<PAGE>

                      SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C. 20549

                                   FORM 10-Q

  [X]Quarterly Report Pursuant to Section 13 or 15(d) of the Securities
     Exchange Act of 1934 for the Quarterly Period Ended September 30, 1999.

                                      OR

  [_]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 000-22647

                        PERITUS SOFTWARE SERVICES, INC.
            (Exact Name of Registrant as Specified in its Charter)

            Massachusetts                            04-3126919
   (State or Other Jurisdiction of                (I.R.S. Employer
   Incorporation or Organization)                Identification No.)

    112 Turnpike Road, Suite 111                       01581
     Westborough, Massachusetts                      (Zip Code)
   (Address of Principal Executive
              Offices)

                                (508) 870-0963
             (Registrant's Telephone Number, Including Area Code)

                               2 Federal Street
                        Billerica, Massachusetts 01821
             (Former Name, Former Address and Former Fiscal Year,
                         If Changed Since Last Report)

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

Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date:

<TABLE>
<CAPTION>
                                                           Shares outstanding at
      Title of Class                                         November 8, 1999
      --------------                                       ---------------------
      <S>                                                  <C>
      Common Stock, $0.01 par value.......................      17,173,975
</TABLE>
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.

                                   FORM 10-Q

               For The Quarterly Period Ended September 30, 1999

                               TABLE OF CONTENTS

<TABLE>
<CAPTION>
                                                                            Page
                                                                            ----
<S>                                                                         <C>
Part I. Financial Information
 Item 1. Financial Statements..............................................   3
   Consolidated Balance Sheet as of September 30, 1999 and December 31,
    1998...................................................................   3
   Consolidated Statement of Operations for the Three and Nine Months Ended
    September 30, 1999 and 1998............................................   4
   Consolidated Statement of Cash Flows for the Nine Months Ended September
    30, 1999 and 1998......................................................   5
   Notes to Unaudited Consolidated Financial Statements....................   6
 Item 2. Management's Discussion and Analysis of Financial Condition and
  Results of Operations....................................................  12
 Item 3. Quantitative and Qualitative Disclosures about Market Risk........  30
Part II. Other Information
 Item 1. Legal Proceedings.................................................  31
 Item 2. Changes in Securities and Use of Proceeds.........................  32
 Item 6. Exhibits and Reports on Form 8-K..................................  32
Signatures.................................................................  33
</TABLE>

  From time to time, information provided by the Company or statements made by
its employees may contain "forward-looking" statements, as that term is
defined in the Private Securities Litigation Reform Act of 1995. For this
purpose, any statements contained herein that are not statements of historical
fact may be deemed to be forward-looking statements. Without limiting the
foregoing, the words "believes", "anticipates", "plans", "expects", and
similar expressions are intended to identify forward-looking statements.

  This Quarterly Report on Form 10-Q may contain forward looking statements
which involve risks and uncertainties. The Company's actual results may differ
materially from the results discussed in such statements. Certain factors that
could cause such a difference include, without limitation, the risks
specifically described in the Company's Annual Report on Form 10-K for the
year ended December 31, 1998, Quarterly Reports on Form 10-Q for the Quarters
ended March 31, 1999 and June 30, 1999 and other public documents, filed by
the Company with the Securities and Exchange Commission (the "Commission"),
which factors are incorporated herein by reference, the factors listed below
in "Factors That May Affect Future Results" and other factors such as the
Company's failure to achieve cash flow breakeven/strategic initiatives,
financing, over the counter listing, revenue risk, litigation risk, limited
operating history, potential fluctuation in quarterly performance, the need to
develop additional products and services, the concentration of clients and
credit risk, the impact of competitive products and services and pricing,
competition for qualified technical, sales and marketing personnel, the
offering of fixed-price, fixed time-frame contracts rather than contracts on a
time and materials basis, the potential for contract liability related to the
provision of year 2000 and other products and services, the potential for
software errors or bugs in the Company's products, limited protection of
proprietary rights, dependence on third party technology, rapid technological
change, product or services demand and market acceptance risks, product
development and services capacity, commercialization and technological
difficulties, capacity and supply constraints or difficulties and the effect
of general business or economic conditions.

                                       2
<PAGE>

                         PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

                        PERITUS SOFTWARE SERVICES, INC.

                           CONSOLIDATED BALANCE SHEET
                   (In Thousands, Except Share-related Data)

<TABLE>
<CAPTION>
                                                      September 30, December 31,
                                                          1999          1998
                                                      ------------- ------------
                                                       (Unaudited)
<S>                                                   <C>           <C>
                       ASSETS
Current Assets:
  Cash and cash equivalents.........................    $  2,470      $  2,809
  Restricted cash...................................         --            569
  Short-term investments............................         --            500
  Accounts receivable, net of allowance for doubtful
   accounts of $187 and $726, respectively, and
   including amounts receivable from related parties
   of $-- and $42, respectively.....................         522         3,720
  Costs and estimated earnings in excess of billings
   on uncompleted contracts.........................         358           951
  Prepaid expenses and other current assets.........         306           816
                                                        --------      --------
    Total Current Assets............................       3,656         9,365
Property and equipment, net.........................         850         3,848
Intangible and other assets, net....................         132           510
                                                        --------      --------
    Total Assets....................................    $  4,638      $ 13,723
                                                        ========      ========
        LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Current portion of capital lease obligations........    $     13      $     90
Current portion of long-term debt...................         --            269
Accounts payable....................................          14           462
Customer advance....................................         296           --
Billings in excess of costs and estimated earnings
 on uncompleted contracts...........................         425           435
Deferred revenue....................................         269         1,890
Other accrued expenses and other current
 liabilities........................................       1,192         4,414
                                                        --------      --------
    Total Current Liabilities.......................       2,209         7,560
Capital lease obligations...........................          28           286
Long-term restructuring.............................         --          1,067
                                                        --------      --------
    Total Liabilities...............................       2,237         8,913
                                                        ========      ========
Stockholders' Equity:
Common stock, $.01 par value; 50,000,000 shares
 authorized; 17,173,975 and 16,344,985 shares issued
 and outstanding at September 30, 1999 and December
 31, 1998, respectively.............................         172           164
Additional paid-in capital..........................     105,279       105,135
Accumulated deficit.................................    (103,046)     (100,488)
Accumulated other comprehensive loss................          (4)           (1)
                                                        --------      --------
    Total Stockholders' Equity......................       2,401         4,810
                                                        --------      --------
    Total Liabilities and Stockholders' Equity......    $  4,638      $ 13,723
                                                        ========      ========
</TABLE>

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

                                       3
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.

                      CONSOLIDATED STATEMENT OF OPERATIONS
                 (In Thousands, Except Per Share-related Data)

<TABLE>
<CAPTION>
                                     Three Months           Nine Months
                                  Ended September 30,   Ended September 30,
                                  --------------------  ---------------------
                                    1999       1998       1999        1998
                                  --------- ----------  ---------  ----------
                                                (Unaudited)
<S>                               <C>       <C>         <C>        <C>
REVENUE:
  Outsourcing services, including
   $-, $106, $- and $872 from
   related parties,
   respectively.................. $  1,354  $    2,270  $   4,846  $    7,685
  License, including $-, $-, $-
   and $255 from related parties,
   respectively..................      149         763      1,937       8,602
  Other services, including $-,
   $-, $- and $204 from related
   parties, respectively.........      457       2,260      2,957       9,522
                                  --------  ----------  ---------  ----------
    Total Revenue................    1,960       5,293      9,740      25,809
                                  --------  ----------  ---------  ----------
COST OF REVENUE:
  Cost of outsourcing services,
   including $-, $86, $- and $750
   from related parties,
   respectively..................      951       1,826      4,125       5,833
  Cost of license................       15         474        162       1,520
  Cost of other services,
   including $-, $-, $- and $56
   from related parties,
   respectively..................      159       2,551      1,842       7,636
                                  --------  ----------  ---------  ----------
    Total Cost of Revenue........    1,125       4,851      6,129      14,989
                                  --------  ----------  ---------  ----------
    Gross Profit.................      835         442      3,611      10,820
                                  --------  ----------  ---------  ----------
OPERATING EXPENSES:
  Sales and marketing............      112       3,980      1,367      10,355
  Research and development.......      264       2,150      1,078       7,195
  General and administrative.....      793       2,969      3,276       6,017
  Impairment of long-lived
   assets........................      207       4,294        961       4,294
  Restructuring charge...........     (450)      3,279       (455)      4,718
                                  --------  ----------  ---------  ----------
    Total Operating Expenses.....      926      16,672      6,227      32,579
                                  --------  ----------  ---------  ----------
Loss from Operations.............      (91)    (16,230)    (2,616)    (21,759)
Interest income, net.............       25          95         63         440
                                  --------  ----------  ---------  ----------
Loss before gain on disposition
 of majority-owned subsidiary,
 income taxes and minority
 interest in majority-owned
 subsidiary......................      (66)    (16,135)    (2,553)    (21,319)
Gain on disposition of majority-
 owned subsidiary................      --          (11)       --          (11)
Provision for income taxes.......        5         --           5          25
                                  --------  ----------  ---------  ----------
Loss before minority interest in
 majority-owned subsidiary.......      (71)    (16,124)    (2,558)    (21,333)
Minority interest in majority-
 owned subsidiary................      --            8        --           (4)
                                  --------  ----------  ---------  ----------
  Net Loss....................... $   ( 71) $  (16,132) $  (2,558) $  (21,329)
                                  ========  ==========  =========  ==========
Net Loss per common share:
  Basic.......................... $  (0.00) $    (0.99) $   (0.16) $    (1.32)
                                  ========  ==========  =========  ==========
  Diluted........................ $  (0.00) $    (0.99) $   (0.16) $    (1.32)
                                  ========  ==========  =========  ==========
Weighted average common shares
 outstanding:
  Basic..........................   16,763      16,294     16,496      16,121
                                  ========  ==========  =========  ==========
  Diluted........................   16,763      16,294     16,496      16,121
                                  ========  ==========  =========  ==========
</TABLE>

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

                                       4
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.

                      CONSOLIDATED STATEMENT OF CASH FLOWS
                                 (In thousands)

<TABLE>
<CAPTION>
                                                           Nine Months Ended
                                                             September 30,
                                                           -------------------
                                                             1999      1998
                                                           --------  ---------
                                                              (Unaudited)
<S>                                                        <C>       <C>
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
Cash flows from operating activities:
Net loss.................................................. $ (2,558) $ (21,329)
Adjustments to reconcile net loss to net cash used for
 operating activities:
 Depreciation and amortization............................    1,215      2,444
 Minority interest in majority-owned subsidiary...........      --          (4)
 Impairment of long-lived assets..........................      961      4,294
 Gain on disposition of majority-owned subsidiary.........      --         (11)
Changes in assets and liabilities:
  Accounts receivable.....................................    3,198      6,837
  Costs and estimated earnings in excess of billings on
   uncompleted contracts..................................      593        855
  Prepaid expenses and other current assets...............      510       (585)
  Other assets............................................      113       (188)
  Accounts payable........................................     (448)      (598)
  Proceeds from customer advance..........................      296        --
  Billings in excess of costs and estimated earnings on
   uncompleted contracts..................................      (10)       290
  Deferred revenue........................................   (1,621)      (693)
  Other accrued expenses and current liabilities excluding
   accrued restructuring..................................   (1,609)      (230)
  Accrued restructuring...................................   (1,835)     3,842
                                                           --------  ---------
    Net cash used for operating activities................   (1,195)    (5,076)
                                                           --------  ---------
Cash flows from investing activities:
  Cash of majority-owned subsidiary disposed, net of cash
   received...............................................      --      (1,074)
  Sale of short-term investments..........................      500        500
  Proceeds from sale of property and equipment............      288        --
  Purchases of property and equipment.....................      (48)    (2,726)
                                                           --------  ---------
    Net cash provided by (used in) investing activities...      740     (3,300)
                                                           --------  ---------
Cash flows from financing activities:
  Restricted cash.........................................      569        --
  Principal payments on long-term debt....................     (269)      (219)
  Principal payments on capital lease obligations.........     (335)       (70)
  Proceeds from issuance of common stock, net of issuance
   costs..................................................      152      1,282
  Proceeds from repayment of note receivable from
   stockholder............................................      --          58
                                                           --------  ---------
    Net cash provided by financing activities.............      117      1,051
                                                           --------  ---------
Effects of exchange rates on cash and cash equivalents....       (1)       (11)
                                                           --------  ---------
Net decrease in cash and cash equivalents.................     (339)    (7,336)
Cash and cash equivalents, beginning of period............    2,809     11,340
                                                           --------  ---------
Cash and cash equivalents, end of period.................. $  2,470  $   4,004
                                                           ========  =========
SUPPLEMENTAL DISCLOSURE OF CASH FLOWS:
 Cash paid for income taxes............................... $     29  $      78
 Cash paid for interest...................................       24         49
</TABLE>

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

                                       5
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.

             NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION AND GOING CONCERN MATTERS

  The accompanying unaudited consolidated financial statements include the
accounts of Peritus Software Services, Inc. and its subsidiaries (the
"Company") and have been prepared by the Company without audit in accordance
with the Company's accounting policies, as described in the Company's Annual
Report on Form 10-K, as amended, for the year ended December 31, 1998, as
filed with the Securities and Exchange Commission ("SEC"). In the opinion of
management, the accompanying unaudited consolidated financial statements
contain all adjustments, which, other than the restructuring and asset
impairment charges, consist only of those of a normal recurring nature,
necessary for a fair presentation of the Company's financial position, results
of operations and cash flows at the dates and for the periods indicated. While
the Company believes that the disclosures presented are adequate to make the
information not misleading, these financial statements should be read in
conjunction with the consolidated financial statements and related notes
included in the Company's 1998 Annual Report on Form 10-K, as amended. The
operating results for the nine months ended September 30, 1999 are not
necessarily indicative of the results to be expected for the full year ending
December 31, 1999.

  The Company's consolidated financial statements have been presented on the
basis that it is a going concern, which contemplates continuity of operations,
realization of assets and the satisfaction of liabilities in the ordinary
course of business. However, the Company experienced net losses of $2,558,000,
$26,673,000 and $67,490,000 in the nine months ended September 30, 1999 and in
the years ended December 31, 1998 and December 31, 1997, respectively, which
raise doubt about its ability to continue as a going concern. The Company's
cash flow requirements will depend on the results of future operations. The
Company's continued existence is dependent upon its ability to achieve a cash
flow breakeven position and/or to obtain additional sources of financing. The
Company has serious concerns that it will be unable to achieve a cash flow
breakeven position in the future and the Company is considering various
alternatives including the possibility of filing for the protection against
creditors or liquidation under applicable bankruptcy laws. The Company
currently maintains its outsourcing service delivery resources and limited
sales and year 2000 resources required to meet current support obligations.
The Company's common stock is traded on the Over The Counter ("OTC") Bulletin
Board which has several requirements for listing. Failure to meet listing
requirements may result in the Company being de-listed. There can be no
assurance that the Company will not be de-listed.

  During 1998, the Company's bank indicated that it would not renew or further
extend its revolving line of credit facility and demanded that cash collateral
be provided for all amounts outstanding under its equipment financing
agreement with the Company since the Company was in default of certain
financial and operating covenants thereunder. At December 31, 1998, $269,000
and $300,000 of cash was pledged as collateral for all amounts outstanding
under the equipment financing agreement and the standby letter of credit,
respectively. Accordingly, these amounts have been classified as restricted
cash on the accompanying Consolidated Balance Sheet. As of September 30, 1999,
there were no amounts outstanding under the revolving credit facility or the
equipment financing agreement. The Company expects to conclude an accounts
receivable purchase agreement with a lender to permit borrowing against
certain acceptable receivables at a rate of 80% of the face amount of such
receivables up to a maximum of $4 million. In exchange for such agreement, the
Company will grant the lender a security interest in substantially all of its
assets. In March 1999, the Company announced that it had retained Covington
Associates to render financial advisory and investment banking services in
connection with exploring strategic alternatives including the potential sale
of the Company. The engagement agreement was entered into in December 1998.
The Company is also exploring strategic initiatives to raise additional funds
or sell all or part of its assets. There can be no assurance that the Company
will achieve a cash flow breakeven position or that it will be able to
successfully borrow against the accounts receivable purchase agreement,
negotiate other borrowing arrangements or raise additional funds through bank
borrowings and/or debt and/or equity financings. Further reductions in
expenses or the sale of assets may not be adequate to bring the Company to a
cash breakeven position. In addition, there can be no assurance that such
actions will not have an adverse

                                       6
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.

       NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

effect on the Company's ability to generate revenue or successfully implement
any strategic alternatives under consideration. The Company's present
expectation is that revenue will continue to decline in the foreseeable
future. Failure to establish a cash flow breakeven position or raise
additional funds through bank borrowings and/or equity and/or debt financings
would adversely impact 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.

2. LEGAL PROCEEDINGS

  The Company and certain of its officers and directors were named as
defendants in purported class action lawsuits filed in the United States
District Court for the District of Massachusetts by Robert Downey on April 1,
1998, by Scott Cohen on April 7, 1998, by Timothy Bonnett on April 9, 1998, by
Peter Lindsay on April 17, 1998, by Harry Teague on April 21, 1998, by Jesse
Wijntjes on April 29, 1998, by H. Vance Johnson and H. Vance Johnson as
Trustee for the I.O.R.D. Profit-Sharing Plan on May 6, 1998, by John B.
Howard, M.D. on May 21, 1998 and by Helen Lee on May 28, 1998 (collectively,
the "complaints"). The complaints principally alleged that the defendants
violated federal securities laws by making false and misleading statements and
by failing to disclose material information concerning the Company's December
1997 acquisition of substantially all of the assets and assumption of certain
liabilities of the Millennium Dynamics, Inc. ("MDI") business from American
Premier Underwriters, Inc., thereby allegedly causing the value of the
Company's common stock to be artificially inflated during the purported class
periods. In addition, the Howard complaint alleged a violation of federal
securities laws as a result of the Company's purported failure to disclose
material information in connection with the Company's initial public offering
on July 2, 1997, and also named Montgomery Securities, Inc., Wessels, Arnold &
Henderson, and H.C. Wainwright & Co., Inc. as defendants. The complaints
further alleged that certain officers and/or directors of the Company sold
stock in the open market during the class periods and sought unspecified
damages.

  On or about June 1, 1998, all of the named plaintiffs and additional
purported class members filed a motion for the appointment of several of those
individuals as lead plaintiffs, for approval of lead and liaison plaintiffs'
counsel and for consolidation of the actions. The Court granted that motion on
June 18, 1998.

  On January 8, 1999, the plaintiffs filed a Consolidated Amended Complaint
applicable to all previously filed actions. The Consolidated Amended Complaint
alleges a class period of October 22, 1997 through October 26, 1998 and
principally claims that the Company and three of its former officers violated
federal securities laws by purportedly making false and misleading statements
(or omitting material information) concerning the MDI acquisition and the
Company's revenue during the proposed class period, thereby allegedly causing
the value of the Company's stock to be artificially inflated. Previously
stated claims against the Company and its underwriters alleging violations of
the federal securities laws as a result of purportedly inadequate or incorrect
disclosure in connection with the Company's initial public offering were not
included in the Consolidated Amended Complaint. The Company and the individual
defendents filed motions to dismiss the Consolidated Amended Complaint on
March 5, 1999. Oral arguments on the motions were held on April 21, 1999 and
the Court granted the Company's and the individual defendants' motions to
dismiss pursuant to an order dated June 1, 1999. The plaintiffs have appealed
the Court's order of dismissal. The Company intends to contest the appeal and
support the Court's order of dismissal. Appellate briefs are due to be filed
with the First Circuit Court of Appeals in November and December 1999.

  While the District Court has dismissed the Consolidated Amended Complaint,
the First Circuit Court of Appeals could reinstate it. While the Company
believes it would have meritorious defenses to the action if it were
reinstated, an adverse resolution of the lawsuit could have a material adverse
effect on the Company's financial condition and results of operations in the
period in which the litigation is resolved. The Company is not able to
reasonably estimate potential losses, if any, related to the Consolidated
Amended Complaint.

                                       7
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.

       NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  On or about April 28, 1999, the Company filed a lawsuit in the United States
District Court for the District of Massachusetts against Micah Technology
Services, Inc. and Affiliated Computer Services, Inc. (collectively, "Micah").
The lawsuit principally alleges that Micah breached its contract with the
Company by failing to pay for services performed by the Company under such
contract. The lawsuit further alleges that since Micah was unjustly enriched
by the services performed by the Company, the Company is entitled to recovery
based on quantum meruit, and that Micah engaged in unfair and/or deceptive
trade practices or acts in violation of Massachusetts General Laws ("M.G.L.")
Chapter 93A by allowing the Company to perform services when Micah did not pay
for such services. The lawsuit seeks unspecified damages on the breach of
contract and quantum meruit claims and double or triple damages on the Chapter
93A claim. Micah has denied the Company's allegations and has filed a
counterclaim against the Company principally alleging fraud, negligent
misrepresentations, breach of contract and that the Company engaged in unfair
and/or deceptive trade practices or acts in violation of M.G.L. Chapter 93A by
its misrepresentations and breach of contract. The Company denied the
allegations contained in Micah's counterclaim and intends to contest the
counterclaim vigorously. The parties are in the initial discovery phase of the
litigation.

  In addition to the matters noted above, the Company is from time to time
subject to legal proceedings and claims which arise in the normal course of
its business. In the opinion of management, the amount of ultimate liability
with respect to these other actions, currently known, will not have a material
adverse effect on the Company's financial position or results of operations
for the nine months ended September 30, 1999.

3. RESTRUCTURING CHARGES

  On March 29, 1999, the Company announced its intention to restructure. The
restructure plan was finalized on March 31, 1999 and the Company recorded a
charge of $291,000, consisting of severance payments associated with the
termination of approximately 30% of the Company's employees representing
substantially all of its sales, marketing and year 2000 delivery personnel (40
employees). Payments related to terminated employees were completed by May 28,
1999. The restructuring resulted in a quarterly reduction of approximately
$1,000,000 in salary and related costs beginning in the third quarter of 1999.

  The amounts accrued to and payments against the accrued restructuring during
the first quarter of 1999 and the composition of the remaining balance at
March 31, 1999 were as follows:

<TABLE>
<CAPTION>
                                   Balance      Q1 1999 Q1 1999     Balance
                              December 31, 1998 Accrual Payments March 31, 1999
                              ----------------- ------- -------- --------------
                                               (in thousands)
<S>                           <C>               <C>     <C>      <C>
Provision for severance and
 benefit payments to
 terminated employees.......       $  536        $291    $(212)      $  615
Provision related to closure
 of facilities and reduction
 of occupied space..........        2,144         --      (361)       1,783
                                   ------        ----    -----       ------
    Total...................       $2,680        $291    $(573)      $2,398
                                   ======        ====    =====       ======
</TABLE>

  In April of 1999, the Company decided to further reduce the amount of space
it occupies in its Billerica, Massachusetts headquarters facility. The space
consolidation was completed in the second quarter of 1999 and the Company
increased the amount of space it was offering for sublease from 50,000 to
75,000 square feet. Accordingly, the Company recorded an additional
restructure accrual of $517,000 consisting of the cost of lease expenses and
real estate commissions associated with the additional vacated 25,000 square
feet net of estimated sublease income. This additional restructuring resulted
in a quarterly reduction in rent expense of $87,000 beginning in the third
quarter of 1999. Payments and reclassifications during the second quarter of
1999 included a settlement payment of $136,000 associated with the early
termination of the Company's lease for its facility in Cincinnati, Ohio and a
$296,000 adjustment to reclassify the rent levelization accrual associated
with the vacated

                                       8
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.

       NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

space in its Billerica headquarters facility from other accrued expenses into
the restructure accrual. At the end of the second quarter of 1999, the Company
re-evaluated the estimated costs associated with its previous restructure
charges based upon activity and experience to date. Based upon its revised
estimates, the Company recorded a release of $813,000 from the restructure
accrual. The combination of the second quarter accrual and the second quarter
release resulted in a net favorable impact of $296,000 to the results of
operations for the three months ended June 30, 1999.

  The amounts accrued to and released from and payments and adjustments made
against the restructure accrual along with the composition of the remaining
balance at June 30, 1999 were as follows:

<TABLE>
<CAPTION>
                             Balance       Q2 1999                      Balance
                            March 31,     Payments/     Q2 1999 Q2 1999 June 30,
                              1999    Reclassifications Accrual Release   1999
                            --------- ----------------- ------- ------- --------
                                               (in thousands)
<S>                         <C>       <C>               <C>     <C>     <C>
Provision for severance
 and benefit payments to
 terminated employees.....   $  615         $(425)       $--     $ (75)  $  115
Provision related to
 closure of facilities and
 reduction of occupied
 space....................    1,783           105         517     (738)   1,667
                             ------         -----        ----    -----   ------
    Total.................   $2,398         $(320)       $517    $(813)  $1,782
                             ======         =====        ====    =====   ======
</TABLE>

  In August of 1999, the Company executed a lease termination agreement for
its Lisle, Illinois facility. Under the agreement, the Company paid $100,000
and relinquished its $16,000 security deposit. These amounts were charged
against the accrued restructuring liability during the third quarter of 1999.

