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                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

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

                                    FORM 10-K

(MARK ONE)

 [X]     ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
         EXCHANGE ACT OF 1934
         For the Fiscal Year Ended December 31, 1998
    
                                       OR

 [ ]     TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
         EXCHANGE ACT OF 1934 
         For the Transition Period From __________ to __________

         COMMISSION FILE NUMBER 0-21752

                         NORTHSTAR HEALTH SERVICES, INC.
                         -------------------------------
             (Exact name of registrant as specified in its charter)

        DELAWARE                                     25-1697152
        --------                                     ----------
(State or other jurisdiction of           (I.R.S. Employer Identification No.)
incorporation or organization)

665 PHILADELPHIA STREET, INDIANA, PENNSYLVANIA           15701
----------------------------------------------           -----
  (Address of principal executive offices)             (Zip Code)

       Registrant's telephone number, including area code: (724) 349-7500
        Securities registered pursuant to Section 12(g) of the Act: None

                                                     Name of each exchange
         Title of each class                         on which registered
         -------------------                         -------------------
   Common Stock-Par Value $.01 Per Share                       *

    *Due to circumstances described herein, the Common Stock was delisted on
  May 31, 1996 and is currently quoted on the Over the Counter Bulletin Board.

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

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

         The aggregate market value of the voting stock held by non-affiliates
of the registrant, based on the closing sale price of such stock as of March 23,
1999 is set forth below:

                                           Aggregate Market Value of the     
         Class of Stock                Voting Stock held by Non-Affiliates 
         --------------                ----------------------------------- 
Common Stock, $.01 par value                        $3,921,073

         The number of shares of Common Stock outstanding at March 23, 1999:

                                                                       5,975,424

     DOCUMENTS INCORPORATED BY REFERENCE:         PART OF FORM 10-K INTO WHICH 
                                                  THIS DOCUMENT IS INCORPORATED:
          None

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FORWARD LOOKING STATEMENTS

         From time to time, the Company will publish forward looking statements
relating to such matters as anticipated financial performance, business
prospects, and projected plans for and results of its operations. The Private
Securities Litigation Reform Act of 1995 provides a safe harbor for forward
looking statements. In order to comply with the terms of the safe harbor, the
Company notes that a variety of factors could cause the Company's actual results
to differ materially from the anticipated results or other expectations
expressed in the Company's forward looking statements. The risks and
uncertainties that may affect the operations and performance of the Company's
business include the following: changes in regulatory, governmental and payor
policies regarding reimbursement; competition, both directly in terms of other
providers of physical therapy and other services, and the competition for
qualified personnel; the outcomes of the current litigation involving the
Company; defaults in borrowing arrangements, defaults in bank financing,
including an inability to comply with various covenants in connection with such
financing; the ability of the Company to have its Common Stock relisted on a
national market or exchange; the uncertainties surrounding the healthcare
industry in general; and the uncertainties relating to the Year 2000 issue.

ITEM 1.      BUSINESS

         In addition to other sections of this document, this Business section
contains the type of forward looking statements and projections discussed above
and must be read in connection with those disclosures.

GENERAL

         Northstar Health Services, Inc., a Delaware corporation ("Northstar" or
the "Company"), is a regional provider of physical rehabilitation and other
health care services, including diagnostic testing, in Pennsylvania and adjacent
states, providing services at outpatient rehabilitation clinics and patient care
facilities to patients suffering from physical disabilities. The goals of
physical rehabilitation are to improve a patient's physical strength and range
of motion, reduce pain, prevent injury and restore the ability to perform basic
activities, including communication. The Company believes that physical
rehabilitation improves patient outcomes and shortens a patient's recovery time
and, as a result, has gained increasing recognition by payors as both a
clinically effective and a cost effective means to lower total healthcare
expenses.

         The Company's corporate and subsidiary operations are organized to
better position itself to efficiently manage existing and emerging opportunities
in its primary markets. As such, the Company has defined three operating
subsidiaries:

         o    KEYSTONE REHABILITATION SYSTEMS, INC. ("Keystone") provides
              outpatient rehabilitation, primarily to ambulatory patients at
              fifty-nine (59) outpatient sites specializing in orthopaedics,
              sports and neurologic rehabilitation. Keystone utilizes physical
              therapists, occupational therapists and speech therapists to
              provide its services. Keystone also contracts with hospitals,
              nursing homes, home health agencies, personal care homes and
              school districts to provide physical therapy, occupational
              therapy, speech language pathology and athletic training services.
              Keystone is one of the largest providers of outpatient
              rehabilitation services in Pennsylvania.

         o    KEYSTONE REHABILITATION MANAGEMENT, INC. ("KRM") provides and
              manages interdisciplinary therapy services to long term care and
              subacute facilities, as well as hospitals, personal care homes and
              home health care agencies on a contract basis. KRM has the ability
              to supply experienced management personnel, rehabilitation and
              related services to nursing homes and hospitals through
              contractual arrangements.

         o    NORTHSTAR MEDICAL SERVICES, INC. ("NMS") is a subsidiary
              corporation that was designed to develop and manage physician
              practices. To date, the primary focus of this company has


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              been Penn Vascusonics, P.C., a radiology practice that provides
              multiple mobile diagnostic services including mammography,
              ultrasound and echocardiography to physicians, nursing homes and
              industries. Through this professional corporation,
              hospital-quality testing is provided onsite in physician offices
              and long term care facilities that provide for an environment that
              makes the diagnostic experience less stressful and more convenient
              for the patient. Mobile services are provided through a fleet of
              customized vans equipped for transporting equipment to physician
              office locations. The Company also operates five (5) freestanding
              diagnostic centers in Western Pennsylvania. In March 1998, the
              Company announced that in keeping with its decision to focus its
              efforts on its core rehabilitation business, it had decided to
              withdraw from the mobile diagnostic industry. However, it has been
              unsuccessful at finding a buyer for this business. Therefore,
              management has reorganized the operations of the diagnostic
              centers to provide more efficient and cost effective operations.

         As of December 31, 1998, the Company had fifty-nine (59) outpatient
rehabilitation clinics, five (5) freestanding diagnostic testing centers and
fourteen (14) contractual agreements with patient care facilities. The Company
continues to strive to expand its presence as a provider of physical
rehabilitation and related services in its geographic marketplace in
Pennsylvania, Ohio and West Virginia.

         As will be discussed in the Business Strategy section, the Company
continues to concentrate its efforts on strengthening operations and increasing
profitability in the outpatient therapy and rehabilitation business, its core
business and primary source of revenue. At the Corporate level, the Company has
consolidated certain regional management functions to contain costs and
streamline the services provided to operating subsidiaries.

OPERATIONS

         OUTPATIENT REHABILITATION CLINICS. As of December 31, 1998, The Company
owned and operated fifty-nine (59) outpatient rehabilitation clinics in
Pennsylvania, Ohio and West Virginia. The Company provides a wide range of
outpatient rehabilitation therapy services to patients who suffer from a variety
of physical ailments including muscular pain, loss of function, injury or
impairment. The Company provides services, prescribed by the patient's
physician, through licensed therapists, therapist assistants, aides and related
personnel, while coordinating the establishment and maintenance of patient
records, billings to third-party payors and management and operations of the
clinics. Northstar leases and purchases equipment for the outpatient clinics
and, although the amount and type of equipment for each clinic may vary, such
equipment typically includes whirlpools, electric stimulation and ultrasound
units, exercise machines and hot and cold pack units.

         The outpatient rehabilitation clinics are dependent upon patient
referrals from various sources within their communities, including
orthopaedists, internists, neurologists, physiatrists, chiropractors, hospital
discharge planners, community organizations and insurance company case managers.
Referrals also come from non-physician sources, including insurance companies,
managed care organizations, lawyers and employers. The Company's ability to
attract managed care and other third-party payor contracts in multiple locations
is aided by its large share of the geographic market, central billing and
collections services and direct marketing efforts to payors.

         CONTRACT REHABILITATION. As of December 31, 1998, the Company had
contractual arrangements with fourteen (14) patient care entities that the
Company considers to be of a significant nature based on the level of revenue
derived from these contractual agreements. Under these contracts, the patient
care facility generally furnishes the space for the delivery of rehabilitative
therapy treatments, and the Company provides all other necessary services,
including the appropriate rehabilitation therapies, on-site management, staff
recruitment, continuing education, and quality assurance. The Company provides
services that allow patient care facilities to offer advanced multidisciplinary
therapies that may not be available through their own in-house resources.
Northstar is compensated under such contracts on a fee-for-service basis and
typically collects payment for services directly from the patient care facility,
which in turn receives reimbursement from other third-party payors. Generally,
the Company enters into


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one-year or renewable contracts that typically can be cancelled upon a notice of
between thirty (30) to ninety (90) days.

INDUSTRY BACKGROUND

         The outpatient rehabilitation industry continues to experience
significant consolidation, due primarily to the highly fragmented nature of the
industry and the preference of managed care organizations to contract with
regional providers offering comprehensive, cost-effective programs. In recent
years, due to regulatory considerations, convenience and cost saving measures,
there has been a trend away from hospital based rehabilitation and toward
outpatient rehabilitation services provided in modern, accessible clinics and in
long term care and subacute facilities. Because the population age group aged
fifty-five and older is expected to increase dramatically over the next ten to
fifteen years, this demographic shift will affect those most intensively in need
of rehabilitation services.

         Within the rehabilitation sector, the focus for growth is likely to be
in the outpatient segment as the trend toward cost containment continues. Under
the managed care environment, outpatient rehabilitation therapy is chosen as an
alternative to inpatient hospital care primarily as a result of the focus on
reducing patient stays and patient visits. Managed care organizations and
third-party payors are seeking to enter into contract relationships with
rehabilitation providers most capable of delivering a full continuum of care at
the lowest cost without sacrificing the quality or effectiveness of patient care
services. As a result, there has been increased demand for more comprehensive
and sophisticated physical rehabilitation services, particularly for services
already provided by the Company such as work reconditioning, aquatic therapy,
functional capacity evaluations and clinically oriented programs specific to
areas such as women's health, wellness/fitness, headache/TMJ and fibromyalgia.

         The Company believes that as the rehabilitation industry continues to
consolidate, it will be necessary to react to industry changes in order to
position the Company to stabilize its operations in its geographic marketplace.
Therefore, the Company will attempt to limit its entry into new contractual
agreements in patient care facilities and opening new outpatient centers to
those contracts or locations where the potential to achieve profitability
appears reasonable. As the outpatient industry achieves more growth resulting
from, among other things, earlier patient discharge from hospitals and other
patient care facilities, the Company believes it can sustain controlled growth
by focusing on its core rehabilitation business while forming strategic
alliances with other entities or providers to capitalize on what it believes are
the inherent growth factors of the rehabilitation industry. They are:

         o    THE EFFECTIVENESS OF PHYSICAL THERAPY. Physical therapy is
              recognized by physicians and payors as a cost-effective method to
              reduce future healthcare expenses, shorten the recuperation time
              for injuries, reduce the likelihood of re-injury, and enable
              patients to regain skills necessary to return to independent
              living or the workplace. Additionally, physical therapy may assist
              in containing healthcare expenses by reducing or eliminating the
              need for ongoing inpatient healthcare services and other related
              costs.

         o    INCREASING EMPHASIS ON PHYSICAL FITNESS AND THE TREATMENT OF
              SPORTS INJURIES. The growing emphasis on wellness, physical
              fitness, leisure sports, and conditioning, such as running and
              aerobics, has led to increased injuries which require physical
              therapy and increased awareness for injury prevention.

         o    DEMOGRAPHIC SHIFT TOWARD AN AGING POPULATION. The aging population
              is expected to increase the demand for rehabilitation services. As
              a person ages, he or she becomes more susceptible to both
              neurologic and orthopaedic-related ailments, including
              osteoporosis, which may result in the type of injury or loss of
              function which can be aided by a rehabilitation program that
              focuses on strengthening and conditioning. Because the aging
              population chooses to remain active well into later years, therapy
              programs can assist individuals to sustain enjoyable activities
              and maintain an active lifestyle.



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         o    EARLIER PATIENT DISCHARGE FROM ACUTE CARE HOSPITALS TO ALTERNATE
              SITES. The trends toward earlier patient discharge from acute care
              hospitals to subacute sites, from patient care facilities to
              outpatient care, and from hospital-based care to clinic-based and
              home-based treatment programs, have combined to increase the
              demand for all forms of rehabilitation services.

         The Company believes that the demand for rehabilitation therapy
services will be favorably affected by the continued recognition of
rehabilitation as both a clinically and a cost-effective method of treating
certain types of disabilities. However, the Company also believes that this
market will be characterized by increased cost containment pressures and the
growing influence of managed care organizations, other third-party payors and
state government mandated workers' compensation programs in the selection of
rehabilitation service providers. In addition, federal and state governments and
other entities, such as managed care organizations and workers' compensation
carriers, increasingly are converging to contain healthcare costs by capping, or
in some cases reducing, the reimbursement rates for rehabilitation services.
Consequently, rehabilitation providers, including Northstar, are addressing this
growing legislative and payor pressure by seeking contract relationships and by
providing services which appeal to the demands of payors, such as work injury
reconditioning, education and prevention and other services which promote
quality care at the lowest possible cost.

         Overall, Northstar believes that the rehabilitation industry remains
highly fragmented. Changes within the healthcare environment are leading some
rehabilitation providers, including sole practitioners and owners of small
groups of outpatient rehabilitation clinics to sell such clinics and merge with
larger rehabilitation companies or establish networks of outpatient
rehabilitation clinics within a geographic area.

BUSINESS RISK

         The Company is currently experiencing critical financial conditions
that raise doubts about the ability of the Company to continue as a going
concern. Although the Company experienced a significant improvement in the
results of its core rehabilitation therapy businesses which resulted in net
income for the year ended December 31, 1998, it has not yet been able to offset
the continued losses in the mobile diagnostics business and generate sufficient
cash flow to service the Company's outstanding debt and other obligations that
are past due. While the Company has been in negotiations with its principal
creditors, including the holder of its senior secured debt, to effectuate a
restructuring of its payment obligations, it has not been able to reach such an
agreement, and existing defaults on its payment obligations give the holder of
its senior debt the right to accelerate the Company's payment obligations at any
time. In addition, the Company's shares have been delisted from the NASDAQ
National Market, where they were formerly traded, thus decreasing the Company's
access to additional equity capital. The Company is operating currently based
upon the voluntary forbearance of its principal creditors, the continuation of
which cannot be assured. Moreover, the Company's current financial condition
will make it more difficult, if not impossible, for the Company to attract
additional financing, or for the Company to present itself to possible
purchasers as an attractive acquisition candidate. If the Company is unable to
effectuate a business combination with a financially stronger entity or to raise
additional capital and/or effect a permanent restructuring of its debt, the
Company could be required to file a petition for relief under the provisions of
the Bankruptcy Code, or could have an involuntary petition thereunder filed
against it.

BUSINESS STRATEGY

         The Company's ability to strengthen its presence as a provider of
rehabilitation services is severely limited by its current financial situation
(See Item 7, Management's Discussion and Analysis of Financial Condition and
Results of Operations). Therefore, the Company's strategy is to concentrate on
internal mechanisms that do not require significant capital resources to
optimize existing operations. Key elements of the Company's business strategy
are summarized below.



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         o    MAINTAIN REGIONAL PRESENCE. The Company provides both inpatient
              and outpatient physical therapy and related services and thus
              seeks to position itself as the preferred rehabilitation provider
              for physicians, hospitals and managed care organizations and other
              referral sources.

         o    EXPAND REFERRAL SOURCES. The Company seeks to expand the referral
              base of the outpatient rehabilitation clinic by aggressively
              marketing its rehabilitation services to local and regional
              referral sources such as primary care physicians, orthopaedic
              surgeons, private industry, insurance companies and managed care
              organizations. As part of its strategy, the Company has increased
              its emphasis on sales and marketing and is targeting existing and
              new markets in order to gain increased referrals.

         o    MAXIMIZE PAYOR REIMBURSEMENT. The Company intends to focus
              attention on its payor mix in order to maximize its levels of
              reimbursement under existing contracts and affiliations with
              managed care organizations and other payors such as workers
              compensation carriers, insurance companies and third party payors.

         o    EXPAND CONTRACTS WITH MANAGED CARE ORGANIZATIONS. As managed care
              organizations become more prevalent in the marketplace, outpatient
              rehabilitation service providers will need to deliver a
              comprehensive range of services in a cost effective manner with
              multiple locations within a metropolitan area or region. The
              Company intends to market its services aggressively to these
              organizations.

         o    EXPAND CONTRACTS WITH PATIENT CARE FACILITIES. The Company
              continues to seek additional contracts with, as well as expand the
              range of services it offers to personal care homes, assisted
              living centers, hospitals, schools and home health care agencies.

         o    INCREASE RANGE OF SERVICES. The Company provides a wide range of
              services, including physical, occupational and speech therapies,
              and intends to increase its more specialized treatments such as
              hand therapy, aquatic therapy, sports therapy, women's health
              programs, neurological therapy and incontinence therapy.

         o    RECRUIT AND RETAIN EXPERIENCED THERAPISTS AND KEY PERSONNEL. The
              Company will continue to recruit and develop professional
              therapists to staff its facilities and contract obligations and
              offer competitive compensation and benefits packages.

         o    INCREASE EFFICIENCY OF OPERATIONS. The Company maintains
              centralized accounting, payroll, accounts receivable/payable and
              other administrative functions such as billing and collection.
              Certain other functions, including regional management, sales and
              marketing, and provider relations have been centralized to contain
              costs and maximize efficiency.

         The Company believes that the success of its future business strategy
and profitability will depend upon several key issues. The Company is aware that
given its limited resources, it must focus its efforts on its core
rehabilitation business and avenues necessary to maximize revenues in its
existing outpatient facilities. In 1998, due to continued losses in the mobile
diagnostic division, the Company decided to withdraw from the mobile diagnostic
business and place the assets for sale. However, it has not been successful in
finding a buyer. Therefore, management is focusing its attention on improving
profitability and operational efficiency in the mobile diagnostic business. In
conjunction with this strategy, the Company realizes the need to control costs
and expenses and subsequently has engaged certain cost containment measures in
order to reduce and/or eliminate unessential costs. These measures include a
reduction of staffing levels, if appropriate, at all locations and the
elimination of any costs not necessary to operations. Management believes that
additional expense reduction measures are necessary in order to achieve desired
levels of profitability.

         In addition to cost containment measures, the Company will attempt to
maximize the performance of its core physical therapy and rehabilitation
business. At the Corporate level, an administrative function



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that encompasses sales, marketing and provider relations, has been created to
conduct an ongoing marketing and sales campaign that targets the key referral
sources of the Company in order to attract and expand existing business. The
Company expects much of its future success will rely on its ability to maximize
referrals from physicians, industries and managed care organizations.

         The Company continues to face severe financial difficulties, described
in more detail in the Management's Discussion and Analysis section, and
management continues to review its existing business in order to identify and
eliminate unprofitable business units. In 1998, approximately sixteen (16)
contractual arrangements with patient care facilities were terminated. In
addition, two (2) outpatient facilities in Pennsylvania and one (1) in West
Virginia, which were unprofitable, were closed. Despite its limited available
resources, the Company was able to open four (4) outpatient facilities in
Pennsylvania and one (1) in Ohio in 1998 with minimal capital investment. The
Company believes that by the assessment and elimination of unprofitable business
units, and the strategic opening of low-cost, low-risk, new business units, it
can protect the core rehabilitation business and improve its cash position.
Overall, the Company realizes that a business strategy aimed toward maximizing
revenues and profitability from existing operations is necessary to achieve
financial results that could ultimately lead to relisting of its Common Stock on
a national market or exchange. However, the Company does not believe that this
will happen anytime in the forseeable future.

PATIENT CARE SERVICES

         The goals of physical rehabilitation are to improve a patient's
physical strength and range of motion, reduce pain, prevent injury and restore
the patient's ability to perform daily activities as functionally as possible.
The Company utilizes licensed therapists and therapist assistants to provide
physical, occupational and speech therapy to patients with musculoskeletal
injuries, physical disabilities associated with neurological disorders, and
post-surgical rehabilitation. The following is a brief description of
rehabilitation services offered by the Company:

         o    PHYSICAL THERAPY. Physical therapy is the evaluation and treatment
              of physical disabilities designed to improve a patient's physical
              strength, range of motion and mobility. Treatments include
              exercise and the application of modalities such as heat, cold,
              water, sound and electricity.

         o    OCCUPATIONAL THERAPY. Occupational therapy is the evaluation and
              treatment of physical and cognitive deficiencies with the goal of
              improving self-care, work and leisure skills. Candidates for this
              treatment include people who have suffered traumatic injuries,
              have disease related disabilities, or who have underdeveloped
              physical and cognitive skills. Occupational therapists use a
              variety of treatment techniques, including using therapeutic
              exercises and activities, designing and fabricating adaptive
              equipment (such as splints and custom made handles for utensils)
              and teaching compensatory techniques to help these individuals
              achieve their potential for independent, productive living.

         o    SPEECH THERAPY. Speech therapy is the evaluation and treatment of
              speech, language, voice and swallowing disorders arising from
              strokes, head injuries, degenerative neurological disorders,
              developmental deficits, cancer and hearing impairment. Speech
              therapists use treatment techniques such as thermal stimulation,
              muscle re-education and hearing and/or speech aid through visual
              communication devices.

         o    WORK RECONDITIONING. Work reconditioning is a rehabilitation
              program that simulates the specific job activities of an injured
              worker in order to prepare the worker to return to work and
              addresses issues of productivity, safety, physical tolerances and
              worker behavior. The goal is to prepare the patient to work a
              complete workday safely and without injury. The Company utilizes a
              standardized industrial rehabilitation program at all of its sites
              to improve both patient and payor acceptance.



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         o    FUNCTIONAL CAPACITY ASSESSMENT. Functional capacity assessment is
              the evaluation of an existing or prospective employee's physical
              condition and endurance and of the ability to meet the
              requirements of employment. Employers, insurers and other payors
              may use the assessment to estimate the extent of rehabilitation
              treatment needed or as an objective method of evaluating specific
              work capacity.

         o    PAIN MANAGEMENT. Pain management programs are used to assist
              patients in the use of compensatory motor patterns and other
              coping mechanisms to minimize or eliminate the debilitating
              effects of acute and chronic pain.

         o    PREVENTIVE SERVICES. The Company also provides services designed
              to prevent or avoid injuries in the workplace. These preventive
              services, which may be performed at an employer's work site,
              include programs to teach employees proper body mechanics and
              techniques and detailed analysis of specific job activities, such
              as lifting, with the goal of educating employees to reduce or
              prevent workplace injuries.

MERGERS, ACQUISITIONS AND JOINT VENTURES

         Keystone Rehabilitation Systems, Inc. ("Keystone")

         On November 15, 1995, NSK Merger Corp., a newly-formed subsidiary of
the Company, was merged with and into Keystone (a Pennsylvania corporation)
(the"Merger"). See Note 3 to the Financial Statements.

         As consideration for the Merger, the shareholders of Keystone, Thomas
W. Zaucha and Alice L. Zaucha and the Zaucha Family Limited Partnership
(collectively, the "Shareholders"), received, in part, an aggregate of 944,352
shares of Common Stock, par value $.01 per share (the "Common Stock"), of the
Company (the "Stock Consideration"). The Company guaranteed the value of the
Stock Consideration to be at least $5,600,000 through certain periods ending no
later than December 31, 1997. Based on the weighted average trading volume of
the daily closing price per share for the ten consecutive trading days
immediately prior to the third business day prior to the determination date of
December 31, 1997, the Company's Common Stock was valued at $0.96 per share. The
Company has a contractual obligation to fund this shortfall in stock value
through a cash payment equal to the shortfall or, with shareholder approval,
through the issuance of additional shares to the Shareholders in an amount equal
to the shortfall. Based on above formula, the Company was obligated to either
make a cash payment of $4,693,423 or issue approximately 4,888,982 additional
shares of stock. The Company does not currently have sufficient cash to pay this
obligation. This amount has been recorded as a liability in accrued expenses at
December 31, 1998 (See Note 8 to the Financial Statements), with the offset
recorded to Additional Paid-In Capital. The Special Committee of the Board of
Directors has been charged with the authority to negotiate the satisfaction of
this obligation with the Shareholders, which could be done through the payment
of cash, issuance of stock, issuance of notes, or a combination of any or all of
these items. At the Company's Annual Meeting held on June 11, 1998, the
Company's stockholders approved the issuance of up to 4,888,982 shares of Common
Stock in order to enable the Company to fully satisfy the obligations of the
Company under the guarantee in stock if deemed appropriate by the Special
Committee.

         The Company also agreed to make additional "earn-out" payments to the
Shareholders of $1,600,000 per year in the event that Keystone's "EBITDA"
exceeds $2,500,000 in any year from 1996 to 2000, inclusive. EBITDA is defined,
generally, to mean Keystone's earnings (including earnings from any internally
generated facility or contract but excluding earnings from any facility or
contract acquired from third parties) before taxes, interest, depreciation and
amortization. In the event an earn-out is not earned and therefore not paid in
any given year, the earn-out will be paid in the next year if EBITDA in such
next year exceeds the greater of $3,200,000 or $2,500,000 plus the amount of the
EBITDA shortfall in such prior year. The Shareholders are to receive an earn-out
of approximately $200,000 for 1995. The calculation for the earn-out amounts for
years 1996 through 2000 includes a reduction in the amount due in the event that
the current liabilities of Keystone at the date of the Merger (other than
permitted capital



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leases) exceeded $2,000,000. In addition, such earn-out payments are to be
reduced by 50% of such current liabilities up to $2,000,000. Former management
of the Company believed that, based on the results of operations for 1996 as
well as that management's interpretation of the above-outlined adjustments, the
1996 earn-out computation resulted in no amounts due to the Shareholders. The
current Board of Directors appointed a Special Committee to review these
calculations and the issues in dispute. The Special Committee and the Zaucha's
have agreed that no earn-out will be paid for 1996, the earn-out for the year
1997 will be reduced by $504,725 and the earn-out for the years 1998 through
2000 will be reduced by a minimum of $192,800 per year. The earn-out payments
for all years will accelerate and become due within 90 days after any change in
ownership or control of the Company or a sale of the majority of the assets of
the business. The Company has determined that, based on the results of
operations for 1997, there are no amounts due to the Shareholders for the 1997
earn-out. However, the Company has determined that the EBITDA for 1998 exceeds
the greater of $3,200,000 or $2,500,000 plus the amount of the EBITDA shortfall
in 1997, and, therefore, in accordance with the carryover provision above, there
is an amount due to the Shareholders in the amount of $1,095,275 for 1997. The
Company has determined that, based on the results of operations for 1998, there
is an amount due to the Shareholders in the amount of $1,407,200 for 1998.
Accordingly, at December 31, 1998, the Company accrued the earn-out payments of
$2,502,475 with an offsetting entry to goodwill.

         Penn Vascular Lab, P.C. ("PVL")

         On November 28, 1995, the Company acquired from PVL (a Pennsylvania
professional corporation) certain assets and the stock of Vascusonics, Inc. (a
Pennsylvania corporation or "Vascusonics"). The agreement provided for a
management services contract whereby the Company would provide such services to
PVL for a period of two years in exchange for a fee equal to the excess of
collected revenue over the sum of $75,000 and PVL's business expenses. Although
the management services contract expired on November 28, 1997, it was renewable
annually at the mutual agreement of both parties. The purchase agreement also
provided the Company with the option to purchase the stock of PVL for one dollar
under certain circumstances, during the period one year after the management
services contract is terminated.

         As consideration, in part, for the above-mentioned items, the Company
promised to pay certain contingent payments to the Seller. The contingent
payments, as revised by mutual agreement in January 1997, to the Seller are
based upon the Net Collected Revenues, as defined, for the years ending December
31, 1997 and 1998. If during either of the two years ending December 31, 1998,
the Net Collected Revenues of the businesses acquired exceeded $3,200,000, then
a payment of $37,500 was to be made to the Seller. If the Collected Revenues
were in excess of $3,400,000 and $3,600,000 in each year then the payment to the
Seller would be $137,500 and $237,500, respectively. The Company has determined
that under the terms of this calculation, there are no contingent payments due
for the years ending December 31, 1998 and 1997.

         In January 1997, the Company reached a settlement agreement with the
Seller of PVL regarding several disputes. In the terms of this agreement, the
Company reduced certain future payments due to the Seller from $100,000 to
$50,000, acquired ownership rights to disputed equipment, and reduced contingent
payment amounts.

