<PAGE>
 
                                                                   EXHIBIT 10.29

                       AUTOMATIC LIQUID PACKAGING, INC.

                         PROCESSING SERVICES AGREEMENT

                                        

          This PROCESSING SERVICES AGREEMENT is made and effective as of May 5,
1998 (the "Effective Date"), by and between PathoGenesis Corporation and
Automatic Liquid Packaging, Inc. (each singularly a "Party" and collectively the
"Parties"):

     A.   PathoGenesis has developed TOBI(TM), which is produced from Bulk
Chemical (as defined below); PathoGenesis has need for Processing of TOBI as set
forth below; and

     B.   ALP possesses suitable facilities and capacity for Processing in
accordance with the Specifications; and

     C.   PathoGenesis and ALP desire to contract for such Processing on the
terms and conditions set forth below.

     NOW, THEREFORE, in consideration of the mutual covenants and conditions set
forth below, the Parties agree as follows:

                            SECTION 1:  DEFINITIONS

     The following terms have the following meanings in this Agreement:

1.1  "Actual Yield" means the number of ampules of Finished Product actually
      ------------                                                          
     produced from a Batch.

1.2  "Agreement" means this Processing Services Agreement, including any
      ---------                                                         
     exhibits, schedules or attachments attached and incorporated into this
     Agreement (including the Specifications), and any valid amendments to any
     of the foregoing.

1.3  "ALP" means Automatic Liquid Packaging, Inc., an Illinois corporation, and
      ---                                                                      
     its successors and permitted assigns.

1.4  "ALP Materials" means all materials other than PathoGenesis Materials
      -------------                                                       
     required for Processing, including Primary Packaging Materials.

1.5  "Batch" means a single lot comprised of the number of Dosage Containers the
      -----                                                                     
     Parties may agree upon in writing from time to time.

1.6  "Bulk Chemical" means Tobramycin raw material provided to ALP by
      -------------                                                  
     PathoGenesis for Processing.

1.7  "Campaign" means Processing of a Batch or Batch(es) during a specified time
      --------                                                                  
     period without interruption (except as is procedurally necessary between
     Batches).

1.8  "cGMPs" mean the current Good Manufacturing Practices for Finished
      -----                                                            
     Pharmaceuticals pursuant to 21 C.F.R 221 et seq., as amended from time to
                                              ------                          
     time.
<PAGE>
 
1.9  "Commencement Date" is defined in Section 3.1(c).
      -----------------                               

1.10 "Completion Date" is defined in Section 3.1(c).
      ---------------                               

1.11 "Dosage Container" means any final dosage form container(s) the Parties
      ----------------                                                      
     may agree upon in writing from time to time.

1.12 "Effective Date" is defined in the introductory paragraph.
      --------------                                           

1.13 "Facilities" means [**********], located at 2200 West Lake Shore Drive,
      ----------                                                            
     Woodstock, Illinois 60098, or such other production suite, designated by
     ALP in a written notice to PathoGenesis, that has been validated and
     approved by the Regulators for Processing prior to any change in
     Facilities.

1.14 "Finished Product" means Bulk Chemical Processed into Dosage Containers
      ----------------                                                      
     and packaged with Secondary Packaging Materials.

1.15 "Non-conforming Finished Product" is defined in Section 4.2.
      -------------------------------                            

1.16 "PathoGenesis" means PathoGenesis Corporation, a Delaware corporation, and
      ------------                                                             
     its successors and permitted assigns.

1.17 "PathoGenesis Equipment" is defined in Section 2.2.
      ----------------------                            

1.18 "PathoGenesis Materials" means all Bulk Chemical, and excipients listed in
      ----------------------                                                   
     the Specifications, including [**********] Secondary Packaging Materials
     that PathoGenesis provides to ALP for Processing.

1.19 "Planning Value" means the predicted Actual Yield that is used for
      --------------                                                   
     production planning purposes, e.g. forecasting and scheduling.

1.20 "Primary Packaging Materials" means all plastic resin and other materials
      ---------------------------                                             
     used to create Dosage Containers, e.g., [**********].

1.21 "Process" or "Processing" means the formulation and compounding of TOBI,
      -------      ----------                                                
     the aseptic filling of Dosage Containers, the packaging of filled sterile
     Dosage Containers to produce Finished Product for PathoGenesis, and the
     testing of such Finished Product, in accordance with this Agreement
     (including the Specifications).

1.22 "Processing Fees" are defined in Section 6.1.
      ---------------                             

1.23 "Processing Plan" is defined in Section 3.1.
      ---------------                            

1.24 "Proprietary Information" is defined in section 9.2.
      -----------------------                            

1.25 "Regulators" means the United States Food and Drug Administration (the
      ----------                                                           
     "FDA") and any other governmental entity (federal, state, local or foreign)
     with jurisdiction over Processing under this Agreement.

* Confidential treatment is requested; filed separately with the Securities and
  Exchange Commission.

                                       2
<PAGE>
 
1.26 "Secondary Packaging Materials" means all pouches, labels, shipping
      -----------------------------                                     
     containers and other materials required under the Specifications to package
     filled, sealed and sterile Dosage Containers as Finished Product ready for
     shipment.

