News Column

KINDRED HEALTHCARE, INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

August 11, 2014

RESULTS OF OPERATIONS

Cautionary Statement

This Form 10-Q includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). All statements regarding the potential acquisition of Gentiva (including financing of the proposed transaction and the benefits, results, effects and timing of such transaction), and the Company's expected future financial position, results of operations, cash flows, financing plans, business strategy, budgets, capital expenditures, competitive positions, growth opportunities, plans and objectives of management and statements containing the words such as "anticipate," "approximate," "believe," "plan," "estimate," "expect," "project," "could," "should," "will," "intend," "may," "potential" and other similar expressions, are forward-looking statements. Such forward-looking statements are inherently uncertain, and stockholders and other potential investors must recognize that actual results may differ materially from the Company's expectations as a result of a variety of factors, including, without limitation, those discussed below. Such forward-looking statements are based upon management's current expectations and include known and unknown risks, uncertainties and other factors, many of which the Company is unable to predict or control, that may cause the Company's actual results, performance or plans to differ materially from any future results, performance or plans expressed or implied by such forward-looking statements. These statements involve risks, uncertainties and other factors discussed below and detailed from time to time in the Company's filings with the SEC. Factors that may affect the Company's plans, results or stock price include, without limitation:



- the impact of healthcare reform, which will initiate significant changes to

the United States healthcare system, including potential material changes to

the delivery of healthcare services and the reimbursement paid for such

services by the government or other third party payors, including reforms

resulting from the Patient Protection and Affordable Care Act and the Healthcare Education and Reconciliation Act (collectively, the "ACA") or future deficit reduction measures adopted at the federal or state level. Healthcare reform is affecting each of the Company's businesses in some manner. Potential future efforts in the U.S. Congress to repeal, amend,



modify or retract funding for various aspects of the ACA create additional

uncertainty about the ultimate impact of the ACA on the Company and the

healthcare industry. Due to the substantial regulatory changes that will need

to be implemented by CMS and others, and the numerous processes required to

implement these reforms, the Company cannot predict which healthcare

initiatives will be implemented at the federal or state level, the timing of

any such reforms, or the effect such reforms or any other future legislation

or regulation will have on the Company's business, financial position,

results of operations and liquidity,

- the Company's ability to adjust to the new patient criteria for LTAC

hospitals under the Pathway for SGR Reform Act of 2013 (the "SGR Reform

Act"), which will reduce the population of patients eligible for the

Company's hospital services and change the basis upon which the Company is

paid,

- the impact of final rules issued by CMS on August 1, 2012 (the "2012 CMS

Rules") which, among other things, will reduce Medicare reimbursement to the

Company's TC hospitals in 2013 and beyond by imposing a budget neutrality

adjustment and modifying the short-stay outlier rules, - the impact of the 2011 CMS Rules which significantly reduced Medicare



reimbursement to the Company's nursing centers and changed payments for the

provision of group therapy services effective October 1, 2011, - the impact of the Budget Control Act of 2011 (as amended by the American



Taxpayer Relief Act of 2012 (the "Taxpayer Relief Act")) which instituted an

automatic 2% reduction on each claim submitted to Medicare beginning April 1,

2013,

- the costs of defending and insuring against alleged professional liability

and other claims and investigations (including those related to pending

investigations and whistleblower and wage and hour class action lawsuits

against the Company) and the Company's ability to predict the estimated costs

and reserves related to such claims and investigations, including the impact

of differences in actuarial assumptions and estimates compared to eventual

outcomes, - the impact of the Taxpayer Relief Act which, among other things, reduces Medicare payments by an additional 25% for subsequent procedures when



multiple therapy services are provided on the same day. At this time, the

Company believes that the rules related to multiple therapy services will

reduce its Medicare revenues by $25 million to $30 million on an annual basis, 41



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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)



Cautionary Statement (Continued)

- changes in the reimbursement rates or the methods or timing of payment from

third party payors, including commercial payors and the Medicare and Medicaid

programs, changes arising from and related to the Medicare prospective

payment system for LTAC hospitals, including potential changes in the

Medicare payment rules, the Medicare Prescription Drug, Improvement, and

Modernization Act of 2003, and changes in Medicare and Medicaid reimbursement

for the Company's TC hospitals, nursing centers, IRFs and home health and

hospice operations, and the expiration of the Medicare Part B therapy cap

exception process,

- the effects of additional legislative changes and government regulations,

interpretation of regulations and changes in the nature and enforcement of

regulations governing the healthcare industry,

- the ability of the Company's hospitals and nursing centers to adjust to

medical necessity reviews,

- the impact of the Company's significant level of indebtedness on its funding

costs, operating flexibility and ability to fund ongoing operations,

development capital expenditures or other strategic acquisitions with

additional borrowings,

- the Company's ability to successfully redeploy its capital and proceeds of

asset sales in pursuit of its business strategy and pursue its development

activities, including through acquisitions, and successfully integrate new

operations, including the realization of anticipated revenues, economies of

scale, cost savings and productivity gains associated with such operations,

as and when planned, including the potential impact of unanticipated issues,

expenses and liabilities associated with those activities,

- the Company's ability to pay a dividend as, when and if declared by the Board

of Directors, in compliance with applicable laws and the Company's debt and

other contractual arrangements,

- the failure of the Company's facilities to meet applicable licensure and

certification requirements,

- the further consolidation and cost containment efforts of managed care

organizations and other third party payors,

- the Company's ability to meet its rental and debt service obligations,

- the Company's ability to operate pursuant to the terms of its debt

obligations, and comply with its covenants thereunder, and the Company's

ability to operate pursuant to its master lease agreements with Ventas,

- the condition of the financial markets, including volatility and weakness in

the equity, capital and credit markets, which could limit the availability

and terms of debt and equity financing sources to fund the requirements of

the Company's businesses, or which could negatively impact the Company's

investment portfolio,

- the Company's ability to control costs, particularly labor and employee

benefit costs,

- the Company's ability to successfully reduce (by divestiture of operations or

otherwise) its exposure to professional liability and other claims, - the Company's obligations under various laws to self-report suspected



violations of law by the Company to various government agencies, including

any associated obligation to refund overpayments to government payors, fines

and other sanctions,

- national, regional and industry-specific economic, financial, business and

political conditions, including their effect on the availability and cost of

labor, credit, materials and other services,

- increased operating costs due to shortages in qualified nurses, therapists

and other healthcare personnel,

- the Company's ability to attract and retain key executives and other

healthcare personnel,

- the Company's ability to successfully dispose of unprofitable facilities,

- events or circumstances which could result in the impairment of an asset or

other charges, such as the impact of the Medicare reimbursement regulations

that resulted in the Company recording significant impairment charges in the

last three fiscal years,

- changes in generally accepted accounting principles or practices, and changes

in tax accounting or tax laws (or authoritative interpretations relating to

any of these matters),

- the Company's ability to maintain an effective system of internal control

over financial reporting, - the Company's ability to realize the anticipated operating and financial synergies from the potential acquisition of Gentiva, 42



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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)



Cautionary Statement (Continued)

the uncertainties as to whether Gentiva or any other companies that the

Company may acquire will have the accretive effect on the Company's earnings

or cash flows that are expected, and

the outcome of the potential acquisition of Gentiva, including the Company's

ability to realize the strategic rationale behind the Gentiva acquisition.

Many of these factors are beyond the Company's control. The Company cautions investors that any forward-looking statements made by the Company are not guarantees of future performance. The Company disclaims any obligation to update any such factors or to announce publicly the results of any revisions to any of the forward-looking statements to reflect future events or developments.



General

The accompanying unaudited condensed consolidated financial statements, including the notes thereto, should be read in conjunction with the following discussion and analysis.

The Company is a healthcare services company that through its subsidiaries operates TC hospitals, IRFs, nursing centers, assisted living facilities, a contract rehabilitation services business and a home health and hospice business across the United States. At June 30, 2014, the Company's hospital division operated 97 TC hospitals (7,145 licensed beds) and five IRFs (215 licensed beds) in 22 states. The Company's nursing center division operated 98 nursing centers (12,394 licensed beds) and six assisted living facilities (341 licensed beds) in 21 states. The Company's rehabilitation division provided rehabilitation services primarily in hospitals and long-term care settings. The Company's care management division (formerly known as the Company's home health and hospice division) primarily provided home health, hospice and private duty services from 153 locations in 13 states. Discontinued operations The Company has completed several strategic divestitures or planned divestitures to improve its future operating results. For accounting purposes, the operating results of these businesses and the losses or impairments associated with these transactions have been classified as discontinued operations in the accompanying unaudited condensed consolidated statement of operations for all periods presented. Assets held for sale at June 30, 2014 have been measured at the lower of carrying value or estimated fair value less costs of disposal and have been classified as held for sale in the accompanying unaudited condensed consolidated balance sheet. During the second quarter of 2014, the Company reclassified as discontinued for all periods presented the operations of three TC hospitals and two nursing centers that were either closed or divested through a planned sale of such facility or the expiration of a lease. The Company recorded a loss on divestiture of $3 million ($2 million net of income taxes) for the three months ended June 30, 2014 related to these divestitures. The Company allowed the lease to expire on a TC hospital during the six months ended June 30, 2014 resulting in a loss on divestiture primarily related to a write-off of an indefinite-lived intangible asset of $3 million ($2 million net of income taxes) for the six months ended June 30, 2014. The Company reflected the operating results of this TC hospital as discontinued operations in the accompanying unaudited condensed consolidated statement of operations for all historical periods. On September 30, 2013, the Company entered into agreements with Ventas to exit the 2013 Expiring Facilities. The lease term for the 2013 Expiring Facilities was initially scheduled to expire in April 2015. Under the terms of the agreements, the lease term for the 2013 Expiring Facilities will now expire on September 30, 2014 unless the Company and Ventas are able to transfer the operations earlier. Through June 30, 2014, the Company has transferred the operations of 43 of the 2013 Expiring Facilities to a new operator. Another facility was closed and its operating license and equipment were sold during the six months ended June 30, 2014. Proceeds from the sale of equipment and inventory for the 2013 Expiring Facilities totaled $9 million and $12 million for the three months and six months ended June 30, 2014, respectively. The Company has transferred the operations of an additional 12 of the 2013 Expiring Facilities since July 1, 2014. For accounting purposes, the 2013 Expiring Facilities qualified as assets held for sale and the Company reflected the operating results as discontinued operations in the accompanying unaudited condensed consolidated statement of operations for all historical periods. 43



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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)



Critical Accounting Policies

Management's discussion and analysis of financial condition and results of operations are based upon the Company's consolidated financial statements which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires the use of estimates and judgments that affect the reported amounts and related disclosures of commitments and contingencies. The Company relies on historical experience and on various other assumptions that management believes to be reasonable under the circumstances to make judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ materially from these estimates. The Company believes the following critical accounting policies, among others, affect the more significant judgments and estimates used in the preparation of its consolidated financial statements.



Revenue recognition

The Company has agreements with third party payors that provide for payments to each of its operating divisions. These payment arrangements may be based upon prospective rates, reimbursable costs, established charges, discounted charges or per diem payments. Net patient service revenue is recorded at the estimated net realizable amounts from Medicare, Medicaid, Medicare Advantage, other third party payors and individual patients for services rendered. Retroactive adjustments that are likely to result from future examinations by third party payors are accrued on an estimated basis in the period the related services are rendered and adjusted as necessary in future periods based upon new information or final settlements.



Collectibility of accounts receivable

Accounts receivable consist primarily of amounts due from the Medicare and Medicaid programs, other government programs, managed care health plans, commercial insurance companies, skilled nursing and hospital customers, and individual patients and other customers. Estimated provisions for doubtful accounts are recorded to the extent it is probable that a portion or all of a particular account will not be collected.

In evaluating the collectibility of accounts receivable, the Company considers a number of factors, including the age of the accounts, changes in collection patterns, the composition of patient accounts by payor type, the status of ongoing disputes with third party payors and general industry conditions. Actual collections of accounts receivable in subsequent periods may require changes in the estimated provision for loss. Changes in these estimates are charged or credited to the results of operations in the period of the change. The provision for doubtful accounts totaled $8 million and $4 million for the second quarter of 2014 and 2013, respectively, and $16 million and $11 million for the six months ended June 30, 2014 and 2013, respectively.



