) and Liberty Management
         Group, Inc. (Liberty Management), certain assets and contractual rights
         from Liberty Bay which constituted Liberty Bay's geropsychiatric
         management services operations in Massachusetts. The Company has
         integrated these operations with MHM Counseling Services and the
         combined operations from the date of acquisition operate under the name
         "MHM/Bay Colony Counseling Services", and, as a result of the
         acquisition and continued development, serve approximately 115 extended
         care facilities.

         As consideration for the purchase, the Company paid Liberty Bay
         $150,000 in cash and issued a promissory note in the principal amount
         of $150,000. The purchase price was primarily allocated to intangible
         assets. The note provides for quarterly interest payments at an annual
         rate of 9 percent and the payment of the principal amount in one
         installment on December 1, 1999. The Company also agreed to pay Liberty
         Bay additional consideration consisting of 20 percent of "cash flow"
         (as such term is defined in the Liberty Bay Agreement) from the
         acquired contracts over the five year period commencing December 1,
         1996. Such additional consideration is calculated, paid, and


                                                                     (Continued)
                                       36
<PAGE>   37
MHM SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements


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

(5)      CONTINUED

         expensed annually by the Company and totaled approximately $37,000 and
         $3,000 for years beginning December 1, 1997 and 1996, respectively.

         On December 31, 1998, the Company entered into an agreement with
         another organization to sell certain assets acquired from
         National Mentor, Inc., Liberty Bay and Liberty Management related to
         the delivery of outpatient mental health services and services to
         patients of extended care facilities in the state of Massachusetts.
         These assets were sold for $850,000, which will result in a gain on
         sale of approximately $200,000 to be recorded by the Company in the
         first quarter of fiscal 1999.

         APOGEE

         Effective as of March 31, 1997, the Company's Extended Care Services
         Division acquired certain assets and contractual rights related to the
         long-term care operations of Apogee, Inc. in Pennsylvania and
         Tennessee, consisting of contracts with approximately 263 facilities.
         The operating results are included in the Company's consolidated
         results of operations from the date of acquisition.

         As consideration for the purchase, the Company paid $100,000 in cash,
         issued a three year promissory note in the principal amount of
         $125,000, and issued 200,000 shares of common stock of MHM Services,
         Inc. at $.50 per share. The purchase price was primarily allocated to
         intangible assets. The note provides for interest payments six months
         after the closing date for the first two quarters and quarterly
         thereafter at an annual interest rate of 7 percent and annual principal
         payments. The Company also agreed to pay Apogee additional
         consideration consisting of 20 percent of "net cash collected" (as such
         term is defined in the Apogee Agreement) from the acquired operations
         over a five year period commencing March 31, 1997. Such additional
         consideration is calculated annually by the Company and did not result
         in a liability for the year beginning March 31, 1997. As of September
         30, 1998 the Company does not anticipate a liability for the year
         beginning March 31, 1998.

         On December 16, 1998, the Company entered into an agreement with
         another organization to divest certain assets related to the delivery
         of mental health services to patients of extended care facilities in
         the state of Tennessee. No consideration was received; however, the
         Company was relieved of managing the business. Losses of approximately
         $176,000 consisting of the write down of related intangibles were
         recognized in fiscal 1998 in anticipation of this transaction.

         On December 31, 1998, the Company entered into an agreement with
         another organization to sell certain assets related to the delivery of
         mental health services to patients of extended care facilities in the
         state of Pennsylvania. The total consideration for this transaction was
         $170,000 of which $20,000 was paid at closing and the remaining
         $150,000 was in the form of a promissory note payable, in its entirety,
         on March 30,


                                                                     (Continued)
                                       37
<PAGE>   38
MHM SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements


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

(5)      CONTINUED

         1999. The assets acquired by the purchaser in this transaction secure
         this note. This transaction will result in a gain on the sale of
         approximately $25,000 to be recorded by the Company in the first
         quarter of fiscal 1999.

(6)      WRITEDOWN OF LONG-TERM ASSETS

         In November 1996, the Company decided that its SCC operation was to be
         discontinued because of continuing losses. The Company shut down
         operations in December 1996. As a result, the carrying value of all
         other assets related to SCC, primarily intangible assets were written
         down resulting in a charge of $461,000 in the year ended September 30,
         1996.

         In September 1997, the Company decided to dispose of the Florida and
         North Carolina operations of its Extended Care Services Division and
         close its Atlanta, Georgia billing office. In connection with these
         decisions, the Company determined that the recoverability of goodwill
         relating to the HCI acquisition (note 5) was permanently impaired. The
         Company evaluated the carrying value of goodwill based on cash flow
         analysis and estimated disposal values. As a result, the carrying value
         of goodwill and other intangibles relating to these operations were
         written down resulting in a charge of $696,000 in the year ended
         September 30, 1997.

         In September 1998, the Company decided to sell certain assets and
         contractual rights related to the Extended Care Services Division. In
         connection with this decision, the Company determined that the
         recoverability of remaining goodwill and other intangible assets
         relating to a portion of the HCI Services and Apogee acquisitions (note
         5) was permanently impaired. As a result, the carrying value of
         goodwill and other intangibles relating to these operations were
         written down resulting in a charge of $430,000 in the year ended
         September 30, 1998.

         HCI Services and Apogee collectively represent revenues of $5,028,000,
         $4,771,000 and $5,510,000 and net losses of $1,205,000, $2,645,000 and
         $539,000 for the years ended September 30, 1998, 1997, and 1996
         respectively.

         As a result of sales of assets related to the Extended Care Division
         and the Company's last free-standing facility described above and in
         note 4, the Company will have virtually no ongoing revenues from those
         operations. Had these sales of assets taken place at the beginning of
         fiscal year 1998, the Company's total revenues for the year ended
         September 30, 1998 would have been approximately $15,000,000.
         Similarly, the Company's loss before extraordinary item for the year
         ended September 30, 1998 would have been approximately $1,300,000 and
         its loss per share before extraordinary item (basic and diluted) would
         have been approximately $(.38).



                                                                     (Continued)
                                       38
<PAGE>   39
MHM SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements


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

(7)      THIRD-PARTY PAYORS


         The Company has agreements with third-party payors that provide for
         payments for patient services at amounts that differ from its
         established rates. The Company is in the process of negotiating final
         settlements for prior reporting periods relating to filed cost reports
         for two of the six freestanding behavioral health facilities sold in
         1996, as well as for the remaining facility sold in 1998.

         Tentative and final settlements with all third-party payors for prior
         cost reporting periods have resulted in adjustments to increase net
         patient service revenue by approximately $762,000 and $965,000 for 1998
         and 1997, respectively.

         A summary of the payment arrangements with major third-party payors
         follows.

         MEDICARE

         Inpatient non-acute services, certain outpatient services and defined
         capital costs related to Medicare beneficiaries are paid primarily on a
         cost reimbursement basis. The Company is reimbursed for cost
         reimbursable items at a tentative rate with final settlement determined
         after submission of annual cost reports by the Company and audits
         thereof by the Medicare fiscal intermediary.

         OTHER THIRD-PARTY PAYORS

         The Company has also entered into payment agreements with certain
         commercial insurance carriers, health maintenance organizations and
         preferred provider organizations. The basis for payment to the Company
         under these agreements includes prospectively determined rates per
         discharge, discounts from established charges and prospectively
         determined daily rates. Services rendered to Blue Cross subscribers are
         paid based upon the provisions of individual plans and include payment
         of predetermined rates or a percentage of charges.