1.27 "Specifications" means the procedures, requirements, standards, quality
      --------------                                                        
     control testing and other data and the scope of services, as all of the
     foregoing are set forth in Exhibit A (master batch record), Exhibit B
     (manufacturing specifications as contained in the Chemistry, Manufacturing
     and Controls section of PathoGenesis' New Drug Application for TOBI filed
     with the FDA, No. 50-753) attached and incorporated into this Agreement,
     and any valid amendments or modifications to any of the foregoing.  The
     Specifications may be amended upon mutual written agreement of the Parties,
     with amendments to Processing Fees as necessary under Section 6.3.  If
     there is any conflict between the terms of the Specifications and the other
     provisions of this Agreement, the Specifications will control.

1.28 "Supply Forecast" is defined in Section 3.1.
      ---------------                            

1.29 "Term" is defined in Section 8.1.
      ----                            

1.30 "Theoretical Yield" means the number of ampules of Finished Product that
      -----------------                                                      
     could be produced from a Batch in the absence of operating waste,
     rejections, or other inefficiencies.

1.31 "TOBI" means TOBI(TM) , which is Tobramycin solution for inhalation for
      ----                                                                  
     any indication.

                 SECTION 2:  PROCESSING SUPPLIES AND EQUIPMENT

2.1  Processing Supplies.  Subject to the other terms of this Agreement, during
     -------------------                                                       
     the Term:

     (a)  ALP Materials.  ALP will make available at the Facilities for
          -------------                                                
          Processing all ALP Materials in quantities sufficient to meet each
          Processing Plan.  ALP warrants and covenants that all ALP Materials
          will meet applicable Specifications and will have been produced in
          compliance with all applicable laws and regulations (including cGMPs).

     (b)  PathoGenesis Materials.  At no cost to ALP, PathoGenesis will supply
          ----------------------                                              
          to ALP for Processing all PathoGenesis Materials in quantities
          sufficient to meet each Processing Plan.  Provided that ALP complies
          with Section 2.4 regarding storage and handling of PathoGenesis
          Materials, PathoGenesis warrants and covenants that all PathoGenesis
          Materials will meet applicable Specifications and will have been
          produced in compliance with all applicable laws and regulations
          (including cGMPs).  PathoGenesis will supply PathoGenesis Materials
          for Processing for a Campaign no later than ten business days before
          the scheduled Commencement Date for the Campaign.  Prior to
          Processing, ALP will test all PathoGenesis Materials received in
          accordance with the Specifications, and will notify PathoGenesis of
          any non-conforming test results.  ALP will Process only Batches
          authorized for Processing by PathoGenesis.  PathoGenesis will be
          responsible for all shipper damage claims relating to delivery of
          PathoGenesis Materials to ALP, and ALP will provide reasonable
          assistance in connection with any such claim at PathoGenesis' request
          and expense.

                                       3
<PAGE>
 
2.2  PathoGenesis Equipment.  PathoGenesis has purchased from ALP certain
     ----------------------                                              
     capital equipment and installed certain of its own capital equipment at the
     Facilities, all for use in Processing.  All such capital equipment at the
     Facilities is referred to as the "PathoGenesis Equipment."
                                       ----------------------  

2.3  Exclusivity.  ALP will use PathoGenesis Materials and PathoGenesis
     -----------                                                       
     Equipment solely and exclusively for Processing, and ALP will dedicate the
     Facilities solely and exclusively to Processing during each Campaign during
     the Term.  ALP may use the Facilities (but not PathoGenesis Equipment),
     when not dedicated to PathoGenesis during a Campaign, for processing of
     other materials, provided that ALP will ensure the cleaning validation of
     equipment and production room for all Processing in the Facilities and will
     reasonably cooperate with PathoGenesis in the evaluation and elimination of
     potential concerns regarding cross-contamination in light of applicable
     requirements and recommendations (including cGMPs) of Regulators.  ALP's
     cooperation will include post-processing cleaning methods (which
     information is Proprietary Information of ALP under section 9 of this
     Agreement).  ALP will not schedule the use of the Facilities for the
     production of materials for customers (including PathoGenesis) whose
     forecasts for required production using the Facilities in the aggregate
     would exceed 80% of the capacity of the Facilities.  ALP agrees that during
     the Term neither ALP nor any entity controlled by or under common control
     with or otherwise affiliated with ALP will process or package in any
     facility, other than for PathoGenesis, any product for inhalation
     containing (a) any aminoglycoside (including Tobramycin) or (b) any other
     class of antibiotic if ALP is then manufacturing an antibiotic of the same
     class for PathoGenesis.

2.4  Storage, Handling and Cleaning of PathoGenesis Equipment and PathoGenesis
     -------------------------------------------------------------------------
     Materials.  ALP warrants and covenants that it will store and handle all
     ---------                                                               
     PathoGenesis Materials and PathoGenesis Equipment in accordance with this
     Agreement (including the Specifications) and all applicable laws and
     regulations (including cGMPs).  Promptly before and after each Campaign,
     ALP will clean and service all PathoGenesis Equipment and all other ALP
     machinery, equipment and utilities used in Processing in compliance with
     the Specifications.  ALP will securely store moveable PathoGenesis
     Equipment in separate storage when not in use for Processing or being
     cleaned.  ALP will take such actions as are reasonably necessary to protect
     PathoGenesis Materials and PathoGenesis Equipment located at ALP from
     damage, destruction, deterioration or other harm, but risk of loss for all
     PathoGenesis Materials, PathoGenesis Equipment and Finished Product located
     at ALP will lie with PathoGenesis.

