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

Forward-Looking Statements

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

OVERVIEW

General

We are a healthcare services management company, providing through our Catasys™ subsidiary behavioral health management services for substance abuse to health plans, employers and unions. Catasys is focused on offering integrated substance dependence solutions, including medical interventions such as 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 a company-managed treatment center that offers the PROMETA Treatment Program, as well as other treatments for substance dependencies.

Segment Reporting

We currently operate within two reportable segments: Healthcare services and Behavioral Health. Our healthcare services segment focuses on providing licensing, administrative and management services to licensees that administer PROMETA and other treatment programs, including the managed treatment center that is licensed and managed by us. Our Behavioral Health segment, through our Catasys™ subsidiary, combines innovative medical and psychosocial treatments with elements of traditional disease management and ongoing member support to help organizations treat and manage substance dependent populations, and is designed to lower both the medical and behavioral health costs associated with substance dependence and the related co-morbidities. Currently, substantially all of our revenue from continuing operations and substantially all of our assets are earned or located within the United States.

Discontinued Operations

On January 20, 2009 we sold our entire interest in our controlled subsidiary CompCare for aggregate gross proceeds of $1.5 million. We recognized a gain of approximately $11.2 million from the sale of our CompCare interest, which is included in our Consolidated Statement of Operations for the six months ended June 30, 2009. Additionally, we entered into an administrative services only (ASO) agreement with CompCare to provide certain administrative services under CompCare's National Committee for Quality Assurance (NCQA) accreditation, including but not limited to case management and authorization services, in support of our newly launched specialty products and programs for autism and ADHD.

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

Operations

Healthcare Services

Licensing Operations

Under our licensing agreements, we provide physicians and other licensed treatment providers access to our PROMETA Treatment Program, education and training in the implementation and use of the licensed technology. The patient's physician determines the appropriateness of the use of the PROMETA Treatment Program. We receive

a fee for the licensed technology and related services generally on a per patient basis. As of June 30, 2009, we had active licensing agreements with physicians, hospitals and treatment providers for 40 sites throughout the United States, with 23 sites contributing to revenue in 2009. We will continue to enter into agreements on a selective basis with additional healthcare providers to increase the availability of the PROMETA Treatment Program, generally in markets we are presently operating or where such sites will provide support for our Catasys products. As such revenues are generally related to the number of patients treated, key indicators of our financial performance for the PROMETA Treatment Program will be the number of facilities and healthcare providers that license our technology, and the number of patients that are treated by those providers using our PROMETA Treatment Program. As discussed below in Recent Developments, we have reduced resources allocated to licensing activities and are currently evaluating and considering additional actions to streamline our operations that may impact the licensing operations.

Managed Treatment Center

We currently manage one treatment center under our licensing agreement, located in Santa Monica, California (dba The Center to Overcome Addiction, formerly named the PROMETA Center). In May 2009, we terminated the Management Services Agreements ("MSA") with a medical professional corporation and a managed treatment center in Dallas, Texas. We manage the business components of the Center to Overcome Addiction and license the PROMETA Treatment Program and use of the name in exchange for management and licensing fees under the terms of a full business service management agreement. This center offers treatment with the PROMETA Treatment Program for dependencies on alcohol, cocaine and methamphetamines and also offer medical interventions for other substance dependencies and psychiatric services. The revenues and expenses of this center are included in our consolidated financial statements under accounting standards applicable to variable interest entities. Revenues from licensed and managed treatment centers, including the Center to Overcome Addiction, accounted for approximately 59% and 56% of our healthcare services revenues for the three and six months ended June 30, 2009, respectively. As discussed below in Recent Developments, we are currently evaluating and considering additional actions to streamline our operations that may impact our managed treatment center.