         EXTENDED CARE SERVICES

         Professional services provided to residents of extended care facilities
         are paid primarily on a fee-for-service basis. Medicare is the primary
         payor for such services. The Company is reimbursed based on fee
         schedules and is subject to prepayment and retroactive reviews of
         medical necessity conducted by the intermediary.


                                                                     (Continued)
                                       39
<PAGE>   40
MHM SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements


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

(8)      PROPERTY, PLANT, AND EQUIPMENT

         Property, plant and equipment includes the following:

<TABLE>
<CAPTION>
                                                              1998                      1997
-----------------------------------------------------------------------------------------------

<S>                                                 <C>                              <C>
Leasehold improvements                              $         21,000                    29,000
Furniture, fixtures, and equipment                           968,000                   994,000
Equipment under capital lease                                323,000                   323,000
-----------------------------------------------------------------------------------------------

                                                           1,312,000                 1,346,000

Less accumulated depreciation and amortization               977,000                   815,000
-----------------------------------------------------------------------------------------------

                                                    $        335,000                   531,000
-----------------------------------------------------------------------------------------------
</TABLE>

         Depreciation and amortization expense related to property, plant, and
         equipment was $191,000, $185,000, and $735,000 for 1998, 1997, and
         1996, respectively.

(9)      OTHER ACCRUED EXPENSES

         Other accrued expenses includes the following:

<TABLE>
<CAPTION>
                                                               1998                      1997
-----------------------------------------------------------------------------------------------

<S>                                                 <C>                              <C>
Accrued rent                                        $             -                    255,000
Accrued refunds                                               166,000                  218,000
Accrued professional fees                                     665,000                  860,000
Accrued miscellaneous taxes                                   184,000                  254,000
Other accrued expenses                                      1,243,000                  813,000
-----------------------------------------------------------------------------------------------

                                                    $       2,258,000                2,400,000
-----------------------------------------------------------------------------------------------
</TABLE>

(10)     LONG-TERM DEBT

         MEDIQ

         In connection with the spin-off of the Company by MEDIQ, its former
         corporate parent, on August 31, 1993, the Company executed a five-year
         note (the MEDIQ Note) for the balance of unpaid payment obligations
         imposed on the Company by MEDIQ and described by MEDIQ as management
         fees and intercompany interest. The original principal amount of the
         MEDIQ Note was $11,500,000 which bore interest at a rate of prime plus
         1.5 percent, with monthly payments of interest only through September
         1995 and then monthly principal and interest payments for the following
         three years. Principal payments of $767,000 were made in 1996 and
         additional principal payments of $256,000


                                                                     (Continued)
                                       40
<PAGE>   41
MHM SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements


--------------------------------------------------------------------------------
(10)     CONTINUED

         representing the contractually required principal payments for October
         1996 through January 1997, were made as of September 30, 1997, based on
         a fifteen year amortization period, with the balance due on August 31,
         1998.

         The Company filed a complaint on February 10, 1997 in Superior Court of
         New Jersey, Law Division against MEDIQ alleging that the MEDIQ Note is
         invalid on the grounds that MEDIQ breached its fiduciary obligations in
         connection with forcing the Company to execute the MEDIQ Note, the
         MEDIQ Note lacks consideration, the MEDIQ Note is unconscionable and it
         unjustly enriches MEDIQ at the Company's expense. The case was then
         transferred by the Court of Camden, New Jersey. The Company asked the
         Court to declare the MEDIQ Note null and void, require MEDIQ to return
         to the Company all payments MEDIQ has received under the MEDIQ Note and
         award the Company compensatory, consequential and punitive damages. The
         Company remained current in its payments under the MEDIQ Note until
         filing the lawsuit at which time it withheld payments commencing with
         the payment due for February 1997 and all subsequent payments. The
         Company received notice from MEDIQ by letter dated February 11, 1997
         stating that as a result of the Company's withholding of the February
         installment due under the MEDIQ Note, MEDIQ claims to have accelerated
         all principal and interest due under the MEDIQ Note. For fiscal year
         ended September 30, 1997, the outstanding amount owed by the Company
         under the MEDIQ Note ($10,478,000) was classified as a current
         liability. Additionally, the Company had accrued interest payable under
         the terms of the note of $777,000 and other accrued expenses of
         $242,000 as of September 30, 1997.

         On November 21, 1997, a Judge of the New Jersey Superior Court, Law
         Division, Camden County, entered a summary judgement against the
         Company and in favor of MEDIQ. The adverse decision dismissed the
         Company's suit against MEDIQ and as a result, judgement was entered in
         MEDIQ's favor for the full principal balances and related accrued
         interest. The Law Division also denied the Company's request for a stay
         in the entry of execution of the judgement.

         On July 15, 1998, the Company and MEDIQ settled the $11,800,000
         judgement against the Company. In return for a cash payment of
         $3,000,000 by the Company, MEDIQ has vacated its claim, and released
         the Company and its affiliates from any and all other liabilities;
         provided, however, no bankruptcy proceedings involving the Company
         occur which result in MEDIQ repaying all or part of the settlement
         amount it received. The settlement resulted in an extraordinary gain
         for fiscal 1998 of approximately $9,185,000.

         A $2,000,000 note obtained from HealthCare Financial Partners as well
         as draws on the Company's existing line of credit funded the
         settlement. The $2,000,000 note is collateralized by substantially all
         the assets of the Company, has a six month term expiring in January
         1999, carries interest of prime plus two percent, a two percent


                                                                     (Continued)
                                       41
<PAGE>   42
MHM SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements


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

(10)     CONTINUED

         commitment fee, and a completion fee of an additional two percent. The
         weighted-average interest rate is 10.42 percent as of September 30,
         1998.

         REVOLVING CREDIT FACILITY

         Effective March 11, 1997, MHM Extended Care Services, Inc. entered into
         a $4,000,000 revolving credit facility with HealthCare Financial
         Partners. The facility, which bears interest at prime plus 2.25
         percent, is secured by accounts receivable and expires in March 1999.
         The loan is also secured by the stock of the Company's subsidiary, MHM
         Extended Care Services, Inc. The amount of credit available fluctuates
         based on the amount of qualified accounts receivable. As of September
         30, 1998 and 1997, the Company had $344,000 and $1,122,000 outstanding
         under this facility, respectively. The weighted-average interest rate
         is 10.75 percent as of September 30, 1998 and 1997.

         LINE OF CREDIT

         On October 1, 1997, the Company secured a line of credit with
         NationsBank, N.A. that permits maximum borrowings by the Company of
         $500,000, with a commitment fee of .5 percent and bears interest at the
         Eurodollar Rate plus 2.6 percent, per annum. Certain members of senior
         management and a Board member personally guaranteed payment of the line
         to include the liability costs, and expenses. For their guarantee the
         Company granted the guarantors a security interest in and lien on all
         real and personal, tangible or intangible property of the Company. As
         of September 30, 1998, the Company had $500,000 outstanding under this
         line of credit. The weighted-average interest rate was 7.16 percent.
         The line of credit expires in March 1999.

         TERM LOANS AND CAPITAL LEASE OBLIGATIONS

         At September 30, 1998 and 1997, term loans totaling $339,000 and
         $450,000, respectively, represent various notes payable relating to the
         Apogee, Liberty Bay, and MHM Counseling acquisitions which bear
         interest at rates ranging from 7 percent to 9 percent and terms through
         March 2000 (see note 5). The note to Apogee totaling $125,000 at
         September 30, 1998, is in default for nonpayment of principal and
         therefore is classified as a current liability in the consolidated
         financial statements.

         Capital lease obligations totaling $72,000 and $126,000 at September
         30, 1998 and 1997, respectively, are payable in monthly installments
         including interest at rates ranging from 9 percent to 13 percent and
         terms through January 2001 and are collateralized by certain assets
         with a net book value of $76,000 and $115,000, respectively.

