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

Forward-Looking Statements

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

OVERVIEW

General

We are a healthcare services management company, providing through our CatasysTM offering behavioral health management services to health plans, employers and unions through a network of licensed and company managed healthcare providers. Catasys offers integrated substance dependence solutions built around our patented PROMETA® Treatment Program for alcoholism and stimulant dependence. The PROMETA Treatment Program, which integrates behavioral, nutritional, and medical components, is also available on a private-pay basis through licensed treatment providers and company managed treatment centers. We also research, develop, license and commercialize innovative physiological, nutritional, and behavioral treatment programs. We manage behavioral health disorders through our controlled subsidiary, Comprehensive Care Corporation (CompCare). We also license or manage treatment centers that offer the PROMETA Treatment Programs, as well as other treatments for substance dependencies.

CompCare Acquisition

Effective January 12, 2007, we acquired a 50.25% controlling interest in Comprehensive Care Corporation (CompCare) through the acquisition of Woodcliff Healthcare Investment Partners, LLP (Woodcliff), which is now at 48.85% as of September 30, 2008. As part of the acquisition, we have obtained anti-dilution protection and the right to designate a majority of the board of directors of CompCare, giving us voting control. Our consolidated financial statements include the business and operations of CompCare subsequent to this date.

CompCare provides managed care services in the behavioral health and psychiatric fields. CompCare manages the delivery of a continuum of psychiatric and substance abuse services to commercial, Medicare and Medicaid members on behalf of employers, health plans, government organizations, third-party claims administrators, and commercial and other group purchasers of behavioral healthcare services. The customer base for CompCare's services includes both private and governmental entities.

Segment Reporting

We currently operate within two reportable segments: healthcare services and behavioral health managed care services. Our healthcare services segment focuses on providing licensing, administrative and management services to licensees that administer PROMETA and other treatment programs, including managed treatment centers that are licensed and/or managed by us. Our behavioral health managed care services segment focuses on providing managed care services in the behavioral health, psychiatric and substance abuse fields, and principally includes the operations of our controlled subsidiary, CompCare. Over 95% of our consolidated revenue and assets are earned or located within the United States.

Operations

Healthcare Services

Under our licensing agreements, we provide physicians and other licensed treatment providers with access to our PROMETA treatment programs, education and training in the implementation and use of the licensed technology and marketing support. The patient's physician determines the appropriateness of the use of the PROMETA Treatment Program. We receive a fee for the licensed technology and related services, generally on a per patient basis. As of September 30, 2008, we had 99 licensed commercial sites throughout the United States, a slight decrease from the 101 licensed sites at September 30, 2007. During the three and nine months ended September 30, 2008, 36 and 50 of these sites, respectively, had treated patients, compared to 52 and 62 sites during the same respective periods in 2007.

Managed Medical Practices and Treatment Centers

In December 2005, The PROMETA Center, Inc., a medical professional corporation (now owned by Lawrence Weinstein, M.D., our senior vice president of medical affairs), opened a state-of-the-art outpatient facility in Santa Monica, California, which we built out under a lease agreement. Under the terms of a full business service management agreement, we manage the business components of the medical practice and license the PROMETA Treatment Programs and the use of our trademarks in exchange for management and licensing fees. The practice offers treatment with the PROMETA Treatment Programs for dependencies on alcohol, cocaine and methamphetamines, as well as medical interventions for other substance dependencies. In January 2007, a second PROMETA Center was opened in San Francisco, which was subsequently closed in January 2008 as part of the effort to steamline our operations. In 2007, we also entered into additional management services agreements with other medical corporations and treatment centers, under similar terms and conditions, including the Murray Hill Recovery Center located in Dallas, Texas. The financial results of the managed medical practices and treatment centers are included in our consolidated financial statements under accounting standards applicable to variable interest entities. Revenue from licensed and managed treatment centers, including the PROMETA Centers, accounted for approximately 42% and 31%, respectively, of our healthcare services revenue in the three and nine months ended September 30, 2008, compared to 30% and 30%, respectively, during the same periods in 2007.

Research and Development

To date, we have spent approximately $12.2 million related to research and development, including $713,000, $3.0 million, $690,000 and $2.4 million, respectively, in the three and nine months ended September 30, 2008 and 2007, in funding for commercial pilots and unrestricted grants for a number of clinical research studies by researchers in the field of substance dependence and leading research institutions to evaluate the efficacy of the PROMETA Treatment Program in treating alcohol and stimulant dependence. For the remainder of 2008, we plan to spend an additional $300,000 for unrestricted research grants and commercial pilots.

