2006 Form 10-K

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2006

Commission File Number 000-14940

HealthSouth Corporation

(Exact Name of Registrant as Specified in its Charter)

Delaware	63-0860407
(State or Other Jurisdiction of Incorporation or Organization)	(I.R.S. Employer Identification No.)

One HealthSouth Parkway Birmingham, Alabama	35243
(Address of Principal Executive Offices)	(Zip Code)

(205) 967-7116

(Registrant’s telephone number)

Securities Registered Pursuant to Section 12(b) of the Act:

Common Stock, $0.01 Par Value

Securities Registered Pursuant to Section 12(g) of the Act:

None

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

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

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

Large accelerated filer x Accelerated filer o Non-Accelerated filer o

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

The aggregate market value of common stock held by non-affiliates of the registrant as of the last business day of the registrant’s most recently completed second fiscal quarter was approximately $1.4 billion. For purposes of the foregoing calculation only, executive officers and directors of the registrant have been deemed to be affiliates. There were 78,684,549 shares of common stock of the registrant outstanding, net of treasury shares, as of February 15, 2007.

DOCUMENTS INCORPORATED BY REFERENCE

The definitive proxy statement relating to the registrant’s 2007 Annual Meeting of Stockholders is incorporated by reference in Part III to the extent described therein.

TABLE OF CONTENTS

		Page
Cautionary Statement Regarding Forward-Looking Statements		ii

PART I

Item 1.	Business	1
Item 1A.	Risk Factors	20
Item 1B.	Unresolved Staff Comments	24
Item 2.	Properties	24
Item 3.	Legal Proceedings	25
Item 4.	Submission of Matters to a Vote of Security Holders	25

PART II

Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	26
Item 6.	Selected Financial Data	28
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	32
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	79
Item 8.	Financial Statements and Supplementary Data	80
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	80
Item 9A.	Controls and Procedures	80
Item 9B.	Other Information	82

PART III

Item 10.	Directors and Executive Officers of the Registrant	83
Item 11.	Executive Compensation	83
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	83
Item 13.	Certain Relationships and Related Transactions	83
Item 14.	Principal Accountant Fees and Services	83

PART IV

Item 15.	Exhibits and Financial Statement Schedules	84

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This annual report contains historical information, as well as forward-looking statements that involve known and unknown risks and relate to future events, our future financial performance, or our projected business results. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “targets,” “potential,” or “continue” or the negative of these terms or other comparable terminology. Such forward-looking statements are necessarily estimates based upon current information and involve a number of risks and uncertainties. Actual events or results may differ materially from the results anticipated in these forward-looking statements as a result of a variety of factors. While it is impossible to identify all such factors, factors that could cause actual results to differ materially from those estimated by us include:

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each of the factors discussed in Item 1A, Risk Factors;

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the outcome of our plan to reposition our primary focus on the post-acute care sector, including the results of our attempts to divest our surgery centers, outpatient, and diagnostic divisions;

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changes or delays in or suspension of reimbursement for our services by governmental or private payors;

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changes in the regulations of the health care industry at either or both of the federal and state levels;

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changes in reimbursement for health care services we provide;

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competitive pressures in the health care industry and our response to those pressures;

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our ability to obtain and retain favorable arrangements with third-party payors;

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our ability to attract and retain nurses, therapists, and other health care professionals in a highly competitive environment with often severe staffing shortages; and

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general conditions in the economy and capital markets.

The cautionary statements referred to in this section also should be considered in connection with any subsequent written or oral forward-looking statements that may be issued by us or persons acting on our behalf. We undertake no duty to update these forward-looking statements, even though our situation may change in the future. Furthermore, we cannot guarantee future results, events, levels of activity, performance, or achievements.

PART I

Item 1.

Business

General

HealthSouth is the largest provider of rehabilitative health care and ambulatory surgery services in the United States, with 978 facilities and approximately 33,000 full- and part-time employees as of December 31, 2006. As used in this report, the terms “HealthSouth,” “we,” “us,” “our,” and the “company” refer to HealthSouth Corporation and its subsidiaries, unless otherwise stated or indicated by context. In addition, we use the term “HealthSouth Corporation” to refer to HealthSouth Corporation alone wherever a distinction between HealthSouth Corporation and its subsidiaries is required or aids in the understanding of this filing.

HealthSouth Corporation was organized as a Delaware corporation in February 1984. Our principal executive offices are located at One HealthSouth Parkway, Birmingham, Alabama 35243, and the telephone number of our principal executive offices is (205) 967-7116.

Strategic Repositioning

On August 14, 2006, we announced our intent to seek strategic alternatives for our surgery centers and outpatient divisions, along with our diagnostic division (previously designated as “non-core”), and to reposition the company as a “pure play” provider of post-acute health care services with an initial focus on rehabilitative health care. We engaged Goldman Sachs & Co. and Deutsche Bank to assist us in the process, which we expect to conclude by the end of 2007. Our decision to seek strategic alternatives was based on a number of factors, including:

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our existing divisions compete in sectors with substantial growth potential;

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our significant debt burden, coupled with settlement obligations paid and to be paid with respect to settlements with the United States Securities and Exchange Commission (the “SEC”) and the United States Department of Justice (the “DOJ”), limit our ability to pursue such growth opportunities;

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we concluded there are very few strategic or financial synergies in operating our existing divisions as one company and, in some instances, the strategic interests of these divisions are at cross purposes with one another;

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we believe that a “pure play” post-acute strategy builds on our core competencies in the area of inpatient rehabilitative care and is responsive to industry trends; and

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the proceeds of any divestitures of the surgery centers, outpatient, and diagnostic divisions would be used to deleverage the company, thereby allowing us to pursue growth opportunities in our inpatient division and complementary post-acute care businesses under the HealthSouth name.

Sale of Outpatient Division

Taking the first step in our strategic repositioning and deleveraging plan, on January 29, 2007, we announced that we had entered into a Stock Purchase Agreement (the “Stock Purchase Agreement”) with Select Medical Corporation (“Select Medical”), pursuant to which Select Medical will acquire our outpatient division for approximately $245 million in cash, subject to certain adjustments. The closing of the transaction is subject to the satisfaction of closing conditions set forth in the Stock Purchase Agreement, including certain regulatory and other approvals. The closing is anticipated to occur on or before April 30, 2007. The foregoing description of the Stock Purchase Agreement is qualified in its entirety by the actual terms of the Stock Purchase Agreement, which is attached as Exhibit 2.1 to our Current Report on Form 8-K filed on January 30, 2007, and is incorporated by reference herein.

Recent Significant Events

Our ability to reposition the company was made possible by the considerable efforts of our employees who have spent the last three years responding to various legal, financial, and operational “rocks in the road” resulting from the fraud perpetrated by certain members of our prior management team. Although we continue to face a challenging operating environment, we achieved a number of goals in 2006 that will enable us to begin focusing on HealthSouth’s future, rather than its past:

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We completed several recapitalization transactions resulting in, we believe, reduced refinancing risk, enhanced operational flexibility, an improved credit profile, and the ability to pre-pay a significant portion of our long-term debt.

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We received court approval of our settlement with the lead plaintiffs in the federal securities class actions and the derivative litigation, as well as with our insurance carriers, relating to claims filed against us, certain of our former directors and officers, and certain other parties. This settlement disposed of the last of the major litigation pending against us.

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We reached a non-prosecution agreement with the United States Department of Justice with respect to the accounting fraud committed by members of our former management.

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We remediated numerous internal control weaknesses.

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We recruited the remaining members of our senior management team, including senior vice presidents for development, payor contracting, and supply chain management.

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Our common stock was relisted on the New York Stock Exchange.

Although we have made significant progress since March 2003—when we discovered the financial fraud committed by certain members of our former management—we continue to face many challenges. We encourage you to read the discussions contained in Item 1A, Risk Factors, and in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, which highlight additional considerations about HealthSouth.

Completion of Recapitalization and Other Significant Financial Transactions

On March 10, 2006, we completed the last of a series of recapitalization transactions (the “Recapitalization Transactions”) enabling us to prepay substantially all of our prior indebtedness and replace it with approximately $3 billion of new long-term debt. Although we remain highly leveraged, we believe these Recapitalization Transactions eliminated significant uncertainty regarding our capital structure and improved our financial position in several important ways:

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Reduced refinancing risk—The terms governing our prior indebtedness would have required us to refinance approximately $2.7 billion between 2006 and 2009, assuming all noteholders holding options to require us to repurchase their notes in 2007 and 2009 were to exercise those options. Under the terms governing our new indebtedness, we have minimal maturities until 2013 when our new term loans come due. The extension of our debt maturities has substantially reduced the risk and uncertainty associated with our near-term refinancing obligations under our prior debt.

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Improved operational flexibility—We negotiated new loan covenants with higher leverage ratios and lower interest coverage ratios. In addition, our new loan agreements increase our ability to enter into certain transactions (e.g. acquisitions and sale-leaseback transactions).

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Increased liquidity—As a result of the Recapitalization Transactions, our revolving line of credit increased by approximately $150 million. In addition, the increased flexibility provided by the covenants governing our new indebtedness will allow us greater access to our revolving credit facility than we had under our prior indebtedness.

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Improved credit profile—By issuing $400 million in convertible perpetual preferred stock and using the net proceeds from that offering to repay a portion of our outstanding indebtedness and to pay fees and expenses related to such prepayment, we were able to reduce the amount we ultimately borrowed under the interim loan agreement. In addition, by increasing the ratio of our secured debt to unsecured debt, our capital structure is now closer to industry norms. Further, a substantial amount of our new indebtedness is prepayable without penalty, which will enable us to reduce debt and interest expense as operating and non-operating cash flows allow without the substantial cost associated with the prepayment of our prior public indebtedness.

The Recapitalization Transactions included (1) entering into credit facilities that provide for extensions of credit of up to $2.55 billion of senior secured financing, (2) entering into an interim loan agreement that provided us with $1.0 billion of senior unsecured financing, (3) completing a $400 million offering of convertible perpetual preferred stock, (4) completing cash tender offers to purchase $2.03 billion of our previously outstanding senior notes and $319 million of our previously outstanding senior subordinated notes and consent solicitations with respect to proposed amendments to the indentures governing each outstanding series of notes, and (5) prepaying and terminating our Senior Subordinated Credit Agreement, our Amended and Restated Credit Agreement, and our Term Loan Agreement (as defined in Note 9, Long-term Debt, to our accompanying consolidated financial statements). In order to complete the Recapitalization Transactions, we also entered into amendments, waivers, and consents to our prior senior secured credit facility, $200 million senior unsecured term loan agreement, and $355 million senior subordinated credit agreement. Detailed descriptions of each of the above transactions are contained in Note 9, Long-term Debt, to our accompanying consolidated financial statements.

We used a portion of the proceeds of the loans under the new senior secured credit facilities, the proceeds of the interim loans, and the proceeds of the $400 million offering of convertible perpetual preferred stock, along with cash on hand, to prepay substantially all of our prior indebtedness and to pay fees and expenses related to such prepayment and the Recapitalization Transactions. The remainder of the proceeds and availability under the senior secured credit facilities are being used for general corporate purposes. In addition, the letters of credit issued under the revolving letter of credit subfacility and the synthetic letter of credit facility is being used in the ordinary course of business to secure workers’ compensation and other insurance coverages and for general corporate purposes.

In June 2006, we repaid our Interim Loan Agreement using cash on hand and the proceeds from a private offering of $1.0 billion aggregate principal amount of senior notes, which included $375 million in aggregate principal amount of floating rate senior notes due 2014 (the “Floating Rate Notes”) at par and $625 million aggregate principal amount of 10.750% senior notes due 2016 at 98.505% of par. The Floating Rate Notes bear interest at a per annum rate equal to LIBOR plus 6.0%. For additional information regarding this transaction, see Note 9, Long-term Debt, to our accompanying consolidated financial statements.

The face value of our long-term debt (excluding notes payable to banks and others, noncompete agreements, and capital lease obligations) before and after the transactions described above is summarized in the following table:

	As of December 31, 2006	As of December 31, 2005
	As of December 31, 2006	As of December 31, 2005
	(In Millions)
Revolving credit facility	$ 170.0	$ –
Term loans	2,039.8	513.4
Bonds payable	1,046.5	2,720.9
	$ 3,256.3	$ 3,234.3

As of December 31, 2006, we had approximately $40.6 million in cash and cash equivalents. This amount excludes approximately $99.6 million in restricted cash and $71.1 million of restricted marketable securities, which are assets whose use is restricted because of various obligations we have under lending agreements, partnership agreements, and other arrangements primarily related to our captive insurance company. For more information about our liquidity, see Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, “Liquidity and Capital Resources,” Note 1, Summary of Significant Accounting Policies, Note 2, Liquidity, and Note 9, Long-term Debt, to our accompanying consolidated financial statements.

We plan to use the proceeds from any divestitures of our surgery centers, outpatient, and diagnostic divisions, along with any proceeds we may receive from income tax refunds and certain derivative litigation, to pay off debt and thereby deleverage the company, which we believe will help us become a consolidator in the post-acute care sector.

On February 20, 2007, we announced that we are seeking certain amendments to our existing Credit Agreement (as defined in Note 9, Long-term Debt, to our accompanying consolidated financial statements). The amendments sought include a reduction in the margin over LIBOR that we currently pay and approval for our divestiture activities.

Securities Litigation Settlement

On January 11, 2007, we received final court approval (the “Orders”) of the previously announced settlement agreements (collectively, the “Settlement Agreement”) with the lead plaintiffs in the federal securities class actions and the derivative actions, as well as certain of our insurance carriers (collectively, the “Carriers”), to settle litigation filed against us, certain of our former directors and officers and certain other parties in the United States District Court for the Northern District of Alabama and the Circuit Court in Jefferson County, Alabama relating to financial reporting and related activity that occurred at HealthSouth during periods ended in March 2003. Pursuant to the Settlement Agreement, federal securities and fraud claims brought in the class action against us and certain of our former directors and officers will be settled for aggregate consideration of $445 million, including HealthSouth common stock and warrants valued at $215 million and cash payments by certain of our insurance carriers of $230 million. In addition, the federal securities class will receive 25% of any net recoveries from future judgments obtained by us or on our behalf with respect to certain claims against Richard Scrushy, our former chairman and chief executive officer (excluding the $48 million judgment against Mr. Scrushy on January 3, 2006, as discussed in Note 25, Contingencies and Other Commitments, to our accompanying consolidated financial statements), Ernst & Young, our former auditors, and UBS, our former primary investment bank, each of which remains a defendant in the derivative actions as well as the federal securities class actions. In connection with the Settlement Agreement, we will issue an aggregate of 5,023,732 shares of common stock and eleven-year warrants to purchase an aggregate of 8,151,265 additional shares of common stock at an exercise price of $41.40 per share. Pursuant to the Settlement

Agreement, we are also required to indemnify the Carriers, to the extent permitted by law, for any amounts that they become legally obligated to pay to any non-settling defendants. However, the order approving the settlement bars claims by the non-settling defendants arising out of or relating to the federal securities class actions and the derivative actions, but does not prevent other security holders excluded from the settlement from asserting claims directly against us. Mr. Scrushy has appealed a portion of this “bar order” that prevents him from seeking advancement of certain legal costs.

For additional information about the Settlement Agreement and underlying legal proceedings, see Note 25, Contingencies and Other Commitments, to our accompanying consolidated financial statements. The foregoing description of the Orders is not complete and is qualified in its entirety by reference to the text of the Orders, copies of which are attached as Exhibits 99.2 and 99.3 to our Current Report on Form 8-K filed on January 12, 2007, and are incorporated herein by reference. The foregoing description of the Settlement Agreement is not complete and is qualified in its entirety by reference to the text of the agreements which make up the Settlement Agreement, copies of which are attached as Exhibits 10.1, 10.2, and 10.3 to our Current Report on Form 8-K filed on September 27, 2006, and are incorporated herein by reference.

Non-Prosecution Agreement

On May 17, 2006, we announced that we reached a non-prosecution agreement (the “Non-Prosecution Agreement”) with the DOJ with respect to the accounting fraud committed by members of our former management. We have pledged to continue our cooperation with the DOJ and have paid $3 million to the U.S. Postal Inspection Services Consumer Fraud Fund during the second quarter of 2006 in connection with the execution of the Non-Prosecution Agreement. Notwithstanding the foregoing, the DOJ has reserved the right to prosecute us for any crimes committed by our employees if we violate the terms of the Non-Prosecution Agreement. The Non-Prosecution Agreement expires on May 17, 2009.

Reverse Stock Split and Relisting

On October 18, 2006, at a special meeting of our stockholders, our stockholders approved a proposal to amend our Restated Certificate of Incorporation to (1) effect a one-for-five reverse stock split of our common stock, whereby each issued and outstanding five shares of common stock were combined into and became one share of common stock, and (2) decrease the number of authorized shares of common stock from 600 million shares to 200 million shares. At the close of business on October 25, 2006, the reverse stock split became effective. Stockholders who would otherwise be entitled to receive fractional shares of our common stock as a result of the reverse stock split received a cash payment in lieu thereof. The foregoing description of the Restated Certificate of Incorporation is not complete and is qualified in its entirety by the text of the Restated Certificate of Incorporation, a copy of which is attached as Exhibit 3.1 to our Current Report on Form 8-K filed on October 31, 2006, and is incorporated herein by reference.

On October 26, 2006, we announced that our common stock had been relisted on the New York Stock Exchange under the ticker symbol “HLS.”

Inpatient Division

We are the nation’s largest provider of inpatient rehabilitation services. Our inpatient division operates inpatient rehabilitation facilities (“IRFs”) and long-term acute care hospitals (“LTCHs”) and provides treatment on both an inpatient and outpatient basis. Our inpatient facilities are located in 27 states, with a concentration of facilities in Texas, Pennsylvania, Florida, Tennessee, and Alabama. We also have a facility in Puerto Rico. Our inpatient division comprised approximately 58% of our 2006 Net operating revenues and approximately 79% of our 2006 operating earnings from our four primary operating divisions. Following the conclusion of our strategic repositioning, we will focus on operating our IRFs and growing our inpatient rehabilitation business through bed expansion, consolidation in existing markets (through joint venturing or acquisition), de-novo projects in existing and new markets, and acquisitions in new markets. Although our initial focus will be to enhance our position in the inpatient rehabilitation industry, over the longer term we plan to begin looking for growth opportunities in long-term acute care, home health, and hospice.

As of December 31, 2006, our inpatient division operated 92 freestanding IRFs (64 of which are wholly owned and 28 of which are jointly owned). As of December 31, 2006, our inpatient division also operated 10 LTCHs (9 of which are wholly owned and 1 of which is jointly owned), 7 of which are freestanding and 3 of which are hospital-within-hospital facilities. As of December 31, 2006, our inpatient division also provided outpatient services through 81 facilities (68 of which are wholly owned and 13 of which are jointly owned) located within our IRFs or in satellite facilities near our IRFs. In addition to facilities in which we have an ownership interest, our inpatient division operated 11 inpatient rehabilitation units, 3 outpatient facilities, and 2 gamma knife radiosurgery centers through management contracts as of December 31, 2006.

Our IRFs provide services to patients who require intensive inpatient rehabilitative care. Inpatient rehabilitation patients typically experience significant physical disabilities due to various conditions, such as head injury, spinal cord injury, stroke, certain orthopedic problems, and neuromuscular disease. Our IRFs provide the medical, nursing, therapy, and

ancillary services required to comply with local, state, and federal regulations, as well as accreditation standards of the Joint Commission on Accreditation of Healthcare Organizations (the “JCAHO”) and, for some facilities, the Commission on Accreditation of Rehabilitation Facilities.

Although the market for inpatient rehabilitation services is highly competitive, it is also highly fragmented. This fragmentation creates potential consolidation and development opportunities for us. For example, in 2006:

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We opened a new 40-bed IRF in Petersburg, Virginia.

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We completed a joint venture in Tucson, Arizona by merging a competitor’s 20-bed IRF with our existing 80-bed IRF.

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We broke ground on a new 40-bed IRF in Fredericksburg, Virginia.

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We reached an agreement to close a competitor’s 48-bed IRF in Wichita Falls, Texas, and consolidated its patients to our existing 63-bed IRF.

In addition, because of our size, we believe we differentiate ourselves from our competitors in the following ways:

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Quality. Our hospitals provide a broad base of clinical experience from which we have developed clinical best practices and protocols. We believe these clinical best practices and protocols help ensure the delivery of consistently high quality rehabilitative services across all of our hospitals.

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Cost Effectiveness. Our size also helps us provide inpatient rehabilitative services on a very cost-effective basis. Specifically, because of our large number of inpatient facilities, we can utilize standardized staffing models and take advantage of certain supply chain efficiencies. We continue to try to reduce our costs by leveraging our size.

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Technology. As a market leader in inpatient rehabilitation, we have devoted substantial resources to creating and leveraging rehabilitative technology. For example, we have developed an innovative therapeutic device called the “AutoAmbulator,” which can help advance the rehabilitative process for patients who experience difficulty walking. In addition, in November 2006, we completed implementation of our patient accounting system, which allowed the division to standardize business office policies and procedures through enhanced technology.

Our inpatient division’s payor mix is weighted toward government-funded sources, particularly Medicare. For the years ended December 31, 2006, 2005, and 2004, Medicare represented 69.7%, 71.2%, and 71.3%, respectively, of the inpatient division’s Net operating revenues, which totaled $1.7 billion, $1.8 billion, and $2.0 billion, respectively.

As discussed later in this Item, “Sources of Revenues,” changes in regulations governing IRF reimbursement have created a challenging operating environment for our inpatient division. Specifically, on May 7, 2004, the United States Centers for Medicare and Medicaid Services (“CMS”) issued a final rule stipulating revised criteria for qualifying as an IRF under Medicare. This rule, known as the “75% Rule,” has created significant volume volatility in our inpatient division.