                                                                     (Continued)
                                       42
<PAGE>   43
MHM SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements


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

(10)     CONTINUED

         OTHER EARLY EXTINGUISHMENT OF DEBT

         In 1996, the Company recorded an extraordinary item in the amount of
         $463,000 consisting primarily of costs related to the early
         extinguishment of the Company's long-term debt and the write off of
         associated loan acquisition costs.

         Scheduled maturities of all long-term debt are as follows:

<TABLE>
<CAPTION>
 Year ending September 30
-------------------------------------------------------------------

<S>                                                  <C>
1999                                                 $     579,000
2000                                                       166,000
2001                                                         8,000
2002                                                         2,000
-------------------------------------------------------------------

                                                     $     755,000
-------------------------------------------------------------------
</TABLE>

(11)   COMMITMENTS AND CONTINGENCIES

         LEASES

         The Company leases certain equipment and office facilities under
         non-cancelable operating leases. The future minimum lease payments
         required under operating leases are as follows:

         Lease expense was $938,000, $1,496,000, and $1,433,000 for 1998, 1997,
         and 1996, respectively.

<TABLE>
<CAPTION>
Year ending September 30
-------------------------------------------------------------------

<S>                                                  <C>
1999                                                 $      355,000
2000                                                        257,000
2001                                                        246,000
2002                                                        200,000
2003                                                        184,000
Thereafter                                                   77,000
-------------------------------------------------------------------

Total future minimum lease payments                  $    1,319,000
-------------------------------------------------------------------
</TABLE>


                                                                     (Continued)
                                       43
<PAGE>   44
MHM SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements


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

(11)    CONTINUED

         The Company is currently negotiating a new lease for its Corporate
         Office. The Company expects this new lease to commence February 1,
         1999.

         LITIGATION

         The Company is involved in various other legal proceedings incidental
         to its business, some of which may be covered by insurance. The Company
         knows of no litigation, either pending or threatened, which is likely
         to have a material adverse effect on the Company's consolidated
         financial statements.

         CONTINGENCIES

         On November 23, 1998, the Company received a notice from the
         Massachusetts Peer Review Organization, Inc. (MassPro), that the
         Company's counseling clinic located in Taunton, Massachusetts had
         failed to comply with certain regulations, rules, standards and
         statutes applicable to providers participating in the Massachusetts
         Medical Assistance Program. As a result of MassPro's audit, the Company
         was requested to repay the Massachusetts Medical Assistance Program
         $215,000. The Company has thirty days to appeal this determination.
         Although the Company believes it will prevail in reducing the amount of
         repayment requested, the full amount of this potential liability has
         been recorded in the consolidated financial statements at September 30,
         1998.

         MassPro performed a similar audit in April 1998 on the Company's clinic
         located in Cambridge, Massachusetts. The Company has not received any
         correspondence from MassPro on the results of this audit. The Company
         does not believe the results of this audit will have a material
         financial impact on the Company's operations.

         The Company has been notified that a claim for refund of certain
         Medicare payments is being made against SCC to which a subsidiary of
         the Company previously provided management services. The claim is being
         asserted by the Medicare fiscal intermediary which was responsible for
         processing and paying SCC's claims for Medicare payments, and arises
         from post payment review by the fiscal intermediary. The claim, which
         seeks approximately $1,700,000 in refunds, relates to Medicare
         reimbursement paid to the group prior to any involvement of the
         Company's subsidiary as well as during the period in which management
         services were provided to SCC. No claim has been asserted against the
         Company or its subsidiary, and the Company does not believe that it has
         any liability with respect to the claims made against SCC.

         MALPRACTICE INSURANCE

         The Company has a general and professional liability policy that is
         written on a claims-made basis with a five year prepaid extended
         reporting period. This means coverage is extended for events reported
         sixty months after the policy ends, as long as the event

                                                                     (Continued)
                                       44
<PAGE>   45
MHM SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements


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

(11)     CONTINUED

         occurred during the policy period. The coverage per occurrence is 
         $1,000,000 with a $3,000,000 aggregate.

(12)     INCOME TAXES

         Income tax (benefit) expense consists of the following:

<TABLE>
<CAPTION>

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

<S>                                             <C>                                  <C>               <C>
Current:
      Federal                                   $       -                              -               (662,000)
      State                                          93,000                            -               (146,000)
-----------------------------------------------------------------------------------------------------------------

                                                     93,000                            -               (808,000)
-----------------------------------------------------------------------------------------------------------------

Deferred:
      Federal                                           -                              -                 500,000
      State                                             -                              -                    -
-----------------------------------------------------------------------------------------------------------------

                                                        -                              -                 500,000
-----------------------------------------------------------------------------------------------------------------

Total income tax (benefit) expense              $    93,000                            -               (308,000)
-----------------------------------------------------------------------------------------------------------------
</TABLE>

         The differences between the effective income tax (benefit) expense and
         the income tax (benefit) expense computed using the U.S. Federal income
         tax rate are as follows:

<TABLE>
<CAPTION>
                                                                  1998                       1997                       1996
------------------------------------------------------------------------------------------------------------------------------------

<S>                                                          <C>                          <C>                       <C>
Statutory expense (benefit)                                  $   (386,000)                (1,676,000)               (4,888,000)
State income taxes, net of federal (benefit) tax                   93,000                    (71,000)                  (96,000)
Valuation allowance                                               383,000                  1,668,000                 4,658,000
Goodwill amortization                                                   -                      5,000                    18,000
Other items-net                                                     3,000                     74,000                      -
------------------------------------------------------------------------------------------------------------------------------------

Total income tax (benefit) expense                           $     93,000                        -                    (308,000)
------------------------------------------------------------------------------------------------------------------------------------
</TABLE>

         The reconciliation presented above reflects tax expense from income
         (loss) before extraordinary items. For 1998, the MEDIQ extraordinary
         gain of $9,185,000 does not result in any tax expense. This is due to
         the extraordinary gain qualifying for income exclusion under Internal
         Revenue Code (IRC) Section 108 and utilization of net operating loss
         carry-forwards.


                                                                     (Continued)
                                       45
<PAGE>   46
MHM SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements


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

(12)     CONTINUED

         Significant components of deferred tax assets and liabilities follow:

<TABLE>
<CAPTION>
                                                           1998                   1997
------------------------------------------------------------------------------------------

<S>                                                   <C>                   <C>
Assets:
             Allowance for doubful acounts            $  1,709,000          $   2,256,000
             Net operating loss carryforwards            1,504,000              4,318,000
             Writedown of long-term assets                 434,000                268,000
             Other                                         105,000                191,000
             Valuation allowance                        (3,700,000)            (6,958,000)
------------------------------------------------------------------------------------------

                                                            52,000                 75,000
------------------------------------------------------------------------------------------

Liabilities:
             Prepaid expenses                               52,000                 39,000
             Depreciation and amoritzation                    -                    36,000
------------------------------------------------------------------------------------------

                                                            52,000                 75,000
------------------------------------------------------------------------------------------

Net deferred tax asset                                $       -                      -
------------------------------------------------------------------------------------------
</TABLE>

         At September 30, 1998, for income tax purposes, the Company had federal
         operating loss carry-forwards of approximately $3,907,000 and, state
         net operating loss carry-forwards of approximately $12,334,000 expiring
         through 2012. The income exclusion under IRC Section 108 causes a
         reduction in tax attributes; thus net operating loss carry-forwards are
         reduced accordingly. The change in valuation allowance was a reduction
         of $3,258,000 in 1998 and an increase of $1,668,000 in 1997.