Allowances for insurance risks

The Company insures a substantial portion of its professional liability risks and workers compensation risks through its limited purpose insurance subsidiary. Provisions for loss for these risks are based upon management's best available information including actuarially determined estimates. The allowance for professional liability risks includes an estimate of the expected cost to settle reported claims and an amount, based upon past experiences, for losses incurred but not reported. These liabilities are necessarily based upon estimates and, while management believes that the provision for loss is adequate, the ultimate liability may be in excess of, or less than, the amounts recorded. To the extent that expected ultimate claims costs vary from historical provisions for loss, future earnings will be charged or credited. Provisions for loss for professional liability risks retained by the Company's limited purpose insurance subsidiary have been discounted based upon actuarial estimates of claim payment patterns using a discount rate of 1% to 5% depending upon the policy year. The discount rate was 1% for the 2014 and 2013 policy years. The discount rates are based upon the risk free interest rate for the respective year. Amounts equal to the discounted loss provision are funded annually. The Company does not fund the portion of professional liability risks related to estimated claims that have been incurred but not reported. Accordingly, these liabilities are not discounted. The allowance for professional liability risks aggregated $313 million at June 30, 2014 and $307 million at December 31, 2013. If the Company did not discount any of the allowances for professional liability risks, these balances would have approximated $316 million at June 30, 2014 and $310 million at December 31, 2013. 44



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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)



Critical Accounting Policies (Continued)

Allowances for insurance risks (Continued)

As a result of deterioration in professional liability and workers compensation underwriting results of the Company's limited purpose insurance subsidiary in 2012, the Company made a capital contribution of $14 million during the six months ended June 30, 2013 to its limited purpose insurance subsidiary. This transaction was completed in accordance with applicable regulations and had no impact on earnings. No contribution was required to be paid during the six months ended June 30, 2014. Changes in the number of professional liability claims and the cost to settle these claims significantly impact the allowance for professional liability risks. A relatively small variance between the Company's estimated and actual number of claims or average cost per claim could have a material impact, either favorable or unfavorable, on the adequacy of the allowance for professional liability risks. For example, a 1% variance in the allowance for professional liability risks at June 30, 2014 would impact the Company's operating income by approximately $3 million. The provision for professional liability risks (continuing operations), including the cost of coverage maintained with unaffiliated commercial reinsurance carriers, aggregated $16 million for the second quarter of both 2014 and 2013, and $30 million and $32 million for the six months ended June 30, 2014 and 2013, respectively. Provisions for loss for workers compensation risks retained by the Company's limited purpose insurance subsidiary are not discounted and amounts equal to the loss provision are funded annually. The allowance for workers compensation risks aggregated $193 million at June 30, 2014 and $188 million at December 31, 2013. The provision for workers compensation risks (continuing operations), including the cost of coverage maintained with unaffiliated commercial insurance carriers, aggregated $9 million and $10 million for the second quarter of 2014 and 2013, respectively, and $18 million and $21 million for the six months ended June 30, 2014 and 2013, respectively.



Accounting for income taxes

The provision for income taxes is based upon the Company's estimate of annual taxable income or loss for each respective accounting period. The Company recognizes an asset or liability for the deferred tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts in the financial statements. These temporary differences will result in taxable or deductible amounts in future years when the reported amounts of the assets are recovered or liabilities are settled. The Company also recognizes as deferred tax assets the future tax benefits from net operating losses and capital loss carryforwards. A valuation allowance is provided for these deferred tax assets if it is more likely than not that some portion or all of the net deferred tax assets will not be realized. The Company's effective income tax rate was 38.3% and 40.1% for the second quarter of 2014 and 2013, respectively, and 35.3% and 39.0% for the six months ended June 30, 2014 and 2013, respectively. The decrease in the effective tax rate for both periods in 2014 was primarily attributable to an increase in pretax income from noncontrolling interests not taxable to the Company. There are significant uncertainties with respect to capital loss carryforwards that could affect materially the realization of certain deferred tax assets. Accordingly, the Company has recognized deferred tax assets to the extent it is more likely than not they will be realized and a valuation allowance is provided for deferred tax assets to the extent that it is uncertain that the deferred tax asset will be realized. The Company recognized net deferred tax assets totaling $34 million and $55 million at June 30, 2014 and December 31, 2013, respectively. The Company is subject to various federal and state income tax audits in the ordinary course of business. Such audits could result in increased tax payments, interest and penalties. While the Company believes its tax positions are appropriate, there can be no assurance that the various authorities engaged in the examination of its income tax returns will not challenge the Company's positions.



Valuation of long-lived assets, goodwill and intangible assets

The Company reviews the carrying value of certain long-lived assets and finite lived intangible assets with respect to any events or circumstances that indicate an impairment or an adjustment to the amortization period is necessary. If circumstances suggest that the recorded amounts cannot be recovered based upon estimated future undiscounted cash flows, the carrying values of such assets are reduced to fair value. 45



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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)



Critical Accounting Policies (Continued)

Valuation of long-lived assets, goodwill and intangible assets (Continued)

In assessing the carrying values of long-lived assets, the Company estimates future cash flows at the lowest level for which there are independent, identifiable cash flows. For this purpose, these cash flows are aggregated based upon the contractual agreements underlying the operation of the facility or group of facilities. Generally, an individual facility is considered the lowest level for which there are independent, identifiable cash flows. However, to the extent that groups of facilities are leased under a master lease agreement in which the operations of a facility and compliance with the lease terms are interdependent upon other facilities in the agreement (including the Company's ability to renew the lease or divest a particular property), the Company defines the group of facilities under a master lease agreement as the lowest level for which there are independent, identifiable cash flows. Accordingly, the estimated cash flows of all facilities within a master lease agreement are aggregated for purposes of evaluating the carrying values of long-lived assets. The Company's intangible assets with finite lives are amortized in accordance with the authoritative guidance for goodwill and other intangible assets using the straight-line method over their estimated useful lives ranging from one to 20 years. In connection with the 2011 CMS Rules, the Company determined that the impact of the 2011 CMS Rules was a triggering event in the third quarter of 2011 and accordingly tested the recoverability of its nursing centers reporting unit goodwill, intangible assets and property and equipment asset groups impacted by the reduced Medicare payments. The Company recorded pretax impairment charges aggregating $0.4 million ($0.3 million net of income taxes) in the second quarter of 2013 for property and equipment expenditures in the nursing center asset groups that were determined to be impaired by the 2011 CMS Rules. The Company also recorded pretax impairment charges aggregating $0.6 million ($0.4 million net of income taxes) for the six months ended June 30, 2013. These charges reflected the amount by which the carrying value of certain assets exceeded their estimated fair value. The impairment charges did not impact the Company's cash flows or liquidity. In accordance with the authoritative guidance for goodwill and other intangible assets, the Company is required to perform an impairment test for goodwill and indefinite-lived intangible assets at least annually or more frequently if adverse events or changes in circumstances indicate that the asset may be impaired. The Company performs its annual goodwill impairment test at the end of each fiscal year for each of its reporting units. A reporting unit is either an operating segment or one level below the operating segment, referred to as a component. When the components within the Company's operating segments have similar economic characteristics, the Company aggregates the components of its operating segments into one reporting unit. Accordingly, the Company has determined that its reporting units are hospitals, nursing centers, skilled nursing rehabilitation services, hospital rehabilitation services, home health and hospice. The home health and hospice reporting units are included in the care management division. The carrying value of goodwill for each of the Company's reporting units at June 30, 2014 and December 31, 2013 follows (in thousands): June 30, December 31, 2014 2013 Hospitals $ 679,480$ 679,480 Nursing centers - - Rehabilitation division: Skilled nursing rehabilitation services - - Hospital rehabilitation services 173,618 173,334 Home health 114,846 112,378 Hospice 26,910 26,910 $ 994,854$ 992,102 The goodwill impairment test involves a two-step process. The first step is a comparison of each reporting unit's fair value to its carrying value. If the carrying value of the reporting unit is greater than its fair value, there is an indication that impairment may exist and the second step must be performed to measure the amount of impairment loss, if any. Based upon the results of the step one impairment test for goodwill for hospitals, hospital rehabilitation services and hospice reporting units for the year ended December 31, 2013, no goodwill impairment charges were recorded in connection with the Company's annual impairment test. The Company recorded a goodwill impairment charge of $76 million ($58 million net of income taxes) in the fourth quarter of 2013 in its home health reporting unit to reflect the amount by which the carrying value of goodwill exceeded the fair value. 46



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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)



Critical Accounting Policies (Continued)

Valuation of long-lived assets, goodwill and intangible assets (Continued)

Since quoted market prices for the Company's reporting units are not available, the Company applies judgment in determining the fair value of these reporting units for purposes of performing the goodwill impairment test. The Company relies on widely accepted valuation techniques, including discounted cash flow and market multiple analyses approaches, which capture both the future income potential of the reporting unit and the market behaviors and actions of market participants in the industry that includes the reporting unit. These types of analyses require the Company to make assumptions and estimates regarding future cash flows, industry-specific economic factors and the profitability of future business strategies. The discounted cash flow approach uses a projection of estimated operating results and cash flows that are discounted using a weighted average cost of capital. Under the discounted cash flow approach, the projection uses management's best estimates of economic and market conditions over the projected period for each reporting unit including growth rates in the number of admissions, patient days, reimbursement rates, operating costs, rent expense and capital expenditures. Other significant estimates and assumptions include terminal value growth rates, changes in working capital requirements and weighted average cost of capital. The market multiple analysis estimates fair value by applying cash flow multiples to the reporting unit's operating results. The multiples are derived from comparable publicly traded companies with similar operating and investment characteristics to the reporting units. The Company has determined that during the six months ended June 30, 2014, there were no events or changes in circumstances since December 31, 2013 requiring an interim impairment test. Although the Company has determined that there was no goodwill or other indefinite-lived intangible asset impairments as of June 30, 2014, adverse changes in the operating environment and related key assumptions used to determine the fair value of the Company's reporting units and indefinite-lived intangible assets or declines in the value of the Company's common stock may result in future impairment charges for a portion or all of these assets. Specifically, if the rate of growth of government and commercial revenues earned by the Company's reporting units were to be less than projected or if healthcare reforms were to negatively impact the Company's business, an impairment charge of a portion or all of these assets may be required.



An impairment charge could have a material adverse effect on the Company's business, financial position and results of operations, but would not be expected to have an impact on the Company's cash flows or liquidity.

The Company's indefinite-lived intangible assets consist of trade names, Medicare certifications and certificates of need. The fair values of the Company's indefinite-lived intangible assets are derived from current market data and projections at a facility level which include management's best estimates of economic and market conditions over the projected period including growth rates in the number of admissions, patient days, reimbursement rates, operating costs, rent expense and capital expenditures. Other significant estimates and assumptions include terminal value growth rates, changes in working capital requirements and weighted average cost of capital. Certificates of need intangible assets are estimated primarily using both a replacement cost methodology and an excess earnings method, a form of discounted cash flows, which is based upon the concept that net after-tax cash flows provide a return supporting all of the assets of a business enterprise. The annual impairment tests for certain of the Company's indefinite-lived intangible assets are performed as of May 1, July 1, September 1 and October 1 while all others are performed as of December 31. No impairment charges were recorded in connection with the annual impairment tests performed at May 1, 2014 or for each of these dates in 2013.



