Forward-Looking Statements

The forward-looking comments contained in the following discussion involve risks and uncertainties. Our actual results may differ materially from those discussed here due to factors such as, among others, limited operating history, difficulty in developing, exploiting and protecting proprietary technologies, intense competition and substantial regulation in the healthcare industry. Additional factors that could cause or contribute to such differences can be found in the following discussion, as well as under Item 1A, "Risks Factors."

OVERVIEW

General

We are a healthcare services management company, providing through our Catasys™ subsidiary behavioral health management services for substance abuse to health plans. Catasys is focused on offering integrated substance dependence solutions, including our patented PROMETA® Treatment Program for alcoholism and stimulant dependence. The PROMETA Treatment Program, which integrates behavioral, nutritional, and medical components, is also available on a private-pay basis through licensed treatment providers and company managed treatment centers that offer the PROMETA Treatment Program, as well as other treatments for substance dependencies. We also research, develop, license and commercialize innovative and proprietary physiological, nutritional, and behavioral treatment programs.

Our Strategy

Our business strategy is to provide quality treatment programs in a cost effective manner that will become the standard-of-care for those suffering from alcoholism and other substance dependencies, autism and ADHD in a cost effective manner. We intend to grow our business through implementing and increasing adoption of our Catasys integrated substance dependence solutions and our autism and ADHD solutions by managed care health plans, employers, unions and other third-party payors. We also intend to grow our business through increased utilization of our PROMETA Treatment Program from within existing and new licensees and managed treatment centers.

Key elements of our business strategy include:

? Providing our Catasys integrated substance dependence solutions to managed care health plans for reimbursement on a case rate or capitated basis

? Demonstrating the potential for improved clinical outcomes and cost effectiveness associated with using the PROMETA Treatment Program, through implementation of our Catasys programs with key managed care and other third-party payors

? Launching autism and ADHD specialty behavioral health products and programs that will be supported by CompCare through our ASO services agreement

? Expanding Catasys into other areas that can benefit from integrated behavioral and medical treatment and case management

? Expanding the base of our self-pay licensed treatment sites and managed treatment centers, focusing primarily on existing service areas

? Seeking additional scientific and clinical research data by leading research institutions and preeminent researchers in the field of alcohol and substance abuse to further validate the benefits of using the PROMETA Treatment Program

CompCare

Effective January 12, 2007, we acquired a 50.3% controlling interest in Comprehensive Care Corporation (CompCare) through the acquisition of Woodcliff Healthcare Investment Partners, LLP (Woodcliff). Our consolidated financial statements include the business and operations of CompCare subsequent to this date.

CompCare provides managed care services in the behavioral health and psychiatric fields. CompCare manages the delivery of a continuum of psychiatric and substance abuse services to commercial, Medicare and Medicaid members on behalf of employers, health plans, government organizations, third-party claims administrators, and commercial and other group purchasers of behavioral healthcare services. The customer base for CompCare's services includes both private and governmental entities. During the year ended December 31, 2008, CompCare provided services under capitated arrangements for Medicare patients in Connecticut, Maryland, Pennsylvania, and Puerto Rico, commercial patients in Georgia, Medicare, Medicaid, and commercial patients in Florida and Michigan, Medicaid and commercial patients in Indiana, Medicare and Medicaid patients in California, and Medicare, Medicaid, and CHIP patients in Texas. CompCare's Medicare, Medicaid and CHIP contracts are subject to agreements with their HMO clients whose contracts with the various governmental agencies may be subject to renegotiation at the election of the specific agency.

On January 20, 2009 we sold our interest in CompCare. Additionally, we entered into an administrative services only (ASO) agreement with CompCare to provide certain administrative services under CompCare's NCQA accreditation, including but not limited to case management and authorization services, in support of our newly launched specialty products and programs for autism and ADHD. See further discussion under Recent Developments below.