2.5  Re-validation.  PathoGenesis and ALP will meet annually to determine the
     -------------                                                           
     need for any re-validation required for purposes of Processing pursuant to
     this Agreement and to plan any work or action in connection with such re-
     validation.  ALP will maintain the Tobramycin Process in a validation ready
     state as required per established ALP validation procedures.  PathoGenesis
     and ALP will negotiate how any costs of re-validation are to be borne.

                    SECTION 3:  PURCHASE ORDERS; PROCESSING

3.1  PathoGenesis Supply Forecast and Processing Plan.  On a quarterly basis
     ------------------------------------------------                       
     PathoGenesis will provide ALP with its good faith non-binding written
     projections of its anticipated Finished Product supply requirements to be
     produced by ALP during the 

                                       4
<PAGE>
 
     next twelve months (as may be amended from time to time by PathoGenesis,
     the "Supply Forecast"). Subject to the other terms of this Agreement:
          ---------------   

     (a)  Processing Plan.  Based on factors including the Supply Forecast, the
          ---------------                                                      
          availability of ALP's Processing capacity in the Facilities and
          comparable ALP facilities, changes in Batch sizes, Dosage Containers
          and/or Specifications, and anticipated changes in any of the
          foregoing, on an on-going basis during the Term, PathoGenesis no later
          than 45 business days before the start of each calendar quarter
          (commencing with the first quarter of 1998) will provide ALP with a
          written processing plan for such quarter and the next three quarters
          (binding as to such quarter and non-binding as to the next three
          quarters), which will specify the amount of Finished Product to be
          Processed and the approximate timing of Campaign(s) (as may be amended
          from time to time in writing by the Parties, the "Processing Plan")
                                                            ---------------  
          [**********].

     (b)  Purchase Orders.  Each Processing Plan (as it may be so amended) will
          ---------------                                                      
          constitute a purchase order for the Finished Product to be Processed
          during the first calendar quarter as specified in that Processing
          Plan.  PathoGenesis may modify a purchase order subject to penalties
          only by submitting a written change order to ALP at least 15 business
          days in advance of the earliest scheduled Commencement Date for the
          Processing covered by the change order.

     (c)  Commencement Date and Completion Date.  Within ten business days of
          -------------------------------------                              
          receipt of each Processing Plan, ALP will acknowledge it in writing,
          specifying the date for commencement (the "Commencement Date") and the
                                                     -----------------          
          date for completion (the "Completion Date") for each Campaign during
                                    ---------------                           
          the next calendar quarter, thereby committing for Processing according
          to that schedule the Facilities, all other machinery, equipment and
          utilities at ALP used in Processing, sufficient appropriately trained
          ALP personnel and all other ALP resources required under this
          Agreement for Processing.

     (d)  Delivery of PathoGenesis Materials and Inventory of ALP Materials.  At
          -----------------------------------------------------------------     
          least ten business days prior to the Commencement Date for a Campaign,
          PathoGenesis will cause to be delivered to ALP the PathoGenesis
          Materials required for the Campaign, and ALP will have in inventory
          the ALP Materials required for the Campaign.

3.2  Due Diligence; Unplanned Delay or Elimination of Processing.  Each Party
     -----------------------------------------------------------             
     will exercise the highest degree of diligence in its efforts to meet the
     Processing Plan as scheduled (subject to change orders and penalties as
     specified in Exhibit C).  Subject to the other terms of this Agreement, ALP
     will Process a given Campaign until it has completely Processed each Batch
     within such Campaign, with a view to achieving the maximum yield consistent
     with the Specifications and all applicable laws and regulations (including
     cGMPs).  ALP will provide PathoGenesis with as much advance notice as
     possible (and will use its best efforts to provide at least 15 business
     days advance notice where possible)  if ALP  determines that  any
     Processing  will be delayed or  eliminated for any

* Confidential treatment is requested; filed separately with the Securities and
  Exchange Commission.

                                       5
<PAGE>
 
     reason.  Thereafter, the Parties agree to use their best efforts to provide
     the maximum possible amount of conforming Finished Product to PathoGenesis
     subject to Section 4.3.

3.3  Testing and Rejection of Finished Product.  Upon completion of Processing
     -----------------------------------------                                
     of each Campaign, ALP will deliver to PathoGenesis (a) within five business
     days thereafter, samples of the Batch for testing by PathoGenesis, (b)
     within 15 business days thereafter, the Batch record for the Campaign and
     (c) within 20 business days thereafter, ALP's test results and written
     approval or rejection of each Batch Processed in the Campaign. No later
     than 45 business days after PathoGenesis' receipt of a Batch of Finished
     Product pursuant to Section 5.1, PathoGenesis will test Finished Product
     and will notify ALP if, in PathoGenesis' determination, any such Finished
     Product is rejected as non-conforming for any reason (provided that,
     although such rejection may be for any reason, ALP will be responsible for
     non-conformity only as set forth in Sections 4.2 and 4.3(a)).

3.4  Warranties.  Each party warrants and covenants that it will perform all its
     ----------                                                                 
     obligations under this Agreement (including, in the case of ALP, its
     Processing of PathoGenesis Materials into Finished Product) in accordance
     with this Agreement (including the Specifications) and all applicable laws
     and regulations (including cGMPs).  ALP warrants that all Finished Product
     will meet the Specifications and all applicable laws and regulations
     (including cGMPs).