         Under the purchase agreement, Ultrasonics, Inc. (Ultrasonics) took
ownership of PVL's and Vascusonics' accounts receivable on the date of purchase
just prior to the consummation of the purchase agreement. Also, Ultrasonics
assumed certain leases for equipment used by the Company and entered into new
lease terms with the Company. Ultrasonics is a related party which is owned and
operated by Jeff Bergman. The Company believed that the lease arrangements with
Ultrasonics were for lease rates which were greatly in excess of market rates.
At the date of the merger, Ultrasonics paid off leases which represented a net
liability to PVL of $155,000. However, the lease arrangement with Ultrasonics
obligated the Company to principal payments totaling $1,333,000 over the term of
the leases. The Company treated the excessive lease payments of $1,178,000 as a
disproportionate dividend, and ceased making payments to Ultrasonics in March
1996. In March 1997, Ultrasonics filed suit against the Company as a result of
these disputed lease agreements. In March 1998, the Company reached a


                                       8
<PAGE>   10


settlement with Jeff Bergman and Ultrasonics that resulted in mutual releases
and no payments to either party.

MARKETING OF FACILITIES AND SERVICES

         As of December 31, 1998, the Company had a sales and marketing staff of
ten (10) employees responsible for expanding its patient base in outpatient
rehabilitation clinics, subacute and long term care facilities through referrals
by physicians, industries and health maintenance organizations and increasing
the number of contracts with patient care facilities served by the Company
through sales visits, direct and database marketing, advertising and public
relations.

         The Company continues to emphasize its sales and marketing activities
at the local outpatient rehabilitation clinic and at the regional and corporate
levels, targeting hospitals, physicians, industries, insurance companies,
managed care organizations and workers' compensation carriers. The Company
believes that due to increased competition, an emphasis on increased marketing
initiatives are vital to further penetrate target markets, expand into new
territories and increase patient flow.

         At the local outpatient rehabilitation clinic level, the facility
directors for each clinic are expected to maintain relationships with existing
referral sources and to establish relationships with new referral sources,
typically physicians, in that clinic's geographic area. Therapists interact with
referral sources on a regular basis in order to maintain personal relationships
and respond to their service needs. The Company believes that being responsive
to the needs of the referral sources will enhance the Company's prospects of
obtaining additional referrals from such sources.

         At the regional level (which are groups of related offices and
services), the Company has recognized the value of sales personnel in marketing
to larger regional referral sources (multi-physician practices, industries and
hospital-owned physicians) that may be in a position to refer groups of patients
to the Company's facilities. Sales personnel can arrange for onsite meetings
between facility directors and referral sources and also meet with case
managers, employers and local community groups. Their marketing efforts are
responsible for developing and expanding business relationships with all
referral sources such as insurance companies, managed care organizations, and
industries as well as the physicians targeted by the clinical personnel.

         At the corporate level, the Company concentrates on establishing
contracts with multi-regional managed care organizations, insurance companies,
employers and long term care facilities. When appropriate, the Company may
consider service provider alliances in which two or more large rehabilitation
organizations enter into an arrangement such that, collectively, these two
organizations are able to secure a contract with a large referral source.
Corporate marketing programs are effective in establishing links with larger
employers and third party payors.

         The Company is aware of the growing importance of managed care
organizations in controlling patient referrals and their demand for high
quality, cost effective care from service providers with a regional presence.
Accordingly, both its corporate and regional sales personnel devote substantial
efforts to building relationships with these organizations. The Company has been
able to secure contracts and establish relationships with such organizations in
the past and believes that its sales and marketing efforts will allow it to
acquire additional contracts from, and establish additional relationships with,
managed care organizations and other referral sources in the future.

COMPETITION

         The rehabilitation industry is highly competitive and subject to
continual changes in the manner in which services are delivered and in which
providers are selected. The Company believes the most significant competitive
factors in the rehabilitation market are quality patient care, comprehensive
scope of services offered, treatment, alignment with physicians, outcome
measures, convenience of rehabilitation locations to patients, regional
dominance and the ability to develop and maintain relationships with referral
sources such as physicians, insurance companies, industries, managed care




                                       9
<PAGE>   11





organizations, lawyers and employers. The Company competes with many national,
local and regional providers of similar rehabilitation and related services,
including the outpatient rehabilitation operations of acute care hospitals,
managed care organizations and other long term care rehabilitation therapy
providers. Many of the Company's competitors have equal or longer histories of
operations and longer term relationships with therapists and referral sources
than the Company and possess greater financial, marketing, human and other
resources than the Company.

         The Company also competes with other healthcare companies in acquiring
rehabilitation providers. Several larger national companies with substantially
greater financial resources than the Company have been actively acquiring
rehabilitation providers. Certain of these companies, because of the size of
their stockholders' equity, may not be affected by present or future laws
limiting or prohibiting referrals by stockholders who may be referral sources.
Continued competition in this area may increase the valuation of rehabilitation
providers and limit the Company's ability to make future acquisitions.

         The Company also competes for the services of therapists with
hospitals, nursing homes, and other outpatient rehabilitation providers and
physicians' offices. Although the Company has not experienced significant
difficulties in attracting and retaining qualified therapists, it is generally
recognized that the demand for qualified therapists exceeds the supply. This
supply shortage is beginning to abate, and expectations are that in future years
there will be increasing numbers of available therapists. However, there can be
no assurance that the Company will continue to be able to attract or retain
sufficient therapists to meet its needs.

GOVERNMENTAL REGULATION

         General. The provision of physical therapy services and reimbursement
for such services is subject to a number of federal, state and local laws,
regulations and rules, some of which are very complex. The various levels of
regulatory activity affect the Company's business activities by controlling its
growth, requiring licensure or certification of its facilities and controlling
the reimbursement to the Company for services provided.

         In the majority of states, outpatient rehabilitation facilities do not
require review or approval by state regulators. States with Certificate of Need
("CON") regulations place certain limits on the expansion and acquisition of
healthcare facilities. Therefore, acquisitions or expansion of existing
facilities in these states may require review by state regulators. Presently,
Pennsylvania (in which the majority of the Company's facilities are located)
does not have a CON requirement. Licensure and certification are both regulatory
activities mandated by either state or local agencies or a federal agency.
Compliance with the regulatory requirements is monitored by on-site inspections
by various representatives of governmental agencies. Although the Company
believes that it is currently in compliance with applicable laws, regulations
and rules, some of such laws, regulations and rules are broadly written and
subject to little or no interpretation by courts or administrative authorities.
Hence, there can be no assurance that a third-party or governmental agency will
not contend that certain aspects of the Company's operations or procedures are
not in compliance with such laws, regulations or rules or that state agencies or
courts would interpret such laws, regulations and rules in the Company's favor.
The sanctions for failure to comply with such laws, regulations or rules could
be denial of the right to conduct business, significant fines and/or criminal
penalties. Additionally, an increase in the complexity or substantive
requirements of such laws, regulations or rules could have a material adverse
effect on the business, financial condition and results of operations of the
Company.

         Fraud and Abuse Laws. The Social Security Act and certain provisions of
state law provide civil and criminal penalties for persons who knowingly and
willfully solicit, pay, offer or receive any remuneration, directly or
indirectly, as an inducement to make a referral of a patient for services or
items for which payment may be made under the Medicare programs. Often termed
"fraud and abuse" or "anti-kickback" laws, the provisions have been broadly
interpreted by the courts.

         The Officer of Inspector General of the Department of Health and Human
Services ("HHS") has issued guidelines specifying certain business arrangements
and payment practices involving providers or



                                       10
<PAGE>   12



other entities, such as the Company, which will not be considered prohibited
activities. Commonly termed "safe harbor regulations," the regulations set forth
certain standards which, if satisfied, will ensure that the arrangement will not
be subject to criminal prosecution or civil sanctions under the fraud and abuse
laws. Failure to satisfy the safe harbors in and of itself does not render an
arrangement illegal. However, there can be no assurance that enforcement
agencies or courts would determine that the Company is in compliance with the
safe harbor regulations applicable to its current operations.

         The Company takes measures to safeguard its compliance with
governmental rules and regulations by employing individuals at the corporate
level who maintain responsibility for identifying, creating and effecting the
appropriate policies with respect to compliance with the laws.

         One principal focus of the fraud and abuse laws has been on
arrangements in which profit distributions are made by a partnership or other
business venture for health-related items or services to persons making
referrals to the venture. Where such arrangements exist, a question is raised as
to whether the profit distributions are illegal payments in exchange for
referrals. Certain safe harbors set forth criteria which, if met, will ensure
that investors in business ventures for health-related items or services will
not be subject to scrutiny under the fraud and abuse laws.

         One safe harbor protects profit distributions to investors made by
publicly traded companies with tangible assets of more than $50 million. At
present, the Company does not satisfy the asset threshold for protection under
this safe harbor. Another safe harbor covers investment interests in small
entities. The criteria that must be satisfied for protection under this safe
harbor include, among other things, requirements that no more than 40% of the
investment interests of each class of investment interests in the entity may be
held by persons, or so-called "tainted investors," who are in a position to make
or influence referrals (including hospitals and physicians), furnish items or
services to the entity or otherwise generate business for the entity, and that
no more than 40% of the entity's gross revenues may come from referrals, items,
or services furnished, or business otherwise generated by "tainted investors."
Unless a large percentage of the Company's Common Stock is held by "tainted
investors," investments in the Company should fall within the safe harbor for
investment interests. None of the Company's physical therapy activities are
carried out through partnerships or other investment vehicles which are owned in
whole or in part by physicians or other third parties which make referrals to,
arrange for services by, or recommend the services of such joint ventures.

         The laws involving fraud and abuse and the safe harbor regulations are
currently in a rapid state of development, and it is difficult to provide a
clear analysis of the risks in this area. There can be no assurance that
enforcement agencies or courts will determine that any existing arrangements
comply with all applicable laws and regulations.

         Stark II. The Omnibus Budget Reconciliation Act of 1993 enacted new
federal anti-referral legislation, more commonly known as "Stark II." Effective
January 1, 1995, Stark II bans referrals by physicians of Medicare patients to
entities for certain designated health services, including physical therapy
services, if a physician or immediate family member has a financial relationship
with the entity providing the service which does not meet any of the exceptions
set forth in Stark II. A financial relationship is generally defined as an
ownership or investment interest in or compensation arrangement with the entity,
subject to certain exceptions. One exception relates to ownership of investment
securities in publicly traded companies that had, at the end of its most recent
fiscal year, or on average during the previous three fiscal years, stockholder
equity exceeding $75 million. At present, the Company does not satisfy the asset
threshold and physicians may not make referrals of Medicare patients to the
Company where the physician or his or her immediate family member holds an
ownership or investment in the Company. Penalties for prohibited referrals
include nonpayment for services rendered pursuant to a prohibited referral,
civil money penalties, and fines and possible exclusion from the Medicare
programs. The Company believes it is currently in compliance with the
requirements of Stark II. However, there can be no assurance that enforcement
agencies or courts will determine that existing arrangements comply with all
applicable laws and regulations.



                                       11
<PAGE>   13



         The Practice of Physical Therapy. The laws and regulations of certain
states restrict the practice of medicine by corporate entities unless such
corporations are professional corporations, with all shareholders being members
of the profession. The continued viability of such restrictions varies among the
states. In many states the applicability of the restrictions has been
significantly reduced. In Pennsylvania, the state in which the majority of the
Company's operations are located, numerous exceptions have substantially eroded
the doctrine. Although the issue is not free from doubt, management does not
believe the doctrine would be applied to the Company's Pennsylvania operations.
The remainder of the Company's operations are in Ohio and West Virginia. Neither
state restricts the corporate practice of physical therapy. If such restrictions
were imposed on the Company, management believes that it could restructure its
operations so as to be in compliance. However, such restructuring could
materially adversely affect the Company and there can be no assurance that a
satisfactory restructuring, under such circumstances, could be accomplished.

         Other Legislative and Regulatory Actions. The Pennsylvania legislature
has enacted automobile insurance reforms which became effective in 1991 and
which limit payments to providers for non-emergency services rendered to
patients who suffer injuries as a result of automobile accidents. The
Pennsylvania Legislature also enacted workers' compensation legislation
effective September 1, 1993 which limits payments to providers for services
rendered to patients with work-related injuries. The Pennsylvania Workers'
Compensation Act, among other things, altered the methodology for payment of
healthcare services to persons covered by workers' compensation, limiting
healthcare providers to payment of no greater than 113% of the applicable
governmentally imposed standard fees for medical services as determined
principally under the Medicare program. If such services do not fall under the
Medicare fee structure, the Pennsylvania Department of Labor and Industry
establishes rates, which may not be more than 80% of the prevailing rate for
such services in the area. The law also requires employees to obtain treatment
from designated providers for a specified period of time and contains
restrictions concerning patient referrals, similar to those established in the
Medicare fraud and abuse and Stark II laws, which are designed to prevent fraud
and abuse in the delivery of services to patients covered by workers'
compensation insurance.

REIMBURSEMENT

         The healthcare industry is generally experiencing a trend toward cost
containment as private and governmental payors seek to respond to rapidly
escalating healthcare costs. One means of cost containment has been to limit
reimbursement rates by capping or lowering fees or restricting the number of
treatments which will be reimbursed for any given condition. Pennsylvania, as
well as the other states in which the Company operates, have fee schedules which
limit the reimbursement rates under workers' compensation programs. Another cost
reduction methodology is increased utilization management by third-party payors
through the use of physician "gatekeepers" and other pre-certification
mechanisms to control utilization of services. The Company expects that
legislation and payors' fee schedules and payment methodologies will continue to
limit the reimbursement of fees for various services and control access to
various services, including rehabilitation services, which may have a material
adverse effect on the business, financial position and results of operations of
the Company.

         An increasing number of the Company's third-party payors are adopting
prospective payment systems. The Company has signed provider contracts with
managed care organizations, which emphasize utilization control and cost
containment, and the Company's business with these managed care organizations is
expected to increase significantly in the next few years. Managed care
organizations either directly transfer risk to healthcare providers though
capitation payment arrangements or pay for units of service on a steeply
discounted basis. These factors cause significant challenges to all providers,
including the Company.

         As a consequence, there can be no assurance that reimbursement for the
Company's services will remain at current levels. The reduction or limitation of
reimbursement levels for the Company's rehabilitation services could have a
material adverse effect on the business, financial condition, and results of
operations of the Company. In addition, such payors are expected to continue to
develop



                                       12
<PAGE>   14


programs designed to control or reduce the cost of healthcare services, which
may have a material adverse effect on the business, financial condition and
results of operations of the Company.

         Since January 1, 1996, all billings directly to Medicare are being
handled through one of seven certified rehabilitation agencies throughout
Pennsylvania, West Virginia and Ohio. Any clinics providing Medicare services
throughout the Company have been certified as extension sites of one of these
agencies. In addition, patient care facilities that contract with the Company
for rehabilitation therapy services and which bill Medicare directly for
reimbursement of such services also must be certified. The Company believes that
all of its facilities are in compliance with such certification requirements;
however, the loss of the Company's Medicare certification, or the Medicare
certification of the patient care facilities with which the Company contracts
could materially adversely affect the Company's ability to obtain Medicare
reimbursement for services.

         Rehabilitation services provided in the Company's outpatient
rehabilitation clinics are reimbursed primarily from third-party payors, which
typically take longer to reimburse the Company than Medicare. Reimbursement from
third-party payors is dependent in large part on the Company's timely and
correct submission of claims in accordance with the varying requirements of
different payors. In addition, any future expansion beyond Pennsylvania might
require the Company to seek payment from a larger number of payors, which could
result in longer collection cycles and increased costs of collection.

         For rehabilitation services provided in the Company's outpatient
rehabilitation clinics, most third-party payors, including Highmark Blue
Cross/Blue Shield, compensate the insured or a service provider, such as the
Company, for physical, occupational and speech therapy at fee levels that are
determined to be "reasonable and customary" for such services within a
geographic area. The determination of what is "reasonable and customary" is
based on "objective industry data." Reimbursement based on this criteria may be
substantially less than rates the Company customarily charges and may not cover
all of the Company's costs and expenses. As a result, the Company often will
seek the balance of such claims, if any, as well as the portion of the claims
not covered by third-party payors, directly from the patient. However, certain
third-party payor agreements may prohibit the Company from billing a patient for
any amount by which the Company's fees exceed those allowed by the payor.
Therefore, attempting to collect fees from patients may be uneconomical in light
of the associated costs, or may be prohibited by governmental regulations or
contractual arrangements with third-party payors, and may be unsuccessful.
Additionally, third-party payors could adopt more restrictive reimbursement
schedules, which may affect the Company's profitability.

         Prior to December 31, 1998, rehabilitation services provided in the
Company's outpatient rehabilitation clinics to Medicare patients were reimbursed
on a cost reimbursement methodology subject to cost limitations. The Company is
reimbursed for services at a tentative interim rate with final settlement
determined after submission of annual cost reports by the Company and audits
thereof by the Medicare fiscal intermediary. Effective January 1, 1999, Medicare
has established fee schedules, by geographic region, with specific reimbursement
amounts for each CPT code. In addition, Part B coverage will limit reimbursement
applicable to physical and speech therapy combined to $1,500 per year per
provider, and a separate $1,500 limit will apply to occupational therapy. The
Company expects that this change will decrease reimbursement for services
provided to Medicare patients in its outpatient facilities.

         The Balanced Budget Act of 1997 ("BBA") significantly modified the way
Medicare will pay for therapy services provided in a long-term care facility.
The BBA requires that each facility be reimbursed by Medicare for Part A
services under a comprehensive prospective payment system ("PPS") which includes
payment for therapy services in an all-inclusive per diem payment based upon the
acuity level of the patient. Contracted therapists or therapy companies may no
longer separately invoice Medicare and must instead contract directly with the
long term care facility to obtain compensation. As a result of this change, and
the amount of compensation certain long-term care facilities were willing or
able to pay for therapy services based upon their reimbursement by Medicare, the
Company has eliminated all but one of its contracts with long-term care
facilities as of December 31, 1998.




                                       13
<PAGE>   15



EMPLOYEES

         As of December 31, 1998, the Company had 449 employees of whom two (2)
were executive officers of the Company; 189 were licensed therapists or
therapist assistants; and ten (10) were involved in marketing and business
development. The Company also has contracts with certain independent physical,
occupational and speech therapists that are utilized by the Company on an as
needed or minimum number of hours per week basis.

         None of the Company's employees is represented by a labor union and the
Company is not aware of any activities seeking such organization. The Company
considers it relationships with its employees to be satisfactory.

          The Company's business is dependent on its ability to attract and
retain qualified therapists and therapist assistants. The Company employs a
variety of recruiting techniques, including employee referral, personal phone
contact and follow-up, advertising, convention attendance, direct mailing and
on-site college recruiting. The Company also maintains relationships with six
local physical therapy colleges and two physical therapy assistant schools. The
ability of the Company to attract and retain qualified physical, occupational
and speech therapists and therapist assistants is crucial to the Company's
operations, and competition for qualified, experienced therapists is intense.
Therapists may be attracted to hospitals and other facilities that may provide
predictable locations and work schedules in contrast to the nature of the
Company's services at patient care facilities, which provide less predictable
work schedules and changing locations. Although there can be no assurance, the
Company believes that it is able to compete effectively for therapists due to
its local Pennsylvania presence near several certified rehabilitation schools,
provision for reimbursement for continuing education, quality reputation and
attractive compensation and benefits package. In addition, the Company believes
that its management philosophy appeals to many therapists because it encourages
therapists to manage the operations of their respective patient care facilities
or outpatient rehabilitation clinics on a semi-autonomous basis, including
scheduling, treatment approaches, facility financial performance, marketing and
staff retention. The Company also provides therapists with career advancement
opportunities beyond the individual facility level. To date, the Company has
been able to attract a sufficient number of physical, occupational and speech
therapists, either as employees or as independent contractors; although there
can be no assurance that this trend will continue. The Company believes its
future success will depend in part on its continued ability to attract and
retain highly skilled employees. If the Company is unable to attract and retain
a sufficient number of qualified therapists to staff all of its facilities, the
Company could be materially adversely affected. The Company believes its annual
turnover rate among therapists compares favorably with that of its competitors.

         In most states, physical, occupational and speech therapists, therapist
assistants, certified occupational therapist assistants ("COTAs") and licensed
technicians must be state licensed clinicians with clinically specific
associate, baccalaureate or masters degrees. All therapists must pass a national
licensure exam administered by the states. A certified physical therapy
assistant provides therapy under the supervision of a physical therapist. In
order to be licensed, physical therapy assistants must have an associate degree
from an approved physical therapy assistant program. In addition, Pennsylvania
requires physical therapy assistants to successfully complete a statewide
written and practical examination. COTAs provide therapy under the supervision
of an occupational therapist. In order to be certified, COTAs must also have an
associate degree and have successfully completed a national certification
examination. Therapists with the Company undergo an initial orientation program
to familiarize themselves with the Company's policies and procedures.

LIABILITY INSURANCE

         As of January 1, 1998, the Company maintained professional malpractice
liability insurance up to $5,000,000 per incident and up to $5,000,000 in the
aggregate on all of its professional employees, in addition to coverage for the
customary risks inherent in the operation of healthcare facilities and
businesses in general. In February 1998, the aggregate limit was increased to
$7,000,000. The cost of liability insurance coverage and the availability of
such coverage have varied in recent years with a trend




                                       14
<PAGE>   16



toward higher cost. In an effort to control the cost associated with such
coverage, the Company has shifted from an occurrence based policy to a claims
made policy. While the Company believes its insurance policies to be adequate in
amount and coverage for its current operations, there can be no assurance that
its coverage will, in fact, be or continue to be available in sufficient amounts
and on reasonable terms, or at all.

ITEM 2.   PROPERTIES

         As of December 31, 1998, The Company leased approximately 13,000 square
feet as corporate office space at 665 Philadelphia Street, Indiana,
Pennsylvania, 15701, under lease agreements extending through November 15, 2005.
The Company also leased fifty-nine (59) outpatient rehabilitation clinics in
Pennsylvania, Ohio and West Virginia. A typical outpatient rehabilitation clinic
encompasses 2,000-3,000 square feet of space and it is leased for an average
term of five (5) years. Monthly rental payments range from approximately $300 to
$15,000 per month, depending on the location, size, and utilities and services
provided. Management continually reviews the size and adequacy of the leased
properties and adjustments are made as office space needs change. In connection
with its reorganization of regional management in 1998, the Company closed three
(3) regional management offices in late 1998 and early 1999. Northstar also
leased five (5) fixed diagnostic sites and one (1) diagnostic management office
in Pennsylvania. In addition, Northstar provided mobile diagnostic services in
more than thirty-five (35) physician offices, which space the Company rents on
an hourly basis.

ITEM 3.   LEGAL PROCEEDINGS

         In the ordinary course of business, the Company may be subject to
claims and legal actions, from time to time, by patients and others. The Company
does not believe that any such pending actions, if adversely decided, would have
a material adverse effect on its financial condition.

         In July 1996, Michael Kulmoski, Jr. ("Kulmoski"), Northstar's former
Chief Financial Officer filed a demand for arbitration against Northstar.
(Kulmoski v. Northstar, American Arbitration Assn., No. 55-116-0106-96-CEW) In
his demand for arbitration, Kulmoski, whose employment with Northstar was
terminated in the summer of 1996, alleges breach of his employment agreement by
Northstar and related claims, including a claim for indemnification under
Northstar's by-laws in suits filed against him by Northstar shareholders.
Kulmoski later agreed, however, to sever the issue of his right to
indemnification from this proceeding to be decided by the courts as an ancillary
issue in the Butler case. See Note 20 to the Financial Statements. An
arbitration hearing was held on November 6 and 7, 1997 on the issue of liability
only, and post-hearing briefs were submitted in mid-February 1998. On March 20,
1998, an arbitration panel decided that the record did not support the
conclusion that Kulmoski's employment had been terminated for "cause" as defined
in his employment agreement. A hearing on the issue of damages was held on May
1, 1998, and in June 1998, Kulmoski was awarded approximately $136,000 by the
arbitration panel on this claim, which has been paid in full as of December 31,
1998.

         In October 1997, in accordance with his agreement to have the issue of
his right to indemnification for counsel fees and expenses incurred in his
defense of the shareholder actions filed against him in the Butler and Bosco
cases, Kulmoski filed a petition for such fees and expenses in the Butler case
in which he sought an award of $69,244.02. (Kulmoski Fee Petition in Butler v.
Northstar, C.A. No. 96-709, W.D. Pa.) Although Northstar had raised an issue
whether Kulmoski was entitled to indemnification under its by-laws under the
circumstances of these cases, in an effort to resolve this matter, Northstar
agreed to confine its objections to the amount of the counsel fees and expenses
claimed in the petition. In an opinion and order dated December 16, 1997, the
court agreed with Northstar's objections and awarded Kulmoski $22,050.77 in
counsel fees and expenses. Notwithstanding Kulmoski's agreement to submit this
issue to the judge for final resolution, he appealed the court's decision to the
United States Court of Appeals for the Third Circuit. By order dated December
17, 1998, the Appeals Court upheld the original award of $22,050.77, which was
paid in February 1999.

         In January 1997, the Justice Department initiated an action against
Samuel Armfield, III, M.D. for claims amounting to $300,000 in connection with
Dr. Armfield's Medicare billings. Although such claims



                                       15
<PAGE>   17


could be trebled if Dr. Armfield is convicted, the Company believes that its
exposure, through its dealings with Vascusonics, would aggregate $50,000 to
$100,000. In addition, the Company has recourse against Dr. Armfield for any
amounts assessed against the Company, which the Company plans to aggressively
pursue, if necessary.

     In March 1998, Robert J. Smallacombe, a former director, consultant and
employee of the Company filed a Writ of Summons against the Company and other
related parties. Mr. Smallacombe was terminated for cause in May 1997. See Note
15 to the Financial Statements. Mr. Smallacombe believes he is entitled to the
balance of his employment contract and certain stock options that may or may not
have been granted. The Company believes that it has counterclaims against Mr.
Smallacombe, and intends to vigorously defend itself against these claims.

     On October 2, 1998, Nicholas P. Horoszko, a named defendant in the lawsuit
filed by the Company in September 1996 described above, filed a demand for
arbitration against the Company for alleged breach of contract. Horoszko is
seeking damages of approximately $225,000. The Company plans to vigorously
contest this liability. No scheduling order has yet been entered on this claim.

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

         Not applicable.

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

         On May 31, 1996, NASDAQ suspended trading in the Company's Common
Stock. Prior to its suspension the Company's Common Stock was traded on the
NASDAQ National Market under the symbol "NSTR". Since the suspension, the
Company's Common Stock is quoted on the Over The Counter Bulletin Board
("OTCBB") under the symbol NSTR. On March 23, 1999 the high and low sales prices
for the Common Stock of the Company as reported by OTCBB were $0.6875 and
$0.6562. Pursuant to current disclosure guidelines, the following table sets
forth the high and low sales prices for the Common Stock of the Company during
the calendar periods indicated, through December 31, 1998, as reported by NASDAQ
and the OTCBB.

CALENDAR YEAR AND QUARTER           HIGH             LOW
-------------------------           ----             ---

1996          First Quarter         6.125            2.625
              Second Quarter        5.500            1.250
              Third Quarter         3.125            1.250
              Fourth Quarter        2.000            0.750

1997          First Quarter         3.500            1.187
              Second Quarter        3.000            1.500
              Third Quarter         3.250            1.625
              Fourth Quarter        2.500            0.750

1998          First Quarter         1.125            0.625
              Second Quarter        1.187            0.593
              Third Quarter         1.687            0.500
              Fourth Quarter        1.282            0.500

         As of December 31, 1998, the Company had approximately 1000 holders of
record, including those who hold in street name, for its Common Stock.

         The Company has not paid nor does it expect to pay in the future cash
dividends on its Common Stock.



                                       16
<PAGE>   18




         The Company's Registrar and Transfer Agent for its Common Stock is
Continental Stock Transfer and Trust Company, New York, New York.

ITEM 6.   SELECTED FINANCIAL DATA

         The information set forth below is provided only for the four years
ended December 31, 1998, 1997, 1996 and 1995 because the Company and its
independent public accountants cannot provide such information for any prior
years due to the resignation of its previous auditors.