The volume volatility created by the 75% Rule has had a significantly negative impact on our inpatient division’s Net operating revenues in 2006. See Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, for additional information about the impact of this rule. Thus far, we have been able to partially mitigate the impact of the 75% Rule on our inpatient division’s operating earnings by implementing the following strategies:

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Refocus Marketing. The 75% Rule reduces the number of patients seeking treatment for orthopedic and other diagnostic conditions that we can accept in our IRFs. Consequently, we are focusing our marketing efforts on neurologists, neurosurgeons, and internists who can refer patients that require treatment for one of the 13 designated medical conditions identified by the 75% Rule, such as spinal cord injury, brain injury, and various neurological disorders.

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Broaden Services. To make up for a potentially reduced inpatient rehabilitation patient census, we are increasing the number of other post-acute care services performed at or complementary to our IRFs, such as long-term acute care, skilled nursing, and home health services.

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Reduce Costs. We are aggressively reducing our costs in proportion to patient census declines in our IRFs.

In addition to the specific mitigation strategies discussed above, we are participating with the rest of the inpatient rehabilitation industry to sponsor research evaluating the efficacy of inpatient rehabilitative care and to inform Members of Congress and other government officials of the adverse effect of the 75% Rule on patients and providers. Because we receive a significant percentage of our revenues from our inpatient division, and because our inpatient division receives a significant percentage of its revenues from Medicare, our inability to achieve continued compliance with or continue to mitigate the

negative effects of the 75% Rule could have a material adverse effect on our business, financial position, results of operations, and cash flows.

Based on recent industry data, we believe the impact of the 75% Rule on the inpatient rehabilitation industry has been significantly greater than CMS estimated when the rule was promulgated. In recognizing this more-than expected result, Congress approved a one-year extension of the phase-in period for the 75% Rule and delayed implementation of the 65% compliance threshold until July 1, 2007. In addition, we believe that we are doing better than the industry as a whole in mitigating the effects of the 75% Rule. We anticipate growth in our inpatient division once the 75% Rule is fully implemented and the division’s operations are re-based to maximize admission of higher acuity compliant cases. In addition, we believe continued phase-in of the 75% Rule will cause certain competitors to exit the market which should create consolidation opportunities for us.

Other Divisions

As discussed above, we are in the process of attempting to divest our surgery centers, outpatient, and diagnostic divisions in order to reposition HealthSouth as a “pure play” provider of post-acute health care services. As mentioned above, we have entered into a Stock Purchase Agreement with Select Medical to sell the outpatient division. Until the actual dispositions are concluded, we will continue to run each division in the ordinary course of business.

Surgery Centers

We operate one of the largest networks of ambulatory surgery centers (“ASCs”) in the United States. As of December 31, 2006, our surgery centers division provided ambulatory surgery services through 144 freestanding ASCs and 3 surgical hospitals in 35 states, with a concentration of centers in California, Texas, Florida, North Carolina, and Alabama.

Our ASCs provide the facilities and medical support staff necessary for physicians to perform nonemergency surgical procedures. Our typical ASC is a freestanding facility with two to six fully equipped operating and procedure rooms and ancillary areas for reception, preparation, recovery, and administration. Each of our ASCs is licensed by the state and certified as a provider under federal programs, including Medicare and Medicaid. Our ASCs are available for use only by licensed physicians, oral surgeons, and podiatrists. To ensure consistent quality of care, each of our ASCs has a medical advisory committee that implements quality control procedures and reviews the professional credentials of physicians applying for medical staff privileges at the center. In addition, all but a few unique specialty centers are certified by the JCAHO.

Like most other ASCs, the majority of our centers are owned in partnership with surgeons and other physicians who perform procedures at the centers. As a result of increased competition in the ASC market and other factors, physicians are demanding increased ownership in ASCs. Consequently, we expect an increasing level of physician ownership in our ASCs, and thus our percentage ownership of centers within our ASC portfolio will decline over time. Currently, our ownership interest in centers within our ASC portfolio varies from 20% to 100%. Our average ownership is over 50%.

A critical component of this division’s performance depends upon our ability to periodically provide physicians who use our ASCs with the opportunity to purchase ownership interests in our ASCs. This so-called “resyndication” of ownership interests is important because it enables us to increase the ownership participation of physicians who use our ASCs as well as attract new physicians to our ASCs. Attracting new physician investors who intend to maintain an active practice promotes, we believe, interest in and support for continuing investments in necessary facility improvements as well as a general focus on quality. Prior to 2005, we had difficulty resyndicating our ASCs primarily because we were unable to produce reliable financial statements for individual partnerships. We assembled a dedicated team of accountants, attorneys, and other specialists in 2005 to expedite the resyndication effort, and we were able to achieve our resyndication objectives in 2006.

Our surgery centers division has a diversified payor mix with managed care and other discount plans representing the highest percentage. For the years ended December 31, 2006, 2005, and 2004, managed care and other discount plans represented 59.9%, 58.3%, and 55.7%, respectively, of the division’s Net operating revenues, which totaled $737.0 million, $755.5 million, and $794.3 million, respectively.

The ASC market continues to grow, due in part to improved anesthesia, new instrumentation, payor pressure to reduce costs, and other factors. Because the market is highly fragmented, however, it is highly competitive. We plan to combat this competition (1) by increasing our concentration in specific markets, (2) by affiliating with acute care networks in selected markets, (3) by leveraging the size of our network to realize improved operating efficiencies, increased marketing opportunities, and better payor contracting, and (4) by using technology such as standardized e-coding to improve division performance.

Outpatient

We are one of the largest operators of outpatient rehabilitation facilities in the United States. As of December 31, 2006, our outpatient division provided outpatient therapy through 582 facilities (550 of which are wholly owned and 32 of which are jointly owned). These facilities are located in 35 states and the District of Columbia, with a concentration of centers in Florida, Texas, New Jersey, and Missouri.

Our outpatient rehabilitation facilities are staffed by physical therapists, occupational therapists, and other clinicians and support personnel, depending on the services provided at a particular location, and are open at hours designed to accommodate the needs of the patient population being served and the local demand for services. Our centers offer a range of rehabilitative health care services, including physical therapy and occupational therapy, with a particular focus on orthopedic, sports-related, work-related, hand and spine injuries, and various neurological and neuromuscular conditions.

Our outpatient division has a diversified payor mix with managed care and other discount plans representing the highest percentage. For the years ended December 31, 2006, 2005, and 2004, managed care and other discount plans represented 53.0%, 50.4%, and 49.9%, respectively, of the division’s Net operating revenues, which totaled $326.6 million, $371.1 million, and $431.1 million, respectively.

As discussed earlier in this Item, on January 29, 2007, we announced that we had entered into a Stock Purchase Agreement to sell our outpatient division for approximately $245 million in cash, subject to certain adjustments. The closing of this transaction, which is subject to the satisfaction of closing conditions set forth in the Stock Purchase Agreement, including certain regulatory and other approvals, is anticipated to occur on or before April 30, 2007.

Diagnostic

We are one of the largest operators of freestanding diagnostic imaging centers in the United States. As of December 31, 2006, our diagnostic division operated 61 diagnostic centers (53 of which are wholly owned and 8 of which are jointly owned) in 19 states and the District of Columbia, with a concentration of centers in Texas, Alabama, Florida, and the Washington, D.C. area.

Our diagnostic centers provide outpatient diagnostic imaging services, including MRI, CT, X-ray, ultrasound, mammography, and nuclear medicine services, as well as fluoroscopy. We do not provide all services at all sites, although approximately 80% of our diagnostic centers are multi-modality centers offering multiple types of services. Our diagnostic centers provide outpatient diagnostic procedures performed by experienced radiological technologists. After the diagnostic procedure is completed, the images are reviewed by radiologists who have contracted with us. Those radiologists prepare an interpretation which is then delivered to the referring physician.

Our diagnostic division has a diversified payor mix with managed care and other discount plans representing the highest percentage. For the years ended December 31, 2006, 2005, and 2004, managed care and other discount plans represented 58.9%, 60.0%, and 59.4%, respectively, of the division’s Net operating revenues, which totaled $186.9 million, $197.5 million, and $197.7 million, respectively.

Although the market for diagnostic services is highly competitive, we are expanding our focus on referring physicians outside of the orthopedic specialty to broaden our base of referrals.

Corporate and Other

This division comprises all revenue-producing activities that do not fall within one of the four operating divisions discussed above, including the operation of the conference center located at our corporate campus, operation of our wholly owned captive insurance company, our clinical research activities, and other services that are generally intended to complement our patient care activities. All our corporate departments and related overhead are also contained within this division. These departments, which include among others accounting, communications, compliance, human resources, information technology, internal audit, legal, payor strategies, reimbursement, tax, and treasury, provide support functions to our operating divisions.

For the years ended December 31, 2006, 2005, and 2004, respectively, the division’s Net operating revenues totaled $48.4 million, $84.9 million, and $94.4 million, respectively. Substantially all of this division’s Net operating revenues relate to the operation of our wholly owned captive insurance company, which eliminate in consolidation.

Competition

Inpatient

Our IRFs and LTCHs compete primarily with rehabilitation units and skilled nursing units, many of which are within acute care hospitals in the markets we serve. It is a highly fragmented segment. In addition, we face competition from large publicly held companies such as Rehabcare Group, Inc. In addition, several privately held companies are beginning to emerge as competitors in this segment, including Integra Healthcare Management, Gulf States Health Services, Reliant Healthcare Partners, and Centerre Healthcare. Other providers of post acute-care services (such as Manor Care, which has already announced its intention to enter the inpatient rehabilitation market) may also become competitors in the future.

Some of these competitors may have greater patient referral support and financial and personnel resources in particular markets than we do. We believe we compete successfully within the marketplace based upon our size, reputation for quality, operational efficiencies, and positive rehabilitation outcomes.

Surgery Centers

We face competition from other providers of ambulatory surgical care in developing ASC joint ventures, acquiring existing centers, attracting patients, and negotiating managed care contracts in each of our markets. There are several publicly held companies, divisions or subsidiaries of publicly held companies, and several private companies that operate ASCs. Our larger competitors include United Surgical Partners, Symbion Healthcare, and AmSurg Corporation. Further, many physician groups develop ASCs without a corporate partner, utilizing consultants who typically perform management services for a fee and who may not require an ownership interest in the ongoing operations of the center. We believe that we compete effectively in this market because of our size, experience, and reputation for providing quality care.

Outpatient

Our outpatient rehabilitation facilities compete directly or indirectly with the physical and occupational therapy departments of hospitals, physician-owned therapy clinics, other private therapy clinics, and chiropractors. We also face competition from large privately held and publicly held physical therapy companies such as Select Medical (which has agreed to acquire our outpatient division), U.S. Physical Therapy, Inc. and Benchmark Medical, Inc., as well as mid-sized regional companies. It is particularly difficult to compete with physician-owned therapy clinics because physicians have traditionally been our customers, rather than our competitors. Consequently, in addition to competing with those physicians who offer physical therapy services as in-office ancillary services, we lose them as a referral source.

Some of these competitors may have greater patient referral support and financial and personnel resources in particular markets than we do. We believe we compete successfully within the marketplace based upon our reputation for quality, competitive prices, positive rehabilitation outcomes, and innovative programs.

Diagnostic

The market for diagnostic services is highly fragmented and highly competitive. Many physicians and physician groups have opened diagnostic facilities as an in-office ancillary service. Our diagnostic centers also compete with local hospitals, other multi-center imaging companies, and local independent diagnostic centers. Because of the age of equipment at many of our facilities, competition will become increasingly intense if we do not make substantial capital expenditures in future periods for the purchase of new equipment or the upgrading of existing equipment.

Other Competition

In some states where we operate, the construction or expansion of facilities, the acquisition of existing facilities, or the introduction of new beds or services may be subject to review by and prior approval of state regulatory agencies under a “certificate of need” program. See this Item, “Regulation—Certificates of Need.” We potentially face competition any time we initiate a certificate of need project or seek to acquire an existing facility or certificate of need. This competition may arise either from competing national or regional companies or from local hospitals or other providers which file competing applications or oppose the proposed certificate of need project. The necessity for these approvals serves as a barrier to entry and has the potential to limit competition. We have generally been successful in obtaining certificates of need or similar approvals when required, although there can be no assurance that we will achieve similar success in the future.

We rely significantly on our ability to attract, develop, and retain physicians, therapists, and other clinical personnel for our facilities. We compete for these professionals with other health care companies, hospitals, and potential clients and partners. In addition, changes in health care regulations have enabled physicians to open facilities in direct competition with us, which has increased the choices for such professionals and therefore made it more difficult and/or expensive for us to hire the necessary personnel for our facilities.

Sources of Revenues

We receive payment for patient care services from the federal government (primarily under the Medicare program), state governments (under their respective Medicaid or similar programs), managed care plans, private insurers, and directly from patients. In addition, we receive payment for non-patient care activities from various sources. The following table identifies the sources and relative mix of our revenues for the periods stated:

	Year Ended December 31,
Source	2006	2005	2004
Medicare	47.4%	47.7%	48.0%
Medicaid	2.3%	2.4%	2.5%
Workers’ compensation	6.8%	7.5%	8.1%
Managed care and other discount plans	34.8%	33.3%	31.5%
Other third-party payors	4.7%	4.9%	4.9%
Patients	1.4%	1.8%	2.9%
Other income	2.6%	2.4%	2.1%
	100.0%	100.0%	100.0%

Medicare is a federal program that provides certain hospital and medical insurance benefits to persons aged 65 and over, some disabled persons, and persons with end-stage renal disease. Medicaid is a jointly administered federal and state program that provides hospital and medical benefits to qualifying individuals who are unable to afford health care.

Our facilities generally offer discounts from established charges to certain group purchasers of health care services, including Blue Cross and Blue Shield (“BCBS”), other private insurance companies, employers, health maintenance organizations (“HMOs”), preferred provider organizations (“PPOs”), and other managed care plans. These discount programs, which are often negotiated for multi-year terms, limit our ability to increase revenues in response to increasing costs.

Patients are generally not responsible for the difference between established gross charges and amounts reimbursed for such services under Medicare, Medicaid, BCBS plans, HMOs, or PPOs, but are responsible to the extent of any exclusions, deductibles, copayments, or coinsurance features of their coverage. The amount of such exclusions, deductibles, copayments, and coinsurance has been increasing each year. Collection of amounts due from individuals is typically more difficult than from governmental or third-party payors.

Medicare Reimbursement

Medicare, through statutes and regulations, establishes reimbursement methodologies for various types of health care facilities and services. These methodologies have historically been subject to periodic revisions that can have a substantial impact on existing health care providers. In accordance with authorization from Congress, CMS makes annual upward or downward adjustments to Medicare payment rates in most areas. These adjustments can result in decreases in actual dollars per procedure or a freeze in reimbursement despite increases in costs.

We expect that Congress and CMS will address reimbursement rates for a variety of health care settings over the next several years. Any downward adjustment to rates for the types of facilities that we operate could have a material adverse effect on our business, financial position, results of operations, and cash flows.

A basic summary of current Medicare reimbursement in our service areas follows:

Inpatient Rehabilitation and the 75% Rule. The Balanced Budget Act of 1997 and its implementing regulations introduced a prospective payment system (“PPS”) for IRFs that became effective on January 1, 2002. To qualify as an IRF under Medicare, a facility must show that a certain percentage of its patients are treated for at least one of a specified list of medical conditions. Under a May 7, 2004 CMS regulation, the “75% Rule” identifies the following 13 qualifying conditions:

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stroke

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spinal cord injury

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congenital deformity

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amputation

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major multiple trauma

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fracture of the femur (hip fracture)

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brain injury

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neurological disorders

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burns

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active, polyarthricular rheumatoid arthritis, psoriatic arthritis, and seronegative arthropathies

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systemic vasculidities with joint inflammation

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severe/advanced osteoarthritis involving two or more major weight-bearing joints (not counting joints with a prosthesis) with joint deformity, substantial loss of range of motion, and atrophy of muscles surrounding the joint

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knee or hip joint replacement, with at least one of three specific circumstances

CMS established an initial phase-in period for compliance with the 75% Rule, as follows:

Cost Reporting Period	Minimum Qualifying Patient Mix	Patient Mix Affected
July 1, 2004—June 30, 2005	50%	Medicare or Total
July 1, 2005—June 30, 2006	60%	Medicare or Total
July 1, 2006—June 30, 2007	65%	Medicare or Total
July 1, 2007 and Thereafter	75%	Total

On February 8, 2006, the Deficit Reduction Act of 2005 was signed into law as Public Law 109-171. The legislation redefined the phase-in period for compliance with the 75% Rule. The following phase-in schedule is now applicable:

Cost Reporting Period	Minimum Qualifying Patient Mix	Patient Mix Affected
July 1, 2006—June 30, 2007	60%	Medicare or Total
July 1, 2007—June 30, 2008	65%	Medicare or Total
July 1, 2008 and Thereafter	75%	Total

Any IRF that fails to meet the requirements of the 75% Rule is subject to prospective reclassification as an acute care hospital. The effect of such reclassification would be to revert Medicare IRF-PPS payment rates to lower acute care payment rates for rehabilitative services (assuming that state certificate of need and licensing rules permit the use of the beds for acute care services).

Our inpatient division has been reducing or refocusing admissions at most locations in response to the phase-in schedule for the 75% Rule. This has resulted in volume volatility that has had a significantly negative impact on our inpatient division’s Net operating revenues in 2006. Thus far, we have been able to partially mitigate the impact of the 75% Rule on our inpatient division’s operating earnings by implementing the mitigation strategies discussed earlier in this Item, “Inpatient Division.”

On August 1, 2006, CMS released a final rule that updates the IRF-PPS for the federal fiscal year 2007 (covering discharges occurring on or after October 1, 2006 and on or before September 30, 2007). Although the final rule includes an overall market basket update of 3.3%, this market basket update is offset by a 2.6% reduction in standard payment rates. We estimate that the final rule will increase our inpatient division’s revenues by approximately $5 million per quarter for federal fiscal year 2007 as compared to federal fiscal year 2006.

On November 1, 2006, CMS issued a final rule that will update the payment methodology under the Physician Fee Schedule beginning January 1, 2007. Specifically, the rule would update the work relative value units (“RVUs”) based on the five-year review required under statute, implement a new payment methodology for practice expense RVUs, and apply a negative budget neutrality adjustment to the work order RVUs. These changes, combined with a 5% reduction to the payment conversion factor under the Physician Fee Schedule, will result in lower reimbursement to us for outpatient services.

On December 20, 2006, the President of the United States signed into law the Tax Relief and Healthcare Act of 2006 that reverses the 5% reduction to the payment conversion factor under the Physician Fee Schedule. We estimate that combined these changes will decrease our inpatient division’s Net operating revenues by approximately $0.5 million per quarter for calendar year 2007 as compared to calendar year 2006.

The combination of volume volatility created by the 75% Rule and lower unit pricing resulting from IRF-PPS and Physician Fee Schedule changes reduced our operating earnings in 2006. See Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, for additional information about the impact of these changes. In addition, because we receive a significant percentage of our revenues from our inpatient division, and because our inpatient division receives a significant percentage of its revenues from Medicare, our inability to achieve continued compliance with or continue to mitigate the negative effects of the 75% Rule could have a material adverse effect on our business, financial position, results of operations, and cash flows.

Although the 75% Rule represents the most significant operating challenge to our inpatient division, coverage policies can also affect our operations. For example, Medicare providers like us can be negatively affected by the adoption of coverage policies, either at the national or local level, that determine whether an item or service is covered and under what clinical circumstances it is considered to be reasonable, necessary, and appropriate. In the absence of a national coverage determination, local Medicare fiscal intermediaries may specify more restrictive criteria than otherwise would apply nationally. For instance, Cahaba Government Benefit Administrators, the fiscal intermediary for many of our inpatient division facilities, has issued a local coverage determination setting forth very detailed criteria for determining the medical appropriateness of services provided by IRFs. Other Medicare fiscal intermediaries also have implemented local coverage rules. We cannot predict how these local coverage rules will affect us.

Long-Term Acute Care Hospitals. LTCHs provide medical treatment to patients with chronic diseases and/or complex medical conditions. In order for a facility to qualify as an LTCH, patients discharged from the facility in any given cost reporting year must have an average length-of-stay in excess of 25 days. LTCHs have been transitioning from cost-based reimbursement to a PPS system over a 5-year period which began for twelve-month periods beginning on or after October 1, 2002. Providers were given the option to transition into the full LTCH-PPS by receiving 100% of the federal payment rate at any time through the transition period. We have elected to receive the full federal payment rate for all of our LTCHs. Under the new LTCH-PPS system, Medicare classifies patients into distinct diagnosis-related groups (“LTC-DRGs”) based upon specific clinical characteristics and expected resource needs. The LTCH-PPS also provides for an adjustment for differences in area wages as well as a cost of living adjustment for LTCHs located in Alaska or Hawaii.

On May 12, 2006, CMS issued final regulations that updated the annual payment rates under the LTCH-PPS for rate year 2007, which is effective for discharges occurring on or after July 1, 2006 through June 30, 2007. This rule (1) provided no market basket increase for rate year 2007, (2) substantially reduced Short Stay Outlier payments, (3) increased the High Cost Outlier threshold, reducing outlier payments, (4) phased-out the Surgical DRG exception for interrupted stays, (5) implemented a new method to determine future market basket increases, (6) increased the labor-related share, and (7) made certain other payment policy changes that would impact the LTCH-PPS.

On August 18, 2006 and October 11, 2006, CMS issued a final rule and correction notice that updated the LTC-DRGs, the relative weights and the geometric mean length of stay that will impact LTCH-PPS payment for federal year 2007, which is effective for discharges occurring on or after October 1, 2006 through September 30, 2007. We estimate that the combined impact on reimbursement for the May 12, and August 18, 2006 payment rules would be a reduction in our inpatient division’s Net operating revenues of approximately $5.6 million on an annualized basis.