(13)     RELATED-PARTY TRANSACTIONS

         ACCRUED EXPENSES - MEDIQ

         As of September 30, 1997, amounts payable to MEDIQ include accrued
         interest payable of $777,000 and other accrued expenses of $242,000
         primarily representing unpaid federal taxes for the period in which the
         Company was included in MEDIQ's consolidated federal tax return and
         expenses incurred by MEDIQ on behalf of the Company. As of September
         30, 1998, there were no accrued expenses payable to MEDIQ.


                                                                     (Continued)
                                       46
<PAGE>   47
MHM SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements


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

(13)     CONTINUED

         INTEREST EXPENSE -  MEDIQ

         The Company incurred interest expense related to the note payable to
         MEDIQ of $757,000, $1,042,000, and $1,097,000 in 1998, 1997, and 1996
         respectively.

         SERVICES AGREEMENT  - MEDIQ

         Since April 1, 1993, the Company has obtained certain legal,
         accounting, tax and risk management services from MEDIQ at prescribed
         rates pursuant to a services agreement. The service agreement
         terminated in 1996. Fees for such services, were $0, $30,000, and
         $38,000 for 1998, 1997, and 1996, respectively, and are included in
         general and administrative expenses.

         TAX ALLOCATION/SHARING AGREEMENT

         Pursuant to a tax allocation/sharing agreement, the Company will
         reimburse MEDIQ for any future tax assessments against MEDIQ resulting
         from the Company's operations, and the Company will be reimbursed by
         MEDIQ for any future tax benefit derived by MEDIQ resulting from the
         Company's operations and the Company will be indemnified for certain
         tax liabilities; in each case, for periods during which the Company had
         been a member of MEDIQ's consolidated group.

  (14)   STOCK OPTIONS AND WARRANTS

         OPTIONS

         The Company has a Stock Option Plan (the Stock Option Plan) and a Stock
         Option Plan for Non-Employee Directors (the Directors' Stock Option
         Plan). Under the Stock Option Plan, up to 350,000 shares of the
         Company's common stock may be subject to stock options granted to
         officers and key employees of the Company. Under the Stock Option Plan
         for Non-Employee Directors there is no limitation of the Company's
         common stock that may be subject to stock options granted. Options vest
         at 20 percent each year and may not be granted for a term in excess of
         ten years from the date of grant. On January 30, 1997, all outstanding
         options, which totaled 233,600, were re-priced at an exercise price of
         $.50. As of September 30, 1998, options to acquire 174,400 shares of
         stock were exercisable under the Stock Option Plan and options to
         acquire 7,500 shares of stock were exercisable under the Directors'
         Stock Option Plan. Exercise prices of stock options granted represent
         fair market value of the common stock at date of grant, or for the
         re-priced options, at January 30, 1997.


                                                                     (Continued)
                                       47
<PAGE>   48
MHM SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements


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

  (14)   CONTINUED

         The Company applies APB Opinion No. 25 in accounting for its stock
         option plan for options granted to employees and directors and,
         accordingly, no compensation expense for stock options has been
         recognized in the consolidated financial statements. Had the Company
         determined compensation expense based on the fair value at the grant
         date for its stock options under SFAS No. 123, the Company's net income
         (loss) would have been decreased (increased) to the pro forma amounts
         indicated below:


<TABLE>
<CAPTION>
                                           1998               1997              1996
-----------------------------------------------------------------------------------------

<S>                                   <C>                 <C>               <C>
Net income (loss):

     As reported                      $  7,996,000        (4,789,000)       (14,377,000)
     Pro forma                           7,961,000        (4,808,000)       (14,391,000)

Income (loss) per common share:

     As reported                      $       2.26             (1.40)             (4.34)
     Pro forma                                2.25             (1.41)             (4.35)
------------------------------------------------------------------------------------------
</TABLE>

         The fair value of each option is estimated on the date of grant using
         the Black-Scholes option pricing model with the following
         weighted-average assumptions generally used for grants in 1998, 1997
         and 1996, respectively: dividend yield of 0 percent (all years);
         expected volatility 126.51, 132.79 and 140.19 percent; risk-free
         interest rate of 5.66, 6.46 and 6.90 percent; and expected lives of 8
         years (all years).

         A summary of the status of the Company's stock options as of September
         30, 1998, 1997, and 1996, and changes during the years ended on those
         dates is presented below:

<TABLE>
<CAPTION>
                                                   1998                           1997                           1996

                                        ---------------------------     -------------------------      --------------------------
                                                          Weighted                      Weighted                       Weighted
                                                          average                       average                        average
                                                          exercise                      exercise                       exercise
                                           Shares          price          Shares         price           Shares         price
---------------------------------------------------------------------------------------------------------------------------------

<S>                                      <C>             <C>            <C>             <C>            <C>             <C>
Outstanding at beginning
     of year                               359,400       $    0.72        259,600       $    3.28        269,600       $    3.68
Granted                                     95,100            0.84        165,000            0.98         61,500            1.99
Exercised                                  (24,800)           0.50         (3,000)           0.50            -                -
Forfeited                                  (47,500)           0.74        (62,200)           1.48        (71,500)           3.68

---------------------------------------------------------------------------------------------------------------------------------
Outstanding at end of year                 382,200            0.76        359,400            0.72        259,600            3.28
---------------------------------------------------------------------------------------------------------------------------------

Options exercisable at end of year         181,900            0.59        176,400            0.50        161,500            3.62
---------------------------------------------------------------------------------------------------------------------------------

Weighted-average fair value
     of options granted
     during the year                    $     0.79                     $     0.93                      $    1.83
---------------------------------------------------------------------------------------------------------------------------------
</TABLE>


                                                                     (Continued)
                                       48
<PAGE>   49
MHM SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements


--------------------------------------------------------------------------------
(14)     CONTINUED

         The following table summarizes information about stock options
         outstanding at September 30, 1998:

<TABLE>
<CAPTION>
                                     Options outstanding                            Options exercisable
                      ---------------------------------------------------        -------------------------
                                      Weighted-average           Weighted                        Weighted
                                             remaining            average                         average
     Exercise                              contractual           exercise                        exercise
       prices          Number                     life              price          Number           price
----------------------------------------------------------------------------------------------------------

<S>                   <C>             <C>                        <C>              <C>            <C>
$0.50 - $0.75         265,700                     6.70            $  0.55         160,000            0.51
 1.00 -  1.50         111,500                     8.90               1.23          21,900            1.22
 1.75                   5,000                     9.81               1.75            -                -
----------------------------------------------------------------------------------------------------------
$0.50 - $1.75         382,200                     7.39               0.76         181,900            0.59
----------------------------------------------------------------------------------------------------------
</TABLE>

        WARRANTS

         On July 15, 1998, the Company issued warrants to purchase 300,000
         shares of common stock at $.01 per share to HealthCare Financial
         Partners (HCFP), in exchange for HCFP granting the Company a $2,000,000
         note payable used to fund the MEDIQ settlement (see note 10). The
         warrants are immediately exercisable and will expire on July 15, 2003.
         This resulted in an expense of $128,000 that served to reduce the MEDIQ
         gain.

         On July 15, 1998, the Company issued warrants to purchase 145,000
         shares of common stock at $.50 per share (which exceeded the current
         fair value of each share) to the Company's Chief Executive Officer in
         exchange for an $800,000 personal guarantee on the $2,000,000 note
         payable to HCFP. The warrants are immediately exercisable and will
         expire on July 15, 2008. No expense was attributed to this grant.