      The following summarizes the activity for fiscal years 1998, 1997, 1996
and 1995 (dollars in thousands, except share data):

<TABLE>
<CAPTION>
                                                                            As of December 31,
                                               ------------------------------------------------------------------------------
BALANCE SHEET DATA:                                  1998                1997                1996                 1995
                                               -----------------    ---------------     ----------------     ---------------
<S>                                                 <C>                <C>                  <C>                <C>
    Current Assets                                      $ 6,606            $ 7,296              $ 9,446             $14,603
    Intangible Assets, net                               19,811             19,221               21,132              23,947
    Total Assets                                         28,774             29,514               34,542              43,355
    Current Liabilities                                  33,634             29,129               26,265              26,584
    Long Term Debt                                        1,051              2,039                4,901               6,288
    Total Liabilities                                    34,866             31,313               31,350              32,988
    Total Stockholders' (Deficit)/Equity                 (6,092)            (1,799)               3,192              10,367

                                                                     Twelve Months Ended December 31,
                                               -----------------------------------------------------------------------------
INCOME STATEMENT DATA                                1998                1997                1996                 1995
                                               -----------------    ---------------     ----------------     ---------------
<S>                                                 <C>                <C>                  <C>                <C>
    Net Revenue                                      $   31,881         $   32,606           $   37,872          $   15,771
    Gross Profit                                         17,030             16,193               19,083               5,131
    Operating Income/(Loss)                               2,150            (3,941)              (5,956)            (11,962)
    Non-Operating Expenses                                1,670              2,279                2,226               1,041
    Extraordinary Loss                                        -                  -                    -               (274)
    Net Income/(Loss)                                       401             (5,613)              (8,947)            (13,101)
    Net Income/(Loss) per Share (Basic and
      Diluted)                                             0.07              (0.95)               (1.44)              (3.28)
    Weighted Average Number of
       Common Shares                                  5,975,424          5,880,501            6,216,840           3,996,147
    Cash Dividends Per Common
       Share                                                  -                  -                    -                   -
</TABLE>

Certain reclassifications have been made to prior year financial statements to
conform with the current year presentation

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

FORWARD LOOKING STATEMENTS

         From time to time, the Company will publish forward looking statements
relating to such matters as anticipated financial performance, business
prospects, and projected plans for and results of its operations. The Private
Securities Litigation Reform Act of 1995 provides a safe harbor for forward
looking statements. In order to comply with the terms of the safe harbor, the
Company notes that a variety of factors could cause the Company's actual results
to differ materially from the anticipated results or other expectations
expressed in the Company's forward looking statements. The risks and
uncertainties that may affect the operations and performance of the Company's
business include the following: changes in regulatory, governmental and payor
policies regarding reimbursement; competition, both directly in terms of other
providers of physical therapy and other services, and the competition for
qualified personnel; the outcomes of the current litigation involving the
Company; defaults in borrowing arrangements, defaults in bank financing,
including an inability to comply with various covenants in connection with such
financing; the ability of the Company to have its Common Stock relisted on a


                                       17
<PAGE>   19


national market or exchange; the uncertainties surrounding the healthcare
industry in general; and the uncertainties surrounding the Year 2000 issue.

OVERVIEW

         The information presented in this Management's Discussion and Analysis
is of a summary nature; please refer to the Financial Statements, including
notes, which are included in this report.

RESULTS OF OPERATIONS

1998 COMPARED TO 1997

Total Revenue
-------------

         In 1998, the Company's total revenues declined by $725,000, or 2.2%,
from $32,606,000 for 1997 to $31,881,000 for 1998. Revenues decreased
approximately $2,668,000 as the result of the closure or termination of certain
clinics and contracts, including $370,000 for the termination of a sub-acute
contract in Illinois, and the termination of diagnostic services in Ohio.
Management fee revenues related to diagnostic services decreased approximately
$232,000 and the Company opened new outpatient offices and entered into new
contracts that resulted in an increase in net patient service revenues of
$918,000. Net patient service revenue from continuing operating units increased
$1,153,000 as a result of the Company's expanded sales and marketing efforts
that contributed to an increase in the number of patient referrals in 1998 and
due to a revision in the Company's fee schedule effective February 1, 1998, that
positively affected net reimbursement from certain payors. Revenues from joint
venture operations in nuclear imaging services increased approximately $104,000.

Costs of Service and Gross Profit
---------------------------------

         Due to the decrease in total revenues and the continued stabilization
of the Company's workforce and revenue base, subcontracted services were
significantly reduced and direct labor costs declined, thereby decreasing the
Company's costs of service by $1,562,000 from $16,413,000 in 1997 to $14,851,000
in 1998, or 9.5%. As a percentage of net patient service revenue, costs of
service decreased from 53.1% in 1997 to 48.8% in 1998. As a result of the
decrease in costs of in 1998, gross profit increased $837,000, from $16,193,000
in 1997 to $17,030,000 in 1998. As a percentage of total revenue, gross profit
also increased, from 49.7% of revenue in 1997 to 53.4% in 1998.

Selling, General and Administrative (SG&A) Expense
--------------------------------------------------

         Total SG&A expenses for the year declined $742,000 from $11,312,000 in
1997 to $10,570,000 in 1998. The expense for 1997 includes a provision of
approximately $441,000 for professional fees compensated with warrants and the
expense for 1998 was reduced by approximately $289,000 for the resolution of a
legal matter for less than the accrual that had been previously booked.
Excluding these items, selling, general and administrative expenses in 1998
decreased $12,000, or less than 1.0%. This slight decrease is the result of
reduced expenses due to the cost reductions implemented in 1998 offset by
increased expenses due to the expansion of corporate services in 1998 in the
areas of sales, marketing, and provider relations that has contributed to the
increased revenues in continuing operations.

Bad Debt Expense
----------------

         The Company incurred bad debt expense of $343,000 or approximately 1.1%
of net patient service revenue during 1998 versus $2,024,000 or approximately
6.5% during 1997. The decrease in bad debt expense was accomplished through
increased billing efficiency, the use of a new collection agency in 1998 that
has increased the rate of bad debt recoveries, and recoveries of contract
billings deemed uncollectible in prior years. The expense in 1997 included a bad
debt reserve of $400,000 directly attributed to a sub-acute contract in Illinois
that had been determined to be uncollectible. Without this specific reserve, bad
debt expense would have been approximately 5.3% of net patient service


                                       18
<PAGE>   20



revenue in 1997. In 1998, bad debt expense without any recoveries would have
been 2.7% of net patient service revenue, which is a more likely level of bad
debt expense that can be expected in the future, after the catch-up effect of
the new collection procedures is fully realized and the full recovery of the
contract billings that are now being paid.

Restructuring and Non-Recurring Items
-------------------------------------

         During 1998, the Company continued to incur additional legal and other
professional fees resulting from the continuing reorganization of the Company
and litigation both against and on behalf of the Company in various matters. As
a result of the resolution of a majority of these matters by the end of 1997,
the expenses deemed non-recurring decreased during 1998 to $1,114,000 compared
to $2,578,000 for 1997.

Depreciation and Amortization
-----------------------------

         Other operating costs include amortization of intangibles arising from
past acquisitions, depreciation and other deferred charges, primarily financing
costs. Amortization of intangibles for 1998 of $929,000 declined by $188,000
from the 1997 total, reflecting (1) intangible asset write-offs in 1997 and (2)
completion of the amortization period for certain assets acquired during
previous acquisitions by the Company. The Company expects that amortization of
intangibles will continue to decrease in 1999 as a result of additional
intangible asset write-offs that occurred during 1998.

Interest and Other Non-Operating Expenses
-----------------------------------------

         Interest expenses were $1,934,000 for 1998 compared to $2,229,000 for
1997. The decrease can be attributed to a decrease in the Company's weighted
average interest rate from 1997 to 1998. This was primarily due to decreases in
the interest rates charged by the Company's senior lender as a result of
decreases in the prime rate during 1998. The Company reported net other
non-operating income of $264,000 in 1998 compared to net other non-operating
expenses of $50,000 in 1997. The income for 1998 includes $190,000 for gains
that resulted from the sale of two joint venture interests, while the expense
for 1997 included $66,000 of expense related to the disposal of fixed assets.

Income Taxes
------------

         The Company has recorded a benefit of $366,000 for 1998 versus a
benefit of $771,000 during 1997. The benefit in 1997 is a result of the
amendment of prior year tax returns for loss carrybacks that resulted in
significant federal and state income tax refunds that were received in 1997. The
benefit in 1998 is a result of the amendment of prior year tax returns for loss
carrybacks that resulted in a federal refund of $272,000 that was received in
February 1999. As a result of the losses experienced in both 1997 and prior
years, the Company does not anticipate any significant taxable income for
federal or state income tax purposes in 1998 or 1999.

Net Income
----------

         The Company reported net income for 1998 of $401,000 compared to a loss
of $5,613,000 for the same period in 1997. This significant increase in
profitability can be attributed to the improved efficiency of operations, the
decrease in the amount of restructuring and other non-recurring expenses and the
decline in bad debt expense.

1997 COMPARED TO 1996

Total Revenue
-------------

         In 1997, the Company's total revenues declined by $5,266,000, or 13.9%,
from $37,872,000 for 1996 to $32,606,000 for 1997. Approximately $2,115,000 of
the decrease was the result of an agreement reached with the former owner of the
Company's subsidiary, NW Rehabilitation Services, Inc., ("NWR")



                                       19
<PAGE>   21


who severed her relationship with the Company in 1996, and retained the rights
to certain of NWR's contract businesses. The Company also experienced the
closure or termination of certain clinics and contracts that resulted in a
decline in net patient service revenues of approximately $1,858,000. A decline
in management fee revenues of approximately $1,128,000 is attributable to a
change in the reimbursement of certain diagnostic services and the termination
of services in unprofitable areas. The Company entered the sub-acute care
business in Illinois in late 1996. These sub-acute revenues contributed
approximately $370,000 in the 1997, compared to $93,000 in 1996. The Company
terminated the separate sub-acute care division of the Company in Illinois in
July 1997 due to its poor operating performance. The Company also opened new
outpatient offices and entered into new contracts that resulted in an increase
in net patient service revenues of $231,000. The remaining decrease in net
patient service revenues of $673,000 is a result of a decline in net
reimbursement in continuing operations for the period as a result of increased
managed care penetration in the central and western Pennsylvania marketplace.

Costs of Service and Gross Profit
---------------------------------

         Due to the decrease in total revenues, the size of the Company's
workforce also decreased, which contributed to a total decrease in the Company's
costs of service of $2,376,000 from $18,789,000 for 1996 to $16,413,000 for
1997, or 12.6%. As a percentage of net patient service revenue, costs of service
decreased slightly during the year, from 53.6% in 1996 to 53.1% in 1997. As a
result of the decline in total revenue, gross profit declined from $19,083,000
for 1996 to $16,193,000 for 1997. As a percentage of total revenue, gross profit
declined slightly, from 50.4% of revenue for 1996 compared to 49.7% in 1997.

Selling, General and Administrative (SG&A) Expense
--------------------------------------------------

         Total SG&A expenses for the year declined $1,580,000 from $12,892,000
in 1996 to $11,312,000 in 1997. The 12.3% decrease can be attributed to
increased efficiency and consolidation of the Indiana, PA and Pittsburgh, PA
corporate office functions, a reduction of expenses arising from the NWR
severance agreement, and a reduction of corporate office salary and consulting
expenses resulting from personnel changes made in connection with the
reinstatement of current management as a result of the Consent Solicitation. The
Company is committed to continuing reductions in overhead expenses wherever
possible by continually evaluating all administrative expenses for necessity and
value.

Bad Debt Expense
----------------

         The Company incurred bad debt expense of $2,024,000 or approximately
6.5% of net patient service revenue during the 1997 versus $1,820,000 or
approximately 5.2% for 1996. This increase is the result of a $400,000 bad debt
reserve in the second quarter of 1997 directly attributed to a receivable for a
sub-acute contract in Illinois that has been determined to be uncollectible.
Without this specific reserve, bad debt expense would have been $1,624,000 for
the year, or 5.3% of net patient service revenue, which is comparable to 1996.

Restructuring and Non-Recurring Items
-------------------------------------

         During 1997, certain net costs deemed non-recurring were $2,578,000
compared to $4,969,000 for 1996. A significant portion of the 1997 expense arose
from legal fees and other expenses incurred relating to the Consent Solicitation
initiated by Thomas Zaucha, the Company's current Chief Executive Officer. These
expenses totaled approximately $2,277,000 for 1997, including $527,000 incurred
by the Brody management team. Current management estimates that approximately
$1,250,000 of the total amount of $1,750,000 incurred by Mr. Zaucha in the proxy
contest was the result of additional legal fees necessitated by the hearing in
Delaware in May 1997 and the appeal of that decision in August 1997, due to the
refusal of the Board of Directors and management team led by Steven Brody (the
"Brody Board") to recognize the vote of the shareholders and the decision of the
Delaware court.



                                       20
<PAGE>   22



         In addition, the Company continued to incur higher than normal audit,
legal and other professional fees resulting from continuing reorganization of
the Company, shareholder litigation against the Company, and the Company's
lawsuit against former management. Intangible assets written off for both 1997
and 1996 represented the write off of the remaining employment contracts with
former employees and, in 1997, a reduction in the value of the Keystone
workforce as a result of the termination and attrition of employees who had been
employed by Keystone at the time of the merger in November 1995. These expenses
were offset by a benefit of $2,001,000 in 1997 as the result of legal
settlements and the opinion of legal counsel relating to the settlement of
certain disputes which resulted in the reduction of certain accrued liabilities.
Non-recurring expenses in 1997 without this benefit would have been $4,579,000.

Depreciation and Amortization
-----------------------------

         Other operating costs include amortization of intangibles arising from
past acquisitions, depreciation and other deferred charges, primarily financing
costs. Amortization of intangibles for 1997 of $1,117,000 declined by $506,000
from the 1996 total, reflecting (1) intangible asset write-offs in 1996, and (2)
completion of the amortization period for certain assets acquired during
previous acquisitions by the Company. The Company expects that amortization of
intangibles will continue to decrease in 1998 as a result of additional
intangible asset write-offs that occurred during 1997.

Interest and Other Non-Operating Expenses
-----------------------------------------

         Interest expenses were $2,229,000 for 1997 compared to $2,130,000 for
1996. The increase can be attributed to an increase in the Company's weighted
average interest rate from 1996 to 1997 due to the inability of the Company to
qualify in 1997 for the lower interest rates that were available in the early
part of 1996 with its senior lender, and additional interest due to the Zauchas'
as a result of the Company's inability to make scheduled principal payments in a
timely manner. The Company reported net other non-operating expenses of $50,000
in 1997 compared to net other non-operating expenses of $96,000 in 1996. The
expense for 1996 includes $25,000 for a reduction in the value of an investment
in a partnership.

Income Taxes
------------

         The Company has recorded a benefit of $770,000 for 1997 versus an
expense of $471,000 during 1996. The benefit in 1997 is a result of the
amendment of prior year tax returns for loss carrybacks that resulted in
significant federal and state income tax refunds that were received in 1997. As
a result of the losses experienced in both 1997 and prior years, the Company
does not anticipate any significant taxable income for federal or state income
tax purposes in 1997 or 1998.

Net Loss
--------

         The net loss for 1997 was $5,613,000 compared to a loss of $8,947,000
for the same period in 1996.

LIQUIDITY AND CAPITAL RESOURCES

         The Company is currently in default of its obligations under the credit
facility with Cerberus Partners, LP. Failure to reach an agreement with this
senior lender relative to a restructuring of the Company's outstanding debt
obligations would likely result in acceleration of the loan and a filing of a
petition for relief under the Federal Bankruptcy Code. The Company has been
engaged in negotiations with Cerberus to reach a mutually agreeable
restructuring of this debt at various times since September 1997. During this
process, the Company has continued to enter into extensions of the forbearance
agreement with Cerberus, which is currently extended through March 31, 1999, and
has made monthly payments to Cerberus that approximate the monthly interest
expenses on the loan. However, there can be no assurance that the Company will
be able to reach a mutually agreeable restructuring of the debt, or that it will
continue to be able to enter into extensions of the current forbearance
agreement. In addition, the Company has other obligations, including obligations
incurred in the Keystone merger with the



                                       21
<PAGE>   23



Zaucha's and professional fees with legal and other professional services firms
that it is currently unable to pay. The Company is attempting to reach payment
agreements with all of these parties; however, there is no assurance that it
will be able to do so on mutually agreeable terms.

         During 1998, the cash provided by operations was $2,186,000 versus
$1,005,000 during 1997. This change in cash provided from operations can be
attributed to a number of items, but is primarily the result of the significant
increase in profitability that can be attributed to the improved efficiency of
operations, the decrease in the amount of restructuring and other non-recurring
expenses and the decline in bad debt expense.

         The net cash used in investing activities was $399,000 in 1998 as
compared to $304,000 in 1997, resulting primarily from an increase in
expenditures for capital items in 1998.

         During 1998, the Company made payments on long-term debt of $1,079,000,
which were primarily scheduled debt and lease payments, as compared to payments
of $1,041,000 in 1997. In addition, the Company paid approximately $396,000 to
minority interest holders in companies controlled by Northstar and $143,000
under contractual obligations with certain employees. During 1998, the Company
entered into capital lease arrangements to finance approximately $194,000 of
capital equipment purchases, but did not make any additional material borrowings
under any other debt arrangements.

SUMMARY OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

         The Company is presently experiencing a severe liquidity crisis as a
result of the expenses related to the contest for corporate control in 1997; the
investigation and litigation expenses arising out of certain actions taken by
the Company's pre-1996 management; prior year's operating losses; and prior
obligations to buy out profit-sharing interests in several of the Company's key
clinics. As a result of these circumstances, the Company's access to the capital
and debt markets has been severely impaired. If it is unable to raise additional
capital and/or effect a permanent restructuring of the terms of its outstanding
long-term debt obligations in the forseeable future, the Company could be
required to file a petition for relief under the provisions of the Bankruptcy
Code.

         In response to these developments, the Company continues to focus its
efforts on improving the performance of its core physical therapy and
rehabilitation businesses. As the Company has been unsuccessful in selling it's
mobile diagnostic business, management is also committed to improving the
efficiency and profitability of this venture. The Company is also continuing to
review all expenses in an effort to reduce costs wherever possible, and to seek
additional sources of revenues. The Company's Chairman has indicated that he
will not demand immediate reimbursement of all amounts currently due to him and
his family partnership. While the Company is currently in default of its
obligations under its Credit Agreement, it has been engaged in negotiations with
Cerberus that the Company anticipates will lead to the execution of a permanent
restructuring of its debt.

         There can be no assurance that the Company will be successful in
raising additional equity or other capital, or that it will be in a position to
do so on terms that will not significantly dilute the equity interest of the
Company's existing stockholders. The Company is not currently eligible to
utilize Form S-3 to register offerings of securities under the Securities Act of
1933, and its shares are not currently listed on either the NASDAQ National
Market or the NASDAQ Small Cap Market. These circumstances could adversely
affect the Company's ability to attract additional equity capital.

RECENT ACCOUNTING PRONOUNCEMENTS

         In February 1998, the Financial Accounting Standards Board issued SFAS
No. 132, "Employers' Disclosures about Pension and Other Postretirement
Benefits". SFAS No. 132 revises employers' disclosures about pension and other
postretirement benefit plans. SFAS No. 132 is effective for financial statements
issued for periods beginning after December 15, 1997. The Company adopted SFAS
No. 132 in 1998.



                                       22
<PAGE>   24


         In June 1998, the Financial Accounting Standards Board issued SFAS No.
133, "Accounting for Derivative Instruments and Hedging Activities". SFAS No.
133 establishes accounting and reporting standards for derivative instruments,
including certain derivative instruments embedded in other contracts, and for
hedging activities. It requires that an entity recognize all derivatives as
either assets or liabilities in the statement of financial position and measure
those instruments at fair value. SFAS No. 133 will be effective for all fiscal
quarters and fiscal years beginning after June 15, 1999. The Company currently
does not invest in derivative financial instruments or engage in hedging
activities.

YEAR 2000 ISSUE

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

         The Company is aware of potential Year 2000 issues in its internal
computer systems and software, payor and supplier systems and software,
Electronic Data Interchange (EDI) software, and certain therapy and diagnostic
equipment that contain computer operating systems. In response to these issues,
the Company has formed a Year 2000 Project Team (the "Team") that is headed by
the Director of Management Information Systems. This team includes members of
senior management, Information Systems professionals, department heads and
outside consultants. The Year 2000 Project Team has developed a work plan that
includes inventory, assessment, planning, implementation and testing. The scope
of this plan encompasses many elements, including hardware, operating systems,
application software, end user computing, communications, facilities, equipment
and suppliers. Monthly status/progress reports, including Y2K Compliance Status
Worksheets, are issued to the Chief Financial Officer who, in turn, updates the
Board of Directors.

         The Company's software systems, including its internal financial and
billing systems, have all been assessed. The Team has obtained compliance
certificates for the General Ledger (general accounting), Accounts Payable,
Billing & Accounts Receivable, Fixed Asset and Stock Option software packages.
All upgrades, if any, to these systems were done at no cost to the Company. The
Payroll system package requires an upgrade for customized features that is
anticipated to be completed by April 30, 1999. The cost for this upgrade is
estimated to be approximately $3,000. The Company generally utilizes Microsoft
based Office Suites and networking products for its office computing software
needs and upgrades to newer software as deemed necessary. The Company's current
standard products are Windows 95 and Office 97, which are Year 2000 compliant.

         The Company has inventoried its computer equipment and identified
potential Year 2000 issues. The upgrade on the Company's IBM RS/6000 operating
system is scheduled to be installed in April 1998. All Personal Computer
hardware is Year 2000 compliant, with the exception of a few older machines that
require a "patch" that will be installed by May 31, 1999, at a total cost of
less than $1,000.

         The Company has initiated formal communications with its significant
payors and suppliers to determine the extent to which the Company is vulnerable
to those third parties' failure to remediate their own Year 2000 Issue. These
communications ask for written assurances that they are or will be Year 2000
compliant. Currently, the Company does not believe the failure of such third
parties to remediate their own Year 2000 Issue will have a material adverse
effect on the Company. There can be no guarantee, however, that the systems of
other companies on which the Company's systems rely will be timely converted, or
that failure to convert by another company, or a conversion that is incompatible
with the Company's systems, would not have a material adverse effect on the
Company.

         As of March 3, 1999, the inventory and assessment phases of the plan
were close to completion. The assessment of certain therapy, diagnostic and
communications equipment is still being performed, but is expected to be
completed by April 15, 1999. The implementation and testing phases are expected
to be completed by July 1, 1999.



                                       23
<PAGE>   25




         Based on the assessment to date, the Company has determined that it
will not be required to invest significant funds to replace hardware or software
in order for its computer systems or equipment to properly utilize dates beyond
December 31, 1999. Estimated costs to upgrade systems or equipment, either
already performed or necessary in the future, are not expected to exceed
$25,000, which will be provided out of internally generated cash flow. The
Company presently believes that if any additional modifications are required
that are unknown at this time, they will be insignificant in scope and cost. To
the extent that the Company's computer systems or equipment need to be modified
to remediate any Year 2000 Issue, the Company plans to complete such remediation
by July 1, 1999.

         The Company does not currently believe that it has any material
exposure for the Year 2000 issue. However, if the Company discovers any such
exposure, it will implement projects to correct or prepare contingency plans to
address any such issue. The Company believes that a material failure would occur
if a major payor, such as Blue Cross/Blue Shield, was unable to reimburse the
Company in a timely manner for services provided. The Company does not believe,
based on its current financial situation and access to capital, that it can
produce an adequate contingency plan if its significant payors are unable to
reimburse the Company on a timely basis for services provided.

         The Company's assessment of its Year 2000 Issue and the associated
costs are based on management's best estimates, which were derived utilizing
assumptions of future events, including the continued availability of certain
resources, third party modification plans and other factors. However, there can
be no guarantee that these estimates will be achieved and actrual results could
differ materially from these plans. Specific factors that might cause such
material differences include, but are not limited to, the availability and cost
of personnel trained in this area, the ability to locate and correct relevant
computer codes and similar uncertainties. Therefore, there can be no assurance
that management's assessment that the Company's Year 2000 Issue is insignificant
is correct.

ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK SENSITIVE
          INSTRUMENTS

         The Company currently does not invest excess funds in derivative
financial instruments or other market risk sensitive instruments for the purpose
of managing its foreign currency exchange rate risk or for any other purpose.

ITEM 8.   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

         This information is set forth as exhibits beginning on page F-1.

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

         Not applicable.





                                       24
<PAGE>   26



ITEM 10.   DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

(a)      Identification of Directors

<TABLE>
<CAPTION>
        Name                        Age               Position                          Held Since
        ----                        ---               --------                          ----------
<S>                               <C>          <C>                                    <C> 
Michael S. Delaney*                 49         Secretary and Assistant Treasurer       March, 1997
Lisa S. Guarino                     40         Executive Vice-President, Chief         September, 1997
                                               Financial Officer and Treasurer
Lawrence F. Jindra, M.D.            40         Director                                March, 1997
James H. McElwain                   53         Director                                March, 1997
Mark G. Mykityshyn                  41         Director                                March, 1997
Roger J. Reschini                   61         Director                                March, 1997
David B. White                      43         Director                                March, 1997
Thomas W. Zaucha                    53         Chairman of the Board of                November, 1995
                                               Directors, President and Chief
                                               Executive Officer
</TABLE>


* Mr. Delaney is not an employee of the Company or its sudsidiaries.

         THOMAS W. ZAUCHA (53) is the Chairman of the Board of Directors,
President and Chief Executive Officer of the Company and has been a Director of
the Company since December 1995. His term as a Director is for 1998 - 1999. He
will stand for re-election at the 1999 Annual Meeting. Mr. Zaucha, founder of
Keystone Rehabilitation Systems, Inc., served as its Chairman, President and
Chief Executive Officer until Keystone merged with Northstar in 1995. Mr. Zaucha
became Chairman of the Board and Chief Executive Officer of Northstar in March
1996. Mr. Zaucha has approximately thirty (30) years of experience in the health
care and physical therapy related industries. He currently serves on the State
Board of Physical Therapy and is a member of the Pennsylvania Physical Therapy
Association and the American Physical Therapy Association. Mr. Zaucha was the
recipient of the Entrepreneur of the Year Award (Health Care) in 1992 and was
named Civic Leader of the Year in 1996. Mr. Zaucha is a member of numerous
community and civic organizations. His business address is that of the Company's
address.

         LISA S. GUARINO (40) has served as the Executive Vice President, Chief
Financial Officer and Treasurer of the Company since September 1997. She is
involved in strategic financial decisions for the Company including cash
management and financial reporting. Prior to her present position, she served as
Chief Financial Officer of Northstar from November 1995 to September 1996 and
served as Chief Financial Officer and Controller for Keystone Rehabilitation
Systems, Inc. from August 1986 to November 1995. Ms. Guarino obtained her public
accounting experience as an auditor with Arthur Andersen LLP in Pittsburgh
(1980-1983). She obtained her MBA from Indiana University of Pennsylvania in
1990. Ms. Guarino is an actively licensed Certified Public Accountant in
Pennsylvania and is a member of the PICPA and AICPA. Her business address is
that of the Company's address.

         LAWRENCE F. JINDRA, M.D. (40) has served as a Director of the Company
since March 1997 and is Chairman of the Special Committee and a member of the
Compensation & Nominating Committee of the Board of Directors. His term as a
Director of the Company is for 1998-1999. He will stand for re-election at the
1999 Annual Meeting. Dr. Jindra has served as the President of Community Eye
Care, P.C., and on the adjunct faculty of the Department of Ophthalmology of the
College of Physicians and Surgeons of Columbia University since 1997. Dr. Jindra
has also served as the Assistant Chief of Ophthalmology of Northport Veterans
Affairs Medical Center and as the Founder and Director of the Glaucoma
Consultation Unit since 1994 and 1989, respectively. From 1992 to 1993, Dr.
Jindra served as a White House Fellow as a member of the Office of Science &
Technology Policy and as a member of the President's Task Force for National
Health Care Reform. Dr. Jindra received a Master's Degree in Public
Administration (Medicine, Science and Technology Concentration) from Harvard
University and a Master of Science Degree in Management from Oxford University.
His business address is The Landmark, Suite 305, 99 Tulip Avenue, Floral Park,
New York.



                                       25
<PAGE>   27



         JAMES H. MCELWAIN (53) has served as a Director of the Company since
March 1997 and is Chairman of the Audit Committee of the Board of Directors. His
term as a Director of the Company is for 1998-1999. He will stand for
re-election at the 1999 Annual Meeting. Mr. McElwain has served as the Chief
Operating Officer of S.W. Jack Drilling Company since 1995. From September 1988
until December 1994, he served as the Vice President of Finance of Keystone
Rehabilitation Systems, Inc., which merged with the Company in 1995. His
business address is 57 South Ninth Street, Indiana, Pennsylvania.