Segment Reporting

We have conducted our operations through two business segments: healthcare services and behavioral health managed care services. Our healthcare services segment provides our Catasys integrated substance dependence, autism and ACHD solutions to health plans, employers and unions through a network of licensed and company managed healthcare providers, and provides licensing, administrative and management services to licensees that administer PROMETA and other treatment programs, including managed treatment centers that are licensed and/or managed by us. Our behavioral health managed care services segment, comprised entirely of the operations of our consolidated subsidiary, CompCare, provides managed care services in the behavioral health, psychiatric and substance abuse fields. A majority of our consolidated revenues and assets are earned or located within the United States.

Operations

Healthcare Services

Catasys

In 2008 we developed and operationalized our Catasys integrated substance dependence solutions for third-party payors, and in January 2009 we launched additional Catasys specialty products for autism and ADHD. We believe that our Catasys offerings will address the largest segment of the healthcare market for substance dependence and other behavioral disorders.

Licensing Operations

Under our licensing agreements, we provide physicians and other licensed treatment providers access to our PROMETA Treatment Program, education and training in the implementation and use of the licensed technology and marketing support. The patient's physician determines the appropriateness of the use of the PROMETA Treatment Program. We receive a fee for the licensed technology and related services generally on a per patient basis. As of December 31, 2008, we had active licensing agreements with physicians, hospitals and treatment providers for 84 sites throughout the United States, with 49 sites contributing to revenue in 2008. We will continue to enter into agreements on a selective basis with additional healthcare providers to increase the availability of the PROMETA Treatment Program, but only in markets we are presently operating or where such sites will provide support for our Catasys products. As such revenues are generally related to the number of patients treated, key

indicators of our financial performance for the PROMETA Treatment Program will be the number of facilities and healthcare providers that license our technology, and the number of patients that are treated by those providers using our PROMETA Treatment Program.

Managed Treatment Centers

We currently manage two treatment centers under our licensing agreements, located in Santa Monica, California (dba The PROMETA Center, Inc.) and Dallas, Texas (Murray Hill Recovery, LLC). In January 2007, a second PROMETA Center was opened in San Francisco, which was subsequently closed in January 2008. We manage the business components of the treatment centers and license the PROMETA Treatment Program and use of the name in exchange for management and licensing fees under the terms of full business service management agreements. These centers offer treatment with the PROMETA Treatment Program for dependencies on alcohol, cocaine and methamphetamines and also offer medical interventions for other substance dependencies.

The revenues and expenses of these centers are included in our consolidated financial statements under accounting standards applicable to variable interest entities. Revenues from licensed and managed treatment centers, including the PROMETA Centers, accounted for approximately 33% of our healthcare services revenues in 2008.

Research and Development, Pilot Studies

To date, we have incurred approximately $12.6 million related to research and development, including $3.4 million in 2008, $3.3 million in 2007 and $3.1 million in 2006, respectively, in funding for commercial pilots and unrestricted grants for a number of clinical research studies by researchers in the field of substance dependence and leading research institutions to evaluate the efficacy of the PROMETA Treatment Program in treating alcohol and stimulant dependence. We plan to incur approximately $400,000 in 2009 for unrestricted research grants and commercial pilots.

Pilot programs are used in conjunction with drug court systems, state programs and managed care organizations to allow such programs to evaluate the outcomes and cost effectiveness of the PROMETA Treatment Program. The focus of these pilot programs is to assist such organizations in assessing the impact on their population, and as a result, the method, manner, timing, participants and metrics may change and develop over time, based on initial results from the particular program, other pilots, and research studies. We generally do not provide updates on status after a pilot is initially announced.

International

In 2007, we expanded our operations into Europe with our Swiss foreign subsidiary commencing operations in the first quarter of 2007. However, in 2008 we decided to substantially curtail our foreign operations to reduce costs and focus on our Catasys product offerings.

Recent Developments

On January 20, 2009 we sold our entire interest in our majority-owned, controlled subsidiary CompCare for aggregate gross proceeds of $1.5 million. We expect to recognize a gain of approximately $11.2 million from the sale of our CompCare interest, which will be included in our Consolidated Statement of Operations for the three month period ending March 31, 2009. Additionally, we entered into an administrative services only (ASO) agreement with CompCare to provide certain administrative services under CompCare's NCQA accreditation, including but not limited to case management and authorization services, in support of our newly launched specialty products and programs for autism and ADHD.

