10-K

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

(Mark One)

þ	Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the fiscal year ended December 31, 2006
	or

o 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 0-20488

Psychiatric Solutions, Inc.

(Exact Name of Registrant as Specified in Its Charter)

DELAWARE
(State or Other Jurisdiction of Incorporation or
Organization) 23-2491707
(I.R.S. Employer Identification No.)

6640 Carothers Parkway, Suite 500
Franklin, TN 37067
(Address of Principal Executive Offices, Including Zip Code)

(615) 312-5700
(Registrant’s Telephone Number, Including Area Code)

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:

Title Of Each Class	Name of Each Exchange On Which Registered
Common Stock, $.01 par value	NASDAQ Global Select Market

     Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. þ Yes o No

     Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. o Yes þ No

     Note – Checking the box above will not relieve any registrant required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act from their obligations under those Sections.

     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. þ Yes o 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 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. þ

     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer þ      Accelerated filer o      Non-accelerated filer o

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). o Yes þ No

     As of February 20, 2007, 53,708,699 shares of the registrant’s common stock were outstanding. As of June 30, 2006, the aggregate market value of the shares of common stock of the registrant held by non-affiliates of the registrant was approximately $1.35 billion. For purposes of calculating such aggregate market value, shares owned by directors, executive officers and 5% beneficial owners of the registrant have been excluded.

DOCUMENTS INCORPORATED BY REFERENCE

     Portions of the registrant’s definitive proxy statement for its 2007 annual meeting of stockholders to be held on May 15, 2007 are incorporated by reference into Part III of this Form 10-K.

INDEX

	PAGE
PART I
Item 1. Business		1
Item 1A. Risk Factors		11
Item 1B. Unresolved Staff Comments		16
Item 2. Properties		16
Item 3. Legal Proceedings		18
Item 4. Submission of Matters to a Vote of Security Holders		18
PART II
Item 5. Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities		18
Item 6. Selected Financial Data		19
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations		20
Item 7A. Quantitative and Qualitative Disclosures About Market Risk		28
Item 8. Financial Statements and Supplementary Data		29
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure		29
Item 9A. Controls and Procedures		29
Item 9B. Other Information		29
PART III
Item 10. Directors, Executive Officers and Corporate Governance		29
Item 11. Executive Compensation		30
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters		30
Item 13. Certain Relationships and Related Transactions, and Director Independence		31
Item 14. Principal Accountant Fees and Services		31
PART IV
Item 15. Exhibits and Financial Statement Schedules		31
Index to Financial Statements		F-1
Signatures
Ex-2.5 Agreement and Plan of Merger
Ex-10.22 Summary of Director Compensation
Ex-21.1 List of Subsidiaries
Ex-23.1 Consent of Ernst & Young LLP
Ex-31.1 Section 302 Certification of the CEO
Ex-31.2 Section 302 Certification of the CAO
Ex-32.1 Section 906 Certification of the CEO and CAO

PART I

     Unless the context otherwise requires, all references in this Annual Report on Form 10-K to “Psychiatric Solutions,” “the Company,” “we,” “us” or “our” mean Psychiatric Solutions, Inc. and its consolidated subsidiaries and all shares and per share amounts have been adjusted to reflect a 2-for-1 stock split that was completed on January 9, 2006.

Item 1. Business

Overview

     We are a leading provider of inpatient behavioral health care services in the United States. We operate 75 inpatient behavioral health care facilities with more than 8,000 beds in 29 states, Puerto Rico, and the U.S. Virgin Islands, and we manage inpatient behavioral health care units for private third parties. We generated revenue of $1,026.5 million and $715.3 million, respectively, for the years ended December 31, 2006 and 2005. We believe that our singular focus on the provision of inpatient behavioral health care services allows us to operate more efficiently and provide higher quality care than our competitors.

     Our inpatient behavioral health care facilities accounted for 94.8% of our revenue for the year ended December 31, 2006. These inpatient facilities offer a wide range of inpatient behavioral health care services for children, adolescents and adults. We offer these services through a combination of acute inpatient behavioral facilities and residential treatment centers. Our acute inpatient behavioral facilities provide the most intensive level of care, including 24-hour skilled nursing observation and care, daily interventions and oversight by a psychiatrist and intensive, highly coordinated treatment by a physician-led team of mental health professionals. Our RTCs offer longer term treatment programs primarily for children and adolescents with long-standing chronic behavioral health problems. Our RTCs provide physician-led, multi-disciplinary treatments that address the overall medical, psychiatric, social and academic needs of the patient.

     Our inpatient management contracts accounted for 5.2% of our revenue for the year ended December 31, 2006. This portion of our business involves the development, organization and management of behavioral health care programs within medical/surgical hospitals and the management of inpatient behavioral health care facilities for government agencies.

     Psychiatric Solutions was incorporated in the State of Delaware in 1988. Our principal executive offices are located at 6640 Carothers Parkway, Suite 500, Franklin, Tennessee 37067. Our telephone number is (615) 312-5700. Information about Psychiatric Solutions and our filings with the Securities and Exchange Commission can be found at our website at www.psysolutions.com.

Major Recent Developments

     During 2006, we completed the acquisitions of 19 inpatient behavioral health care facilities with an aggregate of 1,900 beds, including the December 1, 2006 purchase of the capital stock of Alternative Behavioral Services, Inc. (“ABS”), which owns and operates nine inpatient facilities.

     During January 2007, we completed the acquisition of an 86-bed inpatient behavioral health care facility in Columbia, South Carolina.

     On December 20, 2006, we signed a definitive merger agreement to acquire Horizon Health Corporation (NASDAQ: HORC) (“Horizon Health”) in a transaction valued at $426 million, consisting of cash of $20 per share totaling $321 million and the assumption of Horizon Health’s outstanding debt. Horizon Health produced revenue of $275 million for its 2006 fiscal year, which ended August 31, 2006, primarily through the operation and management of inpatient behavioral health care facilities and units. At November 30, 2006, Horizon Health owned or leased 15 inpatient behavioral health care facilities with approximately 1,561 beds in 11 states. Horizon Health also provided services under 115 behavioral health and physical rehabilitation program management contracts with acute care hospitals at November 30, 2006 and operated an employee assistance program services business. Consummation of the transaction is subject to customary closing conditions, including regulatory approvals, clearance under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 (“Hart-Scott-Rodino Act”), and approval by Horizon Health’s stockholders. On February 12, 2007, we received a request for additional information (commonly referred to as a “Second Request”) from the Federal Trade Commission (“FTC”) in connection with the pending acquisition of Horizon Health. The Second Request extends the waiting period imposed by the Hart-Scott-Rodino Act. The Second Request relates to two markets. The companies intend to respond expeditiously to the Second Request and are working with the FTC to resolve its concerns. Consummation of the transaction is anticipated during the second quarter of 2007.

Our Industry

     According to the National Association of Psychiatric Health Systems’ 2005 Annual Survey, an estimated 26% of the U.S. general population suffers from a diagnosable mental disorder in a given year. Based on the 2000 U.S. census issued in 2002, this figure translates to approximately 73 million Americans.

1

     The behavioral health care industry is extremely fragmented with only a few large national providers. During the 1990s, the behavioral health care industry experienced a significant contraction following a long period of growth. The reduction was largely driven by third-party payors who decreased reimbursement, implemented more stringent admission criteria and decreased the authorized length of stay. We believe this reduced capacity has resulted in an underserved patient population.

     Reduced capacity, mental health parity legislation, and increased demand for behavioral health care services have resulted in favorable industry fundamentals over the last several years. Behavioral health care providers have enjoyed significant improvement in reimbursement rates, increased admissions and stabilized lengths of stay. According to the National Association of Psychiatric Health Systems, payments for the inpatient care of behavioral health and addictive disorders have increased nationwide. Inpatient admissions increased approximately 5% from 2003 to 2004, while the average occupancy rates increased to approximately 73% for 2004 from approximately 71% for 2003. Following a rapid decrease during the early 1990s, inpatient average length of stay stabilized between 9 and 11 days from 1997 to 2004. In 2004, the inpatient average length of stay was 9.6 days. The average inpatient net revenue per day increased from $537 in 2003 to $576 in 2004. The average RTC net revenue per day increased from $309 in 2003 to $328 in 2004 for freestanding RTC facilities. The average number of admissions for freestanding RTC facilities was 165 for 2004. The average occupancy rate for freestanding RTC facilities was 71% in 2004, with an average length of stay of 168 days in 2004.

Our Competitive Strengths

     We believe the following competitive strengths contribute to our strong market share in each of our markets and will enable us to continue to successfully grow our business and increase our profitability:

• Singular focus on inpatient behavioral health care — We focus exclusively on the provision of inpatient behavioral health care services. We believe this allows us to operate more efficiently and provide higher quality care than our competitors. In addition, we believe our focus and reputation have helped us to develop important relationships and extensive referral networks within our markets and to attract and retain qualified behavioral health care professionals.

• Strong and sustainable market position — Our inpatient facilities have an established presence in each of our markets, and many of our inpatient facilities have the leading market share in their respective service areas. We believe that the relationships and referral networks we have established will further enhance our presence within our markets. In addition, many of the states in which we operate require a certificate of need to open a behavioral health care facility, which may be difficult to obtain and may further preclude new market participants.

• Demonstrated ability to identify and integrate acquisitions — We attribute part of our success in integrating acquired inpatient facilities to our rigorous due diligence review of these facilities prior to completing the acquisitions as well as our ability to retain key employees at the acquired facilities. We employ a disciplined acquisition strategy that is based on defined criteria including quality of service, return on invested capital and strategic benefits. We also have a comprehensive post-acquisition strategic plan to facilitate the integration of acquired facilities that includes improving facility operations, retaining and recruiting psychiatrists and expanding the breadth of services offered by the facilities.

• Diversified payor mix and revenue base — As we have grown our business, we have focused on diversifying our sources of revenue. For the year ended December 31, 2006, we received 36% of our revenue from Medicaid, 13% from Medicare, 34% from HMO/PPO, commercial and private payors, 13% from various state agencies and 4% from other payors. As we receive Medicaid payments from more than 40 states, we do not believe that we are significantly affected by changes in reimbursement policies in any one state. Substantially all of our Medicaid payments relate to the care of children and adolescents. We believe that children and adolescents are a patient class that is less susceptible to reductions in reimbursement rates. For the year ended December 31, 2006, no single inpatient facility represented more than 4% of our revenue.

• Experienced management team — Our senior management team has extensive experience in the health care industry. Joey A. Jacobs, our Chairman, President and Chief Executive Officer, has over 30 years of experience in various capacities in the health care industry. Our senior management operates as a cohesive, complementary group and has extensive operating knowledge of our industry and understanding of the regulatory environment in which we operate. Our senior managers employ conservative fiscal policies and have a successful track record in both operating our core business and integrating acquired assets.

• Consistent free cash flow and minimal maintenance capital requirements — We generate consistent free cash flow by profitably operating our business, actively managing our working capital and having low maintenance capital expenditure requirements. As the behavioral health care business does not require the procurement and replacement of expensive medical equipment, our maintenance capital expenditure requirements are less than that of other facility-based health care providers. Historically, our maintenance capital expenditures have amounted to less than 2% of our revenue. In addition, our accounts receivable management is less complex than medical/surgical hospital providers because there are fewer billing codes for inpatient behavioral health care facilities.

2

Our Growth Strategy

     We have experienced significant growth in our operations as measured by the number of our facilities, admissions, patient days, revenue and net income. We intend to continue to successfully grow our business and increase our profitability by improving the performance of our inpatient facilities and through strategic acquisitions. The principal elements of our growth strategy are to:

• Continue to Drive Same-Facility Growth — We increased our same-facility revenue by approximately 9.0% for the year ended December 31, 2006, as compared to the year ended December 31, 2005. Same-facility revenue also increased by approximately 8%, 9%, and 9% for the years ended December 31, 2005, 2004, and 2003, respectively, as compared to the immediately preceding years. Same-facility revenue refers to the comparison of the inpatient facilities we owned during a prior period with the comparable period in the subsequent period. We intend to continue to increase our same-facility growth by increasing our admissions and patient days and obtaining annual reimbursement rate increases. We plan to accomplish these goals by:

• building and expanding relationships that enhance our presence in local and regional markets;

• developing formal marketing initiatives and expanding referral networks;

• continuing to provide high quality service;

• expanding our services and developing new services to take advantage of increased demand in select markets where we operate; and

• expanding bed capacity at our facilities to meet demand.

• Grow Through Strategic Acquisitions — Our industry is highly fragmented and we plan to selectively pursue the acquisition of additional inpatient behavioral health care facilities. There are approximately 500 freestanding acute and residential treatment facilities in the United States and the top two providers operate approximately 35% of these facilities. We believe there are a number of acquisition candidates available at attractive valuations, and we have a number of potential acquisitions that are in various stages of development and consideration. On December 20, 2006, we entered into a definitive merger agreement to acquire Horizon Health, which, among other things, owns or leases 15 inpatient facilities. We believe our focus on inpatient behavioral health care provides us with a strategic advantage when assessing a potential acquisition. We employ a disciplined acquisition strategy that is based on defined criteria, including quality of service, return on invested capital and strategic benefits.

• Enhance Operating Efficiencies — Our management team has extensive experience in the operation of multi-facility health care services companies. We intend to focus on improving our profitability by optimizing staffing ratios, controlling contract labor costs and reducing supply costs through group purchasing. We believe that our focus on efficient operations increases our profitability and will attract qualified behavioral health care professionals and patients.

Services

Inpatient Behavioral Health Care Facilities

     We operate 67 owned and 8 leased inpatient behavioral health care facilities. These facilities offer a wide range of inpatient behavioral health care services for children, adolescents and adults. Our inpatient facilities work closely with mental health professionals, including licensed professional counselors, therapists and social workers; psychiatrists; non-psychiatric physicians; emergency rooms; school systems; insurance and managed care organizations; company-sponsored employee assistance programs; and law enforcement and community agencies that interact with individuals who may need treatment for mental illness or substance abuse. Many of our inpatient facilities have mobile assessment teams who travel to prospective clients in order to assess their condition and determine if they meet established criteria for inpatient care. Those clients not meeting the established criteria for inpatient care may qualify for outpatient care or a less intensive level of care also provided by the facility. During the year ended December 31, 2006, our inpatient behavioral health care facilities division produced approximately 94.8% of our revenue.

     Through the diversity of programming and levels of care available, the patient can receive a seamless treatment experience from acute care to residential long-term care to group home living to outpatient treatment. This seamless care system provides the continuity of care needed to step the patient down and allow the patient to develop and use successful coping skills and treatment interventions to sustain long-term treatment success. Treatment modalities include comprehensive assessment, multi-disciplinary treatment planning including the patient and family, group, individual and family therapy services, medical and dental services, educational services, recreational services and discharge planning services. Specialized interventions such as skills training include basic daily living skills, social skills, work/school adaptation skills and symptom management skills. Collateral consultations are provided to significant others such as family members, teachers, employers and other professionals when needed to help the patient successfully reintegrate back into his/her world. Services offered and disorders treated at our inpatient facilities include:

3

•     bipolar disorder	•     rehabilitation care
•     major depression	•     day treatment
•     schizophrenia	•     detoxification
•     attention deficit/hyperactivity disorder	•     developmentally delayed disorders
•     impulse disorder	•     therapeutic foster care
•     oppositional and conduct disorders	•     neurological disorders
•     partial hospitalization	•     rapid adoption services
•     intensive outpatient	•     day treatment
•     acute eating disorders	•     independent living skills
•     reactive attachment disorder	•     vocational training
•     dual diagnosis	•     chemical dependency

     Acute inpatient hospitalization is the most intensive level of care offered and typically involves 24-hour skilled nursing observation and care, daily interventions and oversight by a psychiatrist, and intensive, highly coordinated treatment by a physician-led team of mental health professionals. Every patient admitted to our acute inpatient facilities is assessed by a medical doctor within 24 hours of admission. Patients with non-complex medical conditions are monitored during their stay by the physician and nursing staff at the inpatient facility. Patients with more complex medical needs are referred to more appropriate facilities for diagnosis and stabilization prior to treatment. Patients admitted to our acute inpatient facilities also receive comprehensive nursing and psychological assessments within 24 to 72 hours of admission. Oversight and management of patients’ medication is performed by licensed psychiatrists on staff at the facility, and individual, family, and group therapy is performed by licensed counselors as appropriate to the patients’ assessed needs. Education regarding patients’ illnesses is also provided by trained mental health professionals.

     Our RTCs provide longer term treatment programs for children and adolescents with long-standing behavioral/mental health problems. Twenty-four hour observation and care is provided in our RTCs, along with individualized therapy that usually consists of one-on-one sessions with a licensed counselor, as well as process and rehabilitation group therapy. Another key component of the treatment of children and adolescents in our inpatient facilities is family therapy. Participation of the child’s or adolescent’s immediate family is strongly encouraged in order to heighten the chance of success once the resident is discharged. Medications for residents are managed by licensed psychiatrists while they remain at the inpatient facility. Our RTCs also provide academic programs conducted by certified teachers to child and adolescent residents. These programs are individualized for each resident based on analysis by the teacher upon admission. Upon discharge, academic reports are forwarded to the resident’s school. Specialized programs for children and adolescents in our RTCs include programs for sexually reactive children, sex offenders, reactive attachment disorders, and children and adolescents who are developmentally delayed with a behavioral component. Our RTCs often receive out-of-state referrals to their programs due to the lack of specialized programs for these disorders within the patient’s own state.

     Our inpatient facilities’ programs have been adapted to the requests of various sources to provide services to patients with multiple issues and specialized needs. Our success rate with these difficult to treat cases has expanded our network of referrals. The services provided at each inpatient facility are continually assessed and monitored through an ongoing quality improvement program. The purpose of this program is to strive for the highest quality of care possible for individuals with behavioral health issues, and includes regular site visits to each inpatient facility in order to assess compliance with legal and regulatory standards, as well as adherence to our compliance program. Standardized performance measures based on a national outcomes measurement data base comparing our inpatient facilities’ performance with national norms are also reported and reviewed and corrective steps are taken when necessary.

Inpatient Management Contracts

     Through inpatient management contracts we develop, organize and manage behavioral health care programs within general third-party medical/surgical hospitals and manage inpatient behavioral health care facilities for government agencies. For the year ended December 31, 2006, our inpatient management contracts produced approximately 5.2% of our revenue.

     Our broad range of services can be customized into individual programs that meet specific inpatient facility and community requirements. Our inpatient management contract division is dedicated to providing high quality programs with integrity, innovation and sufficient flexibility to develop customized individual programs. We provide our customers with a variety of management options, including clinical and management infrastructure, personnel recruitment, staff orientation and supervision, corporate consultation and performance improvement plans. Under the management contracts, the hospital is the actual provider of the mental health services and utilizes its own facilities, support services, and generally its own nursing staff in connection with the operation of its programs. Our management contracts generally have an initial term of two to five years and are extended for successive one-year periods unless terminated by either party.

Seasonality of Services

     Our inpatient behavioral health care facilities typically experience lower patient volumes and revenue during the summer months, the year-end holidays and other periods when school is out of session.

4

Marketing

     Our local and regional marketing is led by clinical and business development representatives at each of our inpatient facilities. These individuals manage relationships among a variety of referral sources in their respective communities. Our national marketing efforts are focused on increasing the census at our RTCs from various state referral sources by developing relationships and identifying contracting opportunities in their respective territories.

Competition

     The inpatient behavioral health care facility industry and the inpatient behavioral health care unit management industry are highly fragmented. The industry is subject to continual changes in the method in which services are provided and the types of companies providing such services. We primarily compete with regional and local competitors. Some of our competitors are owned by governmental agencies and supported by tax revenue and others are owned by nonprofit corporations and may be supported to a large extent by endowments and charitable contributions.

     In addition, we compete for patients with other providers of mental health care services, including other inpatient behavioral health care facilities, medical/surgical hospitals, independent psychiatrists and psychologists. We also compete with hospitals, nursing homes, clinics, physicians’ offices and contract nursing companies for the services of registered nurses. We attempt to differentiate ourselves from our competition through our singular focus on the provision of behavioral health care services, our reputation for the quality of our services, recruitment of first rate medical staff and accessibility to our facilities. In addition, we believe that the active development of our referral network and participation in selected managed care provider panels enable us to successfully compete for patients in need of our services.

Reimbursement

     Our inpatient owned and leased facilities receive payment for services from the federal government primarily under the Medicare program, state governments under their respective Medicaid programs, private insurers, including managed care plans, and directly from patients. Most of our inpatient behavioral health facilities are certified as providers of Medicare and Medicaid services by the appropriate governmental authorities. The requirements for certification are subject to change, and, in order to remain qualified for such programs, it may be necessary for us to make changes from time to time in our inpatient facilities, equipment, personnel and services. If an inpatient facility loses its certification, it will be unable to receive payment for patients under the Medicare or Medicaid programs. Although we intend to continue participating in such programs, there can be no assurance that we will continue to qualify for participation.

     Patient service revenue is recorded net of contractual adjustments at the time of billing by our patient accounting systems at the amount we expect to collect. This amount is calculated automatically by our patient accounting systems based on contractually determined rates, or amounts reimbursable by Medicare or Medicaid under provisions of cost or prospective reimbursement formulas, or a combination thereof. Most payments are determined based on negotiated per-diem rates. An estimate of contractual allowances is manually recorded for unbilled services based upon these contractually negotiated rates.

     Any co-payments and deductibles due from patients are estimated at the time of admission based on the patient’s insurance plan, and payment of these amounts is requested prior to discharge. If the payment is not received prior to discharge or completion of service, collection efforts are made through our normal billing and collection process.

     Our consolidated day’s sales outstanding were 53 and 55 for the years ended December 31, 2006 and 2005, respectively.

Medicare

     Medicare provides insurance benefits to persons age 65 and over and some disabled persons. Current freestanding psychiatric hospitals and certified psychiatric units of acute care hospitals are transitioning to reimbursement based on an inpatient services prospective payment system (“PPS”) from reimbursement based on a reasonable cost basis.

     The Centers for Medicare and Medicaid Services (“CMS”) began implementing a three-year transition period to PPS, starting with the cost reporting periods beginning on or after January 1, 2005. The payment for the first year of the transition period (cost reporting periods beginning on or after January 1, 2005) consisted of 75% based on the cost-based reimbursement system and 25% at the prospective payment rate. In the second year, the split was 50% each and in the third year the split will be 25% based on the cost-based system and 75% PPS. The prospective payment rate percentage will be 100% for cost reporting periods beginning on or after January 1, 2008. Inpatient psychiatric facilities received a 4.3% increase in the Medicare prospective base rate beginning July 1, 2006. Annual updates are anticipated thereafter.

     Under CMS regulations, the PPS base per diem is adjusted for specific patient and facility characteristics that increase the cost of patient care. Payment rates for individual inpatient facilities are adjusted to reflect geographic differences in wages, and rural providers receive an increased payment adjustment, as do teaching facilities. Additionally, the base rate is adjusted by factors that influence the cost of an individual patient’s care, such as each patient’s diagnosis related group, certain other medical and psychiatric

5

comorbidities (i.e., other coexisting conditions that may complicate treatment) and age. Because the cost of inpatient behavioral care tends to be greatest at admission and a few days thereafter, the per diem rate is adjusted for each day up to and including the eighth day to reflect the number of days the patient has been in the facility. Medicare pays this per diem amount, as adjusted, regardless of whether it is more or less than a hospital’s actual costs. Please see www.cms.hhs.gov/providers/ipfpps for additional information.

     Medicare generally deducts from the amount of its payments to hospitals an amount for patient “deductible or coinsurance,” or the amount that the patient is expected to pay. These deductible or coinsurance amounts that are not paid by the patient result in “bad debts.” Medicare will reimburse 70% of these bad debts to the extent that neither a Medicare patient, a guarantor or any secondary payor for that patient pays the Medicare coinsurance amount, provided that a reasonable collection effort or the patient’s indigence is documented.

Medicaid

     Medicaid, a joint federal-state program that is administered by the respective states, provides hospital benefits to qualifying individuals who are unable to afford care. All Medicaid funding is generally conditioned upon financial appropriations to state Medicaid agencies by the state legislatures. As many states face pressures to control their budgets, political pressures have led some state legislatures to reduce such appropriations.

     Some states may adopt substantial health care reform measures that could modify the manner in which all health services are delivered and reimbursed, especially with respect to Medicaid recipients and other individuals funded by public resources. As we receive Medicaid payments from more than 40 states, we are not significantly affected by changes in reimbursement policies by any one state. Most states have applied for and been granted federal waivers from current Medicaid regulations in order to allow them to serve some or all of their Medicaid participants through managed care providers. The majority of our Medicaid payments relate to the care of children and adolescents. We believe that children and adolescents are a patient class that is less susceptible to reductions in reimbursement rates.

Managed Care and Commercial Insurance Carriers

     Our inpatient facilities are also reimbursed for certain behavioral health care services by private payors including health maintenance organizations (“HMOs”), preferred provider organizations (“PPOs”), commercial insurance companies, employers and individual private payors. To attract additional volume, our inpatient facilities offer discounts from established charges to certain large group purchasers of health care services. Generally, patients covered by HMOs, PPOs and other private insurers will be responsible for certain co-payments and deductibles, which are paid by the patient.

     The Mental Health Parity Act of 1996 (“MHPA”) is a federal law that requires annual or lifetime limits for mental health benefits be no lower than the dollar limits for medical/surgical benefits offered by a group health plan. MHPA applies to group health plans or health insurance coverage offered in connection with a group health plan that offers both mental health and medical/surgical benefits. However it does not require plans to offer mental health benefits. MHPA was scheduled to “sunset” on December 31, 2003; however, MHPA has been extended several times on a year to year basis, most recently on December 31, 2006 when MHPA was extended through the end of 2007. Bills have also been introduced in Congress from time to time that could potentially apply this concept on a more far-reaching scale, most recently in the form of the Mental Health Parity Act of 2007 (S. 558), but we cannot predict whether any such legislation will be implemented in the future. Approximately 45 states have also enacted some form of mental health parity laws. Some of these laws apply only to select groups such as those with severe mental illness or a specific diagnosis.

Annual Cost Reports

     All facilities participating in the Medicare program and some Medicaid programs, whether paid on a reasonable cost basis or under a PPS, are required to meet certain financial reporting requirements. Federal regulations require submission of annual cost reports identifying costs and expenses associated with the services provided by each facility to Medicare beneficiaries and Medicaid recipients. Annual cost reports required under Medicare and some Medicaid programs are subject to routine governmental audits, which may result in adjustments to the amounts ultimately determined to be due to us under those reimbursement programs. These audits often require several years to reach the final determination of amounts earned under the programs. Nonetheless, once the Medicare fiscal intermediaries have issued a final Notice of Program Reimbursement (“NPR”) after an audit, any disallowances of claimed costs are due and payable within 30 days of receipt of the NPR. Providers have rights to appeal, and it is common to contest issues raised in audits of prior years’ cost reports.

Regulation and Other Factors

Licensure, Certification and Accreditation

     Health care facilities are required to comply with extensive regulation at the federal, state and local levels. Under these laws and regulations, health care facilities must meet requirements for state licensure as well as additional qualifications to participate in government programs, including the Medicare and Medicaid programs. These requirements relate to the adequacy of medical care, equipment, personnel, operating policies and procedures, fire prevention, maintenance of adequate records, hospital use, rate-setting,

6

and compliance with building codes and environmental protection laws. Facilities are subject to periodic inspection by governmental and other authorities to assure continued compliance with the various standards necessary for licensing and accreditation.

     All of the inpatient facilities owned and operated by us are properly licensed under applicable state laws. Most of the inpatient facilities owned and operated by us are certified under Medicare and/or Medicaid programs and accredited by the Joint Commission on Accreditation of Healthcare Organizations (“JCAHO”), a functional prerequisite to participation in the Medicare and Medicaid programs. Should any of our inpatient facilities lose its accreditation by JCAHO, or otherwise lose its certification under the Medicare and/or Medicaid program, that inpatient facility would be unable to receive reimbursement from the Medicare and/or Medicaid programs. If a provider contracting with us was excluded from any federal health care program, no services furnished by that provider would be reimbursed by any federal health care program. If we were excluded from a federal health care program, our owned and leased inpatient facilities would not be eligible for reimbursement by any federal health care program. In addition, providers would as a practical matter cease contracting for our inpatient behavioral health care unit management services because they could not be reimbursed for any management fee amounts they paid to us.

     We believe that the inpatient facilities we own and operate generally are in substantial compliance with current applicable federal, state, local and independent review body regulations and standards. The requirements for licensure, certification and accreditation are subject to change and, in order to remain qualified, it may be necessary for us to effect changes in our inpatient facilities, equipment, personnel and services. Additionally, certain of the personnel working at inpatient facilities owned and operated by us are subject to state laws and regulations governing their particular area of professional practice. We assist our client hospitals in obtaining required approvals for new programs.

Fraud and Abuse Laws

     Participation in the Medicare and/or Medicaid programs is heavily regulated by federal law and regulation. If a hospital fails to substantially comply with the numerous federal laws governing that facility’s activities, the facility’s participation in the Medicare and/or Medicaid programs may be terminated and/or civil or criminal penalties may be imposed. For example, a behavioral health care facility may lose its ability to participate in the Medicare and/or Medicaid program if it pays money to induce the referral of patients or purchase of items or services where such items or services are reimbursable under a federal or state health care program.

     The portion of the Social Security Act commonly known as the “Anti-Kickback Statute” prohibits the payment, receipt, offer or solicitation of anything of value with the intent of generating referrals or orders for services or items covered by a federal or state health care program. Violations of the Anti-Kickback Statute may be punished by criminal or civil penalties, exclusion from federal and state health care programs, imprisonment and damages up to three times the total dollar amount involved. While evidence of intent is a pre-requisite to any finding that the Anti-Kickback Statute has been violated, the statute has been interpreted broadly by federal regulators and courts to prohibit the payment of anything of value if even one purpose of the payment is to influence the referral of Medicare or Medicaid business. Therefore, many commonplace commercial arrangements between hospitals and physicians could be considered by the government to violate the Anti-Kickback Statute.

     The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) broadened the scope of the fraud and abuse laws by adding several criminal statutes that are not related to receipt of payments from a federal health care program. HIPAA created civil penalties for proscribed conduct, including upcoding and billing for medically unnecessary goods or services. HIPAA established new enforcement mechanisms to combat fraud and abuse. These new mechanisms include a bounty system, where a portion of any payments recovered is returned to the government agencies, as well as a whistleblower program. HIPAA also expanded the categories of persons that may be excluded from participation in federal and state health care programs.

     The Office of Inspector General (the “OIG”) of the Department of Health and Human Services (“HHS”) is responsible for identifying fraud and abuse activities in government programs. In order to fulfill its duties, the OIG performs audits, investigations and inspections. In addition, it provides guidance to health care providers by identifying types of activities that could violate the Anti-Kickback Statute. We have a variety of financial relationships with physicians who refer patients to our owned and leased facilities, as well as to behavioral health programs and facilities we manage, including employment contracts, independent contractor agreements, professional service agreements and medical director agreements.

     The OIG is authorized to publish regulations outlining activities and business relationships that would be deemed not to violate the Anti-Kickback Statute. These regulations are known as “safe harbor” provisions. The safe harbor provisions delineate standards that, if complied with, protect conduct that might otherwise be deemed to violate the Anti-Kickback Statute. While compliance with the safe harbor provisions effectively insulates a practice from being found to be in violation of the Anti-Kickback Statute, the failure of a particular activity to comply with the safe harbor provisions does not mean that the activity violates the Anti-Kickback Statute. Rather, failure to comply with the safe harbor provisions simply denies us the opportunity to avail ourselves of the affirmative defense of compliance. We use our best efforts to structure each of our arrangements, especially each of our business relationships with physicians, to fit as closely as possible within the applicable safe harbors. However, not all of our business arrangements fit wholly within safe harbors so we cannot guarantee that these arrangements will not be scrutinized by government authorities or, if scrutinized, that they will be determined to be in compliance with the Anti-Kickback Statute or other applicable laws. If we violate the Anti- Kickback Statute, we would be subject to criminal and civil penalties and/or possible exclusion from participating in Medicare, Medicaid or other governmental health care programs.

7

     The OIG also issues advisory opinions to outside parties regarding the interpretation and applicability of the Anti-Kickback Statute and other OIG health care fraud and abuse sanctions. An OIG advisory opinion only applies to the party requesting the opinion. We provide services to medical/surgical facilities through behavioral health care management contracts and are compensated, in part, on a per discharge basis. We have not requested an advisory opinion from the OIG with respect to our inpatient management contracts. Because our per discharge payment structure is not intended to induce referrals, we believe that we are in compliance with the Anti-Kickback Statute, despite the fact that our inpatient management contracts do not qualify for the safe harbor for personal services and management contracts because the aggregate compensation paid by our client hospitals is not set in advance. However, there can be no assurances that our contracts will not be reviewed and challenged by the OIG or other regulatory authorities empowered to do so.

     The Social Security Act also includes a provision commonly known as the “Stark Law.” This law prohibits physicians from referring Medicare and Medicaid patients for the furnishing of any “designated health services” to health care entities in which they or any of their immediate family members have an ownership or other financial interest. These types of referrals are commonly known as “self referrals.” Sanctions for violating the Stark Law include civil monetary penalties, assessments equal to twice the dollar value of each service rendered for an impermissible referral and exclusion from the Medicare and Medicaid programs. There are ownership and compensation arrangement exceptions for many customary financial arrangements between physicians and facilities, including employment contracts, personal services agreements, leases and recruitment agreements. We have structured our financial arrangements with physicians to comply with the statutory exceptions included in the Stark Law and subsequent regulations. However, future Stark Law regulations may interpret provisions of this law in a manner different from the manner in which we have interpreted them. We cannot predict the effect such future regulations will have on us.

     Many states in which we operate also have adopted, or are considering adopting, laws similar to the Anti-Kickback Statute and/or the Stark Law. Some of these state laws, commonly known as “all payor” laws, apply even if the government is not the payor. These statutes typically provide criminal and civil penalties as remedies. While there is little precedent for the interpretation or enforcement of these state laws, we have attempted to structure our financial relationships with physicians and others in accordance with these laws. However, if a state determines that we have violated such a law, we may be subject to criminal and civil penalties.

Emergency Medical Treatment and Active Labor Act

     The Emergency Medical Treatment and Active Labor Act (“EMTALA”) is a federal law that requires any health care facility with a dedicated emergency department that participates in the Medicare program to conduct an appropriate medical screening examination, within the capabilities of the facility, of every person who presents to the hospital’s emergency department for treatment and, if the patient is suffering from an emergency medical condition, to either stabilize that condition or make an appropriate transfer of the patient to a facility that can handle the condition. The obligation to screen and stabilize emergency medical conditions exists regardless of a patient’s ability to pay for treatment. There are severe penalties under EMTALA if a hospital fails to screen or appropriately stabilize or transfer a patient or if the hospital delays appropriate treatment in order to first inquire about the patient’s ability to pay. Penalties for violations of EMTALA include civil monetary penalties and exclusion from participation in the Medicare program. In addition, an injured patient, the patient’s family or a medical facility that suffers a financial loss as a direct result of another hospital’s violation of the law can bring a civil suit against the hospital.

     The regulations adopted to implement EMTALA do not provide an abundance of specific guidance and effectively limit the types of emergency services that a hospital subject to EMTALA is required to provide to those services that are within the capability of the hospital. Although we believe that our inpatient behavioral health care facilities comply with the EMTALA regulations, we cannot predict whether CMS will implement additional requirements in the future or the cost of compliance with any such regulations.

The Federal False Claims Act

     The federal False Claims Act prohibits providers from knowingly submitting false claims for payment to the federal government. This law has been used not only by the federal government, but also by individuals who bring an action on behalf of the government under the law’s “qui tam” or “whistleblower” provisions. When a private party brings a qui tam action under the federal False Claims Act, the defendant will generally not be aware of the lawsuit until the government determines whether it will intervene in the litigation.

     Civil liability under the federal False Claims Act can be up to three times the actual damages sustained by the government plus civil penalties for each separate false claim. There are many potential bases for liability under the federal False Claims Act, including claims submitted pursuant to a referral found to violate the Anti-Kickback Statute. Although liability under the federal False Claims Act arises when an entity knowingly submits a false claim for reimbursement to the federal government, the federal False Claims Act defines the term “knowingly” broadly. Although simple negligence will not give rise to liability under the federal False Claims Act, submitting a claim with reckless disregard to its truth or falsity can constitute the knowing submission of a false claim. From time to time, companies in the health care industry, including us, may be subject to actions under the federal False Claims Act.

8

HIPAA Transaction, Privacy and Security Requirements

     There are currently numerous laws at the state and federal levels addressing patient privacy concerns. Federal regulations issued pursuant to HIPAA contain, among other measures, provisions that require many organizations, our inpatient facilities, to implement very significant and potentially expensive new computer systems, employee training programs and business procedures.

     In response to HIPAA, HHS issued regulations requiring health care facilities to use standard data formats and code sets when electronically transmitting information in connection with various transactions, including health claims and equivalent encounter information, health care payment and remittance advice and health claim status. We have implemented or upgraded computer systems, as appropriate, at our facilities and at our corporate headquarters to comply with the HIPAA regulations.

     HIPAA requires HHS to issue regulations establishing standard unique health identifiers for individuals, employers, health plans and health care providers to be used in connection with standard electronic transactions. All health care providers, including our facilities, will be required to obtain a National Provider Identifier (“NPI”) to be used in standard transactions instead of other numerical identifiers beginning no later than May 23, 2007. Health care providers were able to begin applying for NPIs on May 23, 2005. While we began obtaining NPIs for our facilities well in advance of the deadline, we cannot predict whether our facilities will experience payment delays during the transition to the new identifiers. HHS has not yet issued proposed rules that establish the standard for unique health identifiers for health plans or individuals. Once these regulations are issued in final form, we expect to have approximately two years to become fully compliant, but cannot predict the impact of such changes at this time.

     On February 20, 2003, HHS finalized a rule that establishes, in part, standards to protect the confidentiality, availability and integrity of health information by health plans, health care clearinghouses and health care providers that receive, store, maintain or transmit health and related financial information in electronic form, regardless of format. These security standards require our facilities to establish and maintain reasonable and appropriate administrative, technical and physical safeguards to ensure the integrity, confidentiality and the availability of electronic health and related financial information. The security standards were designed to protect electronic information against reasonably anticipated threats or hazards to the security or integrity of the information and to protect the information against unauthorized use or disclosure. We believe that our facilities are in compliance with these security standards.

     On December 28, 2000 (with revisions August 14, 2002), HHS published a final rule establishing standards for the privacy of individually identifiable health information, with compliance required by April 14, 2003. These privacy standards apply to all health plans, all health care clearinghouses and health care providers that transmit health information in an electronic form in connection with the standard transactions, including our facilities. The privacy standards apply to individually identifiable information held or disclosed by a covered entity in any form, whether communicated electronically, on paper or orally. These standards impose extensive new administrative requirements on our facilities. They require our compliance with rules governing the use and disclosure of health information. They create new rights for patients in their health information, such as the right to amend their health information, and they require our facilities to impose these rules, by contract, on any business associate to whom they disclose such information in order to perform functions on their behalf. In addition, our facilities will continue to remain subject to any state laws that are more restrictive than the privacy regulations issued under HIPAA. These state laws vary by state and could impose additional penalties.

     A violation of these regulations could result in civil money penalties of $100 per incident, up to a maximum of $25,000 per person per year per standard. HIPAA also provides for criminal penalties of up to $50,000 and one year in prison for knowingly and improperly obtaining or disclosing protected health information, up to $100,000 and five years in prison for obtaining protected health information under false pretenses, and up to $250,000 and ten years in prison for obtaining or disclosing protected health information with the intent to sell, transfer or use such information for commercial advantage, personal gain or malicious harm. Since there is no significant history of enforcement efforts by the federal government at this time, it is not possible to ascertain the likelihood of enforcement efforts in connection with HIPAA regulations or the potential for fines and penalties that may result from the violation of the regulations.

     Compliance with these regulations has and will continue to require significant commitment and action by us and our facilities. We have appointed members of our management team to direct our compliance with these standards. Implementation of these regulations has and will continue to require our facilities and us to engage in extensive preparation and make significant expenditures. At this time we have appointed a privacy officer at each inpatient facility, prepared privacy policies, trained our workforce on these policies and entered into business associate agreements with the appropriate vendors. Because some of the regulations are proposed regulations, we cannot predict the total financial impact of the regulations on our operations.

Certificates of Need (“CON”)

     The construction of new health care facilities, the acquisition or expansion of existing facilities, the transfer or change of ownership and the addition of new beds, services or equipment may be subject to laws in certain states that require prior approval by state regulatory agencies. These CON laws generally require that a state agency determine the public need for construction or acquisition of facilities or the addition of new services. Failure to obtain necessary state approval can result in the inability to expand facilities, add services, complete an acquisition or change ownership. Violations of these state laws may result in the imposition of civil sanctions or revocation of a facility’s license.

9

Corporate Practice of Medicine and Fee Splitting

     Some states have laws that prohibit unlicensed persons or business entities, including corporations or business organizations that own hospitals, from employing physicians. Some states also have adopted laws that prohibit direct and indirect payments or fee-splitting arrangements between physicians and unlicensed persons or business entities. Possible sanctions for violation of these restrictions include loss of a physician’s license, civil and criminal penalties and rescission of business arrangements. These laws vary from state to state, are often vague and have seldom been interpreted by the courts or regulatory agencies. Although we attempt to structure our arrangements with health care providers to comply with the relevant state laws and the few available regulatory interpretations, there can be no assurance that government officials charged with responsibility for enforcing these laws will not assert that we, or certain transactions in which we are involved, are in violation of such laws, or that such laws ultimately will be interpreted by the courts in a manner consistent with our interpretation.

Health Care Industry Investigations

     Significant media and public attention has focused in recent years on the hospital industry. Because the law in this area is complex and constantly evolving, ongoing or future governmental investigations or litigation may result in interpretations that are inconsistent with industry practices, including our practices. It is possible that governmental entities could initiate investigations of, or litigation against, inpatient facilities owned, leased, or managed by us in the future and that such matters could result in significant penalties as well as adverse publicity.

Risk Management

     As is typical in the health care industry, we are subject to claims and legal actions by patients in the ordinary course of business. To cover these claims, we maintain professional malpractice liability insurance and general liability insurance in amounts we believe to be sufficient for our operations, although it is possible that some claims may exceed the scope of the coverage in effect. At various times in the past, the cost of malpractice insurance and other liability insurance has fluctuated significantly. Therefore, there can be no assurance that such insurance will continue to be available at reasonable prices which would allow us to maintain adequate levels of coverage.

Conversion Legislation

     Many states have adopted legislation regarding the sale or other disposition of hospitals operated by not-for-profit entities. In other states that do not have such legislation, the attorneys general have demonstrated an interest in these transactions under their general obligations to protect charitable assets. These legislative and administrative efforts primarily focus on the appropriate valuation of the assets divested and the use of the proceeds of the sale by the not-for-profit seller. These reviews and, in some instances, approval processes can add additional time to the closing of a not-for-profit hospital acquisition. Future actions by state legislators or attorneys general may seriously delay or even prevent our ability to acquire certain hospitals.

Regulatory Compliance Program

     We are committed to ethical business practices and to operating in accordance with all applicable laws and regulations. Our compliance program was established to ensure that all employees have a solid framework for business, legal, ethical, and employment practices. Our compliance program establishes mechanisms to aid in the identification and correction of any actual or perceived violations of any of our policies or procedures or any other applicable rules and regulations. We have appointed a Chief Compliance Officer as well as compliance coordinators at each inpatient facility. The Chief Compliance Officer heads our Compliance Committee, which consists of senior management personnel and two members of our board of directors. Employee training is a key component of the compliance program. All employees receive training during orientation and annually thereafter.

Insurance

     We are subject to medical malpractice and other lawsuits due to the nature of the services we provide. At December 31, 2006, all of our operations have professional and general liability insurance in umbrella form for claims in excess of a $3.0 million self-insured retention with an insured excess limit of $50.0 million. The self-insured reserves for professional and general liability risks are calculated based on historical claims, demographic factors, industry trends, severity factors, and other actuarial assumptions calculated by an independent third-party actuary. This self-insurance reserve is discounted to its present value using a 5% discount rate. This estimated accrual for professional and general liabilities could be significantly affected should current and future occurrences differ from historical claim trends and expectations. We have utilized our captive insurance company to manage the self-insured retention. While claims are monitored closely when estimating professional and general liability accruals, the complexity of the claims and wide range of potential outcomes often hampers timely adjustments to the assumptions used in these estimates.

10

Employees

     As of December 31, 2006, we employed approximately 18,700 employees, of whom approximately 12,600 are full-time employees. Approximately 17,800 employees staff our owned and leased inpatient behavioral health care facilities, approximately 750 employees staff our inpatient management contract division and approximately 150 are in corporate management including finance, accounting, legal, development, utilization review, compliance, training and education, information systems, member services, and human resources. Of these employees, approximately 300 are union members. We believe that our employee relations are good.

Available Information

     We make available free of charge through our website, which you can find at www.psysolutions.com, our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to these reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission.

Segments

     See Note 14 to the Company’s Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K for financial information about each segment of the Company, as defined by U.S. generally accepted accounting principles.

Item 1A. Risk Factors

If we fail to comply with extensive laws and government regulations, we could suffer penalties, lose our licenses or be excluded from health care programs.

     The health care industry is required to comply with extensive and complex laws and regulations at the federal, state and local government levels relating to, among other things:

• billing for services;

• relationships with physicians and other referral sources;

• adequacy of medical care;

• quality of medical equipment and services;

• qualifications of medical and support personnel;

• confidentiality, maintenance and security issues associated with health-related information and medical records;

• licensure;

• hospital rate or budget review;

• operating policies and procedures; and

• addition of facilities and services.

     Among these laws are the Anti-Kickback Statute and the Stark Law. These laws impact the relationships that we may have with physicians and other referral sources. The OIG has enacted safe harbor regulations that outline practices that are deemed protected from prosecution under the Anti-Kickback Statute. Our current financial relationships with physicians and other referral sources may not qualify for safe harbor protection under the Anti-Kickback Statute. Failure to meet a safe harbor does not mean that the arrangement automatically violates the Anti-Kickback Statute, but may subject the arrangement to greater scrutiny. Further, we cannot guarantee that practices that are outside of a safe harbor will not be found to violate the Anti-Kickback Statute.

     If we fail to comply with the Anti-Kickback Statute, the Stark Law or other applicable laws and regulations, we could be subjected to criminal penalties, civil penalties (including the loss of our licenses to operate one or more inpatient facilities), and exclusion of one or more of our inpatient facilities from participation in the Medicare, Medicaid and other federal and state health care programs. In addition, if we do not operate our inpatient facilities in accordance with applicable law, our inpatient facilities may lose their licenses or the ability to participate in third party reimbursement programs.

