<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 DECEMBER 31, 1998

                                       or

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

                          Commission File No. 1-10968

                        MARINER POST-ACUTE NETWORK, INC.
             (Exact Name of Registrant as Specified in its Charter)

                 Delaware                           74-2012902
     (State or Other Jurisdiction of             (I.R.S. Employer
      Incorporation or Organization)            Identification No.)

      One Ravinia Drive, Suite 1500                    30346
            Atlanta, Georgia                        (Zip Code)
 (Address of Principal Executive Office)

                                 (678) 443-7000
              (Registrant's Telephone Number, Including Area Code)


     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  
                                              -----      -----

  There were 73,270,051 shares of Common Stock of the registrant issued and
outstanding as of February 10, 1999, including approximately 160,000 shares
issuable upon the exchange of certificates formerly representing the common
stock of predecessor corporations acquired by the registrant.
<PAGE>
 
               Mariner Post-Acute Network, Inc. and Subsidiaries
                                        
                                   FORM 10-Q
                               TABLE OF CONTENTS
                               December 31, 1998

<TABLE> 
<CAPTION> 
                                                                                           PAGE
                                                                                           ----
<S>                  <C>                                                                   <C> 
Part I - FINANCIAL INFORMATION

     Item 1.        Condensed Consolidated Financial Statements and Notes                    3
 
     Item 2.        Management's Discussion and Analysis of Financial                       20
                    Condition and Results of Operations
 
     Item 3.        Quantitative and Qualitative Disclousure About Market                   34
                    Risk

Part II - OTHER  INFORMATION

     Item 1.        Legal Proceedings                                                       36
 
     Item 2.        Changes in Securities and Use of Proceeds                               37
 
     Item 3.        Defaults Upon Certain Securities                                        37
 
     Item 4.        Submission of Matters to a Vote of Security Holders                     37
 
     Item 5.        Other Information                                                       37
 
     Item 6.        Exhibits and Reports on Form 8-K                                        37

SIGNATURE PAGE                                                                              38
</TABLE> 

                                       2
<PAGE>
 
PART 1  FINANCIAL INFORMATION
Item 1.  Condensed Consolidated Financial Statements

               MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
                  CONDENSED CONSOLIDATED STATEMENTS OF INCOME
                (dollars in thousands, except per share amounts)
                                  (unaudited)

<TABLE>
<CAPTION>
                                                                                            Three Months
                                                                                          Ended December 31,
                                                                                          1998         1997
                                                                                        --------     --------
<S>                                                                                      <C>         <C>
Net Revenues
    Nursing home revenue:
     Net patient services...........................................................    $498,664     $305,709
     Other..........................................................................       7,860        1,583
    Non-nursing home revenue:
     Pharmacy services..............................................................      77,736       51,586
     Therapy services...............................................................      76,180       40,888
     Home health, hospital services, and other......................................      12,240       21,840
                                                                                        --------     --------
                                                                                         672,680      421,606
Costs and Expenses:
    Salaries and wages..............................................................     276,672      160,021
    Employee benefits...............................................................      48,102       30,392
    Nursing, dietary and other supplies.............................................      33,352       20,178
    Ancillary services..............................................................     127,520       93,783
    General and administrative......................................................      65,141       35,655
    Insurance expense...............................................................      19,426       12,686
    Rent............................................................................      26,996       17,659
    Depreciation and amortization...................................................      30,584       15,363
    Provision for bad debts.........................................................      36,484        8,705
    Recapitalization, indirect merger and other expenses............................       2,015       40,985
                                                                                        --------     --------
                                                                                         666,292      435,427
                                                                                        --------     --------
    Income (loss) from operations...................................................       6,388      (13,821)
Other Income and Expense:
    Interest expense................................................................      46,729       21,612
    Interest and dividend income....................................................      (2,443)      (2,284)
                                                                                        --------     --------
                                                                                          44,286       19,328
    Loss before income taxes, minority interest, and extraordinary loss.............     (37,898)     (33,149)
Provision (Benefit) for Income Taxes................................................         500       (3,803)
                                                                                        --------     --------
    Loss before minority interest and extraordinary loss............................     (38,398)     (29,346)
Minority Interest...................................................................        (625)        (172)
                                                                                        --------     --------
    Loss before extraordinary loss..................................................     (39,023)     (29,518)
Extraordinary Loss on Early Extinguishment of Debt, net of $6,034
 Income Tax Benefit.................................................................         ---      (11,275)
                                                                                        --------     --------
Net Loss............................................................................    $(39,023)    $(40,793)
                                                                                        ========     ========

Loss Per Share:
    Basic and Diluted...............................................................    $  (0.53)    $  (0.86)
                                                                                        ========     ========
Weighted Average Common Shares Outstanding:
    Basic and Diluted...............................................................      73,277       47,590
                                                                                        ========     ========
</TABLE>
                                                                                
   The accompanying notes are an integral part of these financial statements.

                                       3
<PAGE>
 
               MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
                     CONDENSED CONSOLIDATED BALANCE SHEETS
                (dollars in thousands, except per share amounts)


<TABLE>
<CAPTION>
                                                                                    (unaudited)
                                                                                    December 31,     September 30,
                                                                                        1998              1998
                                                                                 ----------------  ---------------
<S>                                                                               <C>               <C>
ASSETS                                                                           
Current Assets:                                                                  
    Cash and cash equivalents....................................................   $    5,303        $    3,314
    Receivables (less allowances of $100,566 and $68,581)........................      617,244           617,380
    Supplies.....................................................................       35,073            31,516
    Income tax refund receivable.................................................       34,200            57,323
    Deferred income taxes........................................................       57,933            58,875
    Prepaid expenses and other current assets....................................       35,822            39,515
                                                                                    ----------        ----------
     Total current assets........................................................      785,575           807,923
Property and Equipment:                                                          
    Land, buildings and improvements.............................................      884,316           863,451
    Furniture, fixtures and equipment............................................      248,400           231,682
    Leased property under capital leases.........................................       89,806            89,718
                                                                                    ----------        ----------
                                                                                     1,222,522         1,184,851
    Less accumulated depreciation................................................      297,895           257,698
                                                                                    ----------        ----------
                                                                                       924,627           927,153
Goodwill, net....................................................................    1,077,842         1,084,473
Restricted Investments...........................................................       77,735            88,467
Notes Receivable, net............................................................       20,805            20,861
Other Assets.....................................................................      118,327           107,774
                                                                                    ----------        ----------
                                                                                    $3,004,911        $3,036,651
                                                                                    ==========        ==========
LIABILITIES AND STOCKHOLDERS' EQUITY                                             
Current Liabilities:                                                             
    Notes payable and current maturities of long-term debt.......................   $   53,570        $   46,250
    Accounts payable.............................................................      160,026           165,484
    Accrued payroll and related expenses.........................................      122,667           127,774
    Accrued interest.............................................................       24,813            35,057
    Other accrued expenses.......................................................       67,832            83,142
                                                                                    ----------        ----------
     Total current liabilities...................................................      428,908           457,707
Long-Term Debt, net of current maturities........................................    2,038,169         1,977,865
Long-Term Insurance Reserves.....................................................       51,603            61,310
Deferred Income Taxes and Other Noncurrent Liabilities...........................      130,488           142,755
Commitments and Contingencies                                                    
Stockholders' Equity:                                                            
    Preferred stock, par value $.01; 5,000,000 shares authorized; none issued....           --                --
    Common stock, par value $.01; 500,000,000 shares authorized;                 
     73,276,866 shares issued....................................................          733               733
    Capital surplus..............................................................      980,142           980,142
    Accumulated deficit..........................................................     (622,134)         (583,111)
    Accumulated other comprehensive income.......................................       (2,998)             (750)
                                                                                    ----------        ----------
     Total stockholders' equity..................................................      355,743           397,014
                                                                                    ----------        ----------
                                                                                    $3,004,911        $3,036,651
                                                                                    ==========        ==========
</TABLE>
                                                                                
     The accompanying notes are an integral part of these financial statements.

                                       4
<PAGE>
 
               MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
            CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
                                 (in thousands)
                                  (unaudited)
                                        
<TABLE>
<CAPTION>
 
                                                                                       
                                                                                        Accumulated 
                                                                                           Other    
                                               Common Stock    Capital   Accumulated   Comprehensive 
                                              Shares  Amount   Surplus     Deficit         Income        Total
                                              ------  ------   -------   -----------   -------------   ---------
<S>                                           <C>     <C>      <C>       <C>           <C>             <C>
Balance, September 30, 1998.................  73,277    $733   $980,142    $(583,111)      $  (750)     $397,014

     Net loss...............................      --      --         --      (39,023)           --       (39,023)
     Unrealized losses on
       available-for-sale securities........      --      --         --           --        (2,248)       (2,248)
                                              ------    ----   --------    ---------       -------      --------
Balance, December 31, 1998..................  73,277    $733   $980,142    $(622,134)      $(2,998)     $355,743
                                              ======    ====   ========    =========       =======      ========
</TABLE>
                                                                                
   The accompanying notes are an integral part of these financial statements.

                                       5
<PAGE>
 
               MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
                 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOW
                             (dollars in thousands)
                                  (unaudited)

                                        
<TABLE>
<CAPTION>
                                                                                         Three Months
                                                                                      Ended December 31,
                                                                                 -----------------------------
                                                                                     1998            1997
                                                                                 -------------  --------------
<S>                                                                              <C>            <C>
Cash Flows From Operating Activities:
    Net loss...................................................................      $(39,023)       $(40,793)
    Adjustments to reconcile net loss to net cash used in
     operating activities:
     Depreciation and amortization.............................................        30,584          15,363
     Interest expense on discounted debt.......................................         4,981           3,118
     Income taxes deferred.....................................................           500            (370)
     Equity earnings/minority interest.........................................           625             172
     Provision for bad debts...................................................        36,484           8,705
    Changes in noncash working capital:
     Receivables...............................................................       (36,348)         (8,586)
     Supplies..................................................................        (3,557)          1,823
     Prepayments and other current assets......................................        23,751           2,510
     Accounts payable..........................................................        (5,458)        (21,783)
     Accrued expenses and other current liabilities............................       (27,825)         11,351
    Changes in long-term insurance reserves....................................        (9,707)          6,091
    Other......................................................................       (12,840)          2,835
                                                                                     --------       ---------
Net Cash Used In Operating Activities..........................................       (37,833)        (19,564)
 
Cash Flows Used In Investing Activities:
    Purchases of property and equipment........................................       (15,921)         (6,993)
    Disposals of property, equipment and other assets..........................            --           2,252
    Restricted investments.....................................................         8,484         (10,454)
    Net collections on notes receivable........................................         4,063             593
    Other......................................................................        (7,367)         (7,463)
                                                                                     --------       ---------
Net Cash Used In Investing Activities..........................................       (10,741)        (22,065)
 
Cash Flows From Financing Activities:
    Issuance of shares to Apollo Management, L.P...............................            --         232,750
    Proceeds from Senior Credit Facility.......................................            --         740,000
    Proceeds from Senior Notes.................................................            --         448,871
    Net draws under credit line................................................        67,000              --
    Repayment of long-term debt................................................        (8,689)       (563,337)
    Repurchase of shares in recapitalization...................................            --        (735,223)
    Deferred financing fees....................................................        (7,313)        (31,678)
    Other......................................................................          (435)          2,484
                                                                                     --------       ---------
Net Cash Provided By Financing Activities......................................        50,563          93,867
                                                                                     --------       ---------
Increase in Cash and Cash Equivalents..........................................         1,989          52,238
Cash and Cash Equivalents, beginning of period.................................         3,314          14,355
                                                                                     --------       ---------
Cash and Cash Equivalents, end of period.......................................      $  5,303       $  66,593
                                                                                     ========       =========     
</TABLE>
   The accompanying notes are an integral part of these financial statements.

                                       6
<PAGE>
 
               MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (unaudited)


NOTE 1.  Organization and Basis of Presentation

 Organization

     Mariner Post-Acute Network, Inc. (the "Company") changed its name
effective August 1, 1998 from its former name, Paragon Health Network, Inc.
("Paragon"), following the consummation of the merger (the "Mariner Merger")
with Mariner Health Group, Inc. ("Mariner Health") on July 31, 1998 pursuant
to an agreement and plan of merger dated as of April 13, 1998 (the "Mariner
Merger Agreement"). See Note 4. The Company had previously changed its name
from Living Centers of America, Inc. ("LCA") to Paragon on November 4, 1997.
At the time of the Mariner Merger, Mariner Health operated long-term health care
facilities that provided skilled nursing and residential care services in 16
states and comprehensive rehabilitation services. The Company was formed in
November 1997 through the recapitalization by merger of LCA with a newly-formed
entity owned by certain affiliates of Apollo Management, L.P. and certain other
investors (the "Recapitalization Merger"), and the subsequent merger of
GranCare, Inc. ("GranCare") with a wholly-owned subsidiary of LCA (the
"GranCare Merger" and collectively with the Recapitalization Merger, the
"Apollo/LCA/GranCare Mergers") pursuant to an agreement and plan of merger
dated as of May 7, 1997, as amended and restated as of September 17, 1997 (the
"GranCare Merger Agreement"). See Notes 2 and 3. At the time of the GranCare
Merger, GranCare operated long-term health care facilities that provided skilled
nursing and residential care services in 15 states, a specialty hospital
geriatric services company, and home health operations. The accompanying
consolidated financial statements include the accounts of the Company and its
subsidiaries and all significant intercompany accounts and transactions have
been eliminated in consolidation.