         On October 1, 1997, the Company issued warrants to purchase 90,000
         shares of common stock at $1.51 per share to certain members of the
         Company's senior management and a certain Board member in exchange for
         personal guarantees on the $500,000 NationsBank, N.A. line of credit
         (see note 10). In addition, for each month there was an outstanding
         balance on the line of credit, the Company issued additional warrants
         to purchase shares of common stock at $1.51 per share. As a result,
         during fiscal 1998, an additional 45,900 warrants were granted. All of
         the warrants are immediately exercisable and have no expiration period.
         No expense was attributed to these grants, as to the exercise price
         exceeded the stock's fair value on each date of grant.


                                                                     (Continued)
                                       49
<PAGE>   50
MHM SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements


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

(15)     RETIREMENT PLAN

         The Company has a 401(k) plan (the Plan). Employees, who are age 21 or
         older, are eligible to join the Plan upon completion of six months of
         service. The Plan provides that the Company will make a matching
         contribution equal to $0.50 for each $1.00 contributed by a participant
         not to exceed 1.5 percent of a participant's compensation. The
         Company's matching contribution is made in cash to be used to purchase
         shares of common stock of the Company for the accounts of the
         participants. For the years ended September 30, 1998, 1997, and 1996,
         the Company's contributions were $44,000 $38,000, and $70,000,
         respectively.

(16)     FOURTH-QUARTER RESULTS

         The fourth quarter income of approximately $7,024,000 resulted
         primarily from the $9,185,000 extraordinary gain on the early
         extinguishment of the MEDIQ liability. Excluding the extraordinary
         gain, the Company would have experienced a net loss of approximately
         $2,161,000, which exceeded prior quarterly reported losses due to
         several fourth quarter adjustments such as the following: write down of
         goodwill and other intangible assets due to a decision to divest the
         Extended Care Services Division ($251,000), an increase in the
         allowance for doubtful accounts related to the Extended Care Services
         Division ($750,000), an increase in the liability due to ICH ($179,000)
         (see note 5), and a liability recorded in connection with a contingency
         ($215,000) (see note 11). Also, during the fourth quarter, an
         adjustment related to changes in estimated third-party payor
         settlements occurred, effectively increasing net patient service
         revenue by $486,000.

(17)     NEW FINANCIAL ACCOUNTING STANDARDS

         The Financial Accounting Standards Board has issued SFAS No. 131,
         Disclosures about Segments of an Enterprise and Related Information
         that will require the Company to report certain information about
         operating segments. In accordance with the provisions of SFAS No. 131,
         the Company will adopt this new standard for the year ending September
         30, 1999. The adoption of this standard will not have a material effect
         on the financial position or results of operations of the Company.

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


                                                                     (Continued)
                                       50
<PAGE>   51
                                                                     SCHEDULE II

MHM SERVICES, INC. AND SUBSIDIARIES

Valuation and Qualifying Accounts and Reserves

Years ended September 30, 1998, 1997, and 1996

<TABLE>
<CAPTION>
------------------------------------------------------------------------------------------------------------------

                                                   Balance at       Charged to                         Balance at
                                                 beginning of        costs and                                end
                                                       period         expenses       Deductions         of period

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

<S>                                              <C>                <C>              <C>               <C>
Year ended September 30, 1998:
  Allowance for doubtful accounts(1)              $ 5,514,000        3,326,000        4,402,000         4,438,000

Year ended September 30, 1997:
  Allowance for doubtful accounts                 $ 4,404,000        3,467,000        2,357,000         5,514,000

Year ended September 30, 1996:
  Allowance for doubtful accounts                 $ 1,299,000        6,320,000        3,215,000         4,404,000

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


                 (1)     Approximately $650,000 of the 1998 deduction is related
                         to the sale of Mountain Crest receivables in the sale
                         described in note 4.



                                      51
<PAGE>   52
ITEM 9.    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

       On May 1, 1997, the Registrant discharged Deloitte & Touche LLP as the
Company's independent accountant to audit the Registrant's consolidated
financial statements. KPMG LLP was engaged as its new independent accountant to
audit the Registrant's consolidated financial statements for the fiscal year
ending September 30, 1998 and 1997.

       The independent accountants' report dated December 30, 1996 on the
consolidated financial statements for the fiscal years ended September 30, 1996
and 1995 contained no qualification or modification as to audit scope or
accounting principles, nor any disclaimer of opinion; however, for each of the
years it included an explanatory paragraph relating to the Company's ability to
continue as a going concern. The decision to change accountants was recommended
by management and approved by the Board of Directors.

       During fiscal years 1996 and 1995 and subsequent interim periods of 1997,
there have been no disagreements with Deloitte & Touche, LLP on any matter of
accounting principles or practices which if not resolved to their satisfaction
would have resulted in a reference to the subject matter in the independent
accountants' report. Similarly, there have been no such disagreements with KPMG
LLP since the date of their engagement.

ITEM 10.    DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.

<TABLE>
<CAPTION>

NAME                                       AGE                     POSITIONS WITH THE COMPANY
----                                       ---                     --------------------------
<S>                                        <C>                     <C>
Michael S. Pinkert                         57                      President, Chief Executive Officer and
                                                                   Director
                                          
John L. Silverman (1)(2)                   57                      Director
                                          
William P. Ferretti (2)(3)                 53                      Director
                                          
Michael F. Sandler (3)(4)                  53                      Director
                                          
Steven H. Wheeler                          36                      Executive Vice President - Operations and
                                                                   Director
                                          
Cleveland E. Slade                         43                      Vice President and Chief Financial Officer
                                          
Robert W. May                              38                      Vice President - Development
</TABLE>                                  

(1) Became a Director February 1998
(2) Member of the Compensation and Stock Option Committee
(3) Member of the Audit Committee
(4) Became a Director August 1998

                                       52
<PAGE>   53

       Mr. Pinkert has been President, Chief Executive Officer and a Director of
the Company since he founded it in 1981. He was formerly Vice President of
Psychiatric Institutes of America ("PIA") from 1979 to 1981. Prior to joining
PIA, he was Vice President of Charter Medical Corporation from 1976 to 1977
where he was responsible for international marketing. He also worked in
conjunction with Charter and PIA from 1974 to 1975 in establishing a hospital
management company in Iran. Mr. Pinkert has worked in the health care management
and consulting industry for over 30 years.

       John L. Silverman became a Director of the Company in January 1998. Mr.
Silverman is currently an independent consultant to the healthcare industry. For
the past three years, he served as the Chief Executive Officer of AsiaCare,
Inc., a southeast Asian healthcare investment company. From 1990 to August 1997,
he was the Vice President and Chief Financial Officer of Chi Systems, Inc., a
healthcare consulting company. Mr. Silverman is currently a Director of
Integrated Health Services, Inc. and Superior Consultant Holding Corporation and
several private companies.

       William P. Ferretti has been a Director of the Company since August 1996.
Mr. Ferretti has been Chief Executive Officer of Medstar Television, Inc.
(producer and syndicator of televised medical news) since 1982 and also is a
Director of U.S. Physicians, Inc. (physician practice management) and Vitas
Healthcare Corporation (provider of hospice services) and a general partner of
the Mid-Atlantic Venture Fund -II (venture capital firm).

       Michael F. Sandler has been a Director of the Company since August 1998.
Mr. Sandler is President and Chief Exexutive Officer of VeriText L.L.C.
Previously, Mr. Sandler held the position Senior Vice President-Finance and
Chief Executive Officer and was on the Board of Directors of MEDIQ, Inc. From
1986 to 1993 the Registrant had been a wholly owned subsidiary of MEDIQ. Mr.
Sandler previously served the Registrant as a Director from August 1993 until
January 1997.