         MARK G. MYKITYSHYN (41) has served as a Director of the Company since
March 1997 and is Chairman of the Compensation & Nominating Committee and a
member of the Special Committee of the Board of Directors. His term as a
Director of the Company is for 1998-1999. He will stand for re-election at the
1999 Annual Meeting. Mr. Mykityshyn has served as Managing Director of Centaurus
Ventures, LLC, since August 1998. He has served as Technical and Financial
Consultant with High Technology Venture Finance since 1995. He has also served
as President of Strategy Partners, Inc. from 1993 to 1998, a Management and
Technology Consultant with Booz Allen & Hamilton, Inc. from 1993 to 1997, and
was an Adjunct Professor of Aeronautics at The George Washington University from
1994 to 1995. Prior to 1993, Mr. Mykityshyn served as an aviator in the United
States Marine Corps (1982-1989) and earned the Degree of Engineer of
Aeronautical and Astronautical Engineering and the Degree of Master of Science
in Aeronautical and Astronautical Engineering from the Massachusetts Institute
of Technology and a Masters Degree in Public Administration (Science and
Technology Policy concentration) from Harvard University (1990-1993). His
business address is 1705 Patriots Way, Atlanta, Georgia.

         ROGER J. RESCHINI (61) has served as a Director of the Company since
March 1997 and is a member of the Compensation & Nominating Committee and the
Audit Committee of the Board of Directors. His term as a director of the Company
is for 1998-1999. He will stand for re-election at the 1999 Annual Meeting. Mr.
Reschini founded the Reschini Agency, Inc., a multiple line insurance agency, in
1979 and founded TFID, Inc., a real estate development company, in 1984. Mr.
Reschini has also been the recipient of a Benjamin Rush Award and a Paul Harris
Fellowship. His business address is 922 Laurel Place, Indiana, Pennsylvania.

         DAVID B. WHITE (43) has served as a Director of the Company since March
1997 and is a member of the Compensation & Nominating Committee and the Audit
Committee of the Board of Directors. His term as a Director of the Company is
for 1998-1999. He will stand for re-election at the 1999 Annual Meeting. Mr.
White is a partner in the law firm of Burns, White & Hickton (Pittsburgh, PA).
Mr. White was admitted to the practice of law in 1982, and he is currently a
member of the Allegheny County, Pennsylvania and American Bar Associations; the
Hospital Association of Pennsylvania; the National Order of Barristers; and the
Academy of Trial Lawyers. Mr. White's principal practice areas are general and
commercial litigation, insurance law and health care law. His business address
is Burns, White & Hickton, 2400 Fifth Avenue Place, 120 Fifth Avenue,
Pittsburgh, Pennsylvania.

         MICHAEL S. DELANEY (49) has served as Corporate counsel to the Company
since November 1995, and as its Secretary and Assistant Treasurer since March
1997. Mr. Delaney has also served as Corporate counsel to Keystone
Rehabilitation Systems, Inc. from 1981 to 1995. Mr. Delaney is in private
practice (Indiana, PA). Mr. Delaney was admitted to the practice of law in 1977,
and is currently a member of the Indiana County, Pennsylvania and American Bar
Associations. His business address is 936 Philadelphia Street, Indiana,
Pennsylvania.

         Directors of the Company hold office until the next annual meeting of
stockholders and until their successors are elected. Executive officers are
elected annually by, and serve at the discretion of, the Board of Directors.
There are no arrangements or understandings known to the Company between any of
the Directors, Nominees for director or executive officers of the Company and
any other person pursuant to which any of such persons was elected as a director
or an executive officer, except various employment agreements between the
Company and certain executive officers. (See Executive Compensation, Employment
Agreements)



                                       26
<PAGE>   28


SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE

         Under the Exchange Act, the Company's directors and executive officers,
and any persons holding more than ten percent (10%) of the outstanding shares of
Common Stock are required to report their initial ownership of Common Stock and
any subsequent changes in that ownership to the Securities and Exchange
Commission (the "Commission"). Specific due dates for these reports have been
established by the Commission, and the Company is required to disclose any
failure by such persons to file these reports in a timely manner during the 1998
fiscal year. Based solely upon the Company's review of copies of such reports
furnished to it, the Company believes that since January 1, 1998 through
December 31, 1998, the Company's current executive officers and directors and
the holders of more than ten percent (10%) of the outstanding Common Stock
complied with all reporting requirements of Section 16(a) under the Exchange
Act.

         ITEM 11.   EXECUTIVE COMPENSATION

         The following table shows, for the fiscal years ended December 1998,
1997 and 1996, the cash compensation paid by the Company and its subsidiaries,
as well as certain other compensation paid or accrued for those years, to (i)
any person who served as the Chief Executive Officer during fiscal year 1998,
and (ii) the other most highly compensated executive officers of the Company to
the extent such person's total annual salary and bonus exceeded $100,000 in 1998
(the "Named Executive Officers") in all capacities in which they served.


                           SUMMARY COMPENSATION TABLE

<TABLE>
<CAPTION>
                                                        Annual Compensation                            Long Term Compensation
                                               ---------------------------------------------      --------------------------------
                                                                                                   Securities
           Name and                                                           Other Annual         Underlying        All Other
       Principal Position         Year            Salary         Bonus       Compensation (1)      Options (#)     Compensation (2)
       ------------------         ----            ------         -----       ----------------      -----------     ----------------
       
<S>                              <C>           <C>              <C>              <C>                 <C>              <C> 
Thomas W. Zaucha                  1998          $ 40,200 (3)      $0               $0                  0                $300
Chairman, President               1997          $125,000 (3)      $0               $0                  0                $300
and CEO                           1996          $125,000 (3)      $0               $0                  0                $300

Lisa S. Guarino                   1998          $125,000 (4)      $0               $0                15,000             $300
Executive Vice President,         1997          $134,445 (4)      $0               $0                15,000             $300
CFO and Treasurer                 1996          $142,630 (4)      $0               $0                10,000             $300

Linda K. Summers                  1998          $184,907 (5)      $0               $0                15,000             $300
Regional Vice President           1997          $141,144 (5)      $0               $0                25,000             $300
of Subsidiary                     1996          $115,086 (5)      $0               $0                  0                $300
</TABLE>

         (1)      The aggregate amount of all perquisite compensation was less
                  than the lesser of $50,000 or 10% of the total annual salary
                  and bonus reported for each Named Executive Officer for fiscal
                  years ended December 31, 1998, 1997 and 1996.

         (2)      All dollar amounts listed in this column represent the
                  Company's contributions made on behalf of the Named Executive
                  Officers pursuant to the Keystone Rehabilitation System's Inc.
                  401(k) Retirement Savings Plan, a qualified plan for the
                  Company's employees pursuant to Section 401(k) of the Internal
                  Revenue Code of 1986, as amended (the "401(k) Plan"). The
                  401(k) Plan calls for certain annual matching contributions up
                  to prescribed limits of fifty percent (50%) of the employee
                  contribution with a maximum of $300 per employee. Employees
                  can defer up to twenty percent (20%) of their salary. The
                  Named Executive Officers were limited to a maximum deferral of
                  $10,000 for 1998, $9,500 for 1997, and $9,500 for 1996. The
                  401(k) Plan also provides that the Company can make
                  discretionary contributions; however, no such contributions
                  were made by the Company during the year ended December 31,
                  1998. During the year ended December 31, 1998, the Named
                  Executives received medical benefits under the Company's group



                                       27
<PAGE>   29



                  insurance policy, including disability and life insurance
                  benefits which are equivalent to such benefits paid to all
                  other full-time employees.

         (3)      During 1998, 1997, and 1996, Mr. Zaucha received annual cash
                  compensation in the amount of $40,200, $125,000 and $125,000,
                  respectively, which consisted entirely of salary pursuant to
                  his employment contract which is summarized herein. In 1998,
                  Mr. Zaucha voluntarily reduced his salary from $125,000 per
                  year to $12,500 per year for the period April 1, 1998 to
                  December 31, 1998. Mr. Zaucha also receives funds from the
                  Company in the form of lease payments, note payments and other
                  related-party transactions that relate to the merger with
                  Keystone. See, "Certain Relationships and Related
                  Transactions." Lease payments to Mr. Zaucha for 1998, 1997 and
                  1996 were $470,360. In conjunction with the merger with
                  Keystone, the Company is required to make earn out payments to
                  Mr. Zaucha, Alice Zaucha and the Zaucha Family Limited
                  Partnership in certain events, none of which have been made to
                  this date. The Company also paid $86,920 in 1998, $80,404 in
                  1997, and $86,320 in 1996 for real estate maintenance,
                  housekeeping and leasehold improvement construction services
                  to Impulse Development Corporation, a company controlled by
                  Mr. Zaucha.

         (4)      Included within Ms. Guarino's salary for 1997 was a severance
                  payment in the amount of $61,285 and consulting fees in the
                  amount of $39,506, which she received for services rendered
                  between May 8, 1997, and August 31, 1997, during which time
                  she was not an employee of the Company. Included within Ms.
                  Guarino's salary for 1996 was a severance payment in the
                  amount of $52,530. Ms. Guarino's position with the Company was
                  terminated on September 30, 1996 and she was reinstated to her
                  position in September 1997 as a result of the Consent
                  Solicitation (defined and discussed below).

         (5)      Included in Ms. Summers salary for 1998, 1997, and 1996 are
                  commissions and certain payments she earned pursuant to the
                  terms of her employment agreement and her termination
                  agreement with the Company. Ms. Summers' salary without taking
                  into account the commissions and other payments she earned
                  pursuant to the terms of her employment and termination
                  agreements was $79,288 for 1998, $86,461 for 1997, and $89,603
                  for 1996. Ms. Summers terminated her employment with the
                  Company on December 31, 1998. For a discussion of the material
                  terms of Ms. Summers' employment and termination agreements,
                  see the caption below entitled "Employment Agreements."

OPTION/SAR GRANTS IN FISCAL YEAR 1998

         The following table sets forth information as of December 31, 1998
concerning individual grants of options to purchase Common Stock made to Named
Executive Officers during 1998.

<TABLE>
<CAPTION>
                                                                                                           Potential Realizable    
                                                                                                          Value at Assumed Annual  
                                 # Securities         % of Total                                            Rates of Stock Price   
                                  Underlying         Options/SARS         Exercise                            Appreciation for    
                                 Options/SARS         Granted to          or Base       Expiration              Option Term       
           Name                    Granted             Employees           Price          Date                5%             10%  
           ----                    -------             ---------           -----          ----                --             ---  

<S>                              <C>                 <C>               <C>             <C>                 <C>            <C>   
Lisa S. Guarino                     5,000                3.99%             $0.73         04/14/03           $1,008         $2,228
                                    5,000                3.99%             $0.61         08/07/03             $843         $1,862
                                    5,000                3.99%             $0.90         11/06/03           $1,243         $2,747

Linda K. Summers (1)                2,500                1.99%             $0.75         03/31/03             $518         $1,145
                                    2,500                1.99%             $1.02         05/08/03             $705         $1,557
                                    5,000                3.99%             $0.61         08/07/03             $843         $1,862
                                    5,000                3.99%             $0.90         11/06/03           $1,243         $2,747
</TABLE>

                                       28


<PAGE>   30


(1)      Based upon Ms. Summers termination of her employment with the Company
         on December 31, 1998, all options held by Ms. Summers will expire on
         March 31, 1999.

AGGREGATED OPTION/SAR EXERCISES IN FISCAL YEAR 1998 AND FISCAL YEAR END 1998
OPTION/SAR VALUES

         The following table sets forth information regarding the exercise of
Options by Named Executive Officers during 1998. The table also shows the number
and value of unexercised Options that were held by the Named Executive Officers
as of December 31, 1998.

<TABLE>
<CAPTION>
                                                                           Number of Securities
                                                                          Underlying Unexercised             Value of Unexercised
                                 Number of Shares                                Options                     In-the-Money Options
                                   Acquired on             Value               Exercisable/                      Exercisable/
           Name                      Exercise            Realized             Unexercisable                     Unexercisable
           ----                      --------            --------             -------------                     -------------
<S>                              <C>                     <C>              <C>                                <C>
Lisa S. Guarino                          0                  $0                   40,000/0                          $3,800/0

Linda K. Summers (1)                     0                  $0                   40,000/0                          $3,075/0
</TABLE>

(1)      As indicated in footnote 1 to the table above, the options held by Ms.
         Summers will expire on March 31, 1999.

COMPENSATION OF DIRECTORS

         In 1998, each Director who was not an employee of the Company received
a quarterly retainer fee of $3,000 and attendance fees of $1,000 for each Board
of Director meeting at which he was present in person or via telephone means.
For the period January 1 through April 14, 1998, each Director who was not an
employee of the Company received an attendance fee of $1,000 for each committee
meeting at which he was present in person or via telephone means. Subsequent to
April 14, 1998, the committee meeting fee was reduced to $500 per meeting. In
addition, Directors were granted options on July 31, 1998, to purchase 25,000
shares, at market value, pursuant to re-election to the Board in June 1998.

EMPLOYMENT AGREEMENTS

Thomas W. Zaucha

         In November 1995, the Company and Thomas W. Zaucha, President and Chief
Executive Officer of the Company entered into an employment agreement for a term
of five years. The agreement specifies Mr. Zaucha's position and duties,
compensation and benefits, and termination provisions. The agreement also
contains a non-competition provision and a confidentiality provision.

         Under the terms of his employment agreement, Mr. Zaucha serves as the
President and Chief Executive Officer of the Company. Mr. Zaucha is entitled to
an annual base salary of $125,000 which may be increased but not decreased by
the Board at any time based on Mr. Zaucha's contribution to the success of the
Company and such other factors as the Board may deem appropriate. In 1998, Mr.
Zaucha voluntarily reduced his salary from $125,000 per year to $12,500 per year
for the time period April 1, 1998 through December 31, 1998. Mr. Zaucha is also
entitled to insurance and health benefit plans available generally to employees
of the Company and is eligible to participate in and receive grants under stock
option or bonus plans, profit sharing or similar plans and certain other
benefits generally available to employees of the Company. In addition, Mr.
Zaucha is entitled to a company car.

         The agreement with Mr. Zaucha also provides that if his employment is
terminated due to illness or disability, he will continue to receive all
payments when due under the agreement. If Mr. Zaucha's employment with the
Company is terminated by reason of his death, he will receive all payments under
the agreement when due as of the time of his death. If the Company terminates
Mr. Zaucha for cause, Mr. Zaucha will only be entitled to accrued and unpaid
salary.

                                       29

<PAGE>   31



Lisa S. Guarino

         In September 1997, the Company and Lisa S. Guarino, Executive Vice
President and Chief Financial Officer of the Company, entered into an employment
agreement for a term of one year which such term will automatically extend for
additional one year periods unless terminated by the Company with ninety days
prior written notice. The term of this agreement automatically extended for one
year on the first anniversary and is currently effective through August 31,
1999. Upon a change of control of the Company (as defined in the agreement) the
term of the agreement will automatically extend for one year from the date of
the change of control. In the event of a change of control, Ms. Guarino will
have the option of remaining with the Company or any surviving company or being
paid six months salary as severance.

         Under the terms of the agreement, Ms. Guarino serves as the Executive
Vice President and Chief Financial Officer and reports directly to the Chief
Executive Officer. Ms. Guarino is entitled to receive an annual salary of
$125,000. This annual salary cannot be reduced without the approval of Ms.
Guarino and may be increased at the Board's discretion, with a minimum increase
of $5,000 per year. Ms. Guarino voluntarily waived her right to the $5,000
increase in her salary that was due in September 1998 in consideration of the
financial circumstances of the Company. Ms. Guarino is entitled to all benefits
customary to full-time, exempt management employees of the Company. Ms. Guarino
is eligible to receive certain options on a quarterly basis if certain corporate
performance goals are achieved under the 1997 Stock Option Plan. In 1997, Ms.
Guarino received no options and in 1998, Ms. Guarino received 15,000 options
pursuant to this incentive stock option program under the 1997 Stock Option
Plan.

         The terms of the agreement also allow Ms. Guarino to operate her
consulting business and her accounting services company. Revenues under these
businesses were less than $2,500 in 1998.

Linda K. Summers

         In December 1997, the Company and Linda K. Summers, Regional Vice
President of the Company's subsidiary, Keystone Rehabilitation Systems, Inc.
("Keystone"), entered into an employment agreement for a term of one year which
would automatically renew for additional one year periods unless the agreement
was terminated or modified in writing pursuant to prior written notice of ninety
days of any anniversary date. This agreement was terminated effective September
30, 1998. As a result of the consolidation of regional management into the
Corporate office, Ms. Summers employment with the Company terminated December
31, 1998.

         Under the terms of the agreement, Ms. Summers served as Regional Vice
President of Keystone and reported directly to the President of Keystone. Ms.
Summers was entitled to receive an annual salary of $95,000. In addition, she
was entitled to certain bonuses and grants of options based on the financial
performance of the Company. In 1998, Ms. Summers received options to purchase
15,000 shares of Common Stock under the Company's 1997 Stock Option Plan. Ms.
Summers was also eligible to participate in the incentive programs which were
from time to time implemented by the Company. Ms. Summers was also entitled to
all benefits customary and usual for full-time exempt employees, and she had the
use of a company car at the discretion of the Chief Executive Officer.

                                       30

<PAGE>   32



      COMPENSATION & NOMINATING COMMITTEE REPORT ON EXECUTIVE COMPENSATION

         Executive Compensation Policy. The Company's compensation policy for
all of its executive officers is formulated and administered by the Compensation
& Nominating Committee of the Board. The Compensation & Nominating Committee
also administers the Company's 1992 Stock Option Plan, the 1994 Non-Employee
Directors Stock Option Plan and the 1997 Stock Option Plan, and the granting of
any options made outside of the Company's stock option plans pursuant to which
the Compensation & Nominating Committee periodically grants options to
directors, executive officers and other employees of the Company.

         The primary goals of the Company's compensation policy are to attract,
retain and motivate skilled executive officers and to encourage them to act in
the best interests of the Company's stockholders. In determining the level of
executive compensation, certain quantitative and qualitative factors, including,
but not limited to, the Company's operating and financial performance, the
individual's level of responsibilities, experience, commitment, leadership and
accomplishments relative to stated objectives, and marketplace conditions are
taken into consideration.

         Chief Executive Officer's Compensation. For 1998, the compensation of
Mr. Zaucha, the Chief Executive Officer of the Company, was set by the terms of
his employment agreement. A summary of the key provisions of Mr. Zaucha's
employment agreement is included elsewhere in this Annual Report. See
"Employment Agreements." Mr. Zaucha also participates in benefit programs that
are generally available to employees of the Company, including medical benefits
and a 401(k) savings plan. Mr. Zaucha has not participated in the Company's
Stock Option Plans to date.

         Executive Officer Compensation. During 1998, the Company also had an
employment agreement with Ms. Guarino, the Chief Financial Officer of the
Company. A summary of the key provisions of this employment agreement is
included elsewhere in this Annual Report. See "Employment Agreements." For the
year ended December 31, 1998, compensation paid to the executive officers of the
Company was determined primarily pursuant to the terms of the employment
agreements negotiated by the Company with the executives. For discretionary
compensation paid to executive officers that is not set by employment
agreements, the Compensation & Nominating Committee made subjective
determinations on a case-by-case basis based on recommendations of the Chief
Executive Officer as to each executive's merit and contribution to the success
of the Company.

         Section 162(m) of the Code. Section 162(m) of the Internal Revenue Code
of 1986, as amended (the "Code"), generally limits to $1 million the
deductibility by the Company of compensation paid in any one year to any
executive officer named in the Summary Compensation Table. As none of the
executive officers of the Company are currently paid compensation in excess of
$1 million, the Company has not yet developed a policy with respect to Section
162(m) of the Code.

                                          As submitted by the
                                          Compensation & Nominating Committee,
                                                   Mark G. Mykityshyn, Chairman
                                                   Lawrence F. Jindra, M.D.
                                                   Roger J. Reschini
                                                   David B. White


                                       31

<PAGE>   33



PERFORMANCE GRAPH

         The following graph compares the cumulative return on the Common Stock
from December 31, 1993 to December 31, 1998 with such return for the NASDAQ
Stock Market Index (U.S.), and The Standard & Poor's Midcap 400 Health Care
Sector Index (an Industry Index consisting of a peer group of 28 companies (1)
("Peer Group Index"). The performance graph assumes an investment of $100 on
December 31, 1993, together with the reinvestment of dividends. Each measurement
point on the graph below represents the cumulative stockholder return as
measured by the closing price at the end of each period during the period from
December 31, 1993 through December 31, 1998.

                  COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
   AMONG NORTHSTAR HEALTH SERVICES, INC., THE NASDAQ STOCK MARKET (U.S.) INDEX
                              AND A PEER GROUP (2)



<TABLE>
<CAPTION>
                                                    CUMULATIVE TOTAL RETURN
                                            -----------------------------------------
                                            12/93   12/94  12/95  12/96  12/97  12/98

<S>                                        <C>      <C>    <C>    <C>    <C>     <C>
NORTHSTAR HEALTH SERVICES, INC.              100      81     68     16     12      2
PEER GROUP                                   100     107    149    157    171    217
NASDAQ STOCK MARKET (U.S.)                   100      98    138    170    208    294
</TABLE>


* $100 INVESTED ON 12/31/93 IN STOCK OR INDEX
  INCLUDING REINVESTMENT OF DIVIDENDS.
  FISCAL YEAR ENDING DECEMBER 31.


(1) The Peer Group Index consists of the following 28 companies: Acuson Corp;
Allegiance Corp; Apria Healthcare Group Inc.; Beckman Coulter, Inc.; Beverly
Enterprises, Inc.; Concentra Managed Care, Inc.; Covance, Inc.; Dentsply Intl.,
Inc. New; First Health Group Corp.; Forest Labs, Inc.; Foundation Health Sys.,
Inc.; Health Mgmt. Assoc., Inc. New; Icn Pharmaceutical Inc., New; Ivax Corp;
Lincare Hldgs, Inc.; Mylan Labs, Inc.; Omnicare, Inc.; Oxford Health Plans,
Inc.; Pacificare Hlth Sys., Inc., Del; Quintiles Transnational Corp; Quorum
Health Group, Inc.; Sepracor, Inc.; Steris Corp.; Stryker Corp.; Sybron Intl.;
Total Renal Care Hldgs, Inc.; Trigon Healthcare Inc.; and Watson
Pharmaceuticals, Inc.

(2) On May 31, 1996, NASDAQ suspended trading in the Company's Common Stock.


                                       32
<PAGE>   34


ITEM 12.   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

         The following table sets forth information as of March 15, 1999 with
respect to the beneficial ownership of the Common Stock by (i) each person known
by the Company to be the beneficial owner of more than five percent (5%) of the
Common Stock; (ii) each person serving as a director of the Company; (iii) each
Named Executive Officer (defined below) and (iv) all current directors and
executive officers of the Company as a group. Unless otherwise indicated, all
shares are owned directly and the indicated owner has sole voting and
dispositive power with respect thereto.

<TABLE>
<CAPTION>
                              Beneficial Owner                          COMMON STOCK BENEFICIALLY OWNED (1)
                              ----------------                          -----------------------------------
                                                                        Number (2)                   Percent
                                                                        ----------                   -------
<S>                                                                   <C>                         <C>  
             5% HOLDERS (3)
             Thomas W. Zaucha (4)                                         963,958                      16.1%

             DIRECTORS (3)
             Lawrence F. Jindra, M.D. (5)                                  75,000                      1.2%
             James H. McElwain (5)                                         75,000                      1.2%
             Mark G. Mykityshyn (5)                                        75,000                      1.2%
             Roger J. Reschini (6)                                        193,271                      3.2%
             David B. White (5)                                            75,000                      1.2%

             NAMED EXECUTIVE OFFICERS (3)
             Lisa S. Guarino (7)                                           47,000                        *
             Linda K. Summers (8)                                          40,000                        *

             ALL CURRENT DIRECTORS AND EXECUTIVE OFFICERS AS A
             GROUP (total 9 persons)                                    1,652,779                    25.3%
</TABLE>

             ---------------------------------------------------
             * LESS THAN 1% OF THE OUTSTANDING COMMON STOCK

     (1)  Pursuant to the regulations of the Securities and Exchange Commission
          (the "Commission"), shares are deemed to be "beneficially owned" by a
          person if such person directly or indirectly has or shares (i) the
          power to vote or dispose of such shares, whether or not such person
          has any pecuniary interest in such shares, or (ii) the right to
          acquire the power to vote or dispose of such shares within 60 days,
          including any right to acquire through the exercise of any option,
          warrant or right.

     (2)  Represents total number of shares of Common Stock owned by each
          person, which each named person or group has the right to acquire,
          through the exercise of options within sixty (60) days, together with
          Common Stock currently owned, as a percentage of the total number of
          shares of Common Stock outstanding as of March 15, 1999. In accordance
          with the Commission's rules, the ownership percentage of each person
          or group is calculated treating all shares, including options to
          purchase shares, beneficially owned by such person or group as issued
          and outstanding shares.

     (3)  Mr. Thomas W. Zaucha is also a Director, the President and the Chief
          Executive Officer of the Company.

     (4)  Includes 681,201 shares of Common Stock owned directly by Mr. Zaucha
          and his wife, Alice L. Zaucha, as joint tenants, 207,757 shares of
          Common Stock are held by the Zaucha Family Limited Partnership whose
          sole partners are currently Mr. Zaucha, Mrs. Zaucha and their four
          children, and 75,000 shares of Common Stock which are held by Mr.
          Zaucha as sole beneficial owner. If the Special Committee of the Board
          of Directors recommends the issuance of additional shares for payment
          of obligations due to the Zaucha's, Mr. Zaucha's beneficial ownership
          of Common Stock would increase significantly. Mr. Zaucha's business
          address is Northstar Health Services, Inc., 665 Philadelphia Street,
          Indiana, Pennsylvania 15701.



                                       33
<PAGE>   35


     (5) Comprised entirely of options to purchase shares of Common Stock.

     (6) Includes 108,271 shares of Common Stock indirectly owned by the
         Reschini Agency, Inc., of which Mr. Reschini is a majority owner,
         10,000 shares of Common Stock which are held by Mr. Reschini as sole
         beneficial owner and options to purchase 75,000 shares of Common Stock.

     (7) Includes 7,000 shares of Common Stock which are held by Ms. Guarino as
         sole beneficial owner and options to purchase 40,000 shares of Common
         Stock.

     (8) Although Ms. Summers was a member of senior management and is a "Named
         Executive Officer" as that term is defined under the Commission's
         regulations, she is not an executive officer of the Company. Ms.
         Summers employment with the Company terminated on December 31, 1998.

ITEM 13.   CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

         Current management does not adopt or affirm any related party
disclosures made in public filings prior to May 16, 1996, including financial
statements. The transactions discussed herein are based on current management's
knowledge at this point in time.

TRANSACTIONS RELATED TO THOMAS W. ZAUCHA

         CONSENT SOLICITATION EXPENSES

         In February 1997, Thomas W. Zaucha, the current Chairman of the Board
of Directors and Chief Executive Officer of Northstar, commenced a solicitation
of Northstar stockholder consents to remove and replace the other members of the
Northstar Board of Directors which at the time consisted of Messrs. Brody,
Jarrett, Pesci, Smallacombe and Watson (the "Brody Board") and effectuate
related changes in Northstar's bylaws (the "Consent Solicitation"). Shortly
thereafter, the Board of Directors terminated Mr. Zaucha's employment with the
Company, though he remained a member of the Board of Directors. On March 24,
1997, Mr. Zaucha delivered executed consents representing the votes of 61% of
the outstanding shares in favor of his proposals and, following confirmation of
the decision of the Delaware Chancery Court on May 8, 1997, Mr. Zaucha resumed
his duties as the Company's Chief Executive.

         Since the decision of the Delaware Chancery Court confirming the
results of the Consent Solicitation was affirmed by the Delaware Supreme Court
on August 1, 1997, the Company will reimburse Mr. Zaucha for the expenses he
incurred in connection with the Consent Solicitation. To date, those expenses,
which primarily consist of investment advisory fees, legal fees, printing and
proxy solicitation costs and incidental expenses approximate $1,750,000.