     Because many of these laws and regulations are relatively new, we do not always have the benefit of significant regulatory or judicial interpretation of these laws and regulations. In the future, different interpretations or enforcement of these laws and regulations could subject our current or past practices to allegations of impropriety or illegality or could require us to make changes in our inpatient facilities, equipment, personnel, services, capital expenditure programs and operating expenses. A determination that we

11

have violated these laws, or the public announcement that we are being investigated for possible violations of these laws, could have a material adverse effect on our business, financial condition, results of operations or prospects and our business reputation could suffer significantly. In addition, we are unable to predict whether other legislation or regulations at the federal or state level will be adopted or the effect such legislation or regulations will have on us.

If federal or state health care programs or managed care companies reduce reimbursement rates for services provided, revenues may decline.

     A large portion of our revenue comes from the Medicare and Medicaid programs. In recent years, federal and state governments have made significant changes in these programs. On November 3, 2004, CMS announced final regulations adopting PPS for services provided by inpatient behavioral health care facilities. Inpatient behavioral health care facilities historically have been reimbursed based on reasonable cost, subject to a discharge ceiling. For cost reporting periods after January 1, 2005, CMS began to phase in PPS over a three-year period, which will pay inpatient behavioral health care facilities a per diem base rate. During the three-year phase-in period, CMS has agreed to a stop loss provision that will guarantee that a provider will receive at least 70% of the amount it would have been paid under the cost-based reimbursement system.

     The per diem base rate will be adjusted by factors that influence the cost of an individual patient’s care, such as each patient’s diagnosis related group, certain other medical and psychiatric comorbidities (i.e., other coexisting conditions that may complicate treatment) and age. The per diem amounts are calculated in part based on national averages, but will be adjusted for specific facility characteristics that increase the cost of patient care. The base rate per diem is intended to compensate a facility for costs incurred to treat a patient with a particular diagnosis, including nearly all labor and non-labor costs of furnishing covered inpatient behavioral health care services as well as routine, ancillary and capital costs. Payment rates for individual inpatient facilities will be adjusted to reflect geographic differences in wages and will allow additional outlier payments for expenses associated with extraordinary cases. Additionally, rural providers will receive an increased payment adjustment. Medicare will pay this per diem amount, as adjusted, regardless of whether it is more or less than a facility’s actual costs. The per diem will not, however, include the costs of bad debt and certain other costs that are paid separately. Future federal and state legislation may reduce the payments we receive for our services.

     Substantially all of the patients admitted to the programs for which we provide unit management services are eligible for Medicare coverage. As a result, the providers rely upon payment from Medicare for the services. Many of the patients are also eligible for Medicaid payments. To the extent that a hospital deems revenue for a program we manage to be inadequate, it may seek to terminate its contract with us or not renew the contract. Similarly, we may not add new unit management contracts if prospective customers do not believe that such programs will generate sufficient revenue.

     Under Medicare and certain Medicaid programs, hospital companies currently are required to file, on a timely basis, cost reports. Such cost reports are subject to amending, reopening and appeal rights, which could materially affect historical costs recognized and reimbursement received from such payors.

     Insurance and managed care companies and other third parties from whom we receive payment are increasingly attempting to control health care costs by requiring that facilities discount their fees in exchange for exclusive or preferred participation in their benefit plans. This trend may continue and may reduce the payments received by us for our services.

Other companies within the health care industry continue to be the subject of federal and state investigations, which increases the risk that we may become subject to investigations in the future.

     Both federal and state government agencies as well as private payors have heightened and coordinated civil and criminal enforcement efforts as part of numerous ongoing investigations of health care organizations. These investigations relate to a wide variety of topics, including:

• cost reporting and billing practices;

• quality of care;

• financial relationships with referral sources;

• medical necessity of services provided; and

• treatment of indigent patients, including emergency medical screening and treatment requirements.

     The OIG and the U.S. Department of Justice have, from time to time, undertaken national enforcement initiatives that focus on specific billing practices or other suspected areas of abuse. Moreover, health care providers are subject to civil and criminal false claims laws, including the federal False Claims Act, which allows private parties to bring whistleblower lawsuits against private companies doing business with or receiving reimbursement under federal health care programs. Some states have adopted similar state whistleblower and false claims provisions. Publicity associated with the substantial amounts paid by other health care providers to settle these lawsuits may encourage our current and former employees and other health care providers to bring whistleblower lawsuits.

12

Any investigations of us or our executives or managers could result in significant liabilities or penalties as well as adverse publicity.

As a provider of health care services, we are subject to claims and legal actions by patients and others.

     We are subject to medical malpractice and other lawsuits due to the nature of the services we provide. Facilities acquired by us may have unknown or contingent liabilities, including liabilities related to patient care and liabilities for failure to comply with health care laws and regulations, which could result in large claims and significant defense costs. Although we generally seek indemnification covering these matters from prior owners of facilities we acquire, material liabilities for past activities of acquired facilities may exist and such prior owners may not be able to satisfy their indemnification obligations. We are also susceptible to being named in claims brought related to patient care and other matters at inpatient facilities owned by third parties and operated by us.

     To protect ourselves from the cost of these claims, professional malpractice liability insurance and general liability insurance coverage is maintained in amounts and with retention common in the industry. We have professional and general liability insurance in umbrella form for claims in excess of a $3.0 million self-insured retention with an insured excess limit of $50.0 million for all of our inpatient facilities. The self-insured reserves for professional and general liability risks are calculated based on historical claims, demographic factors, industry trends, severity factors and other actuarial assumptions calculated by an independent third-party actuary. This self-insured reserve is discounted to its present value using a 5% discount rate. This estimated accrual for professional and general liabilities could be significantly affected should current and future occurrences differ from historical claim trends and expectations. We have utilized our captive insurance company to manage the self-insured retention. While claims are monitored closely when estimating professional and general liability accruals, the complexity of the claims and wide range of potential outcomes often hampers timely adjustments to the assumptions used in these estimates. There are no assurances that our insurance will cover all claims (e.g., claims for punitive damages) or that claims in excess of our insurance coverage will not arise. A successful lawsuit against us that is not covered by, or is in excess of, our insurance coverage may have a material adverse effect on our business, financial condition and results of operations. This insurance coverage may not continue to be available at a reasonable cost, especially given the significant increase in insurance premiums generally experienced in the health care industry.

We may be required to spend substantial amounts to comply with legislative and regulatory initiative relating to privacy and security of patient health information and standards for electronic transactions.

     There are currently numerous legislative and regulatory initiatives at the federal and state levels addressing patient privacy and security concerns. In particular, federal regulations issued under HIPAA require our facilities to comply with standards to protect the privacy, security and integrity of health care information. These regulations have imposed extensive administrative requirements, technical and physical information security requirements, restrictions on the use and disclosure of individually identifiable patient health and related financial information and have provided patients with additional rights with respect to their health information. Compliance with these regulations requires substantial expenditures, which could negatively impact our financial results. In addition, our management has spent, and may spend in the future, substantial time and effort on compliance measures.

     HIPAA also mandates the use of standard formats for electronic transactions and establishing standard unique health identifiers. All health care providers, including our inpatient facilities, will be required to obtain a new National Provider Identifier to be used in standard transactions instead of other numerical identifiers beginning no later than May 23, 2007. We cannot predict whether our inpatient facilities will experience payment delays during the transition to the new identifiers.

     Violations of the privacy and security regulations could subject our inpatient facilities to civil penalties of up to $25,000 per calendar year for each provision contained in the privacy and security regulations that is violated and criminal penalties of up to $250,000 per violation for certain other violations. Because there is no significant history of enforcement efforts by the federal government at this time, it is not possible to ascertain the likelihood of enforcement efforts in connection with these regulations or the potential for fines and penalties that may result from the violation of the regulations.

If competition decreases our ability to acquire additional inpatient facilities on favorable terms, we may be unable to execute our acquisition strategy.

     An important part of our business strategy is to acquire inpatient facilities in growing markets. Some inpatient facilities and health care providers that compete with us have greater financial resources and a larger development staff focused on identifying and completing acquisitions. In addition, some competitors are owned by governmental agencies or not-for-profit corporations supported by endowments and charitable contributions and can finance capital expenditures on a tax-exempt basis. Any or all of these factors may impede our business strategy.

Our substantial indebtedness could adversely affect our financial condition.

     As of December 31, 2006, our total consolidated indebtedness was approximately $743.3 million. Our indebtedness could have important consequences to you, including:

• increasing our vulnerability to general adverse economic and industry conditions;

13

• requiring that a portion of our cash flow from operations be used for the payment of interest on our debt, thereby reducing our ability to use our cash flow to fund working capital, capital expenditures, acquisitions and general corporate requirements;

• restricting our ability to sell assets, including capital stock of our restricted subsidiaries, merge or consolidate with other entities and engage in transactions with our affiliates;

• limiting our ability to obtain additional financing to fund future working capital, capital expenditures, acquisitions and general corporate requirements;

• limiting our flexibility in planning for, or reacting to, changes in our business and the health care industry;

• restricting our ability or the ability of our restricted subsidiaries to pay dividends or make other payments; and

• placing us at a competitive disadvantage to our competitors that have less indebtedness.

     We and our subsidiaries may be able to incur additional indebtedness in the future, including secured indebtedness. If new indebtedness is added to our and our subsidiaries’ current indebtedness levels, the related risks that we and they now face could intensify. In addition, our amended and restated credit facility requires us to maintain specified financial ratios and tests that may require that we take action to reduce our debt or to act in a manner contrary to our business objectives. Events beyond our control, including changes in general business and economic conditions, may affect our ability to meet those financial ratios and tests. We cannot assure you that we will meet those ratios and tests or that the lenders will waive any failure to meet those ratios and tests. A breach of any of these covenants would result in a default under our amended and restated credit facility and any resulting acceleration thereunder may result in a default under the indentures governing our 7 ³ /₄% Senior Subordinated Notes (“7 ³ /₄% Notes”) and 10 ⁵ /₈% Senior Subordinated Notes (“10 ⁵ /₈% Notes”). If an event of default under our amended and restated credit facility occurs, the lenders could elect to declare all amounts outstanding thereunder, together with accrued interest, to be immediately due and payable.

Additional financing may be necessary to fund our acquisition strategy and capital expenditures, and such financing may not be available when needed.

     Our acquisition program requires substantial capital resources. Likewise, the operation of existing inpatient facilities requires ongoing capital expenditures for renovation, expansion and the upgrade of equipment and technology.

     In connection with our acquisition of the capital stock of ABS, we incurred additional indebtedness to finance the $210 million purchase price. In addition, we expect to incur significant additional indebtedness to finance the acquisition of Horizon Health. This may adversely impact our ability to obtain additional financing for future acquisitions and/or capital expenditures on satisfactory terms. In addition, the terms of our outstanding indebtedness as well as our level of indebtedness at any time may restrict our ability to borrow additional funds. If we are not able to obtain additional financing, then we may not be in a position to consummate acquisitions or undertake capital expenditures.

Recently acquired businesses and businesses acquired in the future will expose us to increased operating risks.

     During 2006, we completed the acquisitions of 19 inpatient facilities with an aggregate of 1,900 beds including the December 1, 2006 purchase of the capital stock of ABS, which owns and operates nine inpatient facilities.

     During January 2007, we completed the acquisition of an 86-bed inpatient facility located in Columbia, South Carolina.

     On December 20, 2006, we signed a definitive merger agreement to acquire Horizon Health in a transaction valued at $426 million, consisting of cash of $20 per share totaling $321 million and the assumption of Horizon Health’s outstanding debt. Consummation of the transaction is anticipated during the second quarter of 2007.

     This expansion exposes us to additional business and operating risk and uncertainties, including:

• our ability to effectively manage the expanded activities;

14

• our ability to realize our investment in the increased number of inpatient facilities;

• our exposure to unknown liabilities; and

• our ability to meet contractual obligations.

     If we are unable to manage this expansion efficiently or effectively, or are unable to attract and retain additional qualified management personnel to run the expanded operations, it could have a material adverse effect on our business, financial condition and results of operations.

If we fail to integrate or improve, where necessary, the operations of acquired inpatient facilities, we may be unable to achieve our growth strategy.

     We may be unable to maintain or increase the profitability of, or operating cash flows at, an existing behavioral health care facility or other acquired inpatient facility, effectively integrate the operations of an acquired facility or otherwise achieve the intended benefit of our growth strategy. To the extent that we are unable to enroll in third party payor plans in a timely manner following an acquisition, we may experience a decrease in cash flow or profitability.

     Hospital acquisitions generally require a longer period to complete than acquisitions in many other industries and are subject to additional regulatory uncertainty. Many states have adopted legislation regarding the sale or other disposition of facilities operated by not-for-profit entities. In other states that do not have specific legislation, the attorneys general have demonstrated an interest in these transactions under their general obligations to protect charitable assets from waste. These legislative and administrative efforts focus primarily on the appropriate valuation of the assets divested and the use of the proceeds of the sale by the non-profit seller. In addition, the acquisition of facilities in certain states requires advance regulatory approval under “certificate of need” or state licensure regulatory regimes. These state-level procedures could seriously delay or even prevent us from acquiring inpatient facilities, even after significant transaction costs have been incurred.

We depend on our relationships with physicians and other health care professionals who provide services at our inpatient facilities.

     Our business depends upon the efforts and success of the physicians and other health care professionals who provide health care services at our inpatient facilities and the strength of the relationships with these physicians and other health care professionals.

     Our business could be adversely affected if a significant number of physicians or a group of physicians:

• terminate their relationship with, or reduce their use of, our inpatient facilities;

• fail to maintain acceptable quality of care or to otherwise adhere to professional standards;

• suffer damage to their reputation; or

• exit the market entirely.

We depend on our key management personnel.

     We are highly dependent on our senior management team, which has many years of experience addressing the broad range of concerns and issues relevant to our business. Our senior management team includes talented managers of our divisions, who have extensive experience in all aspects of health care. We have entered into an employment agreement with Joey A. Jacobs, our Chief Executive Officer and President, which includes severance, non-competition and non-solicitation provisions. Key man life insurance policies are not maintained on any member of senior management. The loss of key management or the inability to attract, retain and motivate sufficient numbers of qualified management personnel could have a material adverse effect on us.

Failure to maintain effective internal controls in accordance with Section 404 of the Sarbanes-Oxley Act could have a material adverse effect on our business and stock price.

     Each year we are required to document and test our internal control procedures in order to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act of 2002, which requires annual management assessments of the effectiveness of our internal controls over financial reporting and a report by our independent registered public accounting firm addressing these assessments. During the course of our annual testing we may identify deficiencies that we may not be able to remediate in time to meet the deadline imposed by the Sarbanes-Oxley Act for compliance with the requirements of Section 404. In addition, if we fail to maintain the adequacy of our internal controls, as such standards are modified, supplemented or amended from time to time, we may not be able to ensure that we can conclude on an ongoing basis that we have effective internal controls over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act. Failure to achieve and maintain an effective internal control environment could have a material adverse effect on our business and stock price.

15

Forward-Looking Statements

     This Annual Report on Form 10-K and other materials we have filed or may file with the Securities and Exchange Commission, as well as information included in oral statements or other written statements made, or to be made, by our senior management, contain, or will contain, disclosures that are “forward-looking statements” within the meaning of the safe harbor provisions of The Private Securities Litigation Reform Act of 1995. Forward-looking statements include all statements that do not relate solely to historical or current facts and can be identified by the use of words such as “may,” “will,” “expect,” “believe,” “intend,” “plan,” “estimate,” “project,” “continue,” “should” and other comparable terms. These forward-looking statements are based on the current plans and expectations of management and are subject to a number of risks and uncertainties, including those set forth below, which could significantly affect our current plans and expectations and future financial condition and results.

     We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Stockholders and investors are cautioned not to unduly rely on such forward-looking statements when evaluating the information presented in our filings and reports.

     While it is not possible to identify all these factors, we continue to face many risks and uncertainties that could cause actual results to differ from those forward-looking statements, including:

• our ability to complete the acquisition of Horizon Health and successfully integrate Horizon Health operations;

• potential competition that alters or impedes our acquisition strategy by decreasing our ability to acquire additional inpatient facilities on favorable terms;

• our ability to successfully integrate and improve the operations of acquired inpatient facilities;

• our ability to maintain favorable and continuing relationships with physicians who use our inpatient facilities;

• our ability to receive timely additional financing on terms acceptable to us to fund our acquisition strategy and capital expenditure needs, including financing for the acquisition of Horizon Health;

• risks inherent to the health care industry, including the impact of unforeseen changes in regulation, reimbursement rates from federal and state health care programs or managed care companies and exposure to claims and legal actions by patients and others;

• our ability to comply with extensive laws and government regulations related to billing, physician relationships, adequacy of medical care and licensure;

• our ability to retain key employees who are instrumental to our successful operations;

• our ability to maintain effective internal controls in accordance with Section 404 of the Sarbanes-Oxley Act;

• our ability to ensure confidential information is not inappropriately disclosed and that we are in compliance with federal and state health information privacy standards;

• our ability to comply with federal and state governmental regulation covering health care-related products and services on-line, including the regulation of medical devices and the practice of medicine and pharmacology;

• our ability to obtain adequate levels of general and professional liability insurance; and

• those risks and uncertainties described from time to time in our filings with the SEC.

     In addition, future trends for pricing, margins, revenues and profitability remain difficult to predict in the industries that we serve.

     We caution you that the factors listed above, as well as the risk factors included in this Annual Report on Form 10-K may not be exhaustive. We operate in a continually changing business environment, and new risk factors emerge from time to time. We cannot predict such new risk factors, nor can we assess the impact, if any, of such new risk factors on our businesses or the extent to which any factor or combination of factors may cause actual results to differ materially from those expressed or implied by any forward-looking statements.

Item 1B. Unresolved Staff Comments.

     We have no unresolved SEC Staff Comments.

Item 2. Properties.

     Our inpatient behavioral health care facilities division operates 75 owned or leased inpatient behavioral health care facilities with 8,420 licensed beds in 29 states, Puerto Rico, and the U.S. Virgin Islands. The following table sets forth the name, location, number of licensed beds and the acquisition date for each of our owned and leased inpatient behavioral health care facilities.

16

					Date
Facility	Location	Beds		Own/Lease	Acquired
Cypress Creek Hospital	Houston, TX		96	Own	9/01
West Oaks Hospital	Houston, TX		160	Own	9/01
Texas NeuroRehab Center	Austin, TX		151	Own	11/01
Holly Hill Hospital	Raleigh, NC		108	Own	12/01
Riveredge Hospital	Chicago, IL		210	Own	7/02
Whisper Ridge Behavioral Health System	Charlottesville, VA		102	Lease	4/03
Cedar Springs Behavioral Health System	Colorado Springs, CO		110	Own	4/03
Laurel Ridge Treatment Center	San Antonio, TX		196	Own	4/03
San Marcos Treatment Center	San Marcos, TX		265	Own	4/03
The Oaks Treatment Center	Austin, TX		118	Own	4/03
Shadow Mountain Behavioral Health System	Tulsa, OK		140	Own	4/03
Laurel Oaks Behavioral Health Center	Dothan, AL		113	Own	6/03
Hill Crest Behavioral Health	Birmingham, AL		177	Own	6/03
Gulf Coast Youth Academy	Fort Walton Beach, FL		168	Own	6/03
Manatee Palms Youth Services	Bradenton, FL		60	Own	6/03
Havenwyck Hospital	Auburn Hills, MI		182	Lease	6/03
Heartland Behavioral Health	Nevada, MO		159	Own	6/03
Brynn Marr Behavioral Health	Jacksonville, NC		88	Own	6/03
Mission Vista Hospital	San Antonio, TX		83	Lease	6/03
Benchmark Behavioral Health	Woods Cross, UT		145	Own	6/03
Macon Behavioral Health System	Macon, GA		155	Own	6/03
Manatee Adolescent Treatment Services	Bradenton, FL		85	Own	6/03
Alliance Health Center	Meridian, MS		194	Own	11/03
Calvary Center	Phoenix, AZ		50	Lease	12/03
Brentwood Acute Behavioral Health Center	Shreveport, LA		200	Own	3/04
Brentwood Behavioral Health of Mississippi	Flowood, MS		107	Own	3/04
Palmetto Lowcountry Behavioral Health System	North Charleston, SC		102	Own	5/04
Palmetto Pee Dee Behavioral Health System	Florence, SC		59	Lease	5/04
Fort Lauderdale Hospital	Fort Lauderdale, FL		100	Lease	6/04
Millwood Hospital	Arlington, TX		120	Lease	6/04
Pride Institute	Eden Prairie, MN		36	Own	6/04
Summit Oaks Hospital	Summit, NJ		126	Own	6/04
North Spring Behavioral Healthcare	Leesburg, VA		77	Own	6/04
Peak Behavioral Health	Santa Teresa, NM		144	Own	6/04
Alhambra Hospital	Rosemead, CA		99	Own	7/05
Belmont Pines Hospital	Youngstown, OH		81	Own	7/05
Brooke Glen Behavioral Hospital	Fort Washington, PA		146	Own	7/05
Columbus Behavioral Center	Greenwood, IN		53	Own	7/05
Cumberland Hospital	New Kent, VA		142	Own	7/05
Fairfax Hospital	Kirkland, WA		133	Own	7/05
Fox Run Hospital	St. Clairsville, OH		93	Own	7/05
Fremont Hospital	Fremont, CA		80	Own	7/05
Heritage Oaks Hospital	Sacramento, CA		76	Own	7/05
Intermountain Hospital	Boise, ID		77	Own	7/05
Meadows Hospital	Bloomington, IN		78	Own	7/05
Mesilla Valley Hospital	Las Cruces, NM		125	Own	7/05
Montevista Hospital	Las Vegas, NV		101	Own	7/05
Pinnacle Pointe	Little Rock, AR		102	Own	7/05
Sierra Vista	Sacramento, CA		72	Own	7/05
Streamwood Hospital	Streamwood, IL		261	Own	7/05
Valle Vista Health System	Greenwood, IN		100	Own	7/05
West Hills Hospital	Reno, NV		95	Own	7/05
Willow Springs RTC	Reno, NV		76	Own	7/05
Windsor Hospital	Chagrin Falls, OH		40	Own	7/05
Canyon Ridge Hospital	Chino, CA		59	Own	8/05
Atlantic Shores Hospital	Fort Lauderdale, FL		72	Own	1/06
Desert Springs Medical Center	Midland, TX		64	Own	1/06
Wellstone Regional Hospital	Jeffersonville, IN		100	Own	1/06

17

					Date
Facility	Location	Beds		Own/Lease	Acquired
Diamond Grove	Louisville, MS		50	Own	5/06
Hickory Trail Hospital	DeSoto, TX		76	Own	7/06
National Deaf Academy	Mount Dora, FL		84	Own	7/06
Windmoor Healthcare	Clearwater, FL		100	Own	9/06
University Behavioral Center	Orlando, FL		104	Own	9/06
Sandy Pines	Tequesta, FL		80	Own	9/06
Cumberland Hall Chattanooga	Chattanooga, TN		64	Own	12/06
Cumberland Hall Hopkinsville	Hopkinsville, KY		60	Own	12/06
Nashville Rehabilitation Hospital	Nashville, TN		111	Own	12/06
Panamericano	Cidra, Puerto Rico		195	Own	12/06
PRATS	Cidra, Puerto Rico		48	Own	12/06
The Pines Residential Treatment Center	Portsmouth, VA		402	Own	12/06
The Pines – Charleston	Summerville, SC		60	Lease	12/06
The Pines – Midlands	West Columbia, SC		59	Own	12/06
Virgin Islands Behavioral Services	St. Croix, U.S. Virgin Islands		30	Own	12/06
Virginia Beach Psychiatric Center	Virginia Beach, VA		100	Own	12/06
Three Rivers Behavioral Health	West Columbia, SC		86	Own	01/07

     In addition, our principal executive offices are located in approximately 50,000 square feet of leased space in Franklin, Tennessee. We do not anticipate that we will experience any difficulty in renewing our lease upon its expiration in February 2012, or obtaining different space on comparable terms if such lease is not renewed. We believe our executive offices and our hospital properties and equipment are generally well maintained, in good operating condition and adequate for our present needs.

Item 3. Legal Proceedings.

     We are subject to various claims and legal actions that arise in the ordinary course of our business. In the opinion of management, Psychiatric Solutions is not currently a party to any proceeding that would have a material adverse effect on its financial condition or results of operations.

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

     None.

PART II

Item 5. Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

     Our common stock trades on the Nasdaq Global Select Market under the symbol “PSYS”. The table below sets forth, for the calendar quarters indicated, the high and low sales prices per share as reported on the Nasdaq Global Select Market for our common stock adjusted to give effect to our 2-for-1 stock split on January 9, 2006.

	High		Low
2005
First Quarter	$	23.05	$	17.25
Second Quarter	$	24.54	$	18.01
Third Quarter	$	27.70	$	22.46
Fourth Quarter	$	29.95	$	25.50
2006
First Quarter	$	34.78	$	29.08
Second Quarter	$	34.48	$	26.14
Third Quarter	$	36.35	$	25.59
Fourth Quarter	$	38.84	$	30.19

     At the close of business on February 20, 2007, there were approximately 110 holders of record of our common stock.

     We currently intend to retain future earnings for use in the expansion and operation of our business. Our Second Amended and Restated Credit Agreement prohibits us from paying dividends on our common stock. Also, the indentures governing our 7³/₄% Notes and 10⁵/₈% Notes provide certain financial conditions that must be met in order for us to pay dividends. Subject to the terms of applicable contracts, the payment of any future cash dividends will be determined by our Board of Directors in light of conditions then existing, including our earnings, financial condition and capital requirements, restrictions in financing agreements, business opportunities and conditions, and other factors.

18

Item 6. Selected Financial Data.

     The selected financial data presented below for the years ended December 31, 2006, 2005 and 2004, and at December 31, 2006 and December 31, 2005, are derived from our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K. The selected financial data for the years ended December 31, 2003 and 2002, and at December 31, 2004, 2003 and 2002, are derived from our audited consolidated financial statements not included herein. The selected financial data presented below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and with our consolidated financial statements and notes thereto included elsewhere in this Annual Report on Form 10-K.

Psychiatric Solutions, Inc.
Selected Financial Data
As of and for the Years Ended December 31,

	2006		2005		2004		2003		2002
	(In thousands, except per share amounts)
Income Statement Data:
Revenue	$	1,026,490	$	715,324	$	470,969	$	277,575	$	113,912
Costs and expenses:
Salaries, wages and employee benefits		580,223		392,309		254,897		142,292		62,326
Other operating expenses		266,367		202,229		143,560		95,025		35,716
Provision for doubtful accounts		19,586		13,498		10,794		6,312		3,681
Depreciation and amortization		20,619		14,738		9,808		5,707		1,770
Interest expense		40,307		27,056		18,964		14,778		5,564
Other expenses		—		21,871		6,407		5,271		178
Total costs and expenses		927,102		671,701		444,430		269,385		109,235
Income from continuing operations before income taxes		99,388		43,623		26,539		8,190		4,677
Provision for (benefit from) income taxes		37,507		16,805		10,085		3,477		(1,007	)
Income from continuing operations	$	61,881	$	26,818	$	16,454	$	4,713	$	5,684
Net income	$	60,632	$	27,154	$	16,801	$	5,216	$	5,684
Basic earnings per share from continuing operations	$	1.17	$	0.60	$	0.54	$	0.23	$	0.47
Basic earnings per share	$	1.15	$	0.61	$	0.55	$	0.26	$	0.47
Shares used in computing basic earnings per share		52,953		44,792		29,140		16,740		12,222
Diluted earnings per share from continuing operations	$	1.14	$	0.58	$	0.47	$	0.20	$	0.43
Diluted earnings per share	$	1.12	$	0.59	$	0.48	$	0.22	$	0.43
Shares used in computing diluted earnings per share from continuing operations		54,169		46,296		35,146		23,498		13,972

19

Psychiatric Solutions, Inc.
Selected Financial Data (continued)
As of and for the Years Ended December 31,

	2006		2005		2004		2003		2002
	(In thousands, except operating data)
Balance Sheet Data:
Cash	$	18,541	$	54,700	$	33,451	$	44,948	$	2,392
Working capital		103,287		138,844		39,843		66,446		2,369
Property and equipment, net		543,806		378,162		217,927		149,275		33,547
Total assets		1,581,196		1,175,031		496,684		346,202		90,138
Total debt		743,307		482,389		174,336		175,003		43,822
Series A convertible preferred stock		—		—		—		25,316		—
Stockholders’ equity		627,779		539,712		244,515		91,328		30,549
Operating Data:
Number of facilities		74		55		34		24		5
Number of licensed beds		8,394		6,389		4,295		3,128		699
Admissions		107,199		77,097		49,484		26,278		14,737
Patient days		1,871,244		1,392,877		996,840		525,055		145,575
Average length of stay		17		18		20		20		10

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

     The following discussion and analysis should be read in conjunction with the selected financial data and the accompanying consolidated financial statements and related notes thereto included in this Annual Report on Form 10-K.

Overview

     Our business strategy is to acquire inpatient behavioral health care facilities and improve operating results within new and existing inpatient facilities and our managed inpatient behavioral health care operations. From 2001 to 2004, we acquired 34 inpatient behavioral health care facilities. During 2005, we acquired 20 inpatient behavioral health care facilities in the acquisition of Ardent Health Services, Inc. (“Ardent Behavioral”) and one other inpatient facility. During 2006, we acquired 19 inpatient behavioral health care facilities, including nine inpatient facilities with the acquisition of the capital stock of Alternative Behavioral Services, Inc. (“ABS”) on December 1, 2006. We completed the acquisition of one inpatient facility in January 2007.

     On December 20, 2006, we signed a definitive merger agreement to acquire Horizon Health Corporation (NASDAQ: HORC) (“Horizon Health”) in a transaction valued at $426 million, consisting of cash of $20 per share totaling $321 million and the assumption of Horizon Health’s outstanding debt. Horizon Health produced revenues of $275 million for its fiscal year ended August 31, 2006, primarily through the operation and management of inpatient behavioral health care facilities and units. At November 30, 2006, Horizon Health owned or leased 15 inpatient facilities with approximately 1,561 beds in 11 states. Horizon Health also provided services under 115 behavioral health and physical rehabilitation program management contracts with acute care hospitals at November 30, 2006 and operated an employee assistance program services business. Consummation of the transaction is subject to customary closing conditions, including regulatory approvals, clearance under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 (“Hart-Scott-Rodino Act”), and approval by Horizon Health’s stockholders. On February 12, 2007, we received a request for additional information (commonly referred to as a “Second Request”) from the Federal Trade Commission (“FTC”) in connection with the pending acquisition. The Second Request extends the waiting period imposed by the Hart-Scott-Rodino Act. The Second Request relates to two markets. The companies intend to respond expeditiously to the Second Request and are working with the FTC to resolve its concerns. Consummation of the transaction is anticipated during the second quarter of 2007.

     We strive to improve the operating results of new and existing inpatient behavioral health care operations by providing the highest quality service, expanding referral networks and marketing initiatives and meeting increased demand for our services by expanding our services and developing new services. We also attempt to improve operating results by optimizing staffing ratios, controlling contract labor costs and reducing supply costs through group purchasing. During the year ended December 31, 2006, our same-facility revenue from owned and leased inpatient facilities increased 9.0% for the year ended December 31, 2006, as compared to the year ended December 31, 2005. Same-facility growth also produced gains in owned and leased inpatient facility patient days and revenue per patient day of 3.6% and 5.3%, respectively, during the year ended December 31, 2006. Same-facility growth refers to the comparison of each inpatient facility owned during 2005 with the comparable period in 2006.

20

Sources of Revenue

Patient Service Revenue

     Patient service revenue is generated by our inpatient facilities as a result of services provided to patients on an inpatient and outpatient basis within the inpatient behavioral health care facility setting. Patient service revenue is recorded at our established billing rates less contractual adjustments. Generally, collection in full is not expected on our established billing rates. Contractual adjustments are recorded to state our patient service revenue at the amount we expect to collect for the services provided based on amounts reimbursable by Medicare or Medicaid under provisions of cost or prospective reimbursement formulas or amounts due from other third-party payors at contractually determined rates. For the year ended December 31, 2006, patient service revenue comprised approximately 94.8% of our total revenue.

Management Contract and Other Revenue

     Our inpatient management contract and other segment provides inpatient psychiatric management and development services to hospitals and clinics. Services provided are recorded as management contract revenue in the period the services are provided at contractually determined rates, provided that collectibility of such amounts is reasonably assured. For the year ended December 31, 2006, management contract and other revenue comprised approximately 5.2% of our total revenue.

Results of Operations

     The following table illustrates our consolidated results of operations from continuing operations for the years ended December 31, 2006, 2005 and 2004 (dollars in thousands).

	Results of Operations, Consolidated Psychiatric Solutions
	For the Year Ended December 31,
	2006					2005					2004
	Amount		%			Amount		%			Amount		%
Revenue	$	1,026,490		100.0	%	$	715,324		100.0	%	$	470,969		100.0	%
Salaries, wages, and employee benefits (including share-based compensation of $12,535 in 2006)		580,223		56.5	%		392,309		54.8	%		254,897		54.1	%
Professional fees		97,613		9.5	%		73,177		10.2	%		52,200		11.1	%
Supplies		59,310		5.8	%		42,993		6.0	%		29,717		6.3	%
Provision for doubtful accounts		19,586		1.9	%		13,498		1.9	%		10,794		2.3	%
Other operating expenses		109,444		10.7	%		86,059		12.0	%		61,643		13.1	%
Depreciation and amortization		20,619		2.0	%		14,738		2.1	%		9,808		2.1	%
Interest expense, net		40,307		3.9	%		27,056		3.8	%		18,964		4.0	%
Other expenses:
Loss on refinancing long-term debt		—		—			21,871		3.1	%		6,407		1.4	%
Income from continuing operations before income taxes		99,388		9.7	%		43,623		6.1	%		26,539		5.6	%
Provision for income taxes		37,507		3.7	%		16,805		2.4	%		10,085		2.1	%
Income from continuing operations	$	61,881		6.0	%	$	26,818		3.7	%	$	16,454		3.5	%

Year Ended December 31, 2006 Compared To Year Ended December 31, 2005

     The following table compares key operating statistics for owned and leased inpatient facilities for the years ended December 31, 2006 and 2005 (revenue in thousands). Same-facility statistics for the year ended December 31, 2006 are shown on a comparable basis with total facility statistics for the year ended December 31, 2005.

21

	Year Ended December 31,				%
	2006		2005		Change
Total facility results:
Revenue	$	973,535	$	663,236		46.8	%
Number of facilities at period end		74		55		34.5	%
Admissions		107,199		77,097		39.0	%
Patient days		1,871,244		1,392,877		34.3	%
Average length of stay		17.5		18.1		-3.3	%
Revenue per patient day	$	520	$	476		9.2	%
Same-facility results:
Revenue	$	722,750	$	663,236		9.0	%
Number of facilities at period end		55		55		0.0	%
Admissions		78,961		77,097		2.4	%
Patient days		1,442,570		1,392,877		3.6	%
Average length of stay		18.3		18.1		1.1	%
Revenue per patient day	$	501	$	476		5.3	%

     Revenue. Revenue from continuing operations was $1,026.5 million for the year ended December 31, 2006 compared to $715.3 million for the year ended December 31, 2005, an increase of $311.2 million, or 43.5%. Revenue from owned and leased inpatient facilities accounted for $973.5 million of the 2006 results compared to $663.2 million of the 2005 results, an increase of $310.3 million, or 46.8%. The increase in revenue from owned and leased inpatient facilities relates primarily to acquisitions. The remainder of the increase in revenue from owned and leased inpatient facilities is primarily attributable to same-facility growth in patient days of 3.6% and revenue per patient day of 5.3%. Revenue from inpatient management contracts accounted for $53.0 million of the 2006 results compared to $52.1 million of the 2005 results, an increase of $0.9 million, or 1.7%.

     Salaries, wages, and employee benefits. Salaries, wages and employee benefits (“SWB”) expense was $580.2 million for the year ended December 31, 2006, or 56.5% of total revenue. Effective January 1, 2006, we adopted Statement of Financial Accounting Standards (“SFAS”) No. 123 (Revised 2004) (“SFAS No. 123R”), Share Based Payment, using the modified-prospective transition method. SFAS No. 123R requires companies to measure and recognize the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. Prior to the adoption of SFAS No. 123R, we accounted for our stock option plans using the intrinsic value method in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations, and, as a result, recognized no share-based compensation expense for those prior periods. SWB expense for the year ended December 31, 2006 includes $12.5 million of share-based compensation expense. Based on our stock option and restricted stock grants outstanding at December 31, 2006, we estimate remaining unrecognized share-based compensation expense to be approximately $17.7 million with a weighted average remaining amortization period of 2.6 years. Excluding share-based compensation expense, SWB expense was $567.7 million, or 55.3% of total revenue, in the year ended December 31, 2006 compared to $392.3 million, or 54.8% of total revenue, for the year ended December 31, 2005. SWB expense for owned and leased inpatient facilities was $528.4 million in 2006, or 54.3% of revenue. Same-facility SWB expense for owned and leased inpatient facilities was $388.3 million in 2006, or 53.7% of revenue, compared to $359.7 million in 2005, or 54.2% of revenue. SWB expense for inpatient management contracts was $20.3 million in 2006 compared to $18.9 million in 2005. SWB expense for our corporate office was $31.6 million for 2006 compared to $13.7 million for 2005, increasing primarily as the result of recording the $12.5 million of share-based compensation expense during 2006 and hiring additional staff necessary to manage the inpatient facilities acquired during 2006.

     Professional fees. Professional fees were $97.6 million for the year ended December 31, 2006, or 9.5% of total revenue, compared to $73.2 million for the year ended December 31, 2005, or 10.2% of total revenue. Professional fees for owned and leased inpatient facilities were $90.3 million in 2006, or 9.3% of revenue. Same-facility professional fees for owned and leased inpatient facilities were $67.5 million in 2006, or 9.3% of revenue, compared to $66.0 million in 2005, or 10.0% of revenue. Professional fees for inpatient management contracts were $3.4 million in 2006 compared to $3.7 million in 2005. Professional fees for our corporate office were approximately $4.0 million in 2006 compared to approximately $3.5 million in 2005.

     Supplies. Supplies expense was $59.3 million for the year ended December 31, 2006, or 5.8% of total revenue, compared to $43.0 million for the year ended December 31, 2005, or 6.0% of total revenue. Supplies expense for owned and leased inpatient facilities was $58.3 million in 2006, or 6.0% of revenue. Same-facility supplies expense for owned and leased inpatient facilities was $44.4 million in 2006, or 6.1% of revenue, compared to $41.9 million in 2005, or 6.3% of revenue. Supplies expense for our corporate office and inpatient management contracts is negligible to supplies expense overall.

     Provision for doubtful accounts. The provision for doubtful accounts was $19.6 million for the year ended December 31, 2006, or 1.9% of total revenue, compared to $13.5 million for the year ended December 31, 2005, or 1.9% of total revenue. The provision for doubtful accounts at owned and leased inpatient facilities comprises the majority of our provision for doubtful accounts as a whole.

22

     Other operating expenses. Other operating expenses consist primarily of rent, utilities, insurance, travel, and repairs and maintenance expenses. Other operating expenses were approximately $109.4 million for the year ended December 31, 2006, or 10.7% of total revenue, compared to $86.1 million for the year ended December 31, 2005, or 12.0% of total revenue. Other operating expenses for owned and leased inpatient facilities were $84.8 million in 2006, or 8.7% of revenue. Same-facility other operating expenses for owned and leased inpatient facilities were $63.5 million in 2006, or 8.8% of revenue, compared to $61.2 million in 2005, or 9.2% of revenue. Other operating expenses for inpatient management contracts were $19.3 million in 2006 compared to $18.5 million in 2005.

     Depreciation and amortization. Depreciation and amortization expense was $20.6 million for the year ended December 31, 2006 compared to $14.7 million for the year ended December 31, 2005, an increase of $5.9 million. This increase in depreciation and amortization expense is primarily the result of our numerous acquisitions of inpatient facilities during 2005 and 2006.

     Interest expense, net. Interest expense, net of interest income, was $40.3 million for the year ended December 31, 2006 compared to $27.1 million for the year ended December 31, 2005, an increase of $13.3 million or 49.0%. The increase in interest expense is primarily attributable to debt incurred to fund the 2006 acquisitions and the July 1, 2005 acquisition of Ardent Behavioral. On December 31, 2006, we had $743.3 million in long-term debt compared to $482.4 million at December 31, 2005. During the third and fourth quarters of 2006 we borrowed $101.0 million under our revolving credit facility and $150.0 million under our senior secured term loan facility to fund acquisitions, most notably ABS on December 1, 2006. During July 2005 we borrowed $520.0 million under a bridge loan facility ($150.0 million), senior secured term loan facility ($325.0 million) and our revolving credit facility ($45.0 million) to finance the Ardent Behavioral acquisition. We issued $220.0 million of our 7³/₄% Notes and repaid the $150.0 million bridge loan and $61.3 million of our 10⁵/₈% Notes in July 2005. During September 2005 we repaid $125.0 million of our senior secured term loan facility and all borrowings under our revolving credit facility with proceeds from an offering of our common stock.

     Other expenses. Other expenses in 2005 consisted of $21.9 million in losses on the refinancing of our long-term debt relating to the refinancings of $125.0 million of our senior secured term loan facility, $111.3 million of our 10⁵/₈% Notes and the $150.0 million bridge loan to finance the acquisition of Ardent Behavioral.

     Loss from discontinued operations, net of taxes. The loss from discontinued operations (net of income tax effect) of approximately $1.2 million for the year ended December 31, 2006 and income from discontinued operations of $0.3 million for the year ended December 31, 2005 are primarily from the operations of five contracts to manage inpatient facilities for the Florida Department of Juvenile Justice and the operating results of a therapeutic boarding school sold in 2006. These contracts to manage inpatient facilities for the Florida Department of Juvenile Justice were assumed in the acquisition of Ramsay Youth Services, Inc. (“Ramsay”) in 2003. Three of these contracts were terminated in 2006 and two were terminated in 2005.

Year Ended December 31, 2005 Compared To Year Ended December 31, 2004

     The following table compares key operating statistics for owned and leased inpatient facilities for the years ended December 31, 2005 and 2004 (revenue in thousands). Same-facility statistics for the year ended December 31, 2005 are shown on a comparable basis with total facility statistics for the year ended December 31, 2004.

	Year Ended December 31,				%
	2005		2004		Change
Total facility results:
Revenue	$	663,236	$	419,701		58.0	%
Number of facilities at period end		55		34		61.8	%
Admissions		77,097		49,484		55.8	%
Patient days		1,392,877		996,840		39.7	%
Average length of stay		18.1		20.1		-10.0	%
Revenue per patient day	$	476	$	421		13.1	%
Same-facility results:
Revenue	$	452,161	$	419,701		7.7	%
Number of facilities at period end		34		34		0.0	%
Admissions		50,438		49,484		1.9	%
Patient days		1,035,302		996,840		3.9	%
Average length of stay		20.5		20.1		2.0	%
Revenue per patient day	$	437	$	421		3.8	%

     Revenue. Revenue from continuing operations was $715.3 million for the year ended December 31, 2005 compared to $471.0 million for the year ended December 31, 2004, an increase of $244.4 million, or 51.9%. Revenue from owned and leased inpatient facilities accounted for $663.2 million of the 2005 results compared to $419.7 million of the 2004 results, an increase of

23

$243.5 million, or 58.0%. The increase in revenue from owned and leased inpatient facilities relates primarily to acquisitions. The acquisition of Ardent Behavioral and other acquisitions accounted for $159.5 million and $51.6 million, respectively, of the increase in revenue during 2005 as compared to 2004. The remainder of the increase in revenue from owned and leased inpatient facilities is primarily attributable to same-facility growth in patient days of 3.9% and revenue per patient day of 3.8%, Revenue from inpatient management contracts accounted for $52.1 million of the 2005 results compared to $51.3 million of the 2004 results, an increase of approximately $0.8 million, or 1.6%.

     Salaries, wages, and employee benefits. SWB expense was $392.3 million for the year ended December 31, 2005, or 54.8% of total revenue, compared to $254.9 million for the year ended December 31, 2004, or 54.1% of total revenue. SWB expense for owned and leased inpatient facilities was $359.7 million in 2005, or 54.2% of revenue. Same-facility SWB expense for owned and leased inpatient facilities was $244.7 million in 2005, or 54.1% of revenue, compared to $227.8 million in 2004, or 54.3% of revenue. SWB expense for inpatient management contracts was $18.9 million in 2005 compared to $19.1 million in 2004. SWB expense for our corporate office was $13.7 million for 2005 compared to $8.0 million for 2004 as the result of the hiring of additional staff necessary to manage the inpatient facilities and inpatient management contracts acquired during 2004 and 2005.

     Professional fees. Professional fees were $73.2 million for the year ended December 31, 2005, or 10.2% of total revenue, compared to $52.2 million for the year ended December 31, 2004, or 11.1% of total revenue. Professional fees for owned and leased inpatient facilities were $66.0 million in 2005, or 10.0% of revenue. Same-facility professional fees for owned and leased inpatient facilities were $45.4 million in 2005, or 10.0% of revenue, compared to $45.3 million in 2004, or 10.8% of revenue. Professional fees for inpatient management contracts were $3.7 million in 2005 compared to $3.6 million in 2004. Professional fees for our corporate office were approximately $3.5 million in 2005 compared to approximately $3.3 million in 2004.

     Supplies. Supplies expense was $43.0 million for the year ended December 31, 2005, or 6.0% of total revenue, compared to $29.7 million for the year ended December 31, 2004, or 6.3% of total revenue. Supplies expense for owned and leased inpatient facilities was $42.0 million in 2005, or 6.3% of revenue. Same-facility supplies expense for owned and leased inpatient facilities was $30.6 million in 2005, or 6.8% of revenue, compared to $28.8 million in 2004, or 6.9% of revenue. Supplies expense for our corporate office and inpatient management contracts is negligible to supplies expense overall.

     Provision for doubtful accounts. The provision for doubtful accounts was $13.5 million for the year ended December 31, 2005, or 1.9% of total revenue, compared to $10.8 million for the year ended December 31, 2004, or 2.3% of total revenue. The provision for doubtful accounts at owned and leased inpatient facilities comprises the majority of our provision for doubtful accounts as a whole.