3.5  PathoGenesis Inspection and Control of Processing.  During the Term,
     -------------------------------------------------                   
     PathoGenesis' representatives may inspect the Facilities during regular
     business hours.  Before, during and after each Campaign, PathoGenesis may
     base a reasonable number of its representatives at the Facilities to
     oversee Processing and ALP will provide the PathoGenesis representatives
     with work space and access to telephone and telecopy services at ALP as
     reasonably necessary. ALP will implement any Processing instructions or
     directions given by PathoGenesis which do not violate applicable laws or
     regulations (including cGMPs), the Specifications, or ALP's reasonable
     plant operating procedures, and ALP immediately will correct any aspect of
     the ALP Materials, the PathoGenesis Equipment located at ALP, any other
     machinery, equipment or utilities at ALP used in Processing or the
     Processing itself that PathoGenesis acting in good faith, notifies ALP in
     writing (or orally if confirmed in writing) is not in compliance with this
     Agreement (including the Specifications) or applicable laws and regulations
     (including cGMPs).

3.6  ALP Modifications.  Except as permitted or required in section 3.5 or the
     -----------------                                                        
     Specifications or with PathoGenesis' prior written consent, ALP will not
     modify the PathoGenesis Equipment at all, and ALP will not modify the
     Facilities or any other machinery, equipment or utilities at ALP used in
     Processing or the manufacturing processes and operating procedures in a
     manner that would directly affect Processing or the Processing Plan or
     would adversely affect or conflict with the regulatory status of
     PathoGenesis with any Regulator.  Before making any change in its plant
     manufacturing processes or operating procedures applicable, in whole or in
     part, to the Facilities or Processing, ALP will give PathoGenesis advance
     written notice of the nature and effective date of such change.  In the
     event of a conflict between the Specifications and ALP's plant operating
     procedures, the Specifications will control.

                                       6
<PAGE>
 
     SECTION 4:  RESPONSIBILITY FOR NON-CONFORMING FINISHED PRODUCT

4.1  Non-Conforming Finished Product.  For purposes of this Agreement and
     -------------------------------                                     
     subject to Section 8.3, Finished Product is considered "Non-conforming
                                                             --------------
     Finished Product" if it is rejected by PathoGenesis as non-conforming for
     ----------------                                                         
     any reason under Section 3.3 or if it is found not to conform to the
     Specifications and all applicable laws and regulations (including cGMPs).

4.2  Responsibility for Non-conforming Finished Product.  ALP will be
     --------------------------------------------------              
     responsible for causing Non-conforming Finished Product only on account of
     ALP's breach of its warranties in Sections 2.1 (a), 2.4 or 3.4, which
     include, without limitation, its warranty to perform its obligations under
     this Agreement in accordance with this Agreement (including the
     Specifications) and all applicable laws and regulations (including cGMPs).
     PathoGenesis will be responsible for causing Non-conforming Finished
     Product only on account of PathoGenesis' breach of its warranties in
     Sections 2.1(b) or 3.4, which include, without limitation, its warranty to
     perform it obligations under this Agreement in accordance with this
     Agreement (including the Specifications) and all applicable laws and
     regulations (including cGMPs).  If the Parties, after good faith
     negotiation, cannot agree upon which Party is responsible for causing Non-
     conforming Finished Product, the Parties will mutually agree (such
     agreement not to be unreasonably withheld) upon a third party to review
     records, test data and other relevant information and ascertain
     responsibility.  The third party's finding will be binding on both Parties,
     and the cost of such third-party testing and review will be borne by the
     party found responsible.

4.3  Replacement of Non-conforming Finished Product.  If any Non-conforming
     ----------------------------------------------                        
     Finished Product occurs for any reason, ALP will Process an amount of
     Finished Product equivalent to the amount of Non-conforming Finished
     Product, on whatever timing basis (regular or priority) is necessary to
     continue to meet PathoGenesis' supply requirements under the Processing
     Plan, subject in all cases to the following:

     (a)  ALP. If ALP is responsible for causing any Non-conforming Finished
          ---                                                               
          Product, PathoGenesis will not owe ALP any Processing Fees for the
          Non-conforming Finished Product.  ALP will promptly produce new
          Finished Product to replace such Non-conforming Finished Product, and
          PathoGenesis will owe ALP any Processing Fees for such replacement
          Finished Product.

     (b)  PathoGenesis. If PathoGenesis is responsible for causing any Non-
          ------------                                                    
          conforming Finished Product, PathoGenesis will pay ALP the Processing
          Fees for both the Non-conforming Finished Product and the Finished
          Product.

                         SECTION 5:  DELIVERIES; TITLE

5.1  PathoGenesis Authorization of Release; Delivery.  ALP will hold all
     -----------------------------------------------                    
     Finished Product in refrigerated storage at ALP until receipt of
     PathoGenesis' written authorization of shipment, at which time ALP promptly
     will tender such Finished Product (conforming or non-conforming) for
     delivery in accordance with PathoGenesis' routing instructions and at
     PathoGenesis' expense; provided, however that ALP shall have the right to
     invoice PathoGenesis for any applicable Processing Fees, and PathoGenesis
     shall pay such Processing Fees, in accordance with Section 6.2.  ALP will
     provide shipment 

                                       7
<PAGE>
 
     preparation and packaging of Finished Product in Secondary Packaging
     Materials in accordance with the Specifications.

5.2  Product Coding.  ALP will code and mark all Dosage Containers and other
     --------------                                                         
     packaging materials for Finished Product as required under the
     Specifications and all applicable laws and regulations (including cGMPs).