Recently Issued Accounting Requirements

In June 2014, the FASB issued authoritative guidance which changes the requirements for accounting for share-based payments when the terms of an award provide that a performance target could be achieved after the requisite service period. This guidance is effective for annual and interim periods beginning on or after December 15, 2015. The adoption of this standard is not expected to have a material impact on the Company's business, financial position, net income or liquidity. In May 2014, the FASB issued authoritative guidance which changes the requirements for recognizing revenue when entities enter into contracts with customers. Under the new provisions, an entity will recognize revenue when it transfers promised goods or services to customers in an amount that reflects what it expects in exchange for the goods or services. It also requires more detailed disclosures to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. This guidance is effective for annual and interim periods beginning on or after December 15, 2016 and early adoption is not permitted. The Company is still assessing this guidance. 47



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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)



Recently Issued Accounting Requirements (Continued)

In April 2014, the FASB issued authoritative guidance which changes the requirements for reporting discontinued operations. A disposal of a component of an entity or a group of components of an entity is required to be reported in discontinued operations if the disposal represents a strategic shift that has (or will have) a major effect on an entity's operations and financial results when any of the following occurs: (1) the component or group of components meets the criteria to be classified as held for sale, (2) the component or group of components is disposed of by sale, or (3) the component or group of components is disposed of other than by sale (for example, abandonment). The entity shall present separately, for each comparative period, the assets and liabilities of the discontinued operation in the statement of financial position. In addition to the required disclosures for discontinued operations, entities also will be required to provide disclosures about a disposal of an individually significant component of an entity that does not qualify for discontinued operations presentation in the financial statements. The guidance also states an entity shall expand disclosures about significant continuing involvement with a discontinued operation, until the results of operations of the discontinued operation are no longer presented in the statement of operations. The guidance is applicable prospectively for all disposals that occur within annual periods beginning on or after December 15, 2014 and early adoption is permitted. The adoption of the guidance is not expected to have a material impact on the Company's business, financial position, net income or liquidity but may have a material impact on the Company's income from continuing operations if planned or completed disposals of components of the Company's business do not qualify for discontinued operations under the new guidance. 48



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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)



Results of Operations - Continuing Operations

A summary of the Company's operating data follows (unaudited):

Three months ended Six months ended (In thousands) June 30, June 30, 2014 2013 2014 2013 Revenues: Hospital division $ 632,156$ 606,604$ 1,278,614$ 1,264,418 Nursing center division 280,255 264,847 558,157 535,052 Rehabilitation division: Skilled nursing rehabilitation services 253,989 249,647 508,244 508,397 Hospital rehabilitation services 75,324 69,777 149,288 144,300 329,313 319,424 657,532 652,697 Care management division 87,986 53,039 175,690 104,660 1,329,710 1,243,914 2,669,993 2,556,827 Eliminations: Skilled nursing rehabilitation services (30,031 ) (28,660 ) (59,677 ) (57,317 ) Hospital rehabilitation services (22,855 ) (23,223 ) (46,088 ) (46,832 ) Nursing centers (860 ) (1,001 ) (1,522 ) (2,214 ) (53,746 ) (52,884 ) (107,287 ) (106,363 ) $ 1,275,964$ 1,191,030$ 2,562,706$ 2,450,464 Income (loss) from continuing operations: Operating income (loss): Hospital division $ 132,878$ 129,366$ 278,273$ 276,859 Nursing center division 36,880 36,018 75,351 65,163 Rehabilitation division: Skilled nursing rehabilitation services 19,982 21,623 38,310 34,862 Hospital rehabilitation services 20,084 19,573 39,904 37,705 40,066 41,196 78,214 72,567 Care management division 7,065 3,961 11,762 6,747 Corporate: Overhead (48,365 ) (43,196 ) (92,415 ) (88,781 ) Insurance subsidiary (443 ) (384 ) (849 ) (893 ) (48,808 ) (43,580 ) (93,264 ) (89,674 ) Impairment charges - (438 ) - (625 ) Transaction costs (4,496 ) (108 ) (5,179 ) (1,052 ) Operating income 163,585 166,415 345,157 329,985 Rent (80,209 ) (77,324 ) (161,257 ) (153,843 ) Depreciation and amortization (39,442 ) (38,554 ) (78,779 ) (80,152 ) Interest, net (78,081 ) (27,600 ) (103,697 ) (55,674 ) Income (loss) from continuing operations before income taxes (34,147 ) 22,937 1,424 40,316 Provision (benefit) for income ) taxes (13,082 9,208 503 15,713 $ (21,065 )$ 13,729$ 921$ 24,603 49



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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)



Results of Operations - Continuing Operations (Continued)

A summary of the Company's consolidating statement of operations follows (unaudited): Three months ended June 30, 2014 Rehabilitation division Nursing Skilled Care Hospital center nursing Hospital management Corporate (In thousands) division (a) division (b,c)



services (b) services (b) Total division (b)

(b,d) Transaction costs Eliminations Consolidated Revenues

$ 632,156$ 280,255



$ 253,989$ 75,324$ 329,313$ 87,986 $ - $

- $ (53,746 )$ 1,275,964 Salaries, wages and benefits 271,092 128,641 223,907 50,303 274,210 66,804 29,813 - (239 ) 770,321 Supplies 66,509 10,559 680 32 712 2,833 181 - - 80,794 Rent 52,526 23,856 1,067 22 1,089 2,177 561 - - 80,209 Other operating expenses 161,722 104,317 9,406 4,899 14,305 11,281 18,804 4,496 (53,507 ) 261,418 Other (income) expense (45 ) (142 ) 14 6 20 3 10 - - (154 ) Depreciation and amortization 17,008 7,686 2,885 2,488 5,373 2,139 7,236 - - 39,442 Interest expense 187 7 51 - 51 12 80,273 - - 80,530 Investment income (16 ) (10 ) (225 ) - (225 ) (1 ) (2,197 ) - - (2,449 ) 568,983 274,914 237,785 57,750 295,535 85,248 134,681 4,496 (53,746 ) 1,310,111 Income (loss) from continuing operations before income taxes $ 63,173 $ 5,341 $ 16,204$ 17,574$ 33,778$ 2,738$ (134,681 ) $ (4,496 ) $ - (34,147 ) Income tax benefit (13,082 ) Loss from continuing operations $ (21,065 ) Capital expenditures, excluding acquisitions (including discontinued operations): Routine $ 8,225 $ 5,163 $ 593 $ 44 $ 637 $ 168 $ 10,292 $ - $ - $ 24,485 Development 51 321 - - - - - - - 372 $ 8,276 $ 5,484 $ 593 $ 44 $ 637 $ 168 $ 10,292 $ - $ - $ 24,857



(a) Includes litigation costs (included in other operating expenses) of $4.6 million.

(b) Includes severance costs (included in salaries, wages and benefits) of $4.8

million and other operating expenses of $0.1 million related to restructuring

activities (nursing center division - $3.2 million, rehabilitation division -

$0.3 million (skilled nursing rehabilitation services - $0.2 million and

hospital rehabilitation services - $0.1 million), care management division -

$0.8 million and corporate - $0.6 million).

(c) Includes lease cancellation charges (included in rent) of $0.3 million

incurred in connection with restructuring activities.

(d) Includes $56.6 million of charges (included in interest expense) associated with debt refinancing. 50



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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)



Results of Operations - Continuing Operations (Continued)

Consolidating statement of operations follows (unaudited) (Continued):

Three months ended June 30, 2013 Rehabilitation division Nursing Skilled Care Hospital center nursing Hospital management Corporate Transaction division division services services Total division (a) costs Eliminations Consolidated Revenues $ 606,604$ 264,847$ 249,647



$ 69,777$ 319,424$ 53,039 $ - $

- $ (52,884 )$ 1,191,030

Salaries, wages and benefits 261,362 123,242 219,874

46,236 266,110 39,730 25,242 - (67 ) 715,619 Supplies 64,737 12,568 785 30 815 2,325 158 - - 80,603 Rent 50,221 24,104 1,197 19 1,216 1,155 628 - - 77,324 Other operating expenses 150,959 93,274 7,326 3,930 11,256 7,023 18,178 108 (52,817 ) 227,981 Other (income) expense 180 (255 ) 39 8 47 - 2 - - (26 ) Impairment charges 408 30 - - - - - - - 438



Depreciation and amortization 17,525 6,814 2,878

2,319 5,197 1,615 7,403 - - 38,554 Interest expense 179 1 73 - 73 - 28,821 - - 29,074 Investment income (2 ) (13 ) (74 ) - (74 ) - (1,385 ) - - (1,474 ) 545,569 259,765 232,098 52,542 284,640 51,848 79,047 108 (52,884 ) 1,168,093 Income from continuing operations before income taxes $ 61,035$ 5,082$ 17,549$ 17,235$ 34,784$ 1,191$ (79,047 )$ (108 ) $ - 22,937 Provision for income taxes 9,208 Income from continuing operations $ 13,729 Capital expenditures, excluding acquisitions (including discontinued operations): Routine $ 5,593$ 4,259$ 464$ 45$ 509$ 339$ 6,730 $ - $ - $ 17,430 Development 5,079 7 - - - - - - - 5,086 $ 10,672$ 4,266$ 464$ 45$ 509$ 339$ 6,730 $ - $ - $ 22,516 (a) Includes $1.4 million of charges (included in interest expense) associated with debt refinancing. 51



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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)



Results of Operations - Continuing Operations (Continued)

Consolidating statement of operations follows (unaudited) (Continued):

Six months ended June 30, 2014 Rehabilitation division Nursing Skilled Care Hospital center nursing Hospital management Corporate Transaction division (a) division (b,c)



services (b) services (b) Total division (b)

(b,d) costs Eliminations Consolidated Revenues $ 1,278,614$ 558,157$ 508,244$ 149,288$ 657,532$ 175,690 $ - $ - $ (107,287 )$ 2,562,706 Salaries, wages and benefits 545,928 256,395 448,514 100,302 548,816 135,493 57,651 339 (489 ) 1,544,133 Supplies 133,677 21,328 1,416 67 1,483 5,932 362 - - 162,782 Rent 105,661 47,808 2,156 73 2,229 4,433 1,126 - - 161,257 Other operating expenses 320,814 205,426 19,995 9,004 28,999 22,500

35,241 4,840 (106,798 ) 511,022 Other (income) expense (78 ) (343 ) 9 11 20 3 10 - - (388 ) Depreciation and amortization 33,993 15,228

5,580 5,052 10,632 4,264 14,662 - - 78,779 Interest expense 372 12 109 - 109 22 105,814 - - 106,329 Investment income (18 ) (21 ) (284 ) - (284 ) (1 ) (2,308 ) - - (2,632 ) 1,140,349 545,833 477,495 114,509 592,004 172,646 212,558 5,179 (107,287 ) 2,561,282



Income from continuing operations before income taxes $ 138,265 $ 12,324 $ 30,749$ 34,779$ 65,528$ 3,044$ (212,558 )$ (5,179 ) $

- 1,424 Provision for income taxes 503 Income from continuing operations $ 921 Capital expenditures, excluding acquisitions (including discontinued operations): Routine $ 16,627 $ 10,218 $ 1,442 $ 100 $ 1,542 $ 476 $ 17,299 $ - $ - $ 46,162 Development 562 561 - - - - - - - 1,123 $ 17,189 $ 10,779 $ 1,442 $ 100 $ 1,542 $ 476 $ 17,299 $ - $ - $ 47,285



(a) Includes litigation costs (included in other operating expenses) of $4.6 million.

(b) Includes severance costs (included in salaries, wages and benefits) of $4.8

million and other operating expenses of $0.1 million related to restructuring

activities (nursing center division - $3.2 million, rehabilitation division -

$0.3 million (skilled nursing rehabilitation services - $0.2 million and

hospital rehabilitation services - $0.1 million), care management division -

$0.8 million and corporate - $0.6 million).

(c) Includes lease cancellation charges (included in rent) of $0.3 million

incurred in connection with restructuring activities.