 Basis of Presentation

  The accompanying unaudited condensed consolidated financial statements of the
Company have been prepared in accordance with generally accepted accounting
principles for interim financial information and pursuant to the rules and
regulations of the Securities and Exchange Commission.  Accordingly, they do not
include all of the information and notes required by generally accepted
accounting principles for annual financial statements.  In the opinion of
management, all adjustments (which include normal recurring adjustments)
considered necessary for a fair presentation have been included.  Operating
results for the three months ended December 31, 1998 are not necessarily
indicative of the results that may be expected for the year ended September 30,
1999.  These financial statements should be read in conjunction with the audited
consolidated financial statements and notes thereto for the year ended September
30, 1998 included in the Company's Annual Report filed with the Securities and
Exchange Commission on Form 10-K, file No. 1-10968.

  Certain prior year amounts have been reclassified to conform with the fiscal
year 1999 presentation.

                                       7
<PAGE>
 
               MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (unaudited)

                                        
 Recent Accounting Pronouncements

     In June 1997 the Financial Accounting Standards Board adopted Statement of
Financial Accounting Standards No. 131, "Disclosures about Segments of an
Enterprise and Related Information" ("SFAS 131"). SFAS 131 requires public
business enterprises to report information about operating segments and related
disclosures about products and services, geographic areas, and major customers.
SFAS 131 is effective for fiscal years beginning after December 15, 1997 and is
applicable to interim periods in the second year of application. Comparative
information for earlier years is required to be restated in the initial year of
application.

     In February 1998 the Financial Accounting Standards Board adopted Statement
of Financial Accounting Standards No. 132, "Employers' Disclosures about
Pensions and Other Postretirement Benefits--an amendment of FASB Statements No.
87, 88, and 106" ("SFAS 132"). SFAS 132 standardizes disclosure requirements
for pensions and other postretirement benefits, requires additional information
on changes in the benefit obligations and fair values of plan assets, and
eliminates certain existing disclosure requirements. SFAS 132 is effective for
fiscal years beginning after December 15, 1997.

     SFAS Nos. 131, and 132 become effective in the Company's fiscal year ending
September 30, 1999. The adoption of these statements is not expected to have a
material impact on the Company's financial statements.

     In June 1998 the Financial Accounting Standards Board adopted Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities" ("SFAS 133"). SFAS 133 establishes accounting and
reporting standards for derivative instruments and for hedging activities. SFAS
133 is effective for all fiscal quarters of fiscal years beginning after June
15, 1999. SFAS No. 133 will become effective in the Company's fiscal year ending
September 30, 2000. The adoption of this statement is not expected to have a
material impact on the Company's financial statements.

     In March 1998 the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants issued Statement of Position 98-1,
"Accounting for the Costs of Computer Software Developed or Obtained for
Internal Use" ("SOP 98-1"). SOP 98-1 provides guidance as to whether certain
costs for internal-use software should be capitalized or expensed when incurred.
SOP 98-1 is effective for fiscal years beginning after December 15, 1998, but
earlier application is encouraged. The Company does not expect the adoption of
SOP 98-1 to have a material impact on its financial statements.

     In June 1998 the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants issued Statement of Position 98-5,
"Reporting on the Costs of Start-Up Activities" ("SOP 98-5"). SOP 98-5
provides guidance on the financial reporting of start-up costs. It requires
costs of start-up activities to be expensed as incurred. SOP 98-5 is effective
for fiscal years beginning after December 15, 1998, but earlier application is
encouraged. The Company does not expect the adoption of SOP 98-5 to have a
material impact on its financial statements.

                                       8
<PAGE>
 
               MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (unaudited)
                                        
NOTE 2.  Recapitalization Merger

     During 1997 the Company entered into the Recapitalization Merger which was
completed effective November 1, 1997 for accounting purposes. In connection with
the Recapitalization Merger, certain affiliates of Apollo and certain other
investors (the "Apollo Investors") invested $240 million to purchase
approximately 17.8 million shares of newly issued common stock of LCA.
Concurrent with the Recapitalization Merger, LCA changed its name to Paragon
Health Network, Inc.

     On November 4, 1997, the Company sold $275 million of its 9.5% Senior
Subordinated Notes due 2007, at a price of 99.5% of face value and $294 million
of its 10.5% Senior Subordinated Discount Notes due 2007, at a price of 59.6% of
face value (collectively, the "Notes"), in a private offering to institutional
investors. Concurrent with the private Notes offering, the Company entered into
a new Senior Credit Facility which is composed of $740 million in Term Loans and
a Revolving Credit Facility which provides for borrowings of up to an additional
$175 million. See Note 6.

     The Company used the $240 million invested by the Apollo Investors and the
$1.189 billion of net proceeds provided by the Notes offering and the Term Loans
to (i) purchase approximately 90.5% of the issued and outstanding common stock
of the Company for a per share price of $13.50, (ii) to repay substantially all
amounts outstanding under the Company's and under GranCare's (see Note 3 for
description of the GranCare Merger) previous credit facilities and (iii) pay for
certain costs associated with the Apollo/LCA/GranCare Mergers.


NOTE 3.  GranCare Merger

     Effective November 1, 1997 for accounting purposes, and subsequent to the
Company's recapitalization, the Company completed the acquisition by merger of
GranCare pursuant to the GranCare Merger Agreement. In the GranCare Merger
approximately 17.4 million shares of the Company's common stock were exchanged
for GranCare common stock and approximately 1.3 million options to purchase
shares of the Company's common stock were exchanged for options to purchase
GranCare common stock. The Company's total purchase price of the acquisition was
approximately $250.6 million including legal, consulting and other direct costs.
The acquisition was accounted for under the purchase method of accounting and,
accordingly, the results of GranCare's operations are included in the Company's
consolidated financial statements since the date of acquisition. The assets and
liabilities of GranCare have been recorded at fair market value based on the
total purchase price allocation as follows (in thousands):

<TABLE>
<S>                                                             <C>
     Current assets.........................................  $ 225,617
     Property and equipment.................................    215,455
     Goodwill...............................................    370,120
     Restricted investments.................................     40,987
     Other long-term assets.................................     40,066
     Current liabilities....................................   (117,827)
     Long-term debt.........................................   (369,871)
     Other non-current liabilities..........................   (153,948)
                                                              ---------
     Total purchase price...................................  $ 250,559
                                                              =========
</TABLE>

                                       9

<PAGE>
 
               MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (unaudited)
                                        
     In the quarter ended June 30, 1998, an adjustment was made to record
GranCare's property and equipment at its fair value, assign a purchase price to
unfavorable operating leases for property and equipment and other unfavorable
contract rights, and assign a value to identifiable intangible assets. The
unfavorable operating lease obligation in the amount of $36.4 million is
amortized over the lives of the respective leases and is reflected in the
accompanying consolidated balance sheet as other liabilities. Goodwill resulting
from the GranCare Merger is being amortized on a straight-line basis over 30
years. The Omega Note (see Note 6) assumed by the Company in the GranCare Merger
has been recorded at its fair value with the excess of fair value over the
principle amortized over the remaining life of the mortgage notes. Such amount
is being amortized using the effective interest method over the expected life of
the note. Amortization, which was approximately $1.0 and $0.7 million for the
three month periods ended December 31, 1998 and 1997, respectively, was recorded
as a reduction to interest expense.


NOTE 4.  Mariner Merger

     Effective July 31, 1998 the Company completed the acquisition by merger of
Mariner Health pursuant to the terms of the Mariner Merger Agreement. In the
Mariner Merger approximately 29.6 million shares of the Company's common stock
were exchanged for Mariner Health common stock. The Company's total purchase
price of the acquisition was approximately $535.7 million including cash
payments for options, legal, consulting and other direct costs. The acquisition
was accounted for under the purchase method of accounting and, accordingly, the
results of Mariner Health's operations are included in the Company's
consolidated financial statements since the date of acquisition. The assets and
liabilities of Mariner Health have been recorded at fair market value based on a
preliminary purchase price allocation. The total purchase price has been
allocated as follows (in thousands):

<TABLE>
<S>                                                        <C>
     Current assets......................................  $ 213,862
     Property and equipment..............................    420,047
     Goodwill............................................    564,566
     Restricted investments..............................      3,227
     Other long-term assets..............................     36,378
     Current liabilities.................................    (55,853)
     Long-term debt......................................   (600,202)
     Other non-current liabilities.......................    (46,344)
                                                           ---------
     Total purchase price................................  $ 535,681
                                                           =========
</TABLE>
                                                                                
     During the three month period ended December 31, 1998, Company management
reviewed Mariner Health's allowance for doubtful accounts and concluded that an
additional charge was necessary. As a result, included in the provision for bad
debts is a charge of approximately $24.3 million.
    

NOTE 5.  Recapitalization, Indirect Merger and Other Expenses

     The Company recognized and paid charges for recapitalization, indirect 
merger and other costs of approximately $40.9 million related to its 
Apollo/LCA/GranCare mergers and $2.0 million related to its Mariner Health 
merger for the quarter ended December 31, 1997 and December 31, 1998, 
respectively as follows:

                                              Three months ended December 31,
                                                  1998              1997
                                              -------------------------------

Change of control, severance and retention      $1,528            $12,944
Bridge financing fees                                -              8,952
Investment banking, accounting and legal             -              4,412
Relocation, recruitment and other                  487             14,677
                                              -------------------------------
                                                $2,015            $40,985
                                              ===============================

                                       10
<PAGE>
 
               MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
             NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (unaudited)
 
NOTE 6. Debt

     Long-term debt at December 31, 1998 is summarized in the following table
(in thousands):

<TABLE>
<S>                                                           <C> 
     Senior Debt:                                           
     Senior Credit Facilities:                              
          Revolving Credit Facility.........................  $   78,500
          Term Loans........................................     806,617
          Mariner Health Senior Credit Facility.............     365,500
       Mortgage notes.......................................      52,059
       Other notes payable..................................      91,679
                                                            
     Subordinated Debt:                                     
       Senior Subordinated Notes (due 2007).................     273,916
       Senior Subordinated Discount Notes (due 2007)........     194,292
       Mariner Health Senior Subordinated Notes (due 2006)..     149,757
                                                              ----------
                                                               2,012,320
     Obligations under capital leases.......................      79,419
                                                              ----------
                                                               2,091,739
     Less short-term notes payable and current portion......     (53,570)
                                                              ----------
     Total long-term debt...................................  $2,038,169
                                                              ----------
</TABLE>
                                                                                

Senior Credit Facility

     As of December 31, 1998, outstanding indebtedness under the Revolving
Credit Facility was $78.5 million (out of a possible $175.0 million). In
addition, $307.6 million of the Tranche A Term Loan Facility, $249.5 million of
the Tranche B Term Loan Facility, and $249.5 million of the Tranche C Term Loan
Facility were outstanding.

     Interest on outstanding borrowings under the Revolving Credit Facility
accrue, at the option of the Company, at the Alternate Base Rate (the "ABR") of
The Chase Manhattan Bank ("Chase") or at a reserve adjusted Eurodollar Rate (the
"Eurodollar Rate") plus, in each case, an Applicable Margin.  The term
"Applicable Margin" means a percentage that will vary in accordance with a
pricing matrix based upon the respective term loan tenor and the Company's
leverage ratio.

     Prior to the effectiveness of the December 22, 1998 amendment to the Senior
Credit Facility (the "Amendment"), the Applicable Margins for the Revolving
Credit Facility and the Tranche A Term Loan Facility in the pricing matrix
ranged from 0% to 1.25% for ABR loans and 0.08% to 1.25% for loans under the
Eurodollar rate. The applicable interest rate margin for Tranche B Term Loans
was 1.50% for loans under the ABR and 2.50% for Eurodollar loans.  The
applicable interest rate margin for Tranche C Term Loans was 1.75% for loans
under the ABR and 2.75% for Eurodollar loans.  Immediately prior to the
Amendment, the Applicable Margins for ABR Loans and Eurodollar Loans under the
Revolving Credit Facility and the Tranche A Term Loan Facility were 1.25% and
2.25%, respectively.  The resultant interest rates under the Senior Credit
Facility (in each case first for ABR Loans and then for Eurodollar Loans)
immediately prior to the Amendment, were as follows: for Revolving Loans and
Tranche A Term Loans, 9.00% and 7.83%; for Tranche B Term Loans, 9.25% and
8.08%; and for Tranche C Term Loans, 9.5% and 8.33%.

                                       11
<PAGE>
 
               MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (unaudited)
                                        
     Following the Amendment, the Applicable Margins in the pricing matrix
pertaining to Revolving Loans and Tranche A Term Loans range from 0.25% to 1.25%
for ABR loans and 1.75% to 2.75% for loans under the Eurodollar. The applicable
interest rate margin for Tranche B Term Loans is 2.25% for loans under the ABR
and 3.25% for Eurodollar loans.  The applicable interest rate margin for Tranche
C Term Loans is 2.25% for loans under the ABR and 3.50% for Eurodollar loans.
As of December 31, 1998, the Applicable Margins for ABR Loans and Eurodollar
Loans under the Revolving Credit Facility and the Tranche A Term Loan Facility
were 1.25% and 2.75%, respectively.  The resultant interest rates under the
Senior Credit Facility (in each case first for ABR Loans and then for Eurodollar
Loans) as of December 31, 1998, were as follows: for Revolving Loans and Tranche
A Term Loans, 9.00% and 8.33%; for Tranche B Term Loans, 10.00% and 8.83%; and
for Tranche C Term Loans, 10.25% and 9.08%.

