The following discussion of our financial condition and results of operations should be read in conjunction with our financial statements including the related notes, and the other financial information included in this report. For ease of reference, "we," "us" or "our" refer to Hythiam, Inc., our wholly-owned subsidiaries and The PROMETA Center, Inc. unless otherwise stated.

Forward-Looking Statements

The forward-looking comments contained in this report 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 in the "Risks Factors" set forth in Item 1A of

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.

Segment Reporting

We currently operate within two reportable segments: Healthcare services and Behavioral Health. Our healthcare services segment focuses on providing 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 segment, through our Catasys™ subsidiary, combines innovative medical and psychosocial treatments with elements of traditional disease management and ongoing member support to help organizations treat and manage substance dependent populations, and is designed to lower both the medical and behavioral health costs associated with substance dependence and the related co-morbidities. Over 80% of our revenue from continuing operations and substantially all of our assets are earned or located within the United States.

Discontinued Operations

On January 20, 2009 we sold our entire interest in our controlled subsidiary CompCare for aggregate gross proceeds of $1.5 million. We recognized a gain of approximately $11.2 million from the sale of our CompCare interest, which is included in our Consolidated Statement of Operations for the three months ended March 31, 2009. Additionally, we entered into an administrative services only (ASO) agreement with CompCare to provide certain administrative services under CompCare's National Committee for Quality Assurance (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.

Prior to the sale, we reported the operations of CompCare in our behavioral health managed care segment. For detailed information regarding the impact of the sale of our interest in CompCare, see our consolidated balance sheets, statements of operations, statements of cash flows and Note 5, Discontinued Operations, included with this report.

Operations

Healthcare Services

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. 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 March 31, 2009, we had active licensing agreements with physicians, hospitals and treatment providers for 40 sites throughout the United States, with 18 sites contributing to revenue in 2009. 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. As discussed below in Recent Developments, we are currently evaluating and considering additional actions to streamline our operations that may impact the licensing operations.

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 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 55% of our healthcare services revenues for the three months ended March 31, 2009. As discussed below in Recent Developments, we are currently evaluating and considering additional actions to streamline our operations that may impact the managed treatment centers.

Behavioral Health

In 2007 and 2008, we developed our Catasys integrated substance dependence solutions for third-party payors. We believe that our Catasys offerings will address a large part of the segment of the healthcare market for substance dependence, and we are currently marketing our Catasys integrated substance dependence solutions to managed care health plans for reimbursement on a case rate or monthly fee, which involves educating third party payors on the disproportionately high cost of their substance dependent population and demonstrating the potential for improved clinical outcomes and reduced cost associated with using our Catasys programs. In addition, we may be launching other specialty behavioral health products and programs, including Autism and ADHD, that can leverage our existing infrastructure and sales force, but this effort is largely on hold due to budget constraints.

Recent Developments

In the first quarter of 2009, we completed actions that we began in the fourth quarter of 2008 to reduce our operating expenses by an additional $10.2 million from the third quarter 2008 expenditure level. 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. Additionally, we took further actions in the first quarter of 2009 to streamline our operations and increase the focus on managed care opportunities and to renegotiate certain leasing and vendor agreements to obtain more favorable pricing and to restructure payment terms with vendors, which included negotiating settlements for outstanding liabilities. These efforts have resulted in delays and reductions in operating expenses, resulting in total budgeted operating expenses of approximately $10 million for the remainder of 2009.

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

RESULTS OF OPERATIONS

Table of Summary Consolidated Financial Information

The table below and the discussion that follows summarize our results of
consolidated continuing operations for the three months ended March 31, 2009 and
2008:

                                                                       Three Months Ended
(In thousands, except per share amounts)                                   March 31,
                                                                       2009          2008
Revenues
Healthcare services revenues                                        $      707     $   2,006

Operating expenses

Cost of healthcare services                                         $      273     $     481
General and administrative                                               5,603        11,154
Research and development                                                     -         1,358
Impairment losses                                                        1,113             -
Depreciation and amortization                                              404           463
Total operating expenses                                            $    7,393     $  13,456

Loss from operations                                                $   (6,686 )   $ (11,450 )

Interest and other income                                                   46           429
Interest expense                                                          (408 )        (265 )
Loss on extinguishment of debt                                            (276 )           -
Other than temporary impairment of marketable securities                  (132 )           -
Change in fair value of warrant liability                                   69         2,267
Loss from continuing operations before provision for income taxes   $   (7,387 )   $  (9,019 )

Summary of Consolidated Operating Results

The net loss from continuing operations before provision for income taxes decreased by $1.6 million during the three months ended March 31, 2009 compared to the same period in 2008, primarily due to the decrease in operating expenses, resulting mainly from actions to streamline our Healthcare Services operations, partially offset by a $2.2 million decrease in the change in fair value of warrant liability, a $1.3 million decrease in healthcare services revenue and impairment losses totaling $1.1 million. Additionally, operating expenses in the 2008 period included $1.2 million in costs associated with actions taken to streamline our operations, compared to $212,000 of such expense in 2008. See the discussion of operating results under the headings Healthcare Services and Behavioral Health below for a detailed discussion of these changes.