(d) Includes $56.6 million of charges (included in interest expense) associated with debt refinancing. 52



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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)



Results of Operations - Continuing Operations (Continued)

Consolidating statement of operations follows (unaudited) (Continued):

Six months ended June 30, 2013 Rehabilitation division Nursing Skilled center nursing Hospital Care Hospital division services services management Corporate division (a) (a) (a) (a) Total division (a) (a,b) Transaction costs Eliminations Consolidated Revenues $ 1,264,418$ 535,052$ 508,397$ 144,300$ 652,697$ 104,660 $ - $ - $ (106,363 )$ 2,450,464 Salaries, wages and benefits 551,019 258,425 454,718 98,656 553,374 80,044 54,930 - (308 ) 1,497,484 Supplies 132,883 25,282 1,596 62 1,658 4,563 363 - - 164,749 Rent 99,803 47,980 2,432 36 2,468 2,341 1,251 - - 153,843 Other operating expenses 303,582 186,838 17,182 7,849 25,031 13,306 34,902 1,052 (106,055 ) 458,656 Other (income) expense 75 (656 ) 39 28 67 - (521 ) - - (1,035 ) Impairment charges 584 41 - - - - - - - 625 Depreciation and amortization 37,247 14,155 5,990 4,650 10,640 3,141 14,969 - - 80,152 Interest expense 361 6 169 - 169 - 56,697 - - 57,233 Investment income (6 ) (21 ) (102 ) - (102 ) - (1,430 ) - - (1,559 ) 1,125,548 532,050 482,024 111,281 593,305 103,395 161,161 1,052 (106,363 ) 2,410,148 Income from continuing operations before income taxes $ 138,870$ 3,002$ 26,373$ 33,019$ 59,392$ 1,265$ (161,161 ) $ (1,052 ) $ - 40,316 Provision for income taxes 15,713 Income from continuing operations $ 24,603 Capital expenditures, excluding acquisitions (including discontinued operations): Routine $ 15,864$ 10,078$ 1,069$ 77$ 1,146 $ 534 $ 12,178 $ - $ - $ 39,800 Development 7,467 7 - - - - - - - 7,474 $ 23,331$ 10,085$ 1,069$ 77$ 1,146 $ 534 $ 12,178 $ - $ - $ 47,274



(a) Includes one-time bonus costs (included in salaries, wages and benefits) of

$19.8 million (hospital division - $7.8 million, nursing center division -

$4.6 million, rehabilitation division - $6.3 million (skilled nursing

rehabilitation services - $5.0 million and hospital rehabilitation services -

$1.3 million), care management division - $0.8 million and corporate - $0.3

million).

(b) Includes $1.4 million of charges (included in interest expense) associated with debt refinancing. 53



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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)



Results of Operations - Continuing Operations (Continued)

Operating data: Three months ended Six months ended June 30, June 30, 2014 2013 2014 2013 Hospital division data: End of period data: Number of hospitals: Transitional care 97 97 Inpatient rehabilitation 5 5 102 102 Number of licensed beds: Transitional care 7,145 7,059 Inpatient rehabilitation 215 215 7,360 7,274 Revenue mix %: Medicare 58.9 60.7 59.6 61.6 Medicaid 6.6 5.9 6.5 5.6 Medicare Advantage 11.0 11.1 11.1 10.7 Medicaid Managed 2.9 1.9 2.6 1.9 Commercial insurance and other 20.6 20.4 20.2 20.2 Admissions: Medicare 9,410 9,432 19,268 19,706 Medicaid 914 744 1,749 1,429 Medicare Advantage 1,449 1,474 2,964 2,993 Medicaid Managed 381 208 698 417 Commercial insurance and other 2,055 1,869 4,162 3,820 14,209 13,727 28,841 28,365 Admissions mix %: Medicare 66.2 68.7 66.8 69.5 Medicaid 6.4 5.4 6.1 5.0 Medicare Advantage 10.2 10.8 10.3 10.5 Medicaid Managed 2.7 1.5 2.4 1.5 Commercial insurance and other 14.5 13.6 14.4 13.5 Patient days: Medicare 230,122 234,490 469,881 486,685 Medicaid 32,821 30,425 65,730 59,190 Medicare Advantage 44,094 43,040 89,073 86,056 Medicaid Managed 13,247 8,342 23,980 17,150 Commercial insurance and other 61,892 57,091 124,750 120,318 382,176 373,388 773,414 769,399 Average length of stay: Medicare 24.5 24.9 24.4 24.7 Medicaid 35.9 40.9 37.6 41.4 Medicare Advantage 30.4 29.2 30.1 28.8 Medicaid Managed 34.8 40.1 34.4 41.1 Commercial insurance and other 30.1 30.5 30.0 31.5 Weighted average 26.9 27.2 26.8 27.1 Revenues per admission: Medicare $ 39,559$ 39,004$ 39,520$ 39,550 Medicaid 45,392 48,221 47,687 49,769 Medicare Advantage 48,067 45,709 47,899 45,007 Medicaid Managed 48,953 55,496 48,421 57,137 Commercial insurance and other 63,315 66,306 61,981 66,859 Weighted average 44,490 44,190 44,333 44,577 Revenues per patient day: Medicare $ 1,618$ 1,569$ 1,621$ 1,601 Medicaid 1,264 1,179 1,269 1,202 Medicare Advantage 1,580 1,565 1,594 1,565 Medicaid Managed 1,408 1,384 1,409 1,389 Commercial insurance and other 2,102 2,171 2,068 2,123 Weighted average 1,654 1,625 1,653 1,643 Medicare case mix index (discharged patients only) 1.18 1.18 1.18 1.18 Average daily census 4,200 4,103 4,273 4,251 Occupancy % 64.9 63.5 66.1 65.9 Annualized employee turnover % 20.8 21.7 54



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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)



Results of Operations - Continuing Operations (Continued)

Operating data (Continued): Three months ended Six months ended June 30, June 30, 2014 2013 2014 2013 Nursing center division data: End of period data: Number of facilities: Nursing centers: Owned or leased 94 94 Managed 4 4 Assisted living facilities 6 6 104 104 Number of licensed beds: Nursing centers: Owned or leased 11,909 11,921 Managed 485 485 Assisted living facilities 341 341 12,735 12,747 Revenue mix %: Medicare 31.8 34.0 31.9 34.5 Medicaid 39.7 36.4 40.0 36.0 Medicare Advantage 8.1 8.3 8.4 8.2 Medicaid Managed 3.6 3.5 3.4 3.5 Private and other 16.8 17.8 16.3 17.8 Patient days (a): Medicare 149,385 158,780 298,342 326,171 Medicaid 506,917 506,025 1,023,404 1,011,987 Medicare Advantage 51,355 51,337 105,759 103,032 Medicaid Managed 55,997 52,532 105,854 105,032 Private and other 155,530 163,167 308,337 326,808 919,184 931,841 1,841,696 1,873,030 Patient day mix % (a): Medicare 16.3 17.0 16.2 17.4 Medicaid 55.1 54.3 55.6 54.0 Medicare Advantage 5.6 5.5 5.7 5.5 Medicaid Managed 6.1 5.7 5.8 5.6 Private and other 16.9 17.5 16.7 17.5 Revenues per patient day (a): Medicare Part A $ 551$ 527$ 551$ 528 Total Medicare (including Part B) 597 567 597 566 Medicaid 220 190 218 190 Medicaid (net of provider taxes) (b) 197 168 196 168 Medicare Advantage 442 430 442 428 Medicaid Managed 180 177 179 177 Private and other 302 289 295 291 Weighted average 305 284 303 286 Average daily census (a) 10,101 10,240 10,175 10,348 Admissions (a) 10,170 10,066 20,422 20,872 Occupancy % (a) 80.2 81.5 80.7 82.4 Medicare average length of stay (a) 29.7 31.1 29.7 30.7 Annualized employee turnover % 40.7 44.0



(a) Excludes managed facilities.

(b) Provider taxes are recorded in other operating expenses for all periods presented.

55



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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)



Results of Operations - Continuing Operations (Continued)

Operating data (Continued): Three months ended Six months ended June 30, June 30, 2014 2013 2014 2013 Rehabilitation division data: Skilled nursing rehabilitation services: Revenue mix %: Company-operated 12 11 12 11 Non-affiliated 88 89 88 89 Sites of service (at end of period) 1,863 1,713 Revenue per site $ 136,333$ 145,736$ 273,694$ 295,389 Therapist productivity % 79.8 80.4 79.9 80.7 Hospital rehabilitation services: Revenue mix %: Company-operated 30 33 31 32 Non-affiliated 70 67 69 68 Sites of service (at end of period): Inpatient rehabilitation units 104 103 LTAC hospitals 118 123 Sub-acute units 9 8 Outpatient units 143 104 374 338 Revenue per site $ 201,400$ 206,441$ 396,557$ 430,907 Annualized employee turnover % 14.7 13.2 Hospital division Revenues increased 4% to $633 million in the second quarter of 2014 compared to $606 million for the same period in 2013 and increased 1% to $1.28 billion for the six months ended June 30, 2014 from $1.26 billion for the same period in 2013. The increase in revenues in both periods was primarily a result of an increase in volumes and aggregate reimbursement rates. Aggregate same-facility admissions increased 3% and 1% in the second quarter of 2014 and for the six months ended June 30, 2014 compared to the respective prior year periods. Same-facility average daily census increased 2% in the second quarter of 2014 and was relatively unchanged for the six months ended June 30, 2014 compared to the respective prior year periods. Operating income for the three months ended June 30, 2014 included $5 million related to litigation costs. Excluding these charges, hospital operating margins increased for the three months ended June 30, 2014 compared to the three months ended June 30, 2013, primarily as a result of an increase in reimbursement rates and operating efficiencies associated with increased volumes. Operating income for the six months ended June 30, 2014 included $5 million related to litigation costs. Operating income for the six months ended June 30, 2013 included $8 million related to one-time bonus costs. Excluding these charges, hospital operating margins declined slightly for the six months ended June 30, 2014 compared to the six months ended June 30, 2013 due to changes in revenue mix with growth in Medicaid and Medicaid Managed volumes and revenues that have lower reimbursement per patient day than Medicare, Medicare Advantage and commercial payors. Average hourly wage rates increased 2% in the second quarter of 2014 and were relatively unchanged for the six months ended June 30, 2014 compared to the respective prior year periods. Employee benefit costs increased 6% in the second quarter of 2014 compared to the same period last year, primarily as a result of an increase in health expense, and were relatively unchanged for the six months ended June 30, 2014 compared to the same period last year. Professional liability costs were $10 million and $7 million in the second quarter of 2014 and 2013, respectively, and $18 million and $15 million for the six months ended June 30, 2014 and 2013, respectively. The increase in professional liability costs was attributable to an increase in the frequency and severity of claims. 56



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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)



Results of Operations - Continuing Operations (Continued)

Nursing center division

Revenues increased 6% to $280 million in the second quarter of 2014 compared to $265 million for the same period in 2013 and increased 4% to $558 million for the six months ended June 30, 2014 from $535 million for the same period in 2013. The increase in revenues in both periods was primarily a result of an increase in aggregate revenue rates. Revenue rates in the second quarter of 2014 and for the six months ended June 30, 2014 benefited from the Company's participation in an inter-governmental payment program in the state of Indiana that provides federal matching funds under Medicaid for nursing center providers that partner with county-owned hospitals. The Company operated seven nursing centers under this program beginning July 1, 2013 and added eight additional nursing centers on January 1, 2014. Average daily census declined 1% and 2% in the second quarter of 2014 and for the six months ended June 30, 2014 compared to the respective prior year periods, primarily as a result of the decline in Medicare average length of stay in the second quarter of 2014 and a decline in admissions and Medicare average length of stay for the six months ended June 30, 2014. Admissions increased 1% in the second quarter of 2014 and declined 2% for the six months ended June 30, 2014 compared to the respective prior year periods. The decline in admissions for the six months ended June 30, 2014 was primarily attributable to generally lower healthcare utilization experienced by the Company and some of its referral sources. Operating income for the three months ended June 30, 2014 included $3 million related to severance costs. Excluding these charges, nursing center operating margins increased for the three months ended June 30, 2014 compared to the three months ended June 30, 2013. Operating income for the six months ended June 30, 2014 included $3 million related to severance costs. Operating income for the six months ended June 30, 2013 included $5 million related to one-time bonus costs. Excluding these charges, nursing center operating margins increased for the six months ended June 30, 2014 compared to the six months ended June 30, 2013. The increase in operating income margins for both periods was primarily a result of an increase in aggregate revenue rates and cost efficiencies. Average hourly wage rates increased 4% and 3% in the second quarter of 2014 and for the six months ended June 30, 2014 compared to the respective prior year periods. Employee benefit costs increased 7% in the second quarter of 2014 compared to the same period last year, primarily as a result of an increase in health expense. Employee benefit costs decreased 2% for the six months ended June 30, 2014 compared to the same period last year, primarily as a result of a reduction in workers compensation expense. Professional liability costs were $6 million and $8 million in the second quarter of 2014 and 2013, respectively, and $11 million and $15 million for the six months ended June 30, 2014 and 2013, respectively. The decreases in professional liability costs were attributable to improvement in the frequency and severity of claims. Rehabilitation division