  In September of 1999, the Company entered into a settlement agreement with
BCIA New England Holdings LLC for release from its Billerica real estate
lease. Under the settlement, the Company agreed to pay $200,000 in cash,
relinquish its $300,000 security deposit, issue 500,000 shares of common stock
and provide $71,000 of furniture and equipment. All of these items were
charged against the accrued restructuring liability during the third quarter
of 1999. The Company also charged the liability for an $734,000 write-off of
leasehold improvements and other fixed assets directly tied to its Billerica
and Lisle facilities.

  The third quarter payments and reclassifications also include a $110,000
payment for the settlement of two telephone leases and the elimination of the
associated $270,000 capital lease liability, and a $149,000 adjustment to
reclassify the remaining rent levelization accrual for the Billerica facility
from other accrued expenses into the restructure accrual.

  The Billerica settlement cost the Company less than originally estimated. As
a result, the Company recorded a release of $436,000 associated with the
facilities provision. In total, the Company recorded a net favorable impact of
$450,000 associated with restructuring to the results of operations for the
three months ended September 30, 1999.

  The amounts accrued to and released from and payments and adjustments made
against the restructure accrual along with the composition of the remaining
balance at September 30, 1999 were as follows:

<TABLE>
<CAPTION>
                                             Q3 1999                 Balance
                             Balance        Payments/     Q3 1999 September 30,
                          June 30, 1999 Reclassifications Release     1999
                          ------------- ----------------- ------- -------------
                                             (in thousands)
<S>                       <C>           <C>               <C>     <C>
Provision for severance
 and benefit payments to
 terminated employees....    $  115          $  (101)      $ (14)     $ --
Provision related to
 closure of facilities
 and reduction of
 occupied space..........     1,667           (1,231)       (436)       --
                             ------          -------       -----      -----
    Total................    $1,782          $(1,332)      $(450)     $ --
                             ======          =======       =====      =====
</TABLE>


                                       9
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.

       NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

4. IMPAIRMENT OF LONG-LIVED ASSETS

  The Company periodically assesses whether any events or changes in
circumstances have occurred that would indicate that the carrying amount of a
long-lived asset might not be recoverable. When such an event or change in
circumstance occurs, the Company evaluates whether the carrying amount of such
asset is recoverable by comparing the net book value of the asset to estimated
future undiscounted cash flows, excluding interest charges, attributable to
such asset. If it is determined that the carrying amount is not recoverable,
the Company recognizes an impairment loss equal to the excess of the carrying
amount of the asset over the estimated fair value of such asset.

  In June 1999, as a result of the continuing downsizing of the Company's
operations and continuing decline in operating results, the Company reviewed
the carrying amount of its property and equipment and committed to a plan to
dispose certain of its assets, primarily excess computer equipment and
furniture relating to the restructured operations, either by sale or by
abandonment. The fair value of the assets to be disposed of was measured at
management's best estimate of salvage value, by using the current market
values or the current selling prices for similar assets. Based upon
management's review, the carrying amount of assets having a net book value of
$1,143,000 was written down to a total amount of $389,000, representing the
lower of carrying amount or fair value (salvage value) and the Company
recorded an impairment charge totaling $754,000. The reduction in depreciation
expenses resulting from this write-down is approximately $82,000 on a
quarterly basis beginning in the third quarter of 1999. The Company completed
its sale of assets associated with its June impairment charge in the third
quarter of 1999 and the sale proceeds received were not significantly
different from original estimates.

  During the third quarter of 1999, the Company made a decision to transfer
the research and development responsibility for its SAM Workbench product from
India to the United States. As a result of that decision, the personnel in
India were no longer required and were transferred (with the exception of one)
to another company without cost. The Company's facility lease in India expires
in February of 2000 and the Company expects to complete the sale of all
furniture and equipment before that time. The Company, therefore, recorded an
impairment charge of $145,000 against assets having a net book value of
$182,000 to write down the assets involved to their estimated fair value
(salvage value) of $37,000. The reduction in depreciation expense from this
write-down will be approximately $30,000 on a quarterly basis beginning in the
fourth quarter of 1999.

  During the third quarter of 1999, the Company completed its review of its
product offering going forward. The determination was made that the Company
would not be able to afford to develop future products based upon its patented
technology. In addition, the Company expects that it will receive minimal
future revenue from its existing products that include the patented
technology. Accordingly, management concluded that the remaining patent book
value of $63,000 could no longer be supported and it was written down to zero.
The write-down was included in the third quarter impairment charge. Savings in
amortization expense from this write-down will be $17,000 on a quarterly basis
beginning in the fourth quarter of 1999.

5. OTHER ACCRUED EXPENSES AND CURRENT LIABILITIES

  Other accrued expenses and current liabilities consist of the following:

<TABLE>
<CAPTION>
                                                      September 30, December 31,
                                                          1999          1998
                                                      ------------- ------------
<S>                                                   <C>           <C>
Restructuring costs..................................  $       --    $1,613,000
Employee-related costs...............................     198,000       548,000
Rent levelization....................................          --       357,000
Professional costs...................................     135,000       342,000
Accrued Sales and Use Tax............................     487,000       185,000
Other................................................     372,000     1,369,000
                                                       ----------    ----------
                                                       $1,192,000    $4,414,000
                                                       ==========    ==========
</TABLE>


                                      10
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.

       NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

6. COMPREHENSIVE INCOME (LOSS)

  Comprehensive income is defined as the change in equity of a business
enterprise during a period from transactions and other events and
circumstances from non-owner sources. It includes all changes in equity during
a period except those resulting from investments by owners and distributions
to owners. This standard requires that an enterprise display an amount
representing total comprehensive income for the period. At September 30, 1999,
the balance of accumulated other comprehensive loss was comprised of foreign
currency translation adjustments only.

  For the three and nine months ended September 30, 1999 and 1998, the
Company's comprehensive loss was comprised as follows:

<TABLE>
<CAPTION>
                                                               Nine Months
                                       Three Months Ended         Ended
                                          September 30         September 30
                                       --------------------  -----------------
                                        1999       1998       1999      1998
                                       --------------------  -------  --------
                                                  (in thousands)
<S>                                    <C>      <C>          <C>      <C>
Net loss.............................. $   (71) $   (16,132) $(2,558) $(21,329)
Translation adjustment................       3            2       (3)       13
                                       -------  -----------  -------  --------
                                       $   (68) $   (16,130) $(2,561) $(21,316)
                                       =======  ===========  =======  ========
</TABLE>

7. SEGMENT, GEOGRAPHIC, AND PRODUCT INFORMATION

  The Company operates in one reportable segment under SFAS No. 131,
"Disclosures about Segments of an Enterprise and Related Information," due to
its centralized structure and single industry segment: software maintenance,
tools and services. The Company currently derives its revenue from software
maintenance outsourcing services, software and methodology licensing and other
services (including direct delivery of Year 2000 renovation services and
renovation quality evaluation ("RQE") provided directly to end users or
indirectly via value added integrators).

  Information by geographic area for the three months ended September 30, 1999
and 1998, is summarized below:

<TABLE>
<CAPTION>
                          Outsourcing Services       License Revenue     Other Services Revenue
                         ----------------------- ----------------------- -----------------------
                         Unaffiliated Affiliated Unaffiliated Affiliated Unaffiliated Affiliated
                         ------------ ---------- ------------ ---------- ------------ ----------
                                                     (in thousands)
<S>                      <C>          <C>        <C>          <C>        <C>          <C>
September 30, 1999
United States...........    $1,354        --         $149        --         $  457       --
Foreign.................       --         --          --         --            --        --
                            ------       ----        ----        ---        ------       ---
                            $1,354        --         $149        --         $  457       --
                            ======       ====        ====        ===        ======       ===
September 30, 1998
United States...........    $2,135        --         $763        --         $2,253       --
Foreign.................        34        101         --         --              7       --
                            ------       ----        ----        ---        ------       ---
                            $2,169       $101        $763        --         $2,260       --
                            ======       ====        ====        ===        ======       ===
</TABLE>

                                      11
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.

       NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  Information by geographic area for the nine months ended September 30, 1999
and 1998, is summarized below:

<TABLE>
<CAPTION>
                          Outsourcing Services       License Revenue     Other Services Revenue  Long-
                         ----------------------- ----------------------- ----------------------- Lived
                         Unaffiliated Affiliated Unaffiliated Affiliated Unaffiliated Affiliated Assets
                         ------------ ---------- ------------ ---------- ------------ ---------- ------
                                                     (in thousands)
<S>                      <C>          <C>        <C>          <C>        <C>          <C>        <C>
September 30, 1999
United States...........    $4,846        --        $1,937       --         $2,957       --      $  890
Foreign.................       --         --           --        --            --        --          37
                            ------       ----       ------       ---        ------       ---     ------
                            $4,846        --        $1,937       --         $2,957       --      $  927
                            ======       ====       ======       ===        ======       ===     ======
September 30, 1998
United States...........    $6,562        --        $8,602       --         $9,413       --      $5,413
Foreign.................       251        872          --        --            109       --         267
                            ------       ----       ------       ---        ------       ---     ------
                            $6,813       $872       $8,602       --         $9,522       --      $5,680
                            ======       ====       ======       ===        ======       ===     ======
</TABLE>

  The geographic classification of revenue is determined based on the country
in which the legal entity providing the services is located. Revenue from no
single foreign country was greater than 10% of the consolidated revenues of
the Company in the nine months ended and at September 30, 1999 and 1998.

ITEM 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations

OVERVIEW AND GOING CONCERN MATTERS

  Peritus Software Services, Inc. (the "Company") was founded in 1991 to
address the growing market for managing and maintaining the installed base of
software in organizations. The Company focused its efforts on the delivery of
software maintenance outsourcing services until 1995, when it began to devote
significant resources to the development of software tools addressing the
problems associated with mass changes to application systems and their
associated databases, particularly the year 2000 problem. In 1996, the Company
began licensing its AutoEnhancer/2000 software, which was designed to address
the year 2000 problem, to value added integrators and directly to end users.
In 1996, the Company expanded its research and development efforts through the
acquisition of Vista Technologies Incorporated ("Vista"), a developer of
computer-aided engineering software. In 1997, the Company expanded its product
offerings by releasing an enhanced version of the AutoEnhancer/2000 software
which enables a client to perform logic correction only changes with regard to
year 2000 renovations, and through the acquisition of substantially all of the
assets and the assumption of certain of the liabilities of the business of
Millennium Dynamics, Inc. ("MDI"), a software tools company with year 2000
products for the IBM mainframe and AS/400 platforms, from American Premier
Underwriters, Inc. ("APU").

  In response to changes in the markets for the Company's products and
services, the Company emphasized the direct delivery of year 2000 renovation
services and renovation quality evaluation ("RQE") services in the beginning
of 1998, and also began to refocus business on software maintenance
outsourcing services. As the market continued to shift from the Company's year
2000 products and services during the third quarter of 1998, the Company's
overall strategy was to grow its software maintenance outsourcing business
over the long term and to meet its clients needs for year 2000 renovation
services and RQE services. In July 1998, the Company announced its software
maintenance outsourcing offerings, "Software Asset Maintenance for Software
Providers" and "Software Asset Maintenance for Information Systems", which are
outsourcing solutions designed specifically for the manufacturers of system
software and software products and for information technology departments that
maintain application software, respectively.

                                      12
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.


  In the second half of 1998, the overall market for the year 2000 tools and
services of the Company contracted dramatically, resulting in substantial
financial losses, and, in response, the Company substantially reduced its
workforce in September and December of 1998. As a result of the Company's
degraded financial condition, the Company began encountering major obstacles
in obtaining new outsourcing business. Since most outsourcing engagements are
multi-year and involve critical applications, prospective new clients,
although interested in the capabilities and technology of the Company, were
reluctant or unwilling to commit to contracts. In addition, existing
outsourcing customers were and may continue to be unwilling to renew existing
contracts based on their own business requirements and/or because of the
Company's degraded financial condition. Based upon its continued difficulties,
the Company announced an additional reduction in workforce in March 1999 and
has experienced significant voluntary attrition in its workforce.

  In March 1999, the Company announced that it had retained Covington
Associates to render financial advisory and investment banking services in
connection with exploring strategic alternatives including the potential sale
of the Company. The engagement agreement was entered into in December 1998.
The Company is also exploring strategic initiatives to raise additional funds
or sell all or part of its assets. There can be no assurance that the Company
will achieve a cash flow breakeven position or that it will be able to raise
additional funds through bank borrowings and/or debt and/or equity financings.
Further reductions in expenses or the sale of assets may not be adequate to
bring the Company to a cash flow breakeven position. In addition, there can be
no assurance that such actions will not have an adverse effect on the
Company's ability to generate revenue or successfully implement any strategic
alternatives under consideration. Failure to establish a cash flow breakeven
position or raise additional funds through bank borrowings and/or equity
and/or debt financings would adversely impact the Company's ability to
continue as a going concern.