On February 1, 2007, CMS released a proposed rule that would update payment rates under the LTCH-PPS for rate year 2008, which is effective for discharges occurring on or after July 1, 2007 through June 30, 2008. This proposed rule would (1) provide for a market basket update of 3.2%, (2) reduce overall payments by 2.49% for improvements in coding, (3) increase the High Cost Outlier threshold , reducing outlier payments, (4) modify the Short Stay Outlier payment formula, reducing payments to the acute hospital comparable payment level, and (5) continue the wage index phase-in. The proposed rule also indicates that a budget neutrality requirement will be implemented starting with the October 1, 2007 update to the LTC-DRGs, relative weights and average length of stays. Lastly, this rule extends the 25% hospital-within-hospital referral limitation to freestanding, satellite and grandfathered LTCHs (See this Item, “Regulation—Hospital Within Hospital Rules” for a further discussion of this proposed rule change). We are currently evaluating the impact of this proposed rule on our business, financial position, results of operations, and cash flows.

Ambulatory Surgery Centers. ASC services are reimbursed by Medicare based on prospectively determined rates. Surgical procedures approved by CMS for ASC reimbursement are classified into nine payment groups based on cost for facility reimbursement purposes. All approved surgical procedures within the same payment group are reimbursed at a single rate, adjusted by the location of the facility and applicable wage index. The Deficit Reduction Act of 2005 caps payments for ASC procedures in 2007 to the lesser of the ASC or hospital outpatient prospective payment system (“OPPS”) payment rate. In addition, on August 8, 2006, CMS issued a proposed rule that would substantially change Medicare reimbursement for ASC procedures. The proposed rule would revise ASC payment rates to be based on 221 Ambulatory Payment Classifications currently used to categorize procedures under OPPS and would tentatively set calendar year 2008 ASC payment rates at 62% of applicable OPPS payment rates subject to a phase in period whereby payments during the first year would equal a blend of the existing and proposed rates. Beginning in 2010, the ASC conversion factor would be updated by the consumer price index for urban consumers. The proposed rule would also expand the list of ASC approved procedures beginning in 2008. CMS proposes to phase in the new payment system over two years.

does not cover changes to the ASC payment system that will take effect in 2008. If the final rule relating to the 2008 ASC payment system changes results in downward adjustment to ASC reimbursement rates or limits the expansion of covered surgical procedures, it could have a material adverse effect on our business, financial position, results of operations, and cash flows.

While difficult to predict, we believe these 2008 proposed changes could have a neutral to positive impact on our Net operating revenues once the new system is in place, depending upon the rule’s overall effect on unit pricing and our ability to realize increased case volume as the list of approved ASC procedures is expanded. However, the proposed rule has not been finalized and we cannot provide any assurance that the rule will be finalized in its current form, or that the rule, if finalized in its current form, will have the impact we predict. Moreover, we believe the proposed rule disproportionately impacts certain specialties. We are working with a coalition of ASC companies and associations to provide data to CMS supporting a number of modifications to the proposed rule.

On November 24, 2006, CMS published a final OPPS rule that indicates the Secretary of Health and Human Services may require ASCs to begin reporting certain quality information beginning in 2009. Failure to report this quality data would result in a reduction of the payment update by 2%.

Further reductions in ASC Medicare reimbursement are possible. Any significant reductions in Medicare reimbursement could have a material adverse effect on our business, financial position, results of operations, and cash flows.

Outpatient Rehabilitation. Most of our outpatient rehabilitation facilities are certified by Medicare. Therapy services are reimbursed by Medicare under the Physician Fee Schedule. A fixed fee is paid per reimbursable procedure performed. This fee is adjusted by the geographical area in which the facility is located. The Balanced Budget Act of 1997 changed the reimbursement methodology for Medicare Part B therapy services from cost based to fee schedule payments. It also established two types of annual per-beneficiary limitations on outpatient therapy services provided outside of a hospital outpatient setting: (1) a $1,500 cap for all outpatient therapy services and speech language pathology services; and (2) a $1,500 cap for all outpatient occupational therapy services, as adjusted for inflation (per beneficiary per year caps are set at $1,740 for calendar year 2006 and $1,780 for calendar year 2007). These therapy caps are subject to certain exceptions relating to medically necessary services for calendar year 2006 and 2007. These therapy caps have had a negative impact on our Net operating revenues.

On November 1, 2006, CMS issued a final rule that will update the payment methodology under the Physician Fee Schedule beginning January 1, 2007. Specifically, the rule would update the work RVUs based on the five-year review required under statute, implement a new payment methodology for practice expense relative value units and apply a negative budget neutrality adjustment to the work relative value units. These changes, combined with a 5% reduction to the payment conversion factor under the Physician Fee Schedule, will result in lower reimbursement to us for outpatient services.

On December 20, 2006, the President of the United States signed into law the Tax Relief and Healthcare Act of 2006 that reverses the 5% reduction to the payment conversion factor, restores the therapy cap exception process for 2007 and would extend in 2007 the 1.0 geographic practice cost indices floor under the Physician Fee Schedule. We estimate that these combined changes will decrease our outpatient division’s Net operating revenues by approximately $0.5 million per quarter for calendar year 2007 as compared to calendar year 2006.

Diagnostic Facilities. Medicare allows diagnostic facilities that are independent of physician practices or hospitals to bill for approved diagnostic procedures as Independent Diagnostic Testing Facilities (“IDTFs”). Such procedures must be performed by licensed or certified nonphysician personnel under appropriate physician supervision or by physicians in accordance with detailed guidelines. IDTFs are reimbursed for approved tests with required physician orders on the basis of appropriate Current Procedural Terminology (“CPT”) codes under Medicare Part B. CPT reimbursement is geographically adjusted by CMS. Medicare uses the Physician Fee Schedule to pay for services provided in freestanding imaging centers. Each CPT code is assigned a set of RVUs that reflects the average time, effort, and practice costs (including a geographic adjustment) involved in performing a given procedure. Medicare payment amounts are based on a procedure’s total RVUs multiplied by a dollar conversion factor. Medicare makes payment determinations for diagnostic radiology procedures and imaging agents based on where the procedure is performed. More specifically, Medicare uses different payment methodologies for procedures performed in a hospital outpatient department versus an IDTF.

On November 1, 2006, CMS issued a final rule that will update the payment methodology under the Physician Fee Schedule beginning January 1, 2007. Specifically, the rule would update the work RVUs based on the five-year review required under statute, implement a new payment methodology for practice expense RVUs, and apply a negative budget neutrality adjustment to the work RVUs. In addition, the final rule caps payment rates for imaging services under the Physician Fee Schedule at the hospital outpatient prospective payment system rate. The final rule also maintains at 25% the reduction on payments for the technical component of multiple imaging procedures on contiguous body parts, as opposed to

increasing the reduction to 50% as set forth in the 2006 final rule. The final rule will also implement, for the first time, 14 IDTF supplier standards to remain enrolled in the Medicare program. These changes, combined with a 5% reduction to the payment conversion factor under the Physician Fee Schedule, will result in lower reimbursement to us for diagnostic services.

On December 20, 2006, the President of the United States signed into law the Tax Relief and Healthcare Act of 2006 that reverses the 5% reduction to the payment conversion factor and would extend in 2007 the 1.0 geographic practice cost indices floor under the Physician Fee Schedule. We estimate that these combined changes will decrease our diagnostic division’s Net operating revenues by approximately $5.6 million for calendar year 2007 as compared to calendar year 2006.

Medicaid Reimbursement

Medicaid programs are jointly funded by the federal and state governments. As the Medicaid program is administered by the individual states under the oversight of CMS in accordance with certain regulatory and statutory guidelines, there are substantial differences in reimbursement methodologies and coverage policies from state to state. Many states have experienced shortfalls in their Medicaid budgets and are implementing significant cuts in Medicaid reimbursement rates. Additionally, certain states control Medicaid expenditures through restricting or eliminating coverage of certain services. Continuing downward pressure on Medicaid payment rates could cause a decline in our Net operating revenues.

Cost Reports

Because of our participation in the Medicare, Medicaid, and TRICARE programs, we are required to meet certain financial reporting requirements. Federal and, where applicable, state regulations require the submission of annual cost reports covering the revenue, costs, and expenses associated with the services provided by our inpatient and certain surgery center hospitals to Medicare beneficiaries and Medicaid recipients.

Annual cost reports required under the Medicare and Medicaid programs are subject to routine audits, which may result in adjustments to the amounts ultimately determined to be due HealthSouth under these reimbursement programs. These audits are used for determining if any under- or over-payments were made to these programs and to set payment levels for future years. In addition, as a result of the reconstruction of our accounting records we are reviewing previously submitted cost reports to ensure that they accurately reflect the revenue, costs, and expenses associated with services provided at our facilities. The majority of our revenues are derived from prospective payment system payments, and even if we amend previously filed cost reports we do not expect the impact of those amendments to materially affect our inpatient division or surgery centers division results of operations.

On December 30, 2004, we announced that HealthSouth had signed an agreement with CMS to resolve issues associated with various Medicare cost reporting practices. Subject to certain exceptions, the settlement provides for the release of HealthSouth by CMS from any obligations related to any cost statements or cost reports which had, or could have been submitted to CMS or its fiscal intermediaries by HealthSouth for cost reporting periods ended on or before December 31, 2003. The settlement provides that all covered federal cost reports be closed and considered final and settled. Open state Medicaid cost reports still are subject to potential audits as described above. For additional information about the settlement referenced above, see Note 22, Medicare Program Settlement, to our accompanying consolidated financial statements.

Managed Care and Other Discount Plans

Most of our facilities offer discounts from established charges to certain large group purchasers of health care services, including managed care plans, BCBS, other private insurance companies, and employers. Managed care contracts typically have terms of between one and three years, although we have a number of managed care contracts that automatically renew each year unless a party elects to terminate the contract. While some of our contracts provide for annual rate increases of three to five percent, we cannot provide any assurance that we will continue to receive increases.

Regulation

The health care industry is subject to significant federal, state, and local regulation that affects our business activities by controlling the reimbursement we receive for services provided, requiring licensure or certification of our facilities, regulating the use of our properties, and controlling our growth.

Corporate Integrity Agreement

On December 30, 2004, we entered into a corporate integrity agreement (the “CIA”) with the United States Department of Health and Human Services (“HHS”) Office of Inspector General (“OIG”). This new CIA has an effective date of

January 1, 2005 and a term of five years from that effective date. It incorporates a number of compliance program changes already implemented by us and requires, among other things, that not later than 90 days after the effective date we:

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form an executive compliance committee (made up of our chief compliance officer and other executive management members), which shall participate in the formulation and implementation of HealthSouth’s compliance program;

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require certain independent contractors to abide by our Standards of Business Conduct;

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provide general compliance training to all HealthSouth personnel as well as specialized training to personnel responsible for billing, coding, and cost reporting relating to federal health care programs;

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report and return overpayments received from federal health care programs;

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notify the HHS-OIG of any new investigations or legal proceedings initiated by a governmental entity involving an allegation of fraud or criminal conduct against HealthSouth;

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notify the HHS-OIG of the purchase, sale, closure, establishment, or relocation of facilities furnishing items or services that are reimbursed under federal health care programs; and

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submit annual reports to the HHS-OIG regarding our compliance with the CIA.

The CIA also requires that we engage an Independent Review Organization (“IRO”) to assist us in assessing and evaluating: (1) our billing, coding, and cost reporting practices with respect to our inpatient rehabilitation facilities, (2) our billing and coding practices for outpatient items and services furnished by outpatient departments of our inpatient facilities and through other HealthSouth outpatient rehabilitation facilities; and (3) certain other obligations pursuant to the CIA and the Settlement Agreement. We engaged PricewaterhouseCoopers LLP to serve as our IRO.

On April 28, 2005, we submitted an implementation report to the HHS-OIG stating that we had, within the 90-day time frame, materially complied with the initial requirements of this new CIA. In addition, on April 28, 2006, we submitted our first annual report under the CIA, which included a report by our IRO.

As discussed in Note 25, Contingencies and Other Commitments, to our accompanying consolidated financial statements, we entered into an addendum to our CIA which requires additional compliance training and annual audits of billing practices relating to prosthetic and orthotic devices. The addendum has a term of three years and will run concurrently with our existing five-year CIA.

Failure to meet our obligations under our CIA could result in stipulated financial penalties. Failure to comply with material terms, however, could lead to exclusion from further participation in federal health care programs, including Medicare and Medicaid, which currently account for a substantial portion of our revenues.

Licensure and Certification

Health care facility construction and operation are subject to numerous federal, state, and local regulations relating to the adequacy of medical care, equipment, personnel, operating policies and procedures, maintenance of adequate records, fire prevention, and compliance with building codes and environmental protection laws. Our facilities are subject to periodic inspection by governmental and non-governmental certification authorities to ensure continued compliance with the various standards necessary for facility licensure. All of our inpatient facilities and substantially all of our ASCs are currently required to be licensed. Only a relatively small number of states require licensure for outpatient rehabilitation facilities. Many states do not require diagnostic facilities to be licensed.

In addition, facilities must be “certified” by CMS to participate in the Medicare program and generally must be certified by Medicaid state agencies to participate in Medicaid programs. All of our inpatient facilities participate in (or are awaiting the assignment of a provider number to participate in) the Medicare program. As of December 31, 2006, approximately 91% of our outpatient therapy facilities (including outpatient rehabilitation facilities and other outpatient facilities) participate in, or are awaiting the assignment of a provider number to participate in, the Medicare program. Substantially all of our ASCs and diagnostic centers are certified (or are awaiting certification) under the Medicare program. Our Medicare-certified facilities undergo periodic on-site surveys in order to maintain their certification.

Failure to comply with applicable certification requirements may make our facilities ineligible for Medicare or Medicaid reimbursement. In addition, Medicare or Medicaid may seek retroactive reimbursement from noncompliant facilities or otherwise impose sanctions on noncompliant facilities. Non-governmental payors often have the right to terminate provider contracts if a facility loses its Medicare or Medicaid certification. We have developed operational systems to oversee compliance with the various standards and requirements of the Medicare program and have established ongoing

quality assurance activities; however, given the complex nature of governmental health care regulations, there can be no assurance that Medicare, Medicaid, or other regulatory authorities will not allege instances of noncompliance.

Certificates of Need

In some states where we operate, the construction or expansion of facilities, the acquisition of existing facilities, or the introduction of new beds or services may be subject to review by and prior approval of state regulatory agencies under “certificate of need” laws. Certificate of need laws often require the reviewing agency to determine the public need for additional or expanded health care facilities and services. Certificate of need laws generally require approvals for capital expenditures involving IRFs, LTCHs, acute care hospitals, and ASCs if such capital expenditures exceed certain thresholds. Most states do not require such approvals for outpatient rehabilitation, occupational health, or diagnostic facilities and services. However, any time a certificate of need is required, we must obtain it before acquiring, opening, reclassifying, or expanding a health care facility or starting a new health care program.

False Claims Act

Over the past several years, an increasing number of health care providers have been accused of violating the federal False Claims Act. That act prohibits the knowing presentation of a false claim to the United States government, and provides for penalties equal to three times the actual amount of any overpayments plus up to $11,000 per claim. In addition, the False Claims Act allows private persons, known as “relators,” to file complaints under seal and provides a period of time for the government to investigate such complaints and determine whether to intervene in them and take over the handling of all or part of such complaints. Because of the sealing provisions of the False Claims Act, it is possible for health care providers to be subject to False Claims Act suits for extended periods of time without notice of such suits or an opportunity to respond to them. Because we perform thousands of similar procedures a year for which we are reimbursed by Medicare and other federal payors and there is a relatively long statute of limitations, a billing error or cost reporting error could result in significant civil or criminal penalties under the False Claims Act or other laws. We have entered into a substantial settlement of claims under the False Claims Act. See Note 22, Medicare Program Settlement, to our accompanying consolidated financial statements. We remain a named defendant in certain unsealed suits under the False Claims Act where the United States did not intervene. See Note 25, Contingencies and Other Commitments, “Certain Regulatory Actions.”

Relationships with Physicians and Other Providers

The Anti-Kickback Law. Various state and federal laws regulate relationships between providers of health care services, including employment or service contracts and investment relationships. Among the most important of these restrictions is a federal criminal law prohibiting (1) the offer, payment, solicitation, or receipt of remuneration by individuals or entities to induce referrals of patients for services reimbursed under the Medicare or Medicaid programs or (2) the leasing, purchasing, ordering, arranging for, or recommending the lease, purchase, or order of any item, good, facility, or service covered by such programs (the “Anti-Kickback Law”). In addition to federal criminal sanctions, including penalties of up to $50,000 for each violation plus tripled damages for improper claims, violators of the Anti-Kickback Law may be subject to exclusion from the Medicare and/or Medicaid programs. In 1991, the HHS-OIG issued regulations describing compensation arrangements that are not viewed as illegal remuneration under the Anti-Kickback Law (the “1991 Safe Harbor Rules”). The 1991 Safe Harbor Rules create certain standards (“Safe Harbors”) for identified types of compensation arrangements that, if fully complied with, assure participants in the particular arrangement that the HHS-OIG will not treat that participation as a criminal offense under the Anti-Kickback Law or as the basis for an exclusion from the Medicare and Medicaid programs or the imposition of civil sanctions.

The HHS-OIG closely scrutinizes health care joint ventures involving physicians and other referral sources for compliance with the Anti-Kickback Law. In 1989, the HHS-OIG published a Fraud Alert that outlined questionable features of “suspect” joint ventures, and has continued to rely on such Fraud Alert in later pronouncements. We currently operate some of our rehabilitation hospitals and outpatient rehabilitation facilities as general partnerships, limited partnerships, or limited liability companies (collectively, “partnerships”) with third-party investors, including other institutional health care providers but also including, in a number of cases, physician investors. Some of these partners may be deemed to be in a position to make or influence referrals to our facilities. Those partnerships that are providers of services under the Medicare program, and their owners, are subject to the Anti-Kickback Law. A number of the relationships we have established with physicians and other health care providers do not fit within any of the Safe Harbors. The 1991 Safe Harbor Rules do not expand the scope of activities that the Anti-Kickback Law prohibits, nor do they provide that failure to fall within a Safe Harbor constitutes a violation of the Anti-Kickback Law; however, the HHS-OIG has indicated that failure to fall within a Safe Harbor may subject an arrangement to increased scrutiny. While we do not believe that our rehabilitation facility partnerships engage in activities that violate the Anti-Kickback Law, there can be no assurance that such violations may not be asserted in the future, nor can there be any assurance that our defense against any such assertion would be successful.

Most of our ASCs are owned by partnerships, which include as partners physicians who perform surgical or other procedures at such centers. HHS has promulgated four categories of safe harbors under the Anti-Kickback Law for ASCs (the “ASC Safe Harbors”). Under the ASC Safe Harbors, ownership by a referring physician in a freestanding ASC will be protected if a number of conditions are satisfied. The conditions include the following:

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The center must be ASC certified to participate in the Medicare program and its operating and recovery room space must be dedicated exclusively to the ASC and not a part of a hospital (although such space may be leased from a hospital if such lease meets the requirements of the safe harbor for space rental).

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Each investor must be either (1) a physician who derived at least one-third of his or her medical practice income for the previous fiscal year or 12-month period from performing procedures on the list of Medicare-covered procedures for ASCs, (2) a hospital, or (3) a person or entity not in a position to make or influence referrals to the center, nor to provide items or services to the center, nor employed by the center or any investor.

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Unless all physician-investors are members of a single specialty, each physician-investor must perform at least one-third of his or her procedures at the center each year. (This requirement is in addition to the requirement that the physician-investor has derived at least one-third of his or her medical practice income for the past year from performing procedures.)

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Physician-investors must have fully informed their referred patients of the physician’s investment interest.

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The terms on which an investment interest is offered to an investor are not related to the previous or expected volume of referrals, services furnished, or the amount of business otherwise generated from that investor to the entity.

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Neither the center nor any other investor may loan funds to or guarantee a loan for an investor if the investor uses any part of such loan to obtain the investment interest.

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The amount of payment to an investor in return for the investment interest is directly proportional to the amount of the capital investment (including the fair market value of any pre-operational services rendered) of that investor.

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All physician-investors, any hospital-investor, and the center agree to treat patients receiving medical benefits or assistance under the Medicare or Medicaid programs.

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All ancillary services performed at the center for beneficiaries of federal health care programs must be directly and integrally related to primary procedures performed at the center and may not be billed separately.

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No hospital-investor may include on its cost report or any claim for payment from a federal health care program any costs associated with the center.

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The center may not use equipment owned by or services provided by a hospital-investor unless such equipment is leased in accordance with an agreement that complies with the equipment rental safe harbor and such services are provided in accordance with a contract that complies with the personal services and management contracts safe harbor.

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No hospital-investor may be in a position to make or influence referrals directly or indirectly to any other investor or the center.

Because we invest in each partnership that owns an ASC and often provide management and other services to the ASC, our arrangements with physician investors do not fit within the terms of the ASC Safe Harbors. In addition, because we do not control the medical practices of our physician investors or control where they perform surgical procedures, in some of our ASCs, the quantitative tests described above have not been met and/or will not be met in the future, and certain other conditions of the ASC Safe Harbors have not been or will not be satisfied. We cannot ensure that all physician-investors will perform, or have performed, one-third of their procedures at the ASC or have informed or will inform their referred patients of their investment interests. Accordingly, there can be no assurance that the ownership interests in some of our ASCs will not be challenged under the Anti-Kickback Law.

Some of our diagnostic centers are also owned or operated by partnerships that include radiologists as partners. While those ownership interests are not directly covered by the Safe Harbor Rules, we do not believe that the structure of such arrangements violate the Anti-Kickback Law because radiologists are typically not in a position to make referrals to diagnostic centers. In addition, our mobile lithotripsy operations are conducted by partnerships in which urologists are limited partners. Because such urologists are in a position to, and do, perform lithotripsy procedures utilizing our lithotripsy equipment, we believe that the same analysis underlying the ASC Safe Harbor should apply to ownership interests in

lithotripsy equipment held by urologists. There can be no assurance, however, that the Anti-Kickback Law will not be interpreted in a manner contrary to our beliefs with respect to diagnostic and lithotripsy services.