Skilled nursing rehabilitation services

Revenues increased 2% to $254 million in the second quarter of 2014 compared to $249 million for the same period in 2013 and were relatively unchanged at $508 million for the six months ended June 30, 2014 compared to the same period in 2013. The increase in revenues in the second quarter of 2014 was primarily attributable to contract growth and growth in the volume of services provided to existing customers. Revenues derived from non-affiliated customers aggregated $223 million and $221 million in the second quarter of 2014 and 2013, respectively, and $448 million and $451 million for the six months ended June 30, 2014 and 2013, respectively. Operating margins decreased in the second quarter of 2014 compared to the same period in 2013, primarily as a result of contract pricing concessions provided to customers impacted by Medicare reimbursement reductions under the Taxpayer Relief Act that became effective April 1, 2013. Operating income for the six months ended June 30, 2013 included $5 million related to one-time bonus costs. Excluding these charges, operating margins decreased for the six months ended June 30, 2014 compared to the six months ended June 30, 2013, primarily as a result of the Medicare reimbursement reductions discussed above. Employee benefit costs increased 5% in the second quarter of 2014, primarily as a result of an increase in health expense, and were relatively unchanged for the six months ended June 30, 2014 compared to the respective prior year periods. 57



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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)



Results of Operations - Continuing Operations (Continued)

Rehabilitation division (Continued)

Hospital rehabilitation services

Revenues increased 8% to $75 million in the second quarter of 2014 compared to $70 million for the same period in 2013 and increased 3% to $149 million for the six months ended June 30, 2014 from $144 million for the same period in 2013. The increase in revenues in both periods was primarily attributable to an acquisition completed in the fourth quarter of 2013. Revenues derived from non-affiliated customers aggregated $52 million and $47 million in the second quarter of 2014 and 2013, respectively, and $103 million and $97 million for the six months ended June 30, 2014 and 2013, respectively. Operating margins decreased for the three months ended June 30, 2014 compared to the three months ended June 30, 2013, primarily as a result of an increase in the provision for doubtful accounts. Operating income for the six months ended June 30, 2013 included $1 million related to one-time bonus costs. Excluding these charges, operating margins were relatively unchanged for the six months ended June 30, 2014 compared to the six months ended June 30, 2013. Employee benefit costs increased 11% and 5% in the second quarter of 2014 and for the six months ended June 30, 2014 compared to the respective prior year periods, primarily as a result of an increase in health expense and paid time off expense associated with an increased employee count as a result of an acquisition completed in the fourth quarter of 2013.



Care management division

Revenues increased 66% to $88 million in the second quarter of 2014 compared to $53 million for the same period in 2013 and increased 68% to $176 million for the six months ended June 30, 2014 from $105 million for the same period in 2013. The growth in revenues in both periods was primarily attributable to acquisitions completed during 2013. Operating income for the three months ended June 30, 2014 included $1 million related to severance costs. Excluding these charges, operating margins increased for the three months ended June 30, 2014 compared to the three months ended June 30, 2013, primarily related to increased operating efficiencies associated with progress in integrating and standardizing activities in this business segment. Operating income for the six months ended June 30, 2014 included $1 million related to severance costs. Operating income for the six months ended June 30, 2013 included $1 million related to one-time bonus costs. Excluding these charges, operating margins were relatively unchanged for the six months ended June 30, 2014 compared to the six months ended June 30, 2013.



Corporate overhead

Operating income for the Company's operating divisions excludes allocations of corporate overhead. These costs aggregated $48 million and $43 million in the second quarter of 2014 and 2013, respectively, and $92 million and $89 million for the six months ended June 30, 2014 and 2013, respectively. The increase in corporate overhead in both periods was primarily attributable to an increase in incentive compensation costs and legal costs. As a percentage of consolidated revenues, corporate overhead totaled 3.8% and 3.6% in the second quarter of 2014 and 2013, respectively, and 3.6% for both the six months ended June 30, 2014 and 2013. Transaction costs Operating results included transaction costs associated with acquisition activities totaling $4 million and $0.1 million in the second quarter of 2014 and 2013, respectively, and $5 million and $1 million for the six months ended June 30, 2014 and 2013, respectively. Transaction costs in all periods were included in salaries, wages and benefits, and other operating expenses.



Other expenses

Rent expense increased 4% to $80 million in the second quarter of 2014 compared to $77 million for the same period of 2013 and increased 5% to $161 million for the six months ended June 30, 2014 from $154 million for the same period in 2013. The increase in both periods was primarily attributable to an increase in straight-line rent expense totaling $5 million and $9 million in the second quarter of 2014 and for the six months ended June 30, 2014, respectively, associated with the September 30, 2013 renewal of 26 nursing centers and 22 TC hospitals leased from Ventas, and contingent rent increases. 58



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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)



Results of Operations - Continuing Operations (Continued)

Other expenses (Continued)

Depreciation and amortization expense increased 2% to $40 million in the second quarter of 2014 compared to $38 million for the same period of 2013 and decreased 2% to $79 million for the six months ended June 30, 2014 from $80 million for the same period in 2013. The increase in the second quarter of 2014 resulted from the Company's ongoing capital expenditure program. The decrease for the six months ended June 30, 2014 resulted from an increase in assets becoming fully depreciated as compared to the same periods in 2013. Interest expense in the second quarter of 2014 and for the six months ended June 30, 2014 included $57 million of charges associated with debt refinancing. Interest expense in the second quarter of 2013 and for the six months ended June 30, 2013 included $1 million of charges associated with debt refinancing. Excluding these charges, interest expense decreased 14% to $24 million in the second quarter of 2014 compared to $28 million for the same period of 2013 and decreased 11% to $50 million for the six months ended June 30, 2014 from $56 million for the same period in 2013. The decrease in both periods was primarily attributable to lower borrowing levels and lower interest rates as compared to the same periods in 2013.



Consolidated results

Loss from continuing operations before income taxes aggregated $34 million in the second quarter of 2014 compared to income from continuing operations before income taxes of $23 million for the same period of 2013. Income from continuing operations before income taxes aggregated $2 million for the six months ended June 30, 2014 compared to $40 million for the same period of 2013. Loss from continuing operations aggregated $21 million in the second quarter of 2014 compared to income from continuing operations of $14 million for the same period of 2013. Income from continuing operations aggregated $1 million for the six months ended June 30, 2014 compared to $25 million for the same period of 2013. Severance costs, litigation costs, interest expense related to debt refinancing and transaction costs negatively impacted consolidated pretax operating results by $71 million ($45 million net of income taxes) in the second quarter of 2014 and by $72 million ($45 million net of income taxes) for the six months ended June 30, 2014. Interest expense related to debt refinancing and transaction costs negatively impacted the consolidated pretax operating results by $1 million ($1 million net of income taxes) in the second quarter of 2013. One-time bonus costs, debt refinancing costs and transaction costs negatively impacted the consolidated pretax operating results by $22 million ($13 million net of income taxes) for the six months ended June 30, 2013.



Results of Operations - Discontinued Operations

Loss from discontinued operations aggregated $8 million in the second quarter of 2014 compared to $1 million for the same period of 2013 and $15 million for the six months ended June 30, 2014 compared to $7 million for the same period of 2013. The Company recorded a net loss of $2 million and $11 million in the second quarter of 2014 and 2013, respectively, related to the divestiture of discontinued operations. The Company recorded a net loss of $5 million and $13 million for the six months ended June 30, 2014 and 2013, respectively, related to the divestiture of discontinued operations.



During the second quarter of 2014, the Company reclassified as discontinued for all periods presented the operations of three TC hospitals and two nursing centers that were either closed or divested through a planned sale of such facility or the expiration of a lease.

On September 30, 2013, the Company entered into agreements with Ventas to exit the 2013 Expiring Facilities. The lease term for the 2013 Expiring Facilities was initially scheduled to expire in April 2015. Under the terms of the agreements, the lease term for the 2013 Expiring Facilities will now expire on September 30, 2014 unless the Company and Ventas are able to transfer the operations earlier. Through June 30, 2014, the Company has transferred the operations of 43 of the 2013 Expiring Facilities to a new operator. Another facility was closed and its operating license and equipment were sold during the six months ended June 30, 2014. Proceeds from the sale of equipment and inventory for the 2013 Expiring Facilities totaled $9 million and $12 million for the three months and six months ended June 30, 2014, respectively. The Company has transferred the operations of an additional 12 of the 2013 Expiring Facilities since July 1, 2014. For accounting purposes, the 2013 Expiring Facilities qualified as assets held for sale and the Company reflected the operating results as discontinued operations in the accompanying unaudited condensed consolidated statement of operations for all historical periods. 59



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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Liquidity Operating cash flows Cash flows used in operations (including discontinued operations) aggregated $66 million for the six months ended June 30, 2014 compared to cash flows provided by operations of $78 million for the six months ended June 30, 2013. Operating cash flows for the six months ended June 30, 2014 were negatively impacted by $95 million ($66 million net of income taxes) for litigation, severance, retirement, retention, debt refinancing and transaction payments. Operating cash flows for the six months ended June 30, 2014 also were negatively impacted by growth in accounts receivable, increased cash settlements of certain previously-accrued balance sheet liabilities and other cash flow changes. The Company expects annual 2014 operating cash flows to be negatively impacted from previous expectations by approximately $45 million. Approximately one-half of this reduction relates to unanticipated revenue mix expansion into slower paying Medicaid, Medicaid Managed and commercial payors. Approximately one-fourth of this reduction relates to cash payments for previously accrued contingent reinsurance premiums for malpractice insurance, with the remainder relating to the net impact of a variety of factors. Accounts receivable increased by $113 million for the six months ended June 30, 2014, of which approximately one-half was attributable to revenue growth during the period, approximately one-fourth was attributable to a revenue mix expansion into slower paying Medicaid, Medicaid Managed and temporary payment delays from three state Medicaid programs, and the remainder is attributable to a cash overpayment made under the Medicare periodic interim payment program along with other factors slowing the payment cycle and driving growth in accounts receivable days outstanding.



Operating cash flows for the six months ended June 30, 2013 were negatively impacted by $34 million ($21 million net of income taxes) for one-time employee bonus, severance, retention, debt refinancing and transaction payments.

The Company utilizes its Amended ABL Facility to meet working capital needs and finance its acquisition and development activities. As a result, the Company typically carries minimal amounts of cash on its consolidated balance sheet. Based upon the Company's expected operating cash flows and the availability of borrowings under the Amended ABL Facility ($652 million at June 30, 2014), management believes that the Company has the necessary financial resources to satisfy its expected short-term and long-term liquidity needs.



Equity Offering

On June 25, 2014, the Company closed the underwritten public offering of 9,000,000 shares of Kindred common stock at a public offering price of $23.75 per share and granted the underwriters a 30-day option to purchase up to an additional 1,350,000 shares of Kindred common stock, of which 723,468 shares were purchased on July 14, 2014 at the public offering price of $23.75, less the underwriting discount. After giving effect to the over-allotment option, there were 64,507,940 shares outstanding as of June 30, 2014, as adjusted.



The Company used the net proceeds of $221 million from the Offering to pay down the Company's Amended ABL Facility.