  In July 1999, the Company announced that it reached a settlement with
American Financial Group, Inc. ("AFG") and its subsidiaries and affiliates for
release from its real estate lease in Cincinnati, Ohio and certain other
obligations. Under the settlement, the Company agreed to pay $200,000 in cash
and 300,000 shares of Common Stock in exchange for release of its real estate
lease for 20,500 square feet that required average monthly payments excluding
operating expenses of $36,000 through November 2002. The Company had not made
any payments since October 1998. The settlement also released the Company from
net claims for other services and disputes of $334,500.

  In August 1999, the Company executed a lease termination agreement for its
Lisle, Illinois facility. Under that agreement, the Company agreed to pay
$100,000 in cash and relinquish its $16,000 security deposit. The real estate
lease for 9,000 square feet required average lease and operating expense
payments of $18,000 per month through February 2003. The Company had not made
any payments since March 1999. Effective September 27, 1999, the Company
relocated its corporate headquarters from Billerica, Massachusetts to its
existing facility located at 112 Turnpike Road, Westborough, Massachusetts.
The Company also reached a settlement agreement with BCIA New England Holdings
LLC for release from its real estate lease at 2 Federal Street, Billerica,
Massachusetts. Under the settlement, the Company agreed to pay $200,000 in
cash, relinquish its $300,000 security deposit, issue 500,000 shares of Common
Stock and transfer miscellaneous furnishings and equipment. In exchange, the
Company was released from its real estate lease for 100,000 square feet which
required average lease and operating expense payments of $145,000 per month
through February 2006. The Company had not made any payments since July 1999.

  The Company experienced net losses of $2,558,000, $26,673,000 and
$67,490,000 in the nine months ended September 30, 1999 and in the years ended
December 31, 1998 and December 31, 1997, respectively, which raise doubt about
its ability to continue as a going concern. The Company's cash flow
requirements will depend on the results of future operations. The Company's
continued existence is dependent upon its ability to achieve a cash flow
breakeven position and/or to obtain additional sources of financing. The
Company has serious concerns that it will be unable to achieve a cash flow
breakeven position in the future and the Company is considering

                                      13
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.

various alternatives including the possibility of filing for the protection
against creditors or liquidation under applicable bankruptcy laws. The Company
currently maintains its outsourcing service delivery resources and limited
sales and year 2000 resources required to meet current support obligations.
The Company's common stock is traded on the Over The Counter ("OTC") Bulletin
Board which has several requirements for listing. Failure to meet listing
requirements may result in the Company being de-listed. There can be no
assurance that the Company will not be de-listed.

  The Company's current focus is on minimizing expenses, while preserving its
principal saleable assets: its outsourcing business and its technology. During
the second and third quarters of 1999, the Company spent considerable effort
to reduce its fixed costs. The Company is continuing to selectively pursue
sales of its software tools. The Company is also focusing on renewing its
existing outsourcing contracts and licensing its methodologies and providing
limited consulting services. The Company continues to support its existing
software customers and continues to offer very limited year 2000 services
based on availability of contracted resources.

  The Company currently derives its revenue from software maintenance
outsourcing services, software and methodology licensing and other services
sold directly to end users. The Company's current sales organization includes
one employee. The Company's present expectation is that revenue will continue
to decline in the foreseeable future.

THREE MONTHS ENDED SEPTEMBER 30, 1999 COMPARED TO THREE MONTHS ENDED SEPTEMBER
30, 1998

 Revenue

  Total revenue decreased 63.0% to $1,960,000 in the three months ended
September 30, 1999 from $5,293,000 in the three months ended September 30,
1998. This decrease in revenue was primarily due to a decrease in other
services and outsourcing revenues and, to a lesser extent, in the licensing of
the Company's software, products and tools.

  Outsourcing Services. Outsourcing services revenue decreased 40.4% to
$1,354,000 in the three months ended September 30, 1999 from $2,270,000 in the
three months ended September 30, 1998. As a percentage of total revenue,
outsourcing services revenue increased to 69.1% in the three months ended
September 30, 1999 from 42.9% for the three months ended September 30, 1998.
The increase in outsourcing services revenue as a percentage of total revenue
reflects the decreased contribution of other services and license revenue to
total revenue during the three months ended September 30, 1999 when compared
to the same period in the prior year. The decrease in outsourcing revenue in
the three months ending September 30, 1999 compared to September 30, 1998 was
primarily attributable to the sale of a foreign subsidiary in July 1998, the
loss of a month-to-month customer during the second quarter of 1999, the
inability to renew a customer whose contract expired at the end of the second
quarter, and reduced levels of service for two other customers. The Company
was also informed by another customer that it was exercising its six-month
termination option which took effect November 5, 1999. Outsourcing services
remain a major component of the Company's business. However, due to the
Company's degraded financial condition, the Company anticipates that it will
continue to have difficulty attracting new outsourcing customers and that it
may be difficult to renew or extend outsourcing contracts from existing
customers. Without the addition of new business, the Company will continue to
experience a significant reduction in revenue from outsourcing services in the
future.

  License. License revenue decreased 80.5% to $149,000 in the three months
ended September 30, 1999 (7.6% of total revenue), compared to $763,000 (14.4%
of total revenue), in the three months ended September 30, 1998. The decrease
in license revenue in absolute dollars was primarily attributable to a
decrease in the delivery of licensed software to end users and decreased
license fees from value-added integrators. The

                                      14
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.

market for the Company's year 2000 tools significantly eroded in 1998 and the
first nine months of 1999, and the Company anticipates limited year 2000
related license revenue in the future. The Company will continue to pursue
licenses of its tools associated with outsourcing services.

  Other Services. Other services revenue decreased 79.8% to $457,000 in the
three months ended September 30, 1999 from $2,260,000 in the three months
ended September 30, 1998. As a percentage of total revenue, other services
revenue decreased to 23.3% in the three months ended September 30, 1999 from
42.7% in the three months ended September 30, 1998. The decrease in other
services revenue in absolute dollars was primarily attributable to a decrease
in direct delivery, consulting and client support services relating to the
Company's year 2000 products and services. Given the reduction in demand for
its year 2000 services and the reduction in internal resources announced at
the end of March 1999, the Company anticipates continued reductions in its
year 2000 related service revenue in the future.

Cost of Revenue

  Cost of Outsourcing Services Revenue. Cost of outsourcing services revenue
consists primarily of salaries, benefits, networking, and overhead costs
associated with delivering outsourcing services to clients. The cost of
outsourcing services decreased 47.9% to $951,000 in the three months ended
September 30, 1999 from $1,826,000 for the three months ended September 30,
1998. Cost of outsourcing services revenue as a percentage of outsourcing
services revenue decreased to 70.2% in the three months ended September 30,
1999 from 80.4% in the three months ended September 30, 1998. The decrease in
the cost of outsourcing services revenue in absolute dollars is primarily
attributable to reductions in staffing and other operating expenses.

  Cost of License Revenue. Cost of license revenue consists primarily of
amortization of intangibles related to the MDI acquisition and salaries,
benefits and related overhead costs associated with license-related materials
packaging and freight. Cost of license revenue was $15,000 in the three months
ended September 30, 1999, or 10.0% of license revenue. Cost of license revenue
was $474,000, or 62.1% of license revenue, in the three months ended September
30, 1998. The 96.8% decrease in cost of license revenue was primarily related
to the reduction of amortization expense of intangibles related to the MDI
acquisition as a result of the impairment charge recorded against the MDI
related intangibles by the Company in the third quarter of 1998.

  Cost of Other Services Revenue. Cost of other services revenue consists
primarily of salaries, benefits, subcontracting costs and related overhead
costs associated with delivering other services to clients. Cost of other
services revenue decreased 93.8% to $159,000 in the three months ended
September 30, 1999 from $2,551,000 in the three months ended September 30,
1998. Cost of other services revenue as a percentage of other services revenue
decreased to 34.8% in the three months ended September 30, 1999 from 112.9% in
the three months ended September 30, 1998. Costs decreased in absolute dollars
in the three months ended September 30, 1999 primarily due to reduced staffing
for the Company's client support, training and consulting organizations
related to fewer customers for the Company's year 2000 products and services,
including year 2000 renovations and RQE services.

Operating Expenses

  Sales and Marketing. Sales and marketing expenses consist primarily of
salaries, commissions and related overhead costs for sales and marketing
personnel, sales referral fees to third parties, advertising programs, and
other promotional activities. Sales and marketing expenses decreased 97.2% to
$112,000 in the three months ended September 30, 1999 from $3,980,000 in the
three months ended September 30, 1998. As a percentage of total revenue, sales
and marketing expenses decreased to 5.7% in the three months ended September
30, 1999 from 75.2% in the three months ended September 30, 1998. The decrease
in expenses in absolute dollars and as a percentage of revenue was primarily
attributable to dramatically reduced staffing, commissions and promotional
activities.

                                      15
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.


  Research and Development. Research and development expenses consist
primarily of salaries, benefits and related overhead costs for engineering and
technical personnel and outside engineering consulting services associated
with developing new products and enhancing existing products. Research and
development expenses decreased 87.7% to $264,000 in the three months ended
September 30, 1999 from $2,150,000 in the three months ended September 30,
1998. As a percentage of total revenue, research and development expenses
decreased to 13.5% in the three months ended September 30, 1999 from 40.6% in
the three months ended September 30, 1998. The decrease in research and
development expenses in absolute dollars was primarily attributable to
dramatically reduced staffing for the product development efforts for the
Company's year 2000 products and services, mass change technologies and other
software tools.

  General and Administrative. General and administrative expenses consist
primarily of salaries and related costs for the finance and accounting, human
resources, legal, information systems, and other administrative departments of
the Company, as well as contracted legal and accounting services. General and
administrative expenses decreased 73.3% to $793,000 in the three months ended
September 30, 1999 from $2,969,000 in the three months ended September 30,
1998. As a percentage of total revenue, general and administrative expenses
decreased to 40.5% in the three months ended September 30, 1999 from 56.1% in
the three months ended September 30, 1998. In the three months ended September
30, 1999, general and administrative expenses did not include any bad-debt
related expenses. For the same period in 1998, general and administrative
expense did include a write-down of a significant customer receivable balance
and an increase in the Company's allowance for doubtful accounts receivable.
The remaining expense reduction is primarily a result of reduced staffing from
the third quarter of 1998. In the three months ended September 30, 1999,
excess space that could not be segregated, was charged to general and
administrative expenses.

Restructuring Charges

  In August of 1999, the Company executed a lease termination agreement for
its Lisle, Illinois facility. Under the agreement, the Company paid $100,000
and relinquished its $16,000 security deposit. These amounts were charged
against the accrued restructuring liability during the third quarter of 1999.

  In September of 1999, the Company entered into a settlement agreement with
BCIA New England Holdings LLC for release from its Billerica real estate
lease. Under the settlement, the Company agreed to pay $200,000 in cash,
relinquish its $300,000 security deposit, issue 500,000 shares of common stock
and provide $71,000 of furniture and equipment. All of these items were
charged against the accrued restructuring liability during the third quarter
of 1999. The Company also charged the liability for an $734,000 write-off of
leasehold improvements and other fixed assets directly tied to its Billerica
and Lisle facilities.

  The third quarter payments and reclassifications also include a $110,000
payment for the settlement of two telephone leases and the elimination of the
associated $270,000 capital lease liability, and a $149,000 adjustment to
reclassify the remaining rent levelization accrual for the Billerica facility
from other accrued expenses into the restructure accrual.

  The Billerica settlement cost the Company less than originally estimated. As
a result, the Company recorded a release of $436,000 associated with the
facilities provision. In total, the Company recorded a net favorable impact of
$450,000 associated with restructuring to the results of operations for the
three months ended September 30, 1999.

                                      16
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.


  The amounts accrued to and released from and payments and adjustments made
against the restructure accrual along with the composition of the remaining
balance at September 30, 1999 were as follows:

<TABLE>
<CAPTION>
                                             Q3 1999                 Balance
                             Balance        Payments/     Q3 1999 September 30,
                          June 30, 1999 Reclassifications Release     1999
                          ------------- ----------------- ------- -------------
                                             (in thousands)
<S>                       <C>           <C>               <C>     <C>
Provision for severance
 and benefit payments to
 terminated employees....    $  115          $  (101)      $ (14)     $ --
Provision related to
 closure of facilities
 and reduction of
 occupied space..........     1,667           (1,231)       (436)       --
                             ------          -------       -----      -----
    Total................    $1,782          $(1,332)      $(450)     $ --
                             ======          =======       =====      =====
</TABLE>

Impairment of Long-Lived Assets

  The Company periodically assesses whether any events or changes in
circumstances have occurred that would indicate that the carrying amount of a
long-lived asset might not be recoverable. When such an event or change in
circumstance occurs, the Company evaluates whether the carrying amount of such
asset is recoverable by comparing the net book value of the asset to estimated
future undiscounted cash flows, excluding interest charges, attributable to
such asset. If it is determined that the carrying amount is not recoverable,
the Company recognizes an impairment loss equal to the excess of the carrying
amount of the asset over the estimated fair value of such asset.