       Steven H. Wheeler joined the Company in May 1994 and has served as Vice
President-Operations since December 1997. Prior to this promotion, he served as
Vice President - Integrated Delivery Systems. Before joining the Company, Mr.
Wheeler was Director of Business Development/Operations for Florida Psychiatric
Group from April 1993 to February 1994, General Manager, Psych Options, Inc.
from March 1992 to April 1993, and Regional Director of Operations, Merit
Behavioral Care Corporation (formerly American Biodyne) from May 1990 to
February 1992.

       Cleveland E. Slade has been Vice President and Chief Financial Officer
since July 1998. Previously, Mr. Slade served as Vice President of Finance,
Chief Financial Officer and Secretary of Sheppard Pratt Foundation from February
1997 to June 1998. Mr. Slade served as Regional Controller and the Corporate
Controller for the Company from September 1994 to January 1997.





                                       53
<PAGE>   54

       Robert May has been an employee of the Company for four years and was
promoted in December 1997 to Vice President of Development. Previously, he
served in other managerial positions with the Company including Regional Vice
President and Director of the PASARR program. Prior to joining the Company,  
Mr. May was Vice President/Administrator, Tallahassee Memorial Regional Medical
Center, Psychiatric Center, Tallahassee, Florida.

       Directors are elected annually to serve until the next annual meeting and
until the election and qualification of their successors. Officers are elected
annually by the Board and serve at the discretion of the Board of Directors.



                                       54
<PAGE>   55

ITEM 11. EXECUTIVE COMPENSATION

       Summary Compensation Table

       The following table sets forth certain information regarding compensation
paid during each of the last three fiscal years to the Company's Chief Executive
Officer and the Company's other most highly compensated executive officers whose
annual compensation exceeded $100,000 in fiscal 1998 (collectively "Named
Executive Officers")

<TABLE>
<CAPTION>
                                                                                                    
                                          Annual Compensation        Long Term                      
         Name and                         -------------------       Compensation           All Other
    Principal Position     Year      Salary $          Bonus $      Stock Options      Compensation $ (1)
    ------------------     ----      ---------         -------     --------------     ------------------
<S>                        <C>         <C>                 <C>         <C>                    <C>
Michael S. Pinkert         1998        237,000              -             -                   16,927
  President & Chief        1997        253,293              -          60,000                 18,493
  Executive Officer        1996        297,000              -             -                    5,537
                                                                          -
Steven H. Wheeler          1998        121,687              -          10,000                  8,937
  Executive Vice           1997        124,202              -          30,000                  7,422
President-Operations       1996        105,000              -             -                    6,588
  And Director

Lee Calligaro              1998        110,000              -             -                    7,200
 Vice President-           1997           -                 -             -                      -
 General Counsel           1996           -                 -             -                      -
</TABLE>

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

       1. Amounts reported represent the total of automobile allowances and
          Company contributions to the 401(k) plan.


Compensation of Directors

       Directors who are employees of the Company receive no additional
compensation for their services as Directors or as members of committees of the
Board of Directors. Non-employee Directors receive an annual Director's fee of
$10,000 for their services in such capacities. In 1993 the Company adopted a
Stock Option Plan for Non-Employee Directors. All options granted under this
plan vest 20% at date of grant with the remaining 80% vesting ratably over four
years. Options granted expire ten years from the date of original grant. On
January 30, 1997, the Company granted 10,000 options to William Ferretti and
10,000 options to Kenneth A. Kessler, M.D. In February 1998, Dr. Kessler
resigned as a Director and all nonvested options were terminated. Additionally
Messrs. Silverman and Freedman were granted 12,500 options each at the time they
became Directors in January 1998 and Mr. Sandler was granted 12,500 options when
he became a Director in August 1998.



                                       55
<PAGE>   56

Stock Options Granted

       The following table summarizes stock options granted during fiscal 1998
to the Company's Named Executive Officers.

<TABLE>
<CAPTION>
                                                                                                         Potential Realizable
                                                                                                       Value at Assumed Annual
                                                                                                         Rates of Stock Price
                                     Individual Grants                                                 Appreciation for Option
                                                                                                               Term (1)
    ---------------------------------------------------------------------------------------    ----------------------------------
                                           Percent of Total
                                          Options Granted to        Exercise or
                           Options           Employees in            Base Price        Expiration
   Name                  Granted (2)         Fiscal Year             ($/Share)           Date            5%            10%
   ----                  -----------         -----------             ---------           ----            --            ---
<S>                           <C>                     <C>                 <C>             <C>            <C>           <C>
Steven H. Wheeler             10,000                  17.4%               $0.62           12/18/07       $3,075         $7,423
Robert May                     2,000                   3.5%               $1.50           10/29/07       $1,488         $3,592
Robert May                     7,000                  12.2%               $0.62           12/18/07       $2,152         $5,196
Cleveland E. Slade            20,000                  35.0%               $0.68           05/07/08       $6,745        $16,282
</TABLE>

1.  The information in these columns illustrates the value that might be       
    realized upon exercise of the options assuming the specified compound      
    rates of appreciation of the Company's common stock from its value as of   
    the date of the grant over the term of the options. The potential          
    realizable value columns are based on the total amount of options          
    granted. However, the total amount may not become exercisable (see Note    
    2). In addition, the amounts reflected do not take into account amounts    
    required to be paid for federal or state income taxes. The amounts also    
    do not reflect the effect of option provisions regarding termination of    
    the option following termination of employment or nontransferability       
    requirements. These amounts were calculated based on requirement of the    
    Securities and Exchange Commission and do not necessarily reflect the      
    Company's estimate of future stock price growth.                           
                                                                               
2.  The options indicated become exercisable in 20% installments over a        
    five-year period commencing on the first anniversary of the grant date.    

Aggregated Option and Fiscal Year-End Option Value Table

       The following sets forth information concerning the September 30, 1998
value of the exercisable and unexercisable options held by each of the Named
Executive Officers. No stock options were exercised during fiscal 1998 by any of
the Named Executive Officers.

<TABLE>
<CAPTION>
                                                                                                      Value of Unexercised
                                                                    Total Number of                   In-The-Money Options
                                                                  Un exercised Options                     At Year End
                            Shares
                           Aquired             Value
                         On Exercise         Realized     Exercisable           Unexercisable       Exercisable     Unexercisable
<S>                           <C>                <C>           <C>                   <C>              <C>              <C>
Michael Pinkert               -                  -             100,400               41,600           $53,100             -
Steve  Wheeler                -                  -              12,000               38,000           $ 4,130          $9,420
Lee Calligaro                 -                  -               4,000               16,000           $ 2,360          $9,440
Robert  May                   -                  -               4,000               25,000           $   590          $5,650
Cleveland E. Slade            -                  -                  -                20,000              -             $8,200

</TABLE>

The value of the unexercised in-the-money options does not reflect executory
costs or the impact of federal or state income taxes and may be impacted by
subsequent changes in the market price of the Company's stock. 




                                       56
<PAGE>   57

Board Compensation Committee Report on Executive Compensation

       Compensation arrangements for the Company's executive officers are
determined by the Company's Board of Directors by reference to a survey of
compensation trends by position among hospital management companies. This survey
was prepared by an independent management compensation consultant. The Company's
base compensation levels have averaged at the median for the industry, with
incentive compensation, if any, enabling the Company's executive officers to
receive additional compensation if the Company's financial objectives are
attained. The companies surveyed included some of, but are not limited to, the
companies represented in the peer group index in the performance graph following
this report. This survey was used as a basis for comparison because it included
a broad spectrum of hospital management companies, including the Company. Since
August 1993, the Compensation and Stock Option Committee (the "Committee") has
reviewed compensation levels of the Company's employees and determined
guidelines for the future, including incentive compensation. The Committee is
also authorized to grant stock options to officers and key employees of the
Company pursuant to the Company's 1993 Stock Option Plan, and to determine the
terms of such options.