         KEYSTONE ACQUISITION

          Mr. Thomas Zaucha was the founder and principal owner of Keystone
which merged with the Company in November 1995 and is now the Company's
principal operating subsidiary. In connection with the Keystone acquisition, Mr.
Thomas Zaucha sold his interest in the former Keystone and has gross debt and
other amounts due directly to him by the Company of $3,919,500, respectively, as
of December 31, 1998, 1997 and 1996. In addition, Mr. Zaucha's Family Limited
Partnership is due $1,105,500 from the Company as of December 31, 1998, 1997 and
1996.

         As required under the Keystone Merger Agreement, immediately prior to
the merger, Keystone sold, at fair market value determined by a third party
appraisal, all of the real estate previously owned by Keystone to the Zaucha
Family Limited Partnership, of which Mr. Zaucha is a general partner, and a
related entity, in return for a payment of $5,215,568. The parcels of such real
estate used in Keystone's business were then leased to Keystone. At the request
of Mr. Zaucha, the Company formed a Special Committee of the Board to evaluate
the fairness of the lease agreements as well as certain other financial
arrangements Mr. Zaucha has with the Company. The Special Committee has
evaluated, through an appraisal by an independent real



                                       34
<PAGE>   36



estate professional, the fair market lease rates for these properties, and has
determined that the leases are substantially within the range of market rent in
the aggregate, and therefore, a renegotiation of the leases is not required. The
leases are for a period of either five or ten years, and commenced November 15,
1995. Lease payments were $470,360 for 1998, 1997 and 1996. Future minimum lease
payments under these leases aggregate in excess of $3.5 million.

         In conjunction with the acquisition of Keystone by Northstar, Mr.
Zaucha and the Zaucha Family Limited Partnership were granted certain contingent
payments (earn-out payments) based on the financial performance of Keystone
during the period from 1996 to 2000.

         IMPULSE DEVELOPMENT CORPORATION

         The Company also uses, on an as needed basis, the services of Impulse
Development Corporation, a Company controlled by Thomas Zaucha, for real estate
maintenance, housekeeping and leasehold improvement construction. Payments to
Impulse totaled $86,920 in 1998, $80,404 in 1997, and $86,320 in 1996.

         OTHER

         The Reschini Agency, Inc., of which Roger J. Reschini, a current
Director, is a majority owner, acts as the Company's broker for professional and
general liability insurance. During 1998, 1997 and 1996, the Company paid
premiums of approximately $132,000, $214,000 and $184,000, respectively, for
these insurance coverages. The agency received commissions of approximately
$14,000 in 1998, $25,000 in 1997 and $22,000 in 1996. During 1997, the Company
entered into a simultaneous transaction with the Reschini Agency, Inc. whereby
the Company paid $180,000 for insurance premiums and the Reschini Agency
purchased 108,271 shares of Common Stock.

         The Company retains the law firm of Burns, White & Hickton, of which
Mr. David B. White , a current director, is a named partner, for various
litigation matters.

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

(a)      1.   FINANCIAL STATEMENTS

         The financial statements, together with the report thereon of the
Company's independent accountants, are included in this report on the pages
listed below.

         Report of Independent Public Accountants                            F-1

         Consolidated Balance Sheets
                  as of December 31, 1997 and 1996                           F-2

         Consolidated Statements of Operations
                  for the years ended December 31, 1997, 1996 and 1995       F-4

         Consolidated Statements of Stockholders' Equity
                  for the years ended December 31, 1997, 1996 and 1995       F-5

         Consolidated Statements of Cash Flows
                  for the years ended December 31, 1997, 1996 and 1995       F-7

         Notes to Consolidated Financial Statements                          F-8

(a)      2.   FINANCIAL STATEMENT SCHEDULES



                                       35
<PAGE>   37

                                                                            Page
                                                                            ----

         Schedule II - Valuation and Qualifying Accounts
                  for the years ended December 31, 1997, 1996 and 1995      F-30

         Report of Independent Public Accountants
                  On Financial Statement Schedule                           F-31

(a)      3.   LISTING OF EXHIBITS

         THE EXHIBITS REQUIRED BY ITEM 601 OF REGULATION S-K ARE INCLUDED UNDER
ITEM 14(c) HERETO.

(b)      REPORTS ON FORM 8-K

         Registrant filed no Reports on Form 8-K during the last quarter of the
         period covered by this report.

(c)      EXHIBITS REQUIRED BY ITEM 601 OF REGULATION S-K

         The following exhibits required by Item 601 of Regulation S-K are set
         forth in the following list and are filed either by incorporation or by
         reference from previous filings with the Securities and Exchange
         Commission or by attachment to this Form 10-K.

3.1.1    Articles of Incorporation of Northstar Health Services, Inc., as filed
         in the state of Delaware, filed as an exhibit to the Company's Annual
         Report on Form 10-K for fiscal year ended December 31, 1996, is
         incorporated by reference.

3.1.2    Amendment to Certificate of Incorporation, as filed in the state of
         Delaware, filed as an exhibit to the Company's Quarterly Report on Form
         10-Q dated August 7, 1998, is incorporated by reference.

3.2.1    Bylaws of Northstar Health Services, Inc., filed as an exhibit to the
         Company's Quarterly Report on Form 10-Q dated August 14, 1997, is
         incorporated by reference.

3.2.2    Amendment to the Bylaws of Northstar Health Services, Inc., filed as an
         exhibit in the Company's Form 8-K, dated September 1, 1998, is
         incorporated by reference.

4.1      1997 Stock Option Plan, filed as an exhibit to the Company's Annual
         Report on Form 10-K for fiscal year ended December 31, 1997, is
         incorporated by reference.

4.2      1992 Stock Option Plan, as amended, filed as an exhibit to the
         Company's Annual Report on Form 10-K for fiscal year ended December 31,
         1996, is incorporated by reference.

4.3      Form S-8 Registration Statement (No. 33-94584), 1992 Stock Option Plan
         filed July 14, 1995, is incorporated by reference.

4.4      Form S-8 Registration Statement (No. 333-57051), 1997 Stock Option Plan
         filed June 17, 1998, is incorporated by reference.

4.5      Post Effective Amendment No. 1 to Form S-8 Registration Statement (No.
         33-94584), 1994 Stock Option Plan, filed June 17, 1998, is incorporated
         by reference.

10.1     Employment Agreement dated November 15, 1995, between Northstar Health
         Services, Inc. and Thomas W. Zaucha, filed as an exhibit to the
         Company's Form 8-K dated November 15, 1995, is incorporated by
         reference.



                                       36
<PAGE>   38


10.2     Employment Agreement dated September 1, 1997, between Northstar Health
         Services, Inc. and Lisa S. Guarino, filed as an exhibit to the
         Company's Quarterly Report on Form 10-Q dated November 14, 1997, is
         incorporated by reference.

10.3     Forbearance Agreement between Northstar Health Services, Inc. and IBJ
         Schroder Bank & Trust Co., dated August 18, 1997, filed as an exhibit
         to the Company's Annual Report on Form 10-K for fiscal year ended
         December 31, 1997, is incorporated by reference.

10.4     Extension Supplement between Northstar Health Services, Inc. and IBJ
         Schroder Bank & Trust Co. dated August 29, 1997, filed as an exhibit to
         the Company's Annual Report on Form 10-K for fiscal year ended December
         31, 1997, is incorporated by reference.

10.5     Extension Supplement between Northstar Health Services, Inc., Cerberus
         Partners, LLP and IBJ Schroder Bank & Trust Co. dated October 1, 1997,
         filed as an exhibit to the Company's Annual Report on Form 10-K for
         fiscal year ended December 31, 1997, is incorporated by reference.

10.6     Extension Supplement between Northstar Health Services, Inc., Cerberus
         Partners, LLP and IBJ Schroder Bank & Trust Co. dated November 12,
         1997, filed as an exhibit to the Company's Annual Report on Form 10-K
         for fiscal year ended December 31, 1997, is incorporated by reference.

10.7     Extension Supplement between Northstar Health Services, Inc., Cerberus
         Partners, LP and Bear Sterns & Co., dated August 28, 1998, filed as an
         exhibit to the Company's Quarterly Report on Form 10-Q dated November
         6, 1998, is incorporated by reference.

10.8     Extension Supplement between Northstar Health Services, Inc., Cerberus
         Partners, LP and Bear Sterns & Co., dated October 29, 1998, filed as an
         exhibit to the Company's Quarterly Report on Form 10-Q dated November
         6, 1998, is incorporated by reference.

10.9     Extension Supplement between Northstar Health Services, Inc., Cerberus
         Partners, LP and Bear Sterns & Co., dated December 21, 1998.

10.10    Extension Supplement between Northstar Health Services, Inc., Cerberus
         Partners, LP and Bear Sterns & Co., dated January 26, 1999.

10.11    Extension Supplement between Northstar Health Services, Inc., Cerberus
         Partners, LP and Bear Sterns & Co., dated February 22, 1999.

10.12    Assignment and Acceptance Agreement between Northstar Health Services,
         Inc. and Cerberus Partners, LP, dated September 8, 1997, filed as an
         exhibit to the Company's Annual Report on Form 10-K for fiscal year
         ended December 31, 1997, is incorporated by reference.

21       Subsidiaries of the Registrant

27       Financial Data Schedule


                                       37
<PAGE>   39



                                   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, on the 29th day of
March, 1999.

                                       NORTHSTAR HEALTH SERVICES, INC.

                                       By: /s/ Thomas W. Zaucha
                                          ------------------------------------
                                           Thomas W. Zaucha, Chairman, CEO,
                                           President and Director
                                           (Principal Executive Officer)

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

<TABLE>
<CAPTION>
              Signature                                    Title                                      Date
              ---------                                    -----                                      ----

<S>                                         <C>                                                 <C> 
/s/ Lisa S. Guarino                         Executive Vice President, Chief Financial            March 29, 1999
----------------------------                Officer and Treasurer
                                            (Principal Accounting and Financial Officer)

/s/ Lawrence F. Jindra, MD                  Director                                             March 29, 1999
---------------------------

/s/ James H. McElwain                       Director                                             March 29, 1999
---------------------------

/s/ Mark G. Mykityshyn                      Director                                             March 29, 1999
---------------------------

/s/ Roger J. Reschini                       Director                                             March 29, 1999
---------------------------

/s/ David B. White                          Director                                             March 29, 1999
---------------------------
</TABLE>



                                       38

<PAGE>   40
                                                    
                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS


    To Northstar Health Services, Inc.:

         We have audited the accompanying consolidated balance sheets of
    Northstar Health Services, Inc. (a Delaware corporation and the Company) and
    Subsidiaries as of December 31, 1998 and 1997, and the related consolidated
    statements of operations, stockholders' equity and cash flows for each of
    the three years in the period ended December 31, 1998. These financial
    statements are the responsibility of the Company's management. Our
    responsibility is to express an opinion on these financial statements based
    on our audits.

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

         In our opinion, the financial statements referred to above present
    fairly, in all material respects, the consolidated financial position of
    Northstar Health Services, Inc. and Subsidiaries as of December 31, 1998 and
    1997, and the results of their operations and their cash flows for the three
    years then ended, in conformity with generally accepted accounting
    principles.

         The accompanying financial statements have been prepared assuming that
    the Company will continue as a going concern. As discussed in Note 7 to the
    consolidated financial statements, the Company has suffered significant
    losses from operations, has a net capital deficiency, has not paid all
    creditors on a timely basis and is not meeting its contractual obligations
    with regard to debt principal and interest payments and certain financial
    covenants which the lender has not waived. These matters raise substantial
    doubt about the Company's ability to continue as a going concern.
    Management's plans in regard to these matters are also described in Note 7.
    The financial statements do not include any adjustments relating to the
    recoverability and classification of asset carrying amounts or the amount
    and classification of liabilities that might result should the Company be
    unable to continue as a going concern.

                                                             Arthur Andersen LLP

    Pittsburgh, Pennsylvania,
      March 5, 1999



                                      F-1
<PAGE>   41


                NORTHSTAR HEALTH SERVICES, INC. AND SUBSIDIARIES
                      CONSOLIDATED BALANCE SHEETS (NOTE 1)
                             (Dollars in Thousands)


<TABLE>
<CAPTION>
                                A S S E T S                        December 31,      December 31,
                                -----------                           1998              1997 
                                                                   ------------      ------------

<S>                                                                <C>               <C>    
CURRENT ASSETS:
    Cash and cash equivalents                                        $   901          $   657
    Accounts receivable-
       Patients, net of allowances for doubtful accounts of
           $497 and $1,341 respectively                                4,624            5,818
       Management fees                                                   224              350
       Miscellaneous                                                     458              309
    Prepaid expenses and other current assets                            399              162
                                                                     -------          -------
                  Total current assets                                 6,606            7,296
                                                                     -------          -------
PROPERTY AND EQUIPMENT, net (Notes  5, 6 and 10)                       2,231            2,814

INTANGIBLE ASSETS, net (Note 4)                                       19,811           19,221

OTHER ASSETS                                                             126              183
                                                                     -------          -------
TOTAL ASSETS                                                         $28,774          $29,514
                                                                     =======          =======
</TABLE>



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




                                      F-2
<PAGE>   42


                NORTHSTAR HEALTH SERVICES, INC. AND SUBSIDIARIES
                      CONSOLIDATED BALANCE SHEETS (NOTE 1)
                    (Dollars in Thousands, Except Share Data)


<TABLE>
<CAPTION>

                   LIABILITIES AND STOCKHOLDERS' EQUITY                        December 31,      December 31, 
                   ------------------------------------                           1998               1997
                                                                               ----------        ------------
<S>                                                                            <C>                <C>
CURRENT LIABILITIES:
    Current portion of long-term debt (Notes 6, 7, and 12)
       Senior Debt                                                               $ 14,083         $ 14,083
       Thomas Zaucha and Zaucha Family Limited Partnership                          4,069            2,932
       Other debt                                                                     509            1,206
    Accounts payable                                                                  833            2,401
    Accrued expenses (Note 8)
       Thomas Zaucha and Zaucha Family Limited Partnership                          8,907            2,107
       Other obligations                                                            4,318            5,369
    Contractual obligations to employees (Note 16)                                    915            1,031
                                                                                 --------         --------

                  Total current liabilities                                        33,634           29,129
                                                                                 --------         --------

LONG-TERM DEBT (Notes 6, 7, and 12)
    Thomas Zaucha and Zaucha Family Limited Partnership                               809            1,757
    Other debt                                                                        242              282
                                                                                 --------         --------
                  Total long term debt                                              1,051            2,039

MINORITY INTEREST (Note 3)                                                            181              145
                                                                                 --------         --------

                  Total liabilities                                                34,866           31,313
                                                                                 --------         --------

STOCKHOLDERS' EQUITY (Notes 3, 6, 9, 12 and 13)
    Preferred stock, par value $.01 per share, 1,000,000 shares
       authorized, none issued                                                         --               --
    Common stock, par value $.01 per share, 20,000,000 shares authorized;
       6,337,988 shares issued at December 31, 1998 and 1997
                                                                                       63               63
    Additional paid-in capital                                                     22,599           26,388
    Warrants outstanding                                                            1,487            2,392
    Retained deficit                                                              (29,788)         (30,189)
    Less: Treasury stock, 362,564 shares in 1998 and 1997, at cost                   (453)            (453)
                                                                                 --------         --------
                  Total stockholders' deficit                                      (6,092)          (1,799)
                                                                                 --------         --------

TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY                                       $ 28,774         $ 29,514
                                                                                 ========         ========
</TABLE>


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




                                      F-3
<PAGE>   43


                NORTHSTAR HEALTH SERVICES, INC. AND SUBSIDIARIES
                 CONSOLIDATED STATEMENTS OF OPERATIONS (NOTE 1)
              FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
                    (Dollars in Thousands, Except Share Data)

<TABLE>
<CAPTION>
                                                                              1998                 1997                1996
                                                                           -----------         -----------         -----------
<S>                                                                        <C>                 <C>                 <C>        
REVENUE:
   Net patient service revenue                                             $    30,410         $    30,903         $    35,041
   Management fee revenue                                                        1,471               1,703               2,831
                                                                           -----------         -----------         -----------
            Total revenue                                                       31,881              32,606              37,872

COSTS OF SERVICE                                                                14,851              16,413              18,789
                                                                           -----------         -----------         -----------
       Gross profit                                                             17,030              16,193              19,083

OPERATING EXPENSES:
    Selling, general and administrative expenses                                10,570              11,312              12,892
    Bad debt expense                                                               343               2,024               1,820
    Restructuring and other non-recurring items (Note 9)                         1,114               2,578               4,969
    Amortization of intangibles (Note 4)                                           929               1,117               1,623
    Depreciation and amortization                                                  569                 561                 635
    Management fee expenses                                                      1,355               2,542               3,100
                                                                           -----------         -----------         -----------
           Total operating expenses                                             14,880              20,134              25,039
                                                                           -----------         -----------         -----------
                                                                                                                   -----------

OPERATING INCOME/(LOSS)                                                          2,150              (3,941)             (5,956)

NON-OPERATING EXPENSES:
    Interest expense, net                                                        1,934               2,229               2,130
    Other (income)/expense, net                                                   (264)                 50                  96
                                                                           -----------         -----------         -----------
             Total non-operating  expenses                                       1,670               2,279               2,226
                                                                           -----------         -----------         -----------
                                                                                                                  

INCOME/(LOSS) BEFORE INCOME TAXES                                                  480              (6,220)             (8,182)

INCOME TAXES (Note 14)                                                            (366)               (770)                471
                                                                           -----------         -----------         -----------

INCOME/(LOSS) BEFORE MINORITY INTEREST                                             846              (5,450)             (8,653)

MINORITY INTEREST                                                                  445                 163                 294
                                                                           -----------         -----------         -----------

NET INCOME/(LOSS)                                                          $       401         $    (5,613)        $    (8,947)
                                                                           ===========         ===========         ===========

EARNINGS PER SHARE - BASIC                                                 $      0.07         $     (0.95)        $     (1.44)
                                                                           ===========         ===========         ===========

EARNINGS PER SHARE - DILUTED                                               $      0.07         $     (0.95)        $     (1.44)
                                                                           ===========         ===========         ===========

WEIGHTED AVERAGE NUMBER OF COMMON SHARES AND EQUIVALENTS - BASIC
                                                                             5,975,424           5,880,501           6,216,840
                                                                           ===========         ===========         ===========

WEIGHTED AVERAGE NUMBER OF COMMON SHARES AND EQUIVALENTS  - DILUTED
                                                                             6,015,382           5,880,501           6,216,840
                                                                           ===========         ===========         ===========
</TABLE>




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


                                      F-4
<PAGE>   44




                NORTHSTAR HEALTH SERVICES, INC. AND SUBSIDIARIES
            CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (NOTE 1)
              FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
                             (Dollars in Thousands)


<TABLE>
<CAPTION>
                                              Common Stock              Common Shares Issuable        
                                              ------------              ----------------------        Additional        Warrants
                                      Shares Issue       Amount         Shares          Amount      Paid-in Capital   Outstanding
                                      ------------       ------         ------          ------      ---------------   -----------
<S>                                       <C>                  <C>         <C>              <C>           <C>              <C>   
BALANCE, December 31, 1995                5,285,366            $ 53        944,352          $5,591        $20,626          $1,951
 Issuance of shares issuable
    (Note 3)                                944,352               9      (944,352)         (5,591)          5,582               -
  Receipt of common stock as
      treasury stock through
      surrender of a note                         -               -              -               -              -               -
      receivable (Note 3)
  Write off of uncollectible notes
     receivable                                   -               -              -               -              -               -
  Net Loss                                        -               -              -               -              -               -
                                     --------------------------------------------------------------------------------------------

BALANCE, December 31, 1996                6,229,718              62              -               -         26,208           1,951
  Issuance of common stock                  108,270               1              -               -            180               -
  Issuance of warrants for
    consulting services                           -               -              -               -              -             441
     
  Net Loss                                        -               -              -               -              -               -
                                     --------------------------------------------------------------------------------------------

BALANCE, December 31, 1997                6,337,988              63              -               -         26,388           2,392
  Expiration of warrants                          -               -              -               -            905           (905)
  Recognition of stock guarantee in
    connection with acquisition                   -               -              -               -         (4,694)              -
  Net Income                                      -               -              -               -              -               -

                                     --------------------------------------------------------------------------------------------
BALANCE, December 31, 1998                6,337,988             $63              -               -        $22,599          $1,487
                                     ============================================================================================
</TABLE>






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



                                      F-5
<PAGE>   45



                NORTHSTAR HEALTH SERVICES, INC. AND SUBSIDIARIES
            CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (NOTE 1)
              FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
                             (Dollars in Thousands)

<TABLE>
<CAPTION>
                                                          Treasury Stock
                                         Retained       -------------------       Notes
                                         (Deficit)      Shares       Amount     Receivable      Total
                                         ---------      ------       ------     ----------      -----
                                                           
<S>                                     <C>            <C>         <C>          <C>           <C>    

BALANCE, December 31, 1995               $(15,629)           --     $     --     $ (2,225)     $ 10,367
  Issuance of shares issuable
     (Note 3)                                  --            --           --           --            --
  Receipt of common stock as
    treasury stock through surrender           --       362,564          453        2,150         1,697
    of a note receivable (Note 3)
  Write off of uncollectible
    notes receivable                           --            --           --           75            75
  Net Loss                                 (8,947)           --           --           --        (8,947)
                                         --------      --------     --------     --------      --------

BALANCE, December 31, 1996                (24,576)      362,564          453           --         3,192
  Issuance of common stock                     --            --           --           --           181
  Issuance of warrants for
    consulting services                        --            --           --           --           441
  Net Loss                                 (5,613)           --           --           --        (5,613)
                                         --------      --------     --------     --------      --------

BALANCE, December 31, 1997                (30,189)      362,564          453           --        (1,799)
  Expiration of warrants                       --            --           --           --            --
  Recognition of stock guarantee in
    connection with acquisition                --            --           --           --        (4,694)
  Net Income                                  401            --           --           --           401

                                         --------      --------     --------     --------      --------
BALANCE, December 31, 1998               $(29,788)      362,564     $    453     $     --      $ (6,092)
                                         ========      ========     ========     ========      ========
</TABLE>


    The accompanying notes are an integral part of these financial statements


                                      F-6
<PAGE>   46


                NORTHSTAR HEALTH SERVICES, INC. AND SUBSIDIARIES
              CONSOLIDATED STATEMENTS OF CASH FLOWS (NOTES 1 AND 2)
              FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
                             (Dollars in Thousands)

<TABLE>
<CAPTION>
CASH FLOWS FROM OPERATING ACTIVITIES:                                             1998           1997             1996
                                                                                ---------      --------        ---------

<S>                                                                            <C>             <C>             <C>
    Net income/(loss)                                                           $   401         $(5,613)        $(8,947)
    Adjustments to reconcile net loss to net cash provided by (used in)
       operating activities-
          Depreciation and amortization                                           3,170           3,255           4,293
          Legal settlements                                                          --          (2,001)             --
          Provision for doubtful accounts                                           343           2,020           1,820
          Loss on note receivable collateralized by common stock                     --              --           1,772
          Loss on write off of investment                                            --              --              25
          Interest on discounted obligation                                         209             223             241
          (Gain)/loss on sale of equipment                                          (13)             66              47
          Gain on sale of joint venture interests                                  (190)             --              --
          Provision for increase in contractual obligations to employees             26              63             262
          Compensation expense related to options and warrants                       --             441             113
          Minority interest                                                         445             163             294
          Change in current assets and liabilities-
              Decrease/(increase)/ in receivables                                 1,047          (1,392)           (912)
              (Increase)/decrease in other current assets                          (237)            569             126
              (Decrease)/increase in accounts payable                            (1,568)            353           1,592
              (Decrease)/increase in accrued expenses                            (1,447)          2,858           1,755
                                                                                -------         -------         -------
                  Net cash provided by operating activities                       2,186           1,005           2,481
                                                                                -------         -------         -------

CASH FLOWS FROM INVESTING ACTIVITIES:
    Acquisitions, net of cash acquired                                               --              --             (10)
    Capital expenditures                                                           (544)           (434)           (345)
    Deposits, loans and investments                                                  57              99             (12)
    Proceeds from sale of equipment                                                  88              31              18
                                                                                -------         -------         -------
                  Net cash used in investing activities                            (399)           (304)           (349)
                                                                                -------         -------         -------

CASH FLOWS FROM FINANCING ACTIVITIES:
   Proceeds from issuance of common stock                                            --             181              --
   Payments on long-term debt                                                    (1,079)         (1,041)         (1,566)
   Payment of acquisition note to Thomas Zaucha                                      --              --          (5,100)
   Payments of contractual obligations to employees                                (143)           (665)            (79)
   Distributions to minority interests                                             (396)           (202)           (226)
   Borrowings on long-term debt                                                      75              76             716
                                                                                -------         -------         -------
                  Net cash used by financing activities                          (1,543)         (1,651)         (6,255)
                                                                                -------         -------         -------

NET INCREASE/(DECREASE) IN CASH AND CASH EQUIVALENTS                                244            (950)         (4,123)

CASH AND CASH EQUIVALENTS, beginning balance                                        657           1,607           5,730
                                                                                -------         -------         -------

CASH AND CASH EQUIVALENTS, end balance                                          $   901         $   657         $ 1,607
                                                                                =======         =======         =======

SUPPLEMENTAL DISCLOSURE OF CASH FLOW DATA:
Interest paid                                                                   $ 1,877         $ 1,520         $   821
Income taxes paid                                                                    11              41             216

NONCASH INVESTING ACTIVITIES:
Capital lease obligations                                                       $   194         $    43         $   395
Earn-out accrued on Keystone acquisition                                          2,502              --              --
Accrual for Keystone acquisition stock price guarantee                            4,694              --              --
Issuance of Common Stock warrants for services                                       --             441              --
Treasury stock received through surrender of note receivable collateral              --              --             453
</TABLE>



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


                                      F-7
<PAGE>   47


                NORTHSTAR HEALTH SERVICES, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.  DESCRIPTION OF BUSINESS ORGANIZATION AND SIGNIFICANT EVENTS:

Nature of Operations
--------------------

         Northstar Health Services, Inc. ("Northstar" or the "Company") is a
regional provider of physical rehabilitation and other healthcare services,
including diagnostic testing, in Pennsylvania and adjacent states, providing
services at outpatient rehabilitation clinics and patient care facilities to
patients suffering from physical disabilities. The goals of rehabilitation
therapy are to improve a patient's physical strength and range of motion, reduce
pain, prevent injury and restore the ability to perform basic activities,
including communication. The Company provides these services primarily through
outpatient rehabilitation clinics and under contractual arrangements with other
patient care facilities, such as nursing homes and hospitals. The term "Company"
means, unless otherwise indicated, the Company and its subsidiaries and their
respective predecessors.

Trading of Common Shares
------------------------

         The Company's Common Stock was traded on the NASDAQ National Market
beginning June 3, 1993 under the symbol "NSTR". After some of the events
outlined below occurred, trading of the Company's Common Stock was halted by the
NASDAQ National Market on May 31, 1996.

Resignation of Auditors and Immediate Board Changes
---------------------------------------------------

         In March 1996, the Company's auditors, KPMG Peat Marwick ("KPMG"), who
had been appointed in late 1995, resigned prior to completing an audit of
Northstar. Soon after KPMG's resignation, the Company's former Chairman of the
Board, Mark A. DeSimone was asked to resign from the Company's Board of
Directors along with one independent director. Certain members of management
were also relieved from their duties. Concurrently, Thomas W. Zaucha was
appointed as Chairman of the Board and a non-employee member of the Board of
Directors was appointed to investigate certain allegations of improprieties.

Stockholders' Suits
-------------------

         Following the resignation of KPMG, while the Company was conducting its
investigation and before the Company filed its suit as discussed below, the
Company was named in suits filed by groups of stockholders. See Note 20 for a
discussion of the settlement of this litigation.

Company's Suit
--------------

         Based upon the investigation completed by special independent legal
counsel, the Board of Directors voted to pursue legal actions against the
Company's former Chairman of the Board; certain former employees; the
predecessor auditors of the Company (for years prior to 1995), Richard A. Eisner
& Company; and certain other individuals and entities who were allegedly
involved in improper actions and diversion of funds to other entities. A
complaint was filed in the Western District of Pennsylvania United States
District Court on September 12, 1996. See Note 20 for a further discussion of
the settlement of this litigation.