  During the third quarter of 1999, the Company made a decision to transfer
the research and development responsibility for its SAM Workbench product from
India to the United States. As a result of that decision, the personnel in
India were no longer required and were transferred (with the exception of one)
to another company without cost. The Company's facility lease in India expires
in February of 2000 and the Company expects to complete the sale of all
furniture and equipment before that time. The Company, therefore, recorded an
impairment charge of $145,000 against assets having a net book value of
$182,000 to write down the assets involved to their estimated fair value
(salvage value) of $37,000. The reduction in depreciation expense from this
write-down will be approximately $30,000 on a quarterly basis beginning in the
fourth quarter of 1999.

  During the third quarter, the Company completed its review of its product
offering going forward. The determination was made that the Company would not
be able to afford to develop future products based upon its patented
technology. In addition, the Company expects that it will receive minimal
future revenue from its existing products that include the patented
technology. Accordingly, management concluded that the remaining patent book
value of $63,000 could no longer be supported and it was written down to zero.
The write-down was included in the third quarter impairment charge. Savings in
amortization expense from this write-down will be $17,000 on a quarterly basis
beginning in the fourth quarter of 1999.

Interest Income, Net

  Interest income and expense is primarily comprised of interest income from
cash balances, partially offset by interest expense on debt. The Company had
interest income, net, of $25,000 in the three months ended September 30, 1999
compared to interest income, net, of $95,000 in the three months ended
September 30, 1998. This change in interest income, net, was primarily
attributable to reduced interest income from declining cash balances resulting
from the Company's continued losses from operations.

                                      17
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.


Provision for Income Taxes

  The Company's income tax provision was $5,000 (for several small city and
state tax obligations) for the three months ended September 30, 1999 and $0
for the three months ended September 30, 1998. The Company did not record a
tax provision or benefit in the three months ended September 30, 1998 due to
operating losses incurred. The Company continues to maintain a full valuation
allowance for its net deferred tax assets since, based on the weight of
available evidence, management has concluded that it is more likely than not
that these future benefits will not be realized.

Minority Interest in Majority-owned Subsidiary

  The minority interest in majority-owned subsidiary represents the equity
interest in the operating results of Persist, the Company's majority-owned
Spanish subsidiary, held by stockholders of Persist other than the Company.
The Company had no minority interest in majority-owned subsidiary in the three
months ended September 30, 1999 since it divested its majority interest in
July 1998.

NINE MONTHS ENDED SEPTEMBER 30, 1999 COMPARED TO NINE MONTHS ENDED SEPTEMBER
30, 1998

Revenue

  Total revenue decreased 62.3% to $9,740,000 in the nine months ended
September 30, 1999 from $25,809,000 in the nine months ended September 30,
1998. This decrease in revenue was primarily due to a decrease in other
services revenue as well as the licensing of the Company's software, products
and tools and, to a lesser extent, outsourcing services revenue.

  Outsourcing Services. Outsourcing services revenue decreased 36.9% to
$4,846,000 in the nine months ended September 30, 1999 from $7,685,000 in the
nine months ended September 30, 1998. As a percentage of total revenue,
outsourcing services revenue increased to 49.8% in the nine months ended
September 30, 1999 from 29.8% for the nine months ended September 30, 1998.
The increase in outsourcing services revenue as a percentage of total revenue
reflects the decreased contribution of other services and license revenue to
total revenue during the nine months ended September 30, 1999 when compared to
the same period in the prior year. The decrease in outsourcing revenue in the
nine months ended September 30, 1999 compared to September 30, 1998 was
primarily attributable to the sale of a foreign subsidiary in July 1998, the
termination of an Engineering Consulting Services Agreement during the second
quarter of 1998, and reduced levels of service for several other customers.
The Company was also informed by another customer that it was exercising its
six-month termination option which took effect November 5, 1999. Outsourcing
services remain a major component of the Company's business. However, due to
the Company's degraded financial condition, the Company anticipates that it
will continue to have difficulty attracting new outsourcing customers and that
it may be difficult to renew or extend outsourcing contracts from existing
customers. Without the addition of new business, the Company will continue to
experience a significant reduction in revenue from outsourcing services in the
future.

  License. License revenue decreased 77.5% to $1,937,000 in the nine months
ended September 30, 1999 from $8,602,000 in the nine months ended September
30, 1998. As a percentage of total revenue, license revenue decreased to 19.9%
in the nine months ended September 30, 1999 from 33.3% in the nine months
ended September 30, 1998. The decrease in license revenue for 1999 in absolute
dollars was primarily attributable to a decrease in the delivery of licensed
software to end users and decreased license fees from value-added integrators.
The market for the Company's year 2000 tools significantly eroded in 1998 and
the first nine months of 1999, and the Company anticipates limited year 2000
related license revenue in the future. The Company will continue to pursue
licenses of its tools associated with outsourcing services.

                                      18
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.


  Other Services. Other services revenue decreased 68.9% to $2,957,000 in the
nine months ended September 30, 1999 from $9,522,000 in the nine months ended
September 30, 1998. As a percentage of total revenue, other services revenue
decreased to 30.4% in the nine months ended September 30, 1999 from 36.9% in
the nine months ended September 30, 1998. The decrease in other services
revenue in absolute dollars was primarily attributable to a decrease in direct
delivery, consulting and client support services relating to the Company's
year 2000 products and services. Given the reduction in demand for its year
2000 services and the reduction in internal resources announced at the end of
March 1999, the Company anticipates continued reductions in its year 2000
related service revenue in the future.

Cost of Revenue

  Cost of Outsourcing Services Revenue. Cost of outsourcing services revenue
consists primarily of salaries, benefits, networking, and overhead costs
associated with delivering outsourcing services to clients. The cost of
outsourcing services revenue decreased 29.3% to $4,125,000 in the nine months
ended September 30, 1999 from $5,833,000 for the nine months ended September
30, 1998. Cost of outsourcing services revenue as a percentage of outsourcing
services revenue increased to 85.1% in the nine months ended September 30,
1999 from 75.9% in the nine months ended September 30, 1998. Costs in the
first three months of 1999 were negatively impacted by expenditures in
anticipation of and to generate new business that did not materialize. In
addition, the Company incurred costs in connection with an agreement with
Micah Technology Services, Inc. ("Micah") for which it received no payments.
The Company has filed a lawsuit against Micah to attempt to recover amounts
due under such agreement See "Part II-Item 1. Legal Proceedings."

  Cost of License Revenue. Cost of license revenue consists primarily of
amortization of intangibles related to the MDI acquisition and salaries,
benefits and related overhead costs associated with license-related materials
packaging and freight. Cost of license revenue was $162,000 in the nine months
ended September 30, 1999, or 8.4% of license revenue. Cost of license revenue
was $1,520,000, or 17.7% of license revenue, in the nine months ended
September 30, 1998. The 89.3% decrease in cost of license revenue was
primarily related to the reduction of amortization expense of intangibles
related to the MDI acquisition as a result of the impairment charge recorded
against the MDI related intangibles by the Company in the third quarter of
1998.

  Cost of Other Services Revenue. Cost of other services revenue consists
primarily of salaries, benefits, subcontracting costs and related overhead
costs associated with delivering other services to clients. Cost of other
services revenue decreased 75.9% to $1,842,000 in the nine months ended
September 30, 1999 from $7,636,000 in the nine months ended September 30,
1998. Cost of other services revenue as a percentage of other services revenue
decreased to 62.3% in the nine months ended September 30, 1999 from 80.2% in
the nine months ended September 30, 1998. Costs decreased in absolute dollars
in the nine months ended September 30, 1999 due to reduced staffing for the
Company's client support, training and consulting organizations related to
fewer customers for the Company's year 2000 products and services, including
year 2000 renovations and RQE services.

Operating Expenses

  Sales and Marketing. Sales and marketing expenses consist primarily of
salaries, commissions and related overhead costs for sales and marketing
personnel, sales referral fees to third parties, advertising programs, and
other promotional activities. Sales and marketing expenses decreased 86.8% to
$1,367,000 in the nine months ended September 30, 1999 from $10,355,000 in the
nine months ended September 30, 1998. As a percentage of total revenue, sales
and marketing expenses decreased to 14.0% in the nine months ended September
30, 1999 from 40.1% in the nine months ended September 30 1998. The decrease
in expenses in absolute dollars and as a percentage of revenue was primarily
attributable to dramatically reduced staffing, commissions and promotional
activities.

                                      19
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.


  Research and Development. Research and development expenses consist
primarily of salaries, benefits and related overhead costs for engineering and
technical personnel and outside engineering consulting services associated
with developing new products and enhancing existing products. Research and
development expenses decreased 85.0% to $1,078,000 in the nine months ended
September 30, 1999 from $7,195,000 in the nine months ended September 30,
1998. As a percentage of total revenue, research and development expenses
decreased to 11.1% in the nine months ended September 30, 1999 from 27.9% in
the nine months ended September 30, 1998. The decrease in research and
development expenses in absolute dollars was primarily attributable to
dramatically reduced staffing for the product development efforts for the
Company's year 2000 products and services, mass change technologies and other
software tools.

  General and Administrative. General and administrative expenses consist
primarily of salaries and related costs for the finance and accounting, human
resources, legal, information systems, and other administrative departments of
the Company, as well as contracted legal and accounting services. General and
administrative expenses decreased 45.6% to $3,276,000 in the nine months ended
September 30, 1999 from $6,017,000 in the nine months ended September 30,
1998. As a percentage of total revenue, general and administrative expenses
increased to 33.6% in the nine months ended September 30, 1999 from 23.3% in
the nine months ended September 30, 1998. In the nine months ended September
30, 1999, the decrease in general and administrative expenses in absolute
dollars was primarily due to reduced staffing and the fact that the Company
did not incur any bad-debt related expenses. For the same period in 1998,
general and administrative expense did include a write-down of a significant
customer receivable balance and an increase in the Company's allowance for
doubtful accounts receivable. In the nine months ended September 30, 1999,
excess space that could not be segregated, was charged to general and
administrative expenses.

Restructuring Charges

  On March 29, 1999, the Company announced its intention to restructure. The
restructure plan was finalized on March 31, 1999 and the Company recorded a
charge of $291,000, consisting of severance payments associated with the
termination of approximately 30% of the Company's employees representing
substantially all of its sales, marketing and year 2000 delivery personnel (40
employees). Payments related to terminated employees were completed by May 28,
1999. The restructuring resulted in a quarterly reduction of approximately
$1,000,000 in salary and related costs beginning in the third quarter of 1999.

  The amounts accrued to and payments against the accrued restructuring during
the first quarter of 1999 and the composition of the remaining balance at
March 31, 1999 were as follows:

<TABLE>
<CAPTION>
                                    Balance      Q1 1999 Q1 1999     Balance
                               December 31, 1998 Accrual Payments March 31, 1999
                               ----------------- ------- -------- --------------
                                                (in thousands)
<S>                            <C>               <C>     <C>      <C>
Provision for severance and
 benefit payments to
 terminated employees........       $  536        $291    $(212)      $  615
Provisions related to closure
 of facilities and reduction
 of occupied space...........        2,144         --      (361)       1,783
                                    ------        ----    -----       ------
    Total....................       $2,680        $291    $(573)      $2,398
                                    ======        ====    =====       ======
</TABLE>

  In April of 1999, the Company decided to further reduce the amount of space
it occupies in its Billerica, Massachusetts headquarters facility. The space
consolidation was completed in the second quarter of 1999 and the Company
increased the amount of space it was offering for sublease from 50,000 to
75,000 square feet. Accordingly, the Company recorded an additional
restructure accrual of $517,000 consisting of the cost of lease expenses and
real estate commissions associated with the additional vacated 25,000 square
feet net of estimated sublease income. This additional restructuring resulted
in a quarterly reduction in rent expense of $87,000

                                      20
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.

beginning in the third quarter of 1999. Payments and reclassifications during
the second quarter of 1999 included a settlement payment of $136,000
associated with the early termination of the Company's lease for its facility
in Cincinnati, Ohio and a $296,000 adjustment to reclassify the rent
levelization accrual associated with the vacated space in its Billerica
headquarters facility from other accrued expenses into the restructure
accrual. At the end of the second quarter of 1999, the Company re-evaluated
the estimated costs associated with its previous restructure charges based
upon activity and experience to date. Based upon its revised estimates, the
Company recorded a release of $813,000 from the restructure accrual. The
combination of the second quarter accrual and the second quarter release
resulted in a net favorable impact of $296,000 to the results of operations
for the three months ended June 30, 1999.