     Taking into account the $75.0 million increase in the Tranche A Term Loan
Facility implemented as part of the First Amendment to the Senior Credit
Facility consummated in connection with the Mariner Merger, aggregate
amortization of the Term Loans increased to the following approximate quarterly
amounts: $8.4 million (formerly $6.6 million), $15.8 million (formerly $12.3
million), $16.6 million (formerly $12.9 million), $16.6 million (formerly $12.9
million), $18.2 million (formerly $14.1 million), $48.5 million (formerly $46.5
million), $59.8 million (unchanged) and $20.0 million (unchanged) in fiscal
years 1999 through 2006, respectively.

Mariner Health Senior Credit Facility

     As of December 31, 1998, approximately $155.5 million of loans and $12.0
million of letters of credit were outstanding under the Mariner Health Senior
Credit Facility, and $210.0 million of loans were outstanding under the Mariner
Health Term Loan Facility.

     For prime-based borrowings under the $460.0 million Mariner Health Senior
Credit Facility that existed prior to December 23, 1998, applicable interest
rate margins originally ranged between 0% and 0.25% for prime-base borrowings,
and between 0.50% and 1.75% for Eurodollar based advances.  As of December 22,
1998, the applicable margins were 0% for prime-based revolving loans and 1.25%
for Eurodollar-based loans.  After giving effect to the Mariner Health Senior
Credit Facility Amendment' and the Mariner Health Term Loan Facility, the
applicable interest rate margins range from 0.25% to 1.25% for prime-based
loans, and from 1.75% to 2.75% for Eurodollar-based advances.  The applicable
margins were 0.75% for prime-based revolving loans and 2.25% for Eurodollar-
based loans under each of the Mariner Health Senior Credit Facility and the
Mariner Health Term Loan Facility as of December 31, 1998.  Accordingly, the
applicable interest rates on prime-based loans under those credit facilities was
8.50%, and for Eurodollar-based advances, 7.83%, as of December 31, 1998.


Mariner Health Senior Subordinated Notes

     Mariner Health is also the issuer of certain 9 1/2% Senior Subordinated
Notes due 2006 (the "Mariner Health Notes") which were issued pursuant to that
certain Indenture dated as of April 4, 1996 (the "Mariner Indenture") with
Mariner Health as issuer and State Street Bank and Trust Company as trustee, and
are outstanding in the aggregate principal amount of $150.0 million. The Mariner
Health Notes are unsecured senior subordinated obligations of  Mariner Health
and, as such, are subordinated  in  right of  payment  to all existing  and
future senior

                                       12
<PAGE>
 
               MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (unaudited)

indebtedness of Mariner Health, including indebtedness under the Credit
Facility. The Mariner Health Notes contain certain covenants, including, among
other things, covenants with respect to the following matters: (i) limitation on
indebtedness; (ii) limitation on restricted payments; (iii) limitation on the
incurrence of liens; (iv) restriction on the issuance of preferred stock of
subsidiaries; (v) limitation on transactions with affiliates; (vi) limitation on
the sale of assets; (vii) limitation on other senior subordinated indebtedness;
(viii) limitation on guarantees by subsidiaries; (ix) limitation on the creation
of any restriction on the ability of Mariner Health's subsidiaries to make
distributions; and (x) restriction on mergers, consolidations and the transfer
of all or substantially all of the assets of Mariner Health to another person.


Other Significant Indebtedness

     In connection with the GranCare Merger, the Company became a party to an
agreement between GranCare and Omega Healthcare Investors, Inc. ("Omega").

     A wholly-owned subsidiary of the Company, Professional Health Care
Management, Inc. ("PHCMI"), is the borrower under a $58.8 million mortgage
note executed on August 14, 1992 (the "Omega Note") in favor of Omega, and
under the related Michigan loan agreement dated as of June 7, 1992 as amended
(the "Omega Loan Agreement"). All $58.8 million was outstanding as of
September 30, 1998.

     The Omega Note bears interest at a rate which is adjusted annually based on
either (i) changes in the Consumer Price Index or (ii) a percentage of the
change in gross revenues of PHCMI and its subsidiaries from year to year,
divided by $58.8 million, whichever is higher, but in any event subject to a
maximum rate not to exceed 105% of the interest rate in effect for the Omega
Note for the prior calendar year.  The current interest rate is 15.5% per annum
which is paid monthly.  Additional interest accrues on the outstanding principal
of the Omega Note at the rate of 1% per annum.  Such interest is compounded
annually and is due and payable on a pro rata basis at the time of each
principal payment or prepayment.

     In addition to the interest on the Omega Note described in the preceding
paragraph, and as a condition to obtaining Omega's consent to the February 1997
transaction between Vitalink and GranCare, PHCMI agreed to pay additional
interest to Omega in the amount of $20,500 per month, through and including July
1, 2002.  If the principal balance of the Omega Note for any reason becomes due
and payable prior to that date, there will be added to the indebtedness owed by
PHCMI: (i) the sum of $1.0 million, plus (ii) interest thereon at 11% per annum
to the prepayment date; less (iii) the amount of such additional interest paid
to Omega prior to the prepayment date.

                                       13
<PAGE>
 
               MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (unaudited)
                                        

     Also during quarter ended December 31, 1997, the Company recognized an
extraordinary charge of $11.3 million, net of a $6.0 million income tax benefit,
associated with prepayment penalties incurred on the early extinguishment of
debt and the write-off of certain deferred financing fees in conjunction with
the Apollo/LCA/GranCare Mergers.


NOTE 7.  Income Taxes

  The effective income tax rate for the three months ended December 31, 1998 was
approximately 1% as compared to 42.0% for the same period in 1997.  The
difference in the effective income tax rate between periods is attributable to
the Company's establishment of a valuation allowance which offsets the deferred
tax assets generated from the Company's losses.

                                       14
<PAGE>
 
NOTE 8.  Earnings per Common Share

     The following table sets forth the computation of basic and diluted
earnings per share (in thousands, except per share data) in accordance with
Financial Accounting Standards No. 128, "Earnings per Share" ("SFAS 128"):


<TABLE>
<CAPTION>
                                                                           Three Months Ended
                                                                              December 31,
                                                                       --------------------------
                                                                           1998          1997
                                                                       ------------  ------------
<S>                                                                    <C>           <C>
     Numerator for Basic and Diluted Earnings Per Share:
       Net loss before extraordinary item............................     $(39,023)     $(29,518)
       Extraordinary item............................................           --       (11,275)
                                                                          --------      --------
       Net loss......................................................     $(39,023)     $(40,793)
                                                                          ========      ========
     Denominator:
       Denominator for basic earnings per share-weighted
        average shares...............................................       73,277        47,590
       Effect of dilutive securities--Stock options..................           --            --
                                                                          --------      --------
       Denominator for diluted earnings per share-adjusted
        weighted-average shares and assumed conversions..............       73,277        47,590
                                                                          ========      ========
     Basic and Diluted Loss Per Share:
       Net loss before extraordinary item............................     $  (0.53)     $  (0.62)
       Extraordinary item............................................           --         (0.24)
                                                                          --------      --------
       Net loss per common share.....................................     $  (0.53)     $  (0.86)
                                                                          ========      ========
</TABLE>
                                                                                
     The effect of dilutive securities for the three months ended December 31,
1998 and 1997 has been excluded because the effect is antidilutive as a result
of the net loss for the periods.



NOTE 9.  Commitments and Contingencies

     In October 1996 the Company entered into a leasing program, initially
totaling $70.0 million and subsequently increased to $100.0 million, to be used
as a funding mechanism for future assisted living and skilled nursing facility
construction, lease conversions, and other facility acquisitions. The lease is
an unconditional "triple net" lease for a period of seven years with the
annual lease obligation a function of the amount spent by the lessor to acquire
or construct the project, a variable interest rate, and commitment and other
fees. The Company guarantees a minimum of approximately 83% of the residual
value of the leased property and also has an option to purchase the properties
at any time prior to the maturity date at a price sufficient to pay the entire
amount financed, accrued interest, and certain expenses. At December 31, 1998
approximately $48.6 million of this leasing arrangement was utilized. The
leasing program is accounted for as an operating lease.

                                       15
<PAGE>
 
               MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (unaudited)
                                        
     As is typical in the healthcare industry, the Company is and will be
subject to claims that its services have resulted in resident injury or other
adverse effects, the risks of which will be greater for higher acuity residents
receiving services from the Company than for other long-term care residents. The
Company is, from time to time, subject to such negligence claims and other
litigation. In addition, resident, visitor, and employee injuries will also
subject the Company to the risk of litigation. The Company has experienced an
increasing trend in the past year in the number and severity of litigation
claims asserted against the Company. Management believes that this trend is
endemic to the long-term care industry and is a result of several large
judgments against long-term care providers, other than the Company, in the last
year resulting in an increased awareness by plaintiff's lawyers of potentially
large recoveries. The Company also believes that there has been, and will
continue to be, an increase in governmental investigations of long-term care
providers, particularly in the area of false claims as well as an increase in
enforcement actions resulting from the investigation. While the Company believes
that it provides quality care to the patients in its facilities and materially
complies with all applicable regulatory requirements, an adverse determination
in a legal proceeding or governmental investigation, whether currently asserted
or arising in the future, could have a material adverse effect on the Company.

     From time to time, the Company and its subsidiaries have been parties to
various legal proceedings in the ordinary course of their respective businesses.
In the opinion of management, except as described below, there are currently no
proceedings which, individually or in the aggregate, if determined adversely to
the Company and after taking into account the insurance coverage maintained by
the Company, would have a material adverse effect on the Company's financial
position or results of operations.

     On August 26, 1996, a class action complaint was asserted against GranCare
in the Denver, Colorado District Court, Salas, et al. v. GranCare, Inc., and AMS
Properties, Inc., d/b/a Cedars Health Care Center, Inc. Case No. 96 CV 4449,
asserting five claims for relief, including third-party beneficiary, tortious
interference and negligence per se causes of action arising out of quality of
care issues at a healthcare facility formerly owned by GranCare. Pursuant to the
Third Amended Complaint, the class claims were finally identified as third-party
beneficiary of contract; breach of contract; tortious interference with
contract; fraud; and negligence per se. In addition to the class claims, the
named plaintiffs each asserted claims for promissory estoppel and violation of
the Colorado Consumer Protection Act.

     On March 15, 1998, the court entered an order in which it certified a class
action in the matter. The court has only certified the class with respect to the
issue of liability and the various class rights to restitution. The court
determined that emotional distress damages are of such an individualized and
personal nature that the class-wide request for emotional distress damages was
not appropriate for class treatment. On May 7, 1998, plaintiff's counsel orally
dismissed her promissory estoppel claims on behalf of the named plaintiffs. In
response to the Company's Motion to Dismiss All Claims and Motion for Summary
Judgment Precluding Recovery of Medicaid Funds, on October 30, 1998, the court
partially granted the Company's motions, dismissing the claims of all plaintiffs
who were at all times during the class period Medicare/Medicaid patients, for
lack of jurisdiction. The court further dismissed all restitution claims for the
remaining plaintiffs, except those relating to emotional distress for the period
beginning with their stay at defendants' facility and ending at the moment that
they first received any Medicare/Medicaid benefits. No restitution claims of any
sort were allowed on the claims for tortuous interference, fraud and negligence
per se. In its order, the court requested a conference relative to whether the
class was large enough to justify continuing the case as a class action. After
this order, at the request of plaintiffs' counsel, the court stayed all activity
and allowed plaintiffs to file a Motion for Reconsideration. Plaintiffs' Motion
for Reconsideration was filed, as ordered, on November 16, 1998, and the court
denied plaintiffs' motion on November 19, 1998. On December 10, 1998, the court
certified as a final judgment that portion of its order of October 30, 1998
dismissing for lack of jurisdiction all the claims of plaintiffs who were at all
relevant times Medicare or Medicaid patients. The court further stayed all
remaining proceedings pending resolution of any appeal of the certified final
judgment, and vacated the trial which had been scheduled for March 15, 1999. The
Company intends to vigorously contest the remaining alleged claims and the
certification of the various classes.

                                       16
<PAGE>
 
               MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (unaudited)
                                        

     The Company received a letter dated September 5, 1997 from an Assistant
United States Attorney ("AUSA") in the United States Attorney's Office for the
Eastern District of Texas (Beaumont) advising that the office is involved in an
investigation of allegations that services provided at some of the Company's
facilities may violate the Civil False Claims Act. The AUSA informed the Company
that the investigation is the result of a qui tam complaint (which involves a
private citizen requesting the federal government to intervene in an action
because of an alleged violation of a federal statute) filed under seal against
the Company, and the AUSA is investigating the allegations in order to determine
if the United States will intervene in the proceedings. The AUSA has requested
that the Company voluntarily produce a substantial amount of documents,
including medical records of former residents. In November 1997, counsel for the
Company met with the AUSA and the parties engaged in discussions on whether the
voluntary production of former residents' medical records can be accomplished
without violating the residents' rights to privacy and confidentiality. Based
upon the information currently known about the complaint, the Company believes
that given an opportunity to address the allegations, the AUSA will find
intervention by the United States is without merit. In December 1997, the
Company advised the AUSA that absent the United States agreeing to protect the
confidentiality of the residents' medical records, and to prevent unauthorized
disclosure of the information requested to non-government personnel, the Company
would not agree to a voluntary production. The Company has reopened discussions
with the Department of Justice regarding the Company's position on the alleged
claims. The Company will vigorously contest the alleged claims if the complaint
is pursued.