International

In 2007 we have expanded our operations into Europe, with our Swiss foreign subsidiary commencing operations in the first quarter of 2007. Our European operations were further expanded in 2007 to include the treatment of other dependencies; however, we have determined to curtail a majority of these operations because they have not been profitable. Our international operations have accounted for revenue of $198,000, $1.1 million, $522,000 and $874,000, respectively, for the three and nine months ended September 30, 2008 and 2007.

Recent Developments

In July 2008, we announced that a double-blind, placebo-controlled alcohol study of our PROMETA Treatment Program demonstrated statistically significant improvement in patients with symptoms of alcohol withdrawal. The initial results of the study were presented at the Research Society on Alcoholism (RSA) conference in Washington, DC, by leading alcoholism expert and RSA President, Raymond Anton, M.D., of Medical University of South Carolina. At the time of the RSA presentation, the data presented covered the initial 6-week active treatment phase of the 14-week study. The study was designed to evaluate the impact of PROMETA on percent days abstinent, other use measures and cravings. Additional data reviews of the full 14-week study, including the results

of functional MRI and acoustic startle (sound-based reflex test) are ongoing, and Dr. Anton plans to release these specifics in a peer-reviewed publication.

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

In January 2008 we streamlined our operations to increase our focus on managed care opportunities, which resulted in an overall reduction of 25% to 30% of cash operating expenses compared to 2007 levels. The actions we took included significant reductions in field and regional sales personnel and related corporate support personnel, closing the PROMETA Center in San Francisco, a reduction in outside consultant expense and overall reductions in overhead costs. One-time costs associated with these actions were approximately $1.2 million and have been recognized as a charge to operating expenses in the statement of operations for the nine months ended September 30, 2008. Such costs primarily represent severance and related benefits and costs incurred to close the San Francisco PROMETA Center.

In April 2008 we took further action to streamline our operations by reducing total operating costs an additional 20% to 25%. Additional one-time costs associated with these actions were approximately $1.2 million and have been recognized as a charge to operating expenses in the statement of operations for the three and nine months ended September 30, 2008.

Behavioral Health Managed Care Services

Our consolidated subsidiary, CompCare, typically enters into contracts on an annual basis to provide managed behavioral healthcare and substance abuse treatment to clients' members. Arrangements with clients fall into two broad categories: capitation arrangements, where clients pay CompCare a fixed fee per member per month, and fee-for-service and administrative service arrangements where CompCare may manage behavioral healthcare programs or perform various managed care services. Approximately $8.2 million and $26.5 million, or 97% and 97% respectively, of CompCare's revenue for the three and nine months ended September 30, 2008 were derived from capitation arrangements, compared to $9.5 million and $25.7 million, or 97% and 97% respectively, for the three months ended September 30, 2007 and the period January 13 through September 30, 2007. Under capitation arrangements, CompCare receives premiums from clients based on the number of covered members as reported by the clients. The amount of premiums received for each member is fixed at the beginning of the contract term. These premiums may be subsequently adjusted, up or down, generally at the commencement of each renewal period.

Effective January 1, 2007, CompCare commenced a contract with a health plan to provide behavioral healthcare services to approximately 250,000 Medicaid recipients in Indiana. This contract amounted to $4.5 million and $13.3 million, respectively, in revenue for the three and nine months ended September 30, 2008, compared to $3.8 million and $10.9 million, respectively, in revenue for the three months ended September 30, 2007 and the period January 13 through September 30, 2007. This contract is anticipated to generate approximately $17 million to $18 million, or approximately 48%, of CompCare's anticipated annual revenue in 2008.

Seasonality of Business

Historically, CompCare has experienced increased member utilization during the months of March, April and May, and consistently low utilization by members during the months of June, July, and August. Such variations in member utilization impact CompCare's costs of care during these months, generally having a positive impact on CompCare's gross margins and operating profits during the June through August period and a negative impact on CompCare's gross margins and operating profits during the months of March through May.

Concentration of Risk

For the nine months ended September 30, 2008, 88%, of revenue in our behavioral health managed care services segment (or 73% of consolidated revenue for the same period) was concentrated in CompCare's contracts with four health plans to provide behavioral healthcare services under commercial, Medicare, Medicaid, and children's health insurance plans. CompCare's contracts with two of these health plans, constituting 69% of behavioral health managed care operating revenue, will end December 31, 2008. For the period January 13 through September 30, 2007, 87% of revenue (or 72% of consolidated revenue for the nine months ended September 30, 2007) was concentrated in six health plans providing such services. This includes the Indiana Medicaid HMO contract, which represented approximately 49% and 43% of behavioral health managed care services revenue for the nine months ended September 30, 2008 and for the period January 13 through September 30, 2007, respectively (or 41% and 35% of our consolidated revenue for the nine months ended September 30, 2008 and 2007, respectively). The term of each contract is generally for one year and is automatically renewable for additional one-year periods unless terminated by either party by giving the requisite written notice. The loss of any one of these clients, unless replaced by new business, may require CompCare to delay or reduce operating expenses and curtail its operations.