5.3  Title; Security Interests.  All PathoGenesis Materials and PathoGenesis
     -------------------------                                              
     Equipment in the custody of ALP will be and remain the exclusive property
     of PathoGenesis at all times, and PathoGenesis will own any domestic or
     foreign governmental rights, registrations or licenses associated with
     PathoGenesis Materials or Finished Product.  ALP specifically waives any
     and all liens or security interests that it might acquire (whether by
     operation of law or otherwise) with respect to any property of
     PathoGenesis.  ALP's care, custody, control and use of any property of
     PathoGenesis is determined solely by the terms of this Agreement, and ALP
     will never have the power of sale or disposal over any of it except with
     the express prior written consent of PathoGenesis.

                        SECTION 6:  PRICING AND PAYMENT

6.1  Processing Fees.  Subject to the other terms of this Agreement, in
     ---------------                                                   
     consideration for Processing and performing the other services in the
     "Master Batch Record" set forth in Exhibit A attached and incorporated into
     this Agreement, PathoGenesis will pay to ALP the Processing Fees set forth
     on Exhibit C attached and incorporated into this Agreement (as may be
     amended from time to time, the "Processing Fees").  The fees set forth in
                                     ---------------                          
     the initial Exhibit C are applicable to Processing completed through
     [**********].   Fees for each [**********] period thereafter will be
     negotiated by the parties in good faith prior to the start of such
     [**********] period and will be reflected in an amended Exhibit C.
     [**********].

6.2  Payment.  Subject to the other terms of this Agreement, ALP may invoice
     -------                                                                
     PathoGenesis for any Processing Fee applicable to Finished Product on or
     after the date ALP tenders the Finished Product to which the invoice
     corresponds as set forth in Section 5.1, and Processing Fees will be due
     and payable net 45 days after PathoGenesis' receipt of ALP's invoice
     therefor.

6.3  Changes.  On an ongoing basis during the Term, the Parties will negotiate
     -------                                                                  
     in good faith regarding amendments to Processing Fees based on factors
     including those listed in Section 3.1 (including changes in Batch sizes
     and/or Dosage Containers), and ALP agrees to offer lower Processing Fees to
     PathoGenesis with increases in the scale and annual volume of ALP's
     Processing and larger Batch sizes.  Any amendments in Processing Fees will
     be upon mutual written agreement of the Parties.

* Confidential treatment is requested; filed separately with the Securities and
  Exchange Commission.

                                       8
<PAGE>
 
                    SECTION 7:  RECORDS; REGULATORY MATTERS

7.1  Recordkeeping.  ALP will maintain and retain true and accurate books,
     -------------                                                        
     records, test and laboratory data, reports and all other information
     relating to Processing under this Agreement, including all information
     required to be maintained under this Agreement (including the
     Specifications) or applicable laws and regulations (including cGMPs).  ALP
     will maintain all such information only in separate forms, notebooks and
     records (not commingled with other information) where allowed by ALP
     procedures and will maintain all such information for a period of at least
     two years from the relevant Finished Product expiration date or longer if
     required under applicable laws and regulations (including cGMPs).

7.2  Regulatory Compliance.  ALP understands that PathoGenesis intends to
     ---------------------                                               
     distribute and sell Finished Product in numerous countries throughout the
     world.  PathoGenesis will be solely responsible for all marketing permits
     and licenses required by any Regulator with respect to Finished Product and
     Processing under this Agreement, including any product licenses,
     applications and amendments in connection therewith.  ALP will assist
     PathoGenesis and Regulators in all regulatory matters with respect to
     Processing under this Agreement, including any current or future
     requirements or recommendations of Regulators, at PathoGenesis' request and
     at PathoGenesis' expense, except that ALP, at its expense, will cause
     Primary Packaging Materials to be tested as required in connection with any
     such sales in European Union countries.  Each Party intends and commits to
     cooperate to satisfy all applicable laws and regulations with respect to
     Processing under this Agreement.  Each Party will promptly disclose to the
     other Party any communication between it and any Regulator that may affect
     such other Party with respect to such other Party's rights or obligations
     under this Agreement.

7.3  Audit.  During ALP's regular business hours, ALP will make available any
     -----                                                                   
     technical processing books and records, test and laboratory data, reports
     and all other information relating to Processing under this Agreement,
     including all information required to be maintained under this Agreement
     (including the Specifications) or applicable laws and regulations
     (including cGMPs), to PathoGenesis and Regulators for inspection and
     copying at PathoGenesis' expense.

7.4  Governmental Inspections and Requests.  Upon any Regulator's request to
     -------------------------------------                                  
     inspect the Facilities or audit ALP's technical processing books and
     records (under Section 7.4) or any other inquiry (oral or written) by a
     Regulator with respect to Processing under this Agreement, ALP immediately
     will notify PathoGenesis by telecopy, including a copy of any written
     document received from the Regulator (with written confirmation copy to
     follow by regular mail).  ALP will permit any Regulators to inspect the
     Facilities and any machinery, equipment, utilities at ALP or Primary
     Packaging Materials used in Processing, and any PathoGenesis Materials,
     PathoGenesis Equipment and Finished Product located at ALP.  PathoGenesis
     may send its representatives to participate in any Regulatory inspection,
     audit or other inquiry with respect to Processing under this Agreement, as
     deemed appropriate by PathoGenesis.