     In 1997, the Department of Justice ("DOJ") advised the Company that the
United States had declined to intervene in the qui tam complaint filed against
The Brian Center Corporation ("BCC") and one of its subsidiaries, Med-Therapy
Rehabilitation Services, Inc. ("Med-Therapy"), both wholly-owned subsidiaries
of the Company (and of LCA before the Apollo/LCA/GranCare Mergers) in the
federal district court for the Western District of North Carolina. The
individual plaintiff has continued to pursue the alleged claims that BCC and
Med-Therapy caused certain therapists to make improper therapy record entries
with respect to screening services, and that any claims filed with Medicare for
payments based upon such improper record entries should be viewed as false
claims under the Civil False Claims Act. The Company continues to vigorously
contest these claims. Although the plaintiff's original complaint was dismissed
for failure to state a claim, in September 1998, the court denied the Company's
motion to dismiss an amended complaint. The parties have recently engaged in
settlement negotiations, and if the case does not settle, discovery will
commence. In connection with the Company's acquisition of BCC, the primary
stockholder (Donald C. Beaver) agreed to indemnify and hold harmless the Company
from and against any and all loss, expense, damage, penalty and liability which
could result from this claim, subject to further adjustment. Mr. Beaver's
indemnity requires any payment to the Company to be in the form of shares of the
Company's common stock.

     On May 18, 1998, a class action complaint was asserted against the Company,
certain of its predecessor entities and affiliates and certain other parties in
the Tampa, Florida Circuit Court, Wilson, et al, v. Mariner Post-Acute Network,
Inc., et al., case no. 98-03779, asserting seven claims for relief, including
breach of contract, breach of fiduciary duty, unjust enrichment, violation of
Florida Civil Remedies for Criminal Practices Act, violation of Florida
Racketeer and Corrupt Organization Act, false advertising and common-law
conspiracy arising out of quality of care issues at a health care facility
formerly operated by the Brian Center Health and Rehabilitation/Tampa, Inc. and
later by a subsidiary of LCA as a result of the Brian Center Corporation merger.
The Company removed this case to Federal Court on June 10, 1998 and the matter
is currently pending in the United States District Court for the Middle District
of Florida, Tampa division, case no. 98-1205-CIV-T23B.

     The plaintiffs filed a motion to remand on June 22, 1998 and the Company
filed a motion to dismiss on June 30, 1998. The Company is currently awaiting
the outcome of these motions. The complaint has only been recently filed and no
discovery has been conducted. Accordingly, the information available to the
Company is very limited and the Company is unable to assess at this point the
magnitude of the allegations. The Company intends to vigorously contest the
request for class certification as well as all alleged claims made by the
plaintiffs.

                                       17
<PAGE>
 
               MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (unaudited)
                                        
     On August 25, 1998, a complaint was filed by the United States against the
Company's GranCare and International X-Ray subsidiaries and certain other
parties under the Civil False Claims Act and in common law and equity. The
lawsuit, U.S. v. Sentry X-Ray, Ltd., et al., civil action no. 98-73722, was
filed in United States District Court for the Eastern District of Michigan.
Valley X-Ray operates a mobile X-Ray company in Michigan. A Company subsidiary,
International X-Ray, owns a minority partnership interest in defendant Valley X-
Ray. The interest in Valley X-Ray was acquired by a predecessor corporation as
an incidental part of a large acquisition. International X-Ray was not involved
in the operation of Valley X-Ray. The case asserts five claims for relief,
including two claims for violation of the Civil False Claims Act, two
alternative claims of common law fraud and unjust enrichment, and one request
for application of the Federal Debt Collection Procedures Act. The two primary
allegations of the complaint are: that the X-Ray company received Medicare
overpayments for transportation costs in the amount of $657,767; and that the X-
Ray company "upcoded" Medicare claims for EKG services in the amount of
$631,090. The United States has requested treble damages as well as civil
penalties of $5,000 to $10,000 for each of the alleged 388 submitted Medicare
claims. The total damages sought varies from $5.3 to $7.2 million. The Company
is vigorously contesting all claims and filed two motions to dismiss on behalf
of its subsidiaries on November 23, 1998. The United States has agreed to the
dismissal of GranCare as a party, and the briefing on the second motion
regarding International X-Ray has been completed and awaits scheduling.

     On September 18, 1998, the Company was served with an administrative
subpoena issued by the OIG. The subpoena was addressed to "Paragon Health
Network, Inc." The subpoena seeks, among other things, certain records of
twenty specified current or former LCA nursing facilities. The Company has been
advised that the investigation is civil in nature and focuses on nursing
facilities and nurse aide services. The government has not disclosed the origin
of this civil administrative investigation or its intended scope. The Company is
cooperating with the investigation and has retained experienced counsel to
assist in responding to the subpoena and to advise it with respect to this
investigation. This investigation is still in its preliminary stages; therefore,
the Company is unable to predict the outcome of this matter.

     On October 1, 1998, a class action complaint was asserted against certain
of the Company's predecessor entities and affiliates and certain other parties
in the Tampa, Florida, Circuit Court, Ayres, et al v. Donald C. Beaver, et al,
case no 98-7233. The complaint asserts three claims for relief, including breach
of fiduciary duty against one group of defendants, breach of fiduciary duty
against another group of defendants, and civil conspiracy arising out of issues
involving facilities previously operated by the Brian Center Corporation or one
of its subsidiaries, and later by a subsidiary of LCA, as a result of the merger
with Brian Center Corporation. The Company removed this case to Federal Court on
November 2, 1998, and the matter is currently pending in the United States
District Court for the Middle District of Florida, Tampa Division, case no 98-
2240-CIV-T-17C. The plaintiffs filed a Motion to Remand on November 13, 1998,
and the Company will be presenting a brief in opposition. The complaint has only
been recently filed and no discovery has been conducted. Thus, the information
available to the Company is very limited. At this point, the Company is unable
to access the magnitude of the allegations. The Company intends to vigorously
contest all claims, including all issues relating to the attempted certification
of any alleged class.

     In October, 1998, the Custodian of Records of Cambridge Bedford, Inc., also
known as Bedford Villa Nursing Center ("Bedford"), a wholly-owned subsidiary
of the Company, was served an administrative subpoena issued by the OIG. The
subpoena seeks, among other things, general information on corporate ownership
and organizational structure, therapy and physician service arrangements, and
medical records of eleven former residents of Bedford. Bedford has been advised
that the investigation is civil in nature, and the OIG has assured the facility
that the OIG will follow all applicable federal laws, including the Privacy Act,
that pertain to the confidentiality of medical records, and that Bedford will
face no violation of confidentiality or privacy laws in producing the patient
medical records requested. The Company is cooperating with the investigation and
has transmitted documents responsive to the subpoena on November 17, 1998.

                                       18
<PAGE>
 
               MARINER POST-ACUTE NETWORK, INC. AND SUBSIDIARIES
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (unaudited)
                                        
     In November, 1998, Bedford also received a subpoena duces tecum from the
DOJ, through the U.S. Attorney's Office in Detroit, Michigan, requesting certain
patient medical records as the result of a criminal investigation of a named
physician. The Company has been advised that the facility is not a subject or
target of the investigation. The Company is cooperating with the U.S. Attorney's
Office.

 

                                       19
<PAGE>
 
ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
         RESULTS OF OPERATIONS

Overview

     Effective July 31, 1998, the Company acquired Mariner Health Group, Inc.
("Mariner Health") in a stock for stock merger (the "Mariner Merger")
pursuant to which: (i) Mariner Health became a wholly-owned subsidiary of the
Company; and (ii) the Company changed its name to "Mariner Post-Acute Network,
Inc." The Mariner Merger was accounted for under the purchase method of
accounting and, accordingly, the results of Mariner Health's operations have
been included in the Company's consolidated financial statements since the date
of acquisition.

     Effective November 1, 1997 for accounting purposes, the Company completed
two merger transactions. First, pursuant to an agreement and plan of merger
among Apollo Management, L.P. ("Apollo Management," and together with certain
of its affiliates, "Apollo"), Apollo LCA Acquisition Corp. (a corporation
owned by certain Apollo affiliates and other investors, "Apollo Sub") and
Living Centers of America, Inc. ("LCA"), Apollo Sub was capitalized with $240
million in cash and was merged with and into LCA (the "Recapitalization
Merger"). In the Recapitalization Merger, LCA was the surviving corporation and
was renamed "Paragon Health Network, Inc." Second, pursuant to an agreement
and plan of merger among LCA, GranCare, Inc. ("GranCare"), Apollo Management
and LCA Acquisition Sub, Inc., a wholly-owned subsidiary of the Company ("LCA
Sub"), GranCare merged with LCA Sub with GranCare surviving as a wholly-owned
subsidiary of the Company (the "GranCare Merger," and collectively with the
Recapitalization Merger, the "Apollo/LCA/GranCare Mergers"). The GranCare
Merger was accounted for under the purchase method of accounting and,
accordingly, the results of GranCare's operations have been included in the
Company's consolidated financial statements since the date of acquisition,
which, for accounting purposes, is November 1, 1997.

     Unless otherwise indicated, the information herein does not give pro forma
effect to the Apollo/LCA/GranCare Mergers or the Mariner Merger as if they had
been completed as of the beginning of the period presented. The Company also
completed other acquisitions in fiscal 1998 including Summit Medical Holdings,
Ltd. and Professional Rehabilitation, Inc., among others, all of which were
accounted for as purchase business combinations and were not material to the
Company as a whole.


Results of Operations

     Revenues from nursing home operations accounted for $506.5 million of the
Company's $672.7 million total net revenues for the three months ended December
31, 1998.  Nursing home revenues are derived from the provision of routine and
ancillary services and are a function of occupancy rates and payor mix in the
Company's long-term care facilities. Weighted average occupancy, as identified
in the following table, increased by 1.8% over the comparable period from 1997
to 1998.

                                                        Three Months
                                                     Ended December 31,
                                                     -------------------
                                                       1998        1997
                                                     --------     ------ 
 
    Weighted average licensed bed count                48,169     32,503
                                               
    Weighted average number of residents               41,385     27,347
                                               
    Weighted average occupancy                           85.9%      84.1%

                                       20
<PAGE>
 
     Payor mix is the source of payment for the services provided and consists
of private pay, Medicare and Medicaid. Private pay includes revenue from
individuals who pay directly for services without government assistance through
the Medicare and Medicaid programs, managed care companies, commercial insurers,
health maintenance organizations, Veteran's Administration contractual payments
and payments for services provided under contract management programs. Managed
care as a payor source to health care providers is expected to increase over the
next several years. The Company has increased its managed care contracting
focus, however, the impact to the Company of this payor source can not be
determined at this time.

     Reimbursement rates from government sponsored programs, such as Medicare
and Medicaid, are strictly regulated and subject to funding appropriations from
federal and state governments. Changes in reimbursement rates, including the
transition to the Prospective Payment System ("PPS"), which began on July 1,
1998, and fee screen schedules and therapy caps for Part B Medicare patients
beginning January 1, 1999, may adversely affect the Company. See "Liquidity and
Capital Resources." Revenues derived from the Company's pharmacy and therapy
groups are also influenced by payor mix. The table below presents the
approximate percentage of the Company's net patient revenues derived from the
various sources of payment for the periods indicated:


                                                     Three Months
                                                  Ended December 31,
                                                 -------------------
 
                                                   1998       1997
                                                 --------    -------
 
      Private and other                            32.2%      27.8%
                                        
      Medicare                                     27.3%      32.7%
                                        
      Medicaid                                     40.5%      39.5%


     The combined mix of private/other and Medicare revenue was 59.5% for the
three months ended December 31, 1998 as compared to 60.5% for the same period in
1997. The net revenues from the non-nursing home operations are primarily
reimbursed by facility providers which are considered private pay sources. The
impact of increased therapy revenue resulting from the Mariner Merger has
increased the percentage of private revenue for the Company. As of December 31,
1998, 137 nursing homes had converted to PPS based Medicare payments. Medicare 
rates from PPS declined which influenced the comparison of revenue mix between 
the three month periods ended December 31, 1998 and 1997.

     The administrative procedures associated with the Medicare cost
reimbursement program generally preclude final determination of amounts due the
Company until annual cost reports are audited or otherwise reviewed and settled
with the applicable administrative agencies. Certain Medicare fiscal
intermediaries have made audit adjustments to settle cost reports for some of
the Company's facilities that reduce the amount of reimbursement that was
previously received by the facilities. The Company believes that it has properly
recorded revenue under cost reimbursement programs based on the facts and
current regulations. If the Company was to receive adverse adjustments that it
had not contemplated in recording its revenue in the past, the differences could
be significant to the Company's results of operations in the period of final
determination. For cost reporting periods beginning on or after July 1, 1998,
the Medicare program is in the process of phasing in a new method of payment
whereby nursing home providers will be paid a fixed per diem rate under the PPS
system. See "Liquidity and Capital Resources".  Effective July 1, 1999, all of
the Company's skilled nursing facilities will be reimbursed under the PPS
system. 
                                       21
<PAGE>
 
     Costs and expenses, excluding depreciation, amortization, recapitalization,
indirect merger and other expenses, and impairment of long-lived assets,
primarily consist of salaries, wages, and employee benefits. Various federal,
state, and local regulations impose, depending on the services provided, a
variety of regulatory standards for the type, quality and level of personnel
required to provide care or services. These regulatory requirements have an
impact on staffing levels, as well as the mix of staff, and therefore impact
total costs and expenses. The cost of ancillary services, which includes
pharmaceuticals, is also affected by the level of service provided and patient
acuity. General and administrative expenses include the indirect administrative
costs associated with operating the Company and its lines of business. Insurance
expense includes the costs of the various insurance programs such as automobile,
general and professional liability and workers' compensation.