     Other operating expenses. Other operating expenses consist primarily of rent, utilities, insurance, travel, and repairs and maintenance expenses. Other operating expenses were approximately $86.1 million for the year ended December 31, 2005, or 12.0% of total revenue, compared to $61.6 million for the year ended December 31, 2004, or 13.1% of total revenue. Other operating expenses for owned and leased inpatient facilities were $61.2 million in 2005, or 9.2% of revenue. Same-facility other operating expenses for owned and leased inpatient facilities were $42.3 million in 2005, or 9.4% of revenue, compared to $40.4 million in 2004, or 9.6% of revenue. Other operating expenses for inpatient management contracts were $18.5 million in 2005 compared to $18.0 million in 2004. Other operating expenses at our corporate office increased to $6.4 million in 2005 from approximately $3.3 million in 2004.

     Depreciation and amortization. Depreciation and amortization expense was $14.7 million for the year ended December 31, 2005 compared to $9.8 million for the year ended December 31, 2004, an increase of approximately $4.9 million. This increase in depreciation and amortization expense is primarily the result of our numerous acquisitions of inpatient facilities during 2004 and 2005.

     Interest expense, net. Interest expense, net of interest income, was $27.1 million for the year ended December 31, 2005 compared to $19.0 million for the year ended December 31, 2004, an increase of $8.1 million or 42.7%. The increase in interest expense is primarily attributable to debt incurred to fund the 2005 acquisition of Ardent Behavioral. On December 31, 2005, we had $482.4 million in long-term debt compared to $174.3 million at December 31, 2004. During January 2005, we repaid $50.0 million of our 10⁵/₈ % Notes with $20.0 million in cash and $30.0 million in borrowings under our revolving credit facility. During the July 2005 acquisition of Ardent Behavioral, we borrowed $150.0 million, $45.0 million and $325.0 million, respectively, under a bridge loan, our revolving credit facility and senior secured term loan facility. We issued $220 million of our 7³/₄% Notes and also repaid $61.3 million of our 10⁵/₈% Notes during July 2005. During September 2005 we repaid all our borrowing under our revolving credit facility and $125 million of our senior secured term loan facility with proceeds from an offering of our common stock.

     Other expenses. Other expenses in 2005 consisted of $21.9 million in losses on the refinancing of our long-term debt relating to the refinancings of $125.0 million of our senior secured term loan facility, $111.3 million of our 105/8% Notes and the $150.0 million bridge loan incurred to finance the acquisition of Ardent Behavioral. Other expenses in 2004 consisted of $6.4 million in losses on the refinancing of our long-term debt relating to the termination of our former senior credit facility.

     Income from discontinued operations, net of taxes. The income from discontinued operations (net of income tax effect) of approximately $0.3 million for the years ended December 31, 2005 and 2004 is from the operations of eight contracts to manage inpatient facilities for the Florida Department of Juvenile Justice and the operating results of a therapeutic boarding school sold in

24

2006. The management contracts were assumed in the Ramsay acquisition in 2003 and three were terminated in 2006, two were terminated in 2005, and three were terminated in 2004.

Liquidity and Capital Resources

     Working capital at December 31, 2006 was $103.3 million, including cash and cash equivalents of $18.5 million, compared to working capital of $138.8 million, including cash and cash equivalents of $54.7 million, at December 31, 2005.

     Cash provided by continuing operating activities was $122.0 million for the year ended December 31, 2006 compared to $79.6 million for the year ended December 31, 2005. The increase in cash flows from operating activities was primarily due to the cash generated from the inpatient facilities we acquired in 2006 and the full year operations in 2006 of the Ardent Behavioral inpatient facilities acquired on July 1, 2005. Income tax payments for the year ended December 31, 2006 were reduced by our utilization of net operating loss carryforwards and tax deductions generated by stock option exercises. As of December 31, 2006, our operating loss carryforwards have been substantially utilized and, as a result, future income tax payments will increase and are expected to move closer to our provision for income taxes.

     Billings for patient accounts receivable are generally submitted to the payor within three days of the patient’s discharge or completion of services. Interim billings may be utilized for patients with extended lengths of stay. We verify within a reasonable period of time that claims submitted to third-party payors have been received and are being processed by such payors. Follow-up regarding the status of each claim is made on a periodic basis until payment on the claim is received. Billing notices for self-pay accounts receivable are distributed on a periodic basis. Self-pay accounts receivable are turned over to collection agencies once internal collection efforts have been exhausted. Accounts receivable under our inpatient management contracts are billed at least monthly. Follow-up regarding these amounts is made on a periodic basis until payment is received. Our allowance for doubtful accounts for patient receivables primarily consists of patient accounts which are greater than 180 days past the patient’s discharge date. Our allowance for doubtful accounts for receivables due under our inpatient management contracts primarily consists of amounts that are specifically identified as potential collection issues. Accounts receivable are written off when collection within a reasonable period of time is deemed unlikely.

     Cash used in investing activities was $419.5 million for the year ended December 31, 2006 compared to $536.4 million for the year ended December 31, 2005. Cash used in investing activities for the year ended December 31, 2006 was primarily the result of $385.1 million paid for acquisitions of behavioral health care facilities and $33.8 million paid for the purchases of fixed assets. Cash used in the acquisition of ABS was approximately $210.0 million, which was financed by borrowings on our revolving credit facility and senior secured term loan facility. Cash used for routine and expansion capital expenditures was approximately $20.6 million and $13.2 million, respectively, for the year ended December 31, 2006. We define expansion capital expenditures as those that increase our capacity or otherwise enhance revenue. Routine or maintenance capital expenditures were 2.0% of our net revenue for the year ended December 31, 2006. Cash used in investing activities for the year ended December 31, 2005 was primarily the result of $514.5 million paid for acquisitions of behavioral health care facilities and $21.8 million paid for the purchases of fixed assets.

     Cash provided by financing activities was $259.6 million for the year ended December 31, 2006 compared to $477.9 million for the year ended December 31, 2005. During 2006, we borrowed an additional $150.0 million under our senior secured term loan facility to finance a portion of the ABS acquisition. Also during 2006, we borrowed $101.0 million on our revolving credit facility primarily to finance acquisitions. We received approximately $6.3 million from issuances of our common stock during 2006 from stock option exercises.

     We have a universal shelf registration statement on Form S-3 under which we may sell an indeterminate amount of our common stock, common stock warrants, preferred stock and debt securities. We may from time to time offer these securities in one or more series, in amounts, at prices and on terms satisfactory to us.

     We have entered into interest rate swap agreements to manage our exposure to fluctuations in interest rates. These interest rate swap agreements effectively convert approximately $38.7 million of fixed-rate long-term debt to LIBOR indexed variable rate instruments plus agreed upon interest rate spreads ranging from 5.51% to 5.86%.

     We anticipate financing the acquisition of Horizon Health through additional borrowings of approximately $175 million under our existing $300 million revolving credit facility, borrowings of $250 million under an additional term loan facility to be established under our existing credit agreement and with cash on hand. We have entered into a commitment letter with Merrill Lynch, Pierce, Fenner & Smith Incorporated, Merrill Lynch Capital Corporation and Citigroup Global Markets Inc. to provide the financing for the additional term loan facility, subject to the terms and conditions of such letter.

     We are actively seeking acquisitions that fit our corporate growth strategy and may acquire additional inpatient psychiatric facilities. Management continually assesses our capital needs and, should the need arise, we will seek additional financing, including debt or equity, to fund potential acquisitions or for other corporate purposes. In negotiating such financing, there can be no assurance that we will be able to raise additional capital on terms satisfactory to us. Failure to obtain additional financing on reasonable terms could have a negative effect on our plans to acquire additional inpatient psychiatric facilities.

25

Obligations and Commitments

	Payments Due by Period (in thousands)
			Less than						After
	Total		1 year		1-3 years		3-5 years		5 years
Long-term debt (1):
Senior Credit Facility:
Revolving line of credit facility, expiring on December 21, 2009 and bearing interest of 6.7% at December 31, 2006	$	101,000	$	—	$	101,000	$	—	$	—
Senior secured term loan facility, expiring on July 1, 2012 and bearing interest of 7.1% at December 31, 2006		350,000		1,500		3,000		3,000		342,500
7 3/4% Senior Subordinated Notes due July 15, 2015		220,000		—		—		—		220,000
10 5/8% Senior Subordinated Notes due June 15, 2013		38,681		—		—		—		38,681
Mortgage loans on facilities, maturing in 2036, 2037, and 2038 bearing fixed interest rates of 5.7% to 7.6%		27,062		302		660		745		25,355
		736,743		1,802		104,660		3,745		626,536
Lease and other obligations		57,822		10,989		17,617		8,770		20,446
Total contractual obligations	$	794,565	$	12,791	$	122,277	$	12,515	$	646,982

(1) Excludes capital lease obligations, which are included in lease and other obligations.

     The fair values of our $220.0 million 7³/₄% Notes and $38.7 million 10⁵/₈% Notes were approximately $218.6 million and approximately $42.4 million, respectively, as of December 31, 2006. The fair values of our $220.0 million 7³/₄% Notes and $38.7 million 10⁵/₈% Notes were approximately $227.4 million and approximately $44.0 million, respectively, as of December 31, 2005. The carrying value of our other long-term debt, including current maturities, of $484.6 million and $223.7 million at December 31, 2006 and December 31, 2005, respectively, approximated fair value. We had $101.0 million and $150.0 million, respectively, of variable rate debt outstanding under our revolving credit facility and senior secured term loan facility as of December 31, 2006. In addition, interest rate swap agreements effectively convert $38.7 million of fixed rate debt into variable rate debt at December 31, 2006. At our December 31, 2006 borrowing level, a hypothetical 10% increase in interest rates would decrease our annual net income and cash flows by approximately $2.2 million.

Impact of Inflation and Economic Trends

     Although inflation has not had a material impact on our results of operations, the health care industry is very labor intensive and salaries and benefits are subject to inflationary pressures as are supply costs, which tend to escalate as vendors pass on the rising costs through price increases. Some of the freestanding owned, leased and managed inpatient behavioral health care facilities we operate are experiencing the effects of the tight labor market, including a shortage of nurses, which has caused and may continue to cause an increase in our SWB expense in excess of the inflation rate. Although we cannot predict our ability to cover future cost increases, management believes that through adherence to cost containment policies, labor management and reasonable price increases, the effects of inflation on future operating margins should be manageable. Our ability to pass on increased costs associated with providing health care to Medicare and Medicaid patients is limited due to various federal, state and local laws which have been enacted that, in certain cases, limit our ability to increase prices. In addition, as a result of increasing regulatory and competitive pressures and a continuing industry wide shift of patients into managed care plans, our ability to maintain margins through price increases to non-Medicare patients is limited.

     The behavioral health care industry is typically not directly impacted by periods of recession, erosions of consumer confidence or other general economic trends as most health care services are not considered a component of discretionary spending. However, our inpatient facilities may be indirectly negatively impacted to the extent such economic conditions result in decreased reimbursements by federal or state governments or managed care payors. We are not aware of any economic trends that would prevent us from being able to remain in compliance with all of our debt covenants and to meet all required obligations and commitments in the near future.

Critical Accounting Policies

     Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. In preparing our financial statements, we are required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses included in the financial statements. Estimates are based on historical experience and other information currently available, the results of which form the basis of such estimates. While we believe our estimation processes are reasonable, actual results could differ from our estimates. The following represent the estimates considered most critical to our operating performance and involve the most subjective and complex assumptions and assessments.

26

     Allowance for Doubtful Accounts

     Our ability to collect outstanding patient receivables from third-party payors is critical to our operating performance and cash flows.

     The primary collection risk with regard to patient receivables lies with uninsured patient accounts or patient accounts for which primary insurance has paid, but the portion owed by the patient remains outstanding. We estimate the allowance for doubtful accounts primarily based upon the age of the accounts since the patient discharge date. We continually monitor our accounts receivable balances and utilize cash collection data to support our estimates of the provision for doubtful accounts. Significant changes in payor mix or business office operations could have a significant impact on our results of operations and cash flows.

     The primary collection risk with regard to receivables due under our inpatient management contracts is attributable to contractual disputes. We estimate the allowance for doubtful accounts for these receivables based primarily upon the specific identification of potential collection issues. As with our patient receivables, we continually monitor our accounts receivable balances and utilize cash collection data to support our estimates of the provision for doubtful accounts.

     Allowances for Contractual Discounts

     The Medicare and Medicaid regulations are complex and various managed care contracts may include multiple reimbursement mechanisms for different types of services provided in our inpatient facilities and cost settlement provisions requiring complex calculations and assumptions subject to interpretation. We estimate the allowance for contractual discounts on a payor-specific basis by comparing our established billing rates with the amount we determine to be reimbursable given our interpretation of the applicable regulations or contract terms. Most payments are determined based on negotiated per-diem rates. While the services authorized and provided and related reimbursement are often subject to interpretation that could result in payments that differ from our estimates, these differences are deemed immaterial. Additionally, updated regulations and contract renegotiations occur frequently necessitating continual review and assessment of the estimation process by our management. We periodically compare the contractual rates on our patient accounting systems with the Medicare and Medicaid reimbursement rates or the third-party payor contract for accuracy. We also monitor the adequacy of our contractual adjustments using financial measures such as comparing cash receipts to net patient revenue adjusted for bad debt expense.

     As of December 31, 2006, our patient accounts receivable balance for third-party payors was $171.6 million. A theoretical 1% change in the amounts due from third-party payors at December 31, 2006 could have an after tax effect of approximately $1.0 million on our financial position and results of operations.

     The following table presents the percentage by payor of our net revenue and accounts receivable for the years ended December 31, 2006 and 2005 (in thousands):

	For the Year Ended December 31,
	2006						2005
	Net			Accounts			Net			Accounts
	Revenue			Receivable			Revenue			Receivable
	%			%			%			%
Payor mix:
Medicaid		36	%		32	%		35	%		36	%
Commercial/HMO/Private Pay		34	%		35	%		33	%		38	%
Medicare		13	%		12	%		13	%		10	%
State agency		13	%		18	%		13	%		13	%
Other		4	%		3	%		6	%		3	%
Total		100	%		100	%		100	%		100	%

     The following table presents the percentage by aging category of our accounts receivable at December 31, 2006 and 2005 (in thousands):

27

	At December 31,
	2006			2005
	%			%
0 - 30 days		61	%		61	%
31 - 60 days		16	%		17	%
61 - 90 days		9	%		9	%
91 - 120 days		5	%		6	%
121 - 150 days		4	%		4	%
151 - 180 days		3	%		2	%
> 180 days		2	%		1	%
Total		100	%		100	%

     Our consolidated day’s sales outstanding were 53 and 55 for the years ended December 31, 2006 and 2005, respectively. Our consolidated collections as a percentage of net revenue less bad debt expense was 100.4% and 100.8% for the years ended December 31, 2006 and 2005, respectively.

     Professional and General Liability

     We are subject to medical malpractice and other lawsuits due to the nature of the services we provide. At December 31, 2006, all of our operations have professional and general liability insurance in umbrella form for claims in excess of $3.0 million with an insured limit of $50.0 million. The self-insured reserves for professional and general liability risks are calculated based on historical claims, demographic factors, industry trends, severity factors, and other actuarial assumptions calculated by an independent third-party actuary. This self-insurance reserve is discounted to its present value using a 5% discount rate. This estimated accrual for professional and general liabilities could be significantly affected should current and future occurrences differ from historical claim trends and expectations. We have utilized our captive insurance company to manage the self-insured retention. While claims are monitored closely when estimating professional and general liability accruals, the complexity of the claims and wide range of potential outcomes often hampers timely adjustments to the assumptions used in these estimates.

     Income Taxes

     As part of our process for preparing our consolidated financial statements, our management is required to compute income taxes in each of the jurisdictions in which we operate. This process involves estimating the current tax benefit or expense of future deductible and taxable temporary differences. The future deductible and taxable temporary differences are recorded as deferred tax assets and liabilities which are components of our balance sheet. Management then assesses our ability to realize the deferred tax assets based on reversals of deferred tax liabilities and, if necessary, estimates of future taxable income. A valuation allowance for deferred tax assets is established when we believe that it is more likely than not that the deferred tax asset will not be realized. Management must also assess the impact of our acquisitions on the realization of deferred tax assets subject to a valuation allowance to determine if all or a portion of the valuation allowance will be offset by reversing taxable differences or future taxable income of the acquired entity. To the extent the valuation allowance can be reversed due to the estimated future taxable income of an acquired entity, then our valuation allowance is reduced accordingly as an adjustment to purchase price.

     In June 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”). FIN 48 applies to all tax positions accounted for under SFAS No. 109, Accounting for Income Taxes, defines the confidence level that a tax position must meet in order to be recognized in the financial statements and requires additional disclosures. FIN 48 is effective for us as of the interim reporting period beginning January 1, 2007. We are currently evaluating the effect that the adoption of FIN 48 will have on our consolidated results of operations and financial condition.

     Stock-Based Compensation

     As part of our process for preparing our consolidated financial statements, our management is required to measure and recognize the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value. Share-based compensation recognized under the modified-prospective transition method of SFAS No. 123R includes share-based compensation based on the grant-date fair value determined in accordance with the original provisions of SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), for all share-based payments granted prior to and not yet vested as of January 1, 2006 and share-based compensation based on the grant-date fair-value determined in accordance with SFAS No. 123R for all share-based payments granted on or after January 1, 2006. SFAS No. 123R eliminates the ability to account for the award of these instruments under the intrinsic value method prescribed by Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and allowed under the original provisions of SFAS 123. Prior to the adoption of SFAS No. 123R, we accounted for our stock option plans using the intrinsic value method in accordance with the provisions of APB Opinion No. 25 and related interpretations.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk.

     Our interest expense is sensitive to changes in the general level of interest rates. With respect to our interest-bearing liabilities, approximately $285.7 million of our long-term debt outstanding at December 31, 2006 was subject to a weighted average fixed interest rate of 7.98%, not including our interest rate swaps. Our variable rate debt is comprised of our senior secured term loan facility, which had $350.0 million outstanding at December 31, 2006 and on which interest is generally payable at LIBOR plus 1.75 % to 2.0% (depending on a certain covenant ratio), and our $300.0 million revolving credit facility, which had a $101.0 million balance outstanding at December 31, 2006 and on which interest is generally payable at LIBOR plus 1.25% to 2.25% (depending on a certain covenant ratio). At December 31, 2006, we had $38.7 million in interest rate swaps that effectively changed $38.7 million of our fixed rate 10⁵/₈% Notes to a variable rate. A hypothetical 10% increase in interest rates would decrease our net income and cash flows by approximately $2.2 million on an annual basis based upon our borrowing level at December 31, 2006. In the event we draw on our revolving credit facility and interest rates change significantly, we expect management would take actions intended to further mitigate our exposure to such change. Information on quantitative and qualitative disclosure about market risk is included in Part II, Item 7 of

28

this Annual Report on Form 10-K under the caption “Management’s Discussion and Analysis of Financial Condition and Results of
Operations — Liquidity and Capital Resources.”

Item 8. Financial Statements and Supplementary Data.

     Information with respect to this Item is contained in our consolidated financial statements indicated in the Index on Page F-1 of this Annual Report on Form 10-K.

Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure.

     None.

Item 9A. Controls and Procedures.

Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures

     We carried out an evaluation, under the supervision and with the participation of management, including our Chief Executive Officer and Chief Accounting Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, our Chief Executive Officer and Chief Accounting Officer concluded that our disclosure controls and procedures were effective in ensuring that information required to be disclosed by us (including our consolidated subsidiaries) in reports that we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported on a timely basis.

     On December 1, 2006, we purchased the capital stock of Alternative Behavioral Services, Inc. (“ABS”). We have excluded all of ABS from our assessment of and conclusion on the effectiveness of our internal control over financial reporting. During 2006, ABS contributed approximately $14.6 million, or 1.4% of our net revenue, and, as of December 31, 2006, accounted for approximately $58.3 million, or 7.1% of our total assets, excluding goodwill.

     Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, we have included a report of management’s assessment of the design and operating effectiveness of our internal controls as part of this report. Our independent registered public accounting firm also attested to, and reported on, management’s assessment of the effectiveness of internal control over financial reporting. Management’s report and the independent registered public accounting firm’s attestation report are included in our 2006 consolidated financial statements beginning with the index on page F-1 of this report under the captions entitled “Management’s Report on Internal Control Over Financial Reporting” and “Report of Independent Registered Public Accounting Firm.”

Changes in Internal Control Over Financial Reporting

     There has been no change in our internal control over financial reporting during the fourth quarter ended December 31, 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Item 9B. Other Information.

     None.

PART III

Item 10. Directors and Executive Officers and Corporate Governance.

Directors

     The information relating to our directors set forth in the Company’s Proxy Statement relating to the 2007 Annual Meeting of Stockholders under the caption “Proposal 1: Election of Directors” and “Corporate Governance — Committees of the Board of Directors — Audit Committee” is incorporated herein by reference.

Executive Officers of the Registrant

     The executive officers of the Company are:

Name	Age		Officer Since	Positions
Joey A. Jacobs		53	April 1997	President and Chief Executive Officer
William B. Rutherford		43	March 2006	Chief Operating Officer
Jack E. Polson		40	August 2002	Executive Vice President, Chief Accounting Officer
Brent Turner		41	February 2003	Executive Vice President, Finance and Administration
Christopher L. Howard		40	September 2005	Executive Vice President, General Counsel and Secretary
Steven T. Davidson		49	August 1997	Chief Development Officer

29

     Joey A. Jacobs, President and Chief Executive Officer. Mr. Jacobs serves as President and Chief Executive Officer and was one of our co-founders in April 1997. Prior to our founding, Mr. Jacobs served for 21 years in various capacities with HCA Inc. (“HCA,” also formerly known as Hospital Corporation of America, Columbia and Columbia/HCA), most recently as President of the Tennessee Division. Mr. Jacobs’ background at HCA also includes serving as President of HCA’s Central Group, Vice President of the Western Group, Assistant Vice President of the Central Group and Assistant Vice President of the Salt Lake City Division.

     William B. Rutherford, Chief Operating Officer. Mr. Rutherford has served as Chief Operating Officer since March 2006 and has over 20 years of health care experience. Prior to joining us, Mr. Rutherford served in various capacities at HCA, most recently as the Chief Financial Officer – Eastern Group from 1996 until 2005.

     Jack E. Polson,Executive Vice President, Chief Accounting Officer. Mr. Polson has served as an Executive Vice President since September 2006 and as Chief Accounting Officer since August 2002. Prior to being appointed Chief Accounting Officer, Mr. Polson had served as Controller since June 1997. From June 1995 until joining us, Mr. Polson served as Controller for Columbia Healthcare Network, a risk-bearing physician health organization. From May 1992 until June 1995, Mr. Polson served as an Internal Audit Supervisor for HCA.

     Brent Turner, Executive Vice President, Finance and Administration. Mr. Turner has served as the Executive Vice President, Finance and Administration since August 2005 and previously had served as the Vice President, Treasurer and Investor Relations since February 2003. From April 2002 until joining us, Mr. Turner served as Executive Vice President and Chief Financial Officer of a privately-held owner and operator of schools for children with learning disabilities. From November 2001 until March 2002, Mr. Turner served as Senior Vice President of Business Development for The Brown Schools, Inc., a provider of educational and therapeutic services for at-risk youth. From 1996 until January 2001, Mr. Turner was employed by Corrections Corporation of America, a private prison operator, serving as Treasurer from 1998 to 2001.

     Chris Howard, Executive Vice President, General Counsel and Secretary. Mr. Howard has served as the Executive Vice President, General Counsel and Secretary since September 2005. Prior to joining us, Mr. Howard was a member of Waller Lansden Dortch & Davis, LLP, a law firm based in Nashville, Tennessee.

     Steven T. Davidson, Chief Development Officer. Mr. Davidson has served as Chief Development Officer since August 1997 and has over 24 years of health care experience. Prior to joining us, Mr. Davidson served as the Director of Development at HCA from 1991 until 1997. Mr. Davidson also served as Senior Audit Supervisor and Hospital Controller during his term at HCA, which began in 1983, where he supervised audits of hospitals and other corporate functions. Prior to joining HCA, Mr. Davidson was employed by Ernst & Young LLP as a Senior Auditor. Mr. Davidson is a Certified Public Accountant and a member of the American Institute of Certified Public Accountants.

Code of Ethics

     We adopted a Code of Ethics that applies to all of our directors, officers and employees. The Code of Ethics is available on our website at www.psysolutions.com. We will disclose any amendment to, other than technical, administrative or non-substantive amendments, or waiver of our Code of Ethics granted to a director or executive officer by filing a Current Report on Form 8-K disclosing the amendment or waiver within four business days. Upon the written request of any person, we will furnish, without charge, a copy of our Code of Ethics. Requests should be directed to Psychiatric Solutions, Inc., 6640 Carothers Parkway, Suite 500, Franklin, Tennessee 37067, Attention: Christopher L. Howard, Esq., Executive Vice President, General Counsel and Secretary.

Section 16(a) Compliance

     The information relating to Section 16(a) beneficial ownership reporting compliance set forth in our Proxy Statement relating to the 2007 Annual Meeting of Stockholders under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” is incorporated herein by reference.

Item 11. Executive Compensation.

     The information set forth in our Proxy Statement relating to the 2007 Annual Meeting of Stockholders under the caption “Compensation Discussion and Analysis” and “Executive Compensation” is incorporated herein by reference. The “Compensation Committee Report” also included in the Proxy Statement is expressly not incorporated herein by reference.

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.

     The information set forth in our Proxy Statement relating to the 2007 Annual Meeting of Stockholders under the caption “Security Ownership of Certain Beneficial Owners and Management” and “Executive Compensation—Equity Compensation Plan Information” is incorporated herein by reference.

30

Item 13. Certain Relationships and Related Transactions, and Director Independence.

     The information set forth in our Proxy Statement relating to the 2007 Annual Meeting of Stockholders under the caption “Corporate Governance – Standards of Independence for the Board of Directors” and “Certain Relationships and Related Transactions” is incorporated herein by reference.

Item 14. Principal Accountant Fees and Services.

     The information set forth in our Proxy Statement relating to the 2007 Annual Meeting of Stockholders under the caption “Proposal 2: Ratification of Appointment of Independent Registered Accounting Firm” is incorporated herein by reference.

PART IV

Item 15. Exhibits and Financial Statement Schedules.

     (a) The following documents are filed as part of this Annual Report on Form 10-K:

          1. Consolidated Financial Statements: The consolidated financial statements of Psychiatric Solutions are included as follows:

	Page
Report of Independent Registered Public Accounting Firm		F-2
Management’s Report on Internal Control Over Financial Reporting		F-3
Report of Independent Registered Public Accounting Firm		F-4
Consolidated Balance Sheets		F-5
Consolidated Statements of Income		F-6
Consolidated Statements of Stockholders’ Equity		F-7
Consolidated Statements of Cash Flows		F-8
Notes to Consolidated Financial Statements		F-10

2. Financial Statement Schedules.

All schedules are omitted because they are not applicable or are not required, or because the required information is included in the consolidated financial statements or notes in this report.

3. Exhibits. The exhibits which are filed with this report or which are incorporated herein by reference are set forth in the Exhibit Index on pages 31 through 34.

(b) Exhibits.

Exhibit
Number	Description
2.1	Agreement and Plan of Merger by and among PMR Corporation, PMR Acquisition Corporation and Psychiatric Solutions, Inc., dated May 6, 2002, as amended by Amendment No. 1, dated as of June 10, 2002, and Amendment No. 2, dated as of July 9, 2002 (included as Annex A to Amendment No. 1 to the Company’s Registration Statement on Form S-4, filed on July 11, 2002 (Reg. No. 333-90372) (the “2002 S-4 Amendment”)).
2.2	Agreement and Plan of Merger, dated April 8, 2003, by and among Psychiatric Solutions, Inc., PSI Acquisition Sub, Inc. and Ramsay Youth Services, Inc. (incorporated by reference to Exhibit 2.1 of the Company’s Current Report on Form 8-K, filed on April 10, 2003).
2.3	Amended and Restated Stock Purchase Agreement, dated June 30, 2005, by and among Ardent Health Services LLC, Ardent Health Services, Inc. and Psychiatric Solutions, Inc. (incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K, filed July 8, 2005).
2.4	Amended and Restated Stock Purchase Agreement, dated as of October 27, 2006, by and between FHC Health Systems, Inc. and Psychiatric Solutions, Inc. (incorporated by reference to Exhibit 2 of the Company’s Current Report on Form 8-K, filed on December 7, 2006).
2.5*	Agreement and Plan of Merger, dated December 20, 2006, by and among Psychiatric Solutions, Inc., Panther Acquisition Sub, Inc. and Horizon Health Corporation.

31

Exhibit
Number	Description
3.1	Amended and Restated Certificate of Incorporation of PMR Corporation, filed with the Delaware Secretary of State on March 9, 1998 (incorporated by reference to Exhibit 3.1 to the Company’s Annual Report on Form 10-K for the fiscal year ended April 30, 1998).
3.2	Certificate of Amendment to Amended and Restated Certificate of Incorporation of PMR Corporation, filed with the Delaware Secretary of State on August 5, 2002 (incorporated by reference to Exhibit 3.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended July 31, 2002).
3.3	Certificate of Amendment to Amended and Restated Certificate of Incorporation of Psychiatric Solutions, Inc., filed with the Delaware Secretary of State on March 21, 2003 (incorporated by reference to Appendix A of the Company’s Definitive Proxy Statement, filed on January 22, 2003).
3.4	Certificate of Amendment to Amended and Restated Certificate of Incorporation of Psychiatric Solutions, Inc., filed with the Delaware Secretary of State on December 15, 2005.
3.5	Amended and Restated Bylaws (incorporated by reference to Exhibit 3.2 to the Company’s Annual Report on Form 10-K for the fiscal year ended April 30, 1997 (the “1997 10-K”)).
4.1	Reference is made to Exhibits 3.1 through 3.5.
4.2	Common Stock Specimen Certificate (incorporated by reference to Exhibit 4.2 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2002 (the “2002 10-K”)).
4.3	Indenture, dated as of June 30, 2003, among Psychiatric Solutions, Inc., the Guarantors named therein and Wachovia Bank, National Association, as Trustee (incorporated by reference to Exhibit 4.10 to the Company’s Registration Statement on Form S-4, filed on July 30, 2003 (Registration No. 333-107453) (the “2003 S-4”)).
4.4	Form of Notes (included in Exhibit 4.3).
4.5	Indenture, dated as of July 6, 2005, by and among Psychiatric Solutions, Inc., the Guarantors named therein and Wachovia Bank, National Association, as Trustee (incorporated by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K, filed July 8, 2005).
4.6	Form of Notes (included in Exhibit 4.5).
4.7	Exchange and Registration Rights Agreement, dated as of July 6, 2005, among Psychiatric Solutions, Inc., the subsidiary guarantors from time to time party thereto, and Citigroup Global Markets Inc. on behalf of Banc of America Securities LLC, Merrill Lynch, Pierce, Fenner & Smith Incorporated, J.P. Morgan Securities Inc. and Lehman Brothers Inc. (incorporated by reference to Exhibit 4.4 to the Company’s Current Report on Form 8-K, filed on July 8, 2005).
10.1†	Second Amended and Restated Employment Agreement between Joey A. Jacobs and Psychiatric Solutions, Inc., dated as of August 6, 2002 (incorporated by reference to Exhibit 10.16 to the 2002 10-K).
10.2†	Amendment to Second Amended and Restated Employment Agreement between Joey A. Jacobs and Psychiatric Solutions, Inc., dated as of November 26, 2003 (incorporated by reference to Exhibit 10.14 to Amendment No. 2 to the Company’s Registration Statement on Form S-2, filed on December 18, 2003 (Registration No. 333-110206)).
10.3†	Form of Indemnification Agreement executed by each director of Psychiatric Solutions, Inc. and Psychiatric Solutions, Inc. (incorporated by reference to Exhibit 10.4 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2004).
10.4	Second Amended and Restated Credit Agreement, dated as of July 1, 2005, by and among Psychiatric Solutions, Inc., the subsidiaries named as guarantors thereto, Citicorp North America, Inc., as term loan facility administrative agent, co-syndication agent and documentation agent, Bank of America, N.A., as revolving loan facility administrative agent, collateral agent swing line lender and co-syndication agent, and the various other agents and lenders party thereto. (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K, filed on July 8, 2005).

32

Exhibit
Number	Description
10.5	Amendment No. 1 to Psychiatric Solutions, Inc.’s Second Amended and Restated Credit Agreement, dated as of December 1, 2006, by and between Psychiatric Solutions, Inc., BHC Holdings, Inc., Premier Behavioral Solutions, Inc., Alternative Behavioral Services, Inc., the subsidiaries of Psychiatric Solutions, Inc. party thereto as guarantors, Citicorp North America, Inc., as Term Loan Facility Administrative Agent, Bank of America, N.A., as Revolving Credit Facility Administrative Agent, Citigroup Global Markets Inc. and Banc of America Securities LLC, as the Arrangers (incorporated by reference to Exhibit 10 to the Company’s Current Report on Form 8-K, filed on December 7, 2006).
10.6	Interest Rate Swap Agreement, dated January 28, 2004, between Bank of America, N.A. and Psychiatric Solutions, Inc. (incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2004).
10.7	Confirmation of Interest Rate Swap Agreement, dated April 26, 2004, between Bank of America, N.A. and Psychiatric Solutions, Inc. (incorporated by reference to Exhibit 10.5 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004).
10.8†	Psychiatric Solutions, Inc. 2006 Long-Term Equity Compensation Plan (incorporated by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K, filed on February 28, 2006).
10.9†	Psychiatric Solutions, Inc. 2007 Long-Term Equity Compensation Plan (incorporated by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K, filed on February 22, 2007).
10.10†	Amended and Restated Psychiatric Solutions, Inc. Equity Incentive Plan, as amended by an Amendment adopted on May 4, 2004 (incorporated by reference to Appendix A to the Company’s Definitive Proxy Statement, filed on April 9, 2004).
10.11†	Second Amendment to the Psychiatric Solutions, Inc. Equity Incentive Plan (incorporated by reference to Appendix A to the Company’s Definitive Proxy Statement, filed on April 22, 2005).
10.12†	Third Amendment to the Psychiatric Solutions, Inc. Equity Incentive Plan (incorporated by reference to Appendix B of the Company’s Definitive Proxy Statement, filed on April 21, 2006).
10.13†	Psychiatric Solutions, Inc. Executive Performance Incentive Plan (incorporated by reference to Appendix A of the Company’s Definitive Proxy Statement, filed on April 21, 2006).
10.14†	Form of Incentive Stock Option Agreement under the 1997 Plan (incorporated by reference to Exhibit 10.2 to the 1997 10-K).
10.15†	Form of Nonstatutory Stock Option Agreement under the 1997 Plan (incorporated by reference to Exhibit 10.3 to the 1997 10-K).
10.16†	Amended and Restated Psychiatric Solutions, Inc. Outside Directors’ Non-Qualified Stock Option Plan (incorporated by reference to Appendix C to the Company’s Definitive Proxy Statement, filed on April 14, 2003).
10.17†	Amendment to the Amended and Restated Psychiatric Solutions, Inc. Outside Directors’ Stock Option Plan (incorporated by reference to Appendix B to the Company’s Definitive Proxy Statement, filed on April 22, 2005).
10.18†	Form of Outside Directors’ Non-Qualified Stock Option Agreement (incorporated by reference to Exhibit 10.5 to the 1997 10-K).
10.19†	2007 Executive Officer Compensation (incorporated by reference to the Company’s Current Report on Form 8-K, filed on November 8, 2006).
10.20†	Psychiatric Solutions, Inc. 2006 Cash Bonus Plans (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K, filed on February 28, 2006).
10.21†	Psychiatric Solutions, Inc. 2007 Cash Bonus Plans (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K, filed on February 22, 2007).
10.22*†	Summary of Director Compensation.
10.23†	Form of Restricted Stock Agreement (incorporated by reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2006).
21.1*	List of Subsidiaries.
23.1*	Consent of Ernst & Young LLP, Independent Registered Public Accounting Firm.

33

Exhibit
Number	Description
31.1*	Certification of the Chief Executive Officer of Psychiatric Solutions, Inc. Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2*	Certification of the Chief Accounting Officer of Psychiatric Solutions, Inc. Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1*	Certifications of the Chief Executive Officer and Chief Accounting Officer of Psychiatric Solutions, Inc. Pursuant to Rule 13a-14(b) of the Securities Exchange Act of 1934, as amended, and 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

*	Filed herewith
†	Management contract or compensatory plan or arrangement

34

PSYCHIATRIC SOLUTIONS, INC.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

	PAGE
Report of Independent Registered Public Accounting Firm		F-2
Management’s Report on Internal Control over Financial Reporting		F-3
Report of Independent Registered Public Accounting Firm		F-4
Consolidated Financial Statements:
Consolidated Balance Sheets, December 31, 2006 and 2005		F-5
Consolidated Statements of Income for the years ended December 31, 2006, 2005 and 2004		F-6
Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2006, 2005 and 2004		F-7
Consolidated Statements of Cash Flows for the years ended December 31, 2006, 2005 and 2004		F-8
Notes to Consolidated Financial Statements		F-10

F-1

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders of Psychiatric Solutions, Inc.

We have audited the accompanying consolidated balance sheets of Psychiatric Solutions, Inc. as of December 31, 2006 and 2005, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. 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 the standards of the Public Company Accounting Oversight Board (United States). 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 Psychiatric Solutions, Inc. at December 31, 2006 and 2005, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.

As discussed in Note 1 to the consolidated financial statements, the Company adopted SFAS No. 123(R), Share-Based Payment, effective January 1, 2006.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Psychiatric Solutions, Inc.’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 26, 2007 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

Nashville, Tennessee
February 26, 2007

F-2

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Accounting Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2006 based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on that evaluation, our management concluded that our internal control over financial reporting was effective as of December 31, 2006.

On December 1, 2006, we purchased the capital stock of Alternative Behavioral Services, Inc. (“ABS”). We have excluded all of ABS from our assessment of and conclusion on the effectiveness of our internal control over financial reporting. During 2006, ABS contributed approximately $14.6 million, or 1.4% of our net revenue, and, as of December 31, 2006, accounted for approximately $58.3 million or 7.1% of our total assets, excluding goodwill.

Management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in its report which is included elsewhere herein.

F-3

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders of Psychiatric Solutions, Inc.

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that Psychiatric Solutions, Inc. maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Psychiatric Solutions, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

As indicated in the accompanying Management’s Report on Internal Control Over Financial Reporting, management’s assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of Alternative Behavioral Services, Inc., which is included in the 2006 consolidated financial statements of Psychiatric Solutions, Inc. and constituted $208.6 million and $179.2 million of total and net assets, respectively, as of December 31, 2006 and $14.6 million and $.8 million of revenues and net income, respectively, for the year then ended. Our audit of internal control over financial reporting of Psychiatric Solutions, Inc. also did not include an evaluation of the internal control over financial reporting of Alternative Behavioral Services, Inc.

In our opinion, management’s assessment that Psychiatric Solutions, Inc. maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Psychiatric Solutions, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Psychiatric Solutions, Inc. as of December 31, 2006 and 2005 and the related consolidated statements of income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2006 of Psychiatric Solutions, Inc. and our report dated February 26, 2007 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

Nashville, Tennessee
February 26, 2007

F-4

PSYCHIATRIC SOLUTIONS, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands)

	December 31,
	2006			2005
ASSETS
Current assets:
Cash and cash equivalents	$	18,541		$	54,700
Accounts receivable, less allowance for doubtful accounts of $18,903 and $15,355, respectively		180,137			132,288
Prepaids and other		44,582			52,142
Total current assets		243,260			239,130
Property and equipment:
Land		118,787			79,139
Buildings		418,174			289,946
Equipment		55,328			37,968
Less accumulated depreciation		(48,483	)		(28,891	)
		543,806			378,162
Cost in excess of net assets acquired		761,026			526,536
Other assets		33,104			31,203
Total assets	$	1,581,196		$	1,175,031
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	25,294		$	18,726
Salaries and benefits payable		66,438			46,872
Other accrued liabilities		45,855			34,363
Current portion of long-term debt		2,386			325
Total current liabilities		139,973			100,286
Long-term debt, less current portion		740,921			482,064
Deferred tax liability		44,924			32,151
Other liabilities		27,599			20,818
Total liabilities		953,417			635,319
Stockholders’ equity:
Common stock, $0.01 par value, 125,000 shares authorized; 53,421 and 52,430 issued and outstanding, respectively		534			524
Additional paid-in capital		523,193			495,768
Retained earnings		104,052			43,420
Total stockholders’ equity		627,779			539,712
Total liabilities and stockholders’ equity	$	1,581,196		$	1,175,031

See accompanying notes.

F-5

PSYCHIATRIC SOLUTIONS, INC.

CONSOLIDATED STATEMENTS OF INCOME

(in thousands, except for per share amounts)

	Year Ended December 31,
	2006			2005		2004
Revenue	$	1,026,490		$	715,324	$	470,969
Salaries, wages and employee benefits (including share- based compensation of $12,535 for the year ended December 31, 2006		580,223			392,309		254,897
Professional fees		97,613			73,177		52,200
Supplies		59,310			42,993		29,717
Rentals and leases		13,685			11,450		8,876
Other operating expenses		95,759			74,609		52,767
Provision for doubtful accounts		19,586			13,498		10,794
Depreciation and amortization		20,619			14,738		9,808
Interest expense		40,307			27,056		18,964
Loss on refinancing long-term debt		—			21,871		6,407
		927,102			671,701		444,430
Income from continuing operations before income taxes		99,388			43,623		26,539
Provision for income taxes		37,507			16,805		10,085
Income from continuing operations		61,881			26,818		16,454
(Loss) income from discontinued operations, net of income tax (benefit) provision of $(724), $211 and $213 for 2006, 2005 and 2004, respectively		(1,249	)		336		347
Net income		60,632			27,154		16,801
Accrued preferred stock dividends		—			—		663
Net income available to common stockholders	$	60,632		$	27,154	$	16,138
Basic earnings per share:
Income from continuing operations	$	1.17		$	0.60	$	0.54
(Loss) income from discontinued operations, net of taxes		(0.02	)		0.01		0.01
Net income	$	1.15		$	0.61	$	0.55
Diluted earnings per share:
Income from continuing operations	$	1.14		$	0.58	$	0.47
(Loss) income from discontinued operations, net of taxes		(0.02	)		0.01		0.01
Net income	$	1.12		$	0.59	$	0.48
Shares used in computing per share amounts:
Basic		52,953			44,792		29,140
Diluted		54,169			46,296		35,146

See accompanying notes.

F-6

PSYCHIATRIC SOLUTIONS, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(in thousands)

					Additional		Notes			Accumulated
	Common Stock				Paid-In		Receivable from			Unrealized			Retained
	Shares		Amount		Capital		Stockholders			Losses			Earnings		Total
Balance at December 31, 2003		23,873	$	239	$	91,303	$	(338	)	$	(4	)	$	128	$	91,328
Issuance of common stock		6,570		66		104,625		—			—			—		104,691
Conversion of series A convertible preferred stock		9,627		96		25,819										25,915
Payment of notes receivable from stockholders		—		—		—		338			—			—		338
Exercise of stock options and warrants		865		8		4,420		—			—			—		4,428
Income tax benefit of stock option exercises		—		—		1,673		—			—			—		1,673
Unrealized gain on investments available for sale		—		—		—		—			4			—		4
Net income available to common stockholders		—		—		—		—			—			16,138		16,138
Balance at December 31, 2004		40,935		409		227,840		—			—			16,266		244,515
Issuance of common stock, net of issuance costs		8,050		81		191,917		—			—			—		191,998
Common stock issued in acquisition		2,726		27		64,738		—			—			—		64,765
Exercise of stock options		719		7		6,378		—			—			—		6,385
Income tax benefit of stock option exercises		—		—		4,895		—			—			—		4,895
Net income		—		—		—		—			—			27,154		27,154
Balance at December 31, 2005		52,430		524		495,768		—			—			43,420		539,712
Share-based compensation		—		—		12,535		—			—			—		12,535
Common stock issued in acquisition		130		1		4,276		—			—			—		4,277
Exercise of stock options and grant of restricted stock, net of issuance costs		861		9		6,260		—			—			—		6,269
Income tax benefit of stock option exercises		—		—		4,354		—			—			—		4,354
Net income		—		—		—		—			—			60,632		60,632
Balance at December 31, 2006		53,421	$	534	$	523,193	$	—		$	—		$	104,052	$	627,779

See accompanying notes.

F-7

PSYCHIATRIC SOLUTIONS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

	Year Ended December 31,
	2006			2005			2004
Operating activities:
Net income	$	60,632		$	27,154		$	16,801
Adjustments to reconcile net income to net cash provided by continuing operating activities:
Depreciation and amortization		20,619			14,738			9,808
Amortization of loan costs		1,672			1,187			691
Stock based compensation		12,535			—			—
Loss on refinancing long-term debt		—			21,871			6,407
Change in income tax assets and liabilities		35,322			9,494			6,920
Loss (income) from discontinued operations, net of taxes		1,249			(336	)		(347	)
Changes in operating assets and liabilities, net of effect of acquisitions:
Accounts receivable		(12,723	)		(9,399	)		(3,066	)
Prepaids and other current assets		(9,243	)		(3,673	)		2,388
Accounts payable		312			2,116			(5,327	)
Salaries and benefits payable		5,786			2,598			5,199
Accrued liabilities and other liabilities		5,839			13,340			391
Other		—			463			—
Net cash provided by continuing operating activities		122,000			79,553			39,865
Net cash provided by discontinued operating activities		1,707			222			295
Net cash provided by operating activities		123,707			79,775			40,160
Investing activities:
Cash paid for acquisitions, net of cash acquired		(385,078	)		(514,525	)		(136,495	)
Capital purchases of leasehold improvements, equipment and software		(33,816	)		(21,750	)		(17,201	)
Purchases of short-term investments		—			(29,400	)		—
Sales of short-term investments		—			29,400			—
Sale of long-term securities		—			—			953
Cash paid for investments in equity method investees		—			(1,340	)		—
Other assets		(594	)		1,219			(1,417	)
Net cash used in investing activities		(419,488	)		(536,396	)		(154,160	)

(Continued)

F-8

PSYCHIATRIC SOLUTIONS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

	Year Ended December 31,
	2006			2005			2004
Financing activities:
Net increase in revolving credit facility, less acquisitions	$	101,000		$	—		$	—
Borrowings on long-term debt		150,000			545,000			—
Principal payments on long-term debt		(465	)		(236,822	)		(810	)
Payment of loan and issuance costs		(1,576	)		(13,932	)		(2,300	)
Refinancing of long-term debt		—			(15,398	)		(3,844	)
Excess tax benefit from share based payment arrangements		4,354			—			—
Proceeds from public offering of common stock		—			192,637			104,691
Proceeds from exercises of common stock options		6,309			6,385			4,428
Proceeds from repayment of stockholder notes		—			—			338
Net cash provided by financing activities		259,622			477,870			102,503
Net (decrease) increase in cash		(36,159	)		21,249			(11,497	)
Cash and cash equivalents at beginning of the year		54,700			33,451			44,948
Cash and cash equivalents at end of the year	$	18,541		$	54,700		$	33,451
Supplemental Cash Flow Information:
Interest paid	$	40,177		$	16,694		$	18,821
Income taxes (refunded) paid	$	(2,656	)	$	7,490		$	3,354
Effect of Acquisitions:
Assets acquired, net of cash acquired	$	432,533		$	624,821		$	148,345
Cash paid for prior year acquisitions		—			5,793			—
Liabilities assumed		(32,819	)		(51,324	)		(11,850	)
Common stock issued		(4,277	)		(64,765	)		—
Long-term debt assumed		(10,359	)		—			—
Cash paid for acquisitions, net of cash acquired	$	385,078		$	514,525		$	136,495
Significant Non-cash Transactions:
Refinancing of long-term debt	$	—		$	6,473		$	2,563
Issuance of common stock upon conversion of series A convertible preferred stock	$	—		$	—		$	25,915

See accompanying notes.