       It is the policy of the Committee, and the Board of Directors, as a
whole, that a significant portion of the annual compensation of the Company's
Chief Executive Officer and other executive officers should be directly linked
to the Company's performance, as well as each individual's contribution. The
Company's compensation programs are designed to provide competitive financial
rewards for successfully meeting the Company's strategic and operating
objectives, with the purposes of retaining personnel and supporting a
performance-oriented environment.

       The compensation of the Company's Chief Executive Officer and other
executive officers is comprised of base salary, as well as cash and stock
incentives based on annual and long-term results of the Company. Increases in
base salary, if any, will be based on individual performance, level of
responsibilities and the Company's overall performance.

       Changes in Mr. Pinkert's compensation, if any, would be determined by the
Committee based upon its subjective analysis of his performance and the
Company's overall performance. In 1997 Mr. Pinkert accepted a voluntary
reduction in salary to help improve the Company's cash flow. In consideration of
this reduction, he received stock options for an additional 60,000 shares based
on a survey prepared by an independent management compensation consultant
reporting to the Compensation Committee. In 1998 Mr. Pinkert accepted a
voluntary reduction in salary to help improve the Company's cash flow. There was
no consideration for this reduction.

       The Company has an incentive compensation program that rewards the
Company's executive officers based upon the Committee's subjective determination
concerning individual performance and the Company's achievement of its internal
financial objectives. Executive officers become entitled to receive a percentage
of the bonus potential based upon the percentage achievement of the Company's
internal projected operating profit. Bonuses to be paid, if any, are determined
based upon the amount by which the Company exceeds its projected operating
profit and the allocation of a bonus pool among the plan participants. The bonus
pool is based upon the amount by which the Company exceeds its projected
operating profit, and can range from 25% to 100% of the amount over the
Company's projected operating profit. Allocation factors include salary levels
and individual performance evaluations. Through this plan, a significant portion
of each executive officer's annual total compensation is placed at risk in order
to provide an incentive toward sustained high performance. For fiscal 1998, the
Company did not meet its projected financial goals and, as a result, the
Company's executive officers did not receive any bonus payments under this plan.

       In addition, it has been the policy of the Committee to utilize stock
options to provide a link between compensation and the market performance of the
Company's stock, and to focus attention of management on the enhancement of
shareholder value. As a general rule the options are subject to ratable vesting
over a five-year period.






                                       57
<PAGE>   58

       During fiscal 1998 the Company awarded options for 20,000 shares to
Cleveland E. Slade at the time he joined the Company as Vice President and Chief
Financial Officer. The Company awarded options for 9,000 shares to Robert May
for his achievements in improving operations.

       If the Company's executive officers create additional value for the
Company's shareholders, evidenced by increases in the Company's stock price, the
Company's executive officers will also benefit through appreciation of the
potential value of outstanding stock options. The Committee believes that the
long-term nature of stock options also encourages executive officers to remain
in the employ of the Company.

Compensation and Stock Option Committee

William P. Ferretti
Kenneth Kessler (1)
Michael S. Sandler (2)

(1)  Dr. Kessler resigned from the Board of Directors in February 1998 and at  
     that time ceased to be a member of the Compensation and Stock Option      
     Committee.                                                                
                                                                               
(2)  Mr. Sandler resigned from the Board of Directors in January 1997 and at   
     that time ceased to be a member of the Compensation and Stock Option      
     Committee. Upon rejoining the Board of Director in August 1998, he has    
     been reappointed to the Compensation and Stock Option Committee.          
                                                                               
Compensation Committee Interlocks and Insider Participation

       Dr. Kenneth A. Kessler served on the Compensation Committee of the Board
of Directors prior to his resignation from the Board in February 1998. During
Dr. Kessler's tenure on the Compensation Committee, Michael S. Pinkert served on
the Board of Directors of American Psych Systems, Inc., a corporation for which
Dr. Kessler serves as Chief Executive Officer and Chairman.

STOCK PERFORMANCE CHART

       The following chart compares the cumulative total shareholder return on
the Company's Common Stock for fiscal years 1994 through 1998 with the S&P 600
(small cap companies) and an index of peer companies selected by the Company,
consisting of: Vencor Inc., Comprehensive Care Corp., Magellan Health Services,
Inc. (formerly Charter Medical Corp.), PMR Corporation and Ramsay Health Care,
Inc.

<TABLE>
<CAPTION>

     Comparison of 60 month Cumulative Total Return* Among MHM Services, Inc.,
                the S&P 600 Value Index and a Peer Group

                      9/30/93      9/30/94      9/30/95     9/30/96     9/30/97      9/30/98
<S>                        <C>          <C>          <C>         <C>         <C>          <C>
MHM Services, Inc.         100           68           85          18          32           26
Peer Group                 100          143          129         134         175           29
S&P 600                    100           99          125         145         198          168
</TABLE>




                                       58
<PAGE>   59

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

       The following table sets forth, as of November 30, 1998, the beneficial
ownership of shares of the Company's Common Stock par value $.01 per share by
each person known to the Company to be the owner of in excess of five percent of
the Company's outstanding shares of common stock, each director of the Company,
each Named Executive Officer and by all directors and officers of the Company as
a group.

<TABLE>
<CAPTION>
                  Name                                        Number of                          % of Class
                                                              Shares(1)                     Outstanding (2)
<S>                                                             <C>                                   <C>
Bessie G. Rotko (3)                                             920,811                               26.0%
Michael S. Pinkert                                              567,803  (4) (5)                      16.0%
William P. Ferretti                                              44,661  (4)                           1.3%
Steven H. Wheeler                                                19,885  (4) (5)                          *
John L. Silverman                                                 2,500  (4)                              *
Michael Sandler                                                   2,500  (4)                              *
Cleveland E. Slade                                                    0  (4)                              *
Lee Calligaro                                                    40,646  (4)                           1.1%
HealthCare Financial Partners                                   300,000  (7)                           8.5%
Apogee, Inc.                                                    200,000  (6)                           5.7%
All Executive Officers and Directors as a Group                 684,795                               19.4%
</TABLE>

       * Represents less than one percent

       (1) Except as otherwise indicated below, all shares are expected to be
           beneficially owned, and sole investment and voting power is
           expected to be held, by the person named.
       (2) All percentages are rounded to the nearest tenth, and are based
           upon the number of shares outstanding, including, as appropriate,
           the shares referred to in the notes below.
       (3) Mrs. Rotko is the lifetime income beneficiary of a trust. The
           Trustees, Bessie G. Rotko, Michael J. Rotko, Judith M. Shipon,
           Lionel Felzer and Provident National Bank, share voting and
           investment power with respect to the shares held in the trust. The
           address of the trustees is c/o Provident National Bank, c/o Robert
           Tropp, 1600 Market Street, Philadelphia, PA 19103.
       (4) Includes options exercisable currently or within the next 60 days
           including Mr. Pinkert - 100,400, Mr. Ferretti - 1,130 , Mr.
           Wheeler - 17,000 ,Mr. Silverman - 2,500 , Mr. Sandler - 2,500 and
           Mr. Calligaro 8,000 and warrants issued including Mr. Pinkert -
           238,474, Mr. Ferretti - 31,154 and Mr. Calligaro - 31,154.
       (5) Includes shares held in retirement accounts
       (6) Represents shares issued to Apogee, Inc in connection with
           acquisition of assets for Company's Extended Care Services
           Division during fiscal 1997. The address of Apogee, Inc. is 1060
           First Avenue, Suite 410, King of Prussia, PA 19406.
       (7) Represents warrants issued to HealthCare Financial Partners as
           additional consideration for the $2,000,000 loan the Company used
           as a part of the MEDIQ settlement. The address of HealthCare
           Financial Partners is 2 Wisconsin Circle, 4th Floor, Chevy Chase,
           MD 20815.

