Overview-

National HealthCare Corporation, which we also refer to as NHC or the Company, is a leading provider of long-term health care services. At December 31, 2008, we operate or manage 76 long-term health care centers with 9,772 beds in 10 states and provide other services in two additional states. These operations are provided by separately funded and maintained subsidiaries. We provide long-term health care services to patients in a variety of settings including long-term nursing centers, managed care specialty units, sub-acute care units, Alzheimer's care units, hospice care, homecare programs, assisted living centers and independent living centers. In addition, we provide management and accounting services to owners of long-term health care centers.

Merger of National HealthCare Corporation and National Health Realty, Inc., and Issuance of NHC Convertible Preferred Stock - On October 31, 2007, NHC completed its acquisition of National Health Realty, Inc., ("NHR") as contemplated by the Agreement and Plan of Merger (the "Merger Agreement"), following the approval of the merger and approval of the issuance of shares of NHC Series A Convertible Preferred Stock ("NHC Preferred") by the stockholders of NHC. The acquisition has provided us with ownership of a portfolio of first class health care, retirement and assisted living centers and has enhanced our net cash flows by approximately $4,000,000 in 2008. We estimate that we experienced a reduction in 2008 earnings per share of approximately 26 cents per common share basic (9 cents per share basic in 2007) and 25 cents per common share diluted (one cent per share diluted in 2007) due to the merger. We believe, however, that the negative consequence is offset by the accretive effect that the merger has had and is expected to have in the future on NHC's free cash flow.

$75,000,000 Revolving Credit Agreement - On October 28, 2008, National HealthCare Corporation extended its Credit Agreement (the "Credit Agreement") with Bank of America, N.A., as lender (the "Lender"). The Credit Agreement provides for a $75,000,000 revolving credit facility (the "Credit Facility").
Amounts outstanding under the Credit Facility bear interest at either, (i) the Eurodollar rate plus 0.375% or (ii) the prime rate.

Commitment fees are payable on the daily unused portion of the Credit Facility at a rate of five (5) basis points per annum for each day when utilization is less than $37,500,000 and two (2) basis points per annum when utilization is equal to or more than $37,500,000. The Credit Facility is available for general corporate purposes, including working capital and acquisitions. We obtained the line of credit to fund further growth strategies as opportunities arise.

Earnings - To monitor our earnings, we have developed budgets and management reports to monitor labor, census, and the composition of revenues. Inflationary increases in our costs may cause net earnings from patient services to decline.

Development and Growth - We are undertaking to expand our long-term care operations while protecting our existing operations and markets. The following table lists our recent or expected construction and purchase activities.

                                                    Placed in Service (PS) or
         Description   Beds        Location          Began Construction (BC)
         Purchase       200   Town & Country , MO   March 2006 - PS
         Addition        30   Farragut, TN          Third Quarter 2006 - PS
         Addition        60   Mauldin, SC           Third Quarter 2006 - PS
         Addition        60   Columbia, SC          First Quarter 2007 - PS
         Addition        60   Garden City, SC       First Quarter 2007 - PS
         Addition        20   Franklin, TN          January 2008 - PS
         Purchase       109   Knoxville, TN         January 2008 - PS
         Addition        60   North Augusta, SC     June 2008 - PS
         Purchase       132   Charleston, SC        August 2008 - PS
         Purchase        60   Charleston, SC        August 2008 - PS
         New Center     120   Bluffton, SC          October 2008 - BC

We expect to begin construction in 2009 of a new 92-bed facility in Hendersonville, Tennessee and a new 60-bed long-term care facility in Tullahoma, Tennessee. During 2009, we will apply for Certificates of Need for additional beds in our markets and also evaluate the feasibility of expansion into new markets by building private pay health care centers or by the purchase of existing health care centers.

In 2008, we developed an active hospice program in South Carolina independently of our partnership with Caris Healthcare. On December 15, 2008, we licensed five new hospice locations in South Carolina. One additional office is scheduled to open in the first quarter of 2009.