Beginning in the fourth quarter of 2008, we have initiated actions to reduce our operating expenses by an additional $10.2 million from the third quarter 2008 expenditure level, resulting in total budgeted operating expenses of approximately $17.7 million for 2009. The actions we took included significant reductions in field and regional sales personnel and related corporate support personnel, curtailment of our international operations, a reduction in outside consultant expense and overall reductions in overhead costs.

In May 2008, we entered into an agreement with a CIGNA HealthCare affiliate to be reimbursed for providing our PROMETA based substance dependence treatment program in Texas. The program became effective July 1, was initially offered through our managed treatment center in Dallas and is now being expanded into Houston and Los Angeles. The program will not require any significant infrastructure investment by us to support the agreement. Medical and psychosocial treatment is being provided by our licensed providers to CIGNA HealthCare members, and although we anticipate expansion throughout Texas, the clinical and financial impact of the program will be evaluated with the objective of continued expansion beyond Texas.

Behavioral Health Managed Care Services

Our consolidated subsidiary, CompCare, typically enters into contracts on an annual basis to provide managed behavioral healthcare and substance abuse treatment to clients' members. Arrangements with clients fall into two broad categories: capitation arrangements, where clients pay CompCare a fixed fee per member per month, and fee-for-service and administrative service arrangements where CompCare may manage behavioral healthcare programs or perform various managed care services. Approximately $34.1 million and $35.2 million, or 97% of CompCare's revenues for both the year ended December 31, 2008 and the period January 13 through December 31, 2007, respectively, were derived from capitation arrangements. Under capitation arrangements, CompCare receives premiums from clients based on the number of covered members as reported by the clients. The amount of premiums received for each member is fixed at the beginning of the contract term. These premiums may be subsequently adjusted, up or down, generally at the commencement of each renewal period.

Effective January 1, 2007, CompCare commenced a contract with a health plan to provide behavioral healthcare services to approximately 250,000 Medicaid recipients in Indiana. This contract amounted to $17.8 million and $15 million, respectively, in revenue for the year ended December 31, 2008 and the period January 13 though December 31, 2007. This contract accounted for approximately 51%, of CompCare's annual revenue in 2008. As discussed in "Recent Developments" below, CompCare ceased providing behavioral health services to this client effective on December 31, 2008.

Seasonality of Business

Historically, CompCare's managed care plans have experienced increased member utilization during the months of March, April and May, and consistently lower utilization by members during the months of June, July,

and August. Such variations in member utilization impact the costs of care during these months, generally having a negative impact on gross margins and operating profits during the former period, and a positive impact on gross margins and operating profits during the latter period.

Concentration of Risk

Over eighty percent of CompCare's operating revenue is currently concentrated, and has been concentrated in past fiscal periods, in contracts with four to seven health plans to provide behavioral healthcare services under commercial, Medicare, Medicaid, and CHIP plans. The terms of each contract are generally for one-year periods and are automatically renewable for additional one-year periods unless terminated by either party. The loss of one or more of these clients, without replacement by new business, may adversely impact CompCare's financial results.

Recent Developments

On January 1, 2009, CompCare began providing behavioral health services for approximately 173,000 Medicaid recipients under contracts with two affiliated health plans in the states of Michigan and Illinois. The contracts are expected to generate approximately $1.2 million in annual revenue and are for one-year terms with automatic one-year renewals.

Through its newly formed, majority owned subsidiary, CompCare de Puerto Rico, Inc., CompCare began providing, on December 1, 2008, behavioral health services to approximately 9,000 members of a health plan located in Puerto Rico. Effective January 1, 2009, CompCare also initiated pharmaceutical management services for the plan's members. Services under the contract are expected to generate approximately $1.0 million of annual revenue. The contract is for a term of three years with automatic one-year renewals.