Behavioral Health

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

Recent Developments

In the first half of 2009, we completed actions that we began in the fourth quarter of 2008 to reduce our operating expenses by an additional $10.2 million from the third quarter 2008 expenditure level. The actions we took included significant reductions in field and regional sales personnel and related corporate support personnel, curtailment of our international operations, a reduction in outside consultant expense, termination of a clinical study and overall reductions in overhead and payroll costs. Additionally, we took further actions in the first half of 2009 to streamline our operations and increase the focus on managed care opportunities and to renegotiate certain leasing and vendor agreements to obtain more favorable pricing and to restructure payment terms with vendors, which included negotiating settlements for outstanding liabilities. In addition, we terminated the MSAs with a medical professional corporation and a managed treatment center in Dallas, Texas "for cause" and because the Company had met its funding requirement with respect to such MSAs. These efforts have resulted in delays and reductions in operating expenses, resulting in additional annual savings in operating expenses of approximately $4.5 million.

Dr. Anton's study on alcohol dependent subjects, entitled "Efficacy of a Combination of Flomazenil and Gabapenton in the Treatment of Alcohol Dependence", was published in the August issue of Journal of Clinical Psychopharmacology.

How We Measure Our Results

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

RESULTS OF OPERATIONS

Table of Summary Consolidated Financial Information

The table below and the discussion that follows summarize our results of
consolidated continuing operations for the three and six months ended June 30,
2009 and 2008:

                                              Three Months Ended            Six Months Ended
(In thousands, except per share amounts)           June 30,                     June 30,
                                             2009           2008           2009           2008
Revenues
Healthcare services                        $     371     $    2,031     $    1,078     $    4,037
Total revenues                                   371          2,031          1,078          4,037

Operating expenses
Cost of healthcare services                      161            524            434          1,005
General and administrative expenses            4,526          8,961         10,129         20,115
Research and development                           -            915              -          2,273
Impairment losses                                  -              -          1,113              -
Depreciation and amortization                    302            446            706            909
Total operating expenses                       4,989         10,846         12,382         24,302

Loss from operations                          (4,618 )       (8,815 )      (11,304 )      (20,265 )

Interest & other income                           77            196            123            625
Interest expense                                (370 )         (247 )         (778 )         (512 )
Loss on extinguishment of debt                     -              -           (276 )            -
Other than temporary impairment of
marketable securities                            (28 )            -           (160 )            -
Change in fair value of warrant
liabilities                                       15         (1,312 )           84            955

Loss from continuing operations before
provision
for income taxes                              (4,924 )      (10,178 )      (12,311 )      (19,197 )
Provision for income taxes                         2              7             10             17
Loss from continuing operations            $  (4,926 )   $  (10,185 )   $  (12,321 )   $  (19,214 )

Summary of Consolidated Operating Results

The net loss from continuing operations before provision for income taxes decreased by $5.3 million and $6.9 million during the three and six month periods ended June 30, 2009, respectively, compared to the same periods in 2008, primarily due to the impact of actions to streamline our Healthcare Services operations and focus on opportunities in our Behavioral Health business. Such actions resulted in decreases in general & administrative expenses (excluding share-based compensation expense and costs associated with streamlining operations) and research and development of $2.7 million and $915,000, respectively, for the three month period ended June 30, 2009 when compared to the same period in 2008 and decreases of $6.4 million and $2.3 million for the six month period ended June 30, 2009 when compared to the same period in 2008. These decreases were partially offset by deceases in related Healthcare Services revenue of $1.6 million and $2.9 million, respectively, for the same comparative periods.

Results for the three and six month periods ended June 30, 2009 reflected $222,000 and $360,000, respectively, of costs associated with actions taken to streamline our operations, compared to $1.2 million and $2.4 million of such costs for the same periods in 2008. Share-based compensation expense totaled $1.3 million and $2.5 million for the three and six month periods ended June 30, 2009, compared to $1.9 million and $4.2 million, respectively, for the same periods in 2008. Results for the six months ended June 30, 2009 include $1.1 million of impairment losses on fixed assets and intangible assets, a $276,000 loss on extinguishment of debt and $160,000 of other than temporary losses on marketable securities. Also, results for the three months ended June 30, 2008 were negatively impacted by a $1.3 million change in the fair value of warrant liabilities and results for the six months ended June 30, 2008 were favorably impacted a $1.0 million change in such liabilities.