We have entered into agreements to manage many of our facilities that are owned by partnerships in which physicians have invested. A number of these agreements incorporate a percentage-based management fee. Although there is a safe harbor for personal services and management contracts, this safe harbor requires, among other things, that the aggregate compensation paid to the manager over the term of the agreement be set in advance. Because our management fee may be based on a percentage of revenues, the fee arrangement may not meet this requirement. However, we believe that our management arrangements satisfy the other requirements of the safe harbor for personal services and management contracts and that they comply with the Anti-Kickback Law. The HHS-OIG has taken the position that percentage-based management agreements are not protected by a safe harbor, and consequently, may violate the Anti-Kickback Law. On April 15, 1998, the HHS-OIG issued Advisory Opinion 98-4 which reiterates this proposition. This opinion focused on areas the HHS-OIG considers problematic in a physician practice management context, including financial incentives to increase patient referrals, no safeguards against overutilization, and incentives to increase the risk of abusive billing. The opinion reiterated that proof of intent to violate the Anti-Kickback Law is the central focus of the HHS-OIG. We have implemented programs designed to safeguard against overbilling and otherwise achieve compliance with the Anti-Kickback Law and other laws, but there can be no assurance that the HHS-OIG would find our compliance programs to be adequate.

While several federal court decisions have aggressively applied the restrictions of the Anti-Kickback Law, they provide little guidance as to the application of the Anti-Kickback Law to our partnerships, and we cannot provide any assurances that a federal or state agency charged with enforcement of the Anti-Kickback Law and similar laws might not claim that some of our partnerships have violated or are violating the Anti-Kickback Law. Such a claim could adversely affect relationships we have established with physicians or other health care providers or result in the imposition of penalties on us or on particular HealthSouth facilities. Any conviction of a partnership for violations of the Anti-Kickback Law would have severe consequences on that partnership’s ability to be a viable entity and our ability to attract physician investors to other partnerships and could result in substantial fines as well as our exclusion from Medicare and Medicaid. Moreover, even the assertion of a violation of the Anti-Kickback Law by one or more of our partnerships could have a material adverse effect upon our business, financial position, results of operations, or cash flows.

Stark Prohibitions. The so-called “Stark II” provisions of the Omnibus Budget Reconciliation Act of 1993 amend the federal Medicare statute to prohibit the making by a physician of referrals for “designated health services” including physical therapy, occupational therapy, radiology services, or radiation therapy, to an entity in which the physician has an investment interest or other financial relationship, subject to certain exceptions. Such prohibition took effect on January 1, 1995 and applies to all of our partnerships with physician partners and to our other financial relationships with physicians. Final Phase II Stark Regulations were published in the Federal Register on March 26, 2004 and had an effective date of July 26, 2004. The final regulations substantially clarified recruitment arrangements among health care facilities, individual physicians, and group practices and addressed compensation arrangements with physicians.

Ambulatory surgery is not identified as a “designated health service” under Stark II, and we do not believe the statute is intended to cover ambulatory surgery services. The Phase I Final Stark Regulations expressly clarify that the provision of designated health services in an ASC is excepted from the referral prohibition of Stark II if payment for such designated health services is included in the ambulatory surgery center payment rate. Likewise, the Stark Regulations expressly provide that a referral for designated health services does not include a request by a radiologist for diagnostic radiology services if the request results from a consultation initiated by another physician and the tests or services are furnished by or under the supervision of a radiologist. As a result, we believe that radiologists may enter into joint ventures for diagnostic imaging centers without violating Stark II in most circumstances.

Our lithotripsy units frequently operate on hospital campuses. CMS has indicated that lithotripsy services provided at a hospital would constitute “inpatient and outpatient hospital services” and thus would be subject to Stark II. However, a federal court decision does not support this interpretation. On January 3, 2003, CMS withdrew its appeal of Judge Henry Kennedy’s decision in American Lithotripsy Society and Urology Society of America v. Thompson, made in the Federal District Court for the District of Columbia. The Court of Appeals accepted the withdrawal, and, accordingly, the District Court decision is final. This order permanently enjoined CMS from implementing and enforcing its Stark II Regulations declaring lithotripsy a “designated health service.” However, according to CMS, even if lithotripsy provided under arrangement with a hospital is not a designated health service, this arrangement would result in an “indirect compensation relationship” between the urologist and the hospital with which the lithotripsy entity has an arrangement. Under that theory, referrals by the physician for designated health service other than lithotripsy (e.g. radiology, radiation oncology, etc.) are still prohibited unless the lithotripsy facility/hospital arrangement meets a Stark II exception. If Congress passes revised legislation on this topic, CMS adopts additional regulations or is otherwise successful in re-asserting its position on lithotripsy services and Stark, we would be forced to restructure many of our relationships for lithotripsy services at substantial cost.

While we do not believe that our financial relationships with physicians violate the Stark II statute or the associated regulations, no assurances can be given that a federal or state agency charged with enforcement of the Stark II statute and regulations or similar state laws might not assert a contrary position or that new federal or state laws governing physician relationships, or new interpretations of existing laws governing such relationships, might not adversely affect relationships we have established with physicians or result in the imposition of penalties on us or on particular HealthSouth facilities. Even the assertion of a violation could have a material adverse effect upon our business, financial position, or results of operations. In addition, a number of states have passed or are considering statutes which prohibit or limit physician referrals of patients to facilities in which they have an investment interest. Any actual or perceived violation of these state statutes could have a material adverse effect on business, financial position, results of operations, and cash flows.

HIPAA

The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) broadened the scope of certain fraud and abuse laws by adding several criminal provisions for health care fraud offenses that apply to all health benefit programs. HIPAA also added a prohibition against incentives intended to influence decisions by Medicare beneficiaries as to the provider from which they will receive services. In addition, HIPAA created new enforcement mechanisms to combat fraud and abuse, including the Medicare Integrity Program, and an incentive program under which individuals can receive up to $1,000 for providing information on Medicare fraud and abuse that leads to the recovery of at least $100 of Medicare funds. Federal enforcement officials now have the ability to exclude from Medicare and Medicaid any investors, officers, and managing employees associated with business entities that have committed health care fraud, even if the officer or managing employee had no knowledge of the fraud.

HIPAA also contains certain administrative simplification provisions that require the use of uniform electronic data transmission standards for certain health care claims and payment transactions submitted or received electronically. HHS has issued regulations implementing the HIPAA administrative simplification provisions and compliance with these regulations became mandatory for our facilities on October 16, 2003. Although HHS temporarily agreed to accept noncompliant Medicare claims, CMS stopped processing non-HIPAA-compliant Medicare claims beginning October 1, 2005. We believe that the cost of compliance with these regulations has not had and is not expected to have a material adverse effect on our business, financial position, results of operations, and cash flows.

HIPAA also requires HHS to adopt standards to protect the privacy and security of individually identifiable health-related information. HHS released regulations containing privacy standards in December 2000 and published revisions to the regulations in August 2002. Compliance with these regulations became mandatory on April 14, 2003. The privacy regulations regulate the use and disclosure of individually identifiable health-related information, whether communicated electronically, on paper, or orally. The regulations also provide patients with significant new rights related to understanding and controlling how their health information is used or disclosed. HHS released security regulations on February 20, 2003. The security regulations became mandatory on April 20, 2005 and require health care providers to implement administrative, physical, and technical practices to protect the security of individually identifiable health information that is maintained or transmitted electronically. The privacy regulations and security regulations could impose significant costs on our facilities in order to comply with these standards.

Penalties for violations of HIPAA include civil and criminal monetary penalties. In addition, there are numerous legislative and regulatory initiatives at the federal and state levels addressing patient privacy concerns. Facilities will continue to remain subject to any federal or state privacy-related laws that are more restrictive than the privacy regulations issued under HIPAA. These statutes vary and could impose additional penalties.

Hospital Within Hospital Rules

Effective October 1, 2004, CMS enacted final regulations that provide if a long-term acute care “hospital within hospital” has Medicare admissions from its host hospital that exceed 25% (or an adjusted percentage for certain rural or Metropolitan Statistical Area dominant hospitals) of its Medicare discharges for its cost-reporting period, the LTCH will receive an adjusted payment for its Medicare patients of the lesser of (1) the otherwise full payment under the LTCH-PPS or (2) a comparable payment that Medicare would pay under the acute care inpatient PPS. In determining whether an LTCH meets the 25% criterion, patients transferred from the host hospital that have already qualified for outlier payments at the acute host facility would not count as part of the host hospital’s allowable percentage. Cases admitted from the host hospital before the LTCH crosses the 25% threshold will be paid under the LTCH-PPS. Under the final regulation, this “25% Rule” is being phased in over a four year period which began on October 1, 2004.

On February 1, 2007, CMS issued a proposed rule that would extend the 25% hospital-within-hospital threshold to freestanding, satellite and grandfathered LTCHs. These LTCHs would join the hospital-within-hospital phase-in as if this rule was effective on October 1, 2004. This proposed rule would effectively subject the majority of the LTCH industry to this

referral limitation. If this proposed rule is adopted in its current form, we anticipate that the inpatient division’s business, financial position, results of operations, and cash flows will be negatively impacted. We are currently evaluating the impact of this proposed rule.

Additionally, other excluded hospitals or units of a host hospital, such as inpatient rehabilitation facilities and/or units, must meet certain hospital within hospital requirements in order to maintain their excluded status and not be subject to Medicare’s acute care inpatient PPS.

Risk Management and Insurance

We insure a substantial portion of our professional, general liability, and workers’ compensation risks through a self-insured retention program underwritten by our wholly owned offshore captive insurance subsidiary, HCS, Ltd. (“HCS”), which we fund annually. HCS provides part of our first layer of insurance coverage for professional and general liability risks (up to $6 million per claim and $60 million in the aggregate per year) and workers’ compensation claims (between $0.3 million and $1 million per claim, depending upon the state). We maintain professional and general liability insurance with unrelated commercial carriers for losses in excess of amounts insured by HCS. HealthSouth and HCS maintained reserves for professional, general liability, and workers’ compensation risks that totaled $203.6 million at December 31, 2006. Management considers such reserves, which are based on actuarially determined estimates, to be adequate for those liability risks. However, there can be no assurance that the ultimate liability will not exceed management’s estimates.

We also maintain director and officer, property, and other typical insurance coverages with unrelated commercial carriers. Our director and officer liability insurance coverage for our current officers and directors is in the amount of $200 million, which includes $50 million in coverage for individual directors and officers in circumstances where we are legally or financially unable to indemnify these individuals. Examples of a company’s inability to indemnify would include derivative suits, bankruptcy/financial restraints, and claims that are against public policy. Of the $200 million coverage, we have a self-insured retention of $10 million for claims against us.

In addition to the standard industry exclusions, our director and officer liability policy also includes exclusions of coverage for (1) our former chairman and chief executive officer, Richard M. Scrushy, and our former chief financial officer, William T. Owens and (2) a prior acts exclusion and a pending and prior litigation exclusion as of July 31, 2003. See Note 25, Contingencies and Other Commitments, “Insurance Coverage Litigation,” for a description of various lawsuits that have been filed to contest coverage under certain directors and officers insurance policies.

While to date we have not had difficulty in obtaining director and officer liability insurance coverage for our current directors and officers, the premium costs associated with this coverage have been dramatically higher than in the years prior to March 2003. We believe we will be able to continue to secure comparable coverage for the coming insurance year. We anticipate that, although the premium costs associated with our director and officer liability insurance coverage will be reduced during the coming insurance year, such premium costs will remain higher than in the years prior to March 2003. Despite these increased premium costs, we do not believe these costs are material to our business, financial position, results of operations, or cash flows.

Employees

As of December 31, 2006, we employed approximately 33,000 individuals, of whom approximately 21,000 were full-time employees. We are subject to various state and federal laws that regulate wages, hours, benefits, and other terms and conditions relating to employment. Except for approximately 90 employees at one IRF (about 18% of that facility’s workforce), none of our employees are represented by a labor union. We are not aware of any current activities to organize our employees at other facilities. We believe our relationship with our employees is satisfactory. Like most health care providers, our labor costs are rising faster than the general inflation rate. In some markets, the lack of availability of nurses and other medical support personnel has become a significant operating issue to health care providers. To address this challenge, we are implementing initiatives to improve retention, recruiting, compensation programs, and productivity. The shortage of nurses and other medical support personnel, including physical therapists, may require us to increase utilization of more expensive temporary personnel.

Available Information

Our website address is www.healthsouth.com. We make available through our website the following documents, free of charge: our annual reports (Form 10-K), our quarterly reports (Form 10-Q), our current reports (Form 8-K), and any amendments we file with respect to any such reports promptly after we electronically file such material with, or furnish it to, the SEC. In addition to the information that is available on our website, you may read and copy any materials we file with or furnish to the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Room 1580, Washington, D.C. 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also

maintains a website, www.sec.gov, which includes reports, proxy, and information statements, and other information regarding us and other issuers that file electronically with the SEC.

Item 1A.

Risk Factors

Our business, operations, and financial position are subject to various risks. Some of these risks are described below, and you should take such risks into account in evaluating HealthSouth or any investment decision involving HealthSouth. This section does not describe all risks that may be applicable to our company, our industry, or our business, and it is intended only as a summary of certain material risk factors. More detailed information concerning the risk factors described below is contained in other sections of this annual report.

Risks Related to Our Financial Position

We are highly leveraged. As a consequence, a substantial down-turn in earnings could jeopardize our ability to make our interest payments and could impair our ability to obtain additional financing, if necessary.

We are highly leveraged. As of December 31, 2006 we had approximately $3.4 billion of long-term debt outstanding. As discussed in Item 1, Business, “Recent Significant Events,” we have prepaid substantially all of our prior indebtedness with proceeds from a series of recapitalization transactions and replaced it with approximately $3 billion of new long-term debt. Although we remain highly leveraged, we believe these recapitalization transactions have eliminated significant uncertainty regarding our capital structure and have improved our financial position by reducing our refinancing risk, increasing our liquidity, improving our operational flexibility, improving our credit profile, and reducing our interest rate exposure.

We are required to use a substantial portion of our cash flow to service our debt. A substantial down-turn in earnings could jeopardize our ability to make our interest payments and could impair our ability to obtain additional financing, if necessary. Certain trends in our business, including declining revenues resulting from the 75% Rule, acute care volume weakness, and pricing pressure have created a challenging operating environment, and future changes could place additional pressure on our revenues and cash flow. In addition, we are subject to numerous contingent liabilities and are subject to prevailing economic conditions and to financial, business, and other factors beyond our control. Although we expect to make scheduled interest payments and principal reductions, we cannot assure you that changes in our business or other factors will not occur that may have the effect of preventing us from satisfying obligations under our debt.

We have significant cash obligations relating to government settlements that, in addition to our indebtedness, may limit cash flow available for our operations and could impair our ability to service debt or obtain additional financing, if necessary.

In addition to being highly leveraged, we have significant cash obligations we must meet in the near future as a result of recent settlements with various federal agencies. Specifically, we remain obligated to pay $86.7 million (plus interest) in quarterly installments ending in the fourth quarter of 2007 to satisfy our obligations under a settlement described in Note 22, Medicare Program Settlement, to our accompanying consolidated financial statements. Furthermore, we remain obligated to pay $50.0 million to the SEC in two installments ending in the fourth quarter of 2007 to satisfy our obligations under a settlement described in Note 23, SEC Settlement, to our accompanying consolidated financial statements.

We are still communicating the results of the reconstruction of our accounts to our partners, which could result in litigation.

Following the discovery of the financial fraud committed by members of our former management, we reconstructed our accounting records and restated our previously reported financial statements for 2000 and 2001. As a result of this effort, we also were able to restate the financial statements of our subsidiaries and affiliated entities, including entities owned in partnership with various third parties. We are well underway with the process of communicating the effect of the restatement to our joint venture partners, and have resolved or established agreements in principle to resolve issues arising out of the restatement with many of our joint venture partners. However, we may be unable to resolve issues arising out of the restatement with all of our joint venture partners, which could result in litigation, and the results of any such litigation are currently unknown.

We have determined that our internal controls relating to income taxes are currently ineffective.

As discussed in Item 9A, Controls and Procedures, our management team, under the supervision and with the participation of our chief executive officer and chief financial officer, conducted an evaluation of the effectiveness of the design and operation of HealthSouth’s internal controls. As of December 31, 2006, they concluded that HealthSouth’s internal control over financial reporting as they relate to income taxes is currently ineffective. Although we have made

substantial improvements in our internal controls, any material weakness in our internal controls over income taxes could impair our ability to report our financial position and results of operations accurately and in a timely manner.

Risks Related to Our Business

We may be unable to successfully consummate transactions related to our strategic repositioning and, even if consummated, the implementation of such transactions could adversely affect us.

As discussed above, on August 14, 2006, we announced our intent to seek strategic alternatives for our surgery centers and outpatient divisions, along with our diagnostic division (previously designated as “non-core”), and to reposition the company as a “pure play” provider of post-acute health care services, with an initial focus on rehabilitative health care. We may be unable to complete these transactions on satisfactory terms. In addition, the uncertainty and operational disruption resulting from these transactions, including any interim period during which we are required to provide transition services to one or more divisions, could have a negative effect on our business.

If we fail to comply with the extensive laws and government regulations applicable to us as a health care provider, we could suffer penalties or be required to make significant changes to our operations.

As a health care provider, we are required to comply with extensive and complex laws and regulations at the federal, state, and local government levels. These laws and regulations relate to, among other things:

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licensure, certification, and accreditation,

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coding and billing for services,

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relationships with physicians and other referral sources, including physician self-referral and anti-kickback laws,

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quality of medical care,

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use and maintenance of medical supplies and equipment,

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maintenance and security of medical records,

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accuracy of billing operations, and

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disposal of medical and hazardous waste.

In the future, changes in these laws and regulations could subject our current or past practices to allegations of impropriety or illegality or could require us to make changes in our investment structure, facilities, equipment, personnel, services, capital expenditure programs, operating procedures, and contractual arrangements.

Although we have invested substantial time, effort, and expense in implementing internal controls and procedures designed to ensure regulatory compliance, if we fail to comply with applicable laws and regulations, we could be subjected to liabilities, including (1) criminal penalties, (2) civil penalties, including monetary penalties and the loss of our licenses to operate one or more of our facilities, and (3) exclusion or suspension of one or more of our facilities from participation in the Medicare, Medicaid, and other federal and state health care programs.

If we fail to comply with our Corporate Integrity Agreement, we could be subject to severe sanctions.

In December 2004, we entered into a Corporate Integrity Agreement with the HHS-OIG to promote our compliance with the requirements of Medicare, Medicaid, and all other federal health care programs. Under that agreement, which is effective for five years from January 1, 2005, we are subject to certain administrative requirements and are subject to review of certain Medicare cost reports and reimbursement claims by an Independent Review Organization. Our failure to comply with the material terms of the Corporate Integrity Agreement could lead to suspension or exclusion from further participation in federal health care programs, including Medicare and Medicaid, which currently account for a substantial portion of our revenues. Any of these sanctions would have a material adverse effect on our business, financial position, results of operations, and cash flows.

Although we have entered into a settlement with various government agencies and other parties regarding our participation in federal health care programs, we remain a defendant in litigation relating to our participation in federal health care programs, and the outcome of these lawsuits and others of which we may not be aware may have a material adverse effect on our business, financial position, results of operations, and cash flows.

The False Claims Act, 18 U.S.C. § 287, allows private citizens, called “relators,” to institute civil proceedings alleging violations of the False Claims Act. These so-called qui tam, or “whistleblower,” cases are sealed by the court at the time of filing. The only parties privy to the information contained in the complaint are the relator, the federal government, and the presiding court. We settled one consolidated qui tam lawsuit filed in 2004, the Devage matter, which is discussed in Note 22,

Medicare Program Settlement, to our accompanying consolidated financial statements. We remain a defendant in a qui tam action which is discussed in Note 25, Contingencies and Other Commitments, to our accompanying consolidated financial statements. It is possible that qui tam lawsuits other than those discussed in this report have been filed against us and that we are unaware of such filings or have been ordered by the presiding court not to discuss or disclose the filing of such lawsuits. We may be subject to liability under one or more undisclosed qui tam cases brought pursuant to the False Claims Act.

CMS has been granted authority to suspend payments, in whole or in part, to Medicare providers if CMS possesses reliable information that an overpayment, fraud, or willful misrepresentation exists. If CMS suspects that payments are being or have been made as the result of fraud or misrepresentation, CMS may suspend payment at any time without providing us with prior notice. The initial suspension period is limited to 180 days. However, the payment suspension period can be extended almost indefinitely if the matter is under investigation by the HHS-OIG or the DOJ. Therefore, we are unable to predict if or when we may be subject to a suspension of payments by the Medicare and/or Medicaid programs, the possible length of the suspension period or the potential cash flow impact of a payment suspension. Any such suspension would adversely impact our business, financial position, results of operations, and cash flows.

If the HHS-OIG determines we have violated federal laws governing kickbacks and self-referrals, it could impose substantial civil monetary penalties on us and could seek to exclude our provider entities from participation in the federal health care programs which would severely impact our financial position and ability to continue operations.

If the HHS-OIG determines that we have violated the Anti-Kickback Law, the HHS-OIG may commence administrative proceedings to impose penalties under the Civil Monetary Penalties Law of up to three times the amount of damages and $11,000 per claim for each false or fraudulent claim allegedly submitted by us. If the HHS-OIG determines that we have violated the federal Stark statute’s general prohibition on physician self-referrals (42 U.S.C. § 1395nn), it may impose a civil monetary penalty of up to $15,000 per service billed in violation of the statute.

The HHS-OIG has been granted the authority to exclude persons or entities from participation in the federal health care programs for a variety of reasons, including: (1) committing an act in violation of the Anti-Kickback Law, (2) submitting a false or fraudulent claim, (3) submitting a claim for services rendered in violation of the physician self-referral statute, or (4) violating any other provision of the Civil Monetary Penalties Law. Thus, if the HHS-OIG believes that we have submitted false or fraudulent claims, paid or received kickbacks, submitted claims in violation of the physician self-referral law, or committed any other act in violation of the Civil Monetary Penalties Law, the HHS-OIG could move to exclude our provider entities from participation in the federal health care programs.