Accrued Risk Reserves - Our accrued professional liability reserves, workers' compensation reserves and health insurance reserves totaled $106,000,000 at December 31, 2008 and are a primary area of management focus. We have set aside restricted cash and marketable securities to fund our professional liability and workers' compensation reserves.

As to exposure for professional liability claims, we have developed for our centers performance certification criteria to measure and bring focus to the patient care issues most likely to produce professional liability exposure, including in-house acquired pressure ulcers, significant weight loss and numbers of falls. These programs for certification, which we regularly modify and improve, have produced measurable improvements in reducing these incidents. Our experience is that achieving goals in these patient care areas improves both patient and employee satisfaction. Furthermore, we are continuing efforts to identify and restructure the ownership or management of our higher risk operations and locations to eliminate NHC liability exposure.

Application of Critical Accounting Policies

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates and cause our reported net income to vary significantly from period to period.

Our critical accounting policies that are both important to the portrayal of our financial condition and results and require our most difficult, subjective or complex judgments are as follows:

Revenue Recognition - Third Party Payors - Approximately 61% (2008), 60% (2007), and 63% (2006) of our net revenues are derived from Medicare, Medicaid, and other government programs. Amounts earned under these programs are subject to review by the Medicare and Medicaid intermediaries. In our opinion, adequate provision has been made for any adjustments that may result from these reviews.
Any differences between our estimates of settlements and final determinations are reflected in operations in the year finalized. We have made provisions of approximately $15,594,000 for other various Medicare and Medicaid issues for current and prior year cost reports and claims reviews. Consistent with our revenue recognition policies, we will record revenues associated with the approved requests and the other various issues when the approvals, including the final cost report audits, are assured. We recorded revenues of $490,000, $2,910,000, and $3,928,000 for such settlements in 2008, 2007, and 2006, respectively

Revenue Recognition - Private Pay - For private pay patients in skilled nursing or assisted living facilities, we bill room and board in advance for the current month with payment being due upon receipt of the statement in the month the services are performed. Charges for ancillary, pharmacy, therapy and other services to private patients are billed in the month following the performance of services; however, all billings are recognized as revenue when the services are performed.

Valuations and Impairments to our Investment in a Cash Fund in Liquidation - At December 31, 2008, we reported an aggregate investment of $7,804,000 in the Columbia Strategic Cash Portfolio Fund (the "Fund") which invests principally in corporate debt, mortgage-backed securities and asset-backed securities. On December 7, 2007 at which time our investment in the Fund totaled $39,500,000 the Fund's manager notified us that due to turmoil in credit markets in the United States (1) Fund cash redemptions to investors were suspended, (2) the Fund's valuation will be based on the market value of the underlying securities instead of amortized cost, (3) interest would continue to accrue and be paid and
(4) the Fund would begin an orderly liquidation and dissolution of its assets for distribution to the Fund holders. As the Fund is being liquidated, we have and expect to continue to receive our pro rata share of the Fund in cash distributions.

According to the Fund's manager, total distributions from the Fund since December 6, 2007 through December 31, 2008 have totaled approximately 76% of original units. During that period, we have received cash distributions of $29,041,000, reported realized losses of $859,000, and reported losses to reduce the Fund balance to its net asset value of $1,796,000. During that same period, we have reported interest income from the fund of $810,000.

The Fund's valuation fluctuates based on changes in the market values of the securities held by the Fund. We will continue to evaluate our investment in the Fund for other-than-temporary impairments. It is possible that future events could require us to make significant adjustments or revisions to our estimates of the Fund value.

As to valuation methods, all Fund assets are valued each business day by a third party accounting agent under the oversight of a valuation committee within Columbia Management. Historically, a third party pricing service, or services, delivers the nightly security valuations based on widely available market data and sources to the accounting agent for the Fund.

For securities where prices from third party valuation services are not available (in less than 5% of the cases) , the Columbia Management valuation committee meets and determines a value for the security based on an evaluation of available data, portfolio manager input, trading desk input as well as any other appropriate factors. The portfolio manager of the Fund may present facts to the valuation committee but does not have a vote in this process.