As of December 31, 2008, CompCare ceased providing behavioral health services to 278,000 Medicaid members of its major Indiana HMO client, which had decided to manage its membership through its own provider delivery system. Revenues from this client accounted for $17.8 million, or 51% of CompCare's operating revenue, and $15.0 million, or 40%, of CompCare's operating revenues for the year ended December 31, 2008 and the period from January 13 to December 31, 2007, respectively. In addition, CompCare's contract with a Maryland HMO covering approximately 11,000 Medicare members ended December 31, 2008. This contract accounted for $1.9 million, or 5%, and $1.3 million, or 4% of CompCare's revenues for the year ended December 31, 2008 and the period from January 13 to December 31, 2007, respectively.

In October 2008, CompCare was awarded full accreditation by the NCQA. NCQA accreditation validates that CompCare meets managed behavioral healthcare organization (MBHO) accreditation standards that govern quality improvement, utilization management, provider credentialing, members' rights and responsibilities, and preventative care. These standards confirm that an MBHO is founded on principles of quality and is continuously improving the clinical care and services it provides. Full accreditation is granted for a period of three years to those plans that meet the NCQA's rigorous standards.

How We Measure Our Results

Our healthcare services revenues to date have been primarily generated from fees that we charge to hospitals, healthcare facilities and other healthcare providers that license our PROMETA Treatment Program, and from patient service revenues related to our licensing and management services agreements with managed treatment centers. Our technology license and management services agreements provide for an initial fee for training and other start-up related costs, plus a combined fee for the licensed technology and other related services, generally set on a per-treatment basis, and thus a substantial portion of our revenues is closely related to the number of patients treated. Patients treated by managed treatment centers generate higher average revenues per PROMETA patient than our other licensed sites due to consolidation of their gross patient revenues in our financial statements. Key indicators of our financial performance will be the number of health plans and other organizations that contract with us for our Catasys products, the number of managed care lives covered by such plans, and the number of facilities and healthcare providers that contract with us to license our technology and the number of patients that are treated by those providers using the PROMETA Treatment Program. Additionally, our financial results will depend on our ability to expand the adoption of Catasys and the PROMETA Treatment Program among government and other third

party payer groups, and our ability to effectively price these products, and manage general, administrative and other operating costs.

For behavioral health managed care services, our largest expense to date has been CompCare's cost of behavioral health managed care services that it provides, which is based primarily on its arrangements with healthcare providers. Since CompCare's costs are subject to increases in healthcare operating expenses based on an increase in the number and frequency of the members seeking behavioral health care services, CompCare's profitability depends on its ability to predict and effectively manage healthcare operating expenses in relation to the fixed premiums it receives under capitation arrangements. Providing services on a capitation basis exposes CompCare to the risk that its contracts may ultimately be unprofitable if CompCare is unable to anticipate or control healthcare costs. Estimation of healthcare operating expense is one of our most significant critical accounting estimates. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Estimates."

CompCare currently depends upon a relatively small number of customers for a significant percentage of its behavioral health managed care operating revenues. A significant reduction in sales to any of CompCare's large customers or a customer exerting significant pricing and margin pressures on CompCare would have a material adverse effect on CompCare's consolidated results of operations and financial condition. In the past, some of CompCare's customers have terminated their arrangements or have significantly reduced the amount of services requested (see Note 12 -Major Customers/Contracts).

Results of Operations

Table of Summary Financial Information

The table below and the discussion that follows summarize our results of
operations and certain selected operating statistics for the last three fiscal
years (amounts in thousands):

  (In thousands)                                        Year Ended December 31,
                                                   2008           2007           2006
  Revenues
  Behavioral health managed care services       $   35,156     $   36,306     $        -
  Healthcare services                                6,074          7,695          3,906
  Total revenues                                    41,230         44,001          3,906

  Operating Expenses
  Behavioral health managed care expenses           36,496         35,679              -
  Cost of healthcare services                        1,718          2,052            818
  General and administrative expenses               40,741         45,554         38,680
  Impairment loss                                        -          2,387              -
  Research and development                           3,370          3,358          3,053
  Goodwill Impairment                                9,775              -              -
  Depreciation and amortization                      2,733          2,502          1,281
  Total operating expenses                          94,833         91,532         43,832