Revenue decreased by $1.3 million for the three months ended March 31, 2009 compared to the same period in 2008, due mainly to a decline in licensed sites contributing to revenue and in the number of patients treated at our U.S licensed sites and the managed treatment centers, the decision to shut down sites in our international operations and a decrease in administrative fees earned from new licensees.

General and administrative expenses also include $1.2 million in non-cash expenses for share-based compensation, compared to $2.3 million of such expense in 2008. The impairment losses included $758,000 for capitalized software in our Behavioral Health segment and $355,000 related to intangible assets.

Reconciliation of Segment Results

The following table summarizes and reconciles the loss before provision for
income taxes of our reportable segments in continuing operations to the loss for
continuing operations before provision for income taxes from our consolidated
statements of operations for the three months ended March 31, 2009 and 2008:

                                                                       Three Months Ended
(In thousands)                                                             March 31,
                                                                       2009          2008
Healthcare services                                                 $   (5,693 )   $  (7,767 )
Behavioral health                                                       (1,694 )      (1,272 )
Loss from continuing operations before provision for income taxes   $   (7,387 )   $  (9,019 )

                              Healthcare Services

The following table summarizes the operating results for healthcare services for
the three months ended March 31, 2009 and 2008:

                                                               Three Months Ended
  (In thousands, except patient treatment data)                     March 31,
                                                               2009          2008
  Revenues
  U.S. licensees                                             $     184     $     823
  Managed treatment centers (a)                                    389           664
  Other revenues                                                   134           519
  Total healthcare services revenues                         $     707     $   2,006

  Operating expenses
  Cost of healthcare services                                $     273     $     481
  General and administrative expenses
  Salaries and benefits                                          2,774         6,267
  Other expenses                                                 1,976         3,615
  Research and development                                           -         1,358
  Impairment losses                                                355             -
  Depreciation and amortization                                    321           463
  Total operating expenses                                   $   5,699     $  12,184

  Loss from operations                                       $  (4,992 )   $ (10,178 )

  Interest and other income                                         46           429
  Interest expense                                                (408 )        (265 )
  Loss on extinguishment of debt                                  (276 )           -
  Other than temporary impairment on marketable securities        (132 )           -
  Change in fair value of warrant liability                         69         2,267
  Loss before provision for income taxes                     $  (5,693 )   $  (7,747 )

  PROMETA patients treated
  U.S. licensees                                                    42           144
  Managed treatment centers (a)                                     37            57
  Other                                                             11            29
                                                                    90           230

  Average revenue per patient treated (b)
  U.S. licensees                                             $   5,524     $   5,678
  Managed treatment centers (a)                              $   9,145     $   9,028
  Other                                                      $   9,959     $   8,397
  Overall average                                            $   6,327     $   6,851

(a) Includes managed and/or licensed PROMETA Centers.

(b) The average revenue per patient treated excludes administrative fees and other non-PROMETA patient revenues.

Revenue

Revenues for the three months ended March 31, 2009 decreased $1.3 million compared to the three months ended March 31, 2008. The decrease was attributable to a decline in licensed sites contributing to revenues and in the number of patients treated at our U.S licensed sites and the managed treatment centers, the decision to shut down sites in our international operations and a decrease in administrative fees earned from new licensees. The number of patients treated decreased by 61% in the three months ended March 31, 2009 compared to the same period in 2008. The number of licensed sites that contributed to revenues decreased to 18 in the three months ended March 31, 2009 from 40 in the three months ended March 31, 2008. The average revenue per patient treated at U.S. licensed sites and at the PROMETA Centers did not materially change during the three months ended March 31, 2009 compared to the same period in 2008.

Cost of Healthcare Services

Cost of healthcare services consists of royalties we pay for the use of the PROMETA Treatment Program, and costs incurred by our consolidated managed treatment centers (including PROMETA Centers) for direct labor costs for physicians and nursing staff, continuing care expense, medical supplies and treatment program medicine costs. The decrease in these costs primarily reflects the decrease in revenues from these treatment centers.

General and Administrative Expenses

Excluding costs associated with streamlining our operations totaling $212,000 in 2009 and $1.2 million in 2008, total general and total general and administrative expenses decreased by $5.1 million in the three months ended March 31, 2009 compared to the same period in 2008. This decrease is attributable to decreases of $3.5 million in salaries and benefits and $1.6 million in other general and administrative expenses as a result of the streamlining of our operations. General and administrative expenses include $1.2 million in non-cash expense for share-based compensation, compared to $2.3 million of such expense in 2008.

Research and Development

Our total research and development expenses decreased by $1.4 million in the three months ended March 31, 2009 compared to the same period in 2008. This decrease is attributable to clinical studies undertaken in 2008 and prior years that were substantially completed in 2008 and for which no expense was recognized during the three months ended March 31, 2009.