The valuation committee comprises investment professionals, fixed income and equity traders, risk management professionals and accountants and is advised at each meeting by legal, compliance and internal audit professionals. Valuations used for each individual security within the Fund are reviewed every night by Columbia Management fixed income traders prior to the calculation of the Fund's NAV for that day. If the fixed income traders determine that adjustments are required, they must be verified by an independent third party or approved by the valuation committee.

Accrued Risk Reserves - We are principally self-insured for risks related to employee health insurance, workers' compensation and professional and general liability claims. Our accrued risk reserves primarily represent the accrual for self-insured risks associated with employee health insurance, workers' compensation and professional and general liability claims. The accrued risk reserves include a liability for reported claims and estimates for incurred but unreported claims. Our policy with respect to a significant portion of our workers' compensation and professional and general liability claims is to use an actuary to support the estimates recorded for incurred but unreported claims.
Our health insurance reserve is based on our known claims incurred and an estimate of incurred but unreported claims determined by our analysis of historical claims paid. We reassess our accrued risk reserves on a quarterly basis.

Professional liability remains an area of particular concern to us. The entire long term care industry has seen a dramatic increase in personal injury/wrongful death claims based on alleged negligence by nursing homes and their employees in providing care to residents. As of December 31, 2008, we and/or our managed centers are defendants in 59 such claims inclusive of years 1999 through 2008.
It remains possible that those pending matters plus potential unasserted claims could exceed our reserves, which could have a material adverse effect on our financial position, results of operations and cash flows. It is also possible that future events could cause us to make significant adjustments or revisions to these reserve estimates and cause our reported net income to vary significantly from period to period.

We maintain insurance coverage for incidents occurring in all provider locations owned, leased or managed by us. The coverages include both primary policies and umbrella policies.

For 2002, we maintain primary coverage through our own insurance company with excess coverage provided by a third party insurance company. For 2003-2008, we maintain both primary and excess coverage through our own insurance subsidiary.
In all years, settlements, if any, in excess of available insurance policy limits and our own reserves would be expensed by us.

Revenue Recognition - Subordination of Fees and Uncertain Collections - We provide management services to certain long-term care facilities and to others we provide accounting and financial services. We generally charge 6% of net revenues for our management services and a predetermined fixed rate per bed for the accounting and financial services. Our policy is to recognize revenues associated with both management services and accounting and financial services on an accrual basis as the services are provided. However, under the terms of our management contracts, payments for our management services are subject to subordination to other expenditures of the long-term care center being managed.
Furthermore, there are certain of the third parties with whom we have contracted to provide services and which we have determined, based on insufficient historical collections and the lack of expected future collections, that collection is not reasonably assured and our policy is to recognize income only in the period in which the amounts are realized. We may receive payment for the unpaid and unrecognized management fees in whole or in part in the future only if cash flows from the operating and investing activities of the centers are sufficient to pay the fees. There can be no assurance that such future cash flows will occur. The realization of such previously unrecognized revenue could cause our reported net income to vary significantly from period to period.

We agree to subordinate our fees to the other expenses of a managed center because we believe we know how to improve the quality of patient services and finances of a long-term care center and because subordinating our fees demonstrates to the owner and employees of the managed center how confident we are of the impact we can have in making the center operations successful. We may continue to provide services to certain managed centers despite not being fully paid currently so that we may be able to collect unpaid fees in the future from improved operating results and because the incremental savings from discontinuing services to a center may be small compared to the potential benefit. Also, we may benefit from providing other ancillary services to the managed center. We may receive payment for the unrecognized management fees in whole or in part in the future only if cash flows from the operating and investment activities of the centers are sufficient to pay the fees. There can be no assurance that such future cash flows will occur.

See Notes 3, 4 and 5 to the Consolidated Financial Statements regarding our relationships with National, NHI and centers previously owned by NHI and the recognition of management fees from long-term care centers owned by these parties.

Certain of our accounts receivable from private paying patients and certain of our notes receivable are subject to credit losses. We have attempted to reserve for expected accounts receivable credit losses based on our past experience with similar accounts receivable and believe our reserves to be adequate.