F-9

PSYCHIATRIC SOLUTIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2006

1. Summary of Significant Accounting Policies

     Description of Business

Psychiatric Solutions, Inc. was incorporated in 1988 as a Delaware corporation and has its corporate office in Franklin, Tennessee. Psychiatric Solutions, Inc. and its subsidiaries (“we,” “us” or “our”) are a leading provider of inpatient behavioral health care services in the United States. Through our owned and leased facilities, we operated 74 owned or leased inpatient behavioral health care facilities with approximately 8,400 beds in 29 states, Puerto Rico and the U.S. Virgin Islands at December 31, 2006. In addition, our management contract segment manages inpatient behavioral health care units for third parties.

     Recent Developments

On December 20, 2006, we signed a definitive merger agreement to acquire Horizon Health Corporation (NASDAQ: HORC) (“Horizon Health”) in a transaction valued at $426 million, consisting of cash of $20 per share totaling $321 million and the assumption of Horizon Health’s outstanding debt. Horizon Health produced revenues of $275 million for its 2006 fiscal year, which ended August 31, 2006, primarily through the operation and management of inpatient behavioral health care facilities and units. At November 30, 2006, Horizon Health owned or leased 15 inpatient facilities with approximately 1,561 beds in 11 states. Horizon Health also provided services under 115 behavioral health and physical rehabilitation program management contracts with acute care hospitals at November 30, 2006 and operated an employee assistance program services business. Consummation of the transaction is subject to customary closing conditions, including regulatory approvals, clearance under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 (“Hart-Scott-Rodino Act”) and approval by Horizon Health’s stockholders. On February 12, 2007, we received a request for additional information (commonly referred to as a “Second Request”) from the Federal Trade Commission (“FTC”) in connection with the pending acquisition. The Second Request extends the waiting period imposed by the Hart-Scott-Rodino Act. The Second Request relates to two markets. The companies intend to respond expeditiously to the Second Request and are working with the FTC to resolve its concerns. Consummation of the transaction is expected during the second quarter of 2007.

     Basis of Presentation

The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. The majority of our expenses are “cost of revenue” items. Costs that could be classified as general and administrative expenses at our corporate office, excluding stock-based compensation expense, were approximately 3% of net revenue for the year ended December 31, 2006.

The consolidated financial statements include the accounts of Psychiatric Solutions, Inc. and its subsidiaries. All significant intercompany balances and transactions are eliminated in consolidation.

All shares and per share amounts have been adjusted to reflect a 2-for-1 stock split which was completed on January 9, 2006.

     Cash and Cash Equivalents

Cash consists of demand deposits held at financial institutions. We place our cash in financial institutions that are federally insured. At December 31, 2006, the majority of our cash is deposited with two financial institutions. Cash equivalents are short-term investments with original maturities of three months or less.

     Accounts Receivable

Accounts receivable vary according to the type of service being provided. Accounts receivable for our owned and leased facilities segment is comprised of patient service revenue and is recorded net of allowances for contractual discounts and estimated doubtful accounts. Such amounts are owed by various governmental agencies, insurance companies and private patients. Medicare comprised approximately 12% and 10% of net patient receivables for our owned and leased facilities segment at December 31, 2006 and 2005, respectively. Medicaid comprised approximately 32% and 36% of net patient receivables for our owned and leased facilities segment at December 31, 2006 and 2005, respectively. Concentration of credit risk from other payors is reduced by the large number of patients and payors.

Accounts receivable for our management contract segment is comprised of contractually determined fees for services rendered. Such amounts are recorded net of estimated allowances for doubtful accounts. Concentration of credit risk is reduced by the large number of customers.

F-10

PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006

     Allowance for Doubtful Accounts

Our ability to collect outstanding patient receivables from third party payors is critical to our operating performance and cash flows.

The primary collection risk with regard to patient receivables is uninsured patient accounts or patient accounts for which primary insurance has paid, but the portion owed by the patient remains outstanding. We estimate the allowance for doubtful accounts primarily based upon the age of the accounts since the patient discharge date. We continually monitor our accounts receivable balances and utilize cash collection data to support our estimates of the provision for doubtful accounts. Significant changes in payor mix or business office operations could have a significant impact on our results of operations and cash flows.

     Allowances for Contractual Discounts

The Medicare and Medicaid regulations are complex and various managed care contracts may include multiple reimbursement mechanisms for different types of services provided in our inpatient facilities and cost settlement provisions requiring complex calculations and assumptions subject to interpretation. We estimate the allowance for contractual discounts on a payor-specific basis given our interpretation of the applicable regulations or contract terms. The services authorized and provided and related reimbursement are often subject to interpretation that could result in payments that differ from our estimates. Additionally, updated regulations and contract renegotiations occur frequently necessitating continual review and assessment of the estimation process by our management.

     Income Taxes

We account for income taxes under the asset and liability method. Under this method, deferred tax assets and liabilities are determined based upon differences between the financial statement carrying amounts and tax bases of assets and liabilities and are measured using the enacted tax laws that will be in effect when the differences are expected to reverse. A valuation allowance for deferred tax assets is established when we believe that it is more likely than not that the deferred tax asset will not be realized.

     Long-Lived Assets

     Property and Equipment

Property and equipment are stated at cost and depreciated using the straight-line method over the useful lives of the assets, which range from 25 to 35 years for buildings and improvements and 2 to 7 years for equipment. Leasehold improvements are amortized on a straight-line basis over the shorter of the lease term or estimated useful lives of the assets. Depreciation expense was $19.8 million, $14.0 million and $8.8 million for the years ended December 31, 2006, 2005 and 2004, respectively. Depreciation expense includes the amortization of assets recorded under capital leases.

     Cost in Excess of Net Assets Acquired (Goodwill)

We account for acquisitions using the purchase method of accounting. Goodwill is generally allocated to reporting units based on operating results. Goodwill is reviewed at least annually for impairment. Potential impairment is noted for a reporting unit if its carrying value exceeds the fair value of the reporting unit. For those reporting units that we have identified with potential impairment of goodwill, we determine the implied fair value of goodwill. If the carrying value of goodwill exceeds its implied fair value, an impairment loss is recorded. Our annual impairment test of goodwill in 2006 and 2005 resulted in no goodwill impairment.

The following table presents the changes in the carrying amount of goodwill for the years ended December 31, 2006 and 2005 (in thousands):

Balance at December 31, 2004	$	128,962
Acquisition of Ardent Behavioral		393,017
Release of deferred tax asset valuation allowance		(395	)
Other		4,952
Balance at December 31, 2005		526,536
Acquisition of National Deaf Academy		32,524
Acquisition of Alternative Behavioral Services		148,332
Other Acquisitions		53,634
Balance at December 31, 2006	$	761,026

     Other Assets

Other assets include contracts that represent the fair value of inpatient management contracts and service contracts purchased and are

F-11

PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006

being amortized using the straight-line method over their estimated life, which is between 4 years and 5 years. At December 31, 2006 and 2005, contracts totaled $0.7 million and $1.4 million and are net of accumulated amortization of $2.6 million and $2.0 million, respectively. Amortization expense related to contracts was $0.7 million, $0.7 million and $1.0 million for the years ended December 31, 2006, 2005 and 2004, respectively. Estimated amortization expense for the year ended December 31, 2007 of contracts is approximately $0.7 million.

When events, circumstances and operating results indicate that the carrying values of certain long-lived assets and the related identifiable intangible assets might be impaired, we prepare projections of the undiscounted future cash flows expected to result from the use of the assets and their eventual disposition. If the projections indicate that the recorded amounts are not expected to be recoverable, such amounts are reduced to estimated fair value. Fair value is estimated based upon projections of discounted cash flows.

Other assets also include loan costs that are deferred and amortized over the term of the related debt. Loan costs at December 31, 2006 and 2005 totaled $13.8 million and $13.9 million and are net of accumulated amortization of $3.3 million and $1.6 million, respectively. The weighted average amortization period for loan costs incurred in 2006 is approximately 4 years. Amortization expense related to loan costs, which is reported as interest expense, was approximately $1.7 million, $1.2 million and $0.7 million for the years ended December 31, 2006, 2005 and 2004, respectively. Estimated amortization expense of loan costs for the years ended December 31, 2007, 2008, 2009, 2010 and 2011 is $2.1 million, $2.1 million, $2.2 million, $1.5 million and $1.6 million, respectively.

     Other Accrued Liabilities

At December 31, 2006 and 2005, we had approximately $10.9 million and $10.6 million, respectively, of accrued interest expense in other accrued liabilities.

     Stock-Based Compensation

We adopted Statement on Financial Accounting Standards (“SFAS”) No. 123 (Revised 2004), Share Based Payment (“SFAS 123R”), under the modified-prospective transition method on January 1, 2006. SFAS 123R requires companies to measure and recognize the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value. Share-based compensation recognized under the modified-prospective transition method of SFAS 123R includes share-based compensation based on the grant-date fair value determined in accordance with the original provisions of SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), for all share-based payments granted prior to and not yet vested as of January 1, 2006 and share-based compensation based on the grant-date fair-value determined in accordance with SFAS 123R for all share-based payments granted on or after January 1, 2006. SFAS 123R eliminates the ability to account for the award of these instruments under the intrinsic value method prescribed by Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and allowed under the original provisions of SFAS 123. Prior to the adoption of SFAS 123R, we accounted for our stock option plans using the intrinsic value method in accordance with the provisions of APB Opinion No. 25 and related interpretations.

     Derivatives

We have entered into interest rate swap agreements to manage our exposure to fluctuations in interest rates. These interest rate swap agreements effectively convert $38.7 million of fixed-rate long-term debt to a LIBOR indexed variable rate instrument plus an agreed upon interest rate spread. Under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended (“SFAS 133”), we have designated our interest rate swap agreements as fair value hedges. Accordingly, the changes in the fair value of the interest rate swaps are recorded as interest expense. If our derivatives were deemed to be cash flow hedges under SFAS 133, changes in the fair value of the derivatives would be recognized as other comprehensive income and recorded on the income statement in the period when the hedged item affects earnings. We believe our interest rate swap agreements to be highly effective in offsetting fair value changes in our hedged fixed-rate long-term debt.

     Risk Management

We are subject to medical malpractice and other lawsuits due to the nature of the services we provide. At December 31, 2006, all of our operations have professional and general liability insurance in umbrella form for claims in excess of a $3.0 million self-insured retention with an insured excess limit of $50.0 million. The self-insured reserves for professional and general liability risks are calculated based on historical claims, demographic factors, industry trends, severity factors, and other actuarial assumptions calculated by an independent third-party actuary. This self-insurance reserve is discounted to its present value using a 5% discount rate. This estimated accrual for professional and general liabilities could be significantly affected should current and future occurrences differ from historical claim trends and expectations. We have utilized our captive insurance company to manage the self-insured retention. While claims are monitored closely when estimating professional and general liability accruals, the complexity of the claims and wide

F-12

PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006

range of potential outcomes often hampers timely adjustments to the assumptions used in these estimates. The reserve for professional and general liability was approximately $18.1 million and $13.8 million as of December 31, 2006 and 2005, respectively.

We carry statutory workers’ compensation insurance from an unrelated commercial insurance carrier. Our statutory workers’ compensation program is fully insured with a $350,000 deductible per accident. We believe that adequate provision has been made for workers’ compensation and professional and general liability risk exposures. The reserve for workers’ compensation liability was approximately $18.7 million and $13.5 million as of December 31, 2006 and 2005, respectively.

     Fair Value of Financial Instruments

The carrying amounts reported in the accompanying Consolidated Balance Sheets for cash, accounts receivable, and accounts payable approximate their fair value given the short-term maturity of these instruments. At December 31, 2006, the carrying value and fair value of our 7³/₄% Senior Subordinated Notes (the “7³/₄% Notes”) was $220 million and $218.6 million, respectively, and the carrying value and fair value of our 10⁵/₈% Senior Subordinated Notes (the “10⁵/₈% Notes”) was $38.7 million and $42.4 million, respectively. At December 31, 2005, the carrying value and fair value of our 7³/₄% Notes was $220 million and $227.4 million, respectively, and the carrying value and fair value of our 10⁵/₈% Notes was $38.7 million and $44.0 million, respectively.

     Reclassifications

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

     Recent Accounting Pronouncements

In June 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”). FIN 48 applies to all tax positions accounted for under SFAS No. 109, Accounting for Income Taxes, defines the confidence level that a tax position must meet in order to be recognized in the financial statements and requires additional disclosures. FIN 48 is effective for us as of the interim reporting period beginning January 1, 2007. We are currently evaluating the effect that the adoption of FIN 48 will have on our consolidated results of operations and financial condition

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. We expect to adopt SFAS 157 effective January 1, 2008. We have not fully evaluated the impact the adoption of SFAS 157 will have, if any, on our consolidated financial statements.

2. Revenue

Revenue consists of the following amounts (in thousands):

	December 31,
	2006		2005		2004
Patient service revenue	$	973,535	$	663,236	$	419,701
Management contract and other revenue		52,955		52,088		51,268
Total revenue	$	1,026,490	$	715,324	$	470,969

Patient Service Revenue

Patient service revenue is generated by our inpatient facilities as a result of providing services provided to patients on an inpatient and outpatient basis. Patient service revenue is recorded at our established billing rates less contractual adjustments. Generally, collection in full is not expected on our established billing rates. Contractual adjustments are recorded to state our patient service revenue at the amount we expect to collect for the services provided based on amounts reimbursable by Medicare or Medicaid under provisions of cost or prospective reimbursement formulas or amounts due from other third-party payors at contractually determined rates. During the years ended December 31, 2006 and 2005, approximately 36% and 35%, respectively, of our revenue was obtained from providing services to patients participating in the Medicaid program. During the years ended December 31, 2006 and 2005, approximately 13% of our revenue was obtained from providing services to patients participating in the Medicare program.

We provide care without charge to patients who are financially unable to pay for the health care services they receive. Because we do not pursue collection of amounts determined to qualify as charity care, they are not reported as revenue. Settlements under cost reimbursement agreements with third-party payors are estimated and recorded in the period in which the related services are rendered and are adjusted in future periods as final settlements are determined. Final determination of amounts earned under the Medicare and

F-13

PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006

Medicaid programs often occur in subsequent years because of audits by such programs, rights of appeal and the application of numerous technical provisions.

Our revenue is particularly sensitive to regulatory and economic changes in the State of Texas. At December 31, 2006, we operated ten inpatient facilities in Texas. At December 31, 2005 and 2004, we operated eight inpatient facilities in Texas. We generated approximately 17%, 19% and 28% of our revenue from our Texas operations for the years ended December 31, 2006, 2005 and 2004, respectively.

Management Contract and Other Revenue

Our inpatient management contract and other segment primarily provides inpatient psychiatric management and development services to hospitals and clinics. Services provided are recorded as management contract revenue in the period the services are provided at contractually determined rates, provided that collectibility of such amounts is reasonably assured.

3. Earnings Per Share

SFAS No. 128, Earnings per Share (“SFAS 128”), requires dual presentation of basic and diluted earnings per share by entities with complex capital structures. Basic earnings per share includes no dilution and is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution of securities that could share in the earnings of the entity. We have calculated earnings per share in accordance with SFAS 128 for all periods presented.

The following table sets forth the computation of basic and diluted earnings per share (in thousands, except per share amounts):

F-14

PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006

	Year ended December 31,
	2006			2005		2004
Numerator:
Basic earnings per share:
Income from continuing operations	$	61,881		$	26,818	$	16,454
Accrued dividends on series A convertible preferred stock		—			—		663
Income from continuing operations used in computing basic earnings per share		61,881			26,818		15,791
(Loss) income from discontinued operations, net of taxes		(1,249	)		336		347
Net income available to common stockholders	$	60,632		$	27,154	$	16,138
Diluted earnings per share:
Income from continuing operations	$	61,881		$	26,818	$	16,454
(Loss) income from discontinued operations, net of taxes		(1,249	)		336		347
Net income used in computing diluted earnings per share	$	60,632		$	27,154	$	16,801
Denominator:
Weighted average shares outstanding for basic earnings per share		52,953			44,792		29,140
Effects of dilutive stock options and warrants outstanding		1,216			1,504		1,139
Effect of dilutive series A convertible preferred stock outstanding		—			—		4,867
Shares used in computing diluted earnings per common share		54,169			46,296		35,146
Basic earnings per share:
Income from continuing operations	$	1.17		$	0.60	$	0.54
(Loss) income from discontinued operations, net of taxes		(0.02	)		0.01		0.01
	$	1.15		$	0.61	$	0.55
Diluted earnings per share:
Income from continuing operations	$	1.14		$	0.58	$	0.47
(Loss) income from discontinued operations, net of taxes		(0.02	)		0.01		0.01
	$	1.12		$	0.59	$	0.48

4. Discontinued Operations

SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, requires that all components of an entity that have been disposed of (by sale, by abandonment or in a distribution to owners) or are held for sale and whose cash flows can be clearly distinguished from the rest of the entity be presented as discontinued operations. We terminated three of our contracts to manage state-owned inpatient facilities during 2006, two of our contracts during 2005 and three of our contracts during 2004. The operations of these contracts were previously reported within our management contract segment. In 2006, we sold a therapeutic boarding school, previously reported within our owned and leased facilities segment. Accordingly, these operations, net of applicable income taxes, have been presented as discontinued operations and prior period consolidated financial statements have been reclassified.

The components of (loss) income from discontinued operations, net of taxes, are as follows (in thousands):

F-15

PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006

	Year Ended December 31,
	2006			2005		2004
Revenue	$	2,085		$	14,911	$	26,904
Salaries, wages and employee benefits		1,597			10,331		18,646
Professional fees		116			836		2,039
Supplies		226			1,318		2,329
Rentals and leases		97			256		295
Other operating expenses		1,882			1,398		2,877
Provision for doubtful accounts		118			68		80
Depreciation and amortization		22			109		78
Interest expense		—			48		—
		4,058			14,364		26,344
(Loss) income from discontinued operations before income taxes		(1,973	)		547		560
(Benefit) provision for income taxes		(724	)		211		213
(Loss) income from discontinued operations, net of income taxes	$	(1,249	)	$	336	$	347

5. Acquisitions

     2006 ACQUISITIONS

During 2006, we completed the acquisitions of 19 inpatient behavioral health care facilities with an aggregate of 1,900 beds, including the December 1, 2006 purchase of the capital stock of Alternative Behavioral Services, Inc. (“ABS”), which owns and operates nine inpatient facilities. Each acquisition was accounted for by the purchase method. The aggregate purchase prices of these transactions were allocated to the assets acquired and liabilities assumed based upon their respective fair values. The consolidated financial statements include the accounts and operations of the acquired entities for the period subsequent to the acquisition date. As the acquisition of ABS involved the acquisition of stock, the goodwill associated with this acquisition is not deductible for federal income tax purposes. The purchase price allocation for ABS and certain other 2006 acquisitions is preliminary as of December 31, 2006, pending final measurement of certain assets and liabilities related to the acquisitions.

The following table summarizes the preliminary allocation of the aggregate purchase price of ABS at December 31, 2006 (in thousands):

	ABS
Assets acquired:
Accounts receivable	$	23,579
Other current assets		7,542
Fixed assets		62,852
Costs in excess of net assets acquired		148,332
Other assets		2,249
		244,554
Liabilities assumed		26,848
Common stock issued		4,277
Cash paid, net of cash acquired	$	213,429

     2005 ACQUISITIONS

On July 1, 2005, we acquired Ardent Health Services, Inc. (“Ardent Behavioral”), an owner and operator of 20 inpatient behavioral health care facilities. This acquisition was accounted for by the purchase method. The aggregate purchase price of this transaction was allocated to the assets acquired and liabilities assumed based upon their respective fair values. The consolidated financial statements include the accounts and operations of the acquired entities for the period subsequent to the acquisition date. As the acquisition of

F-16

PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006

Ardent Behavioral involved the acquisition of stock, the goodwill associated with this acquisition is not deductible for federal income tax purposes.

The following table summarizes the allocation of the aggregate purchase price of the aforementioned acquisition (in thousands):

	Ardent
	Behavioral
Assets acquired:
Accounts receivable	$	47,670
Other current assets		23,436
Fixed assets		152,355
Costs in excess of net assets acquired		393,017
Other assets		4,601
		621,079
Liabilities assumed		50,114
Common stock issued		64,765
Cash paid, net of cash acquired	$	506,200

     2004 ACQUISITIONS

During 2004, we acquired two inpatient behavioral health care facilities from Brentwood Behavioral Health (“Brentwood”) and four inpatient behavioral health care facilities from Heartland Healthcare (“Heartland”). These acquisitions were accounted for by the purchase method. The aggregate purchase price of these transactions was allocated to the assets acquired and liabilities assumed based upon their respective fair values. The consolidated financial statements include the accounts and operations of the acquired entities for periods subsequent to the respective acquisition dates. The goodwill associated with the other acquisitions during 2004 is deductible for federal income tax purposes.

The following table summarizes the allocation of the aggregate purchase price of the aforementioned acquisitions (in thousands):

	Brentwood		Heartland		Other		Total
Assets acquired:
Accounts receivable	$	4,086	$	8,637	$	4,999	$	17,722
Other current assets		214		166		692		1,072
Fixed assets		27,868		17,563		14,175		59,606
Costs in excess of net assets acquired		3,956		44,714		18,604		67,274
Other assets		1,899		30		115		2,044
		38,023		71,110		38,585		147,718
Liabilities assumed		7,087		4,481		3,632		15,200
Cash paid, net of cash acquired	$	30,936	$	66,629	$	34,953	$	132,518

     Other Information

The following represents the unaudited pro forma results of consolidated operations as if the aforementioned acquisitions from 2005 and 2004 had occurred at the beginning of the immediate preceding period, after giving effect to certain adjustments, including the depreciation and amortization of the assets acquired based upon their fair values and changes in interest expense resulting from changes in consolidated debt:

	2005		2004
Revenue	$	877,275	$	810,875
Net income available to common stockholders		34,515		25,430
Earnings per common share, basic	$	0.75	$	0.80

The pro forma information for the years ended December 31, 2005 and 2004 includes losses from refinancing long-term debt of approximately $21.9 million and $6.4 million, respectively. The pro forma information given does not purport to be indicative of what our results of operations would have been if the acquisitions had in fact occurred at the beginning of the periods presented, and is not intended to be a projection of the impact on future results or trends.

F-17

PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006

6. Long-term debt

Long-term debt consists of the following (in thousands):

	December 31,
	2006		2005
Senior credit facility:
Revolving line of credit facility, expiring on December 21, 2009 and bearing interest of 6.7% at December 31, 2006	$	101,000	$	—
Senior secured term loan facility, expiring on July 1, 2012 and bearing interest of 7.1% at December 31, 2006		350,000		200,000
7 3/4% Notes		220,000		220,000
10 5/8% Notes		38,681		38,681
Mortgage loans on facilities, maturing in 2036, 2037 and 2038 bearing fixed interest rates of 5.7% to 7.6%		27,062		23,377
Other		6,564		331
		743,307		482,389
Less current portion		2,386		325
Long-term debt	$	740,921	$	482,064

Senior Credit Facility

As a result of entering into a new credit agreement (the “Credit Agreement”) with Bank of America, N.A. (“Bank of America”) and terminating our former senior credit facility, we recorded a loss on refinancing long-term debt of $6.4 million during 2004. On December 21, 2004, our Credit Agreement with Bank of America was amended and restated to provide for a revolving credit facility of up to $150 million. On July 1, 2005, we amended and restated our Credit Agreement to include a $325 million senior secured term loan facility with Citicorp North America, Inc. We borrowed $325 million on the senior secured term loan facility on July 1, 2005 to finance a portion of the purchase price for the Ardent Behavioral acquisition. During the quarter ended September 30, 2005, we repaid $125 million of the senior secured term loan facility with a portion of the proceeds received from the sale of 8,050,000 shares of our common stock. On December 1, 2006, we amended our Credit Agreement to increase our senior secured term loan facility by $150 million and to increase our revolving credit facility to $300 million. On December 1, 2006, we borrowed $150 million under our senior secured term loan facility and $60 million under our revolving credit facility to finance the acquisition of ABS. Beginning March 31, 2007 until July 1, 2012, we must make quarterly principal payments of $375,000 on our senior secured term loan facility. At July 1, 2012, the balance of our senior secured term loan facility is payable in full.

Our Credit Agreement is secured by substantially all of the personal property owned by us or our subsidiaries, substantially all real property owned by us or our subsidiaries that has a value in excess of $5.0 million and the stock of our operating subsidiaries. In addition, the Credit Agreement is fully and unconditionally guaranteed by substantially all of our operating subsidiaries. The revolving credit facility and senior secured term loan facility accrue interest at our choice of the “Base Rate” or the “Eurodollar Rate” (as defined in the Credit Agreement) and are due December 21, 2009 and July 1, 2012, respectively. The “Base Rate” and “Eurodollar Rate” fluctuate based upon market rates and certain leverage ratios, as defined in the Credit Agreement. At December 31, 2006, we had $101 million in borrowings outstanding and $198.4 million available for future borrowings under the revolving credit facility. Until the maturity date, we may borrow, repay and re-borrow an amount not to exceed $300 million on our revolving credit facility. All repayments made under the senior secured term loan facility are permanent. We pay a quarterly commitment fee of 0.25% per annum on the unused portion of our revolving credit facility. Commitment fees were approximately $0.7 million for the year ended December 31, 2006.

Our Credit Agreement contains customary covenants that include: (1) a limitation on capital expenditures and investments, sales of assets, mergers, changes of ownership, new principal lines of business, indebtedness, transactions with affiliates, dividends and redemptions; (2) various financial covenants; and (3) cross-default covenants triggered by a default of any other indebtedness of at least $5.0 million. As of December 31, 2006, we were in compliance with all debt covenant requirements. If we violate one or more of these covenants, amounts outstanding under the revolving credit facility, senior secured term loan facility and the majority of our other debt arrangements could become immediately payable and additional borrowings could be restricted.

F-18

PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006

7³/₄% Notes

On July 6, 2005, we issued $220 million in 7³/₄% Notes, which are fully and unconditionally guaranteed on a senior subordinated basis by substantially all of our existing operating subsidiaries. Proceeds from the issuance of these notes were used to repay indebtedness on the $150 million bridge loan, which financed a portion of the purchase price for the acquisition of Ardent Behavioral, and to repay approximately $61.3 million of our 10⁵/₈% Notes. Interest on these notes accrues at the rate of 7³/₄% per annum and is payable semi-annually in arrears on January 15 and July 15, commencing on January 15, 2006. The 7³/₄% Notes will mature on July 15, 2015.

10⁵/₈% Notes

On June 30, 2003, we issued $150 million in 10⁵/₈% Notes, which are fully and unconditionally guaranteed on a senior subordinated basis by substantially all of our existing operating subsidiaries. Interest on these notes accrues at the rate of 10⁵/₈% per annum and is payable semi-annually in arrears on June 15 and December 15. The 10⁵/₈% Notes will mature on June 15, 2013.

On January 14, 2005, we redeemed $50 million of our 10⁵/₈% Notes and paid a 10⁵/₈% penalty and related accrued interest on the amount redeemed. We borrowed $30 million under our revolving line of credit and used cash on hand for the remainder of the redemption. We classified $20 million of the 10⁵/₈% Notes as current portion of long-term debt on December 31, 2004. On July 6, 2005, we repurchased approximately $61.3 million of our 10⁵/₈% Notes and paid a premium of approximately $8.6 million on the notes repurchased using proceeds from the issuance of our 7³/₄% Notes.

Mortgage Loans

During 2002 and 2003, we borrowed approximately $23.8 million under mortgage loan agreements insured by the U.S. Department of Housing and Urban Development (“HUD”). In connection with the purchase of real estate at a formerly leased inpatient facility, we assumed a mortgage loan agreement insured by HUD of approximately $4.0 million in 2006. The mortgage loans insured by HUD are secured by real estate located at Holly Hill Hospital in Raleigh, North Carolina, West Oaks Hospital in Houston, Texas, Riveredge Hospital near Chicago, Illinois, and Canyon Ridge Hospital in Chino, California. Interest accrues on the Holly Hill, West Oaks, Riveredge, and Canyon Ridge HUD loans at 6.0%, 5.9%, 5.7%, and 7.6% and principal and interest are payable in 420 monthly installments through December 2037, September 2038, December 2038 and January 2036, respectively. The carrying amount of assets held as collateral approximated $29.6 million at December 31, 2006.

Other

The aggregate maturities of long-term debt, including capital lease obligations, are as follows (in thousands):

2007	$	2,386
2008		2,431
2009		103,345
2010		2,168
2011		2,155
Thereafter		630,822
Total	$	743,307

7. Series A Convertible Preferred Stock

In conjunction with our acquisitions of The Brown Schools, Inc. and Ramsay Youth Services, Inc., we issued 4,545,454 shares of our series A convertible preferred stock for $25.0 million in equal installments in April and June of 2003. Each share of series A convertible preferred stock was convertible into one share of our common stock. Holders of our series A convertible preferred stock were entitled to receive pay-in-kind dividends, compounded quarterly, equal to 5% per share of the original share price through March 31, 2005 and 7% per share of the original share price thereafter. Because we may have been required to redeem the series A convertible preferred stock upon certain change of control events that may not have been within our control, the series A convertible preferred stock was classified outside of our permanent stockholders’ equity. During the year ended December 31, 2004, the holders of our series A convertible preferred stock converted all shares of series A convertible preferred stock and related accrued dividends into 9,626,940 shares of our common stock.

8. Leases

At December 31, 2006, future minimum lease payments under operating leases having an initial or remaining non-cancelable lease

F-19

PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006

term in excess of one year are as follows (in thousands):

2007	$	10,405
2008		8,825
2009		7,676
2010		5,019
2011		3,173
Thereafter		16,160
Total	$	51,258

9. Income Taxes

Total provision for income taxes for the years ended December 31, 2006, 2005 and 2004 was allocated as follows (in thousands):

	2006			2005		2004
Provision for income taxes attributable to income from continuing operations	$	37,507		$	16,805	$	10,085
(Benefit from) provision for income taxes attributable to income from discontinued operations		(724	)		211		213
Total provision for income taxes	$	36,783		$	17,016	$	10,298

The provision for (benefit from) income taxes attributable to income from continuing operations consists of the following (in thousands):

	2006		2005			2004
Current:
Federal	$	10,127	$	(1,802	)	$	9,820
State		2,394		2,701			1,609
Foreign		219		—			—
		12,740		899			11,429
Deferred:
Federal		24,132		16,580			(1,279	)
State		342		(908	)		(244	)
Foreign		293		234			179
		24,767		15,906			(1,344	)
Provision for income taxes	$	37,507	$	16,805		$	10,085

The tax benefits associated with nonqualified stock options decreased the current tax liability by $5.2 million, $4.3 million, and $2.2 million in 2006, 2005 and 2004, respectively. Such benefits were recorded as increases to stockholders’ equity.

The reconciliation of income tax computed by applying the U.S. federal statutory rate to the actual income tax (benefit) expense attributable to income from continuing operations is as follows (in thousands):

	2006		2005		2004
Federal tax	$	34,786	$	15,268	$	9,289
State income taxes (net of federal)		1,779		1,165		887
Other		942		372		(91	)
Provision for income taxes	$	37,507	$	16,805	$	10,085

Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The tax effects of significant items comprising temporary differences at December 31, 2006 and 2005 are as follows (in thousands):

F-20

PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006

	2006			2005
Deferred tax assets:
Net operating loss carryforwards	$	11,708		$	34,370
Allowance for doubtful accounts		3,562			5,067
Alternative minimum tax credit carryovers		1,150			1,601
Accrued liabilities		14,027			12,603
Total gross deferred tax assets		30,447			53,641
Less: Valuation allowance		(2,988	)		(4,053	)
Total deferred tax assets		27,459			49,588
Deferred tax liabilities:
Intangible assets		(16,404	)		(11,092	)
Property and equipment		(43,690	)		(40,252	)
Net deferred tax liability	$	(32,635	)	$	(1,756	)

Deferred income taxes of $12.4 million and $30.4 million at December 31, 2006 and 2005, respectively, are included in other current assets. Noncurrent deferred income tax liabilities totaled $44.9 million and $32.2 million at December 31, 2006 and 2005, respectively. In connection with the Ardent Behavioral acquisition, we recorded net deferred tax assets of approximately $12.1 million as of December 31, 2005, with a corresponding reduction in goodwill. Ardent Behavioral’s final income tax returns for the period ending on the acquisition date had not been completed at the time of that filing. We completed the determination of deferred tax assets and liabilities resulting from the Ardent Behavioral acquisition in 2006 after Ardent Behavioral filed its final income tax returns for the period ended July 1, 2005. As a result, we reduced net deferred tax assets from the Ardent Behavioral acquisition by $4.0 million, with a corresponding increase in goodwill.

Current accounting standards generally accepted in the United States (“GAAP”) require that deferred income taxes reflect the tax consequences of differences between the tax bases of assets and liabilities and their carrying values for GAAP. Future tax benefits are recognized to the extent that realization of such benefits is more likely than not. A valuation allowance is established for those benefits that do not meet the more likely than not criteria. We have evaluated the need for a valuation allowance against deferred tax assets and have recorded valuation allowances of $3.0 million, $4.1 million and $3.4 million at December 31, 2006, 2005 and 2004, respectively. The net change in valuation allowance was a decrease of $1.1 million for the year ended December 31, 2006 and an increase of $0.6 million for the year ended December 31, 2005. The valuation allowance reported as of December 31, 2006 of $3.0 million relates primarily to amounts recorded in various acquisitions and any subsequent reductions to this valuation allowance would reduce goodwill. Reductions in valuation allowances of $0.4 million and $0.2 million during the years ended December 31, 2006 and December 31, 2005, respectively, were allocated to reduce goodwill.

As of December 31, 2006, we had federal net operating loss carryforwards of $15.8 million expiring in the years 2018 through 2022, state net operating loss carryforwards of $99.8 million expiring in various years through 2026, foreign net operating loss carryforwards of $2.9 million expiring through 2011 and an alternative minimum tax credit carryover of approximately $1.1 million available to reduce future federal income taxes.

10. Stock Option Plans

The Psychiatric Solutions, Inc. Equity Incentive Plan (the “Equity Incentive Plan”) was amended at our 2006 Annual Meeting of Stockholders to increase the number of shares of our common stock subject to grant under the Equity Incentive Plan to 11,116,666 from 9,866,666. Under the Equity Incentive Plan, options or other stock based compensation may be granted for terms of up to ten years. Grants to employees are generally exercisable in annual increments of 25% each year, commencing on the date of grant or one year after the date of grant. The exercise prices of stock options are equal to the closing sales prices of our common stock on the date of grant or the trading day immediately preceding the date of grant.

A maximum of 683,334 shares of our common stock are authorized for grant as stock options under the Psychiatric Solutions, Inc. Outside Directors’ Stock Option Plan (the “Directors’ Plan”). The Director’s Plan provides for a grant of 8,000 stock options at each annual meeting of stockholders to each outside director at the fair market value of our common stock on the trading day immediately preceding the date of grant. The Directors’ Plan also provides for an initial grant of 12,000 stock options to each new outside director on the date of the director’s initial election or appointment to the board of directors. The options vest 25% on the grant date and 25% on the succeeding three anniversaries of the grant date and generally have terms of ten years.

Stock option activity during 2006 is as follows (number of options and aggregate intrinsic value in thousands):

F-21

PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006

						Weighted
				Weighted		Average
	Number			Average		Remaining		Aggregate
	of			Exercise		Contractual		Intrinsic
	Options			Price		Term (in years)		Value
Outstanding at December 31, 2005		4,472		$	13.01		n/a		n/a
Granted		2,134		$	32.75		n/a		n/a
Canceled		(144	)	$	17.31		n/a		n/a
Exercised		(807	)	$	7.82		n/a		n/a
Outstanding at December 31, 2006		5,655		$	20.76		8.0	$	94,780
Exercisable at December 31, 2006		2,355		$	14.34		7.3	$	54,579

We recognized approximately $12.5 million in share-based compensation expense and approximately $4.7 million of related income tax benefit for the year ended December 31, 2006. Share-based compensation expense for the year ended December 31, 2006 includes $2.2 million recorded in the quarter ended March 31, 2006 resulting from reversing the cancellation and accelerating the vesting of 89,014 stock options previously granted to our former Chief Operating Officer. Remaining share-based compensation expense was recorded as a result of adopting SFAS 123R. The impact of share-based compensation expense, net of tax, on our basic and diluted earnings per share was approximately $0.14 per share for the year ended December 31, 2006, respectively. Also as a result of adopting SFAS 123R, we classified $4.4 million in income tax benefits in excess of share-based compensation expense on stock options exercised in 2006 as a cash flow from financing activities in our Condensed Consolidated Statement of Cash Flows for the year ended December 31, 2006. Prior to the adoption of SFAS 123R, income tax benefits in excess of share-based compensation expense recognized on stock options exercised were classified as cash flows from operations. The fair value of our stock options was estimated using the Black-Scholes option pricing model. We recognize expense on all share-based awards on a straight-line basis over the requisite service period of the entire award.

For periods presented prior to the adoption of SFAS 123R, pro forma information regarding net income and earnings per share as required by SFAS 123R has been determined as if we had accounted for our employee stock options under the original provisions of SFAS 123. The fair value of these options was estimated using the Black-Scholes option pricing model. For purposes of pro forma disclosure, the estimated fair value of the options is amortized to expense over the option’s vesting period. Our pro forma information follows (in thousands, except per share amounts):

	2005		2004
Net income available to common stockholders	$	27,154	$	16,138
Pro forma compensation expense from stock options, net of tax		4,361		1,691
Pro forma net income	$	22,793	$	14,447
Basic earnings per share:
As reported	$	0.61	$	0.55
Pro forma	$	0.51	$	0.50
Diluted earnings per share:
As reported	$	0.59	$	0.48
Pro forma	$	0.49	$	0.43

The following table summarizes the weighted average grant-date fair values of options and the weighted average assumptions we used to develop the fair value estimates under each of the option valuation models for options granted in the years ended December 31, 2006, 2005 and 2004:

	2006			2005			2004
Weighted average grant-date fair value of options	$	9.96		$	7.73		$	3.66
Risk-free interest rate		5	%		4	%		3	%
Expected volatility		31	%		33	%		32	%
Expected life		4			5			5
Dividend yield		0	%		0	%		0	%

Our estimate of expected volatility for stock options granted in 2006 is based upon the historical volatility of our common stock. Our estimate of expected volatility for stock options granted prior to 2006 is based upon the historical volatility of comparable companies.

F-22

PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006

Our estimate of expected term is based upon our historical stock option exercise experience.

Based on our stock option and restricted stock grants outstanding at December 31, 2006, we estimate remaining unrecognized share-based compensation expense to be approximately $17.7 million with a weighted average remaining amortization period of 2.6 years.

The total intrinsic value, which represents the difference between the underlying stock’s market price and the option’s exercise price, of options exercised during the years ended December 31, 2006, 2005 and 2004 was $19.4 million, $11.8 million and $6.6 million, respectively.

Prior to 2006, we had not granted any shares of restricted stock. During February and March 2006, we granted 55,000 shares of restricted stock to certain executive officers. These shares of restricted stock vest 25% on each anniversary of the grant date and had a weighted-average grant-date fair value of $33.11 per share.

11. Employee Benefit Plan

We sponsor the Psychiatric Solutions, Inc. Retirement Savings Plan (the “Plan”). The Plan is a tax-qualified profit sharing plan with a cash or deferred arrangement whereby employees who have completed three months of service and are age 21 or older are eligible to participate. The Plan allows eligible employees to make contributions of 1% to 85% of their annual compensation, subject to annual limitations. The Plan enables us to make discretionary contributions into each participants’ account that fully vest over a four year period based upon years of service.

12. Contingencies and Health Care Regulation

     Contingencies

We are subject to various claims and legal actions which arise in the ordinary course of business. We have professional liability insurance to protect against such claims or legal actions. We believe the ultimate resolution of such matters will be adequately covered by insurance and will not have a material adverse effect on our financial position or results of operations.

     Employment Agreements

Effective August 6, 2002, we entered into a Second Amended and Restated Employment Agreement with Joey A. Jacobs, our Chairman, Chief Executive Officer and President. The Second Amended and Restated Employment Agreement was amended on November 26, 2003. Mr. Jacobs’ agreement provides for an annual base salary and an annual cash incentive compensation award tied to objective criteria as established by the Board of Directors. The employment agreement had an initial term through December 31, 2003 and automatically renews for one year periods absent 30 days prior notice from either party.

Mr. Jacobs’ employment agreement provides for various payments to Mr. Jacobs upon cessation of employment, depending on the circumstances. If we terminate Mr. Jacobs’s employment “without cause” or if he resigns pursuant to a constructive discharge, then (i) all options scheduled to vest during the succeeding 24 month period will immediately vest and will remain exercisable for 12 months from the date of termination, (ii) Mr. Jacobs will receive a cash payment equal to 200% of his base salary and bonus earned during the twelve months prior to termination, and (iii) all benefits and perquisites will continue for 18 months. In the event of a change in control, his employment agreement requires that we pay him 200% of his base salary and bonus earned in the twelve months prior to termination, paid out over a period of 24 months, and to continue all benefits and perquisites for 18 months.

     Current Operations

Final determination of amounts earned under prospective payment and cost-reimbursement arrangements is subject to review by appropriate governmental authorities or their agents. We believe adequate provision has been made for any adjustments that may result from such reviews.

Laws and regulations governing the Medicare and Medicaid programs are complex and subject to interpretation. We believe that we are in substantial compliance with all applicable laws and regulations and are not aware of any material pending or threatened investigations involving allegations of potential wrongdoing. While no material regulatory inquiries have been made, compliance with such laws and regulations can be subject to future government review and interpretation as well as significant regulatory action including fines, penalties, and exclusion from the Medicare and Medicaid programs.

We have acquired and may continue to acquire corporations and other entities with prior operating histories. Acquired entities may have unknown or contingent liabilities for failure to comply with health care laws and regulations, such as billing and reimbursement,

F-23

PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006

fraud and abuse and similar anti-referral laws. Although we attempt to assure ourselves that no such liabilities exist and obtain indemnification from prospective sellers covering such matters, there can be no assurance that any such matter will be covered by indemnification or, if covered, that the liability sustained will not exceed contractual limits or the financial capacity of the indemnifying party.

13. Related Party Transactions

In January 2000, PMR loaned Mark. P. Clein, PMR’s chief executive officer at the time and currently one of our directors, approximately $0.5 million pursuant to promissory notes for the purchase of stock in connection with the exercise of stock options (the “Stock Notes”). The Stock Notes, due December 31, 2004, bear interest at the rate of 6.21% per annum and are with recourse in addition to being secured by stock under pledge agreements. PMR also received promissory notes from Mr. Clein for up to approximately $0.3 million for tax liabilities related to the purchase of such stock (the “Tax Notes”). The Tax Notes, due December 31, 2004, bore interest at the rate of 6.21% and were secured by stock pledges, but were otherwise without recourse. During the third quarter of 2004, Mr. Clein repaid the remaining principal balance of approximately $0.3 million on the Stock Notes and Tax Notes.

William M. Petrie, M.D., a member of our Board of Directors, serves as President of Psychiatric Consultants, P.C. (“PCPC”), a practice group managed by us, and owns a 14% interest in PCPC. The initial term of the management agreement was for three years. It was renewed for additional three year terms on April 11, 2000, April 11, 2003, and April 11, 2006. The management agreement will continue to automatically renew for three year terms unless terminated by either party. Our management fee was for the years ended December 31, 2006, 2005 and 2004 was $0.1 million. At December 31, 2006 and 2005, PCPC owed us $0.1 million.

On February 4, 2003, our stockholders approved the private placement of $25 million of series A convertible preferred stock with affiliates of Oak Investment Partners and Salix Ventures and The 1818 Mezzanine Fund II, L.P. (“the 1818 Fund”). The 1818 Fund invested an aggregate of $1 million and received an aggregate of 181,818 shares of series A convertible preferred stock. Oak Investment Partners invested an aggregate of $20 million and received an aggregate of 3,636,364 shares of series A convertible preferred stock. Salix Ventures invested an aggregate of $4 million and received an aggregate of 727,272 shares of series A convertible preferred stock. One half of the series A convertible preferred stock was issued on April 1, 2003. The other half was issued on June 19, 2003. The 1818 Fund, Oak Investment Partners and Salix Ventures each had a representative who was a member of our board of directors when we sold the series A convertible preferred stock. The proceeds of the sale of the series A convertible preferred stock were used to acquire Ramsay, six facilities from The Brown Schools, and to pay down a portion of our long-term debt. During 2004, the holders of series A convertible preferred stock converted all outstanding shares of series A convertible preferred stock and related pay-in-kind dividends into 9,626,940 shares of our common stock.

14. Disclosures About Reportable Segments

In accordance with the criteria of SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information (“SFAS 131”), we operate two reportable segments: (1) owned and leased facilities and (2) management contracts and other. Each of our inpatient facilities and inpatient management contracts qualifies as an operating segment under SFAS 131; however, none is individually material. We have aggregated our operations into two reportable segments based on the characteristics of the services provided. As of December 31, 2006, the owned and leased facilities segment provides mental health and behavioral heath services to patients in its 66 owned and 8 leased inpatient facilities in 29 states, Puerto Rico and the U.S. Virgin Islands. The management contracts and other segment primarily provides inpatient psychiatric management and development services to inpatient behavioral health units in hospitals and clinics. Activities classified as “Corporate” in the following schedule relate primarily to unallocated home office items and discontinued operations.