  The amounts accrued to and released from and payments and adjustments made
against the restructure accrual along with the composition of the remaining
balance at June 30, 1999 were as follows:

<TABLE>
<CAPTION>
                             Balance       Q2 1999                      Balance
                            March 31,     Payments/     Q2 1999 Q2 1999 June 30,
                              1999    Reclassifications Accrual Release   1999
                            --------- ----------------- ------- ------- --------
                                               (in thousands)
<S>                         <C>       <C>               <C>     <C>     <C>
Provision for severance
 and benefit payments to
 terminated employees.....   $  615         $(425)       $--     $ (75)  $  115
Provision related to
 closure of facilities and
 reduction of occupied
 space....................    1,783           105         517     (738)   1,667
                             ------         -----        ----    -----   ------
    Total.................   $2,398         $(320)       $517    $(813)  $1,782
                             ======         =====        ====    =====   ======
</TABLE>

  In August of 1999, the Company executed a lease termination agreement for
its Lisle, Illinois facility. Under the agreement, the Company paid $100,000
and relinquished its $16,000 security deposit. These amounts were charged
against the accrued restructuring liability during the third quarter of 1999.

  In September of 1999, the Company entered into a settlement agreement with
BCIA New England Holdings LLC for release from its Billerica real estate
lease. Under the settlement, the Company agreed to pay $200,000 in cash,
relinquish its $300,000 security deposit, issue 500,000 shares of common stock
and provide $71,000 of furniture and equipment. All of these items were
charged against the accrued restructuring liability during the third quarter
of 1999. The Company also charged the liability for an $734,000 write-off of
leasehold improvements and other fixed assets directly tied to its Billerica
and Lisle facilities.

  The third quarter payments and reclassifications also include a $110,000
payment for the settlement of two telephone leases and the elimination of the
associated $270,000 capital lease liability, and a $149,000 adjustment to
reclassify the remaining rent levelization accrual for the Billerica facility
from other accrued expenses into the restructure accrual.

  The Billerica settlement cost the Company less than originally estimated. As
a result, the Company recorded a release of $436,000 associated with the
facilities provision. In total, the Company recorded a net favorable impact of
$450,000 associated with restructuring to the results of operations for the
three months ended September 30, 1999.

                                      21
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.


  The amounts accrued to and released from and payments and adjustments made
against the restructure accrual along with the composition of the remaining
balance at September 30, 1999 were as follows:

<TABLE>
<CAPTION>
                             Balance             Q3 1999              Q3 1999          Balance
                          June 30, 1999 Payments/Reclassifications    Release     September 30, 1999
                          ------------- -------------------------- -------------- ------------------
                                                                   (in thousands)
<S>                       <C>           <C>                        <C>            <C>
Provision for severance
 and benefit payments to
 terminated employees...     $  115              $  (101)              $ (14)           $ --
Provision related to
 closure of facilities
 and reduction of
 occupied space.........      1,667               (1,231)               (436)             --
                             ------              -------               -----            -----
    Total...............     $1,782              $(1,332)              $(450)           $ --
                             ======              =======               =====            =====
</TABLE>

Impairment of Long-Lived Assets

  The Company periodically assesses whether any events or changes in
circumstances have occurred that would indicate that the carrying amount of a
long-lived asset might not be recoverable. When such an event or change in
circumstance occurs, the Company evaluates whether the carrying amount of such
asset is recoverable by comparing the net book value of the asset to estimated
future undiscounted cash flows, excluding interest charges, attributable to
such asset. If it is determined that the carrying amount is not recoverable,
the Company recognizes an impairment loss equal to the excess of the carrying
amount of the asset over the estimated fair value of such asset.

  In June 1999, as a result of the continuing downsizing of the Company's
operations and continuing decline in operating results, the Company reviewed
the carrying amount of its property and equipment and committed to a plan to
dispose certain of its assets, primarily excess computer equipment and
furniture relating to the restructured operations, either by sale or by
abandonment. The fair value of the assets to be disposed of was measured at
management's best estimate of salvage value, by using the current market
values or the current selling prices for similar assets. Based upon
management's review, the carrying amount of assets having a net book value of
$1,143,000 was written down to a total amount of $389,000, representing the
lower of carrying amount or fair value (salvage value) and the Company
recorded an impairment charge totaling $754,000. The reduction in depreciation
expenses resulting from this write-down is approximately $82,000 on a
quarterly basis beginning in the third quarter of 1999. The Company completed
its sale of assets associated with its June impairment charge in the third
quarter of 1999 and the sale proceeds received were not significantly
different from original estimates.

  During the third quarter of 1999, the Company made a decision to transfer
the research and development responsibility for its SAM Workbench product from
India to the United States. As a result of that decision, the personnel in
India were no longer required and were transferred (with the exception of one)
to another company without cost. The Company's facility lease in India expires
in February of 2000 and the Company expects to complete the sale of all
furniture and equipment before that time. The Company, therefore, recorded an
impairment charge of $145,000 against assets having a net book value of
$182,000 to write down the assets involved to their estimated fair value
(salvage value) of $37,000. The reduction in depreciation expense from this
write-down will be approximately $30,000 on a quarterly basis beginning in the
fourth quarter of 1999.

  During the third quarter of 1999, the Company completed its review of its
product offering going forward. The determination was made that the Company
would not be able to afford to develop future products based upon its patented
technology. In addition, the Company expects that it will receive minimal
future revenue from its existing products that include the patented
technology. Accordingly, management concluded that the remaining patent book
value of $63,000 could no longer be supported and it was written down to zero.
The write-down was included in the third quarter impairment charge. Savings in
amortization expense from this write-down will be $17,000 on a quarterly basis
beginning in the fourth quarter of 1999.

                                      22
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.


Interest Income, Net

  Interest income and expense is primarily comprised of interest income from
cash balances, partially offset by interest expense on debt. The Company had
interest income, net, of $63,000 in the nine months ended September 30, 1999
compared to interest income, net, of $440,000 in the nine months ended
September 30, 1998. This change in interest income, net, was primarily
attributable to reduced interest income from declining cash balances resulting
from the Company's continued losses from operations.

 Provision for Income Taxes

  The Company's income tax provision was $5,000 for the nine months ended
September 30, 1999 compared to $25,000 in the nine months ended September 30,
1998. The Company continues to maintain a full valuation allowance for its net
deferred tax assets since, based on the weight of available evidence,
management has concluded that it is more likely than not that these future
benefits will not be realized.

Minority Interest in Majority-owned Subsidiary

  The minority interest in majority-owned subsidiary represents the equity
interest in the operating results of Persist, the Company's majority-owned
Spanish subsidiary, held by stockholders of Persist other than the Company.
The Company had no minority interest in majority-owned subsidiary in the nine
months ended September 30, 1999 since it divested its majority interest in
July 1998.

LIQUIDITY AND CAPITAL RESOURCES

  The Company's consolidated financial statements have been presented on the
basis that it is a going concern, which contemplates continuity of operations,
realization of assets and the satisfaction of liabilities in the ordinary
course of business. However, the Company experienced net losses in the years
ended December 31, 1997 and 1998 and the nine months ended September 30, 1999,
which raise doubt about its ability to continue as a going concern. The
Company's cash flow requirements depend on the results of future operations.
The Company's continued existence is dependent upon its ability to achieve a
cash flow breakeven position and/or to obtain additional sources of financing.
The Company has serious concerns that it will be unable to achieve a cash flow
breakeven position in the future and is considering various alternatives
including the possibility of filing for the protection against creditors or
liquidation under applicable bankruptcy laws. The Company has also experienced
significant voluntary attrition due to its degraded financial condition.

  In March 1999, the Company announced that it had retained Covington
Associates to render financial advisory and investment banking services in
connection with exploring strategic alternatives including the potential sale
of the Company. The engagement agreement was entered into in December 1998.
The Company is also exploring strategic initiatives to raise additional funds
or sell all or a part of its assets. There can be no assurance that the
Company will achieve a cash flow breakeven position or that it will be able to
raise additional funds through bank borrowings and/or debt and/or equity
financings. Further reductions in expenses or the sale of assets may not be
adequate to bring the Company to a cash breakeven position. In addition, there
can be no assurance that such actions will not have an adverse affect on the
Company's ability to generate revenue or successfully implement any strategic
alternatives under consideration. The Company's present expectation is that
revenue will continue to decline in the foreseeable future. Failure to
establish a cash flow breakeven position or raise additional funds through
bank borrowings and/or equity and/or debt financing would adversely impact the
Company's ability to continue as a going concern.

  The Company has financed its operations and capital expenditures primarily
with the proceeds from sales of the Company's convertible preferred stock and
common stock, borrowings, and advance payments for services from clients. The
Company's cash balances were $2,470,000 and $2,809,000 at September 30, 1999
and

                                      23
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.

December 31, 1998, respectively. The Company's working capital was $1,447,000
and $1,805,000 at September 30, 1999 and December 31, 1998, respectively.

  The Company's operating activities used cash of $1,195,000 and $5,076,000
during the nine months ended September 30, 1999 and 1998, respectively. The
Company's use of cash during the nine months ended September 30, 1999 was
primarily caused by a net loss of $2,558,000 less non-cash depreciation and
amortization expense of $1,215,000, and a charge for impairment of long-lived
assets of $961,000. Other uses included a decrease in accrued restructuring of
$1,835,000, a decrease in deferred revenue of $1,621,000, a decrease in other
accrued liabilities of $1,609,000, and a decrease in accounts payable of
$448,000. These amounts were partially offset by a decrease in accounts
receivable of $3,198,000, a decrease in costs and estimated earnings in excess
of billings on uncompleted contracts of $593,000 and a decrease in prepaid
expenses and other current assets of $510,000, the receipt of advance payments
from customers of $296,000, and a decrease in other assets of $113,000.

  The Company's investing activities provided cash of $740,000 during the nine
months ended September 30, 1999 and used cash of $3,300,000 during the nine
months ended September 30, 1998. Investing activities in the nine months ended
September 30, 1999 consisted principally of the sale of short-term investments
of $500,000 and the sale of property and equipment of $288,000.

  The Company's financing activities provided cash of $117,000 and $1,051,000
during the nine months ended September 30, 1999 and 1998, respectively.
Financing activities in the nine months ended September 30, 1999 primarily
reflect a decrease in the amount of restricted cash of $569,000, and proceeds
from issuance of common stock net of issuance cost of $152,000. These amounts
were partially offset by principal payments on capital lease obligations of
$335,000 and principal payments on long-term debt of $269,000.

  In September 1996, the Company obtained a revolving line of credit facility
from a bank which bore interest at the bank's prime rate plus 0.5%. The line
of credit expired and all borrowing was paid in full on September 30, 1998. In
addition to this line of credit, the Company also entered into an equipment
financing agreement in September 1996. Under this agreement, the bank agreed
to provide up to $1,500,000 for the purchase of certain equipment (as defined
by the agreement) through June 30, 1997. Ratable principal and interest
payments were payable during the period July 1, 1997 through June 1, 2000, and
bore interest at the bank's prime rate plus 1%. Both of these agreements
required the Company to comply with certain financial covenants and were
secured by all of the assets of the Company. The bank notified the Company in
October 1998 that the Company was in default under its line of credit facility
and equipment financing agreement and requested that the Company provide cash
collateral for the amount of equipment financing outstanding and provide cash
collateral for a $300,000 standby letter of credit issued by the bank. The
Company provided cash collateral for all amounts outstanding under the
equipment financing agreement in December 1998 and for the $300,000 letter of
credit in October 1998. The letter of credit was drawn upon and the equipment
financing debt was paid in the first quarter of 1999. There were no borrowings
outstanding under the revolving credit facility and under the equipment
financing agreement at September 30, 1999. In 1998, the bank indicated that it
would not renew or further extend the Company's revolving credit facility. The
Company expects to conclude an accounts receivable purchase agreement with a
lender to permit borrowing against certain acceptable receivables at a rate of
80% of the face amount of such receivables up to a maximum of $4 million. In
exchange for such agreement, the Company will grant the lender a security
interest in substantially all of its assets. There can be no assurance that
the Company will be able to successfully borrow against such agreement,
negotiate other borrowing arrangements or raise additional funds through bank
borrowings and/or debt and/or equity financings.

  In July 1999, the Company announced that it reached a settlement with
American Financial Group, Inc. ("AFG") and its subsidiaries and affiliates for
release from its real estate lease in Cincinnati, Ohio and certain

                                      24
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.

other obligations. Under the settlement, the Company agreed to pay $200,000 in
cash and 300,000 shares of Common Stock in exchange for release of its real
estate lease for 20,500 square feet that required average monthly payments
excluding operating expenses of $36,000 through November 2002. The Company had
not made any payments since October 1998. The settlement also released the
Company from net claims for other services and disputes of $334,500.

  In August 1999, the Company executed a lease termination agreement for its
Lisle, Illinois facility. Under that agreement, the Company agreed to pay
$100,000 in cash and relinquish its $16,000 security deposit. The real estate
lease for 9,000 square feet required average lease and operating expense
payments of $18,000 per month through February 2003. The Company had not made
any payments since March 1999.