Reductions or changes in reimbursement from government or third-party payors could adversely affect our operating results.

We derive a substantial portion of our Net operating revenues from the Medicare and Medicaid programs. In 2006, 47.4% of our consolidated Net operating revenues was derived from Medicare, 2.3% was derived from Medicaid, 6.8% was derived from workers’ compensation plans, 34.8% was derived from managed care and other discount plans, 4.7% was derived from other third-party payors, 1.4% was derived from patients, and 2.6% was derived from other income. There are increasing pressures from many payors to control health care costs and to reduce or limit increases in reimbursement rates for medical services. Our operating results could be adversely affected by changes in laws or regulations governing the Medicare and Medicaid programs. For a discussion of the 75% Rule and other factors affecting reimbursement for our services, see Item 1, Business, “Sources of Revenues.”

Historically, Congress and some state legislatures have periodically proposed significant changes in the health care system. Many of these changes have resulted in limitations on and, in some cases, significant reductions in the levels of, payments to health care providers for services under many government reimbursement programs. See Item 1, Business, “Regulation” for a discussion of recent and proposed changes to the health care system that could materially and adversely affect our business, financial position, results of operations, and cash flows.

Our relationships with third-party payors, such as HMOs and PPOs, are generally governed by negotiated agreements. These agreements set forth the amounts we are entitled to receive for our services. We could be adversely affected in some of the markets where we operate if we are unable to negotiate and maintain favorable agreements with third-party payors. In addition, our third-party payors may, from time to time, request audits of the amounts paid to us under our agreements with them. We could be adversely affected in some of the markets where we operate and within certain of our operating divisions if the audits uncover substantial overpayments made to us. As part of the reconstruction of accounting records for the preparation of our financial statements for the years ended December 31, 2004, 2003, and 2002 and the restatement for the years ended December 31, 2001 and 2000, we discovered the existence of substantial credit balances, which could represent posting errors, misapplied payments or overpayments due to patients and third-party payors, including the Medicare and Medicaid programs. We are continuing to review these accounts to determine whether and to what extent we may be required

to repay any of these credit balances to patients or third-party payors, including the Medicare and Medicaid programs. We could be adversely affected if the amount we are required to repay exceeds our current estimates.

The adoption of more restrictive Medicare coverage policies at the national and/or local levels could have an adverse impact on our ability to obtain Medicare reimbursement for inpatient rehabilitation services.

Medicare providers also can be negatively affected by the adoption of coverage policies, either at the national or local levels, describing whether an item or service is covered and under what clinical circumstances it is considered to be reasonable, necessary, and appropriate. In the absence of a national coverage determination, local Medicare fiscal intermediaries and carriers may specify more restrictive criteria than otherwise would apply nationally. For instance, Cahaba Government Benefit Administrators, the fiscal intermediary for many of our inpatient division facilities, has issued a local coverage determination setting forth very detailed criteria for determining the medical appropriateness of services provided by IRFs. We cannot predict whether other Medicare contractors will adopt additional local coverage determinations or other policies or how these will affect us.

Downward pressure on pricing from commercial and government payors may adversely affect the revenues and profitability of certain of our operations.

We have experienced downward pressure on prices in our markets, from both commercial and government payors, and we anticipate continuing price pressure in all our divisions. There can be no assurances that we will be able to maintain current prices in the face of continuing pricing pressures. We may be required to implement additional measures to mitigate these pressures and further enhance the efficiency of our operations or, in the alternative, dispose of inefficient operations.

Our facilities face national, regional, and local competition for patients from other health care providers.

We operate in a highly competitive industry. Although we are the largest provider of rehabilitative health care services, and one of the largest providers of ambulatory surgery and outpatient diagnostic services in the United States, in any particular market we may encounter competition from local or national entities with longer operating histories or other competitive advantages. There can be no assurance that this competition, or other competition which we may encounter in the future, will not adversely affect our business, financial position, results of operations, or cash flows. In addition, weakening certificate of need laws in some states could potentially increase competition in those states.

Competition for staffing may increase our labor costs and reduce profitability.

Our operations are dependent on the efforts, abilities, and experience of our management and medical support personnel, such as physical therapists, nurses, and other health care professionals. We compete with other health care providers in recruiting and retaining qualified management and support personnel responsible for the daily operations of each of our facilities. In some markets, the lack of availability of physical therapists, nurses, and other medical support personnel has become a significant operating issue to health care providers. This shortage may require us to continue to enhance wages and benefits to recruit and retain qualified personnel or to hire more expensive temporary personnel. We also depend on the available labor pool of semi-skilled and unskilled employees in each of the markets in which we operate. If our labor costs increase, we may not be able to raise rates to offset these increased costs. Because a significant percentage of our revenues consists of fixed, prospective payments, our ability to pass along increased labor costs is limited. Our failure to recruit and retain qualified management, physical therapists, nurses, and other medical support personnel, or to control our labor costs, could have a material adverse effect on our business, financial position, results of operations, and cash flows.

We depend on our relationships with the physicians who use our facilities.

Our business depends upon the efforts of the physicians who provide health care services at our facilities and/or refer their patients to our facilities and the strength of our relationships with these physicians. Each physician referring or treating patients at one of our facilities may also practice at other facilities not owned by us.

At each of our facilities, our business could be adversely affected if a significant number of key physicians or a group of physicians:

•

terminate their relationship with, or reduced their use of, our facilities,

•

fail to maintain the quality of care provided or otherwise adhere to professional standards at our facilities, or

•

exit the market entirely.

Risks Related to Pending Governmental Investigations and Litigation

Any adverse outcome of continuing governmental investigations relating to certain self-disclosures could have a material adverse effect on us.

We remain the subject of governmental investigations relating to certain self-disclosures, all of which relate to matters previously disclosed in Item 13, Certain Relationships and Related Transactions, “Other Transactions,” to our comprehensive Form 10-K for the years ended December 31, 2003 and 2002. While we are fully cooperating with the DOJ and other governmental authorities in their investigations, we cannot predict the outcome of those investigations. Such investigations could result in material financial penalties.

We remain a defendant in a number of lawsuits, the outcome of which could have a material adverse effect on us.

Although we have settled the major litigation pending against us, we remain a defendant in numerous lawsuits which are discussed in Note 25, Contingencies and Other Commitments, to our accompanying consolidated financial statements. Substantial damages and other remedies assessed against us could have a material adverse effect on our business, financial position, results of operations, and cash flows.

Item 1B.

Unresolved Staff Comments

None.

Item 2.

Properties

Our principal executive offices are located in Birmingham, Alabama, where we own and maintain a headquarters building of approximately 200,000 square feet located on an 85-acre corporate campus. In addition to our headquarters building, as of December 31, 2006 we leased or owned 978 facilities through various consolidated entities to support our operations. Our leases generally have initial terms of 3 to 5 years, but range from 1 to 99 years. Most of our leases contain options to extend the lease period for up to 5 additional years. Our consolidated entities are sometimes responsible for property taxes, property and casualty insurance, and routine maintenance expenses. Other than our headquarters campus and a contiguous 19-acre tract of land that includes an incomplete 13-story building formerly called the “Digital Hospital,” none of our other properties is materially important. Although we marketed the “Digital Hospital” for sale extensively as a hospital, we were unable to find a buyer, and after closing the sale of the Birmingham Medical Center, discussed below, we no longer own the certificate of need that would enable us to market the Digital Hospital as a hospital. We are currently marketing our headquarters campus and the contiguous 19-acre tract of land for sale. Both properties are held and, as applicable, used by our corporate and other segment. See Note 6, Property and Equipment, to our accompanying consolidated financial statements, for a discussion of the impairment charge we recognized in 2006 relating to the incomplete 13-story building formerly called the “Digital Hospital.”

We and our Subsidiary Guarantors have pledged substantially all of our property as collateral to secure the performance of our obligations under our Credit Agreement. In addition, we and the Subsidiary Guarantors agreed to enter into mortgages with respect to certain of our material real property (excluding real property owned by the surgery centers division or otherwise subject to preexisting liens and/or mortgages) in connection with the Credit Agreement. Our obligations under the Credit Agreement are secured by the real property subject to such mortgages. For additional information about our Credit Agreement, see Note 9, Long-term Debt, to our accompanying consolidated financial statements.

In 2006, we sold approximately $13.9 million in land and buildings, not including properties sold in connection with the sale of operating facilities. On July 20, 2005, we executed an asset purchase agreement with The Board of Trustees of the University of Alabama (the “University of Alabama”) for the sale of the real property, furniture, fixtures, equipment, and certain related assets associated with our 219 licensed-bed acute care hospital located in Birmingham, Alabama (the “Birmingham Medical Center”) for $33.0 million. Simultaneously with the execution of this purchase agreement with the University of Alabama, we executed an agreement with an affiliate of the University of Alabama whereby this entity provided certain management services to the Birmingham Medical Center. On December 31, 2005, we executed an amended and restated asset purchase agreement with the University of Alabama. This amended and restated agreement provided that the University of Alabama purchase the Birmingham Medical Center and associated real and personal property, as well as our interest in the gamma knife partnership associated with this hospital. This transaction closed on March 31, 2006 and resulted in a net loss on disposal of assets of approximately $7.3 million.

We have transferred the Birmingham Medical Center and associated real and personal property, including our interest in the gamma knife partnership. Both the certificate of need under which the hospital operated and the licensed beds operated by us at the hospital were transferred as part of the sale of the hospital under the amended and restated agreement. The transaction also required that we acquire and convey title to the University of Alabama or its affiliate for certain professional

office buildings that we leased. During the course of negotiations with the landlord of these properties, we agreed to continue certain rent payment obligations related to the terminated lease. The costs to terminate the lease associated with the professional office buildings approximated $29 million. These lease termination costs are the primary factor that contributed to the $7.3 million net loss on disposal of assets.

Our headquarters, facilities, and other properties are suitable for their respective uses and are, in general, adequate for our present needs. Our properties are subject to various federal, state, and local statutes and ordinances regulating their operation. Management does not believe that compliance with such statutes and ordinances will materially affect our business, financial position, or results from operations.

Item 3.

Legal Proceedings

Information relating to certain legal proceedings in which we are involved is included in Note 25, Contingencies and Other Commitments, Note 22, Medicare Program Settlement, Note 23, SEC Settlement, and Note 24, Securities Litigation Settlement, to our accompanying consolidated financial statements, each of which is incorporated herein by reference.

Item 4.

Submission of Matters to a Vote of Security Holders

On October 18, 2006, at a special meeting of stockholders, our stockholders approved a proposal to amend our Restated Certificate of Incorporation (the “Charter Amendment”) to (1) effect a one-for-five reverse stock split of our common stock (the “Reverse Stock Split”), whereby each issued and outstanding five shares of common stock were combined into and became one share of common stock, and (2) decrease the number of authorized shares of our common stock from 600 million shares to 200 million shares. The votes cast at the special meeting with respect to the Charter Amendment (which are not split-adjusted) were as follows:

For		Against		Abstain		Withheld		Broker Non-Votes
348,665,176		27,936,465		4,332,358		N/A		N/A

The Charter Amendment, including the Reverse Stock Split, became effective at the close of business on October 25, 2006, the date upon which we filed the Charter Amendment with the Secretary of State of the State of Delaware. To avoid the existence of fractional shares of common stock, stockholders who would have otherwise been entitled to receive fractional shares of our common stock as a result of the Reverse Stock Split received a cash payment in lieu thereof. No voting rights or other terms of the common stock were altered in connection with the Charter Amendment. In addition, as a result of the Reverse Stock Split, the conversion price at which shares of our convertible perpetual preferred stock are convertible into shares of our common stock was proportionately increased from $6.10 to $30.50 and, as a result, shares of the convertible perpetual preferred stock are convertible into shares of common stock at a conversion rate of 32.7869 shares of common stock per share of convertible perpetual preferred stock.

PART II

Item 5.

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of

Equity Securities

Market Information

On March 19, 2003, after the Securities and Exchange Commission issued an Order of Suspension of Trading, the New York Stock Exchange (“NYSE”) suspended trading in our common stock, which was then listed under the symbol HRC. That same day, Standard & Poor’s announced that it removed our common stock from the S&P 500 Index. The NYSE continued the trading halt and eventually delisted our common stock. On March 25, 2003, immediately following the delisting from the NYSE, our stock began trading in the over-the-counter “Pink Sheets” market under the symbol HLSH. On August 14, 2006, we announced that we had been cleared to submit an application for the listing of our common stock on the New York Stock Exchange. Shares of our common stock began trading on the New York Stock Exchange on October 26, 2006, under the ticker symbol “HLS.”

The following table sets forth the high and low bid quotations per share of HealthSouth common stock as reported on the over-the-counter market from January 1, 2005 through October 25, 2006, as well as the high and low sales prices per share for HealthSouth common stock as reported on the New York Stock Exchange from October 26, 2006 through December 31, 2006. The stock price information is based on published financial sources. Over-the-counter market quotations reflect inter-dealer prices, without retail mark-up, mark-down or commissions, and may not necessarily represent actual transactions. All quotations per share have been adjusted to reflect the reverse stock split that became effective on October 25, 2006 (see Note 1, Summary of Significant Accounting Policies, to our accompanying consolidated financial statements).

	Market	High	Low
2005
First Quarter	OTC	$ 30.80	$ 25.50
Second Quarter	OTC	29.75	24.00
Third Quarter	OTC	28.45	20.00
Fourth Quarter	OTC	24.00	18.10
2006
First Quarter	OTC	$ 26.25	$ 22.50
Second Quarter	OTC	24.60	21.50
Third Quarter	OTC	25.05	17.50
Fourth Quarter (through October 25, 2006)	OTC	26.65	24.10
Fourth Quarter (from October 26 through December 31, 2006)	NYSE	26.25	19.80

Holders

As of February 15, 2007, there were 78,684,549 shares of HealthSouth common stock issued and outstanding, net of treasury shares, held by approximately 8,351 holders of record.

Dividends

We have never paid cash dividends on our common stock, and we do not anticipate paying cash dividends on our common stock in the foreseeable future. In addition, the terms of our new credit agreement restrict us from declaring or paying cash dividends on our common stock unless: (1) we are not in default under our credit agreement and (2) the amount of the dividend, when added to the aggregate amount of certain other defined payments made during the same fiscal year, does not exceed certain maximum thresholds. We currently anticipate that any future earnings will be retained to finance our operations and reduce debt. However, as described below, our 6.50% Series A Convertible Perpetual Preferred Stock generally provides for the payment of cash dividends subject to certain limitations.

Recent Sales of Unregistered Securities

On February 28, 2006, we entered into a Securities Purchase Agreement (the “Purchase Agreement”) with several investors, pursuant to which we sold 400,000 shares of 6.50% Series A Convertible Perpetual Preferred Stock (the “Series A Preferred Stock”) at a price per share of $1,000, for an aggregate purchase price of $400 million. We received approximately $387 million in net proceeds from this offering (after deducting the placement agents’ fees of $13 million paid to Citigroup Global Markets Inc., J.P. Morgan Securities Inc., Merrill Lynch, Pierce, Fenner and Smith Incorporated, Deutsche Bank Securities Inc., Goldman Sachs & Co., and Wachovia Capital Markets, LLC and before deducting our estimated offering

expenses). The offers and sales of the Series A Preferred Stock were made only to Qualified Institutional Buyers as such term is defined under Rule 144A promulgated by the SEC under the Securities Act and were deemed exempt from registration under the Securities Act, in reliance on Section 4(2) of the Securities Act and Rule 506 promulgated by the SEC under the Securities Act, as transactions not involving a public offering. As of February 15, 2007 there was one holder of record of the Series A Preferred Stock.

The Series A Preferred Stock is convertible, at the option of the holder, at any time into shares of our common stock at an initial conversion price of $30.50 per share, which is equal to an approximate conversion rate of 32.7869 shares of common stock per share of Series A Preferred Stock, subject to specified adjustments. On or after July 20, 2011, we may cause the shares of Series A Preferred Stock to be automatically converted into shares of our common stock at the conversion rate then in effect if the closing sale price of our common stock for 20 trading days within a period of 30 consecutive trading days ending on the trading day before the date we give the notice of forced conversion exceeds 150% of the conversion price of the Series A Preferred Stock.

Holders of Series A Preferred Stock are entitled to receive, when and if declared by our board of directors, cash dividends at the rate of 6.50% per annum on the accreted liquidation preference per share, payable quarterly in arrears on January 15, April 15, July 15 and October 15 of each year, commencing on July 15, 2006. If we are prohibited by the terms of our credit facilities, debt indentures or other debt instruments from paying cash dividends on the Series A Preferred Stock, we may pay dividends in shares of our common stock, or a combination of cash and shares of our common stock, if the shares of our common stock delivered as payment are freely transferable by the recipient thereof (other than by reason of the fact that the recipient is a HealthSouth affiliate) or if a shelf registration statement relating to that common stock is effective to permit the resale thereof. Shares of our common stock delivered as dividends will be valued at 95% of their market value. Unpaid dividends will accrete at an annual rate of 8.0% per year for the relevant dividend period and will be reflected as an accretion to the liquidation preference of the Series A Preferred Stock.

We applied the net proceeds from the issuance of the Series A Preferred Stock to prepay certain existing indebtedness and to pay associated transaction costs in connection with our recapitalization transactions.

The foregoing descriptions of the Series A Preferred Stock is qualified in its entirety by the complete text of the Certificate of Designation of 6.50% Series A Convertible Perpetual Preferred Stock, which is referenced in Item 15, Exhibits and Financial Statement Schedules, and is incorporated herein by reference.

Securities Authorized for Issuance Under Equity Compensation Plans

The information required by Item 201(d) of Regulation S-K is provided under Item 12, Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters, “Securities Authorized for Issuance Under Equity Compensation Plans,” which is incorporated herein by reference.

Purchases of Equity Securities

None.

Company Stock Performance

Set forth below is a line graph comparing the total returns of our common stock, the Standard & Poor’s 500 Index (“S&P 500”), and the Morgan Stanley Health Care Provider Index (“RXH”), an equal-dollar weighted index of 16 companies involved in the business of hospital management and medical/nursing services. The graph assumes $100 invested on December 31, 2001 in HealthSouth common stock and each of the indices. We did not pay dividends during that time period and do not plan to pay dividends.

The information contained in the performance graph shall not be deemed “soliciting material” or to be “filed” with the SEC nor shall such information be deemed incorporated by reference into any future filing under the Securities Act or the Exchange Act, except to the extent that we specifically incorporate it by reference into such filing.

The comparisons in the graph below are based upon historical data and are not indicative of, nor intended to forecast, future performance of HealthSouth’s common stock.

Fiscal Year Ended December 31
	Base Period	Cumulative Total Return
Company/Index Name	12/01	12/02	12/03	12/04	12/05	12/06
HealthSouth Corporation	100.00	28.34	30.97	42.38	33.06	30.57
Standard & Poor’s 500 Index	100.00	76.63	96.85	105.56	108.73	123.54
Morgan Stanley Health Care Provider Index (“RXH”)	100.00	86.92	114.47	124.31	142.64	144.81

Item 6.

Selected Financial Data

We derived the selected historical consolidated financial data presented below for the years ended December 31, 2006, 2005, and 2004 from our audited consolidated financial statements and related notes included elsewhere in this filing. We derived the selected historical consolidated financial data presented below for the years ended December 31, 2003 and 2002 from our audited consolidated financial statements and related notes included in our comprehensive Form 10-K for the years ended December 31, 2003 and 2002. You should refer to Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, and the notes to our accompanying consolidated financial statements for additional information regarding the financial data presented below, including matters that might cause this data not to be indicative of our future financial position or results of operations. In addition, you should note the following information regarding the selected historical consolidated financial data presented below.

•

Certain previously reported financial results have been reclassified to conform to the current year presentation. Such reclassifications relate to facilities we closed or sold in 2006 that qualify under Financial Accounting Standards Board (“FASB”) Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, to be reported as discontinued operations. We reclassified our consolidated financial statements for the years ended December 31, 2005, 2004, 2003, and 2002 to show the results of those qualifying facilities in 2006 as discontinued operations. We also reclassified rent associated with leased facilities, including common area maintenance and similar charges, from Other operating expenses to Occupancy costs in our consolidated statements of operations.

•

During 2006, stock-based compensation increased by approximately $12.1 million due to our adoption of FASB Statement No. 123(R), Share-Based Payment, on January 1, 2006. These increased costs are included in Salaries and benefits in our 2006 consolidated statement of operations.

•

As discussed in more detail in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, we were involved in a legal dispute regarding the lease of Braintree Rehabilitation Hospital in

Braintree, Massachusetts and New England Rehabilitation Hospital in Woburn, Massachusetts. In 2005, a judgment was entered against us that upheld the landlord’s termination of our lease of these two facilities and placed us as the manager, rather than the owner, of these two facilities. Accordingly, our 2006 and 2005 results of operations include only the $4.0 million and $5.4 million management fee we earned for operating these facilities during the nine months ended September 30, 2006 and the year ended December 31, 2005, respectively. In 2004, 2003, and 2002, the results of operations of these two facilities were included in our consolidated statements of operations on a gross basis. Our consolidated Net operating revenues and consolidated operating earnings were negatively impacted by approximately $106.3 million and $3.6 million, respectively, (excluding the lease termination gain described below) in 2005 as a result of the change in ownership of these two facilities. In September 2006, we completed the transition of these two facilities to the landlord.

Also, as a result of the lease termination associated with the Braintree and Woburn facilities, our corporate and other segment recorded a $30.5 million net gain on lease termination during 2005. This net gain is included in Occupancy costs in our consolidated statement of operations. See Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, for additional information regarding this gain.