Seasonality

     The Company's revenues and operating income generally fluctuate from
quarter to quarter. This seasonality is related to a combination of factors
which include the timing of third party payment rate changes, the number of work
days in the period and seasonal census cycles.


 First Quarter of Fiscal 1999 Compared to First Quarter of Fiscal 1998

     Net revenues comprising nursing home and non-nursing home operations
totaled $672.7 million for the quarter ended December 31, 1998, an increase of
$251.1 million or 59.6%, as compared to the same period for fiscal 1998. Nursing
home operations contributed $199.2 million of the increase, which included
$127.5 million related to the acquisition of Mariner Health effective July 31,
1998 and $69.8 million primarily related to the acquisition of GranCare
effective November 1, 1997. Non-nursing home operations contributed $51.8
million of the increase, consisting of an increase of $26.2 million for pharmacy
services, an increase of $35.3 million for therapy services, and a decrease of
$9.6 million from home health, hospital services and other. The increases in
both pharmacy and therapy services net revenues were primarily attributable to
the Mariner Health acquisition. The $9.6 million decrease in home health,
hospital services, and other revenue was the result of the Company's September
1998 divestiture of the majority of its hospice entities. The Company is
evaluating its options with respect to its remaining hospice and home health
agencies.

     Pre-tax indirect merger and other expenses totaled $2.0 million for the
quarter ended December 31, 1998, all of which related to the Mariner Merger and
all of which were paid as of December 31, 1998. The Company anticipates
recording additional charges during fiscal year 1999 to close an existing shared
service center acquired in the Mariner Merger and continue the implementation of
its shared service centers consolidation.

     Insurance expense totaled $19.4 million for the quarter ended December 31,
1998, an increase of $6.7 million or 53.1% as compared to the same period for
fiscal 1998. The increase was primarily the result of the acquisitions of
Mariner Health and GranCare.

                                       22
<PAGE>
 
     Costs and expenses excluding indirect merger and other expenses totaled
$664.3 million for the quarter ended December 31, 1998, an increase of $269.9
million or 68.4% as compared to the same period for fiscal 1998. The increase
was primarily the result of costs for payroll and employee benefits which
increased by $134.4 million, while ancillary and general and administrative
expenses increased by $33.7 and $29.5 million, respectively. The increase in all
three of these cost catagories was primarily attributable to the acquisitions of
Mariner Health and GranCare.

     Provision for bad debts increased by $27.8 million or 319.1% for the
quarter ended December 31, 1998. The increase was primarily the result of
management's review of Mariner Health's allowance for doubtful accounts
at December 31, 1998, and subsequent conclusion that an additional charge of
approximately $24.3 million was necessary for Mariner Health as of December 31, 
1998 to conform to the Company's reserve policy. As such, the allowance for 
doubtful accounts at December 31, 1998 for Mariner Health reflects the 
methodology utilized by the Company.

     Interest expense totaled $46.7 million for the quarter ended December 31,
1998, an increase of $25.1 million as compared to the same period for fiscal
1998.  The acquisition of Mariner Health contributed to $12.7 million of the
increase, while the interest expense on the debt entered into on November 4,
1997 in conjunction with the Apollo/LCA/GranCare Merger primarily contributed to
the remaining $12.4 million increase.


The Year 2000 Issue

     In connection with the coming of the Year 2000, the Company is in the
process of evaluating and addressing issues that could arise in connection with
the potential inability of computer programs to recognize dates that follow
December 31, 1999 (the "Year 2000 Issue"). The Year 2000 Issue presents
potential problems not only for computer hardware and software but also for
devices that incorporate embedded chips, such as critical medical devices
utilized in the Company's facilities. To date, the Company's main focus with
respect to the Year 2000 Issue has been to ensure that its company-wide
information systems will function properly in the Year 2000 and beyond.  In
recent months the Company has began to focus its attention on the assessment
and remediation of embedded chip issues in its facilities. To address issues
inherent in operating disparate information systems utilized by the Company's
predecessor corporations, following the Apollo/LCA/GranCare Mergers the Company
decided to complete the installation of a new client-server based financial and
payroll/human resources software package. The installation of the new system is
in progress and the Company anticipates that it will be fully operational on or
about October 1, 1999. The Company expects that its corporate systems exposure
to the Year 2000 Issue will be substantially eliminated by approximately May
1999, at which time the Company's non-Year 2000 compliant corporate systems will
have been replaced. All other systems to be replaced are currently Year 2000
compliant. The Company has received assurances from the manufacturers that the
new systems are Year 2000 compliant. The implementation of these systems was not
in response to the Year 2000 Issue.

     In addition to its primary information systems, certain of the Company's
business lines also use business line specific information systems. In this
regard, the Company has formed a committee with members from each of the
Company's business lines as well as representatives from the purchasing, legal,
accounting, payroll, and risk management areas of the Company (the "Year 2000
Committee"). This committee reports to the Company's senior management and is
responsible for identifying those business line specific systems potentially
effected by the Year 2000 Issue, as well as identifying and inventorying those
medical devices in the Company's facilities that could be effected. The
Committee is in the process of evaluating the extent to which these systems or
medical devices may be impacted by the Year 2000 Issue. The Year 2000 Committee
has substantially completed the compilation of this data and plans to report its
initial assessment to the Company's Board of Directors on February 19, 1999.

     The Company is in the process of remediating all local area networks
("LANs"), software and individual computers and anticipates that the process
will be substantially complete by July 1999. With respect to these items, the
Company has not expended significant costs related to the Year 2000 Issue and is
remedying the Year 2000 Issue through replacing computers and software in the
ordinary course. On a going forward basis the Company is 

                                       23
<PAGE>
 
endeavoring to ensure that all software and hardware purchased is Year 2000
compliant through testing and inserting appropriate language into its purchase
contracts.

     The Company has also contacted, and will continue to contact, its key
suppliers to gain assurance that they will be year 2000 compliant. This process
will be ongoing, although most key suppliers who have responded to inquiries
have indicated that they expect to be Year 2000 compliant in a timely fashion.
In addition, because the Company maintains a broad base of vendors and
suppliers, it does not believe that it is at risk with respect to any individual
vendor or supplier who may be noncompliant.

     To date, the Company has expended $4.7 million to remedy problems
associated with the Year 2000 Issue and estimates that it will expend an
additional approximately $8.6 million in the future. This amount does not
include funds necessary to remedy Year 2000 Issues in the Company's facilities.

     The Company is aware of the potential for problems associated with the
heating, ventilation and air conditioning ("HVAC") and other systems in its
facilities, which may contain embedded chips that may cause these systems to
shut down following December 31, 1999. Although the Company is conducting a
facility by facility examination to determine which facilities and systems are
susceptible to the Year 2000 Issue, the Company does not believe that there is
significant risk in this area. Most of the Company's facilities are older and
thus do not have systems that are dependent on embedded chips. In the newer
facilities and those facilities where Year 2000 Issues are found to exist, the
Company plans on remediating any potential problems. The Company believes that
this remediation will be completed on or before July 1999 and that the costs
associated therewith, together with the costs of remedying issues with respect
to embedded chips, will approximate $3.0 million.

     With respect to the Company's customers, the largest source of the
Company's revenues is the state and federal governments through the Medicaid and
Medicare programs, respectively. The Company is reimbursed under these programs
through fiscal intermediaries. The Health Care Financing Administration
("HCFA"), the government agency that administers the Medicare program, had
previously publicly stated that it will be Year 2000 compliant by December 31,
1998 and had required all fiscal intermediaries to be Year 2000 compliant by the
same date. HCFA has also stated that it expects state Medicaid agencies to be
Year 2000 compliant by March 31, 1999. While HCFA has made no public
announcement as to whether fiscal intermediaries and state Medicaid agencies
have met this schedule, recent reports by the General Accounting Office report
that the various states may not currently be in compliance. With respect to
itself, HCFA recently issued a Provider Correspondence Letter dated January 12,
1999, available at HCFA's website (http://www.hcfa.gov/y2k/p1011299.htm),
                                  --------------------------------------
indicating that they have not yet met their schedule. This letter states that
HCFA's systems will function on January 1, 2000 and will be able to process
"acceptable" claims. The failure by HCFA to issue appropriate standards for
submitting claims in a timely fashion could affect the ability of the Company to
process claims in a timely fashion which could have a material adverse effect on
the Company. In addition, the Company has sent letters to its fiscal
intermediaries as to their readiness with respect to the Year 2000 Issue.
Because the Company has no control over these entities, in the event the fiscal
intermediaries and the state and federal governments are not Year 2000
compliant, the timely receipt of the Company's receivables may be adversely
affected. A significant delay in the receipt of its receivables would have a
material adverse effect on the Company's financial condition and results of
operations.

     The Company believes that the principal risks for the Company from the Year
2000 Issue are from the embedded computer chips found in certain critical
medical devices in the Company's facilities and from the potential for delay in
the receipt of payment from third-party payors. With respect to identified
medical devices, the Company is inventorying and evaluating the devices to
determine if they are susceptible to the Year 2000 Issue and, where appropriate,
contacting the manufacturers regarding remedying the Year 2000 Issue. In the
event the Company is unable to complete any required upgrades prior to December
31, 1999, the Company will remove the effected devices from service.

                                       24
<PAGE>
 
Liquidity and Capital Resources of the Company

     Cash and cash equivalents were $5.3 million at December 31, 1998. Working
capital was $356.7 million, an increase of $6.5 million during the quarter ended
December 31, 1998. Cash used in operations during the quarter was $37.8 million,
which was net of approximately $2.0 million in payments for indirect merger, and
other expenses. Accrued expenses and other current liabilities decreased by
$27.8 million during the quarter, related to decreased accruals for payroll
expenses and accrued interest expense. Both the decrease in accrued payroll
expenses and the decrease in accrued interest were attributable to timing
differences in payroll dates and the semi-annual interest payment dates on the
Company' Senior Subordinated Notes. Accounts payable decreased by $5.5 million
during the quarter, primarily as a result of timing differences on invoice
payment terms.

     The Company receives payment for nursing facility services based on rates
set by individual state Medicaid programs. Although payment cycles for these
programs vary, payments generally are made within 30 to 60 days after services
are provided. The federal Medicare program, currently changing from a cost-based
reimbursement program to fixed per diem amount under PPS (See "--Changes in
Healthcare Legislation"), with respect to those facilities still reimbursed on a
cost basis, pays interim rates based on estimated costs of services on a 30 to
45-day basis. Final cost settlements, based on the difference between audited
costs and interim rates are paid following final cost report audits by Medicare
fiscal intermediaries. Because of the cost report and audit process, final
settlement may not occur until up to 24 months after each facility's Medicare
year end. Additionally, receivables in respect of specialty medical services are
generally received on a delayed basis. The Company is also moving to a single
operating platform for the inpatient group's accounts receivable. At December
31, 1998, approximately 79% of the former GranCare facilities had been converted
to the Company's field-based accounts receivable system. All former Mariner
Health facilities are scheduled to be converted to the Company's field-based
accounts receivable system during fiscal 2000. The Company reviewed the aging of
the Mariner Health accounts receivable and related allowance for doubtful
accounts and concluded an additional charge was necessary. As a result, the
Company recorded a $24.3 million charge in order to conform the Mariner Health
reserve calculation to the calculation utilized by the Company.

     In July 1998 when PPS was initially implemented, the fiscal intermediaries
were not prepared to reimburse the Company and other providers under the new
system.  Accordingly, the fiscal intermediaries continued to reimburse providers
based on their interim payment rates.  Effective October 1, 1998, the fiscal
intermediaries were required to begin reimbursing providers based on the PPS
rates, and the Company believes that substantially all of the fiscal
intermediaries are in compliance.  With respect to the period between the
implementation of PPS and October 1, 1998, a settlement process will occur
whereby the difference between the PPS rate and the interim rate will be paid to
the provider or to the fiscal intermediary.  The Company only had 17 facilities
that might be affected by this settlement process and the Company does not
believe that this process will have a material effect on the Company's results
of operations.

     Once the fiscal intermediaries begin reimbursing providers based on the PPS
rates, the Company will submit claims monthly and be reimbursed 14 days
following the receipt by the fiscal intermediary of claims for which no dispute
is outstanding, and there will be no cost report and audit process.  The Company
has experienced a delay in the submission of its PPS claims for reimbursement
due to system conversion issues and the problems associated with adapting to a
new reimbursement system.  However, the Company does not believe that these
delays have had or will have a material adverse effect on the Company.

     In addition, the Company provides certain services between subsidiary
companies, some of which are charged at cost and others of which are charged at
market rates.  Subject to certain exceptions, Medicare's "related party rule"
generally requires that services between subsidiary companies or other entities
deemed to be related under the rule be charged at cost.  The Company believes
that the services that are charged at market rates qualify for an exception to
Medicare's related party rule. There can be no assurance, however, that HCFA
will accept the Company's position and the Medicare reimbursement received for
such services may be subject to audit and recoupment. In the event HCFA does not
agree with the Company's position, this may result in a reduction in
reimbursements in the future periods, and may have a material adverse effect on
the Company's business and results of operations.