Adjusted EBITDA is a non-GAAP financial measure and is defined as net income (loss) before discontinued operations, interest expense (net of interest income), income taxes, depreciation, amortization, stock compensation and other items included in the caption labeled “Other expenses.” These other expenses may occur in future periods, but the amounts recognized can vary significantly from period to period and do not directly relate to ongoing operations of our health care facilities. Our management relies on adjusted EBITDA as the primary measure to review and assess the operating performance of our inpatient facilities and their management teams. We believe it is useful to investors to provide disclosures of our operating results on the same basis as that used by management. Management and investors also review adjusted EBITDA to evaluate our overall performance and to compare our current operating results with corresponding periods and with other companies in the health care industry. You should not consider adjusted EBITDA in isolation or as a substitute for net income, operating cash flows or other cash flow statement data determined in accordance with U. S. generally accepted accounting principles. Because adjusted EBITDA is not a measure of financial performance under U. S. generally accepted accounting principles and is susceptible to varying calculations, it may not be comparable to similarly titled measures of other companies. The following is a financial summary by reportable segment for the periods indicated (dollars in thousands):

F-24

PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006

Year Ended December 31, 2006

	Owned and		Management
	Leased		Contracts
	Facilities		and Other		Corporate			Consolidated
Revenue	$	973,535	$	52,955	$	—		$	1,026,490
Adjusted EBITDA	$	192,328	$	9,090	$	(28,569	)	$	172,849
Interest expense, net		13,426		2		26,879			40,307
Provision for income taxes		—		—		37,507			37,507
Depreciation and amortization		18,666		693		1,260			20,619
Inter-segment expenses		28,770		1,913		(30,683	)		—
Other expenses:
Share-based compensation		—		—		12,535			12,535
Total other expenses		—		—		12,535			12,535
Income (loss) from continuing operations	$	131,466	$	6,482	$	(76,067	)	$	61,881
Total assets	$	1,457,449	$	50,934	$	72,813		$	1,581,196
Capital expenditures	$	28,838	$	89	$	4,889		$	33,816
Cost in excess of net assets acquired	$	730,995	$	30,031	$	—		$	761,026

Year Ended December 31, 2005

	Owned and		Management
	Leased		Contracts
	Facilities		and Other		Corporate			Consolidated
Revenue	$	663,236	$	52,088	$	—		$	715,324
Adjusted EBITDA	$	120,930	$	10,074	$	(23,716	)	$	107,288
Interest expense, net		16,406		—		10,650			27,056
Provision for income taxes		2,142		—		14,663			16,805
Depreciation and amortization		13,308		680		750			14,738
Inter-segment expenses		25,716		2,919		(28,635	)		—
Other expenses:
Loss on refinancing long-term debt		—		—		21,871			21,871
Total other expenses		—		—		21,871			21,871
Income (loss) from continuing operations	$	63,358	$	6,475	$	(43,015	)	$	26,818
Total assets	$	1,017,347	$	29,285	$	128,399		$	1,175,031
Capital expenditures	$	17,592	$	52	$	4,106		$	21,750
Cost in excess of net assets acquired	$	506,160	$	20,376	$	—		$	526,536

F-25

PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006

Year Ended December 31, 2004

	Owned and		Management
	Leased		Contracts
	Facilities		and Other			Corporate			Consolidated
Revenue	$	419,701	$	51,268		$	—		$	470,969
Adjusted EBITDA	$	66,351	$	10,007		$	(14,640	)	$	61,718
Interest expense, net		19,645		(15	)		(666	)		18,964
Provision for income taxes		2,737		—			7,348			10,085
Depreciation and amortization		8,366		1,082			360			9,808
Inter-segment expenses		11,471		2,968			(14,439	)		—
Other expenses:
Loss on refinancing long-term debt		—		—			6,407			6,407
Total other expenses		—		—			6,407			6,407
Income (loss) from continuing operations	$	24,132	$	5,972		$	(13,650	)	$	16,454
Total assets	$	401,633	$	31,217		$	63,834		$	496,684
Capital expenditures	$	15,632	$	—		$	1,569		$	17,201
Cost in excess of net assets acquired	$	105,121	$	23,841		$	—		$	128,962

15. Other Information

A summary of activity in allowance for doubtful accounts follows (in thousands):

	Balances		Additions		Additions		Accounts written		Balances
	at beginning		charged to costs		charged to		off, net of		at end
	of period		and expenses		other accounts (1)		recoveries		of period
Allowance for doubtful accounts:
Year ended December 31, 2004	$	7,083	$	10,794	$	3,253	$	10,468	$	10,662
Year ended December 31, 2005		10,662		13,498		5,844		14,649		15,355
Year ended December 31, 2006		15,355		19,586		12,224		28,262		18,903

(1) Allowances as a result of acquisition.

16. Quarterly Information (Unaudited)

Summarized results for each quarter in the years ended December 31, 2006 and 2005 are as follows (in thousands, except per share data):

	1st Quarter		2nd Quarter		3rd Quarter		4th Quarter
2006
Revenue	$	242,312	$	248,404	$	254,814	$	280,960
Income from continuing operations	$	12,398	$	15,869	$	15,570	$	18,044
Net income	$	12,192	$	15,361	$	15,524	$	17,555
Earnings per share:
Basic	$	0.23	$	0.29	$	0.29	$	0.33
Diluted	$	0.23	$	0.28	$	0.29	$	0.32
2005
Revenue	$	134,268	$	139,490	$	220,458	$	221,108
Income from continuing operations	$	3,196	$	8,746	$	1,076	$	13,800
Net income	$	3,328	$	8,707	$	1,179	$	13,940
Earnings per share:
Basic	$	0.08	$	0.21	$	0.03	$	0.27
Diluted	$	0.08	$	0.21	$	0.03	$	0.26

F-26

PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006

As discussed in Note 4, we terminated three of our contracts to manage state-owned inpatient facilities during 2006, two of our contracts during 2005 and three of our contracts during 2004. In 2006, we sold a therapeutic boarding school, previously reported within our owned and leased facilities segment. In accordance with SFAS 144, these operations, net of income tax, have been presented as discontinued operations and all prior quarterly data has been reclassified.

We incurred losses on refinancing long-term debt of approximately $7.0 million and $14.9 million during the first and third quarters of 2005, respectively.

17. Financial Information for the Company and Its Subsidiaries

We conduct substantially all of our business through our subsidiaries. Presented below is consolidated financial information for us and our subsidiaries as of December 31, 2006 and 2005, and for the years ended December 31, 2006, 2005 and 2004. The information segregates the parent company (Psychiatric Solutions, Inc.), the combined wholly-owned subsidiary guarantors, the combined non-guarantors, and eliminations. All of the subsidiary guarantees are both full and unconditional and joint and several.

Condensed Consolidating Balance Sheet
As of December 31, 2006
(Dollars in thousands)

				Combined							Total
				Subsidiary		Combined Non-		Consolidating			Consolidated
	Parent			Guarantors		Guarantors		Adjustments			Amounts
Current Assets:
Cash and cash equivalents	$	—		$	1,118	$	17,423	$	—		$	18,541
Accounts receivable, net		—			180,137		—		—			180,137
Prepaids and other		—			43,372		1,210		—			44,582
Total current assets		—			224,627		18,633		—			243,260
Property and equipment, net of accumulated depreciation		—			515,311		36,085		(7,590	)		543,806
Cost in excess of net assets acquired		—			761,026		—		—			761,026
Investment in subsidiaries		681,856			—		—		(681,856	)		—
Other assets		12,349			17,050		3,705		—			33,104
Total assets	$	694,205		$	1,518,014	$	58,423	$	(689,446	)	$	1,581,196
Current Liabilities:
Accounts payable	$	—		$	25,294	$	—	$	—		$	25,294
Salaries and benefits payable		—			66,438		—		—			66,438
Other accrued liabilities		13,247			32,461		1,737		(1,590	)		45,855
Current portion of long-term debt		2,084			—		302		—			2,386
Total current liabilities		15,331			124,193		2,039		(1,590	)		139,973
Long-term debt, less current portion		714,061			—		26,860		—			740,921
Deferred tax liability		—			44,924		—		—			44,924
Other liabilities		6,539			12,140		8,920		—			27,599
Total liabilities		735,931			181,257		37,819		(1,590	)		953,417
Stockholders’ (deficit) equity:
Total stockholders’ (deficit) equity		(41,726	)		1,336,757		20,604		(687,856	)		627,779
Total liabilities and stockholders’ (deficit) equity	$	694,205		$	1,518,014	$	58,423	$	(689,446	)	$	1,581,196

F-27

PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006

Condensed Consolidating Balance Sheet
As of December 31, 2005
(Dollars in thousands)

				Combined							Total
				Subsidiary		Combined Non-		Consolidating			Consolidated
	Parent			Guarantors		Guarantors		Adjustments			Amounts
Current Assets:
Cash and cash equivalents	$	—		$	44,115	$	10,585	$	—		$	54,700
Accounts receivable, net		—			132,288		—		—			132,288
Prepaids and other		—			52,142		—		—			52,142
Total current assets		—			228,545		10,585		—			239,130
Property and equipment, net of accumulated depreciation		—			356,816		29,179		(7,833	)		378,162
Cost in excess of net assets acquired		—			526,536		—		—			526,536
Investment in subsidiaries		444,888			—		—		(444,888	)		—
Other assets		12,441			15,347		3,415		—			31,203
Total assets	$	457,329		$	1,127,244	$	43,179	$	(452,721	)	$	1,175,031
Current Liabilities:
Accounts payable	$	—		$	18,726	$	—	$	—		$	18,726
Salaries and benefits payable		—			46,872		—		—			46,872
Other accrued liabilities		12,994			21,056		313		—			34,363
Current portion of long-term debt		77			—		248		—			325
Total current liabilities		13,071			86,654		561		—			100,286
Long-term debt, less current portion		458,935			—		23,129		—			482,064
Deferred tax liability		—			32,151		—		—			32,151
Other liabilities		3,011			9,544		8,263		—			20,818
Total liabilities		475,017			128,349		31,953		—			635,319
Stockholders’ (deficit) equity:
Total stockholders’ (deficit) equity		(17,688	)		998,895		11,226		(452,721	)		539,712
Total liabilities and stockholders’ (deficit) equity	$	457,329		$	1,127,244	$	43,179	$	(452,721	)	$	1,175,031

Condensed Consolidating Statement of Income
For the Year Ended December 31, 2006
(Dollars in thousands)

				Combined								Total
				Subsidiary			Combined Non-		Consolidating			Consolidated
	Parent			Guarantors			Guarantors		Adjustments			Amounts
Revenue	$	—		$	1,026,490		$	11,601	$	(11,601	)	$	1,026,490
Salaries, wages and employee benefits		—			580,223			—		—			580,223
Professional fees		—			96,590			1,023		—			97,613
Supplies		—			59,310			—		—			59,310
Rentals and leases		—			13,685			—		—			13,685
Other operating expenses		—			94,948			2,504		(1,693	)		95,759
Provision for doubtful accounts		—			19,586			—		—			19,586
Depreciation and amortization		—			19,773			1,089		(243	)		20,619
Interest expense		39,105			—			1,202		—			40,307
		39,105			884,115			5,818		(1,936	)		927,102
(Loss) income from continuing operations before income taxes		(39,105	)		142,375			5,783		(9,665	)		99,388
(Benefit from) provision for income taxes		(15,067	)		52,457			117		—			37,507
(Loss) income from continuing operations		(24,038	)		89,918			5,666		(9,665	)		61,881
(Loss) income from discontinued operations, net of taxes		—			(1,249	)		—		—			(1,249	)
Net (loss) income	$	(24,038	)	$	88,669		$	5,666	$	(9,665	)	$	60,632

F-28

PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006

Condensed Consolidating Statement of Income
For the Year Ended December 31, 2005
(Dollars in thousands)

				Combined							Total
				Subsidiary		Combined Non-		Consolidating			Consolidated
	Parent			Guarantors		Guarantors		Adjustments			Amounts
Revenue	$	—		$	715,324	$	11,073	$	(11,073	)	$	715,324
Salaries, wages and employee benefits		—			392,309		—		—			392,309
Professional fees		—			72,703		474		—			73,177
Supplies		—			42,993		—		—			42,993
Rentals and leases		—			11,450		—		—			11,450
Other operating expenses		—			73,808		8,313		(7,512	)		74,609
Provision for doubtful accounts		—			13,498		—		—			13,498
Depreciation and amortization		—			14,005		976		(243	)		14,738
Interest expense		25,823			—		1,233		—			27,056
Loss on refinancing long-term debt		21,871			—		—		—			21,871
		47,694			620,766		10,996		(7,755	)		671,701
(Loss) income from continuing operations before income taxes		(47,694	)		94,558		77		(3,318	)		43,623
(Benefit from) provision for income taxes		(18,376	)		35,181		—		—			16,805
(Loss) income from continuing operations		(29,318	)		59,377		77		(3,318	)		26,818
Income from discontinued operations, net of taxes		—			336		—		—			336
Net (loss) income	$	(29,318	)	$	59,713	$	77	$	(3,318	)	$	27,154

Condensed Consolidating Statement of Income
For the Year Ended December 31, 2004
(Dollars in thousands)

				Combined							Total
				Subsidiary		Combined Non-		Consolidating			Consolidated
	Parent			Guarantors		Guarantors		Adjustments			Amounts
Revenue	$	—		$	470,969	$	3,702	$	(3,702	)	$	470,969
Salaries, wages and employee benefits		—			254,897		—		—			254,897
Professional fees		—			52,142		58		—			52,200
Supplies		—			29,717		—		—			29,717
Rentals and leases		—			8,876		—		—			8,876
Other operating expenses		—			52,757		618		(608	)		52,767
Provision for doubtful accounts		—			10,794		—		—			10,794
Depreciation and amortization		—			9,076		975		(243	)		9,808
Interest expense		17,469			—		1,495		—			18,964
Loss on refinancing long-term debt		6,407			—		—		—			6,407
		23,876			418,259		3,146		(851	)		444,430
(Loss) income from continuing operations before income taxes		(23,876	)		52,710		556		(2,851	)		26,539
(Benefit from) provision for income taxes		(9,073	)		19,158		—		—			10,085
(Loss) income from continuing operations		(14,803	)		33,552		556		(2,851	)		16,454
Income from discontinued operations, net of taxes		—			347		—		—			347
Net (loss) income		(14,803	)		33,899		556		(2,851	)		16,801
Accrued preferred stock dividends		663			—		—		—			663
Net (loss) income available to common stockholders	$	(15,466	)	$	33,899	$	556	$	(2,851	)	$	16,138

F-29

PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006

Condensed Consolidating Statement of Cash Flows
For the Year Ended December 31, 2006
(Dollars in thousands)

				Combined
				Subsidiary			Combined Non-			Consolidating			Total Consolidated
	Parent			Guarantors			Guarantors			Adjustments			Amounts
Operating activities:
Net (loss) income	$	(24,038	)	$	88,669		$	5,666		$	(9,665	)	$	60,632
Adjustments to reconcile net (loss) income to net cash (used in) provided by operating activities:
Depreciation and amortization		—			19,773			1,089			(243	)		20,619
Amortization of loan costs		1,627			—			45			—			1,672
Stock based compensation		—			12,535			—			—			12,535
Change in income tax assets and liabilities		—			35,205			117			—			35,322
Loss from discontinued operations		—			1,249			—			—			1,249
Changes in operating assets and liabilities, net of effect of acquisitions:
Accounts receivable		—			(12,723	)		—			—			(12,723	)
Prepaids and other current assets		—			(10,453	)		1,210			—			(9,243	)
Accounts payable		—			312			—			—			312
Salaries and benefits payable		—			5,786			—			—			5,786
Accrued liabilities and other liabilities		(1,366	)		5,050			2,155			—			5,839
Net cash (used in) provided by continuing operating activities		(23,777	)		145,403			10,282			(9,908	)		122,000
Net cash provided by discontinued operating activities		—			1,707			—			—			1,707
Net cash (used in) provided by operating activities		(23,777	)		147,110			10,282			(9,908	)		123,707
Investing activities:
Cash paid for acquisitions, net of cash acquired		(385,078	)		—			—			—			(385,078	)
Capital purchases of leasehold improvements, equipment and software		—			(33,816	)		—			—			(33,816	)
Other assets		—			(611	)		17			—			(594	)
Net cash (used in) provided by investing activities		(385,078	)		(34,427	)		17			—			(419,488	)
Financing activities:
Net increase in revolving credit facility, less acquisitions		101,000			—			—			—			101,000
Borrowings on long-term debt		150,000			—			—			—			150,000
Principal payments on long-term debt		(187	)		—			(278	)		—			(465	)
Net transfers to and from members		153,309			(160,034	)		(3,183	)		9,908			—
Payment of loan and issuance costs		(1,576	)		—			—			—			(1,576	)
Excess tax benefits from share-based payment arrangements		—			4,354			—			—			4,354
Proceeds from exercises of common stock options		6,309			—			—			—			6,309
Net cash provided by (used in) financing activities		408,855			(155,680	)		(3,461	)		9,908			259,622
Net (decrease) increase in cash		—			(42,997	)		6,838			—			(36,159	)
Cash and cash equivalents at beginning of year		—			44,115			10,585			—			54,700
Cash and cash equivalents at end of year	$	—		$	1,118		$	17,423		$	—		$	18,541

F-30

PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006

Condensed Consolidating Statement of Cash Flows
For the Year Ended December 31, 2005
(Dollars in thousands)

				Combined
				Subsidiary			Combined Non-			Consolidating			Total Consolidated
	Parent			Guarantors			Guarantors			Adjustments			Amounts
Operating activities:
Net (loss) income	$	(29,318	)	$	59,713		$	77		$	(3,318	)	$	27,154
Adjustments to reconcile net (loss) income to net cash provided by (used in) operating activities:
Depreciation and amortization		—			14,005			976			(243	)		14,738
Amortization of loan costs		1,140			—			47			—			1,187
Loss on refinancing long-term debt		21,871			—			—			—			21,871
Change in income tax assets and liabilities		—			9,494			—			—			9,494
Income from discontinued operations		—			(336	)		—			—			(336	)
Changes in operating assets and liabilities, net of effect of acquisitions:
Accounts receivable		—			(9,399	)		—			—			(9,399	)
Prepaids and other current assets		—			(4,647	)		974			—			(3,673	)
Accounts payable		—			2,116			—			—			2,116
Salaries and benefits payable		—			2,598			—			—			2,598
Accrued liabilities and other liabilities		10,965			(4,519	)		6,894			—			13,340
Other		—			463			—			—			463
Net cash provided by (used in) continuing operating activities		4,658			69,488			8,968			(3,561	)		79,553
Net cash provided by discontinued operating activities		—			222			—			—			222
Net cash provded by (used in) operating activities		4,658			69,710			8,968			(3,561	)		79,775
Investing activities:
Cash paid for acquisitions, net of cash acquired		(514,525	)		—			—			—			(514,525	)
Capital purchases of property and equipment		—			(21,750	)		—			—			(21,750	)
Purchases of short-term investments		(29,400	)		—			—			—			(29,400	)
Sales of short-term investments		29,400			—			—			—			29,400
Cash paid for investments in equity method investees		—			(1,340	)		—			—			(1,340	)
Other assets		—			1,115			104			—			1,219
Net cash (used in) provided by investing activities		(514,525	)		(21,975	)		104			—			(536,396	)
Financing activities:
Borrowings on long-term debt		545,000			—			—			—			545,000
Principal payments on long-term debt		(236,587	)		—			(235	)		—			(236,822	)
Net transfers to and from members		31,762			(34,608	)		(715	)		3,561			—
Payment of loan and issuance costs		(13,932	)		—			—			—			(13,932	)
Refinancing of long-term debt		(15,398	)		—			—			—			(15,398	)
Proceeds from public offering of common stock		192,637			—			—			—			192,637
Proceeds from exercises of common stock options		6,385			—			—			—			6,385
Net cash provided by (used in) financing activities		509,867			(34,608	)		(950	)		3,561			477,870
Net increase in cash		—			13,127			8,122			—			21,249
Cash and cash equivalents at beginning of year		—			30,988			2,463			—			33,451
Cash and cash equivalents at end of year	$	—		$	44,115		$	10,585		$	—		$	54,700

F-31

PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006

Condensed Consolidating Statement of Cash Flows
For the Year Ended December 31, 2004
(Dollars in thousands)

				Combined
				Subsidiary			Combined Non-			Consolidating			Total Consolidated
	Parent			Guarantors			Guarantors			Adjustments			Amounts
Operating Activities:
Net (loss) income	$	(14,803	)	$	33,899		$	556		$	(2,851	)	$	16,801
Adjustments to reconcile net income (loss) to net cash (used in) provided by operating activities:
Depreciation and amortization		—			9,076			975			(243	)		9,808
Amortization of loan costs		691			—			—			—			691
Loss on refinancing long-term debt		6,407			—			—			—			6,407
Change in income tax assets and liabilities		—			6,920			—			—			6,920
Income from discontinued operations, net of taxes		—			(347	)		—			—			(347	)
Changes in operating assets and liabilities, net of effect of acquisitions:
Accounts receivable		—			(2,110	)		(956	)		—			(3,066	)
Prepaids and other current assets		—			2,388			—			—			2,388
Accounts payable		—			(5,327	)		—			—			(5,327	)
Salaries and benefits payable		—			5,199			—			—			5,199
Accrued liabilities and other liabilities		(363	)		149			605			—			391
Net cash (used in) provided by continuing operating activities		(8,068	)		49,847			1,180			(3,094	)		39,865
Net cash provided by discontinued operating activities		—			295			—			—			295
Net cash (used in) provided by operating activities		(8,068	)		50,142			1,180			(3,094	)		40,160
Investing Activities:
Cash paid for acquisitions, net of cash acquired		(136,495	)		—			—			—			(136,495	)
Capital purchases of property and equipment		—			(17,100	)		(101	)		—			(17,201	)
Sale of long-term securities		—			—			953			—			953
Other assets		—			(2,758	)		1,341			—			(1,417	)
Net cash (used in) provided by continuing investing activities		(136,495	)		(19,858	)		2,193			—			(154,160	)
Financing Activities:
Principal payments on long-term debt		(810	)		—			—			—			(810	)
Net transfers to and from members		42,060			(42,746	)		(2,408	)		3,094			—
Payment of loan and issuance costs		(2,300	)		—			—			—			(2,300	)
Refinancing of long-term debt		(3,844	)		—			—			—			(3,844	)
Proceeds from public offering of common stock		104,691			—			—			—			104,691
Proceeds from exercises of common stock options		4,428			—			—			—			4,428
Proceeds from repayment of stockholder notes		338			—			—			—			338
Net cash provided by (used in) financing activities		144,563			(42,746	)		(2,408	)		3,094			102,503
Net (decrease) increase in cash		—			(12,462	)		965			—			(11,497	)
Cash and cash equivalents at beginning of year		—			43,450			1,498			—			44,948
Cash and cash equivalents at end of year	$	—		$	30,988		$	2,463		$	—		$	33,451

18. Subsequent Events

During January 2007, we completed the acquisition of Three Rivers Behavioral Health, an 86-bed inpatient psychiatric facility located in Columbia, South Carolina. We issued approximately 243,000 shares of our common stock to the sellers as a component of the purchase price of this facility.

F-32

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.

Psychiatric Solutions, Inc.
By:	/s/ Joey A. Jacobs
	Joey A. Jacobs
	Chief Executive Officer

Dated: February 27, 2007

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.

Signature	Title	Date
/s/ Joey A. Jacobs Joey A. Jacobs	Chairman of the Board, President and Chief Executive Officer (Principal Executive Officer)	February 27, 2007
/s/ Jack E. Polson Jack E. Polson	Executive Vice President, Chief Accounting Officer (Principal Financial and Accounting Officer)	February 27, 2007
/s/ William F. Carpenter III William F. Carpenter III	Director	February 27, 2007
/s/ Mark P. Clein Mark P. Clein	Director	February 27, 2007
/s/ David M. Dill David M. Dill	Director	February 27, 2007
/s/ Richard D. Gore Richard D. Gore	Director	February 27, 2007
/s/ Christopher Grant, Jr. Christopher Grant, Jr.	Director	February 27, 2007
/s/ William M. Petrie, M.D. William M. Petrie, M.D.	Director	February 27, 2007
/s/ Edward K. Wissing Edward K. Wissing	Director	February 27, 2007

EX-2.5

Exhibit 2.5

AGREEMENT AND PLAN OF MERGER

BY AND AMONG

PSYCHIATRIC SOLUTIONS, INC.,

PANTHER ACQUISITION SUB, INC.,

and

HORIZON HEALTH CORPORATION

Dated as of

December 20, 2006

TABLE OF CONTENTS

ARTICLE I DEFINED TERMS AND INTERPRETATION	1
Section 1.1. Certain Definitions	1
Section 1.2. Terms Defined Elsewhere	7
ARTICLE II THE MERGER	9
Section 2.1. The Merger	9
Section 2.2. Closing	10
Section 2.3. Certification Closing	10
Section 2.4. Effective Time	10
Section 2.5. Effect of the Merger	10
Section 2.6. Certificate of Incorporation; Bylaws	10
Section 2.7. Directors and Officers	11
ARTICLE III CONVERSION OF SECURITIES; EXCHANGE OF CERTIFICATES	11
Section 3.1. Conversion of Securities	11
Section 3.2. Exchange of Certificates	12
Section 3.3. Dissenters’ Rights	14
Section 3.4. Stock Transfer Books	14
Section 3.5. Company Equity Awards	14
ARTICLE IV REPRESENTATIONS AND WARRANTIES OF THE COMPANY	16
Section 4.1. Organization and Qualification; Subsidiaries	17
Section 4.2. Certificate of Incorporation and Bylaws; Corporate Books	17
Section 4.3. Capitalization; Subsidiaries	17
Section 4.4. Authority	18
Section 4.5. No Conflict; Required Filings and Consents	18
Section 4.6. Compliance with Laws	19
Section 4.7. SEC Filings; Financial Statements	21
Section 4.8. Benefit Plans; Employees and Employment Practices	22
Section 4.9. Company Material Contracts	23
Section 4.10. Litigation	24
Section 4.11. Environmental Matters	25
Section 4.12. Intellectual Property	25
Section 4.13. Taxes	25
Section 4.14. Insurance	27
Section 4.15. Real Estate	27
Section 4.16. Board Approval	27
Section 4.17. Brokers	28
Section 4.18. Absence of Certain Changes	28
Section 4.19. Transactions with Affiliates	28
Section 4.20. Company Information	28
ARTICLE V REPRESENTATIONS AND WARRANTIES OF PARENT AND MERGER SUB	29
Section 5.1. Organization and Qualification	29
Section 5.2. Certificate of Incorporation and Bylaws	29
Section 5.3. Authority	29
Section 5.4. Ownership of Merger Sub; No Prior Activities	29

i

Section 5.5. Financing	30
Section 5.6. Vote Required	30
Section 5.7. No Conflict; Required Filings and Consents	30
Section 5.8. SEC Filings; Financial Statements	31
Section 5.9. Licensing	31
Section 5.10. Litigation	31
Section 5.11. Brokers	32
Section 5.12. Ownership of Company Common Stock	32
Section 5.13. Solvency of the Surviving Corporation	32
Section 5.14. Parent Information	32
ARTICLE VI ADDITIONAL AGREEMENTS	33
Section 6.1. Conduct of Business Pending the Closing	33
Section 6.2. Proxy Statement; Company Stockholders’ Meeting	35
Section 6.3. Access to Information; Confidentiality	37
Section 6.4. No Solicitation of Transactions	38
Section 6.5. Reasonable Best Efforts	39
Section 6.6. Certain Notices	41
Section 6.7. Public Announcements	41
Section 6.8. Employee Matters	41
Section 6.9. Indemnification of Directors and Officers	43
Section 6.10. State Takeover Statutes	44
Section 6.11. Company Rights Agreement	45
Section 6.12. Section 16 Matters	45
Section 6.13. Confidentiality Agreement	45
Section 6.14. Investigation and Agreement by Parent and Merger Sub; No Other Representations or Warranties	45
ARTICLE VII CLOSING CONDITIONS
Section 7.1. Conditions to Obligations of Each Party Under This Agreement	46
Section 7.2. Additional Conditions to Obligations of Parent and Merger Sub	47
Section 7.3. Additional Conditions to Obligations of the Company	47
Section 7.4. Frustration of Closing Conditions	48
ARTICLE VIII TERMINATION, AMENDMENT AND WAIVER	48
Section 8.1. Termination	48
Section 8.2. Effect of Termination	50
Section 8.3. Fees and Expenses	50
Section 8.4. Termination Fee	50
Section 8.5. Specific Performance	51
Section 8.6. Extension; Waiver	51
Section 8.7. Amendment	51
ARTICLE IX GENERAL PROVISIONS	51
Section 9.1. Non-Survival of Representations and Warranties	51
Section 9.2. Notices	52
Section 9.3. Headings	53
Section 9.4. Severability	53

ii

Section 9.5. Entire Agreement	53
Section 9.6. Third-Party Beneficiaries	53
Section 9.7. Assignment	53
Section 9.8. Mutual Drafting	53
Section 9.9. Governing Law; Consent to Jurisdiction	54
Section 9.10. Counterparts	54

iii

EXHIBITS AND SCHEDULES

EXHIBITS

Exhibit A.1 List of Company Executives

Exhibit A.2 List of Parent and Merger Sub Executives

Exhibit B.1 Company Representatives for Access to Information

SCHEDULES

Company Disclosure Schedule

Schedule 3.5.1(a) Equity Compensation Plans

Schedule 3.5.1(b) Certain Persons Subject to Certain Tax Matters

Schedule 4.1 Subsidiaries

Schedule 4.3.2 Company Capitalization Matters

Schedule 4.3.3 Company Subsidiary Capitalization Matters

Schedule 4.5.1 Consents

Schedule 4.5.2 Governmental Entity Approvals

Schedule 4.6.1 Compliance With Laws

Schedule 4.6.2 Health Care Program Participation and Compliance

Schedule 4.6.4 Adverse Actions

Schedule 4.7.4 Internal Controls Matters

Schedule 4.8.1 Material Company Benefit Plans

Schedule 4.8.4 Existing Requirements to Continue Company Benefits

Schedule 4.8.7 Existing Company Payment Requirements as Result of Change of Control

Schedule 4.9 Material Contracts

Schedule 4.10 Litigation

Schedule 4.13 Tax Matters

Schedule 4.14 Insurance

Schedule 4.15 Real Estate

Schedule 4.18 Certain Company Changes

Schedule 6.1(f) Certain Permitted Pre-Closing Company Transactions

Schedule 6.1(k) Permitted Changes in Benefits; Severance Arrangements

Schedule 6.1(l) Certain Pending Claims

Schedule 6.8.1 Certain Actions Relating to Company Benefit Plans

Schedule 6.8.5(i) Executive Agreements

Parent Disclosure Schedule

Schedule 7.2.6 Consents Required by Parent

     The exhibits and schedules to this Agreement and Plan of Merger have been omitted from this filing pursuant to Item 601(b)(2) of Regulation S-K. The Company agrees to furnish supplementally to the Securities and Exchange Commission, upon request, a copy of any omitted exhibit or schedule to the Agreement and Plan of Merger.

iv

AGREEMENT AND PLAN OF MERGER

     THIS AGREEMENT AND PLAN OF MERGER, dated as of December 20, 2006, is by and among Psychiatric Solutions, Inc., a Delaware corporation (“Parent”), Panther Acquisition Sub, Inc., a Delaware corporation and wholly-owned direct Subsidiary of Parent (“Merger Sub”), and Horizon Health Corporation, a Delaware corporation (the “Company”).

     WHEREAS, the respective Boards of Directors of Parent, Merger Sub and the Company have approved and declared advisable the merger of Merger Sub with and into the Company (the “Merger”) upon the terms and subject to the conditions of this Agreement and Plan of Merger, including the exhibits attached hereto and the disclosure schedules delivered by the Company or Parent, as the case may be, to the other such Party concurrently with the execution and delivery of this Agreement (the “Agreement”), and in accordance with the General Corporation Law of the State of Delaware (as amended, the “DGCL”); and

     WHEREAS, Parent, Merger Sub and the Company wish to make certain representations, warranties, covenants and agreements in connection with the Merger and also to prescribe certain conditions to the Merger.

     NOW, THEREFORE, in consideration of the foregoing and the respective representations, warranties, covenants and agreements set forth in this Agreement and intending to be legally bound hereby, the Parties agree as follows:

ARTICLE I
DEFINED TERMS AND INTERPRETATION

     Section 1.1. Certain Definitions. For purposes of this Agreement, the term:

     “Affiliate” shall mean a Person that directly, or indirectly through one or more intermediaries, controls, is controlled by, or is under common control with the first-mentioned Person, where “control” shall mean the possession, directly or indirectly or as trustee or executor, of the power to direct or cause the direction of the management or policies of a Person, whether through the ownership of Equity Interests or as trustee or executor, by contract or otherwise.

     “Benefit Plan” shall mean any employment, consulting, severance, termination, retirement, profit sharing, bonus, incentive or deferred compensation, retention bonus or change in control agreement, pension, stock option, restricted stock or other equity-based benefit, profit sharing, savings, life, health, disability, accident, medical, insurance, vacation, paid time off, long-term care, executive or other employee allowance program, other welfare fringe benefit or other employee compensation or benefit plan, program, arrangement, agreement, fund or commitment, including any “employee benefit plan” as defined in Section 3(3) of ERISA and any program to which Section 6039D of the Code applies.

     “Blue Sky Laws” shall mean state securities or “blue sky” Laws.

1

     “Business Day” shall mean any day other than (i) a Saturday or Sunday or (ii) any day that is a legal holiday under the Laws of either of the States of Texas or New York or is a day on which banking institutions located in either of the States of Texas or New York are authorized or required by Law or other governmental action to close.

     “Code” shall mean the United States Internal Revenue Code of 1986, as amended.

     “Company Benefit Plan” shall mean any Benefit Plan for the benefit or welfare of any current or former director, officer or employee of the Company or any Company Subsidiary or under which the Company or any Company Subsidiary has any present or future liability to any current or former director, officer or employee of the Company or any Company Subsidiary.

     “Company Health Care Business” shall mean any of the Company Health Care Facilities or any health care business operated by the Company or any Company Subsidiary.

     “Company Health Care Facility” shall mean any health care facility that is leased or owned, and operated, by the Company or any Company Subsidiary.

     “Company Material Adverse Effect” shall mean any event, change, circumstance, state of facts or effect that has had a material adverse effect on (i) the business, properties, assets, results of operations or financial condition of the Company and the Company Subsidiaries taken as a whole or (ii) the ability of the Company to consummate the transactions contemplated by this Agreement. In no event shall any of the following (or the effects or consequences thereof) constitute a “Company Material Adverse Effect” or be considered in determining whether a “Company Material Adverse Effect” has occurred: (a) any event, occurrence, circumstance or trend, including a diminution in value, related to the Company, any Company Subsidiary, or any of its respective businesses, properties, assets, results of operations or financial condition that is described with reasonable specificity in the Company Disclosure Schedule or the Company SEC Filings filed prior to the date hereof, (b) any failure by the Company to meet any internal projections or forecasts or published revenue or earnings estimates or predictions for any period ending (or for which revenues or earnings are released) on or after the date hereof (it being understood, however, that any facts, events, changes or developments causing or contributing to such failures to meet expectations or projections may (unless addressed otherwise in this definition) constitute a Company Material Adverse Effect and may be taken into account in determining whether a Company Material Adverse Effect has occurred), (c) any change in Law or any interpretation thereof, including any change in federal or state health care program reimbursement laws, regulations, policies or procedures, or interpretations thereof, applicable or potentially applicable to the services rendered by or operations of, the Company or any of the Company Subsidiaries, in each case to the extent that such changes in Law or interpretations thereof do not have a disproportionate impact on the Company Health Care Businesses as compared to other companies in industries similar to the Company Health Care Businesses, (d) changes generally affecting the industries in which the Company or the Company Subsidiaries operate, in each case to the extent that such changes do not have a disproportionate impact on the Company Health Care Businesses as compared to other companies in industries similar to the Company Health Care Businesses, (e) changes in economic, market or political conditions in the United States, in any region thereof, or in any non-U.S. or global economy,

2

(f) acts of war (whether or not declared), sabotage or terrorism, military actions or the escalation thereof occurring on or after the date hereof, (g) changes in GAAP (or any interpretation thereof), and (h) if the provisions of Section 2.3 become applicable in accordance with the terms of Section 2.2, any event, change, circumstance, state of facts or effect arising or occurring after the Certification Date. Further, in no event shall any adverse effects or consequences suffered by the Company or any Company Subsidiary arising out of or relating to any of the following be considered or taken into account in determining whether a “Company Material Adverse Effect” has occurred: (x) any breach by Parent or Merger Sub of any provision of this Agreement, or (y) the provisions of Section 6.8.2 or Section 6.8.7 as the same relate to employees of the Company, the Surviving Corporation or any of their respective Subsidiaries, or the performance of or compliance with the provisions of Section 6.8.2 or Section 6.8.7.

     “Company Permits” shall mean all permits, licenses, franchises, certificates of occupancy, approvals, registrations, qualifications, rights, variances, permissive uses, accreditations, certificates, certificates of need, certifications, consents, contracts, interim licenses, permits and other authorizations of every nature whatsoever required by or issued under any Laws benefiting, relating to or affecting the Company, the Company Subsidiaries or any of the Company Health Care Businesses, or the construction, development, expansion, maintenance, management, use or operation thereof, or the operation of any programs or services in conjunction with any of the Company Health Care Businesses and all renewals, replacements and substitutions therefor, required or issued by any Governmental Entity.

     “Continuing Employee” shall mean any Person who is employed by the Company or any Company Subsidiary as of the Effective Time (including Persons on disability or leave of absence, whether paid or unpaid).

     “Contract” shall mean any note, bond, mortgage, indenture, lease, contract or other agreement.

     “Environmental Laws” shall mean any applicable Laws relating to pollution or protection of the environment (including ambient air, surface water, ground water, land surface or sub-surface strata), including Laws relating to emissions, discharges, releases or threatened releases of Materials of Environmental Concern, or otherwise relating to the use, treatment, storage, disposal, transport or handling of Materials of Environmental Concern.

     “Equity Interest” shall mean any share, capital stock, partnership, member or similar interest in any entity and any option, warrant, right or security convertible, exchangeable or exercisable therefor.

     “Exchange Act” shall mean the United States Securities Exchange Act of 1934, as amended, and the rules and regulations promulgated thereunder, as amended.

     “Expenses” shall mean all out-of-pocket expenses (including all fees and expenses of counsel, accountants, investment bankers, experts and consultants to a Party hereto) incurred by a Party or on its behalf in connection with or related to the sale of the Company or the transactions contemplated hereby, including expenses in connection with due diligence, the authorization, preparation, negotiation, execution and performance of this Agreement and the

3

transactions contemplated hereby, the preparation, printing, filing and mailing of the Proxy Statement and the solicitation of stockholder approval of this Agreement and the Merger.

     “GAAP” shall mean generally accepted accounting principles as applied in the United States.

     “Governmental Entity” shall mean any domestic or foreign governmental, administrative, judicial or regulatory authority or any entity acting as an agent for such authority, including fiscal intermediaries and carriers.

     “Group” shall have the meaning provided in Section 13(d) of the Exchange Act, except where the context otherwise requires.

     “HSR Act” shall mean the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, and the rules and regulations promulgated thereunder, as amended.

     “Indemnified Party” shall mean any present or former director, officer, employee or agent of the Company or any Company Subsidiary.

     “Intellectual Property” means, collectively, all (i) patents, (ii) trademarks, service marks, trade dress, logos, trade names, corporate names and domain names, (iii) copyrights and copyrightable works, and (iv) trade secrets.

     “Knowledge” shall mean (a) with respect to a natural Person, if such Person has actual knowledge, after reasonable investigation, of the fact or matter, (b) in the case of the Company, if any of the Persons listed on Exhibit A.1 has Knowledge of that fact or other matter (as set forth in (a) above), and (c) in the case of Parent or Merger Sub, if any of the Persons listed on Exhibit A.2 has Knowledge of that fact or other matter (as set forth in (a) above).

     “Law” shall mean any foreign or domestic law, statute, code, ordinance, rule, regulation or Order.

     “Lien” shall mean any mortgage, pledge, security interest, lien or encumbrance of any kind (including any conditional sale or other title retention agreement or lease in the nature thereof).

     “Materials of Environmental Concern” means chemicals, pollutants, contaminants, hazardous materials, hazardous substances and hazardous wastes, medical waste, toxic substances, petroleum and petroleum products and by-products, asbestos-containing materials, polychlorinated biphenyls and any other chemicals, pollutants, substances or wastes, in each case so defined, identified or regulated under any Environmental Law.

     “Medicaid” shall mean the medical assistance program established by Title XIX of the Social Security Act (42 U.S.C. Sections 1396 et seq., as amended) and any statute succeeding thereto.

4

     “Medicare” shall mean the health insurance program for the aged and disabled established by Title XVIII of the Social Security Act (42 U.S.C. Sections 1395 et seq., as amended) and any statute succeeding thereto.

     “Multiemployer Plan” shall mean any “multiemployer plan” within the meaning of Section 3(37) or 4001(a)(3) of ERISA.

     “NASDAQ” shall mean the Nasdaq Stock Market, LLC.

     “Order” shall mean any order, judgment, writ, stipulation, award, injunction, decree or arbitration award of any Governmental Entity.

     “Parent Health Care Business” shall mean any of the Parent Health Care Facilities or any health care business operated by Parent or any Parent Subsidiary.

     “Parent Health Care Facility” shall mean any health care facility that is leased or owned, and operated, by Parent or any Parent Subsidiary.

     “Parent Material Adverse Effect” shall mean any event, change, circumstance, state of facts or effect that has had a material adverse effect on (i) the business, properties, assets, results of operations or financial condition of Parent and the Parent Subsidiaries taken as a whole or (ii) the ability of Parent or Merger Sub to consummate the transactions contemplated by this Agreement. In no event shall any of the following (or the effects or consequences thereof) constitute a “Parent Material Adverse Effect” or be considered in determining whether a “Parent Material Adverse Effect” has occurred: (a) any event, occurrence, circumstance or trend, including a diminution in value, related to Parent, any Parent Subsidiary, or any of its respective businesses, properties, assets, results of operations or financial condition that is described with reasonable specificity in the Parent Disclosure Schedule or the Parent SEC Filings filed prior to the date hereof, (b) any failure by Parent to meet any internal projections or forecasts or published revenue or earnings estimates or predictions for any period ending (or for which revenues or earnings are released) on or after the date hereof (it being understood, however, that any facts, events, changes or developments causing or contributing to such failures to meet expectations or projections may (unless addressed otherwise in this definition) constitute a Parent Material Adverse Effect and may be taken into account in determining whether a Parent Material Adverse Effect has occurred), (c) any change in Law or any interpretation thereof, including any change in federal or state health care program reimbursement laws, regulations, policies or procedures, or interpretations thereof, applicable or potentially applicable to the services rendered by or operations of, Parent or any of the Parent Subsidiaries, in each case to the extent that such changes in Law or interpretations thereof do not have a disproportionate impact on the Parent Health Care Businesses as compared to other companies in industries similar to the Parent Health Care Businesses, (d) changes generally affecting the industries in which Parent or the Parent Subsidiaries operate, in each case to the extent that such changes do not have a disproportionate impact on the Parent Health Care Businesses as compared to other companies in industries similar to the Parent Health Care Businesses, (e) changes in economic, market or political conditions in the United States, in any region thereof, or in any non-U.S. or global economy, (f) acts of war (whether or not declared), sabotage or terrorism, military actions or the

5

escalation thereof occurring on or after the date hereof, and (g) changes in GAAP (or any interpretation thereof).

     “Parent Subsidiary” shall mean any Subsidiary of Parent, including Merger Sub.

     “Party” shall mean Parent, Merger Sub or the Company.

     “Person” shall mean an individual, corporation, limited liability company, partnership, association, trust, unincorporated organization or other entity.

     “SEC” shall mean the United States Securities and Exchange Commission.

     “Securities Act” shall mean the United States Securities Act of 1933, as amended, and the rules and regulations promulgated thereunder, as amended.

     “Subsidiary” or “Subsidiaries” of a Person shall mean any corporation, limited liability company, partnership or other legal entity of which such Person (either alone or through or together with any other Subsidiary or Subsidiaries of such Person) owns, directly or indirectly, a majority of the outstanding stock or other Equity Interests the holders of which are generally entitled to vote for the election of the board of directors or other governing body of such corporation or other legal entity.

     “Superior Proposal” shall mean a bona fide written Takeover Proposal (with all of the percentages included in the definition of Takeover Proposal increased to 50%) that is not solicited by the Company after the date of this Agreement and that the Company Board determines in good faith (after consultation with the Company Financial Advisor or other independent financial advisors of the Company Board, and outside legal counsel) to be (i) more favorable from a financial point of view (taking into account, among other things, the Person or Group making such Takeover Proposal and all legal, financial, regulatory, fiduciary and other aspects of this Agreement and such Takeover Proposal, including any conditions relating to financing, regulatory approvals or other events or circumstances beyond the control of the Person invoking the condition and taking into account any written offer by Parent and Merger Sub that if executed by the Company would become a Top-Up Amendment) to the holders of Company Common Stock than the transactions provided for in this Agreement and (ii) reasonably capable of being consummated upon the terms proposed; provided, however, for the avoidance of doubt, a Superior Proposal may be a transaction where the consideration is comprised of cash and/or other property or securities.

     “Surviving Corporation Benefit Plan” shall mean any Benefit Plan for the benefit or welfare of any Continuing Employee or that applies to all or substantially all employees of Parent, the Surviving Corporation and their respective Subsidiaries, and in each case whether maintained by Parent, the Surviving Corporation or any of their respective Subsidiaries.

     “Takeover Proposal” shall mean any inquiry, proposal or offer relating to (i) the acquisition by any Third Party of 25% or more of the shares of capital stock or any other voting securities of the Company outstanding immediately prior to such transaction, (ii) a merger, consolidation, business combination, reorganization, share exchange, sale of assets,

6

recapitalization, liquidation, dissolution or similar transaction that would result in any Third Party acquiring 25% or more of the fair market value of the assets of the Company and the Company Subsidiaries, taken as a whole (including capital stock of the Company Subsidiaries), immediately prior to such transaction, or (iii) any combination of the foregoing.

     “Taxes” shall mean any and all taxes, fees, levies, duties, tariffs, imposts and other similar charges (together with any and all interest, penalties, additions to tax and additional amounts imposed with respect thereto) imposed by any Governmental Entity, including those on or measured by or referred to as income, franchise, windfall or other profits, gross receipts, property, sales, use, net worth, capital stock, payroll, employment, social security, workers’ compensation, unemployment compensation, excise, withholding, ad valorem, stamp, transfer, value-added and provider taxes.

     “Tax Returns” shall mean any report, return (including any information return), declaration, claim for refund or statement required to be filed with any Governmental Entity relating to Taxes, including any Schedule or attachment thereto, and including any amendment thereof.

     “Third Party” shall mean any Person or Group other than the Company, any Company Subsidiary, Parent or any Parent Subsidiary.