                       SECTION 8:  TERM AND TERMINATION

8.1  Term.  The term of this Agreement (the "Term") will start on the Effective
     ----                                                                      
     Date and will continue until (a) December 31, 2007 or (b) such other date
     as of which this Agreement 

                                       9
<PAGE>
 
     is terminated pursuant to Section 8.2 or by mutual agreement of the parties
     or (c) such other date to which the Term is extended by mutual agreement of
     the parties.

8.2  Termination by Either Party.
     ---------------------------   

     (a)  Regardless of Cause.  Either Party may terminate this Agreement for
          -------------------                                                
          any reason effective upon at least two years' prior written notice to
          the other Party.

     (b)  Material Breach.  Either Party may terminate this Agreement effective
          ---------------                                                      
          upon at least 180 days' prior written notice to the other Party, if
          the other Party commits a material breach of this Agreement which is
          not cured by the end of the notice period (except as otherwise
          provided in Section 8.2(d)).  Failure of PathoGenesis to pay any
          invoice of ALP within the terms as specified in Sections 5.1 and 6.2
          shall, after 15 days prior written notice from ALP to PathoGenesis
          regarding such nonpayment, be deemed automatically a material breach
          (unless cured within such 15-day period), and ALP shall be relieved of
          any further obligation to perform hereunder until PathoGenesis'
          payments are brought current.

     (c)  Bankruptcy.  Either Party may terminate this Agreement effective upon
          ----------                                                           
          at least 60 days' prior written notice to the other Party, if the
          other Party files a petition for bankruptcy, takes advantage of the
          insolvency laws of any state, makes an assignment for the benefit of
          its creditors or has a receiver, trustee or other court officer
          appointed for its properties or assets, any of which is not cured by
          the end of the notice period.

     (d)  Force Majeure.  If any default or delay occurs which prevents or
          -------------                                                   
          materially impairs a Party's performance and is due to a cause beyond
          the Party's reasonable control, including but not limited to an act of
          God, flood, fire, explosion, earthquake, casualty, accident, war,
          revolution, civil commotion, blockade or embargo, injunction, law,
          proclamation, order, regulation or governmental demand, the affected
          Party promptly will notify the other Party in writing of such cause
          and will exercise diligent efforts to resume performance under this
          Agreement as soon as possible.  Neither Party will be liable to the
          other Party for any loss or damage due to such cause, but the Term
          will be extended by a period of time equal to any delay due to such
          cause.  Neither Party may terminate this Agreement because of such
          default or delay except upon 15 days prior written notice to the other
          Party if the default or delay has existed for five months and is
          continuing at the end of the notice period.

8.3  Effect of Termination.
     ----------------------

     (a)  Rights and Obligations Continuing until Expiration or Termination.
          -----------------------------------------------------------------  
          Except as otherwise provided in Section 8.3(b), any expiration or
          termination of this Agreement will be without prejudice to any rights
          accrued to the benefit of either Party prior to expiration or
          termination, will not relieve either Party of any obligations accrued
          to it prior to expiration or termination, and will not relieve either
          Party of any warranties or obligations that survive any expiration or
          termination of this Agreement (including those under Sections 2.1,
          2.4, 3.4, 7, 8.3(b), 9, 10 or 11.3).

                                       10
<PAGE>
 
     (b)  Deliveries upon Termination or Expiration.  If either Party terminates
          -----------------------------------------                             
          this Agreement under Section 8.2(a), effective upon such termination
          the only obligations of either Party will be those obligations and
          warranties that survive under Section 8.3(a) and those obligations
          under this Section 8.4(b).  No later than 30 days after any expiration
          or termination of this Agreements, each Party will deliver to the
          other Party all copies in its possession of the other Party's
          Proprietary Information, ALP will deliver to PathoGenesis all copies
          of all records and information ALP has maintained under this Agreement
          (except that ALP's legal department may retain one copy), and ALP will
          deliver to PathoGenesis all PathoGenesis Materials and PathoGenesis
          Equipment then located at ALP (with all such deliveries at
          PathoGenesis' expense).

                      SECTION 9:  PROPRIETARY INFORMATION

9.1  Nondisclosure.  Except to the extent authorized by this Agreement, during
     -------------                                                            
     the Term and for ten years after expiration or any termination of this
     Agreement, neither Party will:

     (a)  disclose, publish or otherwise make available (orally or in writing)
          any Proprietary Information of the other Party to any third party
          (including any employee of the receiving Party without a need to know
          or to have access to such Proprietary Information or who does not
          agree to be bound by these terms);

     (b)  use any Proprietary Information of the other Party except in
          connection with performance of this Agreement or upon express prior
          written consent of the other party; or

     (c)  sell, transfer or otherwise exploit any such Proprietary Information
          of the other Party, or permit such sale, transfer or exploitation by a
          third party (including any employee of the receiving Party).

9.2  Proprietary Information.  For purposes of this Agreement, "Proprietary
     -----------------------                                    -----------
     Information" means all information disclosed in writing (or orally if
     -----------                                                        
     reduced to writing after oral disclosure) by a Party at any time in
     connection with this Agreement, except for any information expressly
     excluded by the disclosing Party in writing or any information which the
     receiving Party can establish by competent written evidence (a) was known
     to the receiving Party at the time of disclosure by the disclosing Party or
     (b) was generally available to the public at the time of disclosure by the
     disclosing Party.

9.3  Public Announcements.  During the Term, neither Party will make any press
     --------------------                                                     
     release or other disclosure regarding this Agreement except as required
     under applicable law (with advance notice to the other Party of the
     required disclosure) or with the other Party's express prior written
     consent.