     Cash used in investing activities was $10.7 million in the quarter ended
December 31, 1998, as compared to $22.1 million for the quarter ended December
31, 1997.  Investing activities for the quarter ended December 31, 

                                       25


<PAGE>
 
1998 included the use of $15.9 million related to capital expenditures. Capital
expenditures are expected to be funded by cash from operations or the Revolving
Credit Facility (defined below).

     Cash provided by financing activities was $50.6 million in the quarter
ended December 31, 1998, as compared to $93.9 million for the quarter ended
December 31, 1997.  Cash provided by financing activities included $67.0 million
in net draws under the Company's credit line, $8.7 million in principle
repayments on long-term debt, and $7.3 million in payments for financing fees
associated with certain amendments to the Company's long-term debt agreements.

     Senior Credit Facility.  In connection with the Recapitalization Merger,
the Company entered into the Senior Credit Facility, which originally consisted
of a $150.0 million revolving credit facility (the "Revolving Credit Facility"),
and three term loan credit facilities: a 6  1/2 year term loan facility in an
aggregate principal amount of $240.0 million (the "Tranche A Term Loan
Facility"), a 7 1/2 year term loan facility in an aggregate principal amount of
$250.0 million (the "Tranche B Term Loan Facility"), and an 8 1/2 year term loan
facility in an aggregate principal amount of $250.0 million (the "Tranche C Term
Loan Facility").  Loans made under the Tranche A Term Loan Facility ("Tranche A
Term Loans"), the Tranche B Term Loan Facility ("Tranche B Term Loans") and the
Tranche C Term Loan Facility ("Tranche C Term Loans") are collectively referred
to herein as "Term Loans."  Advances under the Revolving Credit Facility are
sometimes referred to as "Revolving Loans."  The proceeds from borrowings under
the Term Loans were used, along with the proceeds of the Notes (defined below)
offering, to fund a portion of the Recapitalization Merger, refinance a
significant portion of LCA's and GranCare's pre-merger indebtedness and to pay
costs and expenses associated with the Apollo/LCA/GranCare Mergers.

     In July 1998 the Revolving Credit Facility was increased to $175.0 million
and the Tranche A Term Loan Facility to $315.0 million in connection with the
Mariner Merger.  The proceeds of the $75.0 million increase in the Tranche A
Credit Facility and of certain Revolving Credit Loans were used to pay various
costs and expenses incurred in connection with the Mariner Merger.  As of
December 31, 1998, there was $78.5 million borrowed under the Revolving Credit
Facility and approximately $6.7 million in letters of credit outstanding.

     The obligations of the Company under the Senior Credit Facility are
guaranteed by substantially all of the Company's subsidiaries other than Mariner
Health and its subsidiaries, and are secured by substantially all of the
otherwise unencumbered owned assets of the Company and such subsidiary.

     Principal amounts outstanding under the Revolving Credit Facility will be
due and payable in April 2005.  The Term Loans are amortized in quarterly
installments which increase over the term of those loans (see note 6 to the
consolidated financial statements).  Interest on outstanding borrowings under
the Senior Credit Facility accrue, at the option of the Company, at the
Alternate Base Rate (the "ABR") of The Chase Manhattan Bank ("Chase") or at a
reserve-adjusted Eurodollar Rate (the "Eurodollar Rate"), plus, in each case, an
Applicable Margin.  The term "Applicable Margin" means a percentage that will
vary in accordance with a pricing matrix based upon the respective term loan
tenor and the Company's leverage ratio (see note 6 to the consolidated financial
statements).

     The Senior Credit Facility is subject to prepayment, in whole or in part,
at the Company's option and in certain minimum increments from time to time, and
is also subject to mandatory prepayment from the net cash proceeds received from
certain transactions.  Those transactions include the sale or issuance of equity
by the Company, the incurrence of certain indebtedness by the Company, and the
sale of certain assets where the net cash proceeds are not reinvested in the
Company's business within 12 months (6 months in certain cases).  The Company
must also make annual prepayments to the extent of 75% of its excess cash flow
for each fiscal year (reduced to 50% of excess cash flow once the Company's
leverage ratio as of the last day of any fiscal year is less than or equal to
4.50 to 1.00).  Mandatory prepayments will be applied pro rata to the unmatured
installments of the Term Loans; provided, however, that holders of Tranche B
Term Loans or Tranche C Term Loans may refuse any such mandatory prepayment
otherwise allocable to them, in which case the amount so refused will be applied
as an additional prepayment of the Tranche A Term Loans.  Amounts applied as
prepayments of the Revolving Credit Facility may be reborrowed; amounts prepaid
under the Term Loans may not be reborrowed.

                                       26
<PAGE>
 
     The covenants contained in the Senior Credit Facility, among other things,
require the Company to maintain certain financial ratios and restrict the
ability of the Company to dispose of assets, repay other indebtedness or amend
other debt instruments, pay dividends, make investments, and make acquisitions.
The Company received the consent of the requisite lenders under the Senior
Credit Facility to permit the Mariner Merger and certain covenants in the Senior
Credit Facility were modified to accommodate the Mariner Merger.  By amendment
effective December 22, 1998, certain of the Senior Credit Facility's financial
and operating covenants were amended to provide the Company with additional
flexibility, in return for which the Applicable Margins were increased (see note
6 to the consolidated financial statements).

     Senior Subordinated Notes.  In connection with the Apollo/LCA/GranCare
Mergers, on November 4, 1997 the Company completed a private offering to
institutional investors of $275 million of its 9.5% Senior Subordinated Notes
due 2007 (the "Senior Subordinated Notes"), at a price of 99.5% of face value
and $294 million of its 10.5% Senior Subordinated Discount Notes due 2007, at a
price of 59.6% of face value (collectively, the "Notes").  Interest on the
Senior Subordinated Notes is payable semi-annually.  Interest on the Senior
Subordinated Discount Notes will accrete until November 1, 2002 at a rate of
10.57% per annum, compounded semi-annually, and will be cash pay at a rate of
10.5% per annum thereafter.  The Notes will mature on November 1, 2007.  The net
proceeds from this offering, along with proceeds from the Senior Credit
Facility, were used to fund a portion of the Recapitalization Merger, refinance
a significant portion of LCA's and GranCare's pre-merger indebtedness and to pay
costs and expenses associated with the Apollo/LCA/GranCare Mergers.  Pursuant to
the terms of the indenture with respect to the Notes, in March 1998, the Company
completed an exchange offer with respect to the Notes whereby Notes registered
under the Securities Act of 1933, as amended, were exchanged for unregistered
Notes.  The terms of the exchange Notes are identical to the original Notes.
Mariner Health and its subsidiaries are "restricted subsidiaries" under the
indenture pursuant to which the Notes were issued.

     Other Significant Indebtedness and Commitments. The Company, through
various of its GranCare subsidiaries, is a party to various agreements between
GranCare and Health and Retirement Properties Trust ("HRPT").

     HRPT is the lessor with respect to certain facilities leased by two
subsidiaries of GranCare (the "Tenant Entities").  In connection with obtaining
HRPT's consent to the Apollo/LCA/GranCare Mergers, GranCare and HRPT executed a
Restructure and Asset Exchange Agreement dated October 31, 1997 pursuant to
which HRPT and GranCare restructured their relationship (the "HRPT/GranCare
Restructuring").  As a part of the HRPT/GranCare Restructuring, HRPT consented
to the consummation of the Apollo/LCA/GranCare Mergers and the transactions
related thereto, and HRPT received an unlimited guaranty by the Company and all
subsidiaries of the Company having an ownership interest in Tenant Entities
which guaranty is secured by a cash collateral deposit of $15 million, the
earned interest on which is retained by HRPT.  The performance by the Tenant
Entities of their respective obligations to HRPT continues to be secured by a
pledge of one million shares of HRPT common stock beneficially owned by GranCare
and, as part of the HRPT/GranCare Restructuring, GranCare agreed to waive the
ability to request a release of such collateral upon the attainment of certain
financial conditions.  Accordingly, the Company does not have the ability to
sell these shares to meet any capital requirements.

     Mariner Health Senior Credit Facility.  At the time of the Mariner Merger,
Mariner Health was the borrower under a $460.0 million revolving credit facility
(the "Mariner Health Senior Credit Facility"), by and among Mariner Health, the
lenders signatory thereto (the "Mariner Lenders"), and PNC Bank, National
Association ("PNC Bank"), as agent for the Mariner Lenders (the "Mariner
Agent"). The Mariner Health Senior Credit Facility expires on January 3, 2000.
The Company plans to refinance the outstanding indebtedness under the Mariner
Health Senior Credit Facility prior to December 31, 1999. However, no assurance
can be given that financing will be available on terms that are acceptable to
the Company.

     Outstanding advances under the Mariner Health Senior Credit Facility bear
interest at interest rates based, at the borrower's option, either on PNC Bank's
prime rate or on a Eurodollar-based rate, in each case plus an applicable margin
which can fluctuate based on a pricing matrix related to Mariner Health's
maximum leverage ratio.  The Mariner Health Senior Credit Facility contains
covenants which, among other things, require Mariner 

                                       27
<PAGE>
 
Health and its subsidiaries to maintain certain financial ratios and impose
certain limitations or prohibitions on Mariner Health with respect to the
incurrence of indebtedness, liens and capital leases; the payment of dividends
on, and the redemption or repurchase of, its capital stock; investments and
acquisitions, including acquisitions of new facilities; the merger or
consolidation of Mariner Health with any person or entity; and the disposition
of any of Mariner Health's properties or assets.

     Effective December 23, 1998, Mariner Health amended the Mariner Health
Senior Credit Facility (the "Mariner Health Senior Credit Facility Amendment")
(a) to reduce the amount of the revolving commitment from $460.0 million to
$250.0 million, (b) to provide additional financial covenant flexibility for
Mariner Health and its subsidiaries, (c) to modify certain of the financial and
operating covenants referred to in the immediately preceding paragraph, (d) to
increase the applicable interest rate margins (see footnote 6 to the financial
statements) and (e) to expand the amount and types of collateral pledged to
secure the Mariner Health Senior Credit Facility.

     Mariner Health's obligations under the Mariner Health Senior Credit
Facility are guaranteed by substantially all of its subsidiaries and are secured
by substantially all of the otherwise unencumbered assets of Mariner Health and
such subsidiary guarantors.

     Contemporaneously with the effectiveness of the Mariner Health Senior
Credit Facility Amendment, Mariner Health entered into a term loan agreement
dated as of December 23, 1998 (the "Mariner Term Loan Agreement") with PNC Bank,
as administrative agent, First Union National Bank, as syndication agent, and
the financial institutions signatory thereto as lenders (the "Term Lenders"),
pursuant to which the Term Lenders made a $210.0 million senior secured term
loan to Mariner Health (the "Mariner Term Loan").  Proceeds of the Mariner Term
Loan were applied to reduce outstanding amounts under the Mariner Health Senior
Credit Facility in connection with the Mariner Health Senior Credit Facility
Amendment.  The interest rate pricing and covenants contained in the Mariner
Health Term Loan Agreement are substantially similar to the corresponding
provisions of the Mariner Health Senior Credit Facility, as amended by the
Mariner Health Senior Credit Facility Amendment. The Mariner Term Loan matures
on January 3, 2000, is guaranteed by the same subsidiary guarantors as the
Mariner Health Senior Credit Facility, and is cross-defaulted and cross-
collateralized with the Mariner Health Senior Credit Facility. The Company plans
to refinance the outstanding indebtedness under the Mariner Health Senior Credit
Facility prior to December 31, 1999. However, no assurance can be given that
financing will be available on terms that are acceptable to the Company.

     As of December 31, 1998, approximately $155.5 million of loans and $12.0
million of letters of credit were outstanding under the Mariner Health Senior
Credit Facility, and all $210.0 million of the Mariner Health Term Loan was
outstanding.

     Mariner Health and its subsidiaries are treated as unrestricted
subsidiaries under the Senior Credit Facility.  Unlike other subsidiaries of the
Company (the "Non-Mariner Subsidiaries"), Mariner Health and its subsidiaries
neither guarantee the Company's obligations under the Senior Credit Facility nor
pledge their assets to secure such obligations.  Correspondingly, the Company
and the Non-Mariner Subsidiaries do not guarantee or assume any obligations
under the Mariner Health Senior Credit Facility or the Mariner Term Loan.
Mariner Health and its subsidiaries are not subject to the covenants contained
in the Senior Credit Facility, and the covenants contained in the Mariner Health
Senior Credit Facility and the Mariner Term Loan are not binding on the Company
and the Non-Mariner Subsidiaries.  Mariner Health and the Mariner Health
subsidiaries are obligated to continue to comply with the covenants contained in
the Mariner Health Senior Credit Facility and the Mariner Term Loan without
taking into account the revenues, expenses, net income, assets or liabilities of
the Company and the Non-Mariner Subsidiaries.  The converse is true with respect
to the Company, which (together with its Non-Mariner Subsidiaries) must continue
to comply with the covenants contained in its Senior Credit Facility without
taking into account the revenues, expenses, net income, assets or liabilities of
Mariner Health and its subsidiaries.