     “Top-Up Amendment” shall mean a binding (with respect to Parent and Merger Sub) amendment to this Agreement (containing no changes to this Agreement other than an increase in the amount of the Merger Consideration per share provided for in this Agreement) which the Company Board determines in good faith (after consultation with the Company Financial Advisor or other independent financial advisors of the Company Board, and outside legal counsel) to be more favorable from a financial point of view to the holders of the Company Common Stock than the transactions contemplated by the Superior Proposal to which it relates.

     Section 1.2. Terms Defined Elsewhere. The following terms are defined elsewhere in this Agreement, as indicated below:

“Adverse Action”	Section 4.6.2
“Agreement”	Recitals
“Certificate of Merger”	Section 2.4
“Certificates”	Section 3.2.2
“Certification Date”	Section 2.3
“Closing”	Section 2.2
“Closing Date”	Section 2.2
“Company”	Preamble
“Company Adverse Recommendation Change”	Section 6.4.2
“Company Board”	Section 3.5.1(a)
“Company Bylaws”	Section 4.2
“Company Certificate”	Section 4.2
“Company Common Stock”	Section 3.1.1

7

“Company Disclosure Schedule”	Article IV
“Company Financial Advisor”	Section 4.16
“Company Form 10-K”	Section 4.2
“Company Leased Premises”	Section 4.15
“Company Material Contract”	Section 4.9
“Company Options”	Section 3.5.1(a)(i)
“Company Owned Properties”	Section 4.15
“Company Preferred Stock”	Section 4.3.1
“Company Properties”	Section 4.15
“Company Recommendation”	Section 4.16
“Company Representatives”	Section 6.3.1(a)
“Company Restricted Stock Awards”	Section 3.5.1(a)(ii)
“Company Rights”	Section 3.1.1
“Company Rights Agreement”	Section 3.1.1
“Company SEC Filings”	Section 4.7.1
“Company Stockholders’ Meeting”	Section 6.2.3
“Company Subsidiary”	Section 4.1
“Confidentiality Agreement”	Section 6.3.2
“D&O Insurance”	Section 6.9.2
“DGCL”	Recitals
“Dissenting Shares”	Section 3.1.1
“Dissenting Stockholders”	Section 3.1.1
“Effective Time”	Section 2.4
“ERISA”	Section 4.8.2
“Exchange Agent”	Section 3.2.1
“Exchange Fund”	Section 3.2.1
“Government Consents”	Section 6.5.2
“Health Care Laws”	Section 4.6.3
“Health Care Programs”	Section 4.6.2
“IRS”	Section 4.8.1
“Merger”	Recitals
“Merger Consideration”	Section 3.1.1
“Merger Sub”	Preamble
“Option Payments”	Section 3.5.1(a)(i)
“Parent”	Preamble
“Parent Bylaws”	Section 5.2
“Parent Certificate”	Section 5.2
“Parent Form 10-K”	Section 5.2
“Parent Representatives”	Section 6.3.1(a)
“Parent SEC Filings”	Section 5.8.1
“Parent Welfare Benefit Plan”	Section 6.8.4
“Permitted Liens”	Section 4.15
“Property Restrictions”	Section 4.15
“Proxy Statement”	Section 4.20
“Restricted Stock Payments”	Section 3.5.1(a)(ii)
“Severance Policy”	Section 6.8.7

8

“Stockholder Approval”	Section 4.4.1
“Surviving Corporation”	Section 2.1
“Termination Date”	Section 8.1(b)(ii)
“Termination Fee”	Section 8.4.1

     Section 1.3. Interpretation. In this Agreement, unless otherwise specified, the following rules of interpretation apply:

     (a) references to Articles, Sections, Subsections, Schedules, Exhibits, Clauses and Parties are references to articles, sections, subsections, schedules, exhibits and clauses of, and parties to, this Agreement;

     (b) references to any Person include references to such Person’s permitted successors and permitted assigns;

     (c) any singular term in this Agreement shall be deemed to include the plural, and any plural term the singular;

     (d) words importing one gender include the other gender;

     (e) references to the word “including” do not imply any limitation;

     (f) references to months are to calendar months;

     (g) the words “hereof,” “herein” and “hereunder” and words of similar import refer to this Agreement as a whole and not to any particular provision of this Agreement;

     (h) references to “$” or “dollars” refer to U.S. dollars;

     (i) to the extent this Agreement refers to information or documents having been made available (or delivered or provided) to Parent or Merger Sub, the Company shall be deemed to have satisfied such obligation if the Company, any Company Subsidiary or any Company Representative has made such information or document available (or delivered or provided such information or document) to any of Parent, Merger Sub, or any Parent Representative; and

     (j) a defined term has its defined meaning throughout this Agreement and in each Exhibit and Schedule to this Agreement, regardless of whether it appears before or after the place where it is defined.

ARTICLE II
THE MERGER

     Section 2.1. The Merger. Upon the terms and subject to satisfaction or waiver of the conditions set forth in this Agreement, and in accordance with the DGCL, Merger Sub shall be merged with and into the Company. As a result of the Merger, the separate corporate existence of

9

Merger Sub shall cease and the Company shall continue as the surviving corporation of the Merger (the “Surviving Corporation”).

     Section 2.2. Closing. Subject to the terms and conditions of this Agreement, the closing of the Merger (the “Closing”) shall take place (i) at the offices of Strasburger & Price, L.L.P., 901 Main Street, Suite 4400, Dallas, Texas 75202 at 10:00 a.m., Dallas time, on the last Business Day of the first calendar month during which the conditions set forth in Article VII have been satisfied (other than (a) those conditions that are waived in accordance with the terms of this Agreement by the Party or Parties for whose benefit such conditions exist and (b) any such conditions which, by their terms, are not capable of being satisfied until the Closing but subject to satisfaction of such conditions at the Closing) or (ii) at such other place, time and/or date as the Parties may otherwise agree upon in writing. The date on which the Closing occurs is referred to herein as the “Closing Date.” Notwithstanding anything in this Section 2.2 to the contrary, in the event the date provided above for the Closing is a date later than the second Business Day following the date on which all conditions set forth in Article VII have been satisfied (other than (a) those conditions that are waived in accordance with the terms of this Agreement by the Party or Parties for whose benefit such conditions exist and (b) any such conditions which, by their terms, are not capable of being satisfied until the Closing but subject to satisfaction of such conditions at the Closing) (the “Certification Date”), then the provisions of Section 2.3 below shall apply.

     Section 2.3 Certification Closing. In the event this Section 2.3 becomes applicable in accordance with the last sentence of Section 2.2, then notwithstanding any provision in this Agreement to the contrary: (i) each of the representations and warranties of the Company contained in this Agreement shall only relate to facts and events occurring on or prior to the Certification Date, and any facts or events occurring after the Certification Date shall be of no force or effect in determining the truthfulness and correctness of such representations and warranties, and (ii) Section 7.2.1 and Section 7.2.2 shall each be deemed amended such that the references to the term “Effective Time” contained therein shall be deemed to refer to the Certification Date.

     Section 2.4. Effective Time. If all of the conditions to the Merger set forth in Article VII have been satisfied or waived and this Agreement shall not have been terminated as provided in Article VIII, the Parties shall cause a certificate of merger (the “Certificate of Merger”) to be properly executed and filed with the Secretary of State of the State of Delaware on the Closing Date, in accordance with the DGCL and the terms of this Agreement. The Merger shall become effective at such time as the Certificate of Merger is duly filed with the Secretary of State of the State of Delaware or at such other time as is mutually agreed to in writing by Parent and the Company and specified as the effective time of the Merger in the Certificate of Merger (the date and time at which the Merger becomes effective, the “Effective Time”).”

     Section 2.5. Effect of the Merger. The Merger shall have the effects set forth in this Agreement, the Certificate of Merger and the applicable provisions of the DGCL.

     Section 2.6. Certificate of Incorporation; Bylaws. At the Effective Time, the Company Certificate and the Company Bylaws in effect immediately prior to the Effective Time shall

10

continue to be the Certificate of Incorporation and Bylaws of the Surviving Corporation, until thereafter amended in accordance with their respective terms and applicable Law.

     Section 2.7. Directors and Officers. The directors of Merger Sub immediately prior to the Effective Time shall at the Effective Time become the directors of the Surviving Corporation, each to hold office in accordance with the Certificate of Incorporation and Bylaws of the Surviving Corporation. The officers of Merger Sub immediately prior to the Effective Time shall at the Effective Time become the officers of the Surviving Corporation, each to hold office in accordance with the Certificate of Incorporation and Bylaws of the Surviving Corporation.

ARTICLE III
CONVERSION OF SECURITIES; EXCHANGE OF CERTIFICATES

     Section 3.1. Conversion of Securities. At the Effective Time, by virtue of the Merger and without any action on the part of Merger Sub or the Company or its stockholders, the following shall occur.

     Section 3.1.1. Each share of common stock, par value $.01 per share, of the Company (“Company Common Stock”) issued and outstanding immediately prior to the Effective Time (other than any shares of Company Common Stock to be canceled pursuant to Section 3.1.2, and any shares of Company Common Stock that are held by stockholders exercising appraisal rights pursuant to Section 262 of the DGCL (“Dissenting Stockholders”)) (and for purposes hereof each share of Company Common Stock shall be deemed to include the associated rights of the Company (the “Company Rights”) attributable to such share pursuant to the Rights Agreement, dated as of February 6, 1997, between the Company and American Stock Transfer & Trust Company, as Rights Agent, as amended (the “Company Rights Agreement”)), shall be converted, subject to Section 3.2.4, into the right to receive Twenty Dollars ($20.00) in cash, payable to the holder thereof, without interest (the “Merger Consideration”). All such shares of Company Common Stock shall no longer be outstanding and shall automatically be canceled and retired and shall cease to exist, and each Certificate that immediately prior to the Effective Time represented such shares shall thereafter represent the right to receive the Merger Consideration therefor; provided, however, that shares of the Company held by Dissenting Stockholders (“Dissenting Shares”) will be treated in accordance with Section 3.3, and shares to be canceled pursuant to Section 3.1.2 shall be treated as provided in Section 3.1.2. Certificates previously representing shares of Company Common Stock (other than Dissenting Shares or shares to be canceled pursuant to Section 3.1.2) shall be exchanged for the Merger Consideration, without interest, upon the surrender of such Certificates in accordance with the provisions of Section 3.2.

     Section 3.1.2. Each share of Company Common Stock held by Parent, Merger Sub, any Subsidiary of Parent or Merger Sub, in the treasury of the Company or by any Company Subsidiary immediately prior to the Effective Time shall be canceled and extinguished without any conversion thereof and no payment shall be made with respect thereto.

     Section 3.1.3. Each share of common stock, par value $.01 per share, of Merger Sub issued and outstanding immediately prior to the Effective Time shall be converted into and

11

be exchanged for one newly and validly issued, fully paid and nonassessable share of common stock of the Surviving Corporation. Following the Effective Time, each certificate evidencing ownership of shares of Merger Sub common stock shall evidence ownership of such shares of the Surviving Corporation.

     Section 3.1.4. If between the date of this Agreement and the Effective Time the outstanding shares of Company Common Stock shall have been changed into a different number of shares or a different class, by reason of any stock dividend, subdivision, reclassification, recapitalization, split, combination or exchange of shares, then the Merger Consideration, the Option Payments and the Restricted Stock Payments shall be correspondingly adjusted to reflect such stock dividend, subdivision, reclassification, recapitalization, split, combination or exchange of shares.

Section 3.2. Exchange of Certificates.

     Section 3.2.1. At the Closing, Parent shall deposit, or shall cause to be deposited, with StockTrans, Inc. or another bank or trust company designated by Parent and satisfactory to the Company (the “Exchange Agent”), for the benefit of the holders of shares of Company Common Stock, for exchange in accordance with this Article III through the Exchange Agent, cash in U.S. dollars in an amount sufficient to pay the aggregate amount of the Merger Consideration (the “Exchange Fund”). The Exchange Agent shall, pursuant to irrevocable instructions, deliver out of the Exchange Fund the Merger Consideration contemplated to be paid pursuant to Section 3.1. The cash included in the Exchange Fund shall be invested by the Exchange Agent as directed by Parent; provided, however, that (i) no such investment or losses thereon shall affect the Merger Consideration payable to the holders of Company Common Stock and, following any losses, Parent shall promptly provide additional funds to the Exchange Agent for the benefit of the holders of the shares of the Company Common Stock in the amount of any such losses, and (ii) such investments shall be (a) in obligations of, or guaranteed by, the United States of America or any agency or instrumentality thereof and backed by the full faith and credit of the United States of America, (b) in commercial paper obligations rated A-1 or P-1 or better by Moody’s Investors Service, Inc. or Standard & Poor’s Corporation, respectively, or (c) in certificates of deposit, bank repurchase agreements or banker’s acceptances of commercial banks with capital exceeding $1 billion (based on the most recent financial statements of such bank that are then publicly available). Any net profit resulting from, or interest or income produced by, such investments shall be payable to the Surviving Corporation or Parent, as Parent directs. The cash in the Exchange Fund shall not be used for any other purpose.

     Section 3.2.2. Promptly following the Effective Time (but in no event later than two (2) Business Days following the Effective Time), Parent shall instruct the Exchange Agent to mail to each holder of record of a certificate or certificates which immediately prior to the Effective Time represented outstanding shares of Company Common Stock (the “Certificates”) (i) a letter of transmittal in customary form (which shall specify that delivery shall be effected, and risk of loss and title to the Certificates shall pass, only upon proper delivery of the Certificates to the Exchange Agent and the form of which shall be subject to the consent of the Company prior to the Effective Time, such consent not to be unreasonably withheld) and (ii) instructions for use in effecting the surrender of the Certificates in exchange for the Merger

12

Consideration. Upon surrender of a Certificate for cancellation to the Exchange Agent together with such letter of transmittal, properly completed and duly executed, and such other documents as may be required pursuant to such instructions (or, if such shares are held in book-entry or other uncertificated form, upon the entry through a book-entry transfer agent of the surrender of such shares on a book-entry account statement (it being understood that any references herein to “Certificates” shall be deemed to include references to book-entry account statements relating to the ownership of shares of Company Common Stock)), the holder of such Certificate shall be entitled to receive in exchange therefor the Merger Consideration that such holder has the right to receive in respect of the shares of Company Common Stock formerly represented by such Certificate, and the Certificate so surrendered shall forthwith be canceled. No interest will be paid or accrued on any Merger Consideration payable to holders of Certificates. In the event of a transfer of ownership of shares of Company Common Stock that is not registered in the transfer records of the Company, the Merger Consideration may be issued to a transferee if the Certificate representing such shares of Company Common Stock is presented to the Exchange Agent, accompanied by all documents required to evidence and effect such transfer and by evidence that any applicable stock transfer taxes have been paid. Until surrendered as contemplated by this Section 3.2, each Certificate shall be deemed at any time after the Effective Time to represent only the right to receive upon such surrender the Merger Consideration or the right to demand to be paid the “fair value” of the shares represented thereby as contemplated by Section 3.3.

     Section 3.2.3. All Merger Consideration paid in accordance with the terms hereof shall be deemed to have been issued in full satisfaction of all rights pertaining to such shares of Company Common Stock (and each Company Right associated therewith) in respect of which such payment is made.

     Section 3.2.4. Any portion of the Exchange Fund that remains undistributed to the holders of Company Common Stock one year after the Effective Time shall be delivered to the Surviving Corporation upon demand, and any holders of Company Common Stock who have not theretofore complied with this Article III shall thereafter look only to the Surviving Corporation for the Merger Consideration, without any interest thereon.

     Section 3.2.5. None of Parent, the Company or the Surviving Corporation shall be liable to any holder of shares of Company Common Stock for any cash from the Exchange Fund delivered to a public official pursuant to any abandoned property, escheat or similar Law.

     Section 3.2.6. If any Certificate shall have been lost, stolen or destroyed, upon the making of an affidavit of that fact by the Person claiming such Certificate to be lost, stolen or destroyed and, if required by Parent, the posting by such Person of a bond, in such reasonable and customary amount as Parent may direct, as indemnity against any claim that may be made against it with respect to such lost, stolen or destroyed Certificate, the Exchange Agent will issue in exchange for such lost, stolen or destroyed Certificate the Merger Consideration payable in respect thereof, without any interest thereon.

     Section 3.2.7. Parent, the Surviving Corporation or the Exchange Agent shall be entitled to deduct and withhold from the consideration otherwise payable pursuant to this

13

Agreement to any holder of Company Common Stock such amounts as Parent, the Surviving Corporation or the Exchange Agent is required to deduct and withhold under the Code, or any provision of state, local or foreign tax Law, with respect to the making of such payment. To the extent that amounts are so withheld by Parent, the Surviving Corporation or the Exchange Agent, such withheld amounts shall be treated for all purposes of this Agreement as having been paid to the holder of Company Common Stock in respect of whom such deduction and withholding was made by Parent, the Surviving Corporation or the Exchange Agent.

     Section 3.3. Dissenters’ Rights. Notwithstanding anything in this Agreement to the contrary, if any Dissenting Stockholder shall demand to be paid the “fair value” of such Dissenting Stockholder’s shares of Company Common Stock, as provided in Section 262 of the DGCL, such shares of Company Common Stock (which shall be deemed to include the Company Rights associated with such shares) shall not be converted into or exchangeable for the right to receive the Merger Consideration (except as provided in this Section 3.3) and shall entitle such Dissenting Stockholder only to payment of the fair value of such shares of Company Common Stock, in accordance with Section 262 of the DGCL, unless and until such Dissenting Stockholder withdraws (in accordance with Section 262(k) of the DGCL) or effectively loses the right to dissent. The Company shall give Parent and Merger Sub prompt notice of any written demands for appraisal, withdrawals of demands for appraisal, and any other instrument served pursuant to Section 262 of the DGCL received by the Company. The Company shall not, except with the prior written consent of Parent, voluntarily make any payment with respect to, or settle or offer to settle, any such demand for payment of the fair value of a Dissenting Stockholder’s shares of Company Common Stock prior to the Effective Time. If any Dissenting Stockholder shall have effectively withdrawn (in accordance with Section 262(k) of the DGCL) or lost the right to dissent, then as of the later of the Effective Time or the occurrence of such event, the shares of Company Common Stock held by such Dissenting Stockholder shall be cancelled and converted into and represent the right to receive the Merger Consideration payable in respect thereof pursuant to Section 3.1.

     Section 3.4. Stock Transfer Books. At the Effective Time, the stock transfer books of the Company shall be closed (after giving effect to the exchange of Certificates described in Section 3.2.2) and thereafter, there shall be no further registration of transfers of shares of Company Common Stock theretofore outstanding on the records of the Company. From and after the Effective Time, the holders of Certificates shall cease to have any rights with respect to such shares of Company Common Stock except as otherwise provided herein or by Law. On or after the Effective Time, any Certificates presented to the Exchange Agent or Parent for any reason shall represent the right to receive the Merger Consideration payable in respect thereof as provided herein.

     Section 3.5. Company Equity Awards.

          Section 3.5.1.

     (a) Prior to the Effective Time, the Board of Directors of the Company (or, if appropriate, any committee thereof) (the “Company Board”) shall adopt appropriate

14

resolutions and take all other actions necessary and appropriate to provide that, concurrent with the Effective Time:

     (i) each outstanding, unexpired and unexercised option to purchase Company Common Stock (the “Company Options”) granted pursuant to the equity compensation plans set forth in Schedule 3.5.1(a) of the Company Disclosure Schedule, whether or not then exercisable, conditioned or vested, and irrespective of the exercise price per share thereof, shall fully vest and be deemed to be exercised in full and cancelled and each holder of a Company Option shall be entitled to receive at the Effective Time, in consideration of the deemed exercise and cancellation of such Company Option, a cash payment (such consideration being the “Option Payments”) in an amount equal to the product of (i) the amount of the per share Merger Consideration, less the applicable exercise price per share of such Company Option, and (ii) the total number of shares of Company Common Stock subject to such Company Option (determined on the basis that such Company Option is fully vested and currently exercisable), without interest and subject to any applicable withholding or other Taxes required by applicable Law to be withheld; and

     (ii) each outstanding and unvested restricted stock award granted by the Company (“Company Restricted Stock Awards”) pursuant to the equity compensation plans set forth in Schedule 3.5.1(a) of the Company Disclosure Schedule, whether or not then conditioned, shall be deemed to be fully vested and cancelled and each holder of a Company Restricted Stock Award shall be entitled to receive at the Effective Time, in consideration of the deemed cancellation of such Company Restricted Stock Award, a cash payment (such consideration being the “Restricted Stock Payments”) equal to the product of (x) the total number of             shares of Company Common Stock subject to such Company Restricted Stock Award immediately prior to the Effective Time and (y) the amount of the per share Merger Consideration; provided, however, that the Restricted Stock Payments shall be paid without interest and shall be subject to any applicable withholding or other Taxes required by applicable Law to be withheld.

Concurrent with the Effective Time, each Company Option and each Company Restricted Stock Award shall be canceled and terminated and shall only entitle the Person who previously held the same to payment of the Option Payment and/or Restricted Stock Payment, as the case may be, payable to such Person as described in this Section 3.5.1. At the Closing, Parent shall take all steps necessary to ensure that the Surviving Corporation or the Company makes all Option Payments and Restricted Stock Payments to the respective Persons entitled thereto in accordance with this Section 3.5.1. Each Option Payment and each Restricted Stock Payment pursuant to this Section 3.5.1(a) shall be made by check, dated the Closing Date, (i) made payable to the respective Person entitled thereto, and (ii) delivered to such Person by hand, or mailed via overnight courier to such Person, on the Closing Date.

15

     (b) Notwithstanding the foregoing, payments pursuant to Section 3.5.1(a) to Persons listed on Schedule 3.5.1(b) of the Company Disclosure Schedule shall be subject to Section 6 of their respective Executive Agreements relating to certain tax matters.

     (c) Concurrently with the execution and delivery of this Agreement, the Company has made available to Parent a schedule stating the name of the holder of each Company Option and each Company Restricted Stock Award, the number of shares of Company Common Stock subject to each such Company Option and Company Restricted Stock Award, and the exercise price of each such Company Option, in each case as of November 30, 2006. Not less than five (5) Business Days prior to the Closing Date, the Company shall update such schedule as necessary so that it will be accurate as of the Closing Date. Such updated schedule shall also reflect (i) the amount of the Option Payment to be made pursuant to this Section 3.5.1 to each holder of a Company Option, (ii) the amount of the Restricted Stock Payment to be made pursuant to this Section 3.5.1 to each holder of a Company Restricted Stock Award, and (iii) the mailing address of each such holder of a Company Option or Company Restricted Stock Award.

          Section 3.5.2. The provisions of this Section 3.5 shall survive the consummation of the Merger and are intended to be for the benefit of, and shall be enforceable by, each holder of any Company Options or Company Restricted Stock Awards, and their respective heirs, beneficiaries and representatives.

ARTICLE IV
REPRESENTATIONS AND WARRANTIES OF THE COMPANY

     Subject to (i) any information contained, or incorporated by reference, in any of the Company SEC Filings filed prior to the date hereof (but excluding any event or occurrence that (x) is contemplated in the sections entitled “Risk Factors” and “Disclosure Regarding Forward-Looking Statements” in such Company SEC Filings and (y) occurred or occurs after August 31, 2006) and (ii) such exceptions as are disclosed in the disclosure schedule delivered by the Company to Parent concurrently with the execution and delivery of this Agreement (the “Company Disclosure Schedule”) (it being understood that (a) any matter or item disclosed in any Schedule of the Company Disclosure Schedule shall be deemed also to be disclosed in (1) any other Schedule of the Company Disclosure Schedule that specifically references or cross-references such first Schedule and (2) other Schedules of the Company Disclosure Schedule to the extent it is reasonably apparent (notwithstanding the absence of a specific cross-reference) from a reading of the disclosure that such disclosure applies to such other Schedules of the Company Disclosure Schedule, and (b) the disclosure of any matter or item in the Company Disclosure Schedule shall not be deemed to constitute an acknowledgement that such matter or item is required to be disclosed therein or is material to a representation or warranty set forth in this Agreement and shall not be used as a basis for interpreting the terms “material,” “materially,” “materiality” or “Company Material Adverse Effect” or any word or phrase of similar import and does not mean that such matter or item would, alone or together with any other matter or item, have or be reasonably expected to have a Company Material Adverse Effect), the Company represents and warrants to Parent and Merger Sub as follows:

16

     Section 4.1. Organization and Qualification; Subsidiaries. The Company is a corporation duly organized, validly existing and in good standing under the laws of the State of Delaware. Each Subsidiary of the Company (“Company Subsidiary”) has been duly organized, and is validly existing and in good standing under the laws of the jurisdiction of its incorporation or organization, as the case may be. Schedule 4.1 of the Company Disclosure Schedule contains a complete list of all of the Company Subsidiaries. Each of the Company and the Company Subsidiaries has the requisite organizational power and authority to own, lease and operate its properties and to carry on its business as it is now being conducted. Each of the Company and the Company Subsidiaries is duly qualified to do business, and is in good standing, in each jurisdiction where the character of the properties owned, leased or operated by it or the nature of its business makes such qualification or good standing necessary, except for such failures to be so qualified or in good standing that, individually or in the aggregate, have not resulted in or would not reasonably be expected to have a Company Material Adverse Effect. The Company has made available or will make available to Parent complete and correct copies of the certificate of incorporation and bylaws (or similar organizational documents) of the Company and each Company Subsidiary, and all amendments thereto, as currently in effect.

     Section 4.2. Certificate of Incorporation and Bylaws; Corporate Books. The copies of the Company’s Certificate of Incorporation, as amended (the “Company Certificate”), and Amended and Restated Bylaws, as amended (the “Company Bylaws”), that are filed, or incorporated by reference, as exhibits to the Company’s Form 10-K for the year ended August 31, 2006 (the “Company Form 10-K”), are complete and correct copies thereof as in effect on the date hereof. True and complete copies of all minute books of the Company will be made available by the Company to Parent.

     Section 4.3. Capitalization; Subsidiaries.

          Section 4.3.1. The authorized capital stock of the Company consists of 40,000,000 shares of Company Common Stock and 500,000 shares of preferred stock, par value $.10 per share (the “Company Preferred Stock”). As of December 1, 2006, there were (i) 15,062,941 shares of Company Common Stock (other than treasury shares) issued and outstanding, (ii) 19,100 shares of Company Common Stock held in the treasury of the Company, (iii) 1,177,440 shares of Company Common Stock issuable upon exercise of outstanding Company Options, (iv) 348,328 shares of Company Common Stock issuable upon vesting of outstanding Company Restricted Stock Awards, and (v) no shares of Company Preferred Stock issued and outstanding.

          Section 4.3.2. All of the outstanding shares of capital stock of the Company have been duly authorized and validly issued and are fully paid and nonassessable and free of preemptive rights and were not issued in violation in any material respect of any federal or state securities Laws. Except as set forth in Section 4.3.1 or in Schedule 4.3.2 of the Company Disclosure Schedule, (i) there are no options, warrants or other rights, agreements, arrangements or commitments of any character to which the Company is a party or by which the Company is bound obligating the Company to issue or sell any Equity Interests, or securities convertible into or exchangeable for Equity Interests, (ii) there are no outstanding contractual obligations of the Company affecting the voting rights of or requiring the repurchase, redemption or disposition of

17

any Equity Interests in the Company, and (iii) since December 1, 2006, the Company has not issued any Equity Interests, or securities convertible into or exchangeable for Equity Interests, other than as would otherwise be permitted by this Agreement.

          Section 4.3.3. All of the outstanding shares of capital stock or other Equity Interests of each Company Subsidiary have been duly authorized and validly issued and are fully paid and nonassessable and free of preemptive rights and, except as set forth in Schedule 4.3.3 of the Company Disclosure Schedule, are held, directly or indirectly, by the Company or another Company Subsidiary free and clear of all Liens. Except as set forth in Schedule 4.3.3 of the Company Disclosure Schedule, (i) there are no options, warrants or other rights, agreements, arrangements or commitments of any character to which the Company or any Company Subsidiary is a party or by which the Company or any Company Subsidiary is bound obligating any Company Subsidiary to issue or sell any Equity Interests, or securities convertible into or exchangeable for Equity Interests, (ii) there are no outstanding contractual obligations of the Company or any Company Subsidiary affecting the voting rights of or requiring the repurchase, redemption or disposition of any Equity Interests in any Company Subsidiary, and (iii) since December 1, 2006, no Company Subsidiary has issued any Equity Interests, or securities convertible into or exchangeable for Equity Interests, other than as would otherwise be permitted by this Agreement.

     Section 4.4. Authority.

          Section 4.4.1. The Company has all necessary corporate power and authority to execute and deliver this Agreement, to perform its obligations hereunder and to consummate the transactions contemplated by this Agreement. The execution and delivery of this Agreement by the Company and the consummation by the Company of the transactions contemplated hereby have been duly and validly authorized by all necessary corporate action on the part of the Company, and no other corporate proceedings on the part of the Company and no votes of the stockholders of the Company are necessary to authorize this Agreement or to consummate the transactions contemplated hereby other than, with respect to the Merger, the affirmative vote of holders of a majority of the outstanding shares of Company Common Stock to adopt this Agreement and approve the transactions provided for herein (the “Stockholder Approval”). This Agreement has been duly authorized and validly executed and delivered by the Company and, assuming this Agreement is a valid and binding obligation of Parent and Merger Sub, this Agreement constitutes a legal, valid and binding obligation of the Company, enforceable against the Company in accordance with its terms.

          Section 4.4.2. Assuming the accuracy of the representation and warranty in Section 5.12, the Company has taken all appropriate actions so that the restrictions on business combinations contained in Section 203 of the DGCL will not apply with respect to or as a result of this Agreement and the transactions contemplated hereby, including the Merger, without any further action on the part of the stockholders of the Company or the Company Board.

     Section 4.5. No Conflict; Required Filings and Consents.

          Section 4.5.1. The execution, delivery and performance by the Company of this Agreement do not (i) assuming the Stockholder Approval is obtained, conflict with or violate any

18

provision of the Company Certificate or the Company Bylaws or any similar organizational documents of any Company Subsidiary, (ii) assuming that all consents, approvals or authorizations described in Section 4.5.2 will have been obtained prior to the Effective Time and all filings and notifications described in Section 4.5.2 will have been made and any waiting periods thereunder will have terminated or expired prior to the Effective Time, conflict with or violate any Law applicable to the Company or any Company Subsidiary or by which any property or asset of the Company or any Company Subsidiary is bound or affected or (iii) except as shown on Schedule 4.5.1 of the Company Disclosure Schedule, require any consent or approval under, result in any breach of or any loss of any benefit under, constitute a default (or an event which with notice or lapse of time or both would become a default) under, or give to others any right of termination, vesting, amendment, acceleration or cancellation of, or result in the creation of a Lien on any property or asset of the Company or any Company Subsidiary pursuant to, any Contract to which the Company or any Company Subsidiary is a party or by which any of their respective properties or assets are bound, except, with respect to clauses (ii) and (iii), for matters that, individually or in the aggregate, have not resulted in or would not reasonably be expected to have a Company Material Adverse Effect.

          Section 4.5.2. The execution, delivery and performance of this Agreement by the Company do not require any consent, approval or authorization of, or filing by the Company with or notification by the Company to, any Governmental Entity, except (i) under the Exchange Act, any applicable Blue Sky Law, the rules and regulations of NASDAQ, applicable Health Care Laws, the HSR Act or any other antitrust, competition, trade or other regulatory Laws, (ii) the filing and recordation of the Certificate of Merger as required by the DGCL, (iii) under any Health Care Program, (iv) under any matter listed on Schedule 4.5.2 of the Company Disclosure Schedule, and (v) where failure to obtain such consents, approvals, or authorizations, or to make such filings or notifications, would not (a) prevent or materially delay the consummation of the Merger, (b) otherwise prevent or materially delay performance by the Company of any of its material obligations under this Agreement, or (c) individually or in the aggregate have or reasonably be expected to have a Company Material Adverse Effect.

     Section 4.6. Compliance with Laws.

          Section 4.6.1. Except for matters that, individually or in the aggregate, have not resulted in or would not reasonably be expected to have a Company Material Adverse Effect, (i) the Company and the Company Subsidiaries hold all Company Permits necessary for the lawful conduct of its business or ownership, use, occupancy and operation of its assets and properties, (ii) except as shown on Schedule 4.6.1 of the Company Disclosure Schedule, the Company and each Company Subsidiary is in compliance with the terms of such Company Permits, except for such matters for which the Company or a Company Subsidiary has received written notice from a Governmental Entity, which notice asserts a lack of compliance with a particular Company Permit, but which permits the Company or a Company Subsidiary to cure such non-compliance within a reasonable period of time following the issuance of such notice, to the extent such cure is being undertaken by the Company or a Company Subsidiary, and (iii) except as shown on Schedule 4.6.1 of the Company Disclosure Schedule, none of the businesses of the Company or any Company Subsidiary is being conducted in violation of any Law applicable to the Company or such Company Subsidiary or by which any property or asset

19

of the Company or such Company Subsidiary is bound, except where such violation is subject to cure within a reasonable period of time by the Company or Company Subsidiary, to the extent such cure is being undertaken by the Company or such Company Subsidiary.

          Section 4.6.2. Schedule 4.6.2 of the Company Disclosure Schedule lists all Company Health Care Facilities that participate in or otherwise seek payments or services from the Medicare, Medicaid, TRICARE or any other state or federal health care programs (collectively, “Health Care Programs”). Except for matters that, individually or in the aggregate, have not resulted in or would not reasonably be expected to have a Company Material Adverse Effect, each Company Health Care Facility listed on Schedule 4.6.2 of the Company Disclosure Schedule is in compliance with the requirements for participation in the Health Care Programs in which such Company Health Care Facility participates as shown on Schedule 4.6.2 of the Company Disclosure Schedule. Except for matters set forth on Schedule 4.6.2 of the Company Disclosure Schedule or matters that, individually or in the aggregate, have not resulted in or would not reasonably be expected to have a Company Material Adverse Effect, there is no claim, action, litigation, proceeding, notice of noncompliance or demand letter (“Adverse Action”) before any Governmental Entity pending, received or, to the Knowledge of the Company, threatened against the Company, any Company Subsidiary or any Company Health Care Facility that relates in any way to a violation of any Law pertaining to the Health Care Programs or that could result in the imposition of penalties on any Company Health Care Business or the exclusion of any Company Health Care Business from participation in any Health Care Programs.

          Section 4.6.3. Except for matters that, individually or in the aggregate, have not resulted in or would not reasonably be expected to have a Company Material Adverse Effect, the operations of each Company Health Care Business are in compliance with (i) all relevant state and federal civil or criminal health care Laws applicable to, or governing payment and reimbursement for the services provided at, such Company Health Care Business, including the federal Anti-kickback Statute (42 U.S.C. § 1320a-7b(b)), the Stark Law (42 U.S.C. § 1395nn), the civil False Claims Act (31 U.S.C. §§ 3729 et seq.), the administrative False Claims Law (42 U.S.C. § 1320a-7b(a)), the Civil Money Penalties Law (42 U.S.C. § 1320a-7a; 42 U.S.C. § 1320c-8(a)), the Health Insurance Portability and Accountability Act of 1996 (42 U.S.C. § 1320d et seq.), the exclusion Laws (42 U.S.C. § 1320a-7), or the regulations promulgated pursuant to such Laws, and comparable state Laws, and (ii) accreditation standards and all other state and federal Laws, regulations, manual provisions, policies and administrative guidance relating to the regulation of such operations, including licensure, claim submission, billing, coding, staffing requirements, medical waste storage and disposal and applicable health and fire safety codes (all of the foregoing referred to in subclauses (i) and (ii) of this Section 4.6.3, collectively, “Health Care Laws”), except in each case for such matters for which the Company or a Company Subsidiary has received written notice from a Governmental Entity or accrediting body, which notice asserts a lack of compliance with a particular Health Care Law, but which permits the Company or a Company Subsidiary to cure such non-compliance within a reasonable period of time following the issuance of such notice, to the extent such cure is being undertaken by the Company or a Company Subsidiary.

20

          Section 4.6.4. Except for matters set forth on Schedule 4.6.4 of the Company Disclosure Schedule or matters that, individually or in the aggregate, have not resulted in or would not reasonably be expected to have a Company Material Adverse Effect, (i) there are no Adverse Actions pending or, to the Knowledge of the Company, threatened with respect to a violation by the Company or any Company Health Care Business of any Health Care Law, and (ii) to the Company’s Knowledge, there are no events or circumstances that, if brought to the attention of a Governmental Entity, could reasonably be expected to result in a violation by the Company or any Company Health Care Business of any Health Care Law.

          Section 4.6.5. Except for matters that, individually or in the aggregate, have not resulted in or would not reasonably be expected to have a Company Material Adverse Effect, all claims for payment or cost reports filed or required to be filed by the Company or any Company Subsidiary with respect to the Company Health Care Businesses under any Health Care Program or any private payor programs have been prepared and filed in accordance with all applicable state and federal Laws and other legal requirements.

     Section 4.7. SEC Filings; Financial Statements.

          Section 4.7.1. The Company has timely filed or furnished all forms, reports and other documents required to be filed or furnished by it under the Securities Act or the Exchange Act, as the case may be, since September 1, 2005 (collectively, the “Company SEC Filings”). Each Company SEC Filing (i) as of its date, complied in all material respects with the requirements of the Securities Act or the Exchange Act, as the case may be, and (ii) did not, at the time it was filed, contain any untrue statement of a material fact or omit to state a material fact required to be stated therein or necessary in order to make the statements made therein, in the light of the circumstances under which they were made, not misleading. As of the date of this Agreement, no Company Subsidiary is subject to the periodic reporting requirements of the Exchange Act.

          Section 4.7.2. Each of the consolidated financial statements (including, in each case, any notes thereto) contained in the Company SEC Filings was prepared in accordance with GAAP applied (except as may be indicated in the notes thereto and, in the case of unaudited financial statements, as permitted by the Securities Act or the Exchange Act, as applicable, and the applicable form thereunder) on a consistent basis during the periods indicated (except as may be indicated in the notes thereto), and each presented fairly, in all material respects, the consolidated financial position of the Company as of the respective dates thereof and the consolidated results of operations and cash flows of the Company for the respective periods indicated therein (subject, in the case of unaudited statements, to normal adjustments which, individually or in the aggregate, have not resulted in or would not reasonably be expected to have a Company Material Adverse Effect).

          Section 4.7.3. The Company and the Company Subsidiaries have no material liabilities or obligations of any nature (whether accrued, absolute, contingent or otherwise) that would be required to be reflected on a consolidated balance sheet of the Company or in notes thereto prepared in accordance with GAAP, except for liabilities or obligations (i) that are reflected in the consolidated financial statements (including the notes thereto) filed by the

21

Company as part of the Company Form 10-K, (ii) that were incurred after August 31, 2006 in the ordinary course of business and consistent with past practice or (iii) that were incurred under this Agreement or in connection with the transactions contemplated hereby.

          Section 4.7.4. The Company has designed internal controls to ensure that material information relating to the Company’s consolidated financial statements and other financial information is made known to its executive officers by other officers and employees of the Company and the Company Subsidiaries. Except as set forth in Schedule 4.7.4 of the Company Disclosure Schedule, there are no significant deficiencies in the design or operation of internal controls that could adversely affect the Company’s ability to record, process, summarize, and report financial data.

     Section 4.8. Benefit Plans; Employees and Employment Practices.

          Section 4.8.1. Schedule 4.8.1 of the Company Disclosure Schedule contains a list of each material Company Benefit Plan. The Company has made available to Parent copies of (i) each material Company Benefit Plan, (ii) the annual report (Form 5500), if any, filed with the U.S. Department of Labor with respect to each such Company Benefit Plan for each of the last three (3) years, (iii) the most recent summary plan description for each such Company Benefit Plan for which a summary plan description is required, and (iv) the most recent determination letter issued by the U.S. Internal Revenue Service (“IRS”) with respect to any such Company Benefit Plan that is intended to be qualified under Section 401(a) of the Code.

          Section 4.8.2. Except for such exceptions that, individually or in the aggregate, have not resulted in or would not reasonably be expected to have a Company Material Adverse Effect: (i) each Company Benefit Plan is in compliance with any applicable provisions of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”) and/or the Code; and (ii) the Company and each Company Subsidiary are in compliance with the requirements of the applicable health care continuation and notice provisions of the Consolidated Omnibus Budget Reconciliation Act of 1985, as amended.

          Section 4.8.3. Each Company Benefit Plan that is intended to be qualified under Section 401(a) of the Code has received a determination letter from the IRS that it is so qualified, and, to the Company’s Knowledge, no fact or event has occurred since the date of such determination letter that could reasonably be expected to materially adversely affect the qualified status of any such Company Benefit Plan.

          Section 4.8.4. Neither the Company nor any trade or business that, together with the Company, would be deemed a single employer within the meaning of Section 4001 of ERISA maintains or contributes to any Multiemployer Plan or multiple employer welfare arrangement within the meaning of Section 3(40) of ERISA or is liable for any “defined benefit plan” (as defined in Section 3(35) of ERISA) subject to Title IV of ERISA. Except as set forth on Schedule 4.8.4 of the Company Disclosure Schedule and for matters that, individually, or in the aggregate, have not resulted in or would not reasonably be expected to have a Company Material Adverse Effect, no Company Benefit Plan provides for, and no agreements have been entered into by the Company or any Company Subsidiary promising or guaranteeing, the continuation of medical, dental, vision, life or disability insurance coverage for any current or

22

former employees of the Company or any Company Subsidiary or their beneficiaries for any period of time beyond the periods set forth in Section 4980B(f) of the Code.

          Section 4.8.5. Neither the Company nor any Company Subsidiary is a party to any collective bargaining or other labor union contracts and no collective bargaining agreement is being negotiated by the Company or any Company Subsidiary. There is no pending labor dispute, strike or work stoppage against the Company or any Company Subsidiary that has interfered with the respective business activities of the Company or the Company Subsidiaries, except where such dispute, strike or work stoppage, individually or in the aggregate, has not resulted in or would not reasonably be expected to have a Company Material Adverse Effect. There is no pending charge or complaint against the Company or any Company Subsidiary by the National Labor Relations Board or any comparable state agency, except where such charge or complaint, individually or in the aggregate, has not resulted in or would not reasonably be expected to have a Company Material Adverse Effect.

          Section 4.8.6. Certain of the Company Subsidiaries lease employees of Atlantic Professional Employers, Inc. pursuant to certain contracts, true, correct and complete copies of which have been made available to Parent. Except for matters that, individually or in the aggregate, have not resulted in or would not reasonably be expected to have a Company Material Adverse Effect, the Company and each Company Benefit Plan has properly classified individuals providing services to the Company as independent contractors or employees, as the case may be. As used herein, the term “Company Benefit Plan” does not include any Benefit Plan maintained by Atlantic Professional Employers, Inc.

          Section 4.8.7. Except as disclosed on Schedule 4.8.7 of the Company Disclosure Schedule , no Company Benefit Plan or other agreement exists that will result in the payment by the Company or any Company Subsidiary to any present or former employee or director of the Company or any Company Subsidiary of any money or other property or accelerate or provide any other rights or benefits to any present or former employee or director of the Company or any Company Subsidiary as a result of the transactions contemplated by this Agreement. No such payments listed on Schedule 4.8.7 of the Company Disclosure Schedule or payable under any such Company Benefit Plans made available to Parent are “excess parachute payments” within the meaning of Section 280G of the Code.

          Section 4.8.8. All Company Options were granted at fair market value on the effective date of grant of the Company Option. All Company Options were either granted on the date of approval by the Compensation Committee of the Company Board or at a later date specified by the Compensation Committee.

     Section 4.9. Company Material Contracts. Except as filed as exhibits to the Company SEC Filings filed prior to the date of this Agreement, or as disclosed in Schedule 4.9 of the Company Disclosure Schedule, neither the Company nor any Company Subsidiary is a party to or bound by any Contract that (i) as of the date hereof, is a “material contract” (as such term is defined in Item 601(b)(10) of Regulation S-K promulgated by the SEC) or (ii) (a) requires aggregate expenditures by the Company or any Company Subsidiary in excess of $2,000,000, (b) requires annual expenditures by the Company or any Company Subsidiary in excess of

23

$1,000,000 and is not cancelable within one year, (c) would prohibit or materially delay the consummation of the Merger, (d) is a material Contract relating to the borrowing of money or the guarantee of any such obligation by the Company or any Company Subsidiary, (e) is a joint venture or partnership arrangement or provides for the sharing of any material revenues or material profits of the Company or any Company Subsidiary with a Third Party, (f) is a material employment, change of control, retention, indemnification or severance agreement, (g) contains covenants limiting the ability of the Company or any Company Subsidiary to engage in any line of business or compete with any Person or operate at any location or (h) any other agreement not in the ordinary course of the business of the Company and the Company Subsidiaries that requires expenditures of at least $300,000 by the Company or any Company Subsidiary. Each Contract of the type described in this Section 4.9, whether or not set forth in Schedule 4.9 of the Company Disclosure Schedule, is referred to herein as a “Company Material Contract.” Except for matters that, individually or in the aggregate, have not resulted in or would not reasonably be expected to have a Company Material Adverse Effect, (i) each Company Material Contract is a legal, valid and binding obligation of the Company or a Company Subsidiary, as applicable, in full force and effect and enforceable against the Company or a Company Subsidiary in accordance with its terms, (ii) the Company has not received written notice that any Company Material Contract is not a legal, valid and binding obligation of the counterparty thereto, in full force and effect and enforceable against such counterparty in accordance with its terms, (iii) neither the Company nor any Company Subsidiary and, to the Company’s Knowledge, no counterparty is in breach or violation of, or default under, any Company Material Contract, (iv) none of the Company or any Company Subsidiary has received any claim of default under any Company Material Contract, and (v) to the Company’s Knowledge, no event has occurred that would result in a breach or violation of, or a default under, any Company Material Contract (in each case, with or without notice or lapse of time or both).

     Section 4.10. Litigation. Except for matters set forth on Schedule 4.10 of the Company Disclosure Schedule or matters that, individually or in the aggregate, have not resulted in or would not reasonably be expected to result in a liability to the Company and/or the Company Subsidiaries in excess of $500,000 or otherwise be material or subject the Company and/or the Company Subsidiaries to a material and adverse injunction, (i) there is no suit, claim, action or proceeding pending or, to the Knowledge of the Company, threatened against the Company or any Company Subsidiary, (ii) none of the Company or any of the Company Subsidiaries is subject to any outstanding Order and (iii) to the Knowledge of the Company, no event has occurred or circumstance exists that would reasonably be expected to give rise to or serve as a basis for the commencement of any investigation, action, suit or proceeding that would reasonably be expected by the Company: (x) not to be covered by insurance maintained by the Company and/or the Company Subsidiaries and (y) to result in a liability to the Company and/or the Company Subsidiaries in excess of $500,000. As of the date hereof, (i) there is no Adverse Action pending or, to the Knowledge of the Company, threatened, against the Company or any Company Subsidiary that seeks to, or would reasonably be expected to, restrain, enjoin or delay the consummation of the Merger or any of the other transactions provided for herein or that seeks damages in connection therewith and (ii) no injunction has been entered or issued with respect to the transactions provided for herein.