Consent Solicitation
--------------------

     In February 1997, Thomas W. Zaucha, the current and then Chairman of the
Board of Directors and Chief Executive Officer of the Company, commenced a
solicitation of Northstar shareholder consents to remove and replace the other
members of the Northstar Board of Directors and effectuate related changes in
Northstar's bylaws (the "Consent Solicitation"). Shortly thereafter, the Board
of Directors terminated Mr. Zaucha's employment with the Company, though he
remained a member of the Board of Directors. On March 24, 1997, Mr. Zaucha
delivered executed consents representing the votes of 61% of the outstanding
shares in favor of his proposals and, following confirmation of the decision by
the Delaware Chancery Court on May 8, 1997, Mr. Zaucha resumed his duties as the
Company's Chief Executive Officer.

     The ruling of the Delaware Chancery Court was appealed to the Delaware
Supreme Court by three of the Board members removed from office as a result of
the Chancery Courts' decision. On August 1, 1997, a unanimous panel of the
Delaware Supreme Court affirmed the decision of the Delaware Chancery Court
confirming the election of the current Board. See Note 9 regarding related legal
costs.


                                      F-8
<PAGE>   48



2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

Principles of Consolidation
---------------------------

         The consolidated financial statements include the accounts of the
Company, its wholly-owned subsidiaries, and its interests in partnerships and
joint venture arrangements only for the period subsequent to their acquisition.
All significant intercompany balances and transactions have been eliminated. The
Company uses the equity method of accounting for less than majority-owned
entities.

Basis of Presentation
---------------------

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

Reclassifications
-----------------

         Certain reclassifications have been made to prior year financial
statements to conform with the current year presentation.

Accounting Pronouncements
-------------------------

         During 1998, the Company has adopted SFAS No. 130, No. 131 and No. 132.
SFAS No. 130, "Reporting Comprehensive Income", establishes standards for the
reporting and display of elements of comprehensive income in the financial
statements. Since the Company does not have any components of comprehensive
income, this pronouncement has had no impact on the financial statements. SFAS
No. 131, "Disclosures about Segments of a Business Enterprise and Related
Information", requires certain information to be reported about operating
segments on a basis consistent with the Company's internal organizational
structure. The Company is operated as a single segment; thus, there are no
additional disclosure requirements. The Company also adopted SFAS No. 132,
"Employers' Disclosures about Pensions and Other Postretirement Benefits", which
revises the disclosures for pensions and other postretirement benefits and
standardizes them into a combined format. As the Company only has a defined
contribution plan for its employees, this pronouncement has had no effect on the
Company's financial statement disclosures.

Industry Risks
--------------

         The healthcare industry in the United States continues to experience
significant change even without passage of comprehensive legislative reform at
the federal level. The primary force for change in today's competitive
marketplace continues to be the consolidation and increased efficiency in
healthcare delivery and financing.

         An increasing number of the Company's third-party payors are adopting
prospective payment systems. The Company has signed provider contracts with
managed care organizations, which emphasize utilization control and cost
containment, and the Company's business with these managed care organizations is
expected to increase significantly in the next few years. Managed care
organizations either directly transfer risk to healthcare providers through
capitation payment arrangements or pay for units of service on a steeply
discounted basis. These factors cause significant challenges to all providers,
including the Company.

Net Patient Service Revenue
---------------------------

         The Company has agreements with certain third-party payors that provide
for payments to the Company at amounts different from its established fee
schedules.

         For 1998 and prior, services rendered to Medicare program beneficiaries
are paid based on a cost reimbursement methodology subject to cost limitations.
The Company is reimbursed for services at a tentative interim rate with final
settlement determined after submission of annual cost reports by the Company and
audits thereof by the Medicare fiscal intermediary. The Company's Medicare cost
reports have been audited with final settlements determined by the Medicare
fiscal intermediary through December 31, 1995 for all providers. Any normal
recurring types of changes arising from audit or settlement after the close of
the fiscal year are reflected in subsequent years' net patient service revenue.
In accordance with the Balanced Budget Act, effective January 1, 1999, the
Company will be reimbursed based upon the physician Medicare fee schedule.



                                      F-9
<PAGE>   49


         The Company has also entered into payment agreements with certain
commercial insurance carriers, health maintenance organizations and preferred
provider organizations. The basis for payment to the Company under these
agreements includes prospectively determined rates and discounts from
established charges. Certain of these contracts provide capitation terms whereby
the Company receives a sum of money per covered member within the certain
insurance plan and in return the Company agrees to provide all of the
rehabilitation and certain diagnostic testing which is deemed medically
necessary for these plan members. In addition to the payments from the insurance
organizations, the Company may, depending on the coverage circumstances, collect
co-payment amounts directly from patients for each event of service.

         The Company grants credit without collateral to its patients, most of
whom are local residents and are insured under third-party payor agreements. The
mix of gross receivables from patients and third-party payors at December 31,
1998 and 1997, was as follows:

<TABLE>
<CAPTION>
                                                                      1998         1997
                                                                     -------      ------
<S>                                                                 <C>         <C>
Workers' compensation                                                     21%         30%
Other third-party payors                                                  36          24
Blue Cross, Blue Shield & related managed care products                   21          21
Contracts with nursing homes and other such providers                      9          12
Medicare                                                                  11          10
Self-pay patients                                                          1           3
Medicaid                                                                   1           -
                                                                     -------      ------
                                                                         100%        100%
                                                                     =======      ======
</TABLE>

         The healthcare industry is subject to numerous laws and regulations of
federal, state and local governments. These laws and regulations include, but
are not necessarily limited to, matters such as licensure, accreditation,
requirements of government healthcare program participation, reimbursement for
patient services, and Medicare and Medicaid fraud and abuse. Recently,
government activity has increased with respect to investigations and allegations
concerning possible violations of fraud and abuse statutes and regulations by
healthcare providers. Violations of these laws and regulations could result in
expulsion from government healthcare programs together with imposition of
significant fines and penalties, as well as significant repayments for patient
services previously billed. Management believes that the Company is in
compliance with fraud and abuse as well as other government laws and
regulations. While the Company is not aware of any current violations,
compliance with such laws and regulations can be subject to future government
review and interpretation as well as regulatory actions unknown or unasserted at
this time.

Management Fees
---------------

         The Company manages, on a contract basis, a mobile diagnostics
business. Also, during a portion of 1996 and 1997, the Company managed a
physician practice, which was discontinued in June 1997. In conjunction with
these contracts, the Company receives compensation in the form of a monthly
management fee. This fee is equal to the net income or loss of the managed
business after the payment of certain agreed-upon salaries and benefits to
certain parties. The management fees and related expenses are presented in the
Revenue and Operating Expenses sections of the Consolidated Statements of
Operations.

Insurance
---------

         The Company presently insures against malpractice with independent
third-party insurers utilizing claims-made policies, and workers' compensation
risks with independent third-party insurers or state Workers' Compensation
insurance funds, where required.

Cash and Cash Equivalents
-------------------------

         All cash equivalents are stated at cost, which approximates market. The
Company considers all highly liquid investments purchased with a maturity of
three months or less when purchased to be cash equivalents.

Property and Equipment
----------------------

         The Company's property and equipment are stated at cost and are
depreciated using the straight-line method over the estimated useful lives of
the assets or the term of the lease, as appropriate. Most non-leased depreciable
assets have estimated useful lives in the range of five to seven years.

         Upon disposal of property items, the asset and related accumulated
depreciation accounts are relieved of 


                                      F-10
<PAGE>   50


the amounts recorded therein for such items, and any resulting gain or loss is
reflected in income.

Deferred Costs
--------------

         Debt issuance costs are amortized over the term of the debt. Such costs
are included in intangibles.

Intangible Assets
-----------------

         Intangible assets consist of the excess of cost over net assets of
acquired organizations (goodwill), non-compete and employment agreements with
certain key employees of organizations which have been acquired, the Keystone
tradename and assembled workforce and other intangibles consisting primarily of
deferred financing costs.

         In March 1995, the Financial Accounting Standards Board (the "FASB")
issued Statement of Financial Accounting Standards ("SFAS") No. 121, "Accounting
for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed
Of." This accounting pronouncement requires that long-lived assets and
identifiable intangibles to be held and used by an entity are to be reviewed for
impairment whenever events or changes in circumstances indicate that the
carrying amount of the assets may not be recoverable.

         The Company chose early adoption of this accounting pronouncement as of
December 31, 1995. As factors indicate that intangible assets should be
evaluated for possible impairment, the Company has used an estimate of the
related operations' undiscounted cash flows over the remaining life of the
various intangible assets in measuring whether these intangible assets are
recoverable. The Company's evaluations have resulted in adjustments to goodwill
and the Keystone assembled workforce as of December 31, 1998 and 1997. See Note
4.

Treasury Stock
--------------

         The Company may periodically repurchase its own stock as a result of a
specific transaction or as part of an organized repurchase plan. The Company
accounts for such stock repurchases on the cost basis and records the stock
value as a contra-equity line item on its financial statements. Treasury Stock
was received in December 1996 as a result of a surrender of 362,564 shares of
Common Stock in connection with a certain note receivable. See Note 3.

Earnings Per Common Share
-------------------------

         The Company has determined earnings per share in accordance with SFAS
No. 128, "Earnings Per Share", for all periods presented. Under SFAS No. 128,
earnings per share are classified as basic earnings per share and diluted
earnings per share. Basic earnings per share includes only the weighted average
common shares outstanding. Diluted earnings per share includes the weighted
average common shares outstanding and any dilutive common stock equivalent
shares in the calculation. All prior periods have been restated to reflect this
adoption. Treasury shares are treated as retired for earnings per share
purposes.

        The following table reflects the calculation of earnings per share under
SFAS No. 128:

<TABLE>
<CAPTION>
                                                                             For the year ended December 31,
                                                                         1998             1997              1996
                                                                         ----             ----              ----
<S>                                                                  <C>          <C>               <C>      
         Basic earnings per share:
            Net income/(loss)                                         $      401       $   (5,613)      $    (8,947)
            Average shares outstanding                                 5,975,424        5,880,501         6,216,840
            Income/(loss) per share                                   $     0.07       $    (0.95)      $     (1.44)
         Diluted earnings per share:
            Net income/(loss)                                         $      401       $   (5,613)      $    (8,947)
            Average shares outstanding                                 5,975,424        5,880,501         6,216,840
            Stock options                                                 39,958                -                 -
                                                                      ----------       ----------       -----------
            Diluted average shares outstanding                         6,015,382        5,880,501         6,216,840
            Loss per share                                            $     0.07       $    (0.95)      $     (1.44)
</TABLE>

         At December 31, 1998, 1997 and 1996, options to purchase 723,333,
1,187,758, and 681,200, and warrants to purchase 565,000, 843,500 and 693,500
shares of common stock, respectively, were outstanding, but were not included in
the computation of diluted earnings per share because the options' and warrants'
exercise prices were greater than the average market price of the Company's
common shares for the periods and due to the loss position of the Company for
1997 and 1996. Also, not included in the calculation of diluted earnings per
share were the shares that may be issued to the Zauchas in connection with the
Keystone merger that is subject to the approval of the Special Committee and of
the Board of Directors. See Note 3. The Zaucha Stock Guarantee, which is
currently


                                      F-11
<PAGE>   51


recorded as a liability in accrued expenses (see Note 8), could be satisfied by
all cash, all stock, or a combination of both cash and stock.

3.  MERGERS, ACQUISITIONS AND JOINT VENTURE AGREEMENTS:

Keystone Rehabilitation Systems, Inc. ("Keystone")
--------------------------------------------------

         On November 15, 1995, NSK Merger Corp., a newly-formed subsidiary of
the Company, was merged with and into Keystone (a Pennsylvania corporation).
Prior to this merger (the "Merger"), Keystone was the largest privately held
rehabilitation company in Pennsylvania, providing services in physical,
occupational and speech therapy, including sports rehabilitation and work
hardening in outpatient clinics, as well as in patient care facilities, located
throughout Pennsylvania and in New York, Ohio and West Virginia.

         As consideration for the Merger, the shareholders of Keystone, Thomas
W. Zaucha and Alice L. Zaucha and the Zaucha Family Limited Partnership
(collectively, the "Shareholders"), received the following: (a) $2,500,000 in
cash; (b) a Time Note due January 3, 1996, in the aggregate principal amount of
$5,100,000; (c) a five-year, interest free Term Note in the aggregate principal
amount of $2,625,000; (d) the agreement by the Company to issue, on January 3,
1996, a three-year, 6% Term Note in the aggregate principal amount of $2,400,000
(the Three-Year Note); and (e) the agreement by the Company to issue to the
Shareholders, on January 3, 1996, an aggregate of 944,352 shares of Common
Stock, par value $.01 per share (the "Common Stock"), of the Company (the "Stock
Consideration"). The debt issued in this acquisition was discounted using
current market rates. See Note 6.

         In connection with the Merger, the Company (i) guaranteed the value of
the Stock Consideration to be at least $5,600,000 through certain periods ending
no later than December 31, 1997; (ii) agreed to seek necessary stockholder
approval to allow the Three-Year Note to be converted into Common Stock at the
conversion price of $5.93 per share and to pay any guaranteed amount in
additional shares of Northstar Common Stock based on the trading price of the
Common Stock at the time of issuance; and (iii) issued a five-year interest-free
note to David D. Watson, Keystone's Chief Operating Officer and Executive Vice
President, in the aggregate principal amount of $375,000, in release of any
interest Mr. Watson might have had in Keystone. Similar to the debt in the
preceding paragraph, this obligation to Mr. Watson was discounted using the
Company's current borrowing rate.

         As discussed above, a stock price of $5.93 per share was guaranteed to
the Shareholders for periods ending not later than December 31, 1997. Based on
the weighted average trading volume of the daily closing price per share for the
ten consecutive trading days immediately prior to the third business day prior
to the determination date of December 31, 1997, the Company's Common Stock was
valued at $0.96 per share. The Company has a contractual obligation to fund this
shortfall in stock value through a cash payment equal to the shortfall or, with
shareholder approval, through the issuance of additional shares to the
Shareholders in an amount equal to the shortfall. Based on above formula, the
Company was obligated to either make a cash payment of $4,693,423 or issue
approximately 4,888,982 additional shares of stock. The Company does not
currently have sufficient cash to pay this obligation. This amount has been
recorded as a liability in accrued expenses at December 31, 1998 (Note 8), with
the offset recorded to Additional Paid-In Capital. The Special Committee of the
Board of Directors has been charged with the authority to negotiate the
satisfaction of this obligation with the Shareholders, which could be done
through the payment of cash, issuance of stock, issuance of notes, or a
combination of any or all of these items. At the Company's Annual Meeting held
on June 11, 1998, the Company's stockholders approved the issuance of up to
4,888,982 shares of Common Stock in order to enable the Company to fully satisfy
the obligations of the Company under the guarantee in stock if deemed
appropriate by the Special Committee.

         The Company also agreed to make additional "earn-out" payments to the
Shareholders of $1,600,000 per year in the event that Keystone's "EBITDA"
exceeds $2,500,000 in any year from 1996 to 2000, inclusive. EBITDA is defined,
generally, to mean Keystone's earnings (including earnings from any internally
generated facility or contract but excluding earnings from any facility or
contract acquired from third parties) before taxes, interest, depreciation and
amortization. In the event an earn-out is not earned and therefore not paid in
any given year, the earn-out will be paid in the next year if EBITDA in such
next year exceeds the greater of $3,200,000 or $2,500,000 plus the amount of the
EBITDA shortfall in such prior year. The Shareholders are to receive an earn-out
of approximately $200,000 for 1995. The calculation for the earn-out amounts for
years 1996 through 2000 includes a reduction in the amount due in the event that
the current liabilities of Keystone at the date of the Merger (other than
permitted capital leases) exceeded $2,000,000. In addition, such earn-out
payments are to be reduced by 50% of such current liabilities up to $2,000,000.
Former management of the Company believed that, based on the results of
operations for 1996 as well as that management's interpretation of the
above-outlined adjustments, the 1996 earn-out computation resulted in no amounts
due to the Shareholders. The current Board of Directors appointed a Special
Committee to review these calculations and the issues in dispute. The Special
Committee and the Zaucha's have agreed that no earn-out will be paid for 1996,
the earn-out for the year 1997 will be reduced by $504,725 and the earn-out for
the years 1998 through



                                      F-12
<PAGE>   52


2000 will be reduced by a minimum of $192,800 per year. The earn-out payments
for all years will accelerate and become due within 90 days after any change in
ownership or control of the Company or a sale of the majority of the assets of
the business. The Company has determined that, based on the results of
operations for 1997, there are no amounts due to the Shareholders for the 1997
earn-out. However, the Company has determined that the EBITDA for 1998 exceeds
the greater of $3,200,000 or $2,500,000 plus the amount of the EBITDA shortfall
in 1997, and, therefore, in accordance with the carryover provision above, there
is an amount due to the Shareholders in the amount of $1,095,275 for 1997. The
Company has determined that, based on the results of operations for 1998, there
is an amount due to the Shareholders in the amount of $1,407,200 for 1998.
Accordingly, at December 31, 1998, the Company accrued the earn-out payments of
$2,502,475 with an offsetting entry to goodwill.

         The consideration for the Merger was determined by arms-length
negotiations among the various parties. In connection with this Merger, the
Company paid fees of approximately $145,000 to Commonwealth Associates and the
Company paid cash of $450,000 and issued 150,000 shares of Common Stock with a
market value of $937,500 to Commercial Financial Corporation. See Note 12.

         At the effective time of the Merger, the Company paid $2,500,000 in
cash to the Shareholders and deposited $5,100,000 in a cash collateral account
with a bank to support a letter of credit securing the Company's obligation to
pay the Shareholders $5,100,000 on January 3, 1996. This obligation was paid on
its due date. The Company borrowed $3,500,000 of such amounts under the
$6,500,000 acquisition line portion of its then existing $16,000,000 credit
facility with IBJ Schroder Bank and Trust Company. The remainder of the funds
required at the effective time of the Merger were provided from working capital.

         Immediately prior to the Merger and in accordance with the Merger
Agreement, Keystone transferred to the Zaucha Family Limited Partnership, of
which Thomas W. Zaucha is a general partner, all of the real estate owned by
Keystone for approximately $5,200,000, the independently appraised value of the
assets involved. These funds were used to pay off real estate and other debt
owed to a bank by Keystone. In connection with the Merger, the parcels of such
real estate used in Keystone's business were then leased to Keystone. See Note
12 for discussion of these rental payments.

         As part of the Merger, certain of the executive officers of Keystone
entered into employment agreements with and became executive officers of the
Company. See Note 15.

Penn Vascular Lab, P.C. ("PVL")
-------------------------------

         On November 28, 1995, the Company acquired from PVL (a Pennsylvania
professional corporation) certain assets and the stock of Vascusonics, Inc. (a
Pennsylvania corporation or Vascusonics). The agreement provided for a
management services contract whereby the Company would provide such services to
PVL for a period of two years in exchange for a fee equal to the excess of
collected revenue over the sum of $75,000 and PVL's business expenses. Although
the management services contract expired on November 28, 1997, it was renewable
annually at the mutual agreement of both parties. The purchase agreement also
provided the Company with the option to purchase the stock of PVL for one dollar
under certain circumstances, during the period one year after the management
services contract is terminated.

         As consideration for the above-mentioned items, the Company (a) paid
$50,000 to the Seller upon the consummation of the agreement; (b) loaned
$2,150,000 to the Seller in exchange for a note; (c) provided the Seller with
shares of Northstar Common Stock with a fair market value equivalent of
$2,150,000 on the date of the acquisition; (d) promised to pay $100,000 to the
Seller in twelve equal non-interest bearing installment payments beginning in
December 1996; and (e) promised to pay certain contingent payments to the
Seller. The non-interest bearing note to the Seller was discounted using a
market rate of interest. See Note 6. Additionally, in exchange for the loan and
the Common Stock the Seller agreed to pay back to Northstar the lesser of
$2,150,000 or the proceeds from the sale of the Common Stock. The aforementioned
Northstar stock was pledged by the Seller as collateral for the note.

         The contingent payments, as revised by mutual agreement in January
1997, to the Seller are based upon the Net Collected Revenues, as defined, for
the years ending December 31, 1997 and 1998. If during either of the two years
ending December 31, 1998, the Net Collected Revenues of the businesses acquired
exceeded $3,200,000, then a payment of $37,500 is to be made to the Seller. If
the Collected Revenues were in excess of $3,400,000 and $3,600,000, in each year
then the payment to the physician would be $137,500 and $237,500, respectively.
The Company has determined that under the terms of this calculation, there is no
contingent payment due for the years ending December 31, 1998 and 1997.

         During 1996, the Seller returned to the Company the shares of Common
Stock which were issued in



                                      F-13
<PAGE>   53



conjunction with the acquisition and the note receivable which was
collateralized with those shares. As of the date of the stock surrender, the
value of the stock collateral had decreased to $1.25 per share. Accordingly, the
Company included in its 1996 consolidated statement of operations the effect of
the reduction in collateral value.

         In January 1997, the Company reached a settlement agreement with the
Seller of PVL regarding several disputes. In the terms of this agreement, the
Company reduced certain future payments due to the Seller from $100,000 to
$50,000, acquired ownership rights to disputed equipment, and reduced contingent
payment amounts.

         The Company borrowed $2,500,000 under the $6,500,000 acquisition
portion of its then existing $16,000,000 credit facility with IBJ Schroder Bank
and Trust Company. These borrowings financed the $2,150,000 promissory note to
the Seller and a $350,000 broker fee. Under the purchase agreement, Ultrasonics,
Inc. (Ultrasonics) took ownership of PVL's and Vascusonics' accounts receivable
on the date of purchase just prior to the consummation of the purchase
agreement. Also, Ultrasonics assumed certain leases for equipment used by the
Company and entered into new lease terms with the Company. Ultrasonics is a
related party that is owned and operated by Jeff Bergman.

         The Company believed that the lease arrangements with Ultrasonics were
for lease rates that were greatly in excess of market rates. At the date of the
merger, Ultrasonics paid off leases that represented a net liability to PVL of
$155,000. However, the lease arrangement with Ultrasonics obligated the Company
to principal payments totaling $1,333,000 over the term of the leases. The
Company treated the excessive lease payments of $1,178,000 as a disproportionate
dividend, and ceased making payments to Ultrasonics in March 1996. In March
1997, Ultrasonics filed suit against the Company as a result of these disputed
lease agreements. In March 1998, the Company reached a settlement in principle
with Ultrasonics, Inc. and Jeff Bergman that resulted in mutual releases and no
payments to either party.

         In connection with the PVL acquisition, the Company paid a brokerage
fee of $350,000 to Mr. James P. Shields. Mr. Shields is a cousin of Mr.
DeSimone, the former Chairman of the Board of Directors of the Company.
Additionally, in connection with the above mentioned management services
contract, the Company provided shares of Common Stock with a fair market value
of approximately $300,000 to Mr. Shields in consideration for him to renegotiate
his employment agreement with the Company so as to include duties with respect
to both PVL and Vascusonics. The term of this management contract was for a
period of seven years and compensation consisted of a management fee of 12% of
the gross collections. Prior to this revised contract, Mr. Shields received
compensation equal to 5% of gross collections. In March 1996, the Company
canceled Mr. Shield's contract and severed his relationship with the Company.
See Note 12.

Joint Venture Activities
------------------------

         Prior to 1995 the Company formed joint ventures with CDL Medical
Technologies, Inc. ("CDL") and C.F. Services, Inc. ("CFS") to provide mobile
diagnostic services, including cardiac services, in Western Pennsylvania. In
1998, the Company sold its 51% interest in each of these joint ventures to CDL
and CFS, recording a gain of approximately $167,000 and 23,000, respectively,
which is recorded as other income in the accompanying statement of consolidated
operations. The proceeds from the sale to CFS were received in 1998, and the
Company recorded the proceeds from the sale to CDL as a miscellaneous receivable
at December 31, 1998, with subsequent receipt in January 1999.

4.  INTANGIBLE ASSETS:

Intangible Assets and the related amortization periods consist of the following
(dollars in thousands):

<TABLE>
<CAPTION>
                                                               December 31,
                                                               ------------
                                                            1998           1997
                                                            ----           ----
<S>                                                      <C>              <C>     
Excess of cost over net assets acquired (40 years)        $ 18,708         $ 17,480
Employment agreements (2 to 7-1/2 years)                       625              625
Keystone tradename (20 years)                                2,500            2,500
Covenant not to compete (5 years)                               78               78
Assembled Keystone workforce (5 years)                         450              600
Deferred financing and other costs (5 years)                   831              846
                                                          --------         --------
                                                          $ 23,192         $ 22,129
Less accumulated amortization                               (3,381)          (2,908)
                                                          ========         ========
Intangible assets                                         $ 19,811         $ 19,221
                                                          ========         ========
</TABLE>


                                      F-14
<PAGE>   54



         As discussed in Note 2, the Company has chosen to adopt SFAS No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
Be Disposed Of" as of December 31, 1995. In accordance therewith, as of December
31, 1998, the Company has used an estimate of the related operations'
undiscounted cash flows over the remaining life of the various intangible assets
in measuring whether these assets are recoverable.

         As of December 31, 1997, management evaluated the remaining intangibles
that resulted in adjustments to decrease the Assembled Keystone workforce in the
amount of $400,000, net of accumulated amortization to date. As of December 31,
1998, management evaluated the remaining intangibles that resulted in
adjustments to decrease goodwill in the amount of $1,274,000 and the Assembled
Keystone workforce in the amount of $150,000, net of accumulated amortization to
date. On a going-forward basis, the Company will continue to evaluate whether
later events and circumstances have occurred that indicate the remaining
estimated useful life of goodwill may warrant revision or that the remaining
balance of intangible assets may not be recoverable. When factors indicate that
intangible assets should be evaluated for possible impairment, the Company will
use an estimate of the related operation's undiscounted cash flow over the
remaining life of the goodwill in measuring whether the goodwill or other
intangible asset is recoverable. Any subsequent asset impairment will be
accounted for as a charge to the operating expenses of the Company.

5.  PROPERTY AND EQUIPMENT:

Property and equipment consists of the following (dollars in thousands):

<TABLE>
<CAPTION>
                                              December 31,
                                              ------------
                                          1998             1997
                                          ----             ----
<S>                                      <C>             <C>
Vehicles                                 $   189         $   301
Clinical equipment                         1,860           1,720
Furniture and fixtures                       850             890
Leased medical equipment                   1,644           1,934
Leasehold improvements                       952             780
                                         -------         -------
                 Total cost basis        $ 5,495         $ 5,625
Less accumulated depreciation             (3,264)         (2,811)
                                         =======         =======
Property and equipment - net             $ 2,231         $ 2,814
                                         =======         =======
</TABLE>

6.  DEBT:

<TABLE>
<CAPTION>
 Debt consists of the following (dollars in thousands):                                     December 31,
                                                                                            ------------
                                                                                         1998            1997
                                                                                         ----            ----
<S>                                                                                    <C>            <C>    
Term loan with senior lender due in 60 monthly graduated 
  payments, plus interest at a Base Rate plus 1.5% in 1998 
  and 1997 (Note 7)                                                                     $ 6,083        $ 6,083
Revolving line of credit with senior lender, due on demand
  and no later than 10/20/00, interest payable monthly a Base
  Rate plus 1.5% in 1998 and 1997 (Note 7)                                                2,000          2,000
Acquisition facility with senior lender, due in equal monthly
  installments beginning 4/30/97 at a Base Rate plus 2% in
  1998 and 1997 (Note 7)                                                                  6,000          6,000
Non-interest bearing term notes to Thomas Zaucha and the
  Zaucha Family Limited Partnership, approximately $85,000
  due on 11/15/97 and then approximately $210,000 due
  quarterly until 11/15/00 (interest imputed at 9%)                                       2,625          2,625
Term notes to Thomas Zaucha and the Zaucha Family
  Limited Partnership, due in equal quarterly installments
  beginning on 9/30/96 of $200,000, 6% stated interest
  rate (interest imputed at 9%)                                                           2,400          2,400
Capital lease obligations with interest rates ranging from
  9% to 15.6%                                                                               579          1,241
Other debt                                                                                  441            685
                                                                                        -------        -------
Total debt                                                                              $20,128        $21,034
</TABLE>



                                      F-15
<PAGE>   55





<TABLE>
<CAPTION>
                                 December 31,
                                 ------------
                             1998             1997
                             ----             ----
<S>                       <C>              <C>
Less:
    Current portion         (18,661)         (18,221)
    Debt discount              (416)            (774)
                           --------         --------
Long-term debt             $  1,051         $  2,039
                           ========         ========
</TABLE>

The Company's weighted average interest rate was 9.0% and 10.4% for 1998 and
1997, respectively.