     Mariner Health Senior Subordinated Notes.  Mariner Health is also the
issuer of $150.0 million of 9 1/2% Senior Subordinated Notes due 2006 (the
"Mariner Notes") which were issued pursuant to an indenture dated as of 

                                       28
<PAGE>
 
April 4, 1996 (the "Mariner Indenture") with Mariner Health as issuer and State
Street Bank and Trust Company as trustee (the "Mariner Trustee"). The Mariner
Notes are obligations solely of Mariner Health and are not guaranteed by the
Company or any of its subsidiaries.

     As a consequence of the Mariner Merger and the resulting change of control
at Mariner Health, the holders of the Mariner Notes had the right under the
Mariner Indenture to require that their Mariner Notes be purchased (the "Change
of Control Purchase") at a purchase price equal to 101% of the outstanding
principal amount of the Mariner Notes purchased.  Effective on September 11,
1998, Mariner and the Mariner Trustee entered into an amendment to the Mariner
Indenture which permitted Mariner to designate a third-party to purchase any
Mariner Notes tendered pursuant to the Change of Control Purchase.  Mariner
Health designated a financial institution as a third-party purchaser, and on
September 21, 1998 such financial institution acquired all $40,661,000 of the
Mariner Notes tendered in connection with the Change of Control Purchase (the
"Tendered Mariner Notes").  In agreeing to act as third-party purchaser, the
financial institution required the Company to enter into a total return swap
agreement (the "Total Return Swap"), with the financial institution as
counterparty.  See "Quantitative and Qualitative Disclosures about Market Risk."
The Tendered Mariner Notes remain outstanding and are owned and controlled by
such third-party purchaser.  The Company's obligations under the Total Return
Swap are guaranteed by Mariner Health and substantially all of the subsidiaries
of Mariner Health.  During the quarter ended December 31, 1998, an additional
$6.0 million of the Mariner Notes were acquired by such financial institution
and made a part of the Total Return Swap.
 
     Healthcare Regulatory Matters.   The Balanced Budget Act enacted in August
1997 (the "Balanced Budget Act"), contains numerous changes to the Medicare and
Medicaid programs with the intent of slowing the growth of payments under these
programs by $115.0 billion and $13.0 billion, respectively, through the year
ended 2002.  Approximately 50% of the savings will be achieved through a
reduction in the growth of payments to providers and physicians.

     The Balanced Budget Act amended the Medicare program by revising the
payment system for skilled nursing services.  Historically, nursing homes were
reimbursed by the Medicare program based on the actual costs of services
provided.  However, the Balanced Budget Act required the establishment of a PPS
system for nursing homes for cost reporting periods beginning on or after July
1, 1998.  Under PPS, nursing homes receive a fixed per diem rate for each of
their Medicare Part A patients which, during the first three years, is based on
a blend of facility specific rates and Federal acuity adjusted rates.
Thereafter, the per diem rates will be based solely on Federal acuity adjusted
rates.  Subsumed in this per diem rate are ancillary services, such as pharmacy
and rehabilitation services, which historically have been provided to many of
the Company's nursing facilities by the Company's pharmacy and therapy
subsidiaries.

     The Balanced Budget Act also required the establishment of an interim
payment system for home health services for cost reporting periods beginning on
or after October 1, 1997.  The interim payment system continues per visit limits
and establishes new per beneficiary annual cost limits.  A permanent prospective
payment system for home health services will be established by October 1, 2000.

     On May 12, 1998, the Health Care Financing Administration released the
nursing home PPS rates for Part A Medicare Patients that are in effect from July
1, 1998 through September 30, 1999.  The Company's experience thus far under PPS
indicates that PPS has resulted in more intense price competition and lower
margins among ancillary service providers (including the Company's pharmacy,
therapy, and hospital services subsidiaries) as well as lower overall
reimbursement and margins for the Company's skilled nursing facilities.

     The Balanced Budget Act also repealed the Boren Amendment ("Boren"), which
had required state Medicaid programs to reimburse nursing facilities for the
costs that are incurred by efficiently and economically operated providers in
order to meet quality and safety standards.  Because of the repeal of Boren,
states now have considerable flexibility in establishing Medicaid payment rates.
In addition, Boren provided a dispute resolution mechanism whereby providers
could challenge Medicaid rates set by the various states, the repeal of which
will now make it more difficult to challenge these rates in the future.  The
Company is not able to predict whether any 

                                       29
<PAGE>
 
states will adopt changes in their Medicaid reimbursement programs, or, if
adopted and implemented, what effect such initiatives would have on the Company.

     On January 30, 1998, the Health Care Financing Administration issued its
new salary equivalency guidelines which change Medicare reimbursement rates for
contracted therapy services.  Under salary equivalency, the Company is
reimbursed for contracted therapy services based on the time spent on the
premises by the contract therapist times a fixed rate, depending on the service
provided.  While the new rates for physical therapy represent an increase over
what the Company previously received for such services, the new rates for
occupational therapy and speech language pathology represent decreases from what
the Company previously received.  The salary equivalency guidelines will remain
in effect until the facility at which such services are provided, including the
Company's facilities and other facilities serviced by the Company's therapy
subsidiaries, start billing under PPS.  The Company believes that while salary
equivalency had a slight adverse effect on its therapy revenue, the Company does
not believe that salary equivalency has had a material adverse effect on the
Company's consolidated revenues.

     The Balanced Budget Act also revised the reimbursement methodology for
therapy services under Medicare Part B.  Historically, Medicare Part B therapy
services were reimbursed based on the cost of the services provided, subject to
prudent buyer and salary equivalency restrictions.  In November 1998, certain
fee screen schedules were published setting forth the amounts that can be
charged for specific therapy services.  Additionally, the Balanced Budget Act
set forth maximum per beneficiary limits of $1,500 per provider for physical
therapy and speech pathology and $1,500 per provider for occupational therapy.
Both the fee screens and per beneficiary limits are effective for services
rendered following December 31, 1998.  The fee screens have only recently been
published and implemented and the Company has not yet determined what effect
they will have on the Company's results of operations.  In the event that the
fee screens are not sufficient to cover the cost of the therapy services
provided, they would have a material adverse effect on the Company.

     Certain Medicare fiscal intermediaries have made audit adjustments to
settle cost reports for some of the Company's facilities that reduce the amount
of reimbursement that was previously received by the facilities.  The Company is
appealing these adjustments, certain of which are significant.  Certain of these
are based on the fiscal intermediaries' denials of the exception to the related
organizations principle with regard to services and supplies furnished by the
Company's pharmacy and rehabilitation divisions to its nursing facilities, and
reductions to costs claimed for therapy services for alleged failures to comply
with prudent buyer requirements.

     The prudent buyer principle states, in part, "the prudent and cost-
conscious buyer not only refuses to pay more than the going price for an item or
service, he also seeks to economize by minimizing cost." Some of the fiscal
intermediaries have alleged that the Company was not prudent in its purchasing
of occupational therapy and speech pathology services prior to HCFA's
establishing salary equivalency guidelines for these services effective in April
1998.  Adjustments have been made in settling cost reports that reduced the cost
from the amounts that were paid to contract therapy providers to the amount that
the intermediary calculated would have been paid if the facility had employed
therapists to provide services.  Appeals were filed with the Provider
Reimbursement Review Board ("PRRB") and resulted in a favorable outcome.
However, on review the Social Security Administrator reversed the PRRB and
allowed the intermediary's adjustments.  The Company believes that it has
substantial arguments to support its position that the contested costs are
allowable and the issue is being pursued through the appropriate legal
processes.  There can be no assurance that the Company will prevail or that it
will not be required to expend significant amounts to complete the appeal
process.  In addition contracts for therapy services generally provide for the
therapy provider to indemnify the nursing facility in the event of denials or
cost report disallowances.  There can be no assurance that the therapy providers
will not contest the indemnity provisions of the contracts or that they will be
able to fund the indemnity provisions.

     The related organization principle states, in part, "a provider's allowable
cost for services, facilities, and supplies furnished by a party related to the
provider are the costs the related party incurred in furnishing the items in
question." The regulations provide for an exception to the related organization
principle if certain requirements are met and the Company believes that it meets
these requirements with respect to its pharmacy and rehabilitation companies.
Some fiscal intermediaries have denied the request for exception and have made
adjustments to reduce 

                                       30
<PAGE>
 
the allowable cost that is included in nursing facility cost reports to the cost
of the related organization. The Company has requested PRRB appeals for these
adjustments, but the appeals have not yet been heard. The Company believes that
it has substantial arguments to support its position that the facilities should
have an exception to the related organization principle. However, there can be
no assurance that the Company will prevail or that it will not be required to
expend significant amounts to complete the appeal process.

     Other Factors Affecting Liquidity and Capital Resources. In addition to
principal and interest payments on its long-term indebtedness, the Company has
significant rent obligations relating to its leased facilities.  The Company's
estimated principal payments, cash interest payments, and rent obligations for
fiscal year 1999 are approximately $295 million.

     The Company's operations require capital expenditures for renovations of
existing facilities in order to continue to meet regulatory requirements, to
upgrade facilities for the treatment of subacute patients and to accommodate the
addition of specialty medical services, and to improve the physical appearance
of its facilities for marketing purposes.  The Company estimates that total
capital expenditures for the year ending September 30, 1999 will be
approximately $79.3 million of which $38.0 million is estimated to be
maintenance capital expenditures.

     In addition to the Senior Credit Facility, the Company has a lease
arrangement providing for up to $100.0 million to be used as a funding mechanism
for future skilled nursing facility construction, lease conversions, and other
facility acquisitions (the "Synthetic Lease").  This leasing program allows the
Company to complete these projects without committing significant financing
resources.  The lease is an unconditional "triple net" lease for a period of
seven years with the annual lease obligation a function of the amount spent by
the lessor to acquire or construct the project, a variable interest rate, and
commitment and other fees.  The Company guarantees a minimum of approximately
83% of the residual value of the leased property and also has an option to
purchase the properties at any time prior to the maturity date at a price
sufficient to pay the entire amount financed, accrued interest, and certain
expenses.  At December 31, 1998, approximately $48.6 million of this leasing
arrangement was utilized.  The leasing program is accounted for as an operating
lease.  The Synthetic Lease was amended on December 23, 1998 to mirror certain
changes made to the Senior Credit Facility.

     The Company has experienced an increasing trend in the past year in the
number and severity of litigation claims asserted against the Company.
Management believes that this trend is endemic to the long-term care industry
and is a result of several large judgments against long-term care providers
other than the Company in the last year resulting in an increased awareness by
plaintiff's lawyers of potentially large recoveries.  The Company also believes
that there has been, and will continue to be, an increase in governmental
investigatory activity of long-term care providers, particularly in the area of
false claims.  While the Company believes that it provides quality care to the
patients in its facilities and materially complies with all applicable
regulatory requirements, an adverse determination in a legal proceeding or
governmental investigation, whether currently asserted or arising in the future,
could have a material adverse effect on the Company.  See "Legal Proceedings."

     The Company currently maintains two captive insurance subsidiaries to
provide for reinsurance obligations under workers' compensation, general and
professional liability, and automobile liability for periods ended prior to
April 1, 1998.  These obligations are funded with long-term, fixed income
investments which are not available to satisfy other obligations of the Company.

     The Mariner Health Senior Credit Facility generally prohibits Mariner
Health from paying dividends or making distributions to the Company, except as
follows: (a) Mariner Health can make a one-time dividend (which has not yet been
utilized) to the Company in an amount not to exceed Mariner Health's
consolidated net income for the most recent 12 fiscal months subject to the
absence of any default under the Mariner Health Senior Credit Facility or the
Mariner Health Term Loan Facility, and subject further to demonstrating pro
forma compliance with certain financial covenants and; (b) Mariner Health may
reimburse the Company for ordinary course of business expenses paid by the
Company on behalf of Mariner Health or its subsidiaries.  By amendments
effective as of January 19, 1999, the Mariner Health Senior Credit Facility and
the Mariner Health Term Loan Facility were each amended to allow Mariner Health
also to make a dividend or distribution of up to $25.0 million to the Company to
enable the Company to purchase Mariner Notes pursuant to the Total Return Swap
or to otherwise satisfy the 

                                       31
<PAGE>
 
Company's obligations under the Total Return Swap, subject to the absence of any
default under the Mariner Health Senior Credit Facility or the Mariner Health
Term Loan Facility, and subject further to demonstrating pro forma compliance
with certain financial covenants thereunder. In the judgment of the Company's
senior management, these restrictions have not had, and are not expected to
have, a material effect on the ability of the Company to meet its obligations.

     The Company believes that the cash flow generated from its operations, the
Company's cash and cash equivalents, together with amounts available under the
Senior Credit Facility and the Mariner Health Senior Credit Facility, should be
sufficient to fund its debt service requirements, working capital needs,
anticipated capital expenditures and other operating expenses in the immediate
future.  However, the Company is not able to predict at this time the effect of
certain regulatory initiatives, particularly PPS, on the Company's cash
position in the future.  The Revolving Credit Facility provides the Company with
revolving loans in an aggregate principal amount at any time not to exceed $175
million, of which $89.8 million was available at December 31, 1998 after
considering $6.7 million in outstanding letters of credit and the $78.5 million
borrowed.  Also as of such date, $82.5 million was available under the Mariner
Health Senior Credit Facility out of the maximum revolving credit commitment of
$250 million, after taking into account $155.5 million in outstanding revolving
loans and $12.0 million in outstanding letters of credit made or issued pursuant
to the Mariner Health Senior Credit Facility.  The Company's future operating
performance and ability to service or refinance the Notes, the Mariner Health
Senior Credit Facility, the Mariner Health Term Loan and the Mariner Notes and
to extend or refinance the Mariner Health Senior Credit Facility will be subject
to future economic conditions and to financial, business and other factors, many
of which are beyond the Company's control.  In order to improve its cash
position and leveraged capital structure, the Company is evaluating alternatives
with respect to certain of its facilities and product groups, which may result
in the divestiture of certain assets during fiscal 1999.  The proceeds from any
divestiture generally would be used to pay down the Company's indebtedness.