  In September 1999, the Company relocated its corporate headquarters from
Billerica, Massachusetts to its existing facility located at 112 Turnpike
Road, Westborough, Massachusetts 01581. The Company also reached a settlement
agreement with BCIA New England Holdings LLC for release from its real estate
lease at 2 Federal Street, Billerica, Massachusetts. Under the settlement, the
Company agreed to pay $200,000 in cash, relinquish its $300,000 security
deposit, issue 500,000 shares of Common Stock, and provide $71,000 of
furniture and equipment. In exchange, the Company was released from its real
estate lease for 100,000 square feet which required average lease and
operating expense payments of $145,000 per month through February 2006. The
Company had not made any payments since July 1999.

  To date, the Company has not invested in derivative securities or any other
financial instruments that involve a high level of complexity or risk. Excess
cash has been, and the Company contemplates that it will continue to be,
invested in interest-bearing, short-term investment grade securities.

FOREIGN CURRENCY

  Assets and liabilities of the Company's subsidiaries are translated into
U.S. dollars at exchange rates in effect at the balance sheet date. Income and
expense items are translated at average exchange rates for the period.
Accumulated net translation adjustments are included in stockholders' equity.

INFLATION

  To date, inflation has not had a material impact on the Company's results of
operations.

FACTORS THAT MAY AFFECT FUTURE RESULTS

 Failure to Achieve Cash Flow Breakeven/Strategic Initiatives

  The Company's ability to achieve a cash flow breakeven position is critical
for achieving financial stability. The Company has serious concerns that it
will be unable to achieve a cash flow breakeven and is considering various
alternatives including the possibility of filing for the protection against
creditors or liquidation under applicable bankruptcy laws. In March 1999, the
Company announced that it had retained Covington Associates to render
financial advisory and investment banking services in connection with
exploring strategic alternatives including the potential sale of the Company.
The engagement agreement was entered into in December 1998. The Company is
also exploring strategic initiatives to raise additional funds or sell all or
a part of its assets. Further reductions in expenses or the sale of assets may
not be sufficient to bring the Company to a cash flow breakeven position. In
addition, there can be no assurance that any actions taken to sell assets or
reduce expenses will not have a material adverse impact on the Company's
ability to generate revenue or successfully implement any strategic
alternatives under consideration. The Company's present expectation is that
revenue will continue to decline in the foreseeable future. Failure to
establish a cash flow breakeven position or raise additional funds

                                      25
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.

through bank borrowings and/or equity and/or debt financings, has and will
continue to adversely impact the Company's ability to continue as a going
concern.

 Financing

  In 1998, the Company's bank indicated that it would not renew or further
extend the Company's revolving credit facility. Although the Company expects
to conclude an accounts receivable purchase agreement with a lender as
described above, there can be no assurance that the Company will be able to
successfully borrow against such agreement, negotiate other borrowing
arrangements or obtain additional funds through equity and/or debt financings.
Failure to establish a cash flow breakeven position or raise additional funds
through bank borrowings and/or equity and/or debt financings will continue to
adversely impact the Company's ability to continue as a going concern.

 Over the Counter Listing

  The Company's common stock trades on the OTC Bulletin Board which has
certain continued listing criteria. Failure to meet those listing requirements
may result in the Company being de-listed. There can be no assurance that the
Company will not be de-listed. Trading of the common stock is conducted in the
over-the- counter market which could make it more difficult for an investor to
dispose of, or obtain accurate quotations as to the market value of, the
common stock. In addition, there are additional sales practice requirements on
broker-dealers who sell such securities to persons other than established
customers and accredited investors. For transactions covered by this rule, the
broker-dealer must make a special suitability determination for the purchaser
and must have received the purchaser's written consent to the transaction
prior to sale. Consequently, delisting, if it occurred, may affect the ability
of broker-dealers to sell the Company's common stock and the ability of the
stockholders to sell their common stock. In addition, if the trading price of
the common stock is below $5.00 per share, trading in the common stock would
also be subject to the requirements of certain rules promulgated under the
Securities Exchange Act of 1934, which require additional disclosure by
broker-dealers in connection with any trades involving a stock defined as a
penny stock (generally any non-Nasdaq equity security that has a market price
of less than $5.00 per share, subject to certain exceptions). Such rules
require the delivery, prior to any penny stock transaction, of a disclosure
schedule explaining the penny stock market and the risks associate therewith,
and impose various sales practice requirements on broker-dealers who sell
penny stocks to persons other than established customers and accredited
investors (generally institutions). For these types of transactions, the
broker-dealer must make a special suitability determination for the purchaser
and have received the purchaser's written consent to the transaction prior to
sale. The additional burdens imposed upon broker-dealers by such requirements
may discourage broker-dealers from effecting transactions in the common stock,
which could severely limit the market liquidity of the common stock and the
ability of purchasers in this offering to sell the common stock in the
secondary market.

 Client Concentration and Revenue Risk

  The Company's revenue is highly concentrated among a small number of
clients. During the quarter ended September 30, 1999, the revenue from three
clients accounted for 54% of the quarter's revenue with one client
representing 31%. The contract for one of these three clients (representing
12% of the revenue for the quarter ended September 30, 1999) terminated in
November.

  The Company is continuing to selectively pursue sales of its software. The
Company is also focusing on renewing its existing outsourcing contracts and
licensing its methodology and providing limited consulting services. However,
due to its degraded financial condition, the Company anticipates that it will
continue to have difficulty attracting new outsourcing customers. In addition,
existing outsourcing customers have been and may continue to be unwilling to
renew existing outsourcing contracts based on their own business requirements
and/or

                                      26
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.

because of the Company's degraded financial condition. The Company's present
expectation is that revenue will continue to decline in the foreseeable
future. There can be no assurance that the Company's current strategy will
generate revenues sufficient for the Company to achieve a cash flow breakeven
position.

 Litigation Risk

  The future course of the class action claims against the Company described
in footnote 2 to the Consolidated Financial Statements could have a material
adverse impact on the Company's financial condition and results of operations
in the period in which the litigation is resolved.

 Potential Fluctuations in Quarterly Performance

  The Company's quarterly revenue, expenses and operating results have varied
significantly in the past and are likely to vary significantly from quarter to
quarter in the future. A significant portion of the Company's revenue in any
quarter is typically derived from a limited number of large client
transactions. In addition, the sales cycle associated with these transactions
is lengthy and is subject to a number of uncertainties, including clients'
budgetary constraints, the timing of clients' budget cycles and clients'
internal approval processes. Accordingly, the timing of significant
transactions is unpredictable and, as a result, the Company's revenue and
results of operations for any particular period are subject to significant
variability. The complexity of certain projects and the requirements of
generally accepted accounting principles can also result in a deferral of
revenue recognition, in whole or in part, on a particular contract during a
quarter, even though the contract has been executed or payment has actually
been received by the Company. Quarterly fluctuations may also result from
other factors such as new product and service introductions or announcements
of new products and services by the Company's competitors, changes in the
Company's or its competitors' pricing policies, changes in the mix of
distribution channels through which the Company's products and services are
sold, the timing and nature of sales and marketing expenses, changes in
operating expenses, the financial stability of major clients, changes in the
demand for software maintenance products and services, foreign currency
exchange rates and general economic conditions.

 Potential for Contract Liability

  The Company's products and services relating to software maintenance,
especially solutions addressing the Year 2000 problem, involve key aspects of
its clients' computer systems. A failure in a client's system could result in
a claim for substantial damages against the Company, regardless of the
Company's responsibility for such failure. The Company attempts to limit
contractually its liability for damages arising from negligent acts, errors,
mistakes or omissions in rendering its products and services. Despite this
precaution, there can be no assurance that the limitations of liability set
forth in its contracts would be enforceable or would otherwise protect the
Company from liability for damages. The successful assertion of one or more
large claims against the Company that exceed any available insurance coverage,
could have a material adverse effect on the Company's business, financial
condition and results of operations. Furthermore, litigation, regardless of
its outcome, could result in substantial cost to the Company and divert
managements's attention from the Company's operations. Any contract liability
claim or litigation against the Company could, therefore, have a material
adverse effect on the Company's business, financial conditions and results of
operations, especially in light of the Company's degraded financial condition.

 Limited Protection of Proprietary Rights

  The Company relies on a combination of patent, copyright, trademark and
trade secret laws and license agreements to establish and protect its rights
in its software products and proprietary technology. In addition, the Company
currently requires its employees and consultants to enter into nondisclosure
and assignment of

                                      27
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.

invention agreements to limit use of, access to and distribution of its
proprietary information. There can be no assurance that the Company's means of
protecting its proprietary rights in the United States or abroad will be
adequate. The laws of some foreign countries may not protect the Company's
proprietary rights as fully or in the same manner as do the laws of the United
States. Also, despite the steps taken by the Company to protect its
proprietary rights, it may be possible for unauthorized third parties to copy
aspects of the Company's products, reverse engineer, develop similar
technology independently or obtain and use information that the Company
regards as proprietary. Furthermore, there can be no assurance that others
will not develop technologies similar or superior to the Company's technology
or design around the proprietary rights owned by the Company.

  The Company has entered into license agreements with clients that allow
these clients access to and use of the Company's AutoEnhance/2000 an Vantage
YR 2000 software and SAM Relay and RQE Tools source code for certain purposes.
Access to the Company's source code may increase the likelihood of
misappropriation or misuse by third parties.

  Some competitors of the Company and others have announced the filing with
the U.S. Patent and Trademark Office ("PTO") of patent applications or have
received patents relating to fixing and assessing the Year 2000 problem. The
Company expects that the risk of infringement claims against the Company might
increase because its competitors and others might successfully obtain patents
for software products and processes or because new and overlapping processes
and methodologies used in such services will become more pervasive, increasing
the likelihood of infringement. There can be no assurance that third parties
will not assert infringement claims against the Company in the future, that
the assertion of such claims will not result in litigation or that the Company
would prevail in such litigation or be able to obtain a license for the use of
any infringed intellectual property from a third party on commercially
reasonable terms, if at all. Furthermore, litigation, regardless of its
outcome, could result in substantial cost to the Company and divert
management's attention from the Company's operations. The Company has become
aware of a patent relating to fixing the Year 2000 problem based on a
"windowing" method. Certain of the Company's technology incorporated in some
of its products may infringe on such patent. The Company is in the process of
reviewing the matter. Any infringement claim or litigation against the Company
could, therefore, have a material adverse effect on the Company's business,
financial condition and results of operations, especially in light of its
degraded financial condition.

  The Company maintains trademarks and service marks to identify its various
service offerings, products and software. Although the Company has registered
a trademark and one service mark with the PTO and has several trademark and
service mark applications pending in the United States and foreign
jurisdictions, not all of the applications have been granted and, even if
granted, there can be no assurance that a particular trademark or service mark
will survive a legal challenge to its validity or provide meaningful or
significant protection to the Company. In some cases, entities other than the
Company are using certain trademarks and service marks, either in
jurisdictions in which the Company has not filed an application or in which
the Company is using a mark in a different manner than a third party. There
may be some risk of infringement claims against the Company in the event that
a service or product of the Company is too similar to that of another entity
that is using a similar mark.

YEAR 2000 MATTERS

  The Year 2000 issue relates to computer programs and systems that recognize
dates using two-digit year data rather than four-digit year data. As a result,
such programs and systems may fail or provide incorrect information when using
dates after December 31, 1999. If the Year 2000 issue were to disrupt the
Company's internal information technology systems, or the information
technology systems of entities with whom the Company has significant
commercial relationships, the Company's business and financial condition could
be materially adversely affected.

                                      28
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.


  The Year 2000 issue is relevant to three areas of the Company's business:
(1) the Company's products and services, (2) the Company's internal computer
systems and (3) the computer systems of significant suppliers or customers of
the Company. Each such area is addressed below.

  1. The Company's Products. In some cases, the Company warrants to its
clients that its software will be year 2000 compliant generally subject to
certain limitations or conditions. The Company also provides solutions
consisting of products and services to address the year 2000 problem involving
key aspects of a client's computer systems. A failure in a client's system or
failure of the Company's software to be Year 2000 compliant could result in
substantial damages and therefore have a material adverse effect on the
Company's business, financial condition and results of operations. Although
the Company does not intend to adopt a formal Year 2000 compliance program for
its existing products, including AutoEnhancer 2000 and Vantage YR2000, it will
use commercially reasonable efforts to make any new products, including SAM
Workbench and RQE Tool, Year 2000 compliant. The Company is analyzing whether
it will adopt a Year 2000 compliance program for its SAM Relay product. There
can be no assurance that these future efforts will be successful.

  2. Internal Systems. The Company's internal computer programs and operating
systems relate to certain segments of the Company's business, including
customer database management, marketing, order processing, order fulfillment,
inventory management, customer service, accounting and financial reporting.
These programs and systems consist primarily of:

    Business Systems. These systems automate and manage business functions
  such as customer database management, marketing, order-taking and order-
  processing, inventory management, customer service, accounting and
  financial reporting,

    Personal Computers and Networks. These systems are used for word
  processing, document management and other similar administrative functions,
  and

    Telecommunications Systems. These systems provide telephone, voicemail,
  e-mail, Internet and intranet connectivity, and enable the Company to
  manage overall internal and external communications.