•

In 2001 and 2002, we reserved approximately $38.0 million related to amounts due from Meadowbrook Healthcare, Inc. (“Meadowbrook”), an entity formed by one of our former chief financial officers related to net working capital advances made to Meadowbrook in 2001 and 2002. In August 2005, we received a payment of $37.9 million from Meadowbrook. This cash payment is included as Recovery of amounts due from Meadowbrook in our 2005 consolidated statement of operations. For more information regarding Meadowbrook, see Note 21, Related Party Transactions, and Note 25, Contingencies and Other Commitments, to our accompanying consolidated financial statements.

•

During 2006, an Alabama Circuit Court issued a summary judgment against Richard M. Scrushy, our former chairman and chief executive officer, on a claim for restitution of incentive bonuses Mr. Scrushy received for years 1996 through 2002. Including pre-judgment interest, the court’s total award was approximately $48 million. Based on this judgment, we recorded $47.8 million during 2006 as Recovery of amounts due from Richard M. Scrushy, excluding approximately $5.0 million of post-judgment interest recorded as Interest income. For additional information, see Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, and Note 25, Contingencies and Other Commitments, to our accompanying consolidated financial statements.

•

On December 8, 2006, we entered into an agreement with the derivative plaintiffs’ attorneys to resolve the amounts owed to them as a result of the award given to us under the claim for restitution of incentive bonuses Mr. Scrushy received in previous years and the Securities Litigation Settlement (as defined in Note 24, Securities Litigation Settlement, and as discussed in Note 25, Contingencies and Other Commitments to our accompanying consolidated financial statements). Under this agreement, we agreed to pay the derivative plaintiffs’ attorneys $32.5 million on an aggregate basis for both claims. We will pay this amount based on amounts received from Mr. Scrushy in the above referenced award. As of December 31, 2006, we owed approximately $21.0 million to the derivative plaintiffs’ attorneys, which is included in Other current liabilities in our consolidated balance sheet.

•

Included in our Net loss for 2006, 2005, 2004, 2003, and 2002 are property and equipment and goodwill and other intangible assets impairment charges of $15.2 million, $43.3 million, $36.5 million, $467.7 million, and $62.4 million, respectively. These charges were recorded as a result of experiencing continued decreases in projected revenue and operating profit at numerous facilities and changes in the business climate over this five-year period. We performed impairment analyses and calculated the fair value of our long-lived assets with the assistance of a third-party valuation specialist using a combination of discounted cash flows and market valuation models based on competitors’ multiples of revenue, gross profit, and other financial ratios. These impairment charges are shown separately as a component of operating loss within the consolidated statements of operations, excluding $4.5 million, $8.7 million, $20.1 million, $0.6 million, and $59.3 million of impairment charges in 2006, 2005, 2004, 2003, and 2002, respectively, related to certain closed facilities which are included in discontinued operations.

•

Our Net loss for 2006 includes approximately $38.8 million in charges related to litigation, settlements, and ongoing settlement negotiations with various entities and individuals as Government, class action, and related settlements expense. These 2006 charges of $38.8 million are net of a $31.2 million reduction to the $215 million charge we recorded in 2005 as a result of the final court approval of our settlement in the federal securities class actions and the derivative litigation.

In 2005, our Net loss includes a $215.0 million charge, to be paid in the form of common stock and common stock warrants, as Government, class action, and related settlements expense under the then-proposed settlement with the lead plaintiffs in the federal securities class actions and the derivative litigation, as well as with our insurance

carriers, to settle claims filed against us, certain of our former directors and officers, and certain other parties. As noted above, this settlement was finalized in January 2007, and an adjustment was recorded to this liability in 2006.

In 2003, our Net loss includes the cost related to our settlement with the United States Securities and Exchange Commission (the “SEC”) and certain additional settlements, as well as legal fees related to this litigation and certain other actions brought against us. Also, as a result of the Medicare Program Settlement (see Note 22, Medicare Program Settlement, to our accompanying consolidated financial statements), our 2002 Net loss includes a $347.7 million charge as Government, class action, and related settlements expense.

For additional information regarding these settlements, ongoing discussions, and litigation, see Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, and Note 22, Medicare Program Settlement, Note 23, SEC Settlement, Note 24, Securities Litigation Settlement, and Note 25, Contingencies and Other Commitments, to our accompanying consolidated financial statements.

•

As noted in this filing, significant changes have occurred at HealthSouth since the financial fraud perpetrated by certain members of our prior management team was uncovered. The steps taken to stabilize our business and operations, provide vital management assistance, and coordinate our legal strategy came at significant financial cost. Our Net loss in each year includes professional fees associated with professional services to support the preparation of our periodic reports filed with the SEC, tax preparation and consulting fees for various tax projects, and legal fees for litigation defense and support matters. For years prior to 2006, these fees include costs associated with the reconstruction and restatement of our previously filed consolidated financial statements for the years ended December 31, 2001 and 2000. These fees are included in our statements of operations as Professional fees—accounting, tax, and legal and approximated $163.6 million, $169.8 million, $206.2 million, and $70.6 million in 2006, 2005, 2004, and 2003, respectively. See Note 1, Summary of Significant Accounting Policies, to our accompanying consolidated financial statements for additional information.

•

During 2006, we recorded an approximate $365.6 million net loss on early extinguishment of debt due to the completion of a private offering of senior notes in June 2006 and a series of recapitalization transactions during the first quarter of 2006. For more information regarding these transactions, see Note 9, Long-term Debt, to our accompanying consolidated financial statements.

•

As discussed in more detail in Note 9, Long-term Debt, to our accompanying consolidated financial statements, we entered into an interest rate swap in March 2006 to effectively convert a portion of our variable rate debt to a fixed interest rate. During 2006, we recorded a net loss of approximately $10.5 million related to the mark-to-market adjustments, quarterly settlements, and accrued interest recorded for the swap.

•

We recorded the cumulative effect of an accounting change in both 2003 and 2002. Effective January 1, 2003, we adopted the provisions of FASB Statement No. 143, Accounting for Asset Retirement Obligations, and recorded a related charge of approximately $2.5 million. On January 1, 2002, we recorded a charge of approximately $48.2 million as a result of the adoption of FASB Statement No. 142, Goodwill and Other Intangible Assets, related to an impairment of goodwill of our diagnostic segment.

	For the year ended December 31,
	2006	2005	2004	2003	2002
	(In Millions, Except Per Share Data)
Income Statement Data:
Net operating revenues	$ 3,000.1	$ 3,117.0	$ 3,409.7	$ 3,544.9	$ 3,519.7

Salaries and benefits	1,398.4	1,386.1	1,571.8	1,550.1	1,586.8
Professional and medical director fees	72.0	71.6	72.3	80.5	87.8
Supplies	287.8	294.2	318.2	304.1	300.5
Other operating expenses	457.2	540.4	428.2	539.6	619.2
Provision for doubtful accounts	119.3	94.3	109.6	120.0	112.0
Depreciation and amortization	148.2	162.6	172.2	180.4	205.7
Occupancy costs	141.4	113.1	152.4	180.0	181.4
Recovery of amounts due from Richard M. Scrushy	(47.8)	–	–	–	–
Recovery of amounts due from Meadowbrook	–	(37.9)	–	–	–
(Gain) loss on disposal of assets	(4.5)	16.6	10.2	(13.7)	82.6
Impairment of goodwill	–	–	–	335.6	–
Impairment of intangible assets	0.2	–	1.0	–	15.3
Impairment of long-lived assets	15.0	43.3	35.5	132.1	47.1
Government, class action, and related settlements expense	38.8	215.0	–	170.9	347.7
Professional fees—accounting, tax, and legal	163.6	169.8	206.2	70.6	–
Loss (gain) on early extinguishment of debt	365.6	–	–	(2.3)	(9.6)
Interest expense and amortization of debt discounts and fees	335.1	337.5	301.4	264.2	250.3
Interest income	(15.7)	(17.1)	(13.1)	(7.2)	(6.6)
Loss (gain) on sale of investments	1.9	0.1	(4.0)	15.8	(11.8)
Loss on interest rate swap	10.5	–	–	–	–
Equity in net income of nonconsolidated affiliates	(21.3)	(29.4)	(9.9)	(15.8)	(15.3)
Minority interests in earnings of consolidated affiliates	92.3	97.2	95.0	97.0	90.5
	3,558.0	3,457.4	3,447.0	4,001.9	3,883.6

Loss from continuing operations before income tax expense	(557.9)	(340.4)	(37.3)	(457.0)	(363.9)
Provision for income tax expense (benefit)	41.1	38.4	11.9	(28.4)	20.3
Loss from discontinued operations, net of income tax expense	(26.0)	(67.2)	(125.3)	(3.5)	(34.4)
Cumulative effect of accounting change, net of income tax expense	–	–	–	(2.5)	(48.2)
Net loss	(625.0)	(446.0)	(174.5)	(434.6)	(466.8)
Convertible perpetual preferred dividends	(22.2)	–	–	–	–
Net loss available to common shareholders	$ (647.2)	$ (446.0)	$ (174.5)	$ (434.6)	$ (466.8)

Weighted average common shares outstanding:
Basic	79.5	79.3	79.3	79.2	79.1
Diluted*	90.3	79.6	79.5	81.2	81.7

Basic and diluted loss per common share:
Loss from continuing operations available to common shareholders	$ (7.81)	$ (4.77)	$ (0.62)	$ (5.41)	$ (4.86)
Loss from discontinued operations, net of tax	(0.33)	(0.85)	(1.58)	(0.05)	(0.43)
Cumulative effect of accounting change, net of tax	–	–	–	(0.03)	(0.61)
Net loss per share available to common shareholders	$ (8.14)	$ (5.62)	$ (2.20)	$ (5.49)	$ (5.90)

* Per share diluted amounts are treated the same as basic per share amounts because the effect of including potentially dilutive shares is antidilutive.

	As of December 31,
	2006	2005	2004	2003	2002
	(In Millions)
Balance Sheet Data:
Cash and marketable securities	$ 40.6	$ 198.3	$ 450.1	$ 462.0	$ 85.8

Restricted cash	99.6	237.4	235.4	170.3	24.0

Restricted marketable securities	71.1	–	–	–	–

Working capital (deficit)	(381.3)	(235.5)	(3.8)	167.0	(490.5)

Total assets	3,359.6	3,592.2	4,083.0	4,209.7	4,536.7

Long-term debt, including current portion	3,402.3	3,401.9	3,493.9	3,499.7	3,480.8

Convertible perpetual preferred stock	387.4	–	–	–	–

Shareholders' deficit	(2,184.6)	(1,540.7)	(1,109.4)	(963.8)	(528.8)

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is designed to provide the reader with information that will assist in understanding our consolidated financial statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles affect our consolidated financial statements. The discussion also provides information about the financial results of the various segments of our business to provide a better understanding of how those segments and their results affect the financial condition and results of operations of HealthSouth as a whole.

Forward Looking Information

This MD&A should be read in conjunction with our accompanying consolidated financial statements and related notes. See “Cautionary Statement Regarding Forward-Looking Statements” on page ii of this report for a description of important factors that could cause actual results to differ from expected results. See also Item 1A, Risk Factors.

Executive Overview

As described in detail in Item 1, Business, 2006 was a year in which we put many of the legal, financial and operational “rocks in the road” behind us and began implementing our plan to reposition the company as a “pure play” provider of post-acute health care services for the future, with an immediate focus on rehabilitative health care. In 2006:

•

We announced our intent to seek strategic alternatives for our surgery centers and outpatient divisions, along with our diagnostic division (previously designated as “non-core”), and to use the net proceeds from any disposition of those divisions to pay down debt. On January 29, 2007, we announced that we had entered into a Stock Purchase Agreement with Select Medical Corporation (“Select Medical”) to sell our outpatient division, marking the first step in our repositioning and deleveraging plan.

•

We prepaid substantially all of our previously existing indebtedness with proceeds from a series of recapitalization transactions and replaced it with approximately $3.0 billion of new long-term debt, which we believe will produce enhanced operational flexibility, reduced refinancing risk, and an improved credit profile. See this Item, “Liquidity and Capital Resources,” and Note 9, Long-term Debt, to our accompanying consolidated financial statements.

•

We received final court approval of our settlement with the lead plaintiffs in the federal securities class actions and the derivative litigation, as well as with our insurance carriers, concluding the last of the major litigation pending against us. See Note 24, Securities Litigation Settlement, to our accompanying consolidated financial statements.

•

We reached a non-prosecution agreement with the United States Department of Justice (the “DOJ”) with respect to the accounting fraud committed by members of our former management.

•

We remediated numerous internal control deficiencies.

•

We recruited the remaining members of our senior management team, including senior vice presidents for development, payor contracting, and supply chain management.

•

Our common stock was relisted on the New York Stock Exchange.

We continue to face operational challenges, but we believe our accomplishments in 2006 have positioned us to capitalize on our core competencies and move forward with implementing our repositioning and deleveraging plan.

Our Business

Our business is currently divided into four primary operating divisions—inpatient, surgery centers, outpatient, and diagnostic—and a fifth division that manages certain other revenue producing activities and corporate functions. These five divisions correspond to our five reporting segments discussed later in this Item and throughout this report.

Inpatient. Our inpatient division, which represented 58% of 2006 Net operating revenues and 79% of 2006 operating earnings from our four primary operating divisions, provides treatment at (as of December 31, 2006) 92 freestanding inpatient rehabilitation facilities (“IRFs”), 10 long-term acute care hospitals (“LTCHs”), and 81 outpatient facilities located within or near our IRFs. In addition to the facilities in which we have an ownership interest, our inpatient division operated 11 inpatient rehabilitation units, 3 outpatient facilities, and 2 gamma knife radiosurgery centers through management contracts as of December 31, 2006. This division continues to be the market leader in inpatient rehabilitation services in terms of revenues, number of IRFs, and patients treated. Between 2005 and 2006, Net operating revenues and operating earnings declined slightly due to the continued phase-in of the 75% Rule. We anticipate increasing volumes in many of our inpatient facilities through the first three quarters of 2007 because most of our IRFs currently operate at, and have maintained since 2006, the 60% minimum qualifying patient mix threshold under the 75% Rule. In the fourth quarter of 2007, as most of our IRFs approach a new cost reporting year, we anticipate declining volumes as we work to achieve compliance with the 65% threshold. We are actively engaged with other health care providers to modify this rule and ensure Medicare recipients receive appropriate care in an appropriate environment.

Surgery Centers. Our surgery centers division, which is our second largest division in terms of Net operating revenues, operates (as of December 31, 2006) 144 freestanding ambulatory surgery centers (“ASCs”) and 3 surgical hospitals. In 2006, our focus within our surgery centers division was on resyndication activities in existing centers, portfolio rationalization, and operational improvements. During the latter part of 2006, we began to see margin expansion through improved revenues and expense management initiatives, including the standardization of non-physician preference items. However, this margin expansion was negatively impacted by an increase in minority interests from our resyndication efforts. We believe, however, that our resyndication efforts helped stabilize our portfolio of surgery centers and will add value to the division over time. Our surgery centers division’s Net operating revenues declined slightly from 2005 to 2006, resulting primarily from certain consolidated affiliates that became equity method affiliates as a result of changes in ownership and facility closures that did not qualify as discontinued operations. However, operating earnings increased over that same period as a result of improved cost control, better pricing, and increased volumes at certain facilities. We expect this division to benefit as outpatient procedures continue to migrate to the more efficient ASC environment. However, potential benefits from industry growth may be offset by physician partners who are demanding a higher ownership interest in our partnerships, thereby lowering our share of partnership earnings.

Outpatient. Our outpatient division currently provides outpatient therapy services (as of December 31, 2006) at 582 facilities. This division’s performance declined between 2005 and 2006 due primarily to continued volume declines resulting from competition from physician-owned physical therapy sites and Medicare therapy caps, as discussed below. On January 29, 2007, we announced that we have entered into a definitive agreement with Select Medical, a privately owned operator of specialty hospital and outpatient rehabilitation facilities, to sell our outpatient division for approximately $245 million in cash, subject to certain adjustments. The closing is anticipated to occur on or before April 30, 2007, and is subject to customary closing conditions, including regulatory approval. See Note 3, Subsequent Event—Divestiture, to our accompanying consolidated financial statements for additional information regarding this disposition.

Diagnostic. Our diagnostic division operates (as of December 31, 2006) 61 diagnostic imaging centers. This division has struggled over the past several years due to poor margins for the diagnostic market in general, strong competition from physician-owned diagnostic equipment, increased pricing pressure from payors, and the age of equipment in our installed base. Competition in 2006 remained strong as diagnostic equipment manufacturers continued to lower prices and offer special financing to encourage physicians to purchase equipment through their own practices, resulting in a decline in the number of procedures performed at our diagnostic centers. In 2006, the division completed the implementation of a new enterprise software platform that provides enhanced administrative, clinical, and revenue cycle functionality. We believe the implementation of this software will assist the segment in increasing referral volume, as well as improve the segment’s collection activities at a reduced cost. While these actions should result in improvement in the segment’s operating results going forward, our operating performance during 2006 was negatively impacted by the nonrecurring costs associated with these changes.

We believe the aging of the U.S. population, changes in technology, and the continuing growth in health care spending will increase demand for the types of services we provide. First, many of the health conditions associated with aging—like stroke and heart attacks, neurological disorders, and diseases and injuries to the muscles, bones, and joints—will increase the demand for ambulatory surgery and rehabilitative services. Second, pressure from payors to provide efficient, high-quality health care services is forcing many procedures traditionally performed in acute care hospitals out of the acute care environment. We believe these market factors align with our strengths and our planned focus on post-acute care services.

Key Challenges

Although our business is continuing to generate substantial revenues, and market factors appear to favor our outpatient and post-acute care business model, we still have several immediate internal and external challenges to overcome before we can realize significant improvements in our business, including:

•

Divestitures. Our attempt to seek strategic alternatives for three of our four operating divisions necessarily creates new operational challenges for us such as retaining key employees, combating uncertainty in our workforce, and continuing to provide necessary corporate support and other services to each division during this transition period. These issues will pose challenges for us in 2007.

•

Single-Payor Exposure. Medicare comprises approximately 47% of our consolidated Net operating revenues and approximately 70% of our largest division’s revenues. Consequently, single-payor exposure presents a serious risk. In particular, as discussed in Item 1, Business, “Sources of Revenues,” changes to the 75% Rule and pricing pressure have combined to create a very challenging operating environment for our inpatient division. The volume volatility created by the 75% Rule has had a significantly negative impact on our inpatient division’s Net operating revenues in 2006. Thus far, we have been able to partially mitigate the impact of the 75% Rule on our inpatient division’s operating earnings by implementing the mitigation strategies discussed in Item 1, Business, “Inpatient Division.” However, the combination of volume volatility created by the 75% Rule and pricing pressure resulting from changes to the prospective payment system applicable to IRFs (“IRF-PPS”) reduced our operating earnings in 2006. Because we receive a significant percentage of our revenues from our inpatient division, and because our inpatient division receives a significant percentage of its revenues from Medicare, our inability to achieve continued compliance with or continue to mitigate the negative effects of the 75% Rule could have a material adverse effect on our business, financial position, results of operations, and cash flows.

•

Leverage. Although we have completed a series of recapitalization transactions that have eliminated significant uncertainty regarding our capital structure and have improved our financial position, we remain highly leveraged. Our high leverage increases our cost of capital and decreases our net income. If we are unable to divest our surgery centers, outpatient, and diagnostic divisions as planned through a spin-off, sale, or other transaction, and use the net proceeds from those transactions to pay down debt, we may be unable to take advantage of growth and consolidation opportunities in the inpatient rehabilitation industry.

•

Settlement Costs. We have significant cash obligations we must meet in the near future as a result of settlements with various federal agencies. Specifically, we will pay the remaining balance of our $325 million settlement to the United States in quarterly installments ending in the fourth quarter of 2007 to satisfy our obligations under a settlement described in Note 22, Medicare Program Settlement, to our accompanying consolidated financial statements. Furthermore, we will pay the remaining balance of our $100 million settlement to the United States Securities and Exchange Commission (the “SEC”) in four installments ending in the fourth quarter of 2007, as described in Note 23, SEC Settlement, to our accompanying consolidated financial statements. Our final payments in 2007 due under these settlement agreements are $86.7 million for the Medicare Program Settlement and $50.0 million for the SEC Settlement.

Consolidated Results of Operations

HealthSouth is the largest provider of rehabilitative health care and ambulatory surgery services in the United States, with 978 facilities and approximately 33,000 full- and part-time employees. We provide these services through a national network of inpatient and outpatient rehabilitation facilities, outpatient surgery centers, diagnostic centers, and other health care facilities.

During 2006, 2005, and 2004, we derived consolidated Net operating revenues from the following payor sources:

	For the year ended December 31,
	2006	•	2005	•	2004
Medicare	47.4%		47.7%		48.0%
Medicaid	2.3%		2.4%		2.5%
Workers' compensation	6.8%		7.5%		8.1%
Managed care and other discount plans	34.8%		33.3%		31.5%
Other third-party payors	4.7%		4.9%		4.9%
Patients	1.4%		1.8%		2.9%
Other income	2.6%		2.4%		2.1%
Total	100.0%		100.0%		100.0%

We provide our patient care services through four primary operating divisions and certain other services through a fifth division. These five divisions correspond to our five reporting segments discussed in this Item, “Segment Results of Operations,” and throughout this report.

When reading our consolidated statements of operations, it is important to recognize the following items included within our results of operations:

•

Stock-Based Compensation. During 2006, stock-based compensation increased by approximately $12.1 million due to our adoption of Financial Accounting Standards Board (“FASB”) Statement No. 123(R), Share-Based Payment, on January 1, 2006. These increased costs are included in Salaries and benefits in our 2006 consolidated statement of operations.