IBJ Schroder and Cerberus Partners Facility 
------------------------------------------- 

         On October 20, 1995, the Company closed on a credit facility with IBJ
Schroder Bank and Trust Company ("IBJ"). The facility consisted of a $6,500,000
term loan to refinance existing obligations, a $3,000,000 revolving line of
credit to fund operations and a $6,500,000 acquisition facility to fund the
Company's existing and future acquisition activity (collectively, the IBJ
Facility). The total facility had a final maturity of five years from the date
of closing. The term loan was funded in full at closing and was used to repay an
existing bank credit facility. The term loan was to be repaid through 60 monthly
payments beginning at $83,333 and ending at $133,337 with interest at either the
LIBOR rate plus 300 basis points or a Base Rate, as defined, plus 1.5%, subject
to the terms and conditions of the credit agreement. Repayment terms required
the revolving line of credit to be paid in full five years from closing, and
interest accrued thereon at either LIBOR rate plus 300 basis points or the Base
Rate plus 1.5% subject to the terms and conditions of the credit agreement. The
repayment terms on the acquisition facility were $142,857 per month beginning
April 30, 1997, and for a period of 42 months at either the LIBOR rate plus 350
basis points or the Base Rate plus 2.0% subject to the terms and conditions of
the credit agreement. The IBJ facility was secured by a first priority lien on
substantially all of the assets of the Company. In addition, the credit
agreement had various financial compliance covenants with which the Company must
comply, including certain ratios and free cash flow requirements. See Note 7.
Fees paid in connection with the IBJ facility consisted of a 1.25% commitment
fee paid at closing, 0.5% unused revolving line of credit fee and a 0.5% unused
acquisition facility fee, subject to the terms and conditions of a credit
agreement.

         In addition, the Company issued to IBJ certain warrants (the "IBJ
Warrants"). The IBJ Warrants may be exercised to purchase up to 240,000 shares
of the Company's Common Stock at an exercise price of $6.76 per share until
October 20, 2000. The IBJ Warrants and the shares underlying the IBJ Warrants
have been registered. The fair market value of the IBJ Warrants on the date of
issuance, October 20, 1995, was $703,000.The Company accounted for the IBJ
Warrants as a debt discount and is amortizing the fair market value of these
warrants on a straight-line basis over the 60 months life of the IBJ Facility.

         As of December 31, 1996, the term loan portion of this facility had
been drawn down in full, the remaining $1,000,000 of the original revolving line
of credit balance was canceled, and $6,000,000 of the acquisition facility had
been used and the remaining $500,000 had been terminated by the bank. See Note
7.

         In September 1997, Cerberus Partners, LP, ("Cerberus") a diversified
financial securities firm that invests in publicly traded and private debt
issues of both large and middle market companies, purchased from IBJ all of the
Company's senior debt amounting to $15.3 million, including principal and
accrued interest. The debt was purchased subject to the existing Credit
Agreement and forbearance agreement and extensions thereof. The Company executed
an Assignment and Acceptance Agreement and consented to the transfer of the IBJ
Warrants to Cerberus in connection with this matter. The Company is currently
negotiating an amended and restated agreement that provides for repayment
through monthly graduated payments, plus interest monthly, and revised financial
and other covenant provisions. A closing date on this agreement has not been
determined at this time.

At December 31, 1998, the scheduled aggregate annual maturities of long-term
debt are as follows (dollars in thousands):

                            1999          $ 18,921
                            2000             1,090
                            2001                94
                            2002                14
                            2003                 9
                                          -------- 
                            Total         $ 20,128
                                          ========



                                      F-16
<PAGE>   56


7.  COVENANTS UNDER CREDIT AGREEMENT:

         Current management does not believe that the Company was ever in
compliance with the covenants of the IBJ Facility. During 1996, the Company
entered into two forbearance agreements with IBJ regarding the events of default
on the IBJ Facility. Under the terms of these forbearance agreements, IBJ agreed
not to institute the default rate of interest on the notes and also agreed not
to force the Company into accelerated payment. The second forbearance agreement
expired on December 31, 1996. On August 18, 1997, current management of the
Company entered into a new forbearance agreement with IBJ that expired on August
31, 1997, and was subsequently extended with Cerberus through March 31, 1999.

         The financial covenants, among other restrictions, of the IBJ Facility
for fiscal year 1995 do not permit (a) the ratio of Consolidated Current Assets
to Consolidated Current Liabilities, as defined, at any time to be less than
1.75 to 1.00; (b) Consolidated EBITDA for the twelve months ended December 31,
1995, to be less than $3,300,000; (c) the Consolidated Net Worth at any time to
be less than the sum of (i) $18,000,000, (ii) 80% of Consolidated Net Income on
a cumulative basis (without deduction for any losses) for the period commencing
on October 1, 1995 and ending on the last day of the Determination Period most
recently ended and (iii) the Net Proceeds of any sale or other disposition of
any equity securities by the Borrower, (d) the ratio, for any Determination
Period ending on the last day of any calendar month during any period set forth,
including the three months ended December 31, 1995, of (i) Consolidated EBITA
for such Determination Period minus Capital Expenditures made during such
Determination Period to (ii) Consolidated Fixed Charges for such Determination
Period, to be less than the ratio set forth of 1.20 and (e) (i) with respect to
any Determination Period, the aggregate principal amount of all Acquisition
Loans and Term Loans outstanding on the last day of such Determination Period
plus the aggregate Revolving Credit Commitments as of the last day of such
Determination Period to exceed the Free Cash Flow of the Borrower and its
consolidated Subsidiaries for such Determination Period multiplied by 3.25, and
(ii) the sum of Consolidated Indebtedness as of the last day of such
Determination Period and the aggregate Available RC Commitment as of the last
day of such Determination Period to exceed the Free Cash Flow of the Borrower
and its consolidated Subsidiaries for such Determination Period multiplied by
3.75. Similar covenants were applicable to fiscal years 1996, 1997 and 1998, and
are stated in the agreement for subsequent fiscal years.

         The non-financial covenants of the IBJ Facility included but were not
limited to the Company furnishing (a) annual audited financial statements within
90 days to IBJ without a "going concern" opinion and (b) quarterly financial
data within 45 days of a quarter-end.

         Effective May 31, 1996, the Company entered into a forbearance
agreement with IBJ Schroder regarding certain events of default on the IBJ
facility. IBJ agreed to forbear on the default events in the event that the
Company complied with certain additional covenants regarding cash receipts and
disbursements, levels of cash collections, and amount of service revenues. Some
of the covenants in the loan agreement may have changed in conjunction with the
negotiation of the forbearance agreement. In addition, there are numerous
reporting requirements of the Company to IBJ regarding these covenants. As of
December 31, 1996, the then current management of the Company believed that it
had substantially complied with all of these covenants. In conjunction with the
forbearance agreements, IBJ and the Company agreed to convert all Eurodollar
based loans to Base Rate loans. As of December 31, 1996, the interest rate on
all outstanding borrowing was denominated in the Base Rate.

         On August 18, 1997, the current management of the Company entered into
a Forbearance Agreement with IBJ that terminated August 31, 1997. After the
purchase of the debt by Cerberus, the Company entered into extensions of this
agreement through March 31, 1999, while negotiations on an amended credit
agreement are taking place. As the Company is in default on the original credit
facility and has not received any waivers regarding events of non-compliance,
all indebtedness due to Cerberus at December 31, 1998, is still classified as
current in the accompanying consolidated balance sheet. Other indebtedness did
not contain cross-default provisions and long-term portions thereof have not
been classified as current.

         The Company experienced a modest profit of $.4 million for the year
ended December 31, 1998. However, during the previous three years the Company
has suffered significant losses from operations of $3.9 million, $6.0 million
and $12.0 million for the years ended December 31, 1997, 1996 and 1995,
respectively. As of December 31, 1998 the Company has a net shareholders equity
deficiency of $6.1 million. Additionally, the Company has not paid all creditors
on a timely basis and is not meeting its contractual obligations with regard to
debt principal and interest payments and certain financial covenants which the
lender has not waived. These matters raise significant doubt about the Company's
ability to continue as a going concern. These financial statements do not
include any adjustments relating to the recoverability and classification of
asset carrying amounts or the amount and classification of liabilities that
might result should the Company be unable to continue as a going concern.



                                      F-17
<PAGE>   57



         Management has focused its efforts in three main areas: reducing costs
in order to improve operating income, resolving outstanding litigation and
renegotiating payment arrangements with lenders and creditors. During the year
ended December 31, 1998, operational improvements were made that resulted in a
modest profit for the year. During 1999 management is continuing their efforts
to obtain operational performance improvements and is working with their senior
and subordinated debt lenders and other creditors to extend payment terms and
amend credit agreements to conform to the Company's present structure and
circumstances.

         If the Company is unable to effectuate a business combination with a
financially stronger entity or to raise additional capital and/or effect a
permanent restructuring of its debt, the Company could be required to file a
petition for relief under the provisions of the Bankruptcy Code, or could have
an involuntary petition thereunder filed against it.

8.  ACCRUED EXPENSES:

Accrued expenses consist of the following (dollars in thousands):

<TABLE>
<CAPTION>
                                                                        December 31,
                                                                    ---------------------
                                                                     1998            1997
                                                                    -------        -------
<S>                                                                 <C>            <C>    
Earn-out payments due to the Zaucha's                               $ 2,704        $   201
Stock guarantee due to the Zaucha's                                   4,694             --
Accrued interest due to the Zaucha's                                    415            293
Reimbursement of consent solicitation costs to Thomas Zaucha          1,094          1,613
Payroll, including payroll taxes and deductions                         921          1,359
Accrued interest - other                                                953          1,167
Other                                                                 2,444          2,843
                                                                    -------        -------
Total accrued expenses                                              $13,225        $ 7,476
                                                                    =======        =======
</TABLE>


9.  RESTRUCTURING AND NON-RECURRING ITEMS:

         During 1997 and 1996, following the resignation of KPMG as its
independent public accountants, the Company incurred professional fees in
connection with the ensuing independent investigation, shareholder litigation
and suit against the parties allegedly responsible for the wrong doings against
the Company and its shareholders. The majority of the most significant expenses
related to these matters were incurred prior to 1998. However, additional
professional fees in connection with these actions are anticipated to continue
until the few remaining legal matters are resolved.

         Because of the actions of the DeSimone management group, the Company
has been faced with recording certain transactions that are unusual in nature
and are not expected to be recurring in future years. These transactions
include, but are not limited to, the recognition of losses on notes receivable
collateralized with Common Stock and other unusual compensation arrangements
offered to certain former employees.

         In addition, significant expenses were incurred as a result of the
Consent Solicitation described in Note 1. All expenses related to this action
have been expensed in 1997. The Company has agreed to reimburse Mr. Zaucha for
the costs incurred. As of December 31, 1998, unpaid professional fees in this
matter are approximately $1,094,000. See Note 8.

<TABLE>
<CAPTION>
         A summary of these unusual and non-recurring items is as follows:

                                                                           1998           1997             1996
                                                                           ----           ----             ----
<S>                                                                       <C>           <C>             <C>
         Company costs related to consent solicitation incurred by
             Brody management (Note 12)                                   $    --        $   527         $    --
         Consent solicitation costs incurred by Mr. Zaucha                     --          1,750              --
         Legal and accounting fees                                             --            693             629
         Litigation costs                                                      75            558             565
         Loss on notes receivable collateralized with Common Stock
                                                                               --             --           1,772
         Write off of intangible assets (Note 4)                              837            707             960
         Corporate restructuring costs                                        202            344             292
         Professional fees related to investigation                            --             --             751
         Ultrasonics and management services legal settlements                 --         (2,001)             --
                                                                          -------        -------         -------
         Total                                                            $ 1,114        $ 2,578         $ 4,969
                                                                          =======        =======         =======
</TABLE>



                                      F-18
<PAGE>   58


         In 1997, the Company realized a benefit of $1,418,751 for the write-off
of lease obligations as the result of the settlement of the Ultrasonics/Jeff
Bergman suit. The Company has also recorded a benefit of $581,933 for the
write-off of accruals related to the management services agreement with James
Shields that are no longer considered, in management's or legal counsel's
opinion, to be due.

10.  LEASES:

         The Company has entered into various non-cancelable operating leases
expiring at various dates through December 31, 2003 for office and medical
equipment, vehicles and office space at its headquarters and certain
rehabilitation centers. During the years ended December 31, 1998, 1997 and 1996,
rental expense included in the statement of operations was $3,407,000,
$3,001,000 and $3,345,000, respectively. As discussed in Note 12, the Company
leases certain properties from a related party.

         Future minimum lease commitments for all non-cancelable leases as of
December 31, 1998 are as follows (dollars in thousands):

<TABLE>
<CAPTION>
                                                    Operating
           Year Ending December 31,                   Leases
           ------------------------                   ------
<S>                                                  <C>    
           1999                                      $ 2,461
           2000                                        2,124
           2001                                        1,645
           2002                                        1,213
           2003                                          949
           Thereafter                                  2,033
                                                     ------- 
           Total Payments                            $10,425
                                                     ======= 
</TABLE>

11.  EMPLOYEE BENEFIT PLANS:

     The Company had a deferred compensation plan for its employees pursuant to
Section 401(k) of the Internal Revenue Code of 1986, as amended (the "Northstar
Plan"). This plan provided for certain matching of employee contributions up to
prescribed limits of 10% of the employee contribution. Keystone also had a
deferred compensation plan for its employees pursuant to Section 401(k) of the
Internal Revenue Code of 1986, as amended (the "Keystone Plan"). Pursuant to IRS
regulations, these two plans have been merged with the Keystone plan remaining
as the surviving plan. The Keystone Plan provides for certain matching of
employee contributions equal to 50% of participants' contributions up to three
hundred dollars per year. The Keystone plan also provides that Keystone may make
discretionary contributions; however, no such contributions were made during
1996, 1997 or 1998.

     During 1998, 1997, and 1996 the Company made contributions to the Plans of
approximately $64,000, $63,000 and $57,000, respectively.

12.  RELATED-PARTY TRANSACTIONS:

         The current management of the Company does not adopt or affirm any
related party disclosures made in prior management's financial statements or
public filings. The transactions disclosed below are based on management's
knowledge at this point in time.

Transactions Directly With Mr. Mark DeSimone
--------------------------------------------

         In February 1996, Mr. DeSimone terminated his employment with the
Company but continued to work as a consultant to the Company. His employment
contract was changed to a consulting arrangement with similar terms. The Company
paid him $47,000 under the terms of this agreement during 1996. In March 1996,
Mr. DeSimone resigned from the Board of Directors and the Company terminated its
relationship with him.

PVL Acquisition
---------------

         In connection with the purchase of PVL and Vascusonics, the Company
transferred to Ultrasonics, Inc. ("Ultrasonics"), all the receivables of PVL and
Vascusonics as of December 1, 1995, with a value as stated in the acquisition
agreement of $350,000 for no known consideration. Ultrasonics is a related party
and is owned by Mr. James Shields and/or Mr. Jeff D. Bergman.

         The purchase agreement stated that certain equipment lease obligations
would be transferred to



                                      F-19
<PAGE>   59


Ultrasonics. White Oak Diagnostic Systems ("White Oak") and Vascusonics then
agreed to sublease the equipment from Ultrasonics such that the Sellers would
have no future liability under the leases. Also, White Oak and the Company
jointly and severally indemnified the Sellers from and against any liability
resulting from the failure of Ultrasonics to discharge all obligations to the
lessors after the date of the sale. The Company is not aware of any
consideration received from Ultrasonics in exchange for the lease contracts,
which management believes yielded lease payments to Ultrasonics which were in
excess of fair market value for the leased equipment, or issuance of the
previously mentioned indemnification.

         During 1996, the Company paid $53,341 in lease payments. Further,
although the lessor paid approximately $155,000 for the equipment that it leased
to the Company, the Company was scheduled to make lease payments totaling
approximately $1,333,000. After March 1996, the Company refused to pay any
further amounts under this contract, believing the payments to be excessive. The
resulting litigation and resolution of such is described in Note 20.

         As discussed in Note 3, in connection with this acquisition, the
Company paid a brokerage fee of $350,000 to Mr. James Shields.

Shields Management Agreement
----------------------------

         Throughout 1995, the Company paid fees to Mr. James Shields or Med-Bill
Corporation, Inc. ("Med-Bill"), in connection with certain management services
that he provided at White Oak. Additionally, upon the acquisition of PVL, Mr.
Shields began providing such services at PVL. In total, management fees of
approximately $270,000 were paid to Mr. Shields/Med-Bill during 1995. As of
December 31, 1995, the Company had approximately $37,000 due to Mr. Shields or
Med-Bill. The Company severed its relationship with Mr. Shields during the first
quarter of 1996. See Note 3 for information relating to the financial incentives
provided to Mr. Shields to renegotiate his employment contract with the Company
to terms more favorable to Mr. Shields.

         During 1996, the Company paid Mr. Shields $59,106 under the terms of
this contract. After March 1996, the Company refused to pay any further amounts
under this contract, believing the payments to be excessive. The Company is
vigorously contesting this obligation, which is described in more detail in Note
20.

Keystone Acquisition
--------------------

         As part of the acquisition of Keystone, the Company paid cash of
$450,000 and issued 150,000 shares of Common Stock with a market value of
$937,500 to Commercial Financial Corporation ("CFC") for services rendered. CFC
is wholly-owned by Nichlaus P. Horoczko who is a personal friend and business
associate of Mr. DeSimone. CFC is believed by the Company to be a related party.
Additionally, the Company had made certain guarantees to CFC that the
aforementioned shares would be able to be sold with net proceeds of at least
$937,500. These costs were expensed during 1995.

         The Company believes that these shares of Common Stock were sold on
February 12, 1996 for approximately $840,000. In the opinion of management, as
Mr. Horoczko did not perform any services of value, he was not entitled to the
common shares discussed above or any additional compensation thereon. Mr.
Horoczko is a defendant in the Company's suit as discussed in Notes 1 and 20.

         In connection with the Keystone acquisition, Mr. Thomas Zaucha and Mr.
David Watson, who both sold interests in the former Keystone, and are now or
were officers with Northstar, have gross debt due directly to them of $3,919,500
and $262,500, respectively, as of December 31, 1998 and 1997, and Mr. Zaucha's
Family Limited Partnership is due $1,105,500 as of December 31, 1998 and 1997.
In addition, Mr. Zaucha and Mr. Zaucha's Family Limited Partnership have other
amounts due directly to them of $6,094,000 and $1,719,000, respectively, as of
December 31, 1998, and $385,000 and $109,000, respectively, as of December
31,1997, for accrued interest, stock guarantee expense, and earn-out payments
due as a result of the Keystone acquisition. See Note 6.

         As required under the Merger Agreement, immediately prior to the
merger, Keystone sold, at fair market value determined by a third party
appraisal, all of the real estate previously owned by Keystone to the Zaucha
Family Limited Partnership, of which Mr. Zaucha, is a general partner, and a
related entity, in return for a payment of $5,215,568. The parcels of such real
estate used in Keystone's business were then leased to Keystone. The Board of
Directors, when led by Steven Brody, one of the directors removed from office as
a result of the Consent Solicitation (see Note 1), alleged that these leasing
arrangements, which were negotiated when Mr. Brody was acting as a consultant to
Mr. Zaucha in the merger of Keystone with Northstar, were in excess of fair
market value. A Special Committee of the current Board of Directors of the
Company has evaluated, through an appraisal by an independent real estate
professional, the fair market lease rates for these properties, and has
determined that the 


                                      F-20
<PAGE>   60


leases are substantially within the range of market rent in the aggregate, and
therefore, a renegotiation of the leases is not required.

         The leases are for a period of either five or ten years, and commenced
November 15, 1995. Lease payments were $470,360 for 1998, 1997 and 1996. Future
minimum lease payments under these leases, which are also disclosed within Note
10, are as follows:

<TABLE>
<S>                                                    <C>    
                                1999                   470,360
                                2000                   478,861
                                2001                   530,140
                                2002                   528,792
                                2003                   528,792
                                Thereafter             991,485
                                                    ----------
                                Total               $3,528,430
                                                    ==========
</TABLE>

         The Company also uses, on an as needed basis, the services of Impulse
Development Corporation, a company controlled by Thomas Zaucha, primarily for
leasehold improvement construction. Subsequent to the Consent Solicitation and
the reinstatement of Thomas Zaucha as Chairman and CEO, the current Board of
Directors solicited bids for these construction services from other companies,
and Impulse submitted the lowest bid. Payments to Impulse totaled $86,920, $
80,404, and $86,320 in 1998, 1997, and 1996, respectively.

Transactions with Board Members
-------------------------------

         In 1996, Brody Associates, a consulting firm wholly-owned by Steven
Brody, one of the Directors removed from office as a result of the Consent
Solicitation (see Note 1), was retained to perform a variety of consulting
services for the Company related to its investigation of former management and
related to the corporate restructuring of the Company. The Company paid $148,103
in 1997 and $223,795 in 1996 to Brody Associates for these services and related
business expenses. The agreement was terminated as a result of the Consent
Solicitation described in Note 1. The Company entered into a settlement and
release agreement with Steven Brody and Brody Associates in November 1997 that
provided for, among other things, a payment of approximately $26,000 in
outstanding consulting bills with Brody Associates, which has been paid in full
as of December 31, 1998. See Note 13 for stock option activity.

         In 1996, the Company retained Executive Advisory Group, Ltd., whose
sole owner is Robert Smallacombe, one of the Directors removed from office as a
result of the Consent Solicitation (see Note 1), to serve as a management
consultant and to aid in the corporate restructuring. For these services and
related business expenses, the Company paid $ 53,179 in 1997 and $189,503 in
1996 to Executive Advisory Group, Ltd. In addition, in February 1997, after the
Brody Board removed Thomas Zaucha from office as Chairman and CEO, Smallacombe
was appointed the new CEO and his existing consulting agreement was converted
into an employment contract. The Company paid $65,708 in salary and expenses in
1997 under this employment agreement. This contract was terminated for cause as
a result of the Consent Solicitation (see Note 1). As of December 31, 1998, the
Company is disputing any obligation to Smallacombe under the terminated
employment agreement. See Note 13 for option activity. See Note 20.

         In conjunction with the investigation of former management, the Company
retained Plowman, Speigel & Lewis, P.C. in order to assist in understanding
certain corporate governance and securities litigation issues. Charles Jarrett,
Jr., one of the directors removed from office as a result of the Consent
Solicitation, is also a member of that firm. During 1996, but prior to Mr.
Jarrett's appointment to the Board of Directors, the Company paid to Plowman,
Speigel & Lewis, P.C. $32,548 for professional services rendered.

         As discussed in Note 16, the Company has certain contractual
obligations due to employees. One such employee is the wife of Mr. Watson, a
former officer and director of the Company. Mrs. Watson's funds provided to the
Company were $126,354 as of December 31, 1996. In August 1997, Mrs. Watson
exercised the buyout provision of her employment contract and terminated her
relationship with the Company. See Note 16.

         The Company obtains it's professional and general liability insurance
through The Reschini Agency, Inc., a company owned by Roger Reschini, a member
of the current Board of Directors. Policy premiums through this company totaled
approximately $132,000, $214,000 and $184,000 in 1998, 1997 and 1996,
respectively, with the agency earning a commission on these premiums of
approximately $14,000, $25,000 and $22,000 in 1998, 1997 and 1996, respectively.
During 1997, the Company entered into a simultaneous transaction with the
Reschini Agency whereby the Company paid approximately $180,000 for insurance
premiums and the Reschini Agency purchased 108,270 shares of the newly issued
Company Common Stock at a per share price of $1.66 per share, which



                                      F-21
<PAGE>   61


represents the average of the previous five days closing stock prices.

         The Company had transactions involving Thomas Zaucha and related
parties as discussed in Notes 3 and earlier in Note 12. The Company also
conducted transactions with Mark DeSimone and related parties as discussed
earlier in Note 12.

13. STOCK OPTIONS AND WARRANTS:

Stock Options
-------------

         The Company adopted a stock option plan in 1992 (the "1992 Plan"), a
1994 stock option plan for non-employee directors (the "1994 Plan") and a 1997
stock option plan (the "1997 Plan"), collectively (the "Plans"). As permitted,
the Company accounts for these plans under APB Opinion No. 25, which does not
normally require recognition of compensation expense. Had compensation cost been
determined consistent with FASB Statement No. 123, the Company's pro forma net
loss and loss per share would have been (dollars in thousands, except share
data):

<TABLE>
<CAPTION>
                                                                        1998          1997           1996
                                                                        ----          ----           ----
<S>                                                                    <C>          <C>           <C>
       Net Profit/(Loss)                  As Reported                   $ 401        $(5,613)      $(8,947)
                                          Pro Forma                     $ 203        $(7,003)      $(9,652)

       Basic income/(loss) per share      As Reported                   $0.07        $ (0.95)      $ (1.44)
                                          Pro Forma                     $0.03        $ (1.19)      $ (1.55)
</TABLE>

  The activity regarding the 1992, 1994, 1997 and Independent Plans is as
follows:

<TABLE>
<CAPTION>
                                               1998                     1997                      1996
                                               ----                     ----                      ----
                                                  Wt. Avg.                   Wt. Avg.                   Wt. Avg.
                                     Shares       Ex Price      Shares       Ex Price      Shares      Ex Price 
                                    ---------     --------      ------       --------      ------      -------- 
<S>                               <C>            <C>          <C>          <C>           <C>           <C>  
Outstanding at beginning of                                        
    year                            1,187,758      $2.54        681,200      $ 4.12        581,980       $5.97
Granted                               402,966       0.68        921,933        2.06        330,000        2.27
Exercised                                  --         --             --          --             --          --
Expired/canceled                     (518,225)      3.07       (415,375)       4.09       (230,780)       6.16
Outstanding at end of year          1,072,499       1.59      1,187,758        2.53        681,200        4.12
Exercisable at end of year          1,072,499       1.59      1,187,758        2.53        681,200        4.12
Wt. Avg. fair value of
    options granted                $     0.61                $     1.90                   $   2.67
</TABLE>

         The fair value of the option grants as outlined above for the 1992,
1994, 1997 and Independent Plans is estimated using the Black-Scholes option
pricing model with the following assumptions: life of the options ranging from 3
to 5 years; an assumed risk free rate of interest ranging from 5.39% to 5.65%;
an expected dividend yield of 0%, consistent with the Company's policy; expected
volatility of 164% for the grants during 1998, 168% for the grants during 1997,
and 173% volatility for grants during 1996.

         A total of 1,800,000 shares is authorized and has been reserved for
issuance under the Plans: 650,000 for the 1992 Plan, 150,000 for the 1994 Plan,
and 1,000,000 for the 1997 Plan. Options may be either "incentive stock options"
within the meaning of Section 422 of the United States Internal Revenue Code of
1986, or non-qualified options. The Plans are administered by the Compensation
and Nominating Committee of the Board of Directors who determine among other
things, those individuals who shall receive options, the time period during
which the options may be partially or fully exercised, the number of shares of
Common Stock that may be purchased under each option, and the option exercise
price.


                                      F-22
<PAGE>   62


    The following summarizes the activity under the 1992 Plan:

<TABLE>
<CAPTION>
                                                 December 31, 1998         December 31, 1997        December 31, 1996
                                                 -----------------         -----------------        -----------------
<S>                                              <C>                       <C>                      <C>
   Options-
   --------
   Outstanding at beginning of year                   564,175                   418,700                  544,480
   Granted                                             2,000                    393,350                   85,000
   Exercised                                             -                         -                        -
   Expired/Canceled                                  (230,225)                 (247,875)                (210,780)
   Outstanding at end of year                         335,950                   564,175                  418,700

                                                 December 31, 1998         December 31, 1997        December 31, 1996
                                                 -----------------         -----------------        -----------------
   Options price share ranges
   --------------------------
   Outstanding at beginning of year                $1.50 - 7.875             $1.50 - 7.875            $5.00 - 7.875
   Granted                                         $0.625 -0.625            $1.625 - 2.3125            $1.50 - 2.00
   Options exercisable at end of year                 335,950                   564,175                  418,700
   Exercisable option price ranges                 $0.625 - 7.875            $1.50 - 7.875             $1.50 - 7.88
   Options available for grant at end of year         290,050                    61,825                  207,300
</TABLE>

         Under the 1992 plan, on October 6, 1997, the Compensation and
Nominating Committee awarded stock option grants to 533 Company employees to
purchase 365,850 shares of Common Stock at $2.31 per share (the fair market
value on the date of grant). Eligible employees included those who were employed
on or before October 1, 1997 and who were still with the Company on January 1,
1998. These options collectively expire on October 6, 2002. In addition, the
Company's Chief Financial Officer received an option to purchase 15,000 shares
of Common Stock at an exercise price of $2.00 per share pursuant to an
employment contract dated September 1, 1997. The plan also has participants who
received stock options that were awarded prior to the Northstar/Keystone merger,
those of whom are still employed with the Company.