Recent Developments

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

In October 2008, CompCare signed a letter of agreement to provide behavioral health and psychotropic pharmaceutical management services for a health plan with approximately 10,000 Medicare members in Puerto Rico. Services under the contract are expected to generate $1.0 million of annual revenue and will be provided through a newly formed, majority owned subsidiary of CompCare. Managed behavioral health services are expected to begin December 1, 2008 while pharmaceutical management services are anticipated to commence January 1, 2009.

At the end of September 2008, CompCare became aware that its major Indiana client had decided to manage its membership through its own provider delivery system and, consequently, CompCare's contract will not be renewed beyond its initial two-year term and will end December 31, 2008. Revenues for this client accounted for $13.3 million, or 48.6% of CompCare's revenues, for the nine months ended September 30, 2008. To offset the loss of this contract, CompCare has increased its sales and marketing efforts, which has increased its prospects for potential new business. CompCare's new contract in Puerto Rico is a result of these efforts and will partially replace the business lost in Indiana.

In August 2008, CompCare's HMO client in Maryland notified them that their contract for the HMO's Maryland membership would not be renewed and would end December 31, 2008. Services provided under this contract accounted for approximately $1.4 million, or 5.1% of behavioral health managed care revenues for the nine-months ended September 30, 2008. The loss of this client, unless replaced by new business, may require CompCare to delay or reduce operating expenses and curtail its operations. As discussed below, CompCare has increased its sales and marketing efforts to offset the loss of contracts.

On June 19, 2008 the court awarded $325,000 in fees and expenses to attorneys for plaintiffs that had filed two class action lawsuits against CompCare in January 2007 seeking to prevent Hythiam from acquiring outstanding common shares it did not own pursuant to a plan of merger between CompCare and Hythiam. The merger was terminated in May 2007 rendering the lawsuits moot, but plaintiffs' attorneys' claims for fees and expenses remained, resulting in the judgment against CompCare for $325,000. CompCare's claim for coverage of the judgment by CompCare's directors' and officers' insurance policy was initially denied, necessitating the accrual of $325,000 of expense in the three months ended June 30, 2008. However, CompCare appealed the denial and the insurance carrier agreed to cover the judgment. Accordingly, CompCare has recognized a $300,000 reduction to

expense, representing CompCare management's estimate of the reimbursable amount of the judgment and related legal fees, less the $100,000 policy deductible, which has been previously been paid.

In March 2008, CompCare signed an amendment to its major HMO contract in Indiana, which accounted for approximately 49% of its total revenue for the nine months ended September 30, 2008. Effective January 1, 2008, CompCare became eligible to receive a 15.9% rate increase, or approximately $200,000 per month, subject to meeting monthly performance measures. CompCare met or exceeded all performance measures for the nine months ended September 30, 2008 and, consequently, has received funds representing the rate increase retroactive to January 1, 2008.

In March 2008, a Medicare Advantage health plan client sent CompCare a termination notice relating to the Pennsylvania region, effectively July 31, 2008. Revenues under this contract accounted for $4.2 million, or approximately 16%, of behavioral health managed care services revenue for the nine months ending September 30, 2008. The loss of this client, unless replaced by new business, may require CompCare to delay or reduce operating expenses and curtail its operations. As discussed above, CompCare has increased its sales and marketing efforts to offset the loss of its contracts.

How We Measure Our Results

Our healthcare services revenue are generated from fees that we charge to hospitals, healthcare facilities and other healthcare providers that license our PROMETA Treatment Programs, and from patient service revenue related to our licensing and management services agreements with managed treatment centers. Our technology license and management services agreements provide for an initial fee for training and other start-up related costs, plus a combined fee for the licensed technology and other related services, generally set on a per-treatment basis, and thus a substantial portion of our revenue are closely related to the number of patients treated. Patients treated by managed treatment centers generate higher average revenue per patient than our other licensed sites due to consolidation of their gross patient revenue in our financial statements. We believe that key indicators of our financial performance are the number of facilities and healthcare providers that contract with us to license our technology and the number of patients that are treated by those providers using the PROMETA Treatment Programs. Additionally, our financial results will depend on our ability to expand the adoption of PROMETA among third party payer groups, and our ability to effectively price these products, and manage general, administrative and other operating costs.