Reconciliation of Segment Results

The following table summarizes and reconciles the loss before provision for
income taxes of our reportable segments in continuing operations to the loss for
continuing operations before provision for income taxes from our consolidated
statements of operations for the three and six months ended June 30, 2009 and
2008:

                                              Three Months Ended           Six Months Ended
(In thousands)                                     June 30,                    June 30,
                                              2009          2008          2009          2008
Healthcare services                        $   (4,290 )   $  (8,780 )   $  (9,985 )   $ (16,543 )
Behavioral health                                (634 )      (1,398 )      (2,326 )      (2,654 )
Loss from continuing operations before
provision for income taxes                 $   (4,924 )   $ (10,178 )   $ (12,311 )   $ (19,197 )

                              Healthcare Services

The following table summarizes the operating results for healthcare services for
the three and six months ended June 30, 2009 and 2008:

                                                   Three Months Ended                   Six Months Ended
(In thousands, except patient treatment
data)                                                   June 30,                            June 30,
                                                 2009               2008              2009            2008
Revenues
U.S. licensees                              $          152       $     1,164       $       336     $    1,987
Managed treatment centers (a)                          219               424               608          1,088
Other revenues                                           -               443               134            962
Total healthcare services revenues          $          371       $     2,031       $     1,078     $    4,037

Operating expenses
Cost of healthcare services                 $          161       $       524       $       434     $    1,005
General and administrative expenses
Salaries and benefits                                1,608             3,878             4,384         10,272
Other expenses                                       2,284             3,685             4,260          7,189
Research and development                                 -               915                 -          2,273
Impairment losses                                        -               447               355            447
Depreciation and amortization                          302                 -               623            463
Total operating expenses                    $        4,355       $     9,449       $    10,056     $   21,649

Loss from operations                        $       (3,984 )     $    (7,418 )     $    (8,978 )   $  (17,612 )

Interest and other income                               77               196               123            625
Interest expense                                      (370 )            (247 )            (778 )         (512 )
Loss on extinguishment of debt                           -                 -              (276 )            -
Other than temporary impairment on
marketable securities                                  (28 )               -              (160 )            -
Change in fair value of warrant
liability                                               15            (1,311 )              84            956
Loss before provision for income taxes      $       (4,290 )     $    (8,780 )     $    (9,985 )   $  (16,543 )

PROMETA patients treated
U.S. licensees                                          30               198                72            342
Managed treatment centers (a)                           19                31                56             84
Other                                                    -                17                11             52
                                                        49               246               139            478

Average revenue per patient treated (b)
U.S. licensees                              $        5,067       $     5,753       $     4,528     $    5,722
Managed treatment centers (a)                        7,211             9,978             6,661          9,823
Other                                                    -            11,390            12,182          8,407
Overall average                                      5,898             6,675             5,993          6,734

(a) Includes managed and/or licensed PROMETA Centers.
(b) The average revenue per patient treated excludes administrative fees and other non-PROMETA patient revenues.

Revenue

Revenue decreased by $1.7 million and $3.0 million for the three and six months ended June 30, 2009, respectively, compared to the same periods in 2008, due mainly to a decline in licensed sites contributing to revenue and in the number of patients treated at our U.S licensed sites and the managed treatment centers, resulting from our decision to streamline our Healthcare Services operation by shutting down unprofitable markets and reducing field staff. We also shut down sites in our international operations during the first quarter of 2009. The number of patients

treated decreased by 80% and 71% in the three and six months ended June 30, 2009, respectively, compared to the same periods in 2008. The number of licensed sites that contributed to revenues decreased to 17 for the three months ended June 30, 2009, compared to 31 for the same period in 2008. The average revenue per patient treated at U.S. licensed sites decreased during the three and six months ended June 30, 2009 compared to the same periods in 2008 due to due to higher average discounts granted by our licensees and the average revenue per patient treated at the managed treatment centers increased during the three and six months ended June 30, 2009 compared to the same periods in 2008 due to an increase in non-PROMETA related services provided to patients. Our revenue may be further impacted in the third quarter and fourth quarter of 2009 by market conditions due to the uncertain economy, impacting both the number of treatments and the average revenue per patient, and also as we maintain our commitment to reduce operating expenses in components of healthcare services that are revenue-generating, but unprofitable.