         The stock option information presented herein represents current
management's belief of the transactions that have occurred. Certain
reclassifications of prior year information have been made to reflect current
management's belief and available information. Due to the dilutive effect of
options, this change has no impact on earnings per share. To date, 24,000
options have been exercised under the 1992 Stock Option Plan.

    The following summarizes the activity under the 1994 Plan:


<TABLE>
<CAPTION>
                                                 December 31, 1998         December 31, 1997        December 31, 1996
                                                 -----------------         -----------------        -----------------
<S>                                              <C>                       <C>                      <C>
   Options-
   --------
   Outstanding at beginning of year                    37,500                    17,500                   37,500
   Granted                                               -                       37,500                     -
   Exercised                                             -                         -                        -
   Expired/Canceled                                      -                      (17,500)                 (20,000)
   Outstanding at end of year                          37,500                    37,500                   17,500

                                                 December 31, 1998         December 31, 1997        December 31, 1996
                                                 -----------------         -----------------        -----------------
   Options price share ranges
   --------------------------
   Outstanding at beginning of year                $2.375 - 2.375           $6.125 - 7.3125          $6.125 - 7.3125
   Granted                                               -                   $2.375 - 2.375                 -
   Options exercisable at end of year                  37,500                    37,500                   17,500
   Exercisable option price ranges                 $2.375 - 2.375            $2.375 - 2.375          $6.125 - 7.3125
   Options available for grant at end of year         112,500                   112,500                  132,500
</TABLE>

         Under the 1994 Plan, on March 24, 1997, the five non-employee members
of the Board of Directors each received an option to purchase 7,500 shares of
Common Stock at an exercise price of $2.375 per share with an expiration date of
March 24, 2007. The option prices represented fair market value at the dates of
grant. During 1997, options for 7,500 shares were cancelled pursuant to a
settlement agreement with a former director. Options totaling 10,000 shares
belonging to a former director expired in March 1997.


                                      F-23
<PAGE>   63


    The following summarizes the activity under the 1997 Plan:

<TABLE>
<CAPTION>
                                                 December 31, 1998         December 31, 1997
                                                 -----------------         -----------------
<S>                                              <C>                       <C>
   Options-
   --------
   Outstanding at beginning of year                   253,583                      -
   Granted                                            400,966                   253,583
   Exercised                                             -                         -
   Expired/Canceled                                    (500)                       -
   Outstanding at end of year                         654,049                   253,583

                                                 December 31, 1998         December 31, 1997
                                                 -----------------         -----------------
   Option price share ranges
   -------------------------
   Outstanding at beginning of year               $1.5625 - 1.875                  -
   Granted                                          $0.61 - 1.02            $1.5625 - 1.875
   Options exercisable at end of year                 654,049                   253,583
   Exercisable option price ranges                 $0.61 - 1.875            $1.5625 - 1.875
   Options available for grant at end of year
                                                      345,951                   746,417
</TABLE>

         The 1997 stock option plan received shareholder approval at the annual
meeting of stockholders in September 1997. The plan authorizes 1,000,000 shares
to be reserved for issuance under the plan. The 1997 plan is intended as an
incentive and to encourage stock ownership by officers, certain key employees,
consultants and directors of the Company. Several members of management
personnel were subsequently awarded stock options by the Compensation and
Nominating Committee pursuant to employment agreements entered into in the
fourth quarter of 1997. In addition, upon re-election to the Board in September
1997, the five non-employee directors and the Corporate Secretary each received
an option to purchase 25,000 shares of Common Stock at an exercise price of
$1.687, which was the fair market value of the grant date of September 11, 1997.

         Beginning in 1994, the Company entered into contracts or agreements
with Directors or officers which bound the Company to provide stock option
grants outside of the existing plans, which have been categorized into an
Independent Plan (the "Independent Plan"). Options granted under this category
typically involve terms which differ from the existing stock option plans of the
Company, namely in the amount of the options granted, the length of the options
and the individuals or groups of individuals to which they are granted.

    The following summarizes the activity under the Independent Plan:

<TABLE>
<CAPTION>
                                                 December 31, 1998         December 31, 1997        December 31, 1996
                                                 -----------------         -----------------        -----------------
<S>                                              <C>                       <C>                      <C>
   Options-
   --------
   Outstanding at beginning of year                   332,500                   245,000                     -
   Granted                                               -                      237,500                  245,000
   Exercised                                             -                         -                        -
   Expired/Canceled                                  (287,500)                 (150,000)                    -
   Outstanding at end of year                          45,000                   332,500                  245,000

                                                 December 31, 1998         December 31, 1997        December 31, 1996
                                                 -----------------         -----------------        -----------------
   Options price share ranges
   --------------------------
   Outstanding at beginning of year                $ 1.25 - 5.25             $ 0.75 - 5.25                  -
   Granted                                               -                   $1.25 - 2.375            $ 0.75 - 5.25
   Options exercisable at end of year                  45,000                   332,500                  245,000
   Exercisable option price ranges                 $1.25 - $5.25              $0.75 - 5.25            $ 0.75 - 5.25
</TABLE>

         The terms of these grants during 1997 are as follows: (a) On March 24,
1997 the five non-employee members of the Board of Directors each received an
option to purchase 17,500 shares of Common Stock at an exercise price of $2.375
per share that expires March 24, 2002. These options were in addition to the
options awarded under the 1994 Director's plan and comprised the 25,000 options
given to Directors upon appointment to the Board in March, 1997; (b) Pursuant to
a separation and settlement agreement with a former executive officer, the
Company awarded an option to purchase 10,000 shares of Common Stock; (c) As part
of a mutual release and settlement agreement with a former director, Steven N.
Brody, the Company set forth an option to purchase 40,000 shares of Common Stock
in exchange for other compensation and consideration which resulted in the
cancellation of 25,000 previously issued options; (d) The Board of Directors
approved that Michael S. Delaney, Secretary and Officer receive an option to
purchase 25,000 shares of Common Stock at an exercise price of $2.375 on March
24, 1997; (e) During 1997 options to purchase 25,000 shares of Common Stock were
granted to former directors who were



                                      F-24
<PAGE>   64


removed form their respective positions with the Company on March 24, 1997. Such
options (for the former directors) expired in March 1998.

Stock Warrants
--------------

         Since the Company's initial public offering of Common Stock in June
1993, the Company had numerous occasions to issue warrants to underwriters,
their lenders and other organizations.

         On June 9, 1997, the Company issued 100,000 warrants to Commonwealth
Associates for the purchase of its Common Stock at $2.55 per share as
compensation for advisory services. The Company also reset the exercise price of
the 70,000 warrants issued on May 18, 1995 to Commonwealth Associates and 17,500
warrants to Andres V. Bello to $2.55 per share. The fair value of these warrants
on the grant date based upon a Black-Scholes model calculation was approximately
$185,000 and $161,875, respectively. In addition, on July 23, 1997, the Company
issued 25,000 warrants to Stephen Booke and Gerald Amato, both of Booke &
Company, for investor relations consulting services. The fair value for each of
these warrants on the grant date based upon a Black-Scholes model calculation
was approximately $47,000.

  The following summarizes the Company's warrant activity:

<TABLE>
<CAPTION>
                                           December 31, 1998          December 31, 1997           December 31, 1996
                                           -----------------          -----------------           -----------------
Warrants-
---------
<S>                                        <C>                        <C>                         <C>
Outstanding at beginning of year                843,500                    693,500                     693,500
Granted                                            -                       237,500                        -
Exercised                                          -                          -                           -
Expired/Canceled                               (278,500)                   (87,500)                       -
Outstanding at end of year                      565,000                    843,500                     693,500

                                           December 31, 1998          December 31, 1997           December 31, 1996
                                           -----------------          -----------------           -----------------
Warrant price per share ranges
------------------------------
Outstanding at beginning of year             $2.55 - 8.29                $5.50 - 6.29               $5.50 - 6.25
Granted during the year                            -                        $2.55                         -
Warrants exercisable at end of year             565,000                    843,500                     693,500
Exercisable warrant price ranges             $2.55 - 8.29                $2.55 - 8.29               $5.50 - 8.29
</TABLE>


14.      INCOME TAXES:

         The provision (benefit) for income taxes consisted of the following (in
thousands):

<TABLE>
<CAPTION>
                                            Year Ended December 31,
                                        1998         1997         1996
                                        ----         ----         ----
<S>                                   <C>          <C>          <C>     
         Current:
              Federal                 $  (272)     $  (770)     $(2,472)
              State                        --           --         (337)
         Deferred:
              Federal                     734       (1,461)          26
              State                      (316)        (150)           9
              Valuation allowance        (512)       1,611        3,245
                                      -------      -------      -------
                                      $  (366)     $  (770)     $   471
                                      =======      =======      =======
</TABLE>


The reconciliation between income taxes computed by applying the statutory U.S.
federal income tax rate to the loss before income taxes and the actual
expense/(benefit) for income taxes is as follows (in thousands):

<TABLE>
<CAPTION>
                                                                        Year Ended December 31,
                                                                    1998         1997          1996
                                                                    ----         ----          ----
<S>                                                                <C>          <C>          <C>     
         Income tax at U.S. federal statutory rate                 $   163      $(2,115)     $(2,782)
         State income taxes, net of federal income tax benefit        (208)        (150)         (69)
         Permanent differences                                         191         (117)         764
         Valuation allowance                                          (512)       1,612        2,558
                                                                   =======      =======      =======
                                                                   $  (366)     $  (770)     $   471
                                                                   =======      =======      =======
</TABLE>

         The Company had $9,460,000 in deferred tax assets at December 31, 1998,
due primarily to timing differences resulting from provisions for doubtful
accounts receivable, net book value of fixed and intangible assets,



                                      F-25
<PAGE>   65


certain reserves and net operating loss carryforwards. The Company had
approximately $13,170,000 of federal net operating losses and approximately
$22,220,000 of state net operating losses at December 31, 1998, which expire in
varying amounts between 2005 and 2018. The Company also has an AMT credit of
$13,000 that does not expire.

         A valuation allowance has been recorded to reduce net deferred tax
assets to zero because the Company believes, based on the weight of available
evidence, it is more likely than not that all of the deferred tax assets may not
be realized.

15. EMPLOYMENT AGREEMENTS:

         During March 1996, the Company terminated Mr. DeSimone's employment
agreement. In accordance with the aforementioned agreement, Mr. DeSimone was to
receive six months salary after termination. The Company has not paid, and
pursuant to a settlement agreement, will not pay any termination salary to Mr.
DeSimone. See Note 20 for additional discussion of this settlement.

         On April 30, 1996, one of the former owners of an acquired business
terminated her employment agreement with the Company due to a change in control
clause in the employee's contract. A new contract was negotiated with the same
salary; however, the new agreement ended approximately six months prior to the
initial contract. The Company and this employee later agreed to terminate this
employee's contract as a result of operational difficulties. The Company is
currently in dispute with this individual over issues related to this
separation.

         In July 1996, the Company terminated a former officer who had been on
suspension pending the outcome of the Board of Director's independent
investigation. The Company was involved in arbitration with this former
employee. See Note 20 for additional discussion of the resolution of this
matter.

         In September 1996, the Company's then, and now current, chief financial
officer left the employment of the Company to pursue other interests as part of
a negotiated settlement. An employment contract was entered into with a new
chief financial officer; however, this contract was terminated in May 1997 as a
result of the outcome of the Consent Solicitation discussed in Note 1, and a
settlement was reached with this former employee in November 1997. The Company
rehired the previous chief financial officer in September 1997 under a new
employment contract.

         In May 1997, the Company's Chief Executive Officer, who was also one of
the Board members removed by the Consent Solicitation, was terminated for cause.
The Company is currently involved in a dispute with this former employee, as the
Company does not believe that it has any obligation for any further payments
under these employment contracts. See Note 20.

         In July 1997, the Company's former President, who was also one of the
Board members removed by the Consent Solicitation, was terminated for cause. The
Company is currently involved in a dispute with this former employee, as the
Company does not believe that it has any obligation for any further payments
under this employee's employment contract. The Company also believes that this
employee is still bound by and has violated the terms of the non-compete
provision in this contract.

         The Company has entered into employment agreements, expiring from 1999
through 2003, with certain of its officers and other key employees. The minimum
annual payments required under these agreements are as follows (dollars in
thousands):


<TABLE>
<CAPTION>
<S>                                       <C>    
                            1999           $ 1,089
                            2000               850
                            2001               512
                            2002               471
                            2003               485
                                           -------
                            Total          $ 3,407
                                           =======  
</TABLE>


         Included in the above figures are employment agreement obligations to
facility directors who have also provided working capital funds to the Company
as discussed in Note 16. The employment agreements for these employees do not
have a fixed termination date. As such, the payments to those individuals of
approximately $500,000 annually will continue indefinitely beyond 2003.

         Between October 29 and November 1, 1997, pursuant to employment
contracts entered into with certain key management personnel, the Company
granted options to purchase a total of 97,500 shares of Common Stock for amounts
of shares ranging from 2,500 to 25,000, at an exercise price of $1.875. The
options were granted at the fair market value on the date of grant. In addition,
certain employees also were entitled to additional options based on



                                      F-26
<PAGE>   66



performance as outlined in the agreements. Subsequently, the Company granted
approximately 6,000 options to purchase Common Stock during the fourth quarter
at exercise prices based upon an average of the closing price of the Company's
stock for the five days preceding the date of grant. These contracts provide for
quarterly option grants based upon the financial performance of certain
operating units of the business. Such grants are made on the filing date of the
Company's financial data with the Securities and Exchange Commission.

     The employment contracts of various members of management include change in
control provisions whereby said employees would receive a maximum of six months
base salary. Change in control provisions include, acquisition by third parties,
mergers, consolidation, sale of more than 50% of assets, any person or group
becoming the beneficial owner of more than 30% of the stock of the Company, or
if Thomas W. Zaucha no longer serves as the CEO or Chairman.

     In addition to the aforementioned employment agreements, the Company had a
management agreement with Mr. James Shields to perform services within certain
business operations of the Company. The agreement, before any extension, expires
on November 29, 2002. Mr. Shield's compensation was to be a fee of 12% of the
gross collections of the operations that he managed. See Note 12.

16. CONTRACTUAL OBLIGATIONS TO EMPLOYEES:

     Prior to the acquisition of Keystone, certain former partners of Keystone
and clinicians executed employment agreements with Keystone. These contracts
required the employees to provide funds to Keystone as part of their incentive
compensation arrangements. In return these employees received incentive
compensation equivalent to 25% of the net income for their facilities for each
month. As of December 31, 1998 and 1997, the balance of the funds provided to
Keystone was $349,190 and $352,065, respectively.

     As provided for within these agreements, the change in controlling interest
in Keystone enables these employees to terminate the contracts and be entitled
to either the funds they provided to Keystone or two times the most recent
twelve months of pre-commission net income of the facility that they operate.
During 1997, six of these employees exercised their buyout option resulting in
an obligation of $904,312. Four of these employees were paid in full in 1997,
with a remaining unpaid liability of $237,000 as of December 31, 1997, which is
being paid pursuant to payment schedules arranged with the remaining two
employees. As of December 31, 1998 and 1997, the calculated maximum amounts due
to the remaining employees under these agreements, including the $237,000
discussed above, is $914,979 and $1,031,331, respectively. See Note 12.

17. FAIR VALUE OF FINANCIAL INSTRUMENTS:

     The carrying amounts and estimated fair values of the Company's financial
instruments as of December 31, 1998 and 1997, are as follows (dollars in
thousands):


<TABLE>
<CAPTION>
                                                        1998                                    1997
                                                        ----                                    ----
                                        Carrying Amount        Fair Value        Carrying Amount        Fair Value
                                        ---------------        ----------        ---------------        ----------
<S>                                     <C>                    <C>                                     <C>  
   Cash and cash equivalents                $   901              $   901             $   657               $   657
                                                                   
   Long-term debt, including
       current portion                      $19,549              $19,549             $19,786               $19,786
</TABLE>


     The following methods and assumptions were used by the Company in
estimating the fair value of each class of financial instruments for which it is
practicable to estimate that value. Fair value is defined as the amount at which
the instrument could be exchanged in a transaction between willing parties.

CASH AND CASH EQUIVALENTS

     The carrying amount reported in the balance for cash and cash equivalents
approximates their fair value.

LONG-TERM DEBT

     The fair value of long-term debt is estimated based on the quoted market
prices for the same or similar issues or on the current rates offered to the
Company for debt of the same remaining maturities.

18. SIGNIFICANT CUSTOMERS:

     Although net patient service revenue is generated by performing procedures
or services for the ultimate patients, who are referred for care through their
physician, the Company receives most of its revenues through payments



                                      F-27
<PAGE>   67


made by certain governmental programs, private insurers such as Blue Cross and
Blue Shield of Western Pennsylvania or organizations such as nursing homes.
Additionally, the Company receives management fees for certain entities for
which it performs certain management services.

19. COMMITMENTS AND CONTINGENCIES:

         David D. Watson, former President of the Company, has made claims
against the Company in excess of $500,000 in relation to an Employment Agreement
and Note. See Notes 3 and 15. Negotiations for settlement of these claims have
not been successful, and no legal action has been taken. The Company believes
and avers that Mr. Watson has breached the Employment Agreement, was terminated
for cause, and as a result thereof, the Company has counterclaims against Mr.
Watson. The Company has and will continue to vigorously defend these claims.

20. LITIGATION:

         In the ordinary course of business, the Company may be subject to
claims and legal actions, from time to time, by patients and others. The Company
does not believe that any such pending actions, if adversely decided, would have
a material adverse effect on its financial condition.

         In November, 1997, a comprehensive settlement of a number of
shareholder lawsuits filed in 1996 and consolidated into one action in federal
court in the Western District of Pennsylvania (Butler v. Northstar, No. 96-701
W.D. Pa) was given approval by the court. The lawsuit alleged violations of
federal securities laws by the Company and certain of its former officers and
directors, and an alleged scheme to disseminate false and misleading information
regarding the Company. In December 1997, with no party having appealed the order
approving the settlement, the decision became final. The settlement agreement
which was approved by the court, created a settlement fund of $6.45 million, of
which $5.75 million, less expenses and legal counsel fees, will be paid to those
Northstar shareholders who submitted proofs of claim and which the court
approves as valid claims. The Company contributed $100,000 to the $6.45 million
settlement fund; the insurer on the Company's directors and officers' liability
policy contributed the $1.0 million limits of coverage of that policy; and the
$5.35 million balance in the fund was contributed by other defendants.

         In September 1996, the Company filed an action in federal court in
Pittsburgh, seeking to recover damages from Northstar's former Chief Executive
Officer and various Northstar related-parties and others. (Northstar v.
DeSimone, C.A. No. 96-1695, W.D. Pa.). Since then, in connection with the
settlement of the Butler class action, Northstar has settled its claims against
its former Chief Executive Officer for the sum of $600,000 which was then
contributed to the settlement fund created in the Butler action. Subsequently,
Northstar has also agreed to settle its claims against another related-party and
his affiliated companies (the Bergman defendants). Northstar's claims against
the two remaining sets of defendants (the Shields and Horoszko defendants) are
being prosecuted vigorously.

         In response to Northstar's suit against Mark A. DeSimone and the other
defendants, Coregis Insurance Company, a professional liability insurer which
insured DeSimone's former law firm, brought an action in federal court (Coregis
Insurance Co. v. Ogg, Jones Cordes & Ignelzi, C.A. No. 96-2243 W.D. Pa.) seeking
a declaratory judgement that Northstar's claims were not covered by the
defendant's professional liability policy. Although the action named Northstar,
its primary purpose was to determine the obligations of the insurance company.
The main defendant was the law firm which Northstar had sued and which claimed
coverage under the professional liability policy in question. The case was
settled as part of the settlement of the Butler action by means of a $250,000
payment into the Butler settlement fund by the defendant law firm's professional
liability insurer.

         In May 1996, a group of approximately 40 Northstar shareholders filed
suit in the state court in California, (Bosco v. Northstar, C.A. No. BC 149867,
Superior Court of California for Los Angeles County), which alleged violations
of various California securities laws and related common law claims. Northstar
and its former Chief Executive Officer, Mark A. DeSimone, and Northstar's former
Chief Financial Officer, Michael J. Kulmoski, Jr. along with the Company's
former auditor, Richard A. Eisner & Co., LLP were named as defendants. In
summary, these claims arose out of the false and misleading statements
concerning Northstar and its financial condition, which were disseminated by the
individual defendants. In November 1997, the lawsuit was settled in connection
with settlement of the Butler action described above for the sum of $500,000,
which was paid out of the settlement fund created in the Bulter action in
December 1997.

         In July 1996, Michael Kulmoski, Jr. ("Kulmoski"), Northstar's former
Chief Financial Officer and a named defendant in both the shareholder class
actions and the individual action described above, filed a demand for
arbitration against Northstar (Kulmoski v. Northstar, American Arbitration
Assn., No. 55-116-0106-96-CEW). In his



                                      F-28
<PAGE>   68


demand for arbitration, Kulmoski, whose employment with Northstar was terminated
in the summer of 1996, alleged breach of his employment agreement by Northstar
and related claims, including a claim for indemnification under Northstar's
by-laws in suits filed against him by Northstar shareholders. Kulmoski later
agreed, however, to sever the issue of his right to indemnification from this
proceeding to be decided by the courts as an ancillary issue in the Butler case.
An arbitration hearing was held on November 6 and 7, 1997 on the issue of
liability only, post-hearing briefs were submitted in mid-February 1998. On
March 20, 1998, an arbitration panel decided that the record does not support
the conclusion that Kulmoski's employment had been terminated for "cause" as
defined in his employment agreement. A hearing on the issue of damages was held
on May 1, 1998, and in June 1998, Kulmoski was awarded approximately $136,000 by
the arbitration panel on this claim, which has been paid in full as of December
31, 1998.

         In October 1997, in accordance with his agreement to have the issue of
his right to indemnification for counsel fees and expenses incurred in his
defense of the shareholder actions filed against him in the Butler and Bosco
cases, Michael Kulmoski, Jr., filed a petition for such fees and expenses in the
Butler case in which he sought an award of $69,244.02. (Kulmoski Fee Petition in
Butler v. Northstar, C.A. No. 96-709, W.D. Pa.) Although Northstar had raised an
issue whether Kulmoski was entitled to indemnification under its by-laws under
the circumstances of these cases, in an effort to resolve this matter, Northstar
agreed to confine its objections to the amount of the counsel fees and expenses
claimed in the petition. In an opinion and order dated December 16, 1997, the
court agreed with Northstar's objections and awarded Kulmoski $22,050.77 in
counsel fees and expenses. Notwithstanding Kulmoski's agreement to submit this
issue to the judge for final resolution, he appealed the court's decision to the
United States Court of Appeals for the Third Circuit. By order dated December
17, 1998, the Appeals Court upheld the original award of $22,050.77, which was
paid in February 1999.

         In March 1997, Ultrasonics, Inc. confessed judgement against two
subsidiaries of the Company, and filed a lawsuit against the Company itself in
the Court of Common Pleas of Allegheny County, Pennsylvania for alleged
non-performance under two lease agreements with the Company. In addition to
challenging the legality and enforceability of these lease agreements as
fraudulent in the RICO action described above, the Company filed an Answer and
Counterclaim against Ultrasonics for fraud. In March 1998, the Company reached a
settlement with Ultrasonics, Inc., which resulted in mutual releases and no
payments to either party.

         In February 1997, Thomas W. Zaucha, the current Chairman of the Board
of Directors and Chief Executive Officer of Northstar, commenced a solicitation
of Northstar stockholder consents to remove and replace the other members of the
Northstar Board of Directors which at the time consisted of Messrs. Brody,
Jarrett, Pesci, Smallacombe and Watson (the "Brody Board") and effectuate
related changes in Northstar's bylaws (the "Consent Solicitation"). Shortly
thereafter, the Board of Directors terminated Mr. Zaucha's employment with the
Company, though he remained a member of the Board of Directors. On March 24,
1997, Mr. Zaucha delivered executed consents representing the votes of 61% of
the outstanding shares in favor of his proposals and, following confirmation of
the decision of the Delaware Chancery Court on May 8, 1997, Mr. Zaucha resumed
his duties as the Company's Chief Executive Officer. The ruling of the Delaware
Chancery Court was appealed to the Delaware Supreme Court by three of the Board
members removed from office as a result of the Chancery Courts' decision. On
August 1, 1997, a unanimous panel of the Delaware Supreme Court affirmed the
decision of the Delaware Chancery Court confirming the election of the current
Board.

         In January 1997, the Company and Samuel Armfield III, M.D., reached a
settlement in regard to the various claims that each had against the other,
resulting from the acquisition by the Company of the stock of Vascusonics, Inc.
and certain of the assets of Penn Vascular Labs, P.C.

         In January 1997, the Justice Department initiated an action against
Samuel Armfield, III, M.D. for claims amounting to $300,000 in connection with
Dr. Armfield's Medicare billings. Although such claims could be trebled if Dr.
Armfield is convicted, the Company believes that its exposure, through its
dealings with Vascusonics, would aggregate $50,000 to $100,000. In addition, the
Company has recourse against Dr. Armfield for any amounts assessed against the
Company, which the Company plans to aggressively pursue, if necessary.

        In March 1998, Robert J. Smallacombe, a former director, consultant and
employee of the Company filed a Writ of Summons against the Company and other
related parties. Mr. Smallacombe was terminated for cause in May 1997. See Note
15. Mr. Smallacombe believes he is entitled to the balance of his employment
contract and certain stock options that may or may not have been granted. The
Company believes that it has counterclaims against Mr. Smallacombe, and intends
to vigorously defend itself against these claims.

        On October 2, 1998, Nicholas P. Horoszko, a named defendant in the
lawsuit filed by the Company in September 1996 described above, filed a demand
for arbitration against the Company for alleged breach of contract. Horoszko is
seeking damages of approximately $225,000. The Company plans to vigorously
contest this liability. No scheduling order has yet been entered on this claim.


                                      F-29
<PAGE>   69


                                                                     Schedule II

                NORTHSTAR HEALTH SERVICES, INC. AND SUBSIDIARIES
                        VALUATION AND QUALIFYING ACCOUNTS
                FOR YEARS ENDING DECEMBER 31, 1998, 1997 AND 1996
                             (Dollars in Thousands)

<TABLE>
<CAPTION>
                                  Balance at       Charged to                                                         Balance at
                                 Beginning of      Costs and                       Deductions from                      End of
                                    Period          Expenses      Recoveries          Reserve (1)         Other         Period
                                 --------------   -------------  --------------    -----------------     ---------    ------------

<S>                              <C>              <C>            <C>               <C>                   <C>          <C>
Year ended December 31,
  1996 - Allowance for
  doubtful accounts (2)               $3,518          1,820               -              (3,323)             -         $ 2,015

Year ended December 31,
  1997 - Allowance for
  doubtful accounts                   $2,015          2,024               -              (2,698)             -         $ 1,341

Year ended December 31,
  1998 - Allowance for
  doubtful accounts                   $1,341            343               -              (1,187)             -           $ 497
</TABLE>

(1) Represents uncollected accounts charged against the allowance account.

(2) Certain reclassifications have been made to conform with the current year
    presentation.


                                      F-30
<PAGE>   70


                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
                         ON FINANCIAL STATEMENT SCHEDULE


To Northstar Health Services, Inc.:

     We have audited in accordance with generally accepted auditing standards,
the financial statements included in Northstar Health Services, Inc.'s Form
10-K, and have issued our report thereon dated March 5, 1999. Our audit was made
for the purpose of forming an opinion on those statements taken as a whole. The
schedule listed in the index in Item 14(a) of this Form 10-K is the
responsibility of the Company's management and is presented for purposes of
complying with the Securities and Exchange Commission's rules and is not part of
the basic financial statements. This schedule has been subjected to the auditing
procedures applied in the audit of the basic financial statements and, in our
opinion, fairly states in all material respects the financial data required to
be set forth therein in relation to the basic financial statements taken as a
whole.

                                             Arthur Andersen LLP

Pittsburgh, Pennsylvania
    March 5, 1999


                                      F-31