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

CompCare currently depends upon a relatively small number of customers for a significant percentage of behavioral health managed care operating revenue. A significant reduction in sales to any of CompCare's large customers or a customer exerting significant pricing and margin pressures on CompCare would have a material adverse effect on our consolidated results of operations and financial condition. In the past, some of CompCare's customers have terminated their arrangements or have significantly reduced the amount of services requested. There can be no assurance that present or future customers will not terminate their arrangements or significantly reduce the amount of services requested. Any such termination of a relationship or reduction in use of our services would have a material adverse effect on our consolidated results of operations or financial condition (see Note 4 - Major Customers/Contracts).

RESULTS OF OPERATIONS

Table of Summary Consolidated Financial Information

We acquired a controlling interest in CompCare, resulting from our acquisition
of Woodcliff on January 12, 2007, and began including its results in our
consolidated financial statements subsequent to that date. These results are
reported in our behavioral health managed care services segment. The table below
and the discussion that follows summarize our results of consolidated operations
and certain selected operating statistics for the three and nine months ended
September 30, 2008 and 2007:

                                        Three Months Ended              Nine Months Ended
(In thousands)                            September 30,                   September 30,
                                       2008            2007            2008           2007
Revenues
Behavioral health managed care
services                            $     8,400     $    9,760      $   27,315     $   26,525
Healthcare services                       1,258          2,260           5,295          5,692
Total revenues                            9,658         12,020          32,610         32,217

Operating expenses
Behavioral health managed care
expenses                                  7,466          9,373          28,912         25,874
Cost of healthcare services                 330            611           1,335          1,370
General and administrative
expenses                                  9,879         11,760          32,449         34,592
Impairment loss                               -          2,387               -          2,387
Research and development                    713            689           2,986          2,429
Depreciation and amortization               713            673           2,104          1,830
Total operating expenses                 19,101         25,493          67,786         68,482

Loss from operations                     (9,443 )      (13,473 )       (35,176 )      (36,265 )

Interest income                             117            271             761          1,179
Interest expense                           (707 )         (622 )        (1,354 )       (1,736 )
Change in fair value of warrant
liabilities                               3,758              -           4,713              -
Other non-operating income, net               -              3               -             32
Loss before provision for income
taxes                               $    (6,275 )   $  (13,821 )    $  (31,056 )   $  (36,790 )

Summary of Consolidated Operating Results

The loss before provision for income taxes decreased by $7.5 million during the three months ended September 30, 2008 when compared to the same period in 2007, mainly due to the change in fair value of the warrant liability, an impairment loss recognized in 2007 as result of the settlement with XINO Corp., lower operating expense in healthcare services operations and a decrease in the net loss from behavioral health managed care services, partially offset by lower revenues. The $5.7 million decrease in loss before provision for income taxes in the nine months ended September 30, 2008 when compared to the same period in 2007 was mainly due to the change in fair value of the warrant liabilities, the $2.4 million impairment charge and lower operating expense in healthcare services operations, partially offset by an increase in the net loss from behavioral health managed care services and one-time costs incurred from actions taken in both January 2008 and April 2008 to streamline our healthcare services operations. Approximately $137,000 in income before provision for income taxes for the three months ended September 30, 2008 and $5.4 million of the loss before provision for income taxes for the nine months ended September 30, 2008, is attributable to CompCare's operations and purchase accounting adjustments, compared to losses of $1.1 million and $3.0 million for the same periods in 2007, respectively.

Our healthcare services revenue decreased by $1.0 million for the three months ended September 30, 2008 compared to the same period in 2007, due mainly to a decline in the number of patients treated at our U.S licensed sites and the managed treatment centers, the decision to shut down unprofitable sites in our international operations and a decrease in administrative fees earned from new licensees, partially offset by an increase in other treatments at

managed treatment centers. CompCare's behavioral health managed care revenue decreased compared to 2007 due to the loss of four contracts, partially offset by additional business from existing clients. Healthcare services revenue decreased by $397,000 for the nine months ended September 30, 2008 compared to the same period in 2007, due mainly to a decrease in administrative fees earned from new licensees, a decrease in the number of patients treated at managed treatment centers and a decrease in revenues from third party payers, partially offset by increases in the number of patients treated at U.S. licensed sites, other treatments at managed treatment centers and revenues from international operations. CompCare's behavioral health managed care revenue increased primarily due to the additional twelve days included in our consolidated . . .