Dividend payments

The Company paid a quarterly cash dividend of $0.12 per common share on June 11, 2014 to shareholders of record as of the close of business on May 21, 2014. The Company also paid a quarterly cash dividend of $0.12 per common share on March 27, 2014 to shareholders of record as of the close of business on March 6, 2014. On August 6, 2014, the Company's Board of Directors approved the quarterly cash dividend to its shareholders of $0.12 per common share to be paid on September 10, 2014 to shareholders of record as of the close of business on August 20, 2014. Future declarations of quarterly dividends will be subject to the approval of Kindred's Board of Directors. The current cash dividend funding will require the use of approximately $31 million on an annual basis. 60



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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)



Liquidity (Continued)

Credit facilities and notes

The Company entered into the Prior ABL Facility and the Prior Term Loan Facility (collectively, the "Prior Credit Agreements") and issued the Notes due 2019 in connection with the acquisition of RehabCare. In addition to customary affirmative covenants and events of default, the Prior Credit Agreements and the indenture governing the Notes due 2019 included a number of restrictive covenants that imposed operating and financial restrictions on the Company and certain of its subsidiaries, including limiting the Company's ability to pay dividends to certain restricted payment baskets. The Prior Credit Agreements also established a minimum fixed charge coverage ratio and a maximum total leverage ratio. All obligations under the Prior Credit Agreements were fully and unconditionally guaranteed, subject to certain customary release provisions, by substantially all of the Company's existing and future direct and indirect domestic 100% owned subsidiaries, as well as certain non-100% owned domestic subsidiaries as the Company determined in its sole discretion. The Notes due 2019 were fully and unconditionally guaranteed, subject to certain customary release provisions, by substantially all of the Company's domestic 100% owned subsidiaries. In addition, the Prior Credit Agreements were collateralized by substantially all of the Company's assets, including certain owned real property. In August 2013, the Company completed amendments and restatements to the Prior Credit Agreements to increase its borrowing capacity and improve its financial flexibility. The amendments included, among other things, the following changes: (1) refreshing the option to increase the credit capacity in the aggregate between the Prior Credit Agreements by $250 million; (2) establishing the option to further increase the credit capacity between the Prior Credit Agreements upon satisfaction of a secured leverage ratio; (3) extending the maturity of the Prior ABL Facility by two years to June 2018; (4) eliminating the annual and cumulative limitations on acquisitions; (5) raising to $150 million the Company's basket for paying cash dividends, buying back stock and making other restricted payments; and (6) easing the restrictions on the Company's ability to make investments and enter into other joint venture arrangements. The interest rate pricing levels were not changed in connection with the amendments. In May 2013, the Company completed an amendment and restatement of its Prior Term Loan Facility to reduce its annual interest cost by 100 basis points. The applicable interest rate on the Prior Term Loan Facility was reduced by 50 basis points to LIBOR plus 325 basis points (previously LIBOR plus 375 basis points). In addition, the LIBOR floor was reduced to 1.00% from 1.50%. The Prior Credit Agreements also included an option to increase the credit capacity in an aggregate amount between the two facilities by $200 million. In October 2012, the Company exercised this option to increase the credit capacity by completing modifications to increase by $100 million the Prior Term Loan Facility and expand by $100 million the borrowing capacity under the Prior ABL Facility. The additional Prior Term Loan Facility borrowings were issued at 97.5% and the net proceeds were used to pay down a portion of the outstanding balance under the Prior ABL Facility. In connection with the $100 million expansion of the borrowing capacity under the Prior ABL Facility, the Company also modified the accounts receivable borrowing base which allowed the Company to more easily access the full amount of the available credit.



April 2014 Debt Refinancing

On April 9, 2014, the Company completed the refinancing of substantially all of its existing debt with $2.25 billion of secured and unsecured debt. The refinancing lowers borrowing costs, extends debt maturities, reduces interest rate risk, improves covenant flexibility and increases the available capacity under the Company's Amended ABL Facility. Aside from the changes noted below, the terms and conditions of the Amended ABL Facility and the Amended Term Loan Facility are each substantially similar to their respective terms and conditions before the effectiveness of the ABL Amendment Agreement and Term Loan Amendment Agreement, as applicable. During the three months ended June 30, 2014, the Company paid approximately $57 million in premiums, lender fees and third party costs related to the April 2014 refinancing. 61



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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Liquidity (Continued) ABL Amendment Agreement On April 9, 2014, the Company entered into the ABL Amendment Agreement. The ABL Amendment Agreement amends and restates the Prior ABL Facility. As used herein, the "Amended ABL Facility" refers to the amended and restate Prior ABL Facility following the ABL Amendment Agreement. The ABL Amendment Agreement, among other items, (1) extends the maturity date of the Prior ABL Facility from June 1, 2018 to April 9, 2019, (2) provides for the replacement of all revolving commitments outstanding under the Prior ABL Facility with new revolving commitments in the same principal amount, (3) increases the amounts available for incremental commitments and (4) amends certain provisions related to the incurrence of debt and liens and the making of acquisitions, investments and restricted payments. The ABL Amendment Agreement also reduces the applicable interest rate margins for LIBOR borrowings under the Prior ABL Facility from a range of 2.50% to 3.00% (depending on average daily excess availability) to a range of 2.00% to 2.50%. The applicable interest rate margins for base rate borrowings are also reduced from a range of 1.50% to 2.00% (depending on average daily excess availability) to a range from 1.00% to 1.50%. At June 30, 2014, the applicable margin for borrowings under the Amended ABL Facility was 2.25% with respect to LIBOR borrowings and 1.25% with respect to base rate borrowings.



Term Loan Amendment Agreement

Also on April 9, 2014, the Company entered into the Term Loan Amendment Agreement. The Term Loan Amendment Agreement amends and restates the Prior Term Loan Facility. As used herein, the "Amended Term Loan Facility" refers to the amended and restated Prior Term Loan Facility following the Term Loan Amendment Agreement. The Term Loan Amendment Agreement, among other items, (1) extends the maturity date of the Prior Term Loan Facility from June 1, 2018 to April 9, 2021, (2) provides for the replacement of all term loans outstanding under the Prior Term Loan Facility with new term loans in a principal amount of $1 billion, (3) reduces the interest rate margins applicable to the term loans, (4) increases the available capacity for incremental term loans and (5) amends certain provisions related to the incurrence of debt and liens and the making of acquisitions, investments and restricted payments.



The Term Loan Amendment Agreement also reduces the applicable margin for LIBOR borrowings under the Prior Term Loan Facility from 3.25% to 3.00% and, with respect to base rate borrowings, from 2.25% to 2.00%.

Notes due 2022

On April 9, 2014, the Company completed a private placement of the Notes due 2022. The Notes due 2022 were issued pursuant to the indenture dated as of April 9, 2014, among the Company, the Guarantors and Wells Fargo Bank, National Association, as trustee. The Notes due 2022 bear interest at an annual rate of 6.375% and are senior unsecured obligations of the Company and of the Guarantors. The indenture governing the Notes due 2022 contains certain restrictive covenants that, among other things, limit the Company's and its restricted subsidiaries' ability to incur, assume or guarantee additional indebtedness; pay dividends, make distributions or redeem or repurchase capital stock; restrict dividends, loans or asset transfers from its subsidiaries; sell or otherwise dispose of assets; and enter into transactions with affiliates. These covenants are subject to a number of limitations and exceptions. The indenture governing the Notes due 2022 also contains customary events of default. Under the terms of the Notes due 2022, the Company may pay dividends pursuant to specified exceptions or, if its consolidated coverage ratio (as defined) is at least 2.0 to 1.0, it may pay dividends in an amount equal to 50% of its consolidated net income (as defined) and 100% of the net cash proceeds from the issuance of capital stock. The making of certain other restricted payments or investments by the Company or its restricted subsidiaries would reduce the amount available for the payment of dividends pursuant to the foregoing exception.



In connection with the Notes due 2022, on April 9, 2014, the Company and the Guarantors entered into the Registration Rights Agreement with J.P. Morgan Securities LLC, on behalf of the initial purchasers of the Notes due 2022.

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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Liquidity (Continued) Notes due 2022 (Continued) Pursuant to the Registration Rights Agreement, the Company and the Guarantors will (among other obligations) use commercially reasonable efforts to file with the SEC a registration statement relating to an offer to exchange the Notes due 2022 for registered notes with substantially identical terms and consummate such offer within 365 days after the issuance of the Notes due 2022. A "Registration Default" will occur if, among other things, the Company and the Guarantors fail to comply with this requirement. If a Registration Default occurs, the annual interest rate of the Notes due 2022 will be increased by 0.25% per annum and will increase by 0.25% per annum at the end of each subsequent 90-day period, but in no event will such increase exceed 1.00% per annum.



Redemption of the Notes Due 2019

On April 9, 2014, an irrevocable notice of redemption of the Notes due 2019 was delivered to the holders thereof, calling for redemption of the entire outstanding $550 million aggregate principal amount of the Notes due 2019 on the Redemption Date pursuant to the terms of the indenture governing the Notes due 2019. The Redemption Price was equal to 100% of the principal amount of the Notes due 2019 plus accrued and unpaid interest on the Notes due 2019 to but excluding the Redemption Date plus the Applicable Premium as defined in the indenture governing the Notes due 2019. On April 9, 2014, the Company deposited funds with the trustee for the Notes due 2019, and provided the trustee with irrevocable instructions to apply the deposit to redeem the Notes due 2019 on the Redemption Date. Pursuant to these actions, the indenture governing the Notes due 2019 was satisfied and discharged in accordance with its terms. As a result, the Company and the guarantors party thereto have been released from their obligations with respect to the Notes due 2019, except with respect to those provisions of the indenture governing the Notes due 2019 that by their terms survive the satisfaction and discharge.



Interest rate swaps

In December 2011, the Company entered into two interest rate swap agreements to hedge its floating interest rate on an aggregate of $225 million of debt outstanding under the Prior Term Loan Facility. The interest rate swaps had an effective date of January 9, 2012, and will expire on January 11, 2016 and continue to apply to the Amended Term Loan Facility. The Company is required to make payments based upon a fixed interest rate of 1.8925% calculated on the notional amount of $225 million. In exchange, the Company will receive interest on $225 million at a variable interest rate that is based upon the three-month LIBOR, subject to a minimum rate of 1.5%. The Company determined these interest rate swaps continue to qualify for cash flow hedge accounting treatment at June 30, 2014. However, an amendment to the Prior Term Loan Facility completed in May 2013 reduced the LIBOR floor from 1.5% to 1.0%, therefore some partial ineffectiveness will result through the expiration of the interest rate swap agreement. In March 2014, the Company entered into an additional interest rate swap agreement to hedge its floating interest rate on an aggregate of $400 million of debt outstanding under the Term Loan Amendment Agreement. On April 8, 2014, the Company completed a novation of a portion of its $400 million swap agreement to two new counterparties, each in the amount of $125 million. The original swap contract was not amended, terminated or otherwise modified. The interest rate swap had an effective date of April 9, 2014, and will expire on April 9, 2018. The Company is required to make payments based upon a fixed interest rate of 1.867% calculated on the notional amount of $400 million. In exchange, the Company will receive interest on $400 million at a variable interest rate that is based upon the three-month LIBOR, subject to a minimum rate of 1.0%. The Company determined this interest rate swap qualifies for cash flow hedge accounting treatment at June 30, 2014.



The Company records the effective portion of the gain or loss on these derivative financial instruments in accumulated other comprehensive income (loss) as a component of stockholders equity and records the ineffective portion of the gain or loss on these derivative financial instruments as interest expense. For the three months and six months ended June 30, 2014, the ineffectiveness related to the interest rate swaps was immaterial.

The aggregate fair value of the interest rate swaps recorded in other accrued liabilities was $4 million and $1 million at June 30, 2014 and December 31, 2013, respectively.

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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Liquidity (Continued) Other financing activities As a result of deterioration in professional liability and workers compensation underwriting results of the Company's limited purpose insurance subsidiary in 2012, the Company made a capital contribution of $14 million during the six months ended June 30, 2013 to its limited purpose insurance subsidiary. This transaction was completed in accordance with applicable regulations and had no impact on earnings. No contribution was required to be paid during the three months ended June 30, 2014. Capital Resources



Capital expenditures and acquisitions

Excluding acquisitions, routine capital expenditures (expenditures necessary to maintain existing facilities that generally do not increase capacity or add services) totaled $46 million for the six months ended June 30, 2014 compared to $40 million for the same period in 2013. Hospital development capital expenditures (primarily new and replacement facility construction) totaled $0.5 million for the six months ended June 30, 2014 compared to $7 million for the same period in 2013. Nursing center development capital expenditures (primarily the addition of transitional care services for higher acuity patients) totaled $0.5 million for the six months ended June 30, 2014 and were immaterial for the same period in 2013. Excluding acquisitions, the Company anticipates that routine capital spending for 2014 should approximate $100 million to $105 million and development capital spending should approximate $15 million to $20 million. Management expects that substantially all of these expenditures will be financed through internal sources. Management believes that its capital expenditure program is adequate to improve and equip existing facilities. At June 30, 2014, the estimated cost to complete and equip construction in progress approximated $16 million. Acquisition expenditures totaled $24 million for the six months ended June 30, 2014 compared to $27 million for the same period in 2013. The Company financed these acquisitions with operating cash flows and its Amended ABL Facility.



Other Information

Effects of inflation and changing prices

The Company derives a substantial portion of its revenues from the Medicare and Medicaid programs. Congress and certain state legislatures have enacted or may enact additional significant cost containment measures limiting the Company's ability to recover its cost increases through increased pricing of its healthcare services. Medicare revenues in TC hospitals and nursing centers are subject to fixed payments under the Medicare prospective payment systems.