     The Mariner Indenture contains a restriction which, with the exception of
certain indebtedness that is expressly excluded from the incurrence test
described in this paragraph ("Permitted Mariner Health Debt"), only permits
Mariner Health and its subsidiaries to incur indebtedness if, after giving pro
forma effect to such incurrence, Mariner Health's consolidated coverage ratio
would equal or exceed 2.25 to 1.00 for the most recently completed four fiscal
quarter period.  This test is not a financial condition which Mariner Health is
required to maintain under the terms of the Mariner Indenture but rather is a
condition to incurring additional debt.  Mariner Health's consolidated coverage
ratio for the four fiscal quarters ended December 31, 1998 was less than 2.25 to
1.00.  Accordingly, until its consolidated coverage ratio for the four trailing
fiscal quarters once again equals or exceeds 2.25 to 1.00, Mariner Health and
its subsidiaries will not be permitted under the Mariner Health Indenture to
incur indebtedness other than Permitted Mariner Health Debt.  Since indebtedness
now or hereafter incurred under the Mariner Health Senior Credit Facility
constitutes Mariner Health Permitted Debt, Mariner Health can continue to obtain
advances thereunder (subject to the other funding conditions contained therein);
consequently, the inability of Mariner Health and its subsidiaries to incur debt
other than Mariner Health Permitted Debt is not expected to have a material
adverse affect on the liquidity of Mariner Health and its subsidiaries.

     In addition, so long as Mariner Health's consolidated coverage ratio for
the trailing four-quarter period is less than 2.25 to 1.00, Mariner Health will
not be allowed to make dividends or distributions to the Company, except for
certain restricted payments expressly permitted under the Mariner indenture.  As
a result thereof, all or a portion of the net income (loss) of Mariner Health
and its subsidiaries may have to be excluded from the Company's consolidated net
income for purposes of determining compliance with the consolidated coverage
incurrence test contained in the indenture pursuant to which the Notes were
issued (the "Company Indenture").  As of December 31, 1998, the Company's
consolidated coverage ratio met the 1.75 to 1.00 incurrence test.  However,
because the incurrence of certain indebtedness is not subject to such incurrence
test, even assuming that the Company were not to meet the incurrence test under
the Company Indenture, any resulting restriction against the incurrence of
additional debt is not expected to have a material adverse impact on the ability
of the Company to conduct its business and to fulfill its projected liquidity
needs.

     Impact of Inflation.  The health care industry is labor intensive.  Wages
and other labor-related costs are especially sensitive to inflation.  Increases
in wages and other labor-related costs as a result of inflation or the 

                                       32
<PAGE>
 
increase in minimum wage requirements without a corresponding increase in
Medicaid and Medicare reimbursement rates would adversely impact the Company. In
certain of the markets where the Company operates there is a labor shortage that
could have an adverse effect upon the Company's ability to attract or retain
sufficient numbers of skilled and unskilled personnel at reasonable wages.
Accordingly, rising wage rates could have an adverse effect on the Company in
certain of its markets.


Cautionary Statements

     Information provided herein by the Company contains, and from time to time
the Company may disseminate materials and make statements which may contain
"forward-looking" information, as that term is defined by the Private
Securities Litigation Reform Act of 1995 (the "Act"). In particular, the
information contained in "Management's Discussion and Analysis of Financial
Position and Results of Operations--Liquidity and Capital Resources" contains
information concerning the ability of the Company to service its debt
obligations and other financial commitments as they come due; and "Management's
Discussion and Analysis of Financial Condition and Results of Operations--Year
2000" contains information concerning management's belief regarding the
Company's and third parties' readiness to face the Year 2000 issue. The
aforementioned forward looking statements, as well as other forward looking
statements made herein, are qualified in their entirety by these cautionary
statements, which are being made pursuant to the provisions of the Act and with
the intention of obtaining the benefits of the "safe harbor" provisions of the
Act.

     The Company cautions investors that any forward-looking statements made by
the Company are not guarantees of future performance and that actual results may
differ materially from those in the forward-looking statements as a result of
various factors, including, but not limited to, the following:

   (i) In recent years, an increasing number of legislative proposals have been
       introduced or proposed by Congress and in some state legislatures which
       would effect major changes in the healthcare system. However, the Company
       cannot predict the type of healthcare reform legislation which may be
       proposed or adopted by Congress or by state legislatures. Accordingly,
       the Company is unable to assess the effect of any such legislation on its
       business. There can be no assurance that any such legislation will not
       have a material adverse impact on the future growth, revenues and net
       income of the Company.

  (ii) The Company derives substantial portions of its revenues from third-party
       payors, including government reimbursement programs such as Medicare and
       Medicaid, and some portions of its revenues from nongovernmental sources,
       such as commercial insurance companies, health maintenance organizations
       and other charge-based contracted payment sources. Both government and
       non government payors have undertaken cost-containment measures designed
       to limit payments to healthcare providers. There can be no assurance that
       payments under governmental and nongovernmental payor programs will be
       sufficient to cover the costs allocable to patients eligible for
       reimbursement, especially with the implementation of PPS and fee screens
       with respect to therapy services. The Company cannot predict whether or
       what proposals or cost-containment measures will be adopted in the future
       or, if adopted and implemented, what effect, if any, such proposals might
       have on the operations of the Company.

 (iii) The Company is subject to extensive federal, state and local regulations
       governing licensure, conduct of operations at existing facilities,
       construction of new facilities, purchase or lease of existing facilities,
       addition of new services, certain capital expenditures, cost-containment
       and reimbursement for services rendered. The failure to obtain or renew
       required regulatory approvals or licenses, the failure to comply with
       applicable regulatory requirements, the delicensing of facilities owned,
       leased or operated by the Company or the disqualification of the Company
       from participation in certain federal and state reimbursement programs,
       or the imposition of harsh enforcement sanctions could have a material
       adverse effect upon the operations of the Company.

                                       33
<PAGE>
 
  (iv) There can be no assurance that the Company will be able to continue its
       growth or be able to fully implement its strategy to develop and its
       business strategies for its inpatient services, pharmaceutical services,
       rehabilitation services, or specialty services divisions.

   (v) With respect to the year 2000 disclosure contained in Management's
       Discussion and Analysis of Financial Position and Results of Operations-
       Year 2000, management is unable to predict the extent to which its third-
       party payors will be affected by the Year 2000 Issue or the extent to
       which it will be able to remedy issues associated with embedded chips in
       critical medical devices located in the Company's facilities, which may
       malfunction as a result of the Year 2000 Issue.

  (vi) There can be no assurance that an adverse determination in a legal
       proceeding or governmental investigation, whether currently asserted or
       arising in the future, will not have a material adverse effect on the
       Company.

 (vii) There can be no assurances that the Company will be able to refinance
       outstanding indebtedness maturing in January 2000 on terms that are
       acceptable to the Company.



Item 3.   Quantitative and Qualitative Disclosure About Market Risk

     The Company periodically enters into interest rate swap agreements (the
"Swap Agreements") to manage its interest rate risk. The Swap Agreements
effectively convert a portion of the Company's floating interest rate debt to
fixed interest rate debt. Notional amounts of interest rate agreements are used
to measure interest to be paid or received relating to such agreements and do
not represent an amount of exposure to credit loss. As of December 31, 1998, the
Company had Swap Agreements in effect totaling $60.0 million notional amount of
which $40.0 million will mature in July 2005 and $20.0 million will mature in
November 2005. Under the Swap Agreements, the Company pays interest at an
average fixed rate of 6.79% and receives interest at a rate of three-month
LIBOR. At December 31, 1998, the fair market value of the Swap Agreements would
represent a loss of approximately $4.8 million for the Company. 

     Additionally, the Company has entered into a total return swap agreement
relating to approximately $43.7 million face amount of Mariner Notes (the
"Total Return Swap Agreement"). The Total Return Swap Agreement provides for
the Company to receive 9.5% interest on approximately $43.7 million of Mariner
Notes and to pay interest at one-month LIBOR plus 2.25%. Upon expiration of the
Total Return Swap, if not extended, the Company has the right, but not the
obligation, to purchase the Mariner Notes. If the Company chooses not to
purchase the Mariner Notes, it is responsible for any decrease in the market
value and receives the benefit of any increase in market value realized by the
third party purchase. At December 31, 1998, the fair market value of the Total
Return Swap Agreement would represent a gain to the Company of approximately
$0.4 million. Although the market value of the Mariner Notes has not been
directly related to interest rate movements in recent months, to the extent
interest rate movements impact the market value of the Mariner Notes, such
fluctuations would affect the Company's obligations at expiration of the Total
Return Swap Agreement.

     The fair market values expressed in this section are based upon discounted 
cash flow analysis and negotiations with third parties willing to assume the 
Swap Agreements and the Total Return Swap. The fair market values of the Swap 
Agreements and the Total Return Swap vary with the fluctuation of LIBOR. As a
result, the principal market risk to the Company arising from the agreements
would be a sharp change in LIBOR. A sharp decline in LIBOR would decrease the
fair market value of the Swap Agreements. Conversely, a similar decline in
LIBOR would increase the fair market value of the Total Return Swap. The Company
does not believe that either a significant increase or decrease in LIBOR would
have a material adverse effect of the Company with respect to either the Swap
Agreements or the Total Return Swap.

                                       34
<PAGE>
 
PART II.  OTHER INFORMATION

Item 1.   Legal Proceedings

     As is typical in the healthcare industry, the Company is and will be
subject to claims that its services have resulted in resident injury or other
adverse effects, the risks of which will be greater for higher acuity residents
receiving services from the Company than for other long-term care residents. The
Company is, from time to time, subject to such negligence claims and other
litigation. In addition, resident, visitor and employee injuries will also
subject the Company to the risk of litigation. The Company has experienced an
increasing trend in the past year in the number and severity of litigation
claims asserted against the Company. Management believes that this trend is
endemic to the long-term care industry and is a result of several large
judgments against long-term care providers, other than the Company, in the last
year resulting in an increased awareness by plaintiff's lawyers of potentially
large recoveries. The Company also believes that there has been, and will
continue to be, an increase in governmental investigations of long-term care
providers, particularly in the area of false claims, as well as an increase in
enforcement actions resulting from the investigations. While the Company
believes that it provides quality care to the patients in its facilities and
materially complies with all applicable regulatory requirements, an adverse
determination in a legal proceeding or governmental investigation, whether
currently asserted or arising in the future, could have a material adverse
effect on the Company.

     From time to time, the Company and its subsidiaries have been parties to
various legal proceedings in the ordinary course of their respective businesses.
In the opinion of management, except as described in the Company's Annual Report
on Form 10-K for the year ended September 30, 1998 and in Note 9 to the
Condensed Consolidated Financial Statements appearing elsewhere herein, (from
which there were no material developments during the three month period ended
December 31, 1998), there are currently no proceedings which, individually or in
the aggregate, if determined adversely to the Company and after taking into
account the insurance coverage maintained by the Company, would have a material
adverse effect on the Company's financial position or results of operations.

 

                                       35
<PAGE>
 
Item 2.  Changes in Securities and Use of Proceeds

            None

Item 3.  Defaults Upon Certain Securities

            None

Item 4.  Submission of Matters to a Vote of Security Holders

            None

Item 5.  Other Information

            None

Item 6.  Exhibits and Reports on Form 8-K

     (a) Exhibits

 
         10.1   Employment Agreement between the Registrant and George Morgan,
                  dated January 25, 1999.
 
         10.2   Employment Agreement between the Registrant and C. Christian
                  Winkle, dated January 20, 1999.
 
         10.3   Amended and Restated $250,000,000 Revolving Credit Facility
                  Credit Agreement (the "Mariner Health Credit Agreement")
                  (through Amendment No. 19) dated, as amended, as of January
                  19, 1999, by and among Mariner Health, PNC Bank, as
                  Administrative Agent, First Union, as Syndication Agent, and
                  the financial institutions referred to therein.
                  
         10.4  Amendment No. 19 to Mariner Health Credit Agreement dated as of
                  January 19, 1999.
 
         10.5  Amended and Restated $210,000,000 Term Loan Facility Credit
                  Agreement (the "Mariner Health Term Loan Agreement"), dated,
                  as amended, as of January 19, 1999, by and among Mariner
                  Health, PNC Bank, as Administrative Agent, First Union, as
                  Syndication Agent, and the financial institutions referred to
                  therein
                  
         10.6  Amendment No. 1 to Mariner Term Loan Agreement dated as of
                  January 19, 1999.
                             
         27    Financial Data Schedule

     (b) Reports on Form 8-K

            None

                                       36
<PAGE>
 
                                   SIGNATURES

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

                                MARINER POST-ACUTE NETWORK, INC.
                                (Registrant)


                                By:  /s/ George D. Morgan
                                    ----------------------- 
                                         George D. Morgan
                                         Senior Vice President and Chief 
                                         Financial Officer


                                By:  /s/ Ronald W. Fleming
                                    ------------------------ 
                                         Ronald W. Fleming
                                         Vice President, Controller and Chief
                                         Accounting Officer


Date: February 15, 1999