We continually monitor and evaluate the carrying amount of our notes receivable in accordance with Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan - An Amendment of FASB Statements No. 5 and 15." It is possible, however, that the accuracy of our estimation process could be materially impacted as the composition of the receivables changes over time. We continually review and refine our estimation process to make it as reactive to these changes as possible. However, we cannot guarantee that we will be able to accurately estimate credit losses on these balances. It is possible that future events could cause us to make significant adjustments or revisions to these estimates and cause our reported net income to vary significantly from period to period.

Potential Recognition of Deferred Income - During 1988, we sold the assets of eight long-term health care centers to National Health Corporation ("National"), our administrative general partner at the time of the sale. The resulting profit of $15,745,000 was deferred. $10,000,000 of the deferred gain and related deferred income taxes of $4,000,000 was recognized as income in December, 2007 with the collection of the $10,000,000 note from National.
$3,745,000 of the deferred gain has been amortized into income on a straight-line basis over the 20-year management contract period (through December 31, 2007). Additional deferred income of $2,000,000 will be recognized when the Company no longer has an obligation to advance the $2,000,000 working capital loan which obligation was extended until January 20, 2018 with the extension of the management agreement with National to that date.

Guarantees - At December 31, 2008, no agreements to guarantee the debt of other parties are outstanding.

Uncertain Tax Positions - NHC continually evaluates for uncertain tax positions.
These uncertain positions may arise where tax laws may allow for alternative interpretations or where the timing of recognition of income is subject to judgment. We believe we have adequate provisions for our uncertain tax positions including related penalties and interest. However, because of uncertainty of interpretation by various tax authorities and the possibility that there are issues that have not been recognized by management, we cannot guarantee we have accurately estimated our tax liabilities.

The above listing is not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by generally accepted accounting principles, with limited need for management's judgment in their application.
There are also areas in which management's judgment in selecting any available alternative would not produce a materially different result. See our audited consolidated financial statements and notes thereto which contain accounting policies and other disclosures required by generally accepted accounting principles.

The following table and discussion sets forth items from the consolidated statements of income as a percentage of net revenues for the audited years ended December 31, 2008, 2007 and 2006.

                           Percentage of Net Revenues


                   Year Ended December 31,                2008     2007     2006

       Revenues:
         Net patient revenues                             89.8%    90.3%    89.1%
         Other revenues                                   10.2      9.7     10.9
              Net Revenues                               100.0    100.0    100.0
       Costs and Expenses:
         Salaries, wages and benefits                     53.6     54.6     53.8
         Other operating                                  29.4     29.4     28.0
         Recovery of notes receivable                        -     (2.3)    (1.3)
         Recognition of deferred gain - National             -     (1.7)       -
         Gain on sale of assets                              -     (1.8)       -
         Rent                                              4.9      6.7      7.2
         Depreciation and amortization                     3.8      2.8      2.5
         Interest                                           .1       .2       .2
              Total costs and expenses                    91.8     87.9     90.4
         Income before income taxes                        8.2     12.1      9.6
         Income tax provision                             (2.6)    (4.5)    (3.1)
         Net Income                                        5.6      7.6      6.5
         Dividends to preferred shareholders              (1.3)     (.3)       -
         Net income available to common shareholders       4.3      7.3      6.5

                      Period to Period Increase (Decrease)


                                                   2008 vs. 2007          2007 vs. 2006
(dollars in thousands)                            Amount     Percent     Amount     Percent
Revenues:
  Net patient revenues                          $  43,296       8.0    $  38,053       7.6
  Other revenues                                    7,613      13.1       (2,977)     (4.9)
       Net revenues                                50,909       8.5       35,076       6.2
Costs and Expenses:
  Salaries, wages and benefits                     21,489       6.6       23,583       7.8
  Other operating                                  14,929       8.5       17,985      11.4
  Write-off (recovery) of notes receivable         13,571     100.0       (6,262)    (85.7)
  Recognition of deferred gain - National          10,000     100.0      (10,000)   (100.0)
  Gain on sale of assets                           11,108     100.0      (11,108)   (100.0)
  Rent                                             (8,752)    (21.8)        (105)      (.3)
  Depreciation and amortization                     7,810      45.9        2,836      20.0
  Interest                                           (299)    (25.5)         192      19.6
       Total costs and expenses                    69,856      13.3       17,121       3.4
  Income Before Income Taxes                      (18,947)    (26.2)      17,955      33.1
  Income Tax Provision                              9,869      36.8       (9,246)    (52.7)
  Net Income                                       (9,078)    (20.0)       8,709      23.7
  Dividends paid to preferred shareholders         (6,842)   (373.7)      (1,831)   (100.0)
  Net income available to common shareholders   $ (15,920)    (36.5)   $   6,878      18.7