•

Restructuring charges. In our continuing efforts to streamline operations, we closed underperforming facilities or consolidated similar facilities within the same market in 2006, 2005, and 2004. As a result of these facility closures or consolidations, we recorded certain restructuring charges approximating $5.1 million, $8.1 million, and $4.0 million in 2006, 2005, and 2004, respectively, for one-time termination benefits and contract termination costs under the guidance in FASB Statement No. 146, Accounting for Costs Associated with Exit or Disposal Activities. The majority of these costs represent contract termination costs associated with leased facilities and are included in Occupancy costs in our consolidated statements of operations. See Note 11, Restructuring Charges, to our accompanying consolidated financial statements for additional information.

•

Changes in ownership of certain inpatient rehabilitation facilities. As discussed in this Item, “Segment Results of Operations – Inpatient,” and Note 25, Contingencies and Other Commitments, to our accompanying consolidated financial statements, we were involved in a legal dispute regarding the lease of Braintree Rehabilitation Hospital in Braintree, Massachusetts and New England Rehabilitation Hospital in Woburn, Massachusetts. In 2005, a judgment was entered against us that upheld the landlord’s termination of our lease of these two facilities and placed us as the manager, rather than the owner, of these two facilities. Accordingly, our results of operations include only the $4.0 million and $5.4 million management fee we earned for operating these facilities on behalf of the landlord during the nine months ended September 30, 2006 and the year ended December 31, 2005, respectively. In 2004, the results of operations of these two facilities were included in our consolidated statements of operations on a gross basis. Our consolidated Net operating revenues and consolidated operating earnings were negatively impacted by approximately $106.3 million and $3.6 million, respectively, in 2005, as a result of the change in ownership of these two facilities. In September 2006, we completed the transition of these two facilities to the landlord.

The lease associated with the Braintree and Woburn facilities was for a period of ten years with rent obligations of approximately $8.7 million per year, which included additional payments relating to rent payable for a group of nursing home facilities owned by the owner of the Braintree and Woburn facilities that HealthSouth had sold but remained liable for as a guarantor. We accounted for the rent on the Braintree and Woburn facilities as rent expense in our inpatient segment. However, the rent expense paid above the negotiated rent for these facilities was recorded as an obligation of our corporate and other segment. As a result of the lease termination associated with the Braintree and Woburn facilities, our corporate and other segment recorded a $30.5 million net gain on lease termination during 2005. This net gain is included in Occupancy costs in our consolidated statement of operations and represents the difference between the $42 million liability that remained under the lease when the lease was terminated and the remaining liability on the date the judgment was entered against us in 2005.

•

Recovery of amounts due from Meadowbrook. In 2001 and 2002, we reserved approximately $38.0 million related to amounts due from Meadowbrook Healthcare, Inc. (“Meadowbrook”), an entity formed by one of our former chief financial officers, related to net working capital advances made to Meadowbrook in 2001 and 2002. In August 2005, we received a payment of $37.9 million from Meadowbrook. This cash payment is included as Recovery of amounts due from Meadowbrook in our 2005 consolidated statement of operations.

See Note 21, Related Party Transactions, and Note 25, Contingencies and Other Commitments, to our accompanying consolidated financial statements for additional information regarding Meadowbrook.

•

Recovery of amounts due from Richard M. Scrushy. On January 3, 2006, the Alabama Circuit Court in the Tucker action (as defined in Note 25, Contingencies and Other Commitments, to our accompanying consolidated financial statements) granted the plaintiff’s motion for summary judgment against Richard M. Scrushy, our former chairman and chief executive officer, on a claim for restitution of incentive bonuses Mr. Scrushy received for years 1996 through 2002. Including pre-judgment interest, the court’s total award was approximately $48 million. On August 25, 2006, the Alabama Supreme Court affirmed the Circuit Court’s order granting summary judgment against Mr. Scrushy on the unjust enrichment claim, and on October 27, 2006, the Alabama Supreme Court denied Mr. Scrushy’s motion for rehearing. On November 16, 2006, Mr. Scrushy signed an agreement indicating his desire and intent to pay the entire amount owed under the judgment.

Based on the above, we recorded approximately $47.8 million during 2006 as Recovery of amounts due from Richard M. Scrushy, excluding approximately $5.0 million of post-judgment interest recorded as Interest income. As of December 31, 2006, we have an approximate $4.9 million receivable related to this award included in Other current assets in our consolidated balance sheet.

•

Amounts owed to derivative plaintiffs’ attorneys. On December 8, 2006, we entered into an agreement with the derivative plaintiffs’ attorneys to resolve the amounts owed to them as a result of the award given to us under the claim for restitution of incentive bonuses Mr. Scrushy received in previous years and the Securities Litigation Settlement (as defined in Note 24, Securities Litigation Settlement, and as discussed in Note 25, Contingencies and Other Commitments). Under this agreement, we agreed to pay the derivative plaintiffs’ attorneys $32.5 million on an aggregate basis for both claims. We will pay this amount primarily from cash and other properties received from Mr. Scrushy in the above referenced award. As of December 31, 2006, we owed approximately $21.0 million to the derivative plaintiffs’ attorneys, which is included in Other current liabilities in our consolidated balance sheet.

•

Impairments. During 2006, we recorded an impairment charge of approximately $15.2 million to reduce the carrying value of certain long-lived and intangible assets of certain operating facilities to their estimated fair market value. During 2005, we recorded an impairment charge of approximately $43.3 million to reduce the carrying value of long-lived assets to their estimated fair market value. During 2004, we recorded an impairment charge of approximately $36.5 million to reduce the carrying value of property and equipment and amortizable intangibles of certain operating facilities to their estimated fair market value. These charges are discussed in more detail in this Item, “Segment Results of Operations,” and Note 6, Property and Equipment, to our accompanying consolidated financial statements.

•

Government, class action, and related settlements expense. Our Net loss for 2006 includes a $1.0 million charge related to our Employee Retirement Income Security Act of 1974 (“ERISA”) litigation, a $5.7 million charge to settle disputes related to our former Braintree and Woburn facilities, and a $1.9 million charge related to the Goodreau litigation in Government, class action, and related settlements expense. Government, class action, and related settlements expense for 2006 also includes a charge of approximately $47.9 million, a portion of which will not require a cash outflow, related to ongoing settlement negotiations with our subsidiary partnerships related to the restatement of their historical financial statements. Government, class action, and related settlements expense for 2006 also includes a $4.0 million charge related to our agreement with the United States to settle civil allegations brought in federal False Claims Act lawsuits regarding alleged improper billing practices relating to certain orthotic and prosthetic devices. Our Net loss for 2006 also includes a $3.0 million charge in Government, class action, and related settlements expense related to a payment made to the U.S. Postal Inspection Services Consumer Fraud Fund in connection with the execution of the non-prosecution agreement reached with the DOJ. These expenses for 2006 also include charges of approximately $6.5 million for certain settlements and other ongoing settlement negotiations.

In 2005, our Net loss includes a $215.0 million charge, to be paid in the form of common stock and common stock warrants, as Government, class action, and related settlements expense under the proposed settlement with the lead plaintiffs in the federal securities class actions and the derivative litigation, as well as with our insurance carriers,

to settle claims filed against us, certain of our former directors and officers, and certain other parties. In January 2007, the proposed settlement received final court approval, and, based on the value of our common stock and the associated common stock warrants on the date the settlement was approved, we reduced this liability by approximately $31.2 million as of December 31, 2006. This reduction in 2006 is included in Government, class action, and related settlements expense in our consolidated statement of operations. The charge for this settlement will be revised in future periods to reflect additional changes in the fair value of the common stock and warrants until they are issued.

For additional information regarding these settlements, ongoing discussions, and litigation, see Note 24, Securities Litigation Settlement, and Note 25, Contingencies and Other Commitments, to our accompanying consolidated financial statements.

•

Professional fees—accounting, tax, and legal. As noted in this filing, significant changes have occurred at HealthSouth since the financial fraud perpetrated by certain members of our prior management team was uncovered. The steps taken to stabilize our business and operations, provide vital management assistance, and coordinate our legal strategy came at significant financial cost. During 2006, Professional fees—accounting, tax, and legal approximated $163.6 million and related primarily to professional services to support the preparation of our 2005 Form 10-K, professional services to support the preparation of our Form 10-Qs for 2006 (including the preparation of quarterly information for 2005, which had never been presented), tax preparation and consulting fees for various tax projects, and legal fees for continued litigation defense and support matters (including $32.5 million of fees to the derivative plaintiffs’ attorneys to resolve the amount owed to them as a result of the award given to us under the claim for restitution of incentive bonuses Mr. Scrushy received in previous years and the Securities Litigation Settlement) discussed in Note 25, Contingencies and Other Commitments, to our accompanying consolidated financial statements. During 2005, Professional fees—accounting, tax, and legal approximated $169.8 million and related primarily to the preparation of our comprehensive Form 10-K for the years ended December 31, 2003 and 2002, including the restatement of our previously issued 2001 and 2000 consolidated financial statements, as well as professional services to support the preparation of our Form 10-K for the year ended December 31, 2004. During 2004, Professional fees—accounting, tax, and legal approximated $206.2 million and related primarily to professional fees resulting from the steps taken to stabilize our business and operations, provide vital management assistance, and coordinate our legal strategy as a result of the fraud mentioned above. These fees in 2004 also included professional services associated with the reconstruction and restatement of our previously issued consolidated financial statements.

•

Loss on early extinguishment of debt. During 2006, we recorded an approximate $365.6 million net loss on early extinguishment of debt due to the completion of a private offering of senior notes in June 2006 and a series of recapitalization transactions during the first quarter of 2006.

On June 14, 2006, we completed a private offering of $1.0 billion aggregate principal amount of senior notes, the proceeds of which, together with cash on hand, were used to repay all borrowings outstanding under our Interim Loan Agreement (as defined in Note 9, Long-term Debt, to our accompanying consolidated financial statements). As a result of this transaction, our net loss on early extinguishment of debt for 2006 includes a charge of approximately $4.1 million. On March 10, 2006, we completed the last of a series of recapitalization transactions enabling us to prepay substantially all of our prior indebtedness and replace it with approximately $3 billion of new long-term debt. As a result of these transactions, our net loss on early extinguishment of debt for 2006 includes a charge of approximately $361.1 million. The remainder of our net loss on early extinguishment of debt for 2006 was due to the repayment of certain bonds payable during the second quarter of 2006.

For more information regarding these transactions, see Note 9, Long-term Debt, to our accompanying consolidated financial statements.

•

Loss on interest rate swap. As discussed in more detail in Note 9, Long-term Debt, to our accompanying consolidated financial statements, we entered into an interest rate swap in March 2006 to effectively convert a portion of our variable rate debt to a fixed interest rate. During 2006, we recorded a net loss of approximately $10.5 million related to the mark-to-market adjustments, quarterly settlements, and accrued interest recorded for the swap. During 2006, we made approximately $0.6 million in net cash settlement payments to our counterparties.

•

Reclassifications. Certain previously reported financial results have been reclassified to conform to the current year presentation. Such reclassifications relate to facilities we closed or sold in 2006 that qualify under FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, to be reported as discontinued operations. We also reclassified rent associated with leased facilities, including common area

maintenance and similar charges, from Other operating expenses into Occupancy costs in our consolidated statements of operations.

From 2004 through 2006, our consolidated results of operations were as follows:

	For the year ended December 31,				Percentage Change
					2006 vs.	2005 vs.
	2006		2005	2004	2005	2004
		(In Millions)
Net operating revenues	$3,000.1		$3,117.0	$3,409.7	(3.8%)	(8.6%)
Operating expenses:
Salaries and benefits	1,398.4		1,386.1	1,571.8	0.9%	(11.8%)
Professional and medical director fees	72.0		71.6	72.3	0.6%	(1.0%)
Supplies	287.8		294.2	318.2	(2.2%)	(7.5%)
Other operating expenses	457.2		540.4	428.2	(15.4%)	26.2%
Provision for doubtful accounts	119.3		94.3	109.6	26.5%	(14.0%)
Depreciation and amortization	148.2		162.6	172.2	(8.9%)	(5.6%)
Occupancy costs	141.4		113.1	152.4	25.0%	(25.8%)
Recovery of amounts due from
Richard M. Scrushy	(47.8)		–	–	N/A	N/A
Recovery of amounts due from
Meadowbrook	–		(37.9)	–	(100.0%)	N/A
(Gain) loss on disposal of assets	(4.5)		16.6	10.2	(127.1%)	62.7%
Impairment of intangible and
long-lived assets	15.2		43.3	36.5	(64.9%)	18.6%
Government, class action, and related
settlements expense	38.8		215.0	–	(82.0%)	N/A
Professional fees—accounting,
tax, and legal	163.6		169.8	206.2	(3.7%)	(17.7%)
Total operating expenses	2,789.6		3,069.1	3,077.6	(9.1%)	(0.3%)

Loss on early extinguishment of debt	365.6		–	–	N/A	N/A
Interest expense and amortization of
debt discounts and fees	335.1		337.5	301.4	(0.7%)	12.0%
Interest income	(15.7)		(17.1)	(13.1)	(8.2%)	30.5%
Loss (gain) on sale of investments	1.9		0.1	(4.0)	1,800.0%	(102.5%)
Loss on interest rate swap	10.5		–	–	N/A	N/A
Equity in net income of nonconsolidated
Affiliates	(21.3)		(29.4)	(9.9)	(27.6%)	197.0%
Minority interests in earnings of
consolidated affiliates	92.3		97.2	95.0	(5.0%)	2.3%
Loss from continuing operations before
income tax expense	(557.9)		(340.4)	(37.3)	63.9%	812.6%
Provision for income tax expense	41.1		38.4	11.9	7.0%	222.7%
Loss from continuing operations	(599.0)		(378.8)	(49.2)	58.1%	669.9%
Loss from discontinued operations,
net of income tax expense	(26.0)		(67.2)	(125.3)	(61.3%)	(46.4%)
Net loss	(625.0)		(446.0)	(174.5)	40.1%	155.6%

Operating Expenses as a % of Net Operating Revenues

	For the year ended December 31,
	2006	2005	2004
Salaries and benefits	46.6%	44.5%	46.1%
Professional and medical director fees	2.4%	2.3%	2.1%
Supplies	9.6%	9.4%	9.3%
Other operating expenses	15.2%	17.3%	12.6%
Provision for doubtful accounts	4.0%	3.0%	3.2%
Depreciation and amortization	4.9%	5.2%	5.1%
Occupancy costs	4.7%	3.6%	4.5%
Recovery of amounts due from Richard M. Scrushy	(1.6%)	0.0%	0.0%
Recovery of amounts due from Meadowbrook	0.0%	(1.2%)	0.0%
(Gain) loss on disposal of assets	(0.1%)	0.5%	0.3%
Impairment of intangible assets and long-lived assets	0.5%	1.4%	1.1%
Government, class action, and related settlements
expense	1.3%	6.9%	0.0%
Professional fees—accounting, tax, and legal	5.5%	5.4%	6.0%
Total operating expenses as a % of net operating
revenues	93.0%	98.5%	90.3%

Net Operating Revenues

Our consolidated Net operating revenues consist primarily of revenues derived from patient care services provided by our four primary operating segments. Net operating revenues also include other revenues generated from management and administrative fees, trainer income, operation of the conference center located on our corporate campus, and other non-patient care services.

Volume decreases in our operating segments was the primary factor that contributed to the declining Net operating revenues in 2006. Our inpatient segment reduced its “non-compliant” case volumes (i.e., cases involving diagnoses not included on the list of 13 qualifying medical conditions under the 75% Rule) due to the continued phase-in of the 75% Rule. Surgery centers that became equity method investments rather than consolidated entities in 2006 and 2005 as a result of ownership changes, facility closures that did not qualify as discontinued operations, and market competition negatively impacted volumes in our surgery centers segment. Competition from physician-owned similar sites, the nationwide physical therapist shortage, closure of underperforming facilities that did not qualify as discontinued operations, and the annual per beneficiary limitations on Medicare outpatient therapy services that became effective January 1, 2006 continued to negatively impact volumes in our outpatient segment. Competition from physician-owned diagnostic equipment and the closure of underperforming facilities that did not qualify as discontinued operations continued to negatively impact volumes in our diagnostic segment.

Our inpatient segment was also negatively impacted by certain regulatory pricing changes implemented as of October 1, 2005. We were able to partially mitigate the negative impact of these pricing changes due to an increase in patient acuity that resulted from our efforts to comply with the 75% Rule and compliant case growth. In our surgery centers and outpatient segments, we were able to partially offset the negative impact of declining volumes through improvement in net revenue per case or visit.

Volume decreases in each of our operating segments and the change in ownership of certain facilities within our inpatient segment were the primary factors that contributed to the declining Net operating revenues in 2005. Our inpatient segment experienced volume decreases due to the continued phase-in of the 75% Rule. Volumes in our surgery centers segment declined due to the limited resyndication activities that took place from 2003 through the first half of 2005. Competition from physician-owned similar sites continued to negatively impact volumes in our outpatient and diagnostic segments. The change in ownership of our Braintree and Woburn inpatient rehabilitation facilities contributed approximately $106.3 million to the decline in Net operating revenues in 2005.

The change in Net operating revenues by segment is discussed in more detail in this Item, “Segment Results of Operations.”

Salaries and Benefits

Salaries and benefits represent the most significant cost to us and include all amounts paid to full- and part-time employees, including all related costs of benefits provided to employees. It also includes amounts paid for contract labor.

During 2006, Salaries and benefits grew as a percent of Net operating revenues due to various factors. First, shortages of therapists and nurses have caused us to raise salaries to retain current employees and to increase our utilization of higher-priced contract labor to properly care for our patients. Second, as a result of our efforts to comply with the 75% Rule, we are increasingly treating higher acuity (i.e., sicker) patients, which has resulted in increased labor costs in our inpatient segment. These increased labor costs resulting from higher salaries, greater reliance on contract labor, and higher case-mix acuity, along with routine inflationary increases, are occurring in a flat or declining unit pricing environment. In addition, as noted earlier in this Item, stock-based compensation increased by approximately $12.1 million during 2006 due to our adoption of FASB Statement No. 123(R) on January 1, 2006. As a result of these factors, Salaries and benefits increased as a percent of Net operating revenues in 2006.

In 2005, our segments demonstrated their ability to manage employee-related costs during periods of declining volumes, with Salaries and benefits decreasing as a percent of Net operating revenues. Approximately $66.1 million of the decrease from 2004 to 2005 was due to the change in ownership of our Braintree and Woburn inpatient rehabilitation facilities. In addition, our inpatient and surgery centers segments reduced their full-time equivalents as their volumes declined throughout the year, and our outpatient segment reduced its full-time equivalents through the closure of underperforming facilities that did not qualify as discontinued operations.

Professional and Medical Director Fees

Professional and medical director fees include professional consulting fees associated with operational initiatives, such as strategic planning and process standardization of billing and collecting procedures. These fees also include fees paid under contracts with radiologists, medical directors, and other clinical professionals at our centers for services provided.

Professional and medical director fees have increased as a percent of Net operating revenues since 2004 due to fees paid to consultants for various projects. In 2006, the increase was due primarily to increased professional fees in our inpatient segment due to fees paid to a consulting firm for process standardization of billing and collection procedures and assistance with technology enhancements with installation of upgraded patient accounting systems. In 2005, these fees increased due to fees paid to consulting firms for corporate strategy and other projects.

Supplies

Supplies include costs associated with supplies used while providing patient care at our facilities. Examples include pharmaceuticals, implants, bandages, food, and other similar items. In each year, our inpatient and surgery centers segments comprise over 95% of our Supplies expense.

The decrease in Supplies expense in each year was due to the decline in volumes in our inpatient and surgery centers segments in each year. In 2005, the decrease also resulted from the change in ownership of our Braintree and Woburn facilities in our inpatient segment, as discussed above.

Supplies expense is increasing as a percent of Net operating revenues due primarily to the reasons discussed above under “Salaries and Benefits.” As a result of our efforts to comply with the 75% Rule in our inpatient segment, we are increasingly treating higher acuity patients, which has resulted in increased supply costs for the segment. These increased supply costs are occurring in a flat or declining unit pricing environment. As a result, our Supplies expense is increasing as a percent of Net operating revenues.

Other Operating Expenses

Other operating expenses include costs associated with managing and maintaining our operating facilities as well as the general and administrative costs related to the operation of our corporate office. These expenses include such items as repairs and maintenance, utilities, contract services, professional fees, and insurance.

Other operating expenses were lower in 2006 compared to 2005 due to declining volumes in our inpatient segment, facility closures that did not qualify as discontinued operations throughout 2005 in our outpatient segment, decreased professional fees associated with projects related to our compliance with the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”) and other similar services from accounting and consulting firms, and a reduction in self-insurance expenses driven by current claims history, exit from the acute care business, and fewer full-time equivalents. Other operating expenses in 2006 also include a gain related to the repayment of a formerly fully reserved note receivable from Source Medical and a gain related to the elimination of our former guarantee of a promissory note for Source Medical. See Note 8, Investment in and Advances to Nonconsolidated Affiliates, to our accompanying consolidated financial statements for additional information related to Source Medical.

The increase in Other operating expenses from 2004 to 2005 primarily related to increased professional fees associated with projects related to our compliance with Sarbanes-Oxley, strategic consulting, and other similar services from accounting

and consulting firms offset by an approximate $17.2 million decrease in Other operating expenses due to the change in ownership of our Braintree and Woburn facilities within our inpatient segment.

Provision for Doubtful Accounts

During 2006, our Provision for doubtful accounts increased as a percent of Net operating revenues due primarily to current collection activities and payment trends in our inpatient and diagnostic segments. The installation of new collections software within our inpatient segment and the implementation of a new enterprise software platform within our diagnostic segment negatively impacted collection activity during 2006, but we believe this distraction and negative impact will be temporary. During 2005, our Provision for doubtful accounts decreased as a percent of Net operating revenues due primarily to the outsourcing of collection activities in our diagnostic segment.

Depreciation and Amortization

The decrease in Depreciation and amortization during each year was due to impairment charges that decreased the depreciable base of our assets and an increase in fully depreciated assets within our operating segments.