Medicaid reimbursement rates in many states in which the Company operates nursing centers also are based upon fixed payment systems. Generally, these rates are adjusted annually for inflation. However, these adjustments may not reflect the actual increase in the costs of providing healthcare services.

Various healthcare reform provisions became law upon the enactment of the ACA. The reforms contained in the ACA have affected each of the Company's businesses in some manner and are directed in large part at increased quality and cost reductions. Several of the reforms are very significant and could ultimately change the nature of the Company's services, the methods of payment for the Company's services and the underlying regulatory environment. These reforms include possible modifications to the conditions of qualification for payment, bundling of payments to cover both acute and post-acute care and the imposition of enrollment limitations on new providers. The ACA also provides for: (1) reductions to the annual market basket payment updates for LTAC hospitals, IRFs, home health agencies and hospice providers which could result in lower reimbursement than in the preceding year; (2) additional annual "productivity adjustment" reductions to the annual market basket payment update as determined by CMS for LTAC hospitals, IRFs, and nursing centers (beginning in federal fiscal year 2012), home health agencies (beginning in federal fiscal year 2015) and hospice providers (beginning in federal fiscal year 2013); (3) new transparency, reporting and certification requirements for skilled nursing facilities, including disclosures regarding organizational structure, officers, directors, trustees, managing employees and financial, clinical and other related data; (4) a quality reporting system for hospitals (including LTAC hospitals and IRFs) beginning in federal fiscal year 2014; and (5) reductions in Medicare payments to hospitals (including LTAC hospitals and IRFs) beginning in federal fiscal year 2014 for failure to meet certain quality reporting standards or to comply with standards in new value based purchasing demonstration project programs. 64



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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)



Other Information (Continued)

Effects of inflation and changing prices (Continued)

The healthcare reforms and changes resulting from the ACA, as well as other similar healthcare reforms, could have a material adverse effect on the Company's business, financial position, results of operations and liquidity.

LTAC Legislation

As part of the SGR Reform Act enacted on December 26, 2013, Congress adopted various legislative changes impacting LTAC hospitals (the "LTAC Legislation"). The LTAC Legislation creates new Medicare criteria and payment rules for LTAC hospitals. Under the new criteria, LTAC hospitals treating patients with at least a three-day prior stay in an acute care hospital intensive care unit and patients on prolonged mechanical ventilation admitted from an acute care hospital will continue to receive payment under the Long-Term Acute Care Prospective Payment System ("LTAC PPS"), a prospective payment system specifically for LTAC hospitals. Other patients will continue to have access to LTAC hospital care, whether they are admitted to LTAC hospitals from acute care hospitals or directly from other settings or the community. LTAC hospitals will be paid at a "site-neutral" rate for these patients, based on the lesser of per diem Medicare rates paid for patients with the same diagnoses under the prospective payment system for general short-term acute care hospitals ("IPPS") or LTAC costs. The effective date of the new patient criteria is October 1, 2015, followed by a two-year phase-in period tied to each LTAC hospital's cost reporting period. During the phase-in period, payment for patients receiving the site neutral rate will be based 50% on the current LTAC PPS and 50% on the new site neutral rate. Nearly all of the Company's TC hospitals have a cost reporting period starting on September 1 of each year. Accordingly, the phase-in will not begin for most of the Company's TC hospitals until September 1, 2016 and full implementation of the new criteria will not begin until September 1, 2018. The Company continues to analyze Medicare and internal data to estimate the number of its cases that will continue to be paid under the LTAC PPS rate. At this time, the Company estimates that approximately 40% of its current LTAC patients will be paid at the site neutral rate under the new criteria once it is fully phased-in. The site-neutral payment rates will be based on LTAC costs or a Medicare per diem rate paid for patients with the same diagnoses under IPPS. There can be no assurance that these site neutral payments will not be materially less than the payments currently provided under LTAC PPS. The additional patient criteria imposed by the LTAC Legislation will reduce the population of patients eligible for LTAC PPS and change the basis upon which the Company is paid for other patients. These changes could have a material adverse effect on the Company's business, financial position, results of operations and liquidity. CMS has regulations governing payments to a LTAC hospital that is co-located with another hospital (a "HIH"). The rules generally limit Medicare payments to the HIH if the Medicare admissions to the HIH from its co-located hospital exceed 25% of the total Medicare discharges for the HIH's cost reporting period, known as the "25 Percent Rule." There are limited exceptions for admissions from rural, urban single or a hospital that generates more than 25% of the Medicare discharges in a metropolitan statistical area ("MSA Dominant hospital"). Admissions that exceed this "25 Percent Rule" are paid using IPPS. Patients transferred after they have reached the short-term acute care outlier payment status are not counted toward the admission threshold. Patients admitted prior to meeting the admission threshold, as well as Medicare patients admitted from a non co-located hospital, are eligible for the full payment under LTAC PPS. If the HIH's admissions from the co-located hospital exceed the limit in a cost reporting period, Medicare will pay the lesser of: (1) the amount payable under LTAC PPS; or (2) the amount payable under IPPS, which will likely reduce the Company's revenues for such admissions. At June 30, 2014, the Company operated 20 HIHs with 768 licensed beds. The LTAC Legislation extends the moratorium on the expansion of the "25 Percent Rule" to LTAC hospitals certified prior to October 1, 2004 for four years. LTAC hospitals certified after October 1, 2004 continue to be ineligible for relief from the "25 Percent Rule." Freestanding LTAC hospitals will not be subject to the "25 Percent Rule" payment adjustment until cost reporting periods beginning on or after July 1, 2016. In addition, for cost reporting periods beginning before October 1, 2016: (1) LTAC hospitals may admit up to 50% of their patients from a co-located hospital and still be paid according to LTAC PPS; and (2) LTAC hospitals that are co-located with an urban single hospital or a MSA Dominant hospital may admit up to 75% of their patients from such urban single or MSA Dominant hospital and still be paid according to LTAC PPS. The LTAC Legislation further provides that co-located LTAC hospitals certified on or before September 30, 1995 are exempt from the provisions of the "25 Percent Rule." The LTAC Legislation also mandates that the Secretary of the Health and Human Services report to Congress by July 1, 2015 on whether the "25 Percent Rule" should continue to be applied. 65



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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)



Other Information (Continued)

Effects of inflation and changing prices (Continued)

LTAC Legislation (Continued)

The LTAC Legislation also will change the 25-day average length of stay requirement for LTAC hospitals. To maintain certification under LTAC PPS, the average length of stay of Medicare patients must be greater than 25 days. Medicare Advantage patients are included with Medicare fee-for-service patients in order to determine compliance with the 25-day average length of stay requirements. Under the LTAC Legislation, the average Medicare 25-day length of stay rule will remain in effect for patients paid for under the new Medicare LTAC payment system. However, for cost reporting periods beginning on or after October 1, 2015, the 25-day requirement will not apply to patients receiving the site neutral rate or to Medicare Advantage patients treated in LTAC hospitals. Beginning in 2020, the LTAC Legislation requires that at least 50% of a hospital's patients must be paid under the new LTAC payment system to maintain Medicare certification as a LTAC hospital. Under the new criteria, LTAC hospitals treating patients with at least a three-day prior stay in an acute care hospital intensive care unit and patients on prolonged mechanical ventilation admitted from an acute care hospital will continue to receive payment under LTAC PPS.



The failure of one or more of the Company's TC hospitals to maintain its Medicare certification as a LTAC hospital could have a material adverse effect on the Company's business, financial position, results of operations and liquidity.

The LTAC Legislation also will impose a new moratorium continuing through September 30, 2017 on the establishment and classification of new LTAC hospitals, LTAC satellite facilities and LTAC beds in existing LTAC hospitals or satellite hospitals. This moratorium will limit the Company's ability to increase LTAC bed capacity, expand into new areas or increase bed capacity in existing markets that it serves. The Protecting Access to Medicare Act of 2014 enacted on April 1, 2014 ("PAMA") moved the start date of this moratorium from January 1, 2015 to April 1, 2014 and provided three possible exceptions for any LTAC hospital or satellite facility that as of April 1, 2014: (1) began its qualifying period for payment as a LTAC hospital; (2) has a binding written contract with an outside, unrelated party for the development of a LTAC hospital or satellite facility and has expended at least 10% of the estimated cost of the project or if less, $2.5 million; or (3) has obtained an approved certificate of need.



The Budget Control Act of 2011 and the Taxpayer Relief Act

The Budget Control Act of 2011, enacted on August 2, 2011, initiated $1.2 trillion in domestic and defense spending reductions automatically on February 1, 2013, split evenly between domestic and defense spending. Payments to Medicare providers are subject to these automatic spending reductions, subject to a 2% cap. As discussed below, the Taxpayer Relief Act subsequently delayed by two months the automatic budget sequestration cuts established by the Budget Control Act of 2011. The automatic 2% reduction on each claim submitted to Medicare began on April 1, 2013. The Taxpayer Relief Act was enacted on January 2, 2013. As noted above, this Act delayed by two months the automatic budget sequestration cuts established by the Budget Control Act of 2011. The Taxpayer Relief Act also: (1) reduced Medicare payments by an additional 25% for subsequent procedures when multiple therapy services are provided on the same day; (2) extended the Medicare Part B outpatient therapy cap exception process to December 31, 2013; (3) suspended until December 31, 2013 the sustainable growth rate adjustment ("SGR") reduction applicable to the Medicare Physician Fee Schedule ("MPFS") for certain services provided under Medicare Part B; and (4) increased the statute of limitations to recover Medicare overpayments from three years to five years. The Company believes that the new rules related to multiple therapy services will reduce its Medicare revenues by $25 million to $30 million on an annual basis. The SGR Reform Act subsequently modified the Budget Control Act of 2011 and the Taxpayer Relief Act by (1) extending the Medicare Part B outpatient therapy cap exception process to March 31, 2014; and (2) suspending until March 31, 2014 the SGR reduction applicable to the MPFS for certain services provided under Medicare Part B. PAMA further extended the Medicare Part B outpatient therapy cap exception process and suspended the SGR reduction applicable to the MPFS for certain services provided under Medicare Part B to March 31, 2015.



The Company believes that its operating margins will continue to be under pressure as the growth in operating expenses, particularly professional liability, labor and employee benefits costs, exceeds payment increases from Medicare, Medicaid and third party payors. In addition, as a result of competitive pressures, the Company's ability to maintain operating margins through price increases to private patients is limited.