  Loss from operations                             (53,603 )      (47,531 )      (39,926 )

  Interest income                                      830          1,584          1,630
  Interest expense                                  (1,939 )       (2,190 )            -
  Other than temporary loss on marketable
  securities                                        (1,428 )            -              -
  Loss on extinguishment of debt                         -           (741 )            -
  Change in fair value of warrant liabilities        5,744          3,471              -
  Other non-operating expense, net                       5             32              -
  Loss before provision for income taxes        $  (50,391 )   $  (45,375 )   $  (38,296 )

Includes results of CompCare, as reported in our behavioral health managed care segment, which was sold in January 2009.

Summary of Consolidated Operating Results

In 2008, our loss before provision for income taxes included a $9.8 million goodwill impairment charge, a $1.4 million other-than-temporary loss on marketable securities and $3.1 million in costs to streamline our operations. The 2007 loss before provision for income taxes includes a $2.4 million impairment charge related to intangible assets. Additionally, the 2008 results reflect $8.6 million in share-based expense compared to $2.6 million in 2007. Excluding the impact of these charges, the loss before provision for income taxes decreased by $12.9 million in 2008 when compared to 2007, primarily due to a $13.2 million reduction in total operating expenses and a $2.3 million increase in income from the change in fair value of warrant liabilities, partially offset by a $2.8 million decline in total revenues.

The decline in total revenues resulted mainly from the impact of streamlining of our healthcare services operations during 2008 to increase our focus on disease management and managed care opportunities, which included the elimination of field and regional sales personnel and closing of the PROMETA Center in San Francisco, as well as the loss of contracts and decline in membership in behavioral health managed care services.

The reduction in total operating expenses also resulted mainly from the streamlining in healthcare services operations, which accounted for a $13.9 million decrease in operating expenses in that segment compared to 2007 (excluding the impact of impairment charges, costs to streamline our operations and share-based expense), partially offset by an increase in claims expense in behavioral health managed care services.

The 2007 loss before provision for income taxes includes the $2.4 million impairment charge and $2.6 million of share-based expense and the 2006 results include $3.7 million of share-based expense. Excluding the impact of these charges, the loss before provision for income taxes in 2007 increased by $5.9 million compared to 2006, due to the inclusion of a $4.1 million loss from CompCare's operations, a $6.1 million increase in operating expenses in healthcare services, $2.2 million increase in interest expense on debt outstanding and a $741,000 loss on extinguishment of debt, partially offset by a $3.8 million increase in revenues from healthcare services and favorable $3.5 million fair value adjustment of the warrant liability. We acquired a majority controlling interest in CompCare, resulting from our acquisition of Woodcliff on January 12, 2007, and began including its results in our consolidated financial statements subsequent to that date. These results are reported in our behavioral health managed care services segment.

Our healthcare services revenues virtually doubled in 2007, when compared to 2006. The increase was due to the increase in the number of patients treated at our U.S. licensed sites and at our managed treatment centers, administrative fees from new licensees and other revenues from the commencement of international operations and licenses with government agencies and other third-party payors.

Excluding the impact of CompCare, impairments and share-based expense, operating expenses increased by approximately $6.1 million in 2007 when compared to the same period in 2006. The increase is due mainly to the increase in the number of our sales field personnel, the expansion in number of licensees, the strengthening and expansion in our management and support teams, an increase in funding of clinical research studies and investment in development of additional markets for our services, including managed care, statewide agencies, criminal justice systems and other third-party payors as well as international opportunities.

We incurred approximately $1.9 million of interest expense during the year ended December 31, 2007 associated with the CompCare acquisition-related financing with Highbridge International LLC (Highbridge) that originally consisted of the issuance of a $10 million senior secured note and warrants to purchase our common stock.

Reconciliation of Segment Results

The following table summarizes and reconciles the loss from operations of our
reportable segments to the loss before provision for income taxes from our
consolidated statements of operations for the years ended December 31, 2008,
2007 and 2006:
. . .