                   SECTION 10:  INDEMNIFICATION AND INSURANCE

10.1 Indemnification by ALP.  ALP will indemnify and hold harmless PathoGenesis
     ----------------------                                                    
     and its directors, officers, employees and agents from and against any
     suit, claims, losses, demands, liabilities, damages, costs and expenses
     (including court costs, reasonable attorneys' fees and reasonable
     investigative costs) in connection with any suit, demand or action by any
     third party arising out of or resulting from (a) any act or omission,
     proven or alleged, of ALP in its performance of this Agreement, except to
     the extent that 

                                       11
<PAGE>
 
     any of the foregoing arises out of or results from the negligence or
     willful misconduct of PathoGenesis or (b) any proven or alleged claim of
     patent infringement, violation of intellectual property rights or unfair
     competition relating to any equipment, method, process or design used by
     ALP in its performance of this Agreement.

10.2 Indemnification by PathoGenesis.  PathoGenesis will indemnify and hold
     -------------------------------                                       
     harmless ALP and its directors, officers, employees and agents from and
     against all suits, claims, losses, demands, liabilities, damages, costs and
     expenses (including court costs, reasonable attorney's fees and reasonable
     investigative costs) in connection with any suit, demand or action by any
     third party arising out of or resulting from (a) any act or omission,
     proven or alleged, of PathoGenesis in its performance of this Agreement or
     in connection with any use of Finished Product, except to the extent that
     any of the foregoing arises out of or results from the negligence or
     willful misconduct of ALP or (b) PathoGenesis' exercise of control over
     Processing under Section 3.5 of this Agreement, to the extent that
     PathoGenesis' instructions or directions violate applicable laws or
     regulations (including cGMPs).

10.3 Indemnification Procedures.  All indemnification obligations in this
     --------------------------                                          
     Agreement are conditioned upon the Party seeking indemnification promptly
     notifying the indemnifying Party of any claim or liability of which the
     Party seeking indemnification becomes aware (including a copy of any
     related complaint, summons, notice or other instrument), cooperating with
     the indemnifying Party in the defense of any such claim or liability (at
     the indemnifying Party's expense), and not compromising or settling any
     claim or liability without prior written consent of the indemnifying Party.
     The indemnifying Party shall have the right to select legal counsel
     reasonably acceptable to it to defend against any suits, claims or demands.

10.4 Limitation of Liability.  ALP shall not be liable for any indirect,
     -----------------------                                            
     incidental or consequential damage arising out of any breach by ALP of this
     Agreement (including its representations and warranties herein contained)
     to an extent greater than $5,000,000 in the aggregate with respect to all
     breaches occurring during any twelve-month period.

10.5 Insurance.
     --------- 

     (a)  ALP.  During the Term and for five years thereafter, ALP will obtain
          ---                                                                 
          and maintain comprehensive general liability insurance (including
          broad form general liability, completed operations and products
          liability, personal injury liability, blanket contractual liability
          and broad form property damage liability) with limits of not less than
          $5,000,000 combined single limit for bodily injury and property damage
          liability per occurrence and annual aggregate, containing a cross-
          liability or severability of interests clause, and with any deductible
          or self insured retention being subject to PathoGenesis' previous
          written approval.  During the Term, ALP will obtain and maintain
          worker's compensation insurance as required under Illinois law and
          employer's liability insurance with a limit of not less than $500,000.
          With respect to all insurance coverage required under this Section
          10.5(a):  (i) all insurance carriers will be subject to PathoGenesis'
          prior approval (not to be unreasonably withheld); (ii) ALP will
          furnish PathoGenesis with certificates of insurance evidencing at
          least the required coverage as soon as practicable after the Effective
          Date and each anniversary of the Effective Date during the Term (and
          for five years thereafter if such coverage is then required

                                       12
<PAGE>
 
          hereunder); and (iii) all policies will include provisions for at
          least 30 days prior written notice of any material change or
          cancellation (whether for non-payment or otherwise).

     (b)  PathoGenesis.  During the Term and for five years thereafter,
          ------------                                                 
          PathoGenesis will obtain and maintain comprehensive general liability
          insurance (including broad form general liability, completed
          operations and products liability, personal injury liability, blanket
          contractual liability and broad form property damage liability) with
          limits of not less than $5,000,000 combined single limit for bodily
          injury and property damage liability per occurrence and annual
          aggregate, containing a cross liability or severability of interests
          clause.  During the Term, PathoGenesis will obtain and maintain
          worker's compensation insurance as required under applicable law and
          employer's liability insurance with a limit of not less than
          $1,000,000.  With respect to such insurance coverage required under
          this section 10.5(b):  (i) PathoGenesis will furnish ALP with
          certificates of insurance evidencing at least the required coverage as
          soon as practicable evidencing at least the required coverage as soon
          as practicable after the Effective Date and each anniversary of the
          Effective Date during the Term (and for five years thereafter if such
          coverage is then required hereunder); and (ii) all policies will
          include Provisions for at least 30 days prior written notice of any
          material change or cancellation (whether for non-payment or
          otherwise).

                           SECTION 11:  MISCELLANEOUS

11.1 Entire Agreement; Amendments.  This Agreement is the entire understanding
     ----------------------------                                             
     between the Parties and supersedes any contracts, agreements or
     understandings (oral or written) of the Parties with respect to the subject
     matter hereof.  No term of this Agreement may be amended except upon
     written agreement of both Parties, unless provided otherwise in this
     Agreement.