24

     Section 4.11. Environmental Matters. Except for matters that, individually or in the aggregate, have not resulted in or would not reasonably be expected to have a Company Material Adverse Effect: (i) each of the Company and the Company Subsidiaries is in compliance with Environmental Law, (ii) each of the Company and the Company Subsidiaries possesses all Company Permits issued pursuant to Environmental Law that are required to conduct the business of the Company and each Company Subsidiary as it is currently conducted, (iii) neither the Company nor any Company Subsidiary has received any written claim or notice of violation from any Governmental Entity alleging that the Company or any Company Subsidiary is in violation of, or liable under, any Environmental Law and (iv) the Company has not treated, stored, managed, disposed of, transported, handled, released, or used any Materials of Environmental Concern except in the ordinary course of its business and in compliance with all applicable Environmental Laws, and, to the Company’s Knowledge, no Third Party has treated, stored, managed, disposed of, transported, handled, released or used any Materials of Environmental Concern on any premises used in the conduct of any Company Health Care Business except in the ordinary course of such Company Health Care Business and in compliance with all applicable Environmental Laws.

     Section 4.12. Intellectual Property. Except for matters that, individually or in the aggregate, have not resulted in or would not reasonably be expected to have a Company Material Adverse Effect, (i) the Company and each Company Subsidiary own or possess valid rights to use all Intellectual Property necessary to conduct the business of the Company and the Company Subsidiaries as it is currently conducted, (ii) during the past three (3) years (or earlier, if not resolved), the Company has not received any written complaint, demand or notice alleging that the Company or any Company Subsidiary has infringed upon or misappropriated any Intellectual Property right of any Third Party in connection with the operation of their business, and (iii) to the Company’s Knowledge, no Third Party is currently infringing or misappropriating Intellectual Property owned by the Company or any Company Subsidiary.

     Section 4.13. Taxes. Except for matters set forth on Schedule 4.13 of the Company Disclosure Schedule or matters that, individually or in the aggregate, have not resulted in or would not reasonably be expected to have a Company Material Adverse Effect:

          Section 4.13.1. All Tax Returns required to be filed by or with respect to the Company or any Company Subsidiary have been timely filed when due (taking into account any extension of time within which to file). All such Tax Returns are true, correct, and complete in all respects.

          Section 4.13.2. All Taxes of the Company and each Company Subsidiary (whether or not shown on any Tax Return) that have become due and payable have been fully and timely paid, other than any amount that is being contested in good faith by appropriate proceedings and for which proper accruals pursuant to GAAP have been established on the Company’s consolidated financial statements with respect thereto.

          Section 4.13.3. No deficiencies for Taxes have been proposed or assessed in writing against the Company or any Company Subsidiary by any Governmental Entity. To the Knowledge of the Company, (i) none of the Tax Returns of the Company or any Company

25

Subsidiary is currently being examined by the IRS or relevant state, local or foreign taxing authorities and (ii) there are no threatened or pending disputes, claims, audits, examinations, assessments or proposed assessments regarding any Taxes of the Company or any Company Subsidiary.

          Section 4.13.4. The Company and each Company Subsidiary has duly and timely withheld, collected, paid and reported to the proper Governmental Entity all Taxes required to have been withheld, collected, paid or reported by the Company or such Company Subsidiary, as applicable. The Company and each Company Subsidiary has complied in all respects with all applicable Laws relating to the withholding of Taxes and the payment thereof to the appropriate Governmental Entity.

          Section 4.13.5. There are no Liens upon any property or assets of the Company or any Company Subsidiary for Taxes, except for Liens for Taxes not yet due and payable or the amount or validity of which is being contested in good faith by appropriate proceedings.

          Section 4.13.6. Neither the Company nor any Company Subsidiary has constituted either a “distributing corporation” or a “controlled corporation” in a distribution of stock qualifying for tax-free treatment under Section 355 of the Code in the past three (3) years.

          Section 4.13.7. Neither the Company nor any Company Subsidiary has granted (or is subject to) any waiver or extension (that is currently in effect) of the period of limitations for the assessment or payment of any Tax or other filing of any Tax Return.

          Section 4.13.8. Neither the Company nor any Company Subsidiary is a party to any Tax allocation or sharing agreement. Neither the Company nor any Company Subsidiary has been a member of an affiliated group filing a consolidated federal income Tax Return (other than a group the common parent of which was the Company) or has any liability for Taxes of any Person under Treasury Regulation Section 1.1502-6 or any similar provision of state, local or foreign Law (other than the other members of the consolidated group of which the Company is parent), or as a transferee or successor, by Contract or otherwise.

          Section 4.13.9. The Company has not been a United States real property holding corporation within the meaning of Section 897(c)(2) of the Code during the applicable period specified in Section 897(c)(1)(A)(ii) of the Code.

          Section 4.13.10. Neither the Company nor any Company Subsidiary will be required to include any item of income in, or exclude any item of deduction from, taxable income for any taxable period (or portion thereof) ending after the Closing Date as a result of any (i) change in method of accounting for a taxable period ending on or prior to the Closing Date; (ii) “closing agreement” as described in Section 7121 of the Code (or any corresponding or similar provision of state, local or foreign Law) executed on or prior to the Closing Date; or (iii) intercompany transactions or any excess loss account described in Treasury Regulations under Section 1502 of the Code (or any corresponding or similar provision of state, local or foreign Law).

26

          Section 4.13.11. Neither the Company nor any Company Subsidiary has participated in a reportable transaction as such term is defined in Treasury Regulation Section 1.6011-4(b).

     Section 4.14. Insurance. The Company or a Company Subsidiary maintains the insurance coverages listed on Schedule 4.14 of the Company Disclosure Schedule. All material policies of title, liability, fire, casualty, business interruption, workers’ compensation and other forms of insurance and bonds insuring each of the Company and the Company Subsidiaries and their assets, properties and operations are in full force and effect. None of the Company or the Company Subsidiaries is in material default under any provisions of any such policy of insurance nor has any of the Company or the Company Subsidiaries received notice of cancellation of or cancelled any such insurance. For all material claims made under such policies, the Company and the Company Subsidiaries have timely complied with any applicable notice provisions.

     Section 4.15. Real Estate. Schedule 4.15 of the Company Disclosure Schedule identifies all material real property owned by the Company or the Company Subsidiaries (the “Company Owned Properties”) and all material real property leased by the Company or the Company Subsidiaries as lessee or sublessee (the “Company Leased Premises”, and together with the Company Owned Properties, the “Company Properties”). The Company Leased Premises are leased or subleased to the Company or a Company Subsidiary pursuant to written leases or subleases, true, correct and complete copies, including all amendments thereto, of which have been made available to Parent. The Company or the respective Company Subsidiary owns fee simple title to each of the Company Owned Properties or has a valid leasehold interest in each of the Company Leased Premises free and clear of any rights of way, easements, encumbrances, written agreements or reservations of an interest in title (collectively, “Property Restrictions”), and other Liens, except for the following (collectively, the “Permitted Liens”): (i) Property Restrictions imposed or promulgated by Laws with respect to real property and improvements, including zoning regulations, (ii) Liens and Property Restrictions disclosed on any title commitments, title policies or surveys copies of which have been delivered or made available to Parent, (iii) mechanics’, carriers’, workmen’s, repairmen’s and similar Liens, incurred in the ordinary course of business and which (a) are not yet due and payable, (b) are duly budgeted to be paid and (c) do not materially detract from the value of or materially interfere with the present use of any of the Company Properties subject thereto or affected thereby, (iv) Liens for Taxes that are not yet due and payable, and (v) Liens set forth on Schedule 4.15 of the Company Disclosure Schedule. Except for matters that, individually or in the aggregate, have not resulted in or would not reasonably be expected to have a Company Material Adverse Effect, the Company Properties and the business conducted thereon by the Company and the Company Subsidiaries comply in all material respects with the terms of the applicable leases and applicable Laws. The leases or subleases of the Company Leased Premises are in full force and effect and neither the Company nor any Company Subsidiary is in material default under any of such leases or subleases and, to the Company’s Knowledge, there is no material default by any of the landlords thereunder.

     Section 4.16. Board Approval. On or prior to the date of this Agreement, the Company Board has (i) received from UBS Securities LLC (the “Company Financial Advisor”) its opinion that the Merger Consideration to be received by the holders of Company Common Stock in the Merger is fair from a financial point of view to the holders of Company Common Stock,

27

(ii) determined that this Agreement and the transactions provided for herein, including the Merger, are fair to and in the best interest of the Company and the holders of Company Common Stock, and (iii) adopted resolutions (a) approving this Agreement, (b) declaring this Agreement and the Merger advisable and (c) recommending to the holders of Company Common Stock that they vote in favor of adopting this Agreement (the “Company Recommendation”).

     Section 4.17. Brokers. No broker, finder, financial advisor, investment banker or other Person (other than the Company Financial Advisor, the unpaid fees and expenses of which will be paid by the Company at the Closing) is entitled to any brokerage, finder’s, financial advisor’s or other similar fee or commission in connection with the Merger based upon arrangements made by or on behalf of the Company or any Company Subsidiary.

     Section 4.18. Absence of Certain Changes. Since September 1, 2006, except as disclosed in the Company SEC Filings or on Schedule 4.18 of the Company Disclosure Schedule, (i) the business of the Company and each of its Subsidiaries has been conducted in the ordinary course consistent with past practice, except for actions taken pursuant to, in connection with, or in contemplation of the negotiation and execution of this Agreement and the consummation of the Merger, and (ii) there has not been any event, change, development or set of circumstances that has had, or would reasonably be expected to have, individually or in the aggregate, a Company Material Adverse Effect.

     Section 4.19. Transactions with Affiliates. Except as set forth in the Company SEC Filings, there are no transactions, agreements, arrangements or understandings between the Company or any of the Company Subsidiaries, on the one hand, and any director, executive officer or other Affiliate of the Company, on the other hand, that are required to be disclosed under Item 404 of Regulation S-K under the Securities Act.

     Section 4.20. Company Information. None of the written information supplied or to be supplied by the Company or any of its Affiliates specifically for inclusion or incorporation by reference in the proxy statement relating to the Company Stockholders’ Meeting to be held in connection with this Agreement and the transactions contemplated herein (the “Proxy Statement”) will, as of the time the Proxy Statement (or any amendment thereof or supplement thereto) is first mailed to the record holders of shares of Company Common Stock or at the time of the Company Stockholders’ Meeting, contain any untrue statement of a material fact, or omit to state any material fact required to be stated therein or necessary in order to make the statements therein, in light of the circumstances under which they were made, not misleading, except for any such matters that are corrected by an amendment or supplement to the Proxy Statement filed with the SEC and made available to the record holders of shares of Company Common Stock prior to the time when the Stockholder Approval is obtained. All documents that the Company is responsible for filing with the SEC in connection with the transactions contemplated herein will comply as to form and substance in all material respects with the applicable requirements of the Exchange Act and other applicable Laws. Notwithstanding the foregoing, the Company makes no representation, warranty or agreement with respect to any information supplied or to be supplied by Parent or any of its Affiliates for inclusion or incorporation by reference in the Proxy Statement or any such other documents that the Company is responsible for filing with the SEC.

28

ARTICLE V
REPRESENTATIONS AND WARRANTIES OF PARENT AND MERGER SUB

     Subject to any information contained, or incorporated by reference, in any of the Parent SEC Filings filed prior to the date hereof (but excluding any event or occurrence that (i) is contemplated in the sections entitled “Risk Factors” and “Special Note Regarding Forward Looking Statements” in such Parent SEC Filings and (ii) occurred or occurs after December 31, 2005), Parent and Merger Sub jointly and severally represent and warrant to the Company as follows:

     Section 5.1. Organization and Qualification. Parent is a corporation duly organized, validly existing and in good standing under the laws of the State of Delaware. Merger Sub is a corporation duly organized, validly existing and in good standing under the laws of the State of Delaware. Each of Parent and Merger Sub has the requisite power and authority to own, lease and operate its properties and to carry on its business as it is now being conducted. Each of Parent and Merger Sub is duly qualified to do business, and is in good standing, in each jurisdiction where the character of the properties owned, leased or operated by it or the nature of its business makes such qualification or good standing necessary, except for such failures to be so qualified or in good standing that, individually or in the aggregate, have not resulted in or would not reasonably be expected to have a Parent Material Adverse Effect.

     Section 5.2. Certificate of Incorporation and Bylaws . The copies of Parent’s Amended and Restated Certificate of Incorporation, as amended (the “Parent Certificate”), and Amended and Restated Bylaws (the “Parent Bylaws”) that are filed, or incorporated by reference, as exhibits to Parent’s Form 10-K for the year ended December 31, 2005 (the “Parent Form 10-K”), are complete and correct copies thereof as in effect on the date hereof.

     Section 5.3. Authority. Each of Parent and Merger Sub has all necessary corporate power and authority to execute and deliver this Agreement, to perform its obligations hereunder and to consummate the transactions contemplated by this Agreement. The execution and delivery of this Agreement by each of Parent and Merger Sub, and the consummation by Parent and Merger Sub of the transactions contemplated hereby, have been duly and validly authorized by all necessary corporate action on the part of Parent and Merger Sub, and no other corporate proceedings on the part of Parent or Merger Sub are necessary to authorize this Agreement or to consummate the transactions contemplated hereby. This Agreement has been duly authorized and validly executed and delivered by Parent and Merger Sub and, assuming this Agreement is a valid and binding obligation of the Company, this Agreement constitutes a legal, valid and binding obligation of Parent and Merger Sub, enforceable against each of them in accordance with its terms.

     Section 5.4. Ownership of Merger Sub; No Prior Activities. Parent owns 100% of the issued and outstanding capital stock of Merger Sub. Merger Sub was formed solely for the purpose of engaging in the transactions contemplated by this Agreement. Except for obligations or liabilities incurred in connection with its formation and the transactions contemplated by this Agreement, Merger Sub has not incurred, directly or indirectly, through any Subsidiary or

29

Affiliate, any obligations or liabilities or engaged in any business activities of any type or kind whatsoever or entered into any agreements or arrangements with any Person.

     Section 5.5. Financing. Parent will have at the Effective Time sufficient cash or cash-equivalent funds to consummate the transactions contemplated by this Agreement, including (i) acquiring all of the outstanding shares of Company Common Stock in the Merger and paying the Merger Consideration therefor, (ii) performing the obligations of Parent under the last two sentences of Section 3.5.1(a), and (iii) to the extent necessary, satisfying obligations of the Company and the Company Subsidiaries under existing credit facilities of the Company.

     Section 5.6. Vote Required. No vote of the holders of any class or series of capital stock or other Equity Interests of Parent or Merger Sub is necessary to approve or adopt this Agreement, the Merger or any of the transactions contemplated hereby (other than in the case of Merger Sub, any required vote by Parent as the holder of 100% of Merger Sub’s Equity Interests). All votes, approvals or consents required to be given by Parent as the holder of 100% of Merger Sub’s Equity Interests to approve and adopt this Agreement, the Merger and any of the transactions contemplated hereby have been duly given by Parent.

     Section 5.7. No Conflict; Required Filings and Consents.

          Section 5.7.1. The execution, delivery and performance by Parent and Merger Sub of this Agreement do not (i) conflict with or violate any provision of the Parent Certificate, the Parent Bylaws or the certificate of incorporation or bylaws of Merger Sub, (ii) assuming that all consents, approvals or authorizations described in Section 5.7.2 will have been obtained prior to the Effective Time and all filings and notifications described in Section 5.7.2 will have been made and any waiting periods thereunder will have terminated or expired prior to the Effective Time, conflict with or violate any Law applicable to Parent or any Parent Subsidiary or by which any property or asset of Parent or any Parent Subsidiary is bound or affected or (iii) require any consent or approval under, result in any breach of or any loss of any benefit under, constitute a default (or an event which with notice or lapse of time or both would become a default) under, or give to others any right of termination, vesting, amendment, acceleration or cancellation of, or result in the creation of a Lien on any property or asset of Parent or any Parent Subsidiary pursuant to, any Contract to which Parent or any Parent Subsidiary is a party or by which any of their respective properties or assets are bound, except, with respect to clauses (ii) and (iii), for matters that, individually or in the aggregate, have not resulted in or would not reasonably be expected to have a Parent Material Adverse Effect.

          Section 5.7.2. The execution, delivery and performance of this Agreement by Parent and Merger Sub do not require any consent, approval or authorization of, or filing by Parent or Merger Sub with or notification by Parent or Merger Sub to, any Governmental Entity or other Person, except (i) under the Exchange Act, any applicable Blue Sky Law, the rules and regulations of NASDAQ, applicable Health Care Laws, the HSR Act or any other antitrust, competition, trade or other regulatory Laws, (ii) the filing and recordation of the Certificate of Merger as required by the DGCL and (iii) under any Health Care Program.

30

     Section 5.8. SEC Filings; Financial Statements.

          Section 5.8.1. Parent has timely filed or furnished all forms, reports and other documents required to be filed or furnished by it under the Securities Act or the Exchange Act, as the case may be, since January 1, 2005 (collectively, the “Parent SEC Filings”). Each Parent SEC Filing (i) as of its date, complied in all material respects with the requirements of the Securities Act or the Exchange Act, as the case may be, and (ii) did not, at the time it was filed, contain any untrue statement of a material fact or omit to state a material fact required to be stated therein or necessary in order to make the statements made therein, in the light of the circumstances under which they were made, not misleading. As of the date of this Agreement, no Parent Subsidiary is subject to the periodic reporting requirements of the Exchange Act.

          Section 5.8.2. Each of the consolidated financial statements (including, in each case, any notes thereto) contained in the Parent SEC Filings was prepared in accordance with GAAP applied (except as may be indicated in the notes thereto and, in the case of unaudited financial statements, as permitted by the Securities Act or the Exchange Act, as applicable, or the applicable form thereunder) on a consistent basis during the periods indicated (except as may be indicated in the notes thereto), and each presented fairly, in all material respects, the consolidated financial position of Parent as of the respective dates thereof and the consolidated results of operations and cash flows of Parent for the respective periods indicated therein (subject, in the case of unaudited statements, to normal adjustments which, individually or in the aggregate, have not resulted in or would not reasonably be expected to have a Parent Material Adverse Effect).

          Section 5.8.3. Parent and the Parent Subsidiaries have no material liabilities or obligations of any nature (whether accrued, absolute, contingent or otherwise) that would be required to be reflected on a consolidated balance sheet of Parent or in notes thereto prepared in accordance with GAAP, except for liabilities or obligations (i) that are reflected in the consolidated financial statements (including the notes thereto) filed by Parent as part of the Parent Form 10-K, (ii) that were incurred after December 31, 2005 in the ordinary course of business and consistent with past practice or (iii) that were incurred under this Agreement or in connection with the transactions contemplated hereby.

     Section 5.9. Licensing. There is no fact, event or circumstance relating to Parent or any Parent Subsidiary that would reasonably be expected to prevent Parent and/or any Parent Subsidiary from assuming all Company Permits, or obtaining or causing the Surviving Corporation or its Subsidiaries from obtaining new Government Consents, necessary for the lawful conduct of the business of the Surviving Corporation and its Subsidiaries or ownership of the assets and properties of the Surviving Corporation and its Subsidiaries.

     Section 5.10. Litigation. As of the date hereof, (i) there is no Adverse Action pending or, to the Knowledge of Parent, threatened against Parent or any Parent Subsidiary that seeks to, or would reasonably be expected to, restrain, enjoin or delay the consummation of the Merger or any of the other transactions provided for herein or that seeks damages in connection therewith and (ii) no injunction has been entered or issued with respect to the transactions provided for herein.

31

     Section 5.11. Brokers. No broker, finder, financial advisor, investment banker or other Person (other than Merrill Lynch, Pierce, Fenner and Smith Incorporated and Citigroup Global Markets Inc., the fees and expenses of which will be paid by Parent) is entitled to any brokerage, finder’s, financial advisor’s or other similar fee or commission in connection with the Merger based upon arrangements made by or on behalf of Parent or Merger Sub.

     Section 5.12. Ownership of Company Common Stock. Neither Parent nor Merger Sub is, nor at any time during the last three (3) years has been, an “interested stockholder” of the Company as defined in Section 203 of the DGCL.

     Section 5.13. Solvency of the Surviving Corporation. Immediately after giving effect to the transactions contemplated by this Agreement and actions taken in connection with the financing of these transactions, (i) each of the Surviving Corporation and its Subsidiaries will not have incurred debts beyond its ability to pay such debts as they mature or become due, (ii) the then present fair salable value of the assets of each of the Surviving Corporation and its Subsidiaries will exceed the amount that will be required to pay their liabilities (including the amount necessary to provide for contingent liabilities), and their respective debts as they become absolute and mature, (iii) the assets of each of the Surviving Corporation and its Subsidiaries, in each case at a fair valuation, will exceed their respective debts (including the amount necessary to provide for contingent liabilities) and (iv) each of the Surviving Corporation and its Subsidiaries will not have unreasonably small capital to carry on their respective business, either (a) as presently conducted or (b) as intended by Parent to be conducted. No transfer of property is being made and no obligation is being incurred in connection with the transactions contemplated by this Agreement with the intent to hinder, delay or defraud any present or future creditors of the Surviving Corporation and its Subsidiaries.

     Section 5.14. Parent Information. None of the written information supplied or to be supplied by Parent or any of its Affiliates specifically for inclusion or incorporation by reference in the Proxy Statement will, as of the time the Proxy Statement (or any amendment thereof or supplement thereto) is first mailed to the record holders of shares of Company Common Stock or at the time of the Company Stockholders’ Meeting, contain any untrue statement of a material fact, or omit to state any material fact required to be stated therein or necessary in order to make the statements therein, in light of the circumstances under which they were made, not misleading, except for any such matters that are corrected by an amendment or supplement to the Proxy Statement filed with the SEC and made available to the record holders of shares of Company Common Stock prior to the time when the Stockholder Approval is obtained. All documents that Parent is responsible for filing with the SEC in connection with the transactions contemplated herein will comply as to form and substance in all material respects with the applicable requirements of the Exchange Act and other applicable Laws. Notwithstanding the foregoing, neither Parent nor Merger Sub makes any representation, warranty or agreement with respect to any information supplied or to be supplied by the Company or any of its Affiliates for inclusion or incorporation by reference in the Proxy Statement or any such other documents that Parent is responsible for filing with the SEC.

32

ARTICLE VI
ADDITIONAL AGREEMENTS

     Section 6.1. Conduct of Business Pending the Closing. The Company agrees that, between the date of this Agreement and the Effective Time, except as otherwise contemplated by this Agreement (including as allowed by any provision of this Section 6.1), as required by applicable Law or as consented to in writing by Parent (such consent not to be unreasonably withheld or delayed), the Company will, and will cause each Company Subsidiary to, in all material respects (it being understood that in no event shall the Company’s participation in the negotiation (including activities related to due diligence), execution, delivery or public announcement (in accordance with this Agreement) or the pendency of this Agreement or the transactions contemplated hereby or any actions taken in compliance herewith or the consequences thereof on the respective businesses of the Company and the Company Subsidiaries, be considered a breach of any of the provisions of this Section 6.1), (i) carry on its business in the ordinary course consistent with past practice and (ii) use all reasonable efforts to preserve the relationship with its employees and consultants and to preserve intact its current relationships with such of its customers, suppliers and other Persons (including physicians) with which it has significant business relations. Without limiting the foregoing, and as an extension thereof, except as otherwise contemplated by this Agreement (including any provision of this Section 6.1), as required by applicable Law or as consented to in writing by Parent (such consent not to be unreasonably withheld or delayed), the Company shall not, and shall not permit any Company Subsidiary to, between the date of this Agreement and the Effective Time, directly or indirectly, do, or agree to do, any of the following:

     (a) amend or otherwise change the Company Certificate, the Company Bylaws or equivalent organizational documents;

     (b) except as permitted by Section 6.1(k) below, issue, deliver, sell, pledge or encumber, or authorize, propose or agree to the issuance, delivery, sale, pledge or encumbrance of, any shares of its capital stock or the capital stock of the Company Subsidiaries, or securities convertible into or exchangeable for, or options, warrants, calls, commitments or rights of any kind to acquire, any shares of any class or series of its capital stock (other than pursuant to the exercise of options, warrants, conversion rights, vesting of Company Restricted Stock Awards and other contractual rights existing on the date hereof) or the capital stock of the Company Subsidiaries;

     (c) declare, set aside, make or pay any dividend or other distribution (whether payable in cash, stock, property or a combination thereof) with respect to any of its capital stock (other than dividends paid by a wholly-owned Company Subsidiary to the Company or to any other wholly-owned Company Subsidiary) or enter into any agreement with respect to the voting of its capital stock;

     (d) reclassify, combine, split, subdivide or redeem, purchase or otherwise acquire, directly or indirectly, any of its capital stock or other Equity Interests, except pursuant to the exercise of options, warrants and Company Restricted Stock Awards

33

(i) existing on the date hereof or (ii) issued or granted after the date hereof as permitted by Section 6.1(k);

     (e) acquire (including by merger, consolidation, or acquisition of stock or assets), outside of the ordinary course of business, any interest in any Person or any division thereof or any assets, other than any other acquisitions for consideration that is individually not in excess of $2,500,000, or in the aggregate not in excess of $10,000,000;

     (f) sell, lease, license, or otherwise dispose of any of its material assets, other than (i) sales of inventory in the ordinary course of business consistent with past practice, (ii) other dispositions in the ordinary course of business so long as the aggregate value of all assets so disposed of as described in this subclause (ii) does not exceed $500,000, and (iii) as set forth on Schedule 6.1(f) of the Company Disclosure Schedule;

     (g) incur any indebtedness for borrowed money or issue any debt securities or assume, guarantee or endorse, or otherwise as an accommodation become responsible for, the obligations of any Person (other than a wholly-owned Company Subsidiary) for borrowed money, except for (i) indebtedness for borrowed money incurred in the ordinary course of business under existing credit facilities, (ii) indebtedness for borrowed money incurred in connection with an acquisition permitted under the preceding clause (e), and (iii) indebtedness owing by any Company Subsidiary to the Company or any other wholly-owned Company Subsidiary;

     (h) grant any Lien in any of its material assets to secure any indebtedness for borrowed money, except in connection with such indebtedness permitted under the preceding clause (g);

     (i) enter into any new line of business outside of its existing business segments;

     (j) make investments in Persons other than wholly-owned Subsidiaries of the Company, except for ordinary course investments in accordance with the Company’s existing investment policy;

     (k) except as set forth on Schedule 6.1(k) of the Company Disclosure Schedule, adopt or amend any material Company Benefit Plan, increase in any material manner the compensation or fringe benefits of any director, officer or employee of the Company or pay any material benefit not provided for by any existing Company Benefit Plan, in each case except (i) as reasonably necessary to comply with applicable Law, (ii) in connection with entering into or extending in the ordinary course of business any employment or other compensatory agreements or arrangements (A) with individuals other than executive officers or directors of the Company, or (B) that are made available generally to all or substantially all employees of the Company and the Company Subsidiaries (which may include executive officers or directors of the Company), or (iii) general salary increases in the ordinary course of business;

34

     (l) pay, discharge, settle or satisfy any material claims, liabilities or obligations (absolute, accrued, contingent or otherwise), other than (i) in the ordinary course of business consistent with past practice, (ii) the performance of contractual obligations in accordance with their terms, or (iii) the payment, discharge, settlement or satisfaction in accordance with their terms, of any individual claim (including a claim for Taxes), liability or obligation that (x) involves payments to or by the Company or any Company Subsidiary of less than $500,000 in the aggregate (plus any additional amounts paid by insurance maintained by the Company or any Company Subsidiary), (y) was or is disclosed in the most recent financial statements (or the notes thereto) of the Company included in the Company SEC Filings filed prior to the date hereof, contemplated by documents made available to Parent prior to the date hereof or incurred since the date of such financial statements in the ordinary course of business, or (z) is listed on Schedule 6.1(l) of the Company Disclosure Schedule;

     (m) other than as required by SEC guidelines or GAAP, revalue any assets or make any changes with respect to accounting policies, procedures and practices or change its fiscal year;

     (n) make or change any election for Taxes, change any annual accounting period for Taxes, adopt or change any method of accounting for Taxes, amend any Tax Returns or file claims for material refunds for Taxes or surrender any right to claim a material refund, offset or other reduction in liability for Taxes, enter into any material closing agreement, settle any material Tax claim or assessment relating to the Company or any Company Subsidiary or consent to any extension or waiver of the limitation period applicable to any material Tax claim or assessment relating to the Company or any Company Subsidiary;

     (o) enter into, terminate, renew, amend or modify in any material respect or fail to enforce in any material respect any Company Material Contract; or

     (p) except as otherwise contemplated by this Agreement, including Sections 6.1(e) and 6.4, or as otherwise required by Law or any Governmental Entity, adopt or enter into a plan of complete or partial liquidation, dissolution, merger, consolidation, restructuring, recapitalization or other reorganization of the Company or any Company Subsidiary (other than the Merger).

     Section 6.2. Proxy Statement; Company Stockholders’ Meeting.

          Section 6.2.1. Each of Parent and the Company shall cooperate with each other and promptly prepare, and the Company, in consultation with Parent, shall file with the SEC, as soon as reasonably practicable, the Proxy Statement. The respective Parties, in consultation with each other, will cause the Proxy Statement to comply as to form in all material respects with the applicable provisions of the Securities Act and the Exchange Act. The Company shall advise Parent and Merger Sub, promptly after the Company receives notice thereof, when any supplement or amendment to the Proxy Statement has been filed, of any request by the SEC for amendment of the Proxy Statement or comments thereon and responses thereto or requests by the SEC for additional information and when the Proxy Statement has been cleared by the SEC. The

35

Company shall also promptly provide Parent and Merger Sub copies of all written correspondence received by the Company from the SEC and summaries of all oral comments received by the Company from the SEC in connection with the transactions contemplated by this Agreement. Each Party shall promptly provide the other Parties with drafts of all correspondence intended to be sent by such Party to the SEC in connection with the transactions contemplated by this Agreement and allow each such other Party the opportunity to comment thereon prior to delivery to the SEC. The Company, after consultation with Parent, shall use its commercially reasonable best efforts to respond to any comments made by the SEC with respect to the Proxy Statement, and the Company shall have the Proxy Statement cleared by the SEC as promptly as reasonably practicable.

          Section 6.2.2. As promptly as reasonably practicable after the Proxy Statement is cleared by the SEC, the Company shall mail the Proxy Statement to the record holders of shares of Company Common Stock. Subject to Section 6.4.2, the Proxy Statement shall include the Company Recommendation. If, at any time prior to the Effective Time, any information relating to any of the Parties hereto, or their respective Affiliates, officers or directors, is discovered by any Party which should be set forth in an amendment or supplement to the Proxy Statement so that the Proxy Statement would not include any misstatement of a material fact or omit to state any material fact necessary to make the statements therein, in light of the circumstances under which they were made, not misleading, the Party which discovers such information shall promptly notify the other Parties hereto and, to the extent required by Law, an appropriate amendment or supplement describing such information shall be promptly filed with the SEC and disseminated to the stockholders of the Company.

          Section 6.2.3. Subject to Section 6.4.2, (i) the Company shall call and use its commercially reasonable efforts to hold a meeting of its stockholders for the purpose of obtaining the Stockholder Approval (the “Company Stockholders’ Meeting”) as promptly as reasonably practicable following the date on which the Proxy Statement is cleared by the SEC, and (ii) the Company will use all commercially reasonable efforts to obtain from its stockholders proxies in favor of the adoption and approval of this Agreement and to take all other action necessary to secure the vote or consent of stockholders of the Company required by the DGCL to effect the Merger. Without limiting the generality of the foregoing, but subject to Section 6.4.2, the Company’s obligation to establish a record date for, duly call, give notice of, convene and hold the Company Stockholders’ Meeting as provided in this Section 6.2.3 shall not be affected by (i) the commencement, public proposal, public disclosure or communication to Parent of any Takeover Proposal or (ii) the withdrawal, qualification or modification by the Company Board of the Company Recommendation to holders of Company Common Stock; provided, however, that the Company may adjourn or postpone the Company Stockholders’ Meeting if the Company is advised by outside legal counsel that failure to do so could reasonably be expected to result in a violation of the U.S. federal securities Laws. Parent covenants and agrees that, at the Company Stockholders’ Meeting, all shares of Company Common Stock, if any, owned by Parent or any Affiliate of Parent shall be voted in favor of adoption and approval of this Agreement, the Merger and the other transactions contemplated hereby.

          Section 6.2.4. Nothing in this Section 6.2 shall be deemed to prevent the Company or the Company Board from taking any action they are permitted or required to take

36

under, and in compliance with, Section 6.4 or are required to take under applicable Law. Subject to Section 6.1, nothing contained in this Agreement shall give Parent or Merger Sub, directly or indirectly, the right to control or direct the Company’s or its Subsidiaries’ operations prior to the Effective Time.

     Section 6.3.  Access to Information; Confidentiality.

          Section 6.3.1.

     (a) From the date of this Agreement to the Effective Time, the Company shall, and shall cause each Company Subsidiary and each of its and their respective directors, officers, employees, accountants, consultants, legal counsel, advisors, agents and other representatives (collectively, “Company Representatives”) to: (i) provide to Parent and the Parent Subsidiaries and each of their respective directors, officers, employees, accountants, consultants, legal counsel, advisors, agents and other representatives (collectively, “Parent Representatives”) access at reasonable times during normal business hours, upon prior notice to a Company Representative designated in Exhibit B.1 hereto, to the officers, employees, agents, properties, offices and other facilities of the Company or such Company Subsidiary and to the books and records thereof and (ii) furnish or cause to be furnished such reasonably available information concerning the business, properties, Contracts, assets, liabilities, personnel and other aspects of the Company and the Company Subsidiaries as Parent, Merger Sub or the Parent Representatives may reasonably request. Without limiting the foregoing, during the period prior to the Closing Date, the Company shall provide Parent as promptly as practicable (and in any event within thirty (30) days following the end of each month) a copy of the following items (each of which shall be prepared in the same format as the comparable items that were made available to Parent prior to the date of this Agreement with respect to the month of October 2006): (a) an unaudited consolidated balance sheet of each division of the Company for each of the months ended after October 31, 2006 and prior to the Closing Date, and (b) the monthly operating report and a monthly income statement for each division of the Company and for each Company Health Care Facility for each such month, along with a comparison of the actual results for each line item to the budgeted amounts for such line item.

     (b) Without the prior written consent of the Company and, if required by the Company, without being accompanied by a Company Representative, prior to the Effective Time none of Parent, any Parent Subsidiary, or any Parent Representative shall contact or engage in any discussions with any customer or referral source of the Company or any Company Subsidiary regarding this Agreement or any of the transactions or actions contemplated by this Agreement.

          Section 6.3.2. With respect to the information disclosed pursuant to Section 6.3.1, the Parties shall comply with, and Parent shall cause each Parent Representative and the Company shall cause each Company Representative to comply with, all of their respective obligations under the confidentiality agreement, dated as of September 26, 2006, between the Company and Parent (as such agreement may be amended from time to time, the

37

“Confidentiality Agreement”), it being understood and agreed by the Parties that, notwithstanding Section 6.3.1, (i) the Company, the Company Subsidiaries and the Company Representatives shall have no obligation to furnish, or provide any access to, any information to any Person not a party or subject to the Confidentiality Agreement, (ii) Section 6.3.1 shall not require the Company to take or allow actions that would unreasonably interfere with the Company’s or any Company Subsidiary’s operation of its business, and (iii) the Company shall not be required to provide access to or furnish any information if to do so would contravene any agreement to which the Company or any Company Subsidiary is a party or violate any Law, or where such access to information may involve the waiver of a disclosure privilege or be otherwise adverse to the interests of the Company or any Company Subsidiary.

     Section 6.4. No Solicitation of Transactions.

          Section 6.4.1. Subject to the other provisions of this Section 6.4, the Company shall, and shall cause each Company Subsidiary to, immediately cease and cause to be suspended any discussions or negotiations with any parties (other than Parent, Merger Sub and the Parent Representatives) that may be ongoing with respect to a Takeover Proposal. The Company shall not, and shall cause each Company Subsidiary not to, (i) directly or indirectly (through any Person) solicit, initiate, or knowingly encourage any Takeover Proposal, (ii) enter into any agreement or agreement in principle with respect to a Takeover Proposal, or (iii) participate in any way in any negotiations or discussions regarding, or furnish or disclose to any Third Party any confidential information with respect to, any Takeover Proposal; provided, however, that at any time prior to obtaining the Stockholder Approval and notwithstanding any provision of this Agreement to the contrary (including this Section 6.4), in response to a bona fide written Takeover Proposal that was received but not solicited by the Company, a Company Subsidiary, or a Company Representative on its behalf, after the date hereof that the Company Board determines in good faith constitutes, or could reasonably be expected to lead to, a Superior Proposal, the Company may furnish information and/or draft agreements with respect to the Company and the Company Subsidiaries to, and enter into negotiations or discussions with, the Person making such Takeover Proposal (and its officers, directors, partners, employees, accountants, consultants, legal counsel, advisors, agents and other representatives) pursuant to a customary confidentiality agreement not less favorable in any material respect to the Company than the Confidentiality Agreement (exclusive of any standstill provisions contained therein). Parent and Merger Sub agree and acknowledge that, with respect to any agreement between the Company and any Third Party that contains a provision prohibiting such Third Party from making a Takeover Proposal without first obtaining from the Company Board a waiver of such provision or consent to such Takeover Proposal, any such waiver or consent on the part of the Company Board may be given by the Company Board and, if given, shall not be considered a solicitation of a Takeover Proposal in violation of this Section 6.4.

          Section 6.4.2. Notwithstanding any provision of this Section 6.4 to the contrary, the Company Board may (i) withdraw or modify in a manner adverse to Parent (or not continue to make) the Company Recommendation, (ii) approve or recommend a Superior Proposal (any action described in clause (i) or this clause (ii), a “Company Adverse Recommendation Change”), and/or (iii) subject to Section 6.4.3, enter into an agreement regarding a Superior Proposal, if (x) in the case of clause (i), (ii) or (iii) above, the Company Board has determined in

38

good faith that the failure to take such action would be inconsistent with its fiduciary duties to the holders of shares of Company Common Stock under applicable Law and (y) in the case of clause (iii) above, the Company shall have terminated this Agreement in accordance with the provisions of Section 8.1(c)(iii) hereof.

          Section 6.4.3. The Company shall promptly (and in any event within forty-eight (48) hours) advise Parent orally and in writing of the Company’s receipt of any Takeover Proposal or any request for information in connection with a possible Takeover Proposal and the material terms and conditions of such Takeover Proposal or request, but not the identity of the Person making such Takeover Proposal. In addition, the Company shall not accept or enter into any agreement, letter of intent or similar document (other than a confidentiality agreement as contemplated by Section 6.4.1) concerning a Takeover Proposal for a period of not less than three (3) Business Days after Parent’s receipt of notice concerning a Takeover Proposal, and during such three (3) Business Day period, at Parent’s request, the Company shall negotiate with Parent in good faith. If, prior to the conclusion of such three (3) Business Day period, Parent and Merger Sub shall execute and deliver a Top-Up Amendment to the Company, then the Company shall cease all discussions or negotiations with respect to the Takeover Proposal unless and until a subsequent Superior Proposal is made.

          Section 6.4.4. Nothing contained in this Agreement shall prohibit the Company or the Company Board from (i) taking and disclosing to the stockholders of the Company a position contemplated by Rule 14e-2 promulgated under the Exchange Act or (ii) making any disclosure to the stockholders of the Company if, in the good faith judgment of the Company Board, such disclosure would be necessary under applicable Law (including Rule 14d-9 and Rule 14e-2 promulgated under the Exchange Act).

     Section 6.5. Reasonable Best Efforts.

          Section 6.5.1. Subject to the terms and conditions of this Agreement, including Section 6.4, each of the Parties shall use its reasonable best efforts to take, or cause to be taken, all actions, and to do, or cause to be done, and to assist and cooperate with the other Parties in doing, all things necessary, proper or advisable under applicable Laws to consummate and make effective, in the most expeditious manner practicable, the transactions provided for in this Agreement, including (i) preparing and filing, as soon as practicable, all forms, registrations and notices required to be filed to consummate the transactions contemplated by this Agreement and the taking of all such actions as are necessary to obtain any requisite approvals, consents, Orders, exemptions or waivers by, or to avoid an action or proceeding by, any Third Party or Governmental Entity, including filings pursuant to the HSR Act with the United States Federal Trade Commission and the Antitrust Division of the United States Department of Justice (and the preparation and filing, as soon as practicable, of any form or report required by any other Governmental Entity, relating to antitrust, competition, trade or other regulatory matters) and (ii) causing the satisfaction of all conditions set forth in Article VII (including the prompt termination of any waiting period under the HSR Act (including any extension of the initial thirty (30) day waiting period thereunder)). Notwithstanding anything to the contrary contained in this Section 6.5, in connection with the Merger or the consummation of the transactions contemplated by this Agreement, Parent shall not be required to agree to any terms, conditions,

39

or modifications with respect to (i) obtaining any Governmental Consents (as hereinafter defined) or (ii) avoiding any action or proceeding by any Third Party or Governmental Entity, to the extent such terms, conditions or modifications would result in, or would be reasonably likely to result in, (a) a Company Material Adverse Effect or (b) Parent, the Company or any of their respective Subsidiaries having to cease, sell or otherwise dispose of any assets or business (including the requirement that any such assets or businesses be held separate) that a reasonably prudent investor would determine to be material to Parent or to the material benefits of the transaction for which Parent has bargained for hereunder.

          Section 6.5.2. Parent and Merger Sub shall use their respective reasonable best efforts to obtain, as promptly as practicable following the date hereof, all licenses, certifications, permits, approvals, provider numbers and authorizations (“Government Consents”), if any, from all applicable Governmental Entities in connection with the Merger and as may be required to authorize Parent, the Surviving Corporation or the Subsidiaries of the Surviving Corporation, as the case may be, to operate or to continue to operate, as may be applicable, the Company Health Care Businesses as they are currently operated. Within thirty (30) days following the execution of this Agreement, Parent shall submit to the applicable Governmental Entities all applications or other materials, if any, required to obtain such Government Consents, including payment of all appropriate fees related thereto. Parent shall promptly respond to any request by any relevant Governmental Entity for supplemental information. Parent shall, and shall cause each Parent Subsidiary, if applicable, to, take all reasonable measures to shorten the time periods required under applicable Law for notice, licensure or other similar regulatory requirement in connection with receipt of Government Consents as described in this Section 6.5.2. Parent shall pay all fees and expenses required in connection with the matters described in this Section 6.5.2. Parent shall keep the Company fully apprised at all times concerning the matters described in this Section 6.5.2.

          Section 6.5.3. The Company and Parent shall have the right to review in advance, and to the extent reasonably practicable each will consult the other on, all the information relating to the other and each of their respective Subsidiaries and Affiliates that appears in any filing made with, or written materials submitted to, any Third Party or any Governmental Entity in connection with the Merger. If a Party fails to respond within three (3) Business Days to any filings or written materials furnished to such Party for its review, such Party shall be deemed to have approved such filing or written material.

          Section 6.5.4. Each Party shall promptly inform the others of any communication from any Governmental Entity regarding any of the transactions contemplated by this Agreement and keep the others informed of the status of the proceedings related to obtaining any approvals of any Governmental Entity or Third Party (including with respect to the termination or expiration of any waiting period). Each Party shall use commercially reasonable efforts to consult with the others in advance of any meeting or conference with a Governmental Entity or, in connection with any proceeding by a Third Party, with any other Person, relating to this Agreement and the transactions contemplated hereby and, to the extent permitted by such applicable Governmental Entity or other Person, give the other Parties the opportunity to attend and participate in such meetings and conferences. If any Party receives a request for additional information or documentary material from any such Governmental Entity or other Person with

40

respect to the transactions provided for in this Agreement, then such Party shall endeavor in good faith to make, or cause to be made, as soon as reasonably practicable and after consultation with the other Parties, an appropriate response in compliance with such request.

     Section 6.6. Certain Notices. From and after the date of this Agreement until the Effective Time, each Party shall promptly notify the other Parties of (i) the occurrence, or nonoccurrence, of any event that would be likely to cause any condition to the obligations of any Party to effect the Merger and the other transactions provided for in this Agreement not to be satisfied or (ii) the failure of the Company, Merger Sub or Parent, as the case may be, to comply with or satisfy any covenant, condition or agreement to be complied with or satisfied by it pursuant to this Agreement that would reasonably be expected to result in any condition to the obligations of any Party to effect the Merger and the other transactions provided for in this Agreement not to be satisfied.

     Section 6.7. Public Announcements. None of the Parties shall (and, in the case of Parent, Parent shall cause each Parent Subsidiary and each Parent Representative, if applicable, and in the case of the Company, the Company shall cause each Company Subsidiary and each Company Representative, if applicable, not to) issue any press release or make any public announcement concerning this Agreement or the transactions contemplated hereby without obtaining the prior written approval of (i) the Company, in the event the disclosing Party is Parent, Merger Sub, any Parent Subsidiary or any Parent Representative, or (ii) Parent, in the event the disclosing Party is the Company, any Company Subsidiary or any Company Representative, such consent not to be unreasonably withheld or delayed; provided, however, that if a Party determines, based upon advice of counsel, that disclosure is otherwise required by applicable Law (including any Laws relating to the filing obligations of the respective Parties under Section 6.5.2) or the rules or regulations of any stock exchange or market or trading system upon which the securities of such Party is listed, such Party may make such disclosure to the extent so required; provided, further, that such disclosure is made in consultation with the other Parties to this Agreement.

     Section 6.8. Employee Matters.

          Section 6.8.1. In connection with the change of control contemplated by this Agreement, Schedule 6.8.1 of the Company Disclosure Schedule sets forth the actions (in addition to those actions set forth in Schedule 6.1(k) of the Company Disclosure Schedule) with respect to Company Benefit Plans that the Company will implement, effective concurrent with the Effective Time, including acceleration of vesting, partial or full funding, amendment, termination or other similar actions.