For additional information regarding Medicare and Medicaid reimbursement and other government regulations impacting the Company, see the Company's Annual Report on Form 10-K for 2013 as filed with the SEC. 66



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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)



Other Information (Continued)

Effects of inflation and changing prices (Continued)

Hospital division

LTAC PPS maintains LTAC hospitals as a distinct provider type, separate from short-term acute care hospitals. Only providers certified as LTAC hospitals may be paid under this system. As of June 30, 2014, 96 of the Company's TC hospitals are certified as LTAC hospitals (with certification pending for one TC hospital). On August 4, 2014, CMS issued final regulations regarding Medicare reimbursement for LTAC hospitals for the federal fiscal year beginning October 1, 2014. Included in the final regulations are: (1) a market basket increase to the standard federal payment rate of 2.9%; (2) offsets to the standard federal payment rate mandated by the ACA of: (a) 0.5% to account for the effect of a productivity adjustment, and (b) 0.2% as required by statute; (3) a wage level budget neutrality factor of 1.0016703 applied to the adjusted standard federal payment rate; (4) adjustments to area wage indexes; and (5) an increase in the high cost outlier threshold per discharge to $14,972. In addition, the proposed regulations also would implement the third year of a three-year phase-in of a 3.75% budget neutrality adjustment which would reduce LTAC hospital rates by 1.3% in 2015. CMS has projected the impact of these changes will result in a 1.1% increase to average Medicare payments to LTAC hospitals. On August 2, 2013, CMS issued final regulations regarding Medicare reimbursement for LTAC hospitals for the federal fiscal year beginning October 1, 2013. Included in the final regulations are: (1) a market basket increase to the standard federal payment rate of 2.5%; (2) offsets to the standard federal payment rate mandated by the ACA of: (a) 0.5% to account for the effect of a productivity adjustment, and (b) 0.3% as required by statute; (3) a wage level budget neutrality factor of 1.0010531 applied to the adjusted standard federal payment rate; (4) adjustments to area wage indexes; and (5) a decrease in the high cost outlier threshold per discharge to $13,314. In addition, the final regulations also would implement the second year of a three-year phase-in of a 3.75% budget neutrality adjustment which would reduce LTAC hospital rates by 1.3% in 2014. CMS has projected the impact of these changes will result in a 1.3% increase to average Medicare payments to LTAC hospitals. On August 1, 2012, CMS issued the 2012 CMS Rules, which, among other things, reduced Medicare reimbursement to the Company's TC hospitals in 2013 and beyond by imposing a budget neutrality adjustment and modifying the short-stay outlier rules. Included in the 2012 CMS Rules are: (1) a market basket increase to the standard federal payment rate of 2.6%; (2) offsets to the standard federal payment rate mandated by the ACA of: (a) 0.7% to account for the effect of a productivity adjustment, and (b) 0.1% as required by statute; (3) a wage level budget neutrality factor of 0.999265 applied to the adjusted standard federal payment rate; (4) adjustments to area wage indexes; and (5) a decrease in the high cost outlier threshold per discharge to $15,408. Effective December 29, 2012, the 2012 CMS Rules (1) began a three-year phase-in of a 3.75% budget neutrality adjustment which will reduce LTAC hospital rates by 1.3% in 2013, 2014 and 2015; and (2) restored a payment reduction that will limit payments for very short-stay outliers that will reduce the Company's TC hospital payments by approximately 0.5%. The ACA requires a quality reporting system for LTAC hospitals beginning in federal fiscal year 2014 under which any market basket update would be reduced by 2% for any LTAC hospital that does not meet the quality reporting standards. CMS has issued final regulations that require LTAC hospitals to report quality measures related to, among other items, catheter-associated urinary tract infections, central line associated blood stream infections, new or worsening pressure ulcers, unplanned readmissions and falls with major injury. The Job Creation Act of 2012 (the "Job Creation Act") provides for reductions in reimbursement of Medicare bad debts at the Company's hospitals and nursing centers. For the hospitals, the bad debt reimbursement rate of 70% for all bad debts was lowered to 65% effective for cost reporting periods beginning on or after October 1, 2012. The Company cannot predict the ultimate long-term impact of LTAC PPS. This payment system is subject to significant change. Slight variations in patient acuity or length of stay could significantly change Medicare revenues generated under LTAC PPS. In addition, the Company's TC hospitals may not be able to appropriately adjust their operating costs to changes in patient acuity and length of stay or to changes in reimbursement rates. In addition, there can be no assurance that LTAC PPS will not have a material adverse effect on revenues from commercial third party payors. Various factors, including a reduction in average length of stay, have negatively impacted revenues from commercial third party payors in recent years. 67



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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)



Other Information (Continued)

Effects of inflation and changing prices (Continued)

Hospital division (Continued)

On July 31, 2014, CMS issued final regulations regarding Medicare reimbursement for IRFs for the federal fiscal year beginning October 1, 2014. Included in these final regulations are: (1) a market basket increase to the standard payment conversion factor of 2.9%; (2) offsets to the standard payment conversion factor mandated by the ACA of: (a) 0.5% to account for the effect of a productivity adjustment, and (b) 0.2% as required by statute; (3) adjustments to area wage indexes; and (4) a decrease in the high cost outlier threshold per discharge to $8,848. CMS has projected the impact of these changes will result in a 2.4% increase to average Medicare payments to IRFs. On July 31, 2013, CMS issued final regulations regarding Medicare reimbursement for IRFs for the federal fiscal year beginning October 1, 2013. Included in these final regulations are: (1) a market basket increase to the standard payment conversion factor of 2.6%; (2) offsets to the standard payment conversion factor mandated by the ACA of: (a) 0.5% to account for the effect of a productivity adjustment, and (b) 0.3% as required by statute; (3) adjustments to area wage indexes; and (4) a decrease in the high cost outlier threshold per discharge to $9,272. CMS has projected the impact of these changes will result in a 2.3% increase to average Medicare payments to IRFs. On July 25, 2012, CMS issued final regulations regarding Medicare reimbursement for IRFs for the federal fiscal year beginning October 1, 2012. Included in these final regulations are: (1) a market basket increase to the standard payment conversion factor of 2.7%; (2) offsets to the standard payment conversion factor mandated by the ACA of: (a) 0.7% to account for the effect of a productivity adjustment, and (b) 0.1% as required by statute; (3) adjustments to area wage indexes; and (4) a decrease in the high cost outlier threshold per discharge to $10,466. Similar to LTAC hospitals, the ACA requires a quality reporting system for IRFs beginning in fiscal year 2014 in which any market basket update would be reduced by 2% for any IRF that does not meet quality reporting standards. CMS has finalized regulations that require IRFs to report quality measures related to, among other items, catheter-associated urinary tract infections, pressure ulcers and unplanned readmissions. Nursing center division On July 31, 2014, CMS issued final regulations updating Medicare payment rates for nursing centers effective October 1, 2014. These final regulations implement a net market basket increase of 2.0% consisting of: (1) a 2.5% market basket inflation increase, less (2) a 0.5% adjustment to account for the effect of a productivity adjustment. On July 31, 2013, CMS issued final regulations updating Medicare payment rates for nursing centers effective October 1, 2013. These final regulations implement a net market basket increase of 1.3% consisting of: (1) a 2.3% market basket inflation increase, less (2) a 0.5% adjustment to account for the effect of a productivity adjustment, and less (3) a 0.5% market basket forecast error adjustment. On July 27, 2012, CMS issued final regulations updating Medicare payment rates for nursing centers effective October 1, 2012. These final regulations implement a net market basket increase of 1.8% consisting of: (1) a 2.5% market basket inflation increase, less (2) a 0.7% adjustment to account for the effect of a productivity adjustment. On April 1, 2014, PAMA was enacted, which directed CMS to create a value-based purchasing initiative applicable to nursing centers beginning October 1, 2018. The initiative will focus on a preventable hospital readmission measure to be provided on or before October 1, 2015 and corresponding preventable hospital readmission rates to be provided on or before October 1, 2016. Nursing centers will be ranked according to performance on this preventable hospital readmission rate, with corresponding incentive payments based upon such ranking. CMS also will reduce the Medicare per diem rate by 2% beginning October 1, 2018 in connection with the launch of this initiative. In February 2012, the Middle Class Tax Relief Act of 2012 was enacted, which provides that certain Medicare Part B therapy services exceeding a threshold of $3,700 would be subject to a pre-payment manual medical review process effective October 1, 2012. The review process for these services was scheduled to expire on December 31, 2012 but was extended through December 31, 2013 under the Taxpayer Relief Act. The SGR Reform Act extended the therapy cap exception process to March 31, 2014, which was later extended to March 31, 2015 by PAMA. This review process has had an adverse effect on the provision and billing of services for patients and could negatively impact therapist productivity. 68



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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)



Other Information (Continued)

Effects of inflation and changing prices (Continued)

Nursing center division (Continued)

In February 2012, Congress passed the Job Creation Act which provides for reductions in reimbursement of Medicare bad debts for nursing centers. The Job Creation Act provides for a phase-in of the reduction in the rate of reimbursement for bad debts of patients that are dually eligible for Medicare and Medicaid. The rate of reimbursement for bad debts for these dually eligible patients were reduced from 88% to 76% for cost reporting periods beginning on or after October 1, 2013 and will be reduced to 65% for cost reporting periods beginning on or after October 1, 2014. The rate of reimbursement for bad debts for patients not dually eligible for both Medicare and Medicaid was reduced from 70% to 65%, effective for cost reporting periods beginning on or after October 1, 2012. Approximately 80% of the Company's Medicare bad debt reimbursements are associated with patients that are dually eligible.



Rehabilitation division

Medicare Part B provides reimbursement for certain physician services, limited drug coverage and other outpatient services, such as therapy and other services, outside of a Medicare Part A covered patient stay. Payment for these services is determined according to the MPFS. Annually since 1997, the MPFS has been subject to the SGR, which is intended to keep spending growth in line with allowable spending. Each year since the SGR was enacted, this adjustment produced a scheduled negative update to payment for physicians, therapists and other healthcare providers paid under the MPFS. Annually, since 2002, Congress has stepped in with the so-called "doc fix" legislation to suspend payment cuts to physicians. Subsequent legislation annually suspended the payment cut with PAMA most recently suspending the payment cut until March 31, 2015. Effective January 1, 2011, reimbursement rates for Medicare Part B therapy services included in the MPFS were reduced by 25% of the practice expense component for subsequent procedures when multiple therapy services are provided on the same day. Effective April 1, 2013, the Taxpayer Relief Act further reduced the practice expense component of Medicare payments for subsequent procedures when multiple therapy services are provided on the same day by an additional 25%. The Company believes that the rules related to multiple therapy services have reduced its revenues by $25 million to $30 million on an annual basis. In February 2012, the Middle Class Tax Relief Act of 2012 was enacted, which provides that certain Medicare Part B therapy services exceeding a threshold of $3,700 would be subject to a pre-payment manual medical review process effective October 1, 2012. The review process for these services was scheduled to expire on December 31, 2012 but was extended through December 31, 2013 under the Taxpayer Relief Act. The SGR Reform Act extended the therapy cap exception process to March 31, 2014, which was later extended to March 31, 2015 by PAMA. This review process has had an adverse effect on the provision and billing of services for patients and could negatively impact therapist efficiencies.



Care management division

On July 1, 2014, CMS issued proposed regulations regarding Medicare payment rates for home health agencies effective January 1, 2015. These proposed regulations implement a net 0.3% reduction consisting of a 2.6% market basket inflation increase, less (1) a 0.4% productivity adjustment, and (2) a 2.5% rebasing adjustment mandated under the ACA.

On November 22, 2013, CMS issued final regulations regarding Medicare payment rates for home health agencies effective January 1, 2014. These final regulations implement a net 1.05% reduction consisting of a 2.3% market basket inflation increase, less (1) a 0.62% ICD-9 grouper refinement, and (2) a 2.73% rebasing adjustment mandated under the ACA. Rebasing the rates includes adjustments to the 60-day episode and per visit payment rates, the non-national medical supply conversion factor and low utilization payment factors. A rebasing adjustment will be applied in each of the next four years, beginning January 1, 2014. On November 2, 2012, CMS issued final regulations regarding Medicare payment rates for home health agencies effective January 1, 2013. These final regulations implement a net market basket increase of 1.3% consisting of: (1) a 2.3% market basket inflation increase, less (2) a 1.0% adjustment mandated by the ACA. In addition, CMS implemented a 1.32% reduction in case mix. On August 4, 2014, CMS issued final regulations regarding Medicare payment rates for hospice providers effective October 1, 2014. These final regulations implement a net market basket increase of 2.1% consisting of: (1) a 2.9% market basket inflation increase, less (2) offsets to the standard payment conversion factor mandated by the ACA of: (a) a 0.5% adjustment to account for the effect of a productivity adjustment, and (b) 0.3% as required by statute. In addition, CMS continued the phase-out of the wage index budget neutrality adjustment. CMS has projected the impact of these changes will result in a 1.4% increase in payments to hospice providers. 69



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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)



Other Information (Continued)

Effects of inflation and changing prices (Continued)

Care management division (Continued)

On August 2, 2013, CMS issued final regulations regarding Medicare payment rates for hospice providers effective October 1, 2013. These final regulations implement a net market basket increase of 1.7% consisting of: (1) a 2.5% market basket inflation increase, less (2) offsets to the standard payment conversion factor mandated by the ACA of: (a) a 0.5% adjustment to account for the effect of a productivity adjustment, and (b) 0.3% as required by statute. In addition, CMS continued the phase-out of the wage index budget neutrality adjustment. CMS has projected the impact of these changes will result in a 1.0% increase in payments to hospice providers. On July 24, 2012, CMS issued final regulations regarding Medicare payment rates for hospice providers effective October 1, 2012. These final regulations implement a net market basket increase of 1.6% consisting of: (1) a 2.6% market basket inflation increase, less (2) offsets to the standard payment conversion factor mandated by the ACA of: (a) a 0.7% adjustment to account for the effect of a productivity adjustment, and (b) 0.3% as required by statute. 70



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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS (Continued)


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