Beneficial Ownership Reporting Compliance

       To the best of the Company's knowledge, all Directors and Executive
Officers timely filed all forms required by Section 16(a); except that Messrs.
Ferretti and Wheeler each inadvertently filed a Form 4 late, which forms have
been subsequently filed.



                                       59
<PAGE>   60




ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

       In October 1997, the Company obtained an unsecured $500,000 line of
credit from NationsBank. This line of credit was required in order to meet the
cash demands of the Company, and there were no other reasonable sources for
financing. Michael S. Pinkert personally guaranteed and collateralized the line
of credit. William P. Ferretti and Lee Calligaro personally guaranteed the
payment of the line of credit to NationsBank up to $100,000 each. In
consideration of the risks assumed in connection with the guarantee, the Company
granted 90,000 warrants to purchase common stock of the Company at a price of
$1.51 per share. The warrants were issued as follows, Mr. Pinkert - 54,000
shares, Messrs. Ferretti and Calligaro 18,000 shares each. In addition, warrants
are granted each month following that there is a balance outstanding on the
loan. Additional warrants granted through November 30, 1998, were Mr. Pinkert -
33,514, Messrs. Ferretti and Calligaro 11,168 each. The total warrants
outstanding at November 30, 1998 were 590,850.

       In funding the MEDIQ settlement, the Company secured a loan for
$2,000,000 from its principle lender HealthCare Financial Partners in July 1998.
The loan from HealthCare Financial Partners has a six-month term and an interest
rate of prime plus 2.6% above the Eurodollar rate. As a condition of granting
the loan, HealthCare Financial Partners required Michael S. Pinkert to guarantee
$800,000 of the $2,000,000 loan. For his guaranty, the Company granted Mr.
Pinkert ten year warrants for 145,000 share of stock exercisable at $.50 per
share.

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

       (a) Financial Statement Schedules are set forth on pages 23 to 27 of
           this report
       (b) Reports on Form 8-K
              The Company filed a voluntary report on Form 8-K on September 29,
              1998, announcing the appointment of Michael F. Sandler to the
              Board of Directors replacing Richard S. Freedman, who resigned
              from the Board. Mr. Freedman gave no reason for his resignation.
       (c) Exhibits are listed in the Exhibit Index which is on page 62 of
       this Form 10-K and which is incorporated by reference herein.





                                       60
<PAGE>   61

                                INDEX TO EXHIBITS

<TABLE>
<CAPTION>
EXHIBIT NO.              DESCRIPTION
-----------              -----------
<S>                      <C>
3.1                      Restated Articles of Incorporation of MHM Services, Inc. (1)

3.2                      Amended By-laws of MHM Services, Inc. (2)

4.1                      Specimen certificate (3)

4.2                      Common Stock Purchase Warrant Agreement between the Company
                         and Health Care Financial Partners, Inc. dated July 15, 1998 (4)

4.3                      Registration Rights Agreement between the Company and Health
                         Care Financial Partners, Inc. dated July 15, 1998 (4)

4.4                      Registration Rights Agreement between the Company and
                         Michael S. Pinkert dated July 15, 1998

4.5                      Common Stock Purchase Warrant Agreement between the Company
                         and Michael S. Pinkert dated July 15, 1998 (4)

10.1                     1993 Stock Option Plan (5)

10.2                     1993 Non-Employee Directors' Stock Option Plan (5)

10.3                     1993 Bonus Plan (3)

10.4                     1996 Non-Employee Directors' Stock Option Plan (6)

10.5                     Amendment to 1993 Stock Option Plan (6)

10.6                     Sublease Agreement between the Company and Stanley Martin
                         Companies, Inc. dated June 1996 (7)

10.7                     Contract with Tennessee Department of Corrections (8)

10.8                     Consent to Assignment of Contract with Tennessee 
                         Department of Corrections (8)

10.9                     Contract with Georgia Department of Corrections (8)
</TABLE>







                                       61
<PAGE>   62

<TABLE>

<S>                      <C>
10.10                    Purchase Agreement with Apogee, Inc. (8)

10.11                    Settlement Agreement among MHM Services, Inc., Oakview
                         Limited Partnership, Columbia Health Associated Limited
                         Partnership, Michael S. Pinkert and MEDIQ, Incorporated
                         dated July 15, 1998 (4)

10.12                    Promissory Note of MHM Services, Inc., MHM Extended Care
                         Services, Inc., MHM of Colorado, Inc., Oakview Limited
                         Partnership and Columbia Health Associated Limited
                         Partnership to Michael S. Pinkert dated July 15, 1998 (4)

10.13                    Credit and Security Agreement among MHM Services, Inc.;
                         MHM Correctional Services, Inc., MHM Extended Care Services,
                         Inc. MHM of Colorado, Inc., Oakview Limited Partnership,
                         Columbia Health Associated Limited Partnership, Michael
                         S. Pinkert and Health Care Financial Partners Funding II, Inc.
                         dated July 15, 1998 (4)

10.14                    $2,000,000 Promissory Note of MHM Services, Inc., MHM Extended
                         Care Services, Inc., MHM of Colorado, Inc., Oakview Limited
                         Partnership, Columbia Health Associated Limited Partnership
                         to HealthCare Financial Partners Funding II, Inc. dated
                         July 15, 1998 (9)

21                       Subsidiaries of MHM Services, Inc. (9)

23                       Consents of KPMG LLP and Deloitte & Touche LLP (9)

27                       Financial Data Schedule (9)
</TABLE>

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

(1)    Incorporated by reference to the Registrant's Form 8-K/A dated May 15,
       1996
(2)    Incorporated by reference to the Registrant's Form 10-K for the fiscal
       year ended September 30, 1995
(3)    Incorporated by reference to the Registrant's Form 10 filed August 13,
       1993
(4)    Incorporated by reference to the Registrant's Form 10-Q for the quarter
       ended June 30, 1998
(5)    Incorporated by reference to the Registrant's Form 10-K for the fiscal
       year ended September 30, 1993
(6)    Incorporated by reference to the Registrant's 1996 Annual Meeting Proxy
       Statement
(7)    Incorporated by reference to the Registrant's Form 10-K for the fiscal
       year ended September 30, 1996
(8)    Incorporated by reference to the Registrant's Form 10-K for the fiscal
       year ended September 30, 1997
(9)    Filed herewith





                                       62


<PAGE>   63
7.1  SIGNATURES

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

<TABLE>
<S>                                                <C>
Dated January 14, 1999                                      MHM SERVICES, INC.


                                                   By:   /s/ Michael Pinkert             
                                                        ---------------------------------
                                                          Chief Executive Officer, President
                                                          And Director
                           
                           
                                                        /s/ Steven H. Wheeler            
                                                       ----------------------------------
                                                         Executive Vice President-Operations
                                                         And Director
                           
                           
                           
                                                        /s/ Cleveland E. Slade            
                                                       -----------------------------------
                                                         Vice President - Finance
                                                         Chief Financial Officer
                           
                           
                           
                                                        /s/ John L. Silverman              
                                                       ------------------------------------
                                                         Director
                           
                           
                           
                           
                                                        /s/ William P. Ferretti             
                                                       -------------------------------------
                                                         Director
                           
                           
                       
                       
                                                        /s/ Michael F. Sandler             
                                                       ------------------------------------
                                                         Director
</TABLE>




                                       63