  The Company's Business Systems are licensed from outside vendors and the
Company generally expects that these Business Systems installed in or after
1997 will be Year 2000 compliant through upgrades and maintenance. Other
Internal Systems consist of widely available office applications and
application suites for word-processing, voicemail and other office-related
functions. The Company maintains recent versions of all such key applications
and all are, or are expected to be, Year 2000 compliant. Accordingly, the
Company does not intend to adopt a formal Year 2000 compliance program for its
Internal Systems. However, there can be no assurance that the Company's
Internal Systems or the combination thereof will be Year 2000 compliant. A
failure of an Internal System to be Year 2000 compliant could have a material
adverse impact on the Company's business, financial condition and results of
operations.

  3. Third-Party Systems. The computer programs and operating systems used by
entities with whom the Company has commercial relationships pose potential
problems relating to the Year 2000 issue, which may affect the Company's
operations in a variety of ways. These risks are more difficult to assess than
those posed by internal programs and systems, and the Company has not yet
completed the process of formulating a plan for assessing them. The Company
believes that the programs and operating systems used by entities with whom it
has commercial relationships generally fall into two categories: (A) First,
the Company relies upon programs and systems used by providers of basic
services necessary to enable the Company to reach, communicate and transact
business with its suppliers and customers. Examples of such providers include
the United States Postal Service, overnight delivery services, telephone
companies, other utility companies and banks. Services provided by such
entities affects almost all facets of the Company's operations. However, these
third-party dependencies

                                      29
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.

are not specific to the Company's business, and disruptions in their
availability would likely have a negative impact on most enterprises within
the software and services industry and on many enterprises outside the
software and services industry. The Company believes that all of the most
reasonably likely worst-case scenarios involving disruptions to its operations
stemming from the Year 2000 issue relate to programs and systems in this first
category. (B) Second, the Company relies upon third parties for certain
software code or programs that are embedded in, or work with, its products.
The Company believes that the functionality of its products may be materially
adversely affected by a failure of such third-party software to be Year 2000
compliant. There can be no assurance that the Company may not experience
unanticipated expenses or be otherwise adversely impacted by a failure of
third-party systems or software to be Year 2000 compliant. The most reasonably
likely worst-case scenarios may include: (i) corruption of data contained in
the Company's internal information systems, (ii) hardware and/or software
failure, and (iii) failure of infrastructure services provided by utilities
and/or government. The Company intends to include an evaluation of such
scenarios in its plan for assessing the programs and systems of the entities
with whom it has commercial relationships.

  The Company has substantially completed the formulation of its plan for
assessing its internal programs and systems and the programs and systems of
the entities with whom it has commercial relationships and it expects to
complete the identification of the related risks and uncertainties in the
fourth quarter of 1999. Once such identification has been completed, the
Company intends to resolve any material risks and uncertainties that are
identified by communicating further with the relevant vendors and providers,
by working internally to identify alternative sourcing and by formulating
contingency plans to deal with such material risks and uncertainties. To date,
however, the Company has not formulated such a contingency plan. The Company
expects the resolution of such material risks and uncertainties to be an
ongoing process until all key year 2000 problems are satisfactorily resolved.
The Company does not currently anticipate that the total cost of any Year 2000
remediation efforts that it plans to undertake will be material.

ITEM 3. Quantitative And Qualitative Disclosures About Market Risk

  As of September 30, 1999, the Company was exposed to market risks which
primarily include changes in U.S. interest rates. The Company maintains a
significant portion of its cash and cash equivalents in financial instruments
with purchased maturities of three months or less. These financial instruments
are subject to interest rate risk and will decline in value if interest rates
increase. Due to the short duration of these financial instruments, an
immediate increase in interest rates would not have a material effect of the
Company's financial condition or results of operations.

                                      30
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.

                          PART II. OTHER INFORMATION

ITEM 1. Legal Proceedings

  The Company and certain of its officers and directors were named as
defendants in purported class action lawsuits filed in the United States
District Court for the District of Massachusetts by Robert Downey on April 1,
1998, by Scott Cohen on April 7, 1998, by Timothy Bonnett on April 9, 1998, by
Peter Lindsay on April 17, 1998, by Harry Teague on April 21, 1998, by Jesse
Wijntjes on April 29, 1998, by H. Vance Johnson and H. Vance Johnson as
Trustee for the I.O.R.D. Profit-Sharing Plan on May 6, 1998, by John B.
Howard, M.D. on May 21, 1998 and by Helen Lee on May 28, 1998 (collectively,
the "complaints"). The complaints principally alleged that the defendants
violated federal securities laws by making false and misleading statements and
by failing to disclose material information concerning the Company's December
1997 acquisition of substantially all of the assets and assumption of certain
liabilities of the Millennium Dynamics, Inc. ("MDI") business from American
Premier Underwriters, Inc., thereby allegedly causing the value of the
Company's common stock to be artificially inflated during the purported class
periods. In addition, the Howard complaint alleged a violation of federal
securities laws as a result of the Company's purported failure to disclose
material information in connection with the Company's initial public offering
on July 2, 1997, and also named Montgomery Securities, Inc., Wessels, Arnold &
Henderson, and H.C. Wainwright & Co., Inc. as defendants. The complaints
further alleged that certain officers and/or directors of the Company sold
stock in the open market during the class periods and sought unspecified
damages.

  On or about June 1, 1998, all of the named plaintiffs and additional
purported class members filed a motion for the appointment of several of those
individuals as lead plaintiffs, for approval of lead and liaison plaintiffs'
counsel and for consolidation of the actions. The Court granted that motion on
June 18, 1998.

  On January 8, 1999, the plaintiffs filed a Consolidated Amended Complaint
applicable to all previously filed actions. The Consolidated Amended Complaint
alleges a class period of October 22, 1997 through October 26, 1998 and
principally claims that the Company and three of its former officers violated
federal securities laws by purportedly making false and misleading statements
(or omitting material information) concerning the MDI acquisition and the
Company's revenue during the proposed class period, thereby allegedly causing
the value of the Company's stock to be artificially inflated. Previously
stated claims against the Company and its underwriters alleging violations of
the federal securities laws as a result of purportedly inadequate or incorrect
disclosure in connection with the Company's initial public offering were not
included in the Consolidated Amended Complaint. The Company and the individual
defendants filed motions to dismiss the Consolidated Amended Complaint on
March 5, 1999. Oral arguments on the motions were held on April 21, 1999 and
the Court granted the Company's and the individual defendants' motions to
dismiss pursuant to an order dated June 1, 1999. The plaintiffs have appealed
the Court's order of dismissal. The Company intends to contest the appeal and
support the Court's order of dismissal. Appellate briefs are due to be filed
with the First Circuit Court of Appeals in November and December 1999.

  While the District Court has dismissed the Consolidated Amended Complaint,
the First Circuit Court of Appeals could reinstate it. While the Company
believes it would have meritorious defenses to the action if it were
reinstated, an adverse resolution of the lawsuit could have a material adverse
effect on the Company's financial condition and results of operations in the
period in which the litigation is resolved. The Company is not able to
reasonably estimate potential losses, if any, related to the Consolidated
Amended Complaint.

  On or about April 28, 1999, the Company filed a lawsuit in the United States
District Court for the District of Massachusetts against Micah Technology
Services, Inc. and Affiliated Computer Services, Inc. (collectively, "Micah").
The lawsuit principally alleges that Micah breached its contract with the
Company by failing to pay for services performed by the Company under such
contract. The lawsuit further alleges that since Micah was unjustly enriched
by the services performed by the Company, the Company is entitled to recovery
based on quantum meruit, and that Micah engaged in unfair and/or deceptive
trade practices or acts in violation of Massachusetts General Laws ("M.G.L.")
Chapter 93A by allowing the Company to perform services when

                                      31
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.

Micah did not pay for such services. The lawsuit seeks unspecified damages on
the breach of contract and quantum meruit claims and double or triple damages
on the Chapter 93A claim. Micah has denied the Company's allegations and has
filed a counterclain against the Company principally alleging fraud, negligent
misrepresentations, breach of contract and that the Company engaged in unfair
and/or deceptive trade practices or acts in violation of M.G.L. Chapter 93A by
its misrepresentations and breach of contract. The Company denied the
allegations contained in Micah's counterclaim and intends to contest the
counterclaim vigorously. The parties are in the initial discovery phase of the
litigation.

ITEM 2. Changes in Securities and Use of Proceeds

  Pursuant to a settlement agreement dated September 15, 1999 by and between
the Company and BCIA New England Holdings LLC ("BCIA"), the landlord for the
Company's former headquarters at 2 Federal Street, Billerica, MA 01821, the
Company agreed to issue 500,000 shares of its common stock to BCIA in a
transaction exempt from registration under the Securities Act of 1933. The
securities were issued in consideration for the release by BCIA of the
Company's lease obligations to it. The securities were issued in a transaction
by an issuer not involving any public offering and pursuant to an exemption
from registration under Section 4(2) of the Securities Act of 1933 and/or the
rules and regulations promulgated thereunder. No underwriters were utilized in
connection with the issuance of the securities and no underwriting discounts
or commissions were paid or incurred thereby. Item 2 of Part I is incorporated
herein by reference.

ITEM 6. Exhibits and Reports on Form 8-K

 (a) Exhibits:

  Documents listed below, except for documents identified by footnotes, are
being filed as exhibits herewith. Documents identified by footnotes, if any,
are not being filed herewith and, pursuant to Rule 12b-32 of the General Rules
and Regulations promulgated by the Commission under the Securities Exchange
Act of 1934 (the "Exchange Act") reference is made to such documents as
previously filed as exhibits with the Commission. The Company's file number
under the Exchange Act is 000-22647.

<TABLE>
 <C>           <S>
 Exhibit 10.1. Settlement Agreement dated September 15, 1999 by and between the
               Company and BCIA New England Holdings LLC.
 Exhibit 10.2. Agreement for Termination of Lease dated August 12, 1999 by and
               between the Company and The Prudential Insurance Company of
               America.
 Exhibit 10.3. Amended Employment Agreement between the Company and John
               Giordano dated as of September 9, 1999.
 Exhibit 10.4. Addendum to Employment Agreement between the Company and John
               Giordano dated October 5, 1999.
 Exhibit 10.5. Letter Agreement dated September 30, 1999 between the Company
               and Siemens Credit Corporation
 Exhibit 10.6. Lease dated February 2, 1999, as amended between the Company and
               OTR.
 Exhibit 11.   Statement re computation of net loss per common share
 Exhibit 27.   Financial Data Schedule
</TABLE>

 (b) Reports on Form 8-K:

  A Current Report on Form 8-K dated July 2, 1999 was filed by the Company on
July 9, 1999. The Company reported under Item 5 (Other Events) that Dominic K.
Chan was elected to the Board of Directors and that Henry F. McCance and W.
Michael Humphreys had resigned from the Board. Separately, the Company
announced that it reached a settlement agreement with American Financial
Group, Inc. and its subsidiaries and affiliates for release from its real
estate lease in Cincinnati, Ohio and certain other obligations. Under the
settlement, the Company agreed to pay $200,000 in cash and issue 300,000
shares of Common Stock in exchange for release from its real estate lease for
20,500 square feet which required average monthly payments excluding operating
expenses of $36,000 through November 2002.

                                      32
<PAGE>

                                   SIGNATURES

  Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.

Dated: November 12, 1999

                                          Peritus Software Services, Inc.

                                                   /s / JOHN D. GIORDANO
                                          By:__________________________________
                                                     John D. Giordano
                                            President, Chief Executive Officer
                                                and Chief Financial Officer
                                               (Principal Financial Officer)

                                       33
<PAGE>

                        PERITUS SOFTWARE SERVICES, INC.

                                   FORM 10-Q

               FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1999

                                 EXHIBIT INDEX

<TABLE>
<CAPTION>
 Exhibit No. Description
 ----------- -----------
 <C>         <S>
 10.1        Settlement Agreement dated September 15, 1999 by and between the
             Company and BCIA New England Holdings LLC.
 10.2        Agreement for Termination of Lease dated August 12, 1999 between
             the Company and The Prudential Insurance Company of America.
 10.3        Amended Employment Agreement between the Company and John Giordano
             dated as of September 9, 1999.
 10.4        Addendum to Employment Agreement between the Company and John
             Giordano dated October 5, 1999.
 10.5        Letter Agreement dated September 30, 1999 between the Company and
             Siemens Credit Corporation
 10.6        Lease dated February 2, 1999, as amended between the Company and
             OTR.
 11          Statement re computation of net loss per common share
 27          Financial Data Schedule
</TABLE>

                                       34