Occupancy Costs

Occupancy costs include amounts paid for rent associated with leased facilities, including common area maintenance and similar charges. The change in Occupancy costs in each year is a result of the $30.5 million net gain on lease termination associated with the Braintree and Woburn facilities that was recorded in 2005, as discussed above,

(Gain) Loss on Disposal of Assets

The net gain on disposal of assets in 2006 primarily resulted from various facility sales and asset disposals in our surgery centers segment. In 2005, the net loss on disposal of assets primarily resulted from asset disposals at inpatient rehabilitation facilities in Florida and Arizona. The net loss on disposal of assets in 2004 primarily resulted from facility closures in our outpatient and diagnostic segments.

Interest Expense and Amortization of Debt Discounts and Fees

The decrease in Interest expense and amortization of debt discounts and fees for 2006 was the result of decreased amortization charges offset by increased interest expense.

Amortization of debt discounts and fees was approximately $20.7 million less during 2006 compared to 2005. Amortization in 2005 includes the amortization of consent fees associated with debt that was extinguished as part of the 2006 recapitalization transactions discussed in Note 9, Long-term Debt, to our accompanying consolidated financial statements. Amortization in 2005 also includes the amortization related to our 6.875% Senior Notes that were repaid in June 2005.

Due to the recapitalization transactions and the private offering of senior notes described in Note 9, Long-term Debt, to our accompanying consolidated financial statements, our average interest rate for 2006 approximated 9.5% compared to an average interest rate of 8.7% for 2005. This increase in average interest rates contributed to an approximate $24.7 million of increased interest expense during 2006. The impact of the increase in average interest rates was offset by lower average borrowings, which decreased interest expense by approximately $6.4 million during 2006.

Interest expense and amortization of debt discounts and fees increased from 2004 to 2005 primarily due to the amortization of consent fees and bond issue costs associated with the 2004 consent solicitation and 2005 refinancings. During 2004, consent fees paid for all of our debt issues approximated $80.2 million, and we paid approximately $11.1 million in debt issuance costs. We amortize these fees to interest expense over the remaining term of the debt. In 2004, we amortized these costs for approximately six months, as compared to a full year of amortization in 2005. We also paid approximately $17.9 million in debt issuance costs in 2005. These costs are also amortized to interest expense over the life of the related debt. As a result of the above amortization charges, interest expense increased by approximately $17.2 million in 2005. An additional $11.2 million of interest expense was recorded in 2005 related to payments under our Medicare Program Settlement (see Note 22, Medicare Program Settlement, to our accompanying consolidated financial statements). The remaining $7.7 million of the increase in interest expense was primarily the result of higher average borrowing rates in 2005. In 2005, our average borrowing rate was 8.7% compared to an average rate of 8.3% in 2004.

For more information regarding the above changes in debt, see Note 9, Long-term Debt, to our accompanying consolidated financial statements.

Interest Income

From 2005 to 2006, Interest income decreased due to lower average cash balances throughout 2006 and the repayment of a note receivable from Source Medical, as discussed in this Item, “Segment Results of Operations – Corporate and Other.” As discussed earlier in this Item, Interest income in 2006 includes $5.0 million of post-judgment interest recorded on our recovery of incentive bonuses from Mr. Scrushy.

From 2004 to 2005, Interest income increased due to higher average cash balances and our investments in U.S. government and agency securities (see Note 5, Cash and Marketable Securities, to our accompanying consolidated financial statements).

Loss (Gain) on Sale of Investments

In each year presented in our consolidated statements of operations, the net gain or loss on sale of investments was primarily comprised of numerous individually insignificant transactions related to less than 100% owned entities, including investments in nonconsolidated affiliates. In 2005 and 2004, the net gain on sale of investments was solely comprised of these types of transactions. In 2006, the net gain or loss on sale of investments also includes the realized gains and losses recorded on the sale of marketable securities. For additional information regarding our marketable securities, please see Note 5, Cash and Marketable Securities, to our accompanying consolidated financial statements.

Equity in Net Income of Nonconsolidated Affiliates

Our Equity in net income of nonconsolidated affiliates decreased from 2005 to 2006 due primarily to the year over year volume declines experienced by certain surgery centers accounted for under the equity method. Equity in net income of nonconsolidated affiliates increased from 2004 to 2005 due primarily to the change in five surgery centers from consolidated entities to equity method investments during 2005. Our 2005 Equity in net income of nonconsolidated affiliates includes the recovery of approximately $6.9 million of equity losses during the first quarter of 2005.

Minority Interests in Earnings of Consolidated Affiliates

Minority interests in earnings of consolidated affiliates represent the share of net income or loss allocated to members or partners in our consolidated affiliates. As of December 31, 2006, 2005, and 2004, the number and average external ownership interest in these consolidated affiliates were as follows:

	As of December 31,
	2006	2005	2004
Active consolidated affiliates	251	257	276
Average external ownership interest	34.0%	33.6%	32.1%

During the years ended December 31, 2006, 2005, and 2004, approximately 97.1%, 95.2%, and 94.8% of our Minority interest in earnings of consolidated affiliates resulted from consolidated affiliates in our inpatient and surgery centers segments. Fluctuations in Minority interests in earnings of consolidated affiliates are primarily driven by trends experienced in our surgery centers segment, and, to a lesser extent, trends in our inpatient segment.

Loss from Continuing Operations Before Income Tax Expense

Our Loss from continuing operations before income tax expense (“pre-tax loss from continuing operations”) for 2006 included a $365.6 million Loss on early extinguishment of debt related primarily to our private offering of senior notes in June 2006 and a series of recapitalization transactions in the first quarter of 2006 and a $31.2 million reduction in our liability associated with our securities litigation settlement. Our pre-tax loss from continuing operations for 2005 included a $215.0 million settlement associated with our securities litigation. If we exclude these items, our pre-tax loss from continuing operations for 2006 was $223.5 million, and our pre-tax loss from continuing operations for 2005 was $125.4 million, resulting in an increase of $98.1 million year over year. As discussed earlier in this Item, we recorded a $30.5 million net gain on lease termination during 2005. The remainder of the difference relates primarily to the items discussed above.

As noted above, our pre-tax loss from continuing operations in 2005 includes a charge of $215.0 million associated with the settlement of our securities litigation. It also includes a $37.9 million recovery of bad debt associated with Meadowbrook, as discussed earlier in this Item. If these two items are excluded, our pre-tax loss from continuing operations becomes $163.3 million, which represents a $126.0 million increase over our 2004 pre-tax loss from continuing operations. This increase is primarily due to a decrease in Net operating revenues as a result of declining volumes, higher other operating expenses associated with professional service fees, and increased interest expense, as discussed above.

Provision for Income Tax Expense

We recognized a $41.1 million income tax expense from continuing operations in 2006 as compared to a $38.4 million income tax expense from continuing operations in 2005. Deferred tax expense increased by approximately $16.2 million to reflect the change in noncurrent deferred taxes associated with certain indefinite-lived assets. Additionally, HealthSouth Corporation and its subsidiaries file separate income tax returns in a number of states, some of which results in current state tax liabilities. A current federal tax expense was also charged in 2006 and 2005 associated with ownership in corporate joint ventures that are not part of our consolidated income tax return. During 2006, interest income with respect to expected income tax refunds resulting from updated prior tax filings, which are still in progress, increased by $3.7 million. Also during 2006, we filed a request for a tax accounting method change which accelerated the amortization of certain indefinite-lived assets. This tax accounting method change gave rise to an additional difference between the book and tax bases of the assets effected and, accordingly, resulted in our recording an additional deferred tax liability and deferred tax expense of approximately $8.3 million related to these indefinite-lived assets during 2006.

We recognized a $38.4 million income tax expense from continuing operations in 2005 as compared to an $11.9 million income tax expense from continuing operations in 2004. Deferred tax expense increased by approximately $22.4 million to reflect the change in noncurrent deferred taxes associated with certain indefinite-lived assets. Additionally, HealthSouth Corporation and its subsidiaries file separate income tax returns in a number of states, some of which results in current state tax liabilities. A current federal tax expense was also charged in 2005 and 2004 associated with ownership in corporate joint ventures that are not part of our consolidated income tax return.

Adjusted Consolidated EBITDA

Management continues to believe Adjusted Consolidated EBITDA under our 2006 Credit Agreement is a measure of operating performance, leverage capacity, our ability to service our debt, and our ability to make capital expenditures.

We use Adjusted Consolidated EBITDA on a consolidated basis as a liquidity measure. We believe this financial measure on a consolidated basis is important in analyzing our liquidity because it is the key component of certain material covenants contained within our 2006 Credit Agreement, which is discussed in more detail in Note 9, Long-term Debt, to our accompanying consolidated financial statements. These covenants are material terms of the 2006 Credit Agreement, and the 2006 Credit Agreement represents a substantial portion of our capitalization. Non-compliance with these financial covenants under our 2006 Credit Agreement—our interest coverage ratio and our leverage ratio—could result in our lenders requiring us to immediately repay all amounts borrowed. In addition, if we cannot satisfy these financial covenants, we would be prohibited under our 2006 Credit Agreement from engaging in certain activities, such as incurring additional indebtedness, making certain payments, and acquiring and disposing of assets. Consequently, Adjusted Consolidated EBITDA is critical to our assessment of our liquidity.

We also use Adjusted Consolidated EBITDA to assess our operating performance. We believe it is meaningful because it provides investors with a measure used by our internal decision makers for evaluating our business. Our internal decision makers believe Adjusted Consolidated EBITDA is a meaningful measure because it represents a view of our recurring operating performance and allows management to readily view operating trends, perform analytical comparisons, and perform benchmarking between segments. Additionally, our management believes the inclusion of professional fees associated with litigation, financial restructuring, government investigations, forensic accounting, creditor advisors, accounting reconstruction, audit and tax work associated with the reconstruction process, and non-ordinary course charges incurred after March 19, 2003 (the date the SEC filed a lawsuit against us and our former chairman and chief executive officer alleging that we historically overstated earnings) and related to our overall corporate restructuring (including matters related to internal controls) distort within EBITDA their ability to efficiently assess and view the core operating trends on a consolidated basis and within segments. We reconcile Adjusted Consolidated EBITDA to Net loss.

In general terms, the definition of Adjusted Consolidated EBITDA, per our 2006 Credit Agreement, allows us to add back to Adjusted Consolidated EBITDA all unusual non-cash items or non-recurring items. These items include, but may not be limited to, (1) expenses associated with government, class action, and related settlements, (2) fees, costs, and expenses related to our recapitalization transactions, (3) any losses from discontinued operations and closed locations, (4) charges in respect of professional fees for reconstruction and restatement of financial statements, including fees paid to outside professional firms for matters related to internal controls and legal fees for continued litigation defense and support matters discussed in Note 25, Contingencies and Other Commitments, to our accompanying consolidated financial statements, and (5) compensation expenses recorded in accordance with FASB Statement No. 123(R).

However, Adjusted Consolidated EBITDA is not a measure of financial performance under generally accepted accounting principles in the United States of America (“GAAP”), and the items excluded from Adjusted Consolidated EBITDA are significant components in understanding and assessing financial performance. Therefore, Adjusted

Consolidated EBITDA should not be considered a substitute for Net loss or cash flows from operating, investing, or financing activities. Because Adjusted Consolidated EBITDA is not a measurement determined in accordance with GAAP and is thus susceptible to varying calculations, Adjusted Consolidated EBITDA, as presented, may not be comparable to other similarly titled measures of other companies. Revenues and expenses are measured in accordance with the policies and procedures described in Note 1, Summary of Significant Accounting Policies, to our accompanying consolidated financial statements.

As noted earlier in this Item, certain previously reported financial results have been reclassified to conform to the current year presentation. Such reclassifications relate to facilities we closed or sold in 2006 that qualify under FASB Statement No. 144 to be reported as discontinued operations. These reclassifications may also impact previously reported Adjusted Consolidated EBITDA amounts. Furthermore, Adjusted Consolidated EBITDA, as presented below, was computed using the definition of Adjusted Consolidated EBITDA contained within our 2006 Credit Agreement. The definition of Adjusted Consolidated EBITDA within our 2006 Credit Agreement differs from the definition contained within the documents that governed our prior indebtedness. The facilities that were classified as discontinued operations in 2006 and changes made to our Adjusted Consolidated EBITDA calculation based on our 2006 Credit Agreement impacted Adjusted Consolidated EBITDA in 2005 and 2004 reported in our 2005 Form 10-K by approximately ($1.5) million and ($1.2) million, respectively.

Under our 2006 Credit Agreement, our Adjusted Consolidated EBITDA for the years ended December 31, 2006, 2005, and 2004 was as follows:

Reconciliation of Net Loss to Adjusted Consolidated EBITDA

	For the Year Ended December 31,
	2006	2005	2004
	(In Millions)
Net loss	$ (625.0)	$ (446.0)	$ (174.5)
Loss from discontinued operations	26.0	67.2	125.3
Provision for income tax expense	41.1	38.4	11.9
Loss on interest rate swap	10.5	–	–
Loss on sale of marketable securities	0.3	–	–
Interest income	(15.7)	(17.1)	(13.1)
Interest expense and amortization of debt
discounts and fees	335.1	337.5	301.4
Loss on early extinguishment of debt	365.6	–	–
Professional fees—accounting, tax, and legal	163.6	169.8	206.2
Government, class action, and related
settlements expense	38.8	215.0	–
Impairment charges	15.2	43.3	36.5
Net non-cash loss on disposal of assets	6.4	16.6	10.2
Depreciation and amortization	148.2	162.6	172.2
Compensation expense under FASB Statement
No. 123(R)	15.5	–	–
Sarbanes-Oxley related costs	4.8	32.2	17.5
Restructuring activities under FASB Statement
No. 146	5.1	8.1	4.0
Adjusted Consolidated EBITDA	$ 535.5	$ 627.6	$ 697.6

Reconciliation of Adjusted Consolidated EBITDA to Net Cash (Used in) Provided by Operating Activities

	For the year ended December 31,
	2006	2005	2004
	(In Millions)
Adjusted Consolidated EBITDA	$ 535.5	$ 627.6	$ 697.6
Compensation expense under FASB Statement No. 123(R)	(15.5)	–	–
Restructuring charges under FASB Statement No. 146	(5.1)	(8.1)	(4.0)
Sarbanes-Oxley related costs	(4.8)	(32.2)	(17.5)
Provision for doubtful accounts	119.3	94.3	109.6
Net gain on disposal of assets	(10.9)	-	–
Professional fees—accounting, tax, and legal	(163.6)	(169.8)	(206.2)
Interest expense and amortization of debt discounts and fees	(335.1)	(337.5)	(301.4)
Interest income	15.7	17.1	13.1
Loss (gain) on sale of investments, excluding marketable
securities	1.6	0.1	(4.0)
Equity in net income of nonconsolidated affiliates	(21.3)	(29.4)	(9.9)
Minority interest in earnings of consolidated affiliates	92.3	97.2	95.0
Amortization of debt issue costs, debt discounts, and fees	18.3	39.0	21.8
Amortization of restricted stock	3.4	2.0	0.6
Distributions from nonconsolidated affiliates	14.1	22.5	17.0
Stock-based compensation	12.1	–	(0.5)
Current portion of income tax provision	(7.9)	(21.4)	(17.3)
Change in assets and liabilities, net of acquisitions	(215.4)	(101.8)	35.6
Cash portion of 2006 government, class action, and related
settlements expense	(14.9)	–	–
Change in government, class action, and related settlements
liability	(118.4)	(165.4)	(7.0)
Other operating cash used in discontinued operations	(19.6)	(36.5)	(31.9)
Other	(0.2)	(0.6)	0.2
Net Cash (Used In) Provided by Operating Activities	$ (120.4)	$ (2.9)	$ 390.8

Adjusted Consolidated EBITDA decreased in 2006 due to the declining volumes experienced by each of our operating segments and the increase to our Provision for doubtful accounts, as discussed above. Adjusted Consolidated EBITDA for 2006 includes the recovery of incentive bonuses from Mr. Scrushy, as discussed above. Adjusted Consolidated EBITDA for 2005 includes the net gain on lease termination associated with our former Braintree and Woburn facilities and the Meadowbrook recovery, as discussed above. Adjusted Consolidated EBITDA decreased from 2004 to 2005 due to the declining volumes experienced by each of our operating segments and increased operating expenses associated with professional service fees, as discussed above.

Impact of Inflation

The health care industry is labor intensive. Wages and other expenses increase during periods of inflation and when labor shortages occur in the marketplace. In addition, suppliers pass along rising costs to us in the form of higher prices. Although we cannot predict our ability to cover future cost increases, we believe that through adherence to cost containment policies and labor and supply management, the effects of inflation on future operating results should be manageable.

However, we have little or no ability to pass on these increased costs associated with providing services to Medicare and Medicaid patients due to federal and state laws that establish fixed reimbursement rates. In addition, as a result of increasing regulatory and competitive pressures and a continuing industry-wide shift of patients to managed care plans, our ability to maintain margins through price increases to non-Medicare patients is limited.

Relationships and Transactions with Related Parties

Historically, HealthSouth and its prior management and board of directors engaged in numerous relationships and transactions with related parties. However, since 2003, we have eliminated our interests in and relationships with related parties. Related party transactions are not material to our ongoing operations, and therefore, will not be presented as a separate discussion within this Item. When these relationships or transactions were significant to our results of operations

during the years ended December 31, 2006, 2005, or 2004, information regarding the relationship or transaction(s) have been included within this Item.

For information regarding our relationships and transactions with related parties, see Note 8, Investments in and Advances to Nonconsolidated Affiliates, and Note 21, Related Party Transactions, to our accompanying consolidated financial statements.

Segment Results of Operations

Our internal financial reporting and management structure is focused on the major types of services provided by HealthSouth. We currently provide various patient care services through four operating divisions and certain other services through a fifth division, which correspond to our five reporting business segments: (1) inpatient, (2) surgery centers, (3) outpatient, (4) diagnostic, and (5) corporate and other. For additional information regarding our business segments, including a detailed description of the services we provide and financial data for each segment, please see Item 1, Business, and Note 26, Segment Reporting, to our accompanying consolidated financial statements.

As part of the continued implementation of our strategic plan, management continues to evaluate the role of each segment and the services provided within each segment. Based on this evaluation, in the second quarter of 2006, our management realigned five electro-shock wave lithotripter units from our diagnostic segment to our corporate and other segment, as the services performed by these lithotripter units are not diagnostic services. We also realigned five occupational medicine centers from our corporate and other segment into our outpatient segment, as these centers provide therapy services that are consistent with other services provided by our outpatient segment. Prior periods have been reclassified to conform to this presentation.

Future changes to this organizational structure may result in changes to the reportable segments disclosed.

Inpatient

We are the nation’s largest provider of inpatient rehabilitation services. Our inpatient rehabilitation facilities provide comprehensive services to patients who require intensive institutional rehabilitation care. Patient care is provided by nursing and therapy staff as directed by a physician order. Internal case managers monitor each patient’s progress and provide documentation of patient status, achievement of goals, functional outcomes and efficiency.

Our inpatient segment operates IRFs and LTCHs and provides treatment on both an inpatient and outpatient basis. As of December 31, 2006, our inpatient segment operated 92 freestanding IRFs, 10 LTCHs, and 81 outpatient facilities located within or near our IRFs. In addition to HealthSouth facilities, our inpatient segment manages 11 inpatient rehabilitation units, 3 outpatient facilities, and 2 gamma knife radiosurgery centers through management contracts. Our inpatient facilities are located in 27 states, with a concentration of facilities in Texas, Pennsylvania, Florida, Tennessee, and Alabama. We also have a facility in Puerto Rico.

For the years ended December 31, 2006, 2005, and 2004, our inpatient segment comprised approximately 57.5%, 56.8%, and 58.1%, respectively, of consolidated Net operating revenues. For 2004 through 2006, this segment’s operating results were as follows:

	For the year ended December 31,
	2006	2005	2004
	(Dollars In Millions)
Inpatient
Net operating revenues	$ 1,724.8	$ 1,769.1	$ 1,979.5
Operating expenses*	1,365.3	1,380.4	1,545.8
Operating earnings	$ 359.5	$ 388.7	$ 433.7

Discharges (in thousands)	102.4	105.7	120.0
Outpatient visits (in thousands)	1,435.6	1,616.6	2,153.0

Full time equivalents (actual amounts)	15,780	16,555	19,294
Average length of stay	15.3 days	15.7 days	15.8 days

* Includes divisional overhead, but excludes corporate overhead allocation. See Note 26, Segment Reporting, to our accompanying consolidated financial statements. Includes the effect of Minority interests in earnings of consolidated affiliates and Equity in net income of nonconsolidated affiliates.

During 2006, 2005, and 2004, inpatient’s Net operating revenues were derived from the following payor sources:

	For the year ended December 31,
	2006	2005	2004
Medicare	69.7%	71.2%	71.3%
Medicaid	2.1%	2.4%	2.7%
Workers' compensation	2.5%	2.8%	3.4%
Managed care and other discount plans	18.2%	16.0%	15.2%
Other third-party payors	5.1%	5.1%	5.8%
Patients	0.3%	0.5%	0.0%
Other income	2.1%	2.0%	1.6%
Total	100.0%	100.0%	100.0%

Our inpatient segment’s payor mix is weighted heavily towards Medicare. Our IRFs receive Medicare reimbursements under IRF-PPS. Under IRF-PPS, our IRFs receive fixed payment amounts per discharge based on certain rehabilitation impairment categories established by the Department of Health and Human Services. With IRF-PPS, our facilities retain the difference, if any, between the fixed payment from Medicare and their operating costs. Thus, our facilities are rewarded for being high quality, low cost providers. For additional information regarding Medicare reimbursement, please see the “Sources of Revenues” section of Item 1, Business, of this Form 10-K.

Due to the significance of Medicare payments to our inpatient facilities, the number of patient discharges is a key metric utilized by the segment to monitor and evaluate its performance. The number of outpatient visits is also tracked in order to measure the volume of outpatient activity within the segment. The segment’s primary operating expenses include Salaries and benefits and Supplies. Salaries and benefits represent the most significant cost to the segment and