11.2 No Waiver.  Failure by either Party to insist upon strict compliance with
     ---------                                                                
     any term of this Agreement in one or more instances will not be deemed to
     be a waiver of its rights to insist upon such strict compliance with
     respect to any subsequent failure.

11.3 Notices.  Any notice from either Party to the other Party will be
     -------                                                          
     effective upon receipt and must be personally delivered to such other party
     or sent to such other Party by deposit in the Unites States mail, first
     class, postage prepaid or telecopy transmission (with written confirmation
     copy to follow via United States mail), to the address for such Party below
     or such other address as a Party may designate from time to time in
     accordance with this Section:

          To PathoGenesis:    PathoGenesis Corporation
                              Attn:  Wilbur H. Gantz, President
                              5215 Old Orchard Road, #900
                              Skokie, Illinois  60077
                              Telecopy:  (847) 583-5409

                                       13
<PAGE>
 
          To ALP:             Automatic Liquid Packaging, Inc.
                              Attn:  Frank Leo
                              2200 West Lake Shore Drive
                              Woodstock, Illinois 60098
                              Telecopy:  (815) 338-5504

11.4  Successors and Assigns.  This Agreement will be binding upon and inure to
      ----------------------                                                   
      the benefit of the Parties, their successors and permitted assigns.
      Neither Party may assign this Agreement, in whole or in part, without the
      prior written consent of the other party, except that without ALP's
      consent PathoGenesis may assign this Agreement, in whole or in part, to
      any corporate entity which controls, is controlled by or is under common
      control with PathoGenesis.

11.5  Independent Contractors.  The relationship of the parties is that of
      -----------------------                                             
      independent contractors, and neither party will incur any debts or make
      any commitments for the other Party except to the extent expressly
      provided in this Agreement. Nothing in this Agreement is intended to
      create or will be construed as creating between the Parties the
      relationship of joint ventures, co-partners, employer/employee or
      principal and agent.

11.6  Further Assurances.  The Parties agree to execute, acknowledge and deliver
      ------------------                                                        
      such further instruments and do all such other incidental acts as may be
      reasonably necessary or appropriate to carry out the purpose and intent of
      this Agreement.

11.7  Arbitration.  All disputes, controversies or disagreements which may arise
      -----------                                                               
      between the parties in connection with this Agreement will be subject to
      non-binding mediation in accordance with the then existing alternative
      dispute resolution rules of the American Arbitration Association, and
      thereafter, if not settled, final and exclusive settlement by arbitration
      in accordance with the then existing commercial arbitration rules of the
      American Arbitration Association. Arbitration will be conducted in
      Illinois.

11.8  Prevailing Party.  In any litigation or other proceeding between the
      ----------------                                                    
      parties in connection with this Agreement, the prevailing party will be
      entitled to recover from the other Party its reasonable attorneys' fees
      and costs in such proceeding.

11.9  Severability.  If any term of this Agreement is declared invalid or
      ------------                                                       
      unenforceable by a court or other body of competent jurisdiction, the
      remaining terms of this Agreement will continue in full force and effect.

11.10 Governing Law.  This Agreement will be governed by and construed under
      -------------                                                         
      the laws of the State of Illinois, without giving effect to any principle
      or rule of conflict or choice of laws.

11.11 Headings.  The headings in this Agreement are only for convenience and
      --------                                                              
      are not a part of this Agreement.

11.12 Counterparts.  This Agreement may be executed in one or more
      ------------                                                
      counterparts, each of which will be deemed an original but all of which
      together will constitute one and the same instrument.

                                       14
<PAGE>
 
          IN WITNESS WHEREOF, the Parties have caused their duly authorized
representatives to execute this Agreement effective on the Effective Date.

AUTOMATIC LIQUID PACKAGING, INC.      PATHOGENESIS CORPORATION

By:  /s/ Frank Leo                    By:  Wilbur H. Gantz
     -------------------------             -------------------------------------

Its:  V.P. New Products R&D           Its:  Chairman and Chief Executive Officer
      ------------------------              ------------------------------------


Exhibits:
  A - Master Batch Record [(S)(S) 1.27; 6.1]
  B - Chemistry, Manufacturing and Controls Section of TOBI NDA [(S) 1.27]
  C - Processing Fees [(S) 6.1]

                                       15
<PAGE>
 
                                                                       EXHIBIT A
                                                                                
                              MASTER BATCH RECORD

ALP Document Number [***********] (PathoGenesis' TOBI(R) Tobramycin for
Inhalation 300 mg/5mL), in the form approved by PathoGenesis from time to time,
is incorporated herein by reference.

* Confidential treatment is requested; filed separately with the Securities and
  Exchange Commission.

                                       16
<PAGE>
 
                                                                       EXHIBIT B
                                                                                
           CHEMISTRY, MANUFACTURING AND CONTROLS SECTION OF TOBI NDA

The chemistry, manufacturing and controls section of New Drug Application number
50-753, contained in volumes with numbered pages 1-1484, submitted to the United
States Food and Drug Administration on April 30, 1997 and approved by the FDA on
December 22, 1997 is incorporated herein by reference, as are any updates and
revisions thereto furnished to ALP by PathoGenesis.

                                       17
<PAGE>
 
                                                                       EXHIBIT C
                                                                                
                                PROCESSING FEES

[**********]


* Confidential treatment is requested; filed separately with the Securities and
  Exchange Commission.

                                       18