          Section 6.8.2. Parent hereby agrees that following the Effective Time, it shall, or it shall cause the Surviving Corporation and its Subsidiaries to, (i) provide each Continuing Employee with a substantially similar position at a substantially similar salary and wages and on substantially the same terms and conditions as was provided to the Continuing Employee immediately prior to the Effective Time, and (ii) allow each Continuing Employee employed by the Surviving Corporation or any Subsidiary of the Surviving Corporation to participate in either (A) all Surviving Corporation Benefit Plans (except to the extent any such plan provides equity

41

based compensation) that apply at that time to all or substantially all other employees of Parent and its Subsidiaries or (B) Company Benefit Plans (except to the extent any such plan provides equity based compensation) in which such Company Employee participates immediately prior to the Effective Time. Nothing herein shall be deemed to be a guarantee of employment for any Continuing Employee or to restrict the right of the Surviving Corporation or its Subsidiaries to terminate any Continuing Employee.

          Section 6.8.3. Continuing Employees shall receive credit for all purposes (including for purposes of eligibility to participate, vesting, and eligibility to receive benefits) under any Surviving Corporation Benefit Plan under which any Continuing Employee may be eligible to participate on or after the Effective Time to the same extent recognized by the Company or any of the Company Subsidiaries under comparable Company Benefit Plans immediately prior to the Effective Time; provided, however, that such crediting of service shall not operate to duplicate any benefit.

          Section 6.8.4. With respect to any Surviving Corporation Benefit Plan that is a welfare benefit plan, program or arrangement (a “Parent Welfare Benefit Plan”) and in which any Continuing Employee may be eligible to participate on or after the Effective Time, Parent shall, or it shall cause the Surviving Corporation and its Subsidiaries to, provide credit to each Continuing Employee (and his/her spouse, dependents and beneficiaries) for any co-payments, deductibles and out-of-pocket expenses paid by such Continuing Employee (and his/her spouse, dependents and beneficiaries) under the comparable Company Benefit Plan during the relevant plan year, up to and including the Effective Time.

          Section 6.8.5. From and after the Effective Time, Parent shall cause the Surviving Corporation and its Subsidiaries to honor, in accordance with their terms, (i) all change in control, severance, retention and employment agreements or arrangements (including an employee’s right to terminate employment for “Good Reason”), in each case with the current and former employees of the Company and the Company Subsidiaries as set forth in Schedule 6.8.5(i) of the Company Disclosure Schedule, and (ii) the severance arrangements set forth on Schedule 6.1(k) of the Company Disclosure Schedule.

          Section 6.8.6. Prior to the Effective Time, the Company shall make available all background checks conducted by the Company or any Company Subsidiary, and the Company shall cause all Company Subsidiaries to conduct background checks on employees hired by them after the date hereof, in accordance with the currently existing employment practices of the Company and the respective Company Subsidiaries.

          Section 6.8.7. Not later than thirty (30) days prior to the anticipated Effective Time, Parent shall deliver to the Company a complete list of all employees of the Company and the Company Subsidiaries whose employment Parent desires to be terminated by the Company or the applicable Company Subsidiary, as the case may be, at or prior to the Effective Time. The employment of each such listed employee shall be terminated by the Company or the applicable Company Subsidiary effective on or before the Closing Date and at or prior to the Effective Time, and Parent and the Surviving Corporation, jointly and severally, shall pay or cause to be paid to each such terminated employee as and when due the reduction in force severance benefits

42

payable to him or her pursuant to the severance policy of the Company in effect on the date hereof (a copy of which has been made available to Parent on or prior to the date hereof) (the “Severance Policy”) as a result of such termination. With respect to all Continuing Employees whose employment is not terminated on or before the Closing Date pursuant to the preceding provisions of this Section 6.8.7 but whose employment by the Surviving Corporation or any of its Subsidiaries is terminated not later than ninety (90) days after the Closing Date, Parent shall, or it shall cause the Surviving Corporation and its Subsidiaries to, honor in accordance with its terms and for the benefit of all such Continuing Employees, the Severance Policy.

     Section 6.9. Indemnification of Directors and Officers.

          Section 6.9.1. From and after the Effective Time until six (6) years from the Effective Time, unless otherwise required by Law, the Certificate of Incorporation and Bylaws of the Surviving Corporation and the comparable organizational documents of its Subsidiaries shall contain provisions no less favorable with respect to the elimination of liability of directors and indemnification of and advancement of expenses to directors, officers, employees and agents than are set forth in the Company Certificate and the Company Bylaws (or the equivalent documents of the relevant Company Subsidiary) as in effect on the date hereof; provided, however, that in the event any claim or claims are asserted against any individual entitled to the protections of such provisions within such six (6) year period, such provisions shall not be modified until the final disposition of any such claims. During the period when any of such provisions referred to in the immediately preceding sentence are required to be maintained in effect as stated in such sentence, Parent and the Surviving Corporation, jointly and severally, promise to cause the Surviving Corporation and each Subsidiary of the Surviving Corporation to honor and perform each such provision in accordance with its terms.

          Section 6.9.2. For a period of six (6) years after the Effective Time, Parent shall, or shall cause the Surviving Corporation to, maintain in effect the Company’s current directors’ and officers’ liability insurance (the “D&O Insurance”) in respect of acts or omissions occurring at or prior to the Effective Time, covering each Person currently covered by the D&O Insurance (a complete and accurate copy of which has been heretofore made available to Parent), on terms with respect to the coverage, deductible and amounts no less favorable than those of the D&O Insurance in effect on the date of this Agreement; provided, however, that (i) in satisfying its obligations under this Section 6.9.2, neither Parent nor the Surviving Corporation shall be obligated to pay annual premiums in excess of 200% of the annual amount currently paid by the Company, it being understood and agreed that Parent or the Surviving Corporation shall nevertheless be obligated to provide the maximum amount of such coverage as may be obtained for such annual 200% amount and (ii) in the event of the application of clause (i), any present or former officer or director, upon reasonable written notice thereof (which notice shall be provided no later than twenty (20) days prior to the Effective Time and shall set forth in reasonable detail for each Person to be covered the policy coverage, premiums, deductibles, limitations and other pertinent information), who desires to obtain additional coverage such that, when combined with the coverage obtained by Parent or the Surviving Corporation in accordance with clause (i), it provides insurance coverage equivalent to the D&O Insurance in effect on the date hereof, may so elect and Parent shall or shall cause the Surviving Corporation to acquire such additional coverage on behalf of such Person; provided, further, that in the event any present or former

43

officer or director makes such an election, such present or former officer or director shall pay the portion of the premium of such D&O Insurance in excess of the amount that Parent or the Surviving Corporation is obligated to pay pursuant to this Section 6.9.2. The insurance purchased pursuant to this Section 6.9.2 shall be prepaid in full at the Effective Time and shall be non-cancelable. At the request of the Company, Parent shall arrange for such insurance prior to the Effective Time to be effective only at and after the Effective Time; provided, that Parent shall pay in full for such insurance coverage no later than the Effective Time. At Parent’s election, the Company may acquire a six (6) year tail policy for Persons currently covered by D&O Insurance that is consistent with the first sentence of this Section 6.9.2. Such policy, if acquired by the Company, shall be prepaid at the Effective Time and shall be non-cancelable. If the Company acquires such a tail policy, Parent’s obligations pursuant to the first sentence of this Section 6.9.2 shall be deemed completely satisfied. The obligation to maintain insurance provided in this Section 6.9.2 shall continue in full force and effect for a period of not less than six (6) years from and after the Effective Time; provided, that in the event any claim or claims are asserted or made within such six year period, Parent and the Surviving Corporation shall ensure that such insurance remains in full force and effect with respect to such claims until final disposition thereof.

          Section 6.9.3. If Parent or the Surviving Corporation or any of its successors or assigns shall (i) consolidate with or merge into any other Person and shall not be the continuing or surviving corporation or entity of such consolidation or merger or (ii) transfer all or substantially all of its properties and assets to any Person, then, and in each such case, proper provisions shall be made so that the successors and assigns of Parent or the Surviving Corporation (or acquirer of such assets), as the case may be, shall assume all of the obligations of Parent or the Surviving Corporation, as the case may be, set forth in this Section 6.9.

          Section 6.9.4. The rights of each Indemnified Party under this Section 6.9 shall be in addition to any right such Person might have under the Company Certificate and the Company Bylaws, the Certificate of Incorporation or the Bylaws of the Surviving Corporation or any comparable organizational documents of their Subsidiaries, or under any agreement of any Indemnified Party with the Company, the Surviving Corporation or any of their respective Subsidiaries.

          Section 6.9.5. The provisions of this Section 6.9 shall survive the consummation of the Merger and are intended to be for the benefit of, and shall be enforceable by, each of the Indemnified Parties and their respective heirs and representatives.

     Section 6.10. State Takeover Statutes. Parent, the Company and their respective Boards of Directors shall (i) take all reasonable action necessary to ensure that no state takeover statute or similar statute or regulation is or becomes applicable to this Agreement or the transactions provided for in this Agreement and (ii) if any state takeover statute or similar statute becomes applicable to this Agreement or the transactions contemplated by this Agreement, take all reasonable action necessary to ensure that the transactions provided for in this Agreement may be consummated as promptly as practicable on the terms contemplated by this Agreement and otherwise to minimize the effect of such statute or regulation on this Agreement or the transactions provided for in this Agreement.

44

     Section 6.11. Company Rights Agreement. The Company covenants and agrees that, concurrently with or promptly following the execution and delivery of this Agreement, it will take all necessary action (including, if required, redeeming all of the outstanding Company Rights or amending or terminating the Company Rights Agreement) (i) to render the Company Rights Agreement inapplicable to the Merger, this Agreement or any of the transactions contemplated hereby, and (ii) to ensure that no Person is able to exercise any Company Rights under the Company Rights Agreement or enable or require the Company Rights to be separated from the shares of Company Common Stock to which they are attached or to be triggered or to become exercisable, in each case as a result of the Merger, this Agreement or any of the transactions contemplated hereby.

     Section 6.12. Section 16 Matters. Prior to the Effective Time, the Company shall take all such steps as may reasonably be necessary and permitted to cause the transactions contemplated by this Agreement, including any dispositions of shares of Company Common Stock (including derivative securities with respect to such shares of Company Common Stock) by each individual who is or will be subject to the reporting requirements of Section 16(a) of the Exchange Act with respect to the Company, to be exempt under Rule 16b-3 promulgated under the Exchange Act.

     Section 6.13. Confidentiality Agreement. The Confidentiality Agreement shall continue in full force and effect in accordance with its terms until the earlier of (i) the Effective Time or (ii) the expiration of the Confidentiality Agreement according to its terms.

     Section 6.14. Investigation and Agreement by Parent and Merger Sub; No Other Representations or Warranties.

          Section 6.14.1. Each of Parent and Merger Sub acknowledges and agrees that it has made its own inquiry and investigation into, and, based thereon, has formed an independent judgment concerning, the Company and the Company Subsidiaries and their businesses and operations, and Parent and Merger Sub have requested such documents and information from the Company as each such Party considers material in determining whether to enter into this Agreement and to consummate the transactions contemplated in this Agreement. In connection with Parent’s and Merger Sub’s investigation of the Company and the Company Subsidiaries and their businesses and operations, Parent, Merger Sub and the Parent Representatives have received from the Company or the Company Representatives certain projections and other forecasts for the Company and the Company Subsidiaries and certain estimates, plans and budget information. Each of Parent and Merger Sub acknowledges and agrees that there are uncertainties inherent in attempting to make such projections, forecasts, estimates, plans and budgets; that Parent and Merger Sub are familiar with such uncertainties; and that Parent and Merger Sub are taking full responsibility for making their own evaluation of the adequacy and accuracy of all estimates, projections, forecasts, plans and budgets so furnished to them or their representatives.

          Section 6.14.2. Each of Parent and Merger Sub agrees that, except for the representations and warranties made by the Company that are expressly set forth in this Agreement, the Company has not made and shall not be deemed to have made to Parent, Merger Sub or any of the Parent Representatives any representation or warranty of any kind. Without

45

limiting the generality of the foregoing, each of Parent and Merger Sub agrees that neither the Company, any holder of the Company’s securities nor any of their respective Affiliates or Company Representatives, makes or has made any representation or warranty to Parent, Merger Sub or any of their Representatives or Affiliates with respect to:

     (i) any projections, forecasts, estimates, plans or budgets of future revenues, expenses or expenditures, future results of operations (or any component thereof), future cash flows (or any component thereof) or future financial condition (or any component thereof) of the Company or any of the Company Subsidiaries or the future business, operations or affairs of the Company or any of the Company Subsidiaries heretofore or hereafter delivered to or made available to Parent, Merger Sub or any Parent Representatives or Affiliates; or

     (ii) any other information, statement or documents heretofore or hereafter delivered to or made available to Parent, Merger Sub or any Parent Representatives or Affiliates with respect to the Company or any of its Subsidiaries or the business, operations or affairs of the Company or any of its Subsidiaries, except to the extent and as expressly covered by a representation and warranty made by the Company and contained in this Agreement.

ARTICLE VII
CLOSING CONDITIONS

     Section 7.1. Conditions to Obligations of Each Party Under This Agreement. The respective obligations of each Party to effect the Merger shall be subject to the satisfaction, or in the case of Sections 7.1.3 and 7.1.4 the waiver in writing by both Parent and the Company, at or prior to the Closing of the following conditions:

          Section 7.1.1. The Stockholder Approval shall have been obtained.

          Section 7.1.2. All filing and waiting periods applicable (including any extensions thereof) to the consummation of the Merger under the HSR Act shall have expired or been terminated.

          Section 7.1.3. There shall not have been any Law or executive or any other Order or similar action of any Governmental Entity enacted or issued, which would render the Parties unable to consummate the Merger or make the Merger illegal or prohibit, restrict or delay consummation of the Merger (other than a de minimis civil violation of any Law that does not affect the ability of the Surviving Corporation, Parent or their Affiliates to obtain and maintain licenses, certifications, Company Permits, approvals, provider numbers and authorizations for the ownership and operation of Company Health Care Businesses or participation in any Health Care Program). Subject to Section 7.2.6, Parent, the Company or the Company Subsidiaries, as applicable, shall have received all Government Consents required in connection with the operation of the Company Health Care Business after the Effective Time, except where the failure to obtain any such Government Consent would not reasonably be expected to have, individually or in the aggregate, a Company Material Adverse Effect.

46

          Section 7.1.4. No Law or Order issued by any court of competent jurisdiction or other Governmental Entity or other legal restraint or prohibition prohibiting the consummation of the Merger shall be in effect; provided, however, that the Party asserting this condition shall have complied in all material respects with its obligations under Section 6.5; and provided, further, that the right to assert this condition shall not be available to any Party whose breach of any provision of this Agreement results in the imposition of any such Order or the failure of such Order to be resisted, resolved or lifted, as applicable.

     Section 7.2. Additional Conditions to Obligations of Parent and Merger Sub. The obligations of Parent and Merger Sub to effect the Merger are also subject to the following conditions, any or all of which may be waived in writing by Parent:

          Section 7.2.1. The representations and warranties of the Company set forth in this Agreement shall be true and correct as of the date of this Agreement and as of the Effective Time as if made at and as of the Effective Time (except for those representations and warranties that address matters only as of an earlier date, which shall have been true and correct as of such earlier date), disregarding for these purposes any exception in such representations and warranties relating to materiality or a Company Material Adverse Effect, except for such failures to be true and correct which, individually or in the aggregate, would not reasonably be expected to result in a Company Material Adverse Effect and except for changes or matters contemplated or permitted by this Agreement.

          Section 7.2.2. The Company shall have performed or complied in all material respects with all agreements and covenants required by this Agreement to be performed or complied with by it at or prior to the Effective Time.

          Section 7.2.3. Parent shall have received a certificate of an executive officer of the Company to the effect set forth in Sections 7.2.1 and 7.2.2.

          Section 7.2.4. Since September 1, 2006, there shall not have occurred a Company Material Adverse Effect, and no event shall have occurred or circumstance shall exist that, in combination with any other events or circumstances, would reasonably be expected to have or result in a Company Material Adverse Effect.

          Section 7.2.5. Not more than 5% of the shares of Company Common Stock outstanding immediately prior to the Effective Time shall be Dissenting Shares.

          Section 7.2.6. Parent, the Company or the applicable Company Subsidiary, as applicable, shall have received the consents and approvals set forth on that certain Schedule 7.2.6 hereto (which Schedule Parent delivered to the Company concurrently with the execution and delivery of this Agreement), that are required in connection with the operation after the Effective Time of the Company Health Care Facilities or Company Health Care Business referenced on such Schedule.

     Section 7.3. Additional Conditions to Obligations of the Company. The obligations of the Company to effect the Merger are also subject to the following conditions, any or all of which may be waived in writing by the Company:

47

          Section 7.3.1. The representations and warranties of Parent and Merger Sub set forth in this Agreement shall be true and correct as of the date of this Agreement and as of the Effective Time as if made at and as of the Effective Time (except for those representations and warranties that address matters only as of an earlier date, which shall have been true and correct as of such earlier date), disregarding for these purposes any exception in such representations and warranties relating to materiality, except for such failures to be true and correct which, individually or in the aggregate, (i) would not reasonably be expected to result in a Parent Material Adverse Effect, and (ii) would not prevent or materially impede, interfere with, hinder or delay the consummation of the Merger.

          Section 7.3.2. Parent and Merger Sub shall have performed or complied in all material respects with all agreements and covenants required by this Agreement to be performed or complied with by Parent and/or Merger Sub at or prior to the Effective Time.

          Section 7.3.3. The Company shall have received a certificate of an executive officer of Parent to the effect set forth in Sections 7.3.1 and 7.3.2.

     Section 7.4. Frustration of Closing Conditions. None of the Company, Parent or Merger Sub may rely on the failure of any condition set forth in Article VII to be satisfied if such failure was caused by such Party’s failure to act in good faith to comply with this Agreement and consummate the transactions provided for herein.

ARTICLE VIII
TERMINATION, AMENDMENT AND WAIVER

     Section 8.1. Termination. This Agreement may be terminated, and the Merger contemplated hereby may be abandoned, at any time prior to the Effective Time, as set forth below in this Section 8.1, by action taken or authorized by the Board of Directors of the terminating Party or Parties, whether before or after the Stockholder Approval:

     (a) By mutual written consent of Parent and the Company;

     (b) by either Parent or the Company:

     (i) if the Stockholder Approval is not obtained at the Company Stockholders’ Meeting or any adjournment thereof at which this Agreement has been voted upon;

     (ii) if the Merger shall not have been consummated by August 31, 2007 (the “Termination Date”); provided, however, that the right to terminate this Agreement under this Section 8.1(b)(ii) shall not be available to any Party whose material breach of any provision of this Agreement has been the cause of, or resulted in, the failure of the Merger to occur on or before the Termination Date; or

     (iii) if there shall be any Law that makes consummation of the Merger illegal or otherwise prohibited or any Order of any Governmental Entity having

48

competent jurisdiction enjoining the Company, Parent or Merger Sub from consummating the Merger is entered and such Order has become final and nonappealable and, prior to termination pursuant to this Section 8.1(b)(iii), the terminating Party shall have complied in all material respects with its obligations under Section 6.5; provided, however, that the right to terminate this Agreement pursuant to this Section 8.1(b)(iii) shall not be available to any Party whose breach of any provision of this Agreement results in the imposition of any such Order or the failure of such Order to be resisted, resolved or lifted, as applicable.

     (c) by the Company:

     (i) if (x) Parent or Merger Sub shall have breached any of the covenants or agreements contained in this Agreement to be complied with by Parent or Merger Sub such that the closing condition set forth in Section 7.3.2 would not be satisfied or (y) there exists a breach of any representation or warranty of Parent or Merger Sub contained in this Agreement such that the closing condition set forth in Section 7.3.1 would not be satisfied, and, in the case of either (x) or (y), such breach is incapable of being cured by the earlier to occur of (i) twenty (20) Business Days after Parent or Merger Sub receives written notice of such breach from the Company or (ii) the Termination Date;

     (ii) if, prior to the obtaining of the Stockholder Approval, there has been a Company Adverse Recommendation Change; or

     (iii) if, prior to the obtaining of the Stockholder Approval, (x) the Company is concurrently entering into a definitive agreement for a Superior Proposal and (y) not later than the day of such termination, Parent has received any Termination Fee required to be paid under Section 8.4.

     (d) by Parent:

     (i) if (x) the Company shall have breached any of the covenants or agreements contained in this Agreement to be complied with by the Company such that the closing condition set forth in Section 7.2.2 would not be satisfied or (y) there exists a breach of any representation or warranty of the Company contained in this Agreement such that the closing condition set forth in Section 7.2.1 would not be satisfied, and, in the case of either (x) or (y), such breach is incapable of being cured by the earlier to occur of (i) twenty (20) Business Days after the Company receives written notice of such breach from Parent or (ii) the Termination Date;

     (ii) if, prior to the obtaining of the Stockholder Approval, (x) there has been a Company Adverse Recommendation Change, (y) the Company has failed to include the Company Recommendation in the Proxy Statement or (z) the Company Board approves or recommends a Takeover Proposal to the holders of Company

49

Common Stock or approves or recommends that holders of Company Common Stock tender their shares of Company Common Stock in any tender offer or exchange offer that is a Takeover Proposal; or

     (iii) if the Company shall have materially breached any of its covenants or agreements contained in Section 6.2.3, Section 6.4.1, or Section 6.4.3 of this Agreement such that the closing condition set forth in Section 7.2.2 would not be satisfied and, with respect to a material breach of Section 6.2.3, such breach is incapable of being cured prior to the expiration of ten (10) calendar days after the Company receives written notice of such breach from Parent; provided, however, that the right to terminate this Agreement pursuant to this Section 8.1(d)(iii) shall not be available to Parent if it or Merger Sub is in material breach of any provision of this Agreement.

     Section 8.2. Effect of Termination. Except as otherwise set forth in this Section 8.2, in the event of a termination of this Agreement by either the Company or Parent as provided in Section 8.1, this Agreement shall forthwith become void and there shall be no liability or obligation on the part of Parent, Merger Sub or the Company or their respective officers or directors; provided, however, that (i) the provisions of Sections 8.2, 8.3, 8.4, and 8.5 and Article IX and the Confidentiality Agreement shall remain in full force and effect and survive any termination of this Agreement and (ii) the Termination Fee shall be the exclusive remedy of Parent and Merger Sub under circumstances where the Termination Fee is payable by the Company; provided, further, that no Party shall be relieved or released from any liabilities or damages arising out of its willful and material breach of any provision of this Agreement and, in such event, the non-breaching Party or Parties shall be entitled to seek recovery for any and all damages, losses, claims, liabilities, demands, charges, penalties, costs, expenses and/or diminution in value of such Party or Parties. In no event shall any Party be liable for punitive damages.

     Section 8.3. Fees and Expenses. Except as otherwise expressly set forth in this Agreement, all fees and expenses incurred in connection herewith and the transactions contemplated hereby shall be paid by the Party incurring such expenses, whether or not the Merger is consummated, except that each of Parent and the Company shall bear and pay one-half of the costs and expenses incurred in connection with the filing, printing and mailing of the Proxy Statement (including any SEC filing fees).

     Section 8.4. Termination Fee.

          Section 8.4.1. If this Agreement is terminated pursuant to Section 8.1(c)(ii), Section 8.1(c)(iii)(x), Section 8.1(d)(ii) or Section 8.1(d)(iii) and neither Parent nor Merger Sub is in material breach of this Agreement at the time of such termination, then the Company shall pay, or cause to be paid, to Parent $10,000,000 (the “Termination Fee”), which amount shall be inclusive of all Expenses of Parent and Merger Sub, not later than the day of such termination. The Termination Fee shall be paid by wire transfer of immediately available funds to an account designated in writing to the Company by Parent. For the avoidance of doubt, in no event shall the Company be obligated to pay, or cause to paid, the Termination Fee on more than one occasion.

50

          Section 8.4.2. The Company acknowledges that the agreements contained in this Section 8.4 are an integral part of the transactions contemplated in this Agreement, that the damages resulting from termination of this Agreement under circumstances where a Termination Fee is payable are uncertain and incapable of accurate calculation and that the amounts payable pursuant to Section 8.4.1 are reasonable forecasts of the actual damages that may be incurred and constitute liquidated damages and not a penalty, and that, without these agreements, Parent would not enter into this Agreement; accordingly, if the Company fails to promptly pay the Termination Fee, and, in order to obtain such payments Parent commences a suit that results in a judgment against the Company for the Termination Fee, the Company shall pay to Parent its costs and expenses (including reasonable attorney’s fees) in connection with such suit.

     Section 8.5. Specific Performance. The Parties recognize that in the event Parent or Merger Sub should refuse to perform under the provisions of this Agreement, monetary damages alone will not be adequate. The Company shall therefore be entitled, in addition to any other remedies that may be available, including money damages, to obtain specific performance of the terms of this Agreement. In the event of any action to enforce this Agreement specifically, Parent and Merger Sub hereby waive the defense that there is an adequate remedy at law.

     Section 8.6. Extension; Waiver. At any time prior to the Effective Time, the Parties may, to the extent permitted by applicable Law, subject to Section 8.7, (i) extend the time for the performance of any of the obligations or other acts of the other Parties, (ii) waive any inaccuracies in the representations and warranties contained herein or in any document delivered pursuant hereto or (iii) waive compliance with any of the agreements or conditions contained herein; provided, however, that after the Stockholder Approval has been obtained, there may not be any extension or waiver of this Agreement that decreases the Merger Consideration or that adversely affects the rights of the holders of Company Common Stock hereunder without the approval of the holders of Company Common Stock. Any agreement on the part of a Party to any such extension or waiver shall be valid only if set forth in a written instrument signed on behalf of such Party. The failure of any Party to assert any of its rights under this Agreement or otherwise shall not constitute a waiver of those rights.

     Section 8.7. Amendment. This Agreement may be amended by the Parties but only by action taken by or on behalf of their respective Boards of Directors at any time prior to the Effective Time; provided, however, that, after the Stockholder Approval has been obtained, no amendment may be made without further approval of the holders of Company Common Stock that, by Law or in accordance with the rules of any relevant stock exchange or market or trading system, requires further approval by the holders of Company Common Stock. This Agreement may not be amended except by an instrument in writing signed by the Parties.

ARTICLE IX
GENERAL PROVISIONS

     Section 9.1. Non-Survival of Representations and Warranties. None of the representations and warranties in this Agreement or in any instrument delivered pursuant to this Agreement shall survive the Effective Time, and after the Effective Time no claim, action, suit or proceeding may be asserted or brought based on or relating to any such representation or

51

warranty or any breach or alleged breach thereof. This Article IX, the agreements of Parent, Merger Sub and the Company in Section 3.5 (Company Equity Awards), Section 6.8 (Employee Matters), Section 6.9 (Indemnification of Directors and Officers), and Section 8.3 (Fees and Expenses) and those other covenants and agreements contained herein that by their terms apply, or that are to be performed in whole or in part, after the Effective Time shall survive the consummation of the Merger.

     Section 9.2. Notices. Any notices or other communications required or permitted under, or otherwise in connection with, this Agreement shall be in writing and shall be deemed to have been duly given when delivered in person or upon confirmation of receipt when transmitted by facsimile transmission or by electronic mail (but only if followed by transmittal by national overnight courier or by hand delivery on the next Business Day) or on receipt after dispatch by registered or certified mail, postage prepaid, or on the next Business Day if transmitted by national overnight courier, addressed in each case as follows:

If to Parent or Merger Sub, addressed to it at:	Psychiatric Solutions, Inc.
	6640 Carothers Parkway, Suite 500
	Franklin, Tennessee 37067
	Attention: Christopher L. Howard
	Facsimile: (615) 312-5711
	Email: chris.howard@psysolutions.com
with a mandated copy to:	Waller Lansden Dortch & Davis, LLP
	511 Union Street, Suite 2700
	Nashville, Tennessee 37219
	Attention: George W. Bishop III
	Facsimile: (615) 244-6804
	Email: george.bishop@wallerlaw.com
If to the Company, addressed to it at:	Horizon Health Corporation
	2941 S. Lake Vista Drive
	Lewisville, Texas 75067
	Attention: James Ken Newman
	Facsimile: (972) 420-8282
	Email: ken.newman@horizonhealth.com
with mandated copies to:	Strasburger & Price, L.L.P.
	901 Main Street, Suite 4400
	Dallas, Texas 75202
	Attention: Patrick Owens
	Facsimile: (214) 651-4330
	Email: patrick.owens@strasburger.com
and to:	Vinson & Elkins L.L.P.
	Trammel Crow Center
	2001 Ross Avenue, Suite 3700
	Dallas, Texas 75201

52

Attention: Jeffrey A. Chapman

Facsimile: (214) 999-7797

Email: jchapman@velaw.com

     Section 9.3. Headings. The headings contained in this Agreement are for reference purposes only and shall not affect in any way the meaning or interpretation of this Agreement.

     Section 9.4. Severability. If any term or other provision of this Agreement is invalid, illegal or incapable of being enforced by any rule of Law or public policy, all other conditions and provisions of this Agreement shall nevertheless remain in full force and effect so long as the economic or legal substance of the transactions contemplated hereby is not affected in any manner materially adverse to any Party. Upon such determination that any term or other provision is invalid, illegal or incapable of being enforced, the Parties shall negotiate in good faith to modify this Agreement so as to effect the original intent of the Parties as closely as possible in an acceptable manner to the end that transactions contemplated hereby are fulfilled to the greatest extent possible.

     Section 9.5. Entire Agreement. This Agreement (together with the Exhibits, the Company Disclosure Schedule and the other documents delivered pursuant hereto) and the Confidentiality Agreement constitute the entire agreement of the Parties and supersede all prior agreements and undertakings, both written and oral, among the Parties, or any of them, with respect to the subject matter hereof and thereof.

     Section 9.6. Third-Party Beneficiaries. No provision of this Agreement is intended to confer any rights, benefits, remedies, obligations or liabilities hereunder upon any Person other than the Parties hereto and their respective successors and permitted assigns; provided, however, that (i) the provisions of Section 3.5, Section 6.8 and Section 6.9 shall inure to the benefit of, and shall be enforceable by, the Persons described in such Sections; and (ii) the stockholders of the Company shall be third party beneficiaries of Article III of this Agreement and shall have the right to enforce such provisions, including the right to seek and recover any and all damages that the stockholders of the Company may incur or suffer as a result of a breach of such provisions.

     Section 9.7. Assignment. Neither this Agreement nor any of the rights, interests or obligations hereunder shall be assigned by any of the Parties (whether by operation of law or otherwise) without the prior written consent of the other Parties. Any assignment in violation of the foregoing shall be null and void. No assignment by any Party shall relieve such Party of any of its obligations hereunder. Subject to the foregoing, this Agreement will be binding upon, inure to the benefit of and be enforceable by the Parties and their respective permitted successors and permitted assigns.

     Section 9.8. Mutual Drafting. Each Party has participated in the drafting of this Agreement, which each Party acknowledges is the result of extensive negotiations between the Parties.

53

     Section 9.9. Governing Law; Consent to Jurisdiction.

          Section 9.9.1. This Agreement shall be governed by, and construed in accordance with, the Laws of the State of Delaware, without regard to conflict of law principles that would result in the application of any Law other than the Laws of the State of Delaware.

          Section 9.9.2. Any legal action, suit or proceeding arising out of or relating to this Agreement or the transactions contemplated hereby shall be brought solely in the Chancery Court of the State of Delaware; provided, that if (and only after) such courts determine that they lack subject matter jurisdiction over any such legal action, suit or proceeding, such legal action, suit or proceeding shall be brought in the Federal courts of the United States located in the State of Delaware; provided, further, that if (and only after) both the Chancery Court of the State of Delaware and the Federal courts of the United States located in the State of Delaware determine that they lack subject matter jurisdiction over any such legal action, suit or proceeding, such legal action, suit or proceeding shall be brought in the United States District Court for the Northern District of Texas. Each Party hereby irrevocably submits to the exclusive jurisdiction of such courts in respect of any legal action, suit or proceeding arising out of or relating to this Agreement or the transactions contemplated hereby, and hereby waives, and agrees not to assert, as a defense in any such action, suit or proceeding, any claim that it is not subject personally to the jurisdiction of such courts, that the action, suit or proceeding is brought in an inconvenient forum, that the venue of the action, suit or proceeding is improper or that this Agreement or the transactions contemplated hereby may not be enforced in or by such courts. Each Party agrees that notice or the service of process in any action, suit or proceeding arising out of or relating to this Agreement or the transactions contemplated hereby shall be properly served or delivered if delivered in the manner contemplated by Section 9.2.

     Section 9.10. Counterparts. This Agreement may be executed in one or more counterparts, and by the different Parties in separate counterparts, each of which when executed shall be deemed to be an original but all of which taken together shall constitute one and the same agreement. The delivery by or on behalf of any Party of its signature to this Agreement by facsimile transmission, electronic mail or similar means shall for all purposes be the equivalent of the delivery of the original signature of such Party.

(Remainder of Page Intentionally Left Blank)

54

     IN WITNESS WHEREOF, Parent, Merger Sub and the Company have caused this Agreement to be executed as of the date first written above by their respective officers thereunto duly authorized.

PSYCHIATRIC SOLUTIONS, INC.
By:	/s/ Christopher L. Howard
Name: Christopher L. Howard
Title: EVP, General Counsel & Secretary
PANTHER ACQUISITION SUB, INC.
By:	/s/ Christopher L. Howard
Name: Christopher L. Howard
Title: VP & Secretary
HORIZON HEALTH CORPORATION
By:	/s/ James Ken Newman
Name: James Ken Newman
Title: Chairman, President and CEO

EX-10.22

Exhibit 10.22

Summary of Director Compensation

     Directors who are employees of the Company receive no additional compensation for their services as directors. Each non-employee director receives:

• an annual retainer in the amount described below;

• a meeting fee of $2,000 for each Board or committee meeting attended in person and $1,000 for each telephonic meeting (but only one fee in the event that more than one such meeting is held on a single day);

• an initial grant of an option to purchase 12,000 shares of common stock on the date of such director’s appointment to the Board of Directors;

• an annual grant of an option to purchase 8,000 shares of common stock; and

• reimbursement for necessary travel expenses incurred in attending such meetings.

     Additionally, the Board member serving as Chairman of the Audit Committee and the Board member serving as Chairman of the Compliance Committee receive an additional $2,000 per month. The Board member serving as Chairman of the Nominating and Corporate Governance Committee and the Board member serving as Chairman of the Compensation Committee receive an additional $1,000 per month.

     In 2006, each non-employee director received an annual retainer of $12,000. On November 2, 2006, the Board of Directors increased the annual cash retainer to be paid to each non-employee director in 2007 and for subsequent years to $40,000.

EX-21.1

Exhibit 21.1

Subsidiaries of Psychiatric Solutions, Inc.

	State of
Name	Organization
ABS-First Step, Inc.	Virginia
ABS LINCS DC, LLC	Virginia
ABS LINCS KY, Inc.	Virginia
ABS LINCS, LLC	Virginia
ABS LINCS NJ, Inc.	Virginia
ABS LINCS PA, Inc.	Virginia
ABS LINCS PR, Inc.	Virginia
ABS LINCS SC, Inc.	South Carolina
ABS LINCS TN, Inc.	Virginia
ABS LINCS TX, Inc.	Kentucky
ABS LINCS VA, Inc.	Virginia
ABS LINCS VI, Inc.	Virginia
ABS New Hope, Midlands, Inc.	South Carolina
Alliance Crossings, LLC	Delaware
Alliance Health Center, Inc.	Mississippi
Alternative Behavioral Services, Inc.	Virginia
Atlantic Shores Hospital, LLC	Delaware
Behavioral Educational Services, Inc.	Delaware
Behavioral Healthcare LLC	Delaware

	State of
Name	Organization
Benchmark Behavioral Health System, Inc.	Utah
BHC Alhambra Hospital, Inc.	Tennessee
BHC Belmont Pines Hospital, Inc.	Tennessee
BHC Cedar Vista Hospital, Inc.	California
BHC Fairfax Hospital, Inc.	Tennessee
BHC Fort Lauderdale Hospital, Inc.	Tennessee
BHC Fox Run Hospital, Inc.	Tennessee
BHC Fremont Hospital, Inc.	Tennessee
BHC Health Services of Nevada, Inc.	Nevada
BHC Heritage Oaks Hospital, Inc.	Tennessee
BHC Holdings, Inc.	Delaware
BHC Intermountain Hospital, Inc.	Tennessee
BHC Management Services of Louisiana, LLC	Delaware
BHC Management Services of New Mexico, LLC	Delaware
BHC Management Services of Streamwood, LLC	Delaware
BHC Mesilla Valley Hospital, LLC	Delaware
BHC Montevista Hospital, Inc.	Nevada
BHC Newco 2, LLC	Delaware
BHC Newco 3, LLC	Delaware
BHC Newco 4, LLC	Delaware
BHC Newco 5, LLC	Delaware
BHC Newco 6, LLC	Delaware

	State of
Name	Organization
BHC Newco 7, LLC	Delaware
BHC Newco 8, LLC	Delaware
BHC Newco 9, LLC	Delaware
BHC Newco 10, LLC	Delaware
BHC Northwest Psychiatric Hospital, LLC	Delaware
BHC of Indiana General Partnership		N/A
BHC Pinnacle Pointe Hospital, Inc.	Tennessee
BHC Properties, LLC	Tennessee
BHC Sierra Vista Hospital, Inc.	Tennessee
BHC Spirit of St. Louis Hospital, Inc.	Tennessee
BHC Streamwood Hospital, Inc.	Tennessee
BHC Windsor Hospital, Inc.	Ohio
Bloomington Meadows, General Partnership		N/A
Brentwood Acquisition, Inc.	Tennessee
Brentwood Acquisition-Shreveport, Inc.	Delaware
Brynn Marr Hospital, Inc.	North Carolina
Calvary Center, Inc.	Delaware
Canyon Ridge Hospital, Inc.	California
Canyon Ridge Real Estate, LLC	Delaware
Cedar Springs Hospital, Inc.	Delaware
Cedar Springs Hospital Real Estate, Inc.	Colorado
Children’s Hospital of Vicksburg, L.L.C.	Louisiana

	State of
Name	Organization
Collaborative Care LLC	Tennessee
Columbus Hospital, LLC	Delaware
Columbus Hospital Partners, LLC	Tennessee
Compass Hospital, Inc.	Delaware
CPC/Clinicas Del Este, Inc.	Puerto Rico
Crawford First Education, Inc.	Virginia
Cumberland Hospital, LLC	Virginia
Cypress Creek Real Estate, L.P.	Texas
Diamond Grove Center, LLC	Delaware
FHCHS of Puerto Rico, Inc.	Virginia
First Corrections—Puerto-Rico, Inc.	Virginia
First Hospital Corporation of Nashville	Virginia
First Hospital Corporation of Virginia Beach	Virginia
First Hospital Panamericano, Inc.	Virginia
Fort Lauderdale Hospital, Inc.	Florida
Great Plains Hospital, Inc.	Missouri
Gulf Coast Treatment Center, Inc.	Florida
H. C. Corporation	Alabama
H. C. Partnership		N/A
Havenwyck Hospital Inc.	Michigan
Hickory Trail Hospital, L.P.	Delaware
High Plains Behavioral Health, L.P.	Delaware

	State of
Name	Organization
Holly Hill Hospital, LLC	Tennessee
Holly Hill Real Estate, LLC	North Carolina
HSA Hill Crest Corporation	Alabama
HSA of Oklahoma, Inc.	Oklahoma
Indiana Psychiatric Institutes, LLC	Delaware
InfoScriber Corporation	Delaware
Integrated Healthcare Systems Corp.	Puerto Rico
KMI Acquisition, LLC	Delaware
Lakeland Behavioral, LLC	Florida
Laurel Oaks Behavioral Health Center, Inc.	Delaware
Lebanon Hospital Partners, LLC	Tennessee
Liberty Point Behavioral Healthcare, LLC	Delaware
Mesilla Valley Hospital, Inc.	New Mexico
Mesilla Valley Mental Health Associates, Inc.	New Mexico
Michigan Psychiatric Services, Inc.	Michigan
Millwood Hospital, L.P.	Texas
Mission Vista Behavioral Health Services, Inc.	Delaware
Neuro Institute of Austin, L.P.	Texas
North Spring Behavioral Healthcare, Inc.	Tennessee
Northern Indiana Partners, LLC	Tennessee
Palmetto Behavioral Health Holdings, LLC	Delaware
Palmetto Behavioral Health Solutions, L.L.C.	South Carolina

	State of
Name	Organization
Palmetto Behavioral Health System, L.L.C.	South Carolina
Palmetto Lowcountry Behavioral Health, L.L.C.	South Carolina
Palmetto Pee Dee Behavioral Health, L.L.C.	South Carolina
Panther Acquisition Sub, Inc.	Delaware
Peak Behavioral Health Services, LLC	Delaware
Premier Behavioral Solutions of Florida, Inc.	Delaware
Premier Behavioral Solutions, Inc.	Delaware
Pride Institute, Inc.	Minnesota
PSI Surety, Inc.	South Carolina
Psychiatric Management Resources, Inc.	California
Psychiatric Solutions Hospitals, LLC	Delaware
Psychiatric Solutions of Virginia, Inc.	Tennessee
Ramsay Managed Care, LLC	Delaware
Ramsay Youth Services of Georgia, Inc.	Delaware
Ramsay Youth Services Puerto Rico, Inc.	Puerto Rico
Red Rock Behavioral Health LLC	Delaware
Red Rock Solutions, LLC	Delaware
Riveredge Hospital Holdings, Inc.	Delaware
Riveredge Hospital, Inc.	Illinois
Riveredge Real Estate, Inc.	Illinois
Rolling Hills Hospital, LLC	Tennessee
Samson Properties, LLC	Florida

	State of
Name	Organization
Shadow Mountain Behavioral Health System, LLC	Delaware
Somerset, Incorporated	California
SP Behavioral, LLC	Florida
Springfield Hospital, Inc.	Delaware
Summit Oaks Hospital, Inc.	New Jersey
Sunstone Behavioral Health, LLC	Tennessee
TBD Acquisition, LLC	Delaware
TBJ Behavioral Center, LLC	Delaware
Texas Cypress Creek Hospital, L.P.	Texas
Texas Hospital Holdings, Inc.	Delaware
Texas Hospital Holdings, LLC	Texas
Texas Laurel Ridge Hospital, L.P.	Texas
Texas Oaks Psychiatric Hospital, L.P.	Texas
Texas San Marcos Treatment Center, L.P.	Texas
Texas West Oaks Hospital, L.P.	Texas
The Counseling Center of Middle Tennessee, Inc.	Tennessee
The National Deaf Academy, LLC	Florida
The Pines Residential Treatment Center, Inc.	Virginia
Therapeutic School Services, L.L.C.	Oklahoma
Three Rivers Behavioral Health, LLC	South Carolina
Three Rivers Healthcare Group, LLC	South Carolina
Three Rivers SPE Holding, LLC	South Carolina

	State of
Name	Organization
Three Rivers SPE, LLC	South Carolina
Three Rivers SPE Manager, Inc.	South Carolina
Transitional Care Ventures, Inc.	Delaware
Tucson Health Systems, Inc.	Delaware
University Behavioral, LLC	Florida
Valle Vista Hospital Partners, LLC	Tennessee
Valle Vista, LLC	Delaware
Wekiva Springs Center, LLC	Delaware
Wellstone Holdings, Inc.	Delaware
Wellstone Regional Hospital Acquisition, LLC	Indiana
West Oaks Real Estate, L.P.	Texas
Willow Springs, LLC	Delaware
Windmoor Healthcare Inc.	Florida
Windmoor Healthcare of Pinellas Park, Inc.	Delaware
Zeus Endeavors, LLC	Florida

EX-23.1

EXHIBIT 23.1

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

We consent to the incorporation by reference in the following Registration Statements:

(i)	Registration Statement (Form S-8, No. 333-100635) pertaining to the Psychiatric Solutions, Inc. 1997 Incentive and Nonqualified Stock Option Plan for Key Personnel of Psychiatric Solutions, Inc.;
(ii)	Registration Statement (Form S-8, No. 333-94983) pertaining to the 1997 Equity Incentive Plan of PMR Corporation;
(iii)	Registration Statement (Form S-8, No. 333-38419) pertaining to the 1997 Equity Incentive Plan, 1995 Warrant Grant and the 1996 Stock Option Grants of PMR Corporation;
(iv)	Registration Statement (Form S-8, No. 333-118529) pertaining to the Amended and Restated Psychiatric Solutions, Inc. Equity Incentive Plan and the Amended and Restated Outside Directors’ Non-Qualified Stock Option Plan;
(v)	Registration Statement (Form S-3, No. 333-139013) of Psychiatric Solutions, Inc.;
(vi)	Registration Statement (Form S-8, No. 333-128047) pertaining to the Amended and Restated Psychiatric Solutions, Inc. Equity Incentive Plan; and
(vii)	Registration Statement (Form S-8, No. 333-136339) pertaining to the Amended and Restated Psychiatric Solutions, Inc. Equity Incentive Plan;

of our reports dated February 26, 2007, with respect to the consolidated financial statements of Psychiatric Solutions, Inc., Psychiatric Solutions, Inc. management’s assessment of the effectiveness of internal control over financial reporting, and the effectiveness of internal control over financial reporting of Psychiatric Solutions, Inc., included in this Annual Report (Form 10-K) for the year ended December 31, 2006.

/s/ Ernst & Young LLP

February 26, 2007
Nashville, Tennessee

EX-31.1

EXHIBIT 31.1

CERTIFICATIONS

I, Joey A. Jacobs, certify that:

1. I have reviewed this annual report on Form 10-K of Psychiatric Solutions, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

     a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

     b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles;

     c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

     d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

     a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

     b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: February 27, 2007	/s/ Joey A. Jacobs
	Joey A. Jacobs
	Chairman, Chief Executive Officer
	and President

EX-31.2

EXHIBIT 31.2

CERTIFICATIONS

I, Jack E. Polson, certify that:

1. I have reviewed this annual report on Form 10-K of Psychiatric Solutions, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

     a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

     b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles;

     c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

     d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

     a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

     b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: February 27, 2007	/s/ Jack E. Polson
	Jack E. Polson
	Executive Vice President,
	Chief Accounting Officer

EX-32.1

EXHIBIT 32.1

PSYCHIATRIC SOLUTIONS, INC.
CERTIFICATIONS PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

     In connection with the Annual Report of Psychiatric Solutions, Inc. (the “Company”) on Form 10-K for the year ended December 31, 2006, as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Joey A. Jacobs, Chairman, Chief Executive Officer and President of the Company, and I, Jack E. Polson, Executive Vice President, Chief Accounting Officer of the Company, each certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:

     (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended; and

     (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

     A signed original of this written statement required by Section 906 has been provided to the Company and will be retained by the Company and furnished to the Securities and Exchange Commission or its staff upon request.

Date: February 27, 2007
	/s/ Joey A. Jacobs
	Joey A. Jacobs
	Chairman, Chief Executive Officer
	and President
	/s/ Jack E. Polson
	Jack E. Polson
	Executive Vice President,
	Chief Accounting Officer