Our long-term health care services, including therapy and pharmacy services, provided 91.4%, 91.8% and 91.0% of net patient revenues in 2008, 2007, and 2006, respectively. Homecare programs provided 8.6%, 8.2%, and 9.0% of net patient revenues in 2008, 2007, and 2006, respectively.

The overall average census in owned and leased health care centers for 2008 was 92.5% compared to 92.5% in 2007 and 93.6% in 2006.

Approximately 61% (2008), 60% (2007) and 63% (2006) of our net patient revenues are derived from Medicare, Medicaid, and other government programs. As discussed above in the Application of Critical Accounting Policies section, amounts earned under these programs are subject to review by the Medicare and Medicaid intermediaries. See Application of Critical Accounting Policies for discussion of the effects that this revenue concentration and the uncertainties related to such revenues have on our revenue recognition policies.

Government Program Financial Changes

Cost containment will continue to be a priority for Federal and State governments for health care services, including the types of services we provide. Government reimbursement programs such as Medicare and Medicaid prescribe, by law, the billing methods and amounts that health care providers may charge and be reimbursed to care for patients covered by these programs. Congress has passed a number of laws that have effected major changes in the Medicare and Medicaid programs. The Balanced Budget Act of 1997 sought to achieve a balanced federal budget by, among other things, reducing federal spending on Medicare and Medicaid to various providers. In February 2006, Congress enacted the Deficit Reduction Act, or DRA, which reduced net Medicare and Medicaid spending, and in December 2006, Congress passed the Tax Relief and Health Care Act of 2006, which also affects payments under the Medicare and Medicaid programs. In the Tax Relief and Health Care Act of 2006, Congress reduced the limit on Medicaid provider taxes for the period January 1, 2008 through September 30, 2011 from the 6 percent set by CMS regulations to a 5.5 percent limit set by statute.

Medicare-

Effective October 1, 2008, our PPS rates were increased by 3.4% due to an inflation update. Our annual 2008 Medicare revenues increased by 6.5% over our annual 2007 Medicare revenues. The inflation update (or market basket increase) was 3.1% in 2006 and 3.3% in 2007.

Overall our average Medicare per diem increased 1.8% in 2008 compared to 2007.
No assurances can be given as to whether Congress will increase or decrease reimbursement in the future, the timing of any action or the form of relief, if any, that may be enacted.

Medicaid-

Tennessee annual Medicaid rate increases were implemented effective July 1, 2008. We estimate that the resulting increase in revenue was approximately $514,000 per quarter.

Missouri Medicaid funded a global rate increase for all providers of $6.00 per day effective after July 1, 2008. The quarterly effect of these rate increases was approximately $330,000 in 2008.

Overall our average Medicaid per diem increased 3.23% in 2008 compared to 2007. We face challenges with respect to states' Medicaid payments, because many currently do not cover the total costs incurred in providing care to those patients. States will continue to control Medicaid expenditures but also look for adequate funding sources, including provider assessments. The DRA includes several provisions designed to reduce Medicaid spending. These provisions include, among others, provisions strengthening the Medicaid asset transfer restrictions for persons seeking to qualify for Medicaid long-term care coverage, which could, due to the timing of the penalty period, increase facilities' exposure to uncompensated care. Other provisions could increase state funding for home and community-based services, potentially having an impact on funding for nursing facilities. There is no assurance that the funding . . .