Impairment Losses

Impairment charges included $122,000 for intangible assets related to our managed treatment center in Dallas and $233,000 related to intellectual property for additional indications for the use of the PROMETA Treatment Program that are currently non-revenue-generating, both of which resulted from impairment testing at March 31, 2009.

Interest and Other Income

Interest income for the three months ended March 31, 2009 decreased by $383,000 compared to the same period in 2008 due to a decrease in the invested balance of marketable securities and a decrease in interest rates.

Interest Expense

Interest expense for the three months ended March 31, 2009 increased by $143,000 compared to the same period in 2008 due to higher debt balances from the UBS line of credit during the three months ended March 31, 2009, partially offset by the effect of lower interest rates during this same period.

Loss from Extinguishment of Debt

We recognized a $276,000 loss on extinguishment of debt resulting from the $1.4 million pay down on the Highbridge senior secured note, primarily representing unamortized discount.

Other than Temporary Impairment on Marketable Securities

An impairment charge of $132,000 related to certain of our auction rate securities (ARS) was recognized for the three months ended March 31, 2009. The charge was based on an updated valuation of the securities performed by management as of March 31, 2009 and deemed necessary after an analysis of other-than-temporary impairment factors, most notably, our inability to hold the ARS until they are expected to recover in value.

Change in fair value of warrant liability

Warrants issued in connection with a registered direct stock placement completed on November 7, 2007 and warrants issued in connection with the Highbridge note issued on January 18, 2007 and amended on July 31, 2008, are being accounted for as liabilities in accordance with EITF 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock (EITF 00-19), based on an analysis of the terms and conditions of the warrant agreement.

Both warrants are re-valued at each reporting period using the Black-Scholes pricing model to determine the fair market value per share. The change in fair value of the warrants issued in connection with the November 7, 2007 registered direct stock placement amounted to a $26,000 non-operating gain in the Consolidated Statement of Operations for the three months ended March 31, 2009. The change in fair value for the warrants issued in connection with the Highbridge note amounted to a $43,000 non-operating gain in the Consolidated Statement of Operations for the three months ended March 31, 2009. We will continue to mark the warrants to market value each quarter-end until they are completely settled.

Behavioral Health

The following table summarizes the operating results for Behavioral Health for
the three months ended March 31, 2009 and 2008:

                                                      Three Months Ended
           (in thousands)                                  March 31,
                                                       2009          2008

           Revenues                                 $        -      $     -

           Operating Expenses
           General and administrative expenses
           Salaries and benefits                    $      656      $   564
           Other expenses                                  197          708
           Impairment charges                              758            -
           Depreciation and amortization                    83            -
           Total operating expenses                 $    1,694      $ 1,272

           Loss before provision for income taxes   $    1,694      $ 1,272

General and Administrative Expenses

Total general and administrative expenses decreased by $419,000 in the three months ended March 31, 2009 compared to the same period in 2008. This decrease is attributable primarily to a reduction of $511,000 in other expenses, which was a result of the streamlining of our operations, partially offsetting a $92,000 increase in salaries and benefits.

Impairment Losses

An impairment charge of $758,000 was recognized during the three months ended March 31, 2009 related to capitalized software for our Behavioral Health segment. We performed an impairment analysis in accordance with SFAS 144 and determined that the carrying value was not recoverable and was fully impaired.

Depreciation and Amortization

Depreciation and amortization for the three months ended March 31, 2009 consisted of depreciation of the capitalized software prior to the impairment discussed above. There was no depreciation during the three months ended March 31, 2008 as the asset had not yet been placed in service.

LIQUIDITY AND CAPITAL RESOURCES

Liquidity and Going Concern

As of March 31, 2009, we had a balance of approximately $6.0 million in cash, cash equivalents and current marketable securities. In addition, we had approximately $10.4 million of auction rate securities (ARS), which is classified in long-term assets as of March 31, 2009.

ARS are variable-rate instruments with longer stated maturities whose interest rates are reset at predetermined short-term intervals through a Dutch auction system. However, commencing in February 2008, auctions for these securities have failed, meaning the parties desiring to sell securities could not be matched with an adequate number of buyers, resulting in our having to continue to hold these securities. We believe that we ultimately should be able to liquidate all of our ARS investments without significant loss because the securities are Aaa/AAA rated and collateralized by portfolios of student loans guaranteed by the U.S. government. However, current conditions in the ARS market make it likely that auctions will continue to be unsuccessful in the short-term, limiting the liquidity of these investments until the auction succeeds, the issuer calls or refinances the securities, or they mature. As a result of the current turmoil in the credit markets, our ability to liquidate our investment and fully recover the carrying value of our investment in the near term may be limited or not exist. Based on the foregoing, management believes at the current time that its ARS investments most likely cannot be sold at par within the next 12 months. Therefore, we have classified the ARS investments in long-term assets at March 31, 2009.

In October 2008, UBS made a rights offering to its clients, pursuant to which we are entitled to sell to UBS all auction-rate securities held by us in our UBS account. The rights offering permits us to require UBS to purchase our ARS for a . . .