Cost of Healthcare Services

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

General and Administrative Expenses

General and administrative expense included share-based compensation expense and costs associated with streamlining our operations, which totaled $1.3 million and $222,000, respectively, for the three months ended June 30, 2009, compared to $1.9 million and $1.2 million, respectively for the same period in 2008. Excluding such costs, total general and administrative expense decreased by $2.0 million in 2009 when compared to 2008, due mainly to decreases in outside services, salaries and benefits and other expenses resulting from the continued streamlining of operations to focus on opportunities in our Behavioral Health segment.

For the six months ended June 30, 2009, share-based compensation expense and costs associated with streamlining our operations totaled $2.5 million and $360,000, respectively, compared to $4.2 million and $2.4 million, respectively for the same period in 2008. Excluding such costs, total general and administrative expense decreased by $5.2 million in 2009 when compared to 2008, due mainly to decreases in outside services, salaries and benefits and other expenses resulting from the continued streamlining of operations.

Research and Development

Our total research and development expenses decreased by $915,000 and $2.3 million for the three and six months ended June 30, 2009 compared to the same periods in 2008. These decreases are attributable to clinical studies undertaken in 2008 and prior years that were substantially completed in 2008 and for which no expense was recognized during the three and six months ended June 30, 2009. In addition, we agreed to terminate funding for the grant that supported the Cedar Sinai research study on alcohol-dependent subjects as the site had been unable to recruit patients with the desired clinical profile in a timely manner and in light of the two additional alcohol studies that had been completed.

Impairment Losses

Impairment charges for the six months ended June 30, 2009 included $122,000 for intangible assets related to our managed treatment center in Dallas and $233,000 for intellectual property related to additional indications for the use of the PROMETA Treatment Program that are currently non-revenue-generating, both of which resulted from impairment testing at March 31, 2009. No further impairment was deemed See additional information below under the heading "Critical Accounting Estimates -- Impairment of Intangible Assets."

Interest and Other Income

Interest and other income for the three and six months ended June 30, 2009 decreased by $119,000 and $502,000, respectively, compared to the same periods in 2008 due to decreases in the invested balance of marketable securities and a decrease in interest rates.

Interest Expense

Interest expense for the three and six months ended June 30, 2009 increased by $123,000 and $266,000, respectively, compared to the same periods in 2008 due to higher debt balances from the UBS line of credit during the three and six months ended June 30, 2009, partially offset by the effect of lower interest rates during this same period.

Loss from Extinguishment of Debt

We recognized a $276,000 loss on extinguishment of debt for the six months ended June 30, 2009 resulting from the $1.4 million pay down on the Highbridge senior secured note in February 2009, which reflected an unamortized discount of $208,000 and a $68,000 prepayment penalty.

Other than Temporary Impairment on Marketable Securities

Impairment charges of $28,000 and $160,000 related to certain of our auction-rate securities (ARS) were recognized for the three and six months ended June 30, 2009. The charges were based on an updated valuation of the securities performed by management as of March 31, 2009 and June 30, 2009 and were deemed necessary after an analysis of other-than-temporary impairment factors, most notably, the likelihood that we will be required to sell the ARS before they recover in value.

Change in fair value of warrant liability

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

Both warrants are re-valued at each reporting period using the Black-Scholes pricing model to determine the fair market value per share. The change in fair value of the warrants issued in connection with the November 7, 2007 registered direct stock placement amounted to $7,000 and $33,000 for the three and six months ended June 30, 2009, respectively. The change in fair value for the warrants issued in connection with the Highbridge note amounted to $8,000 and $43,000 for the three and six months ended June 30, 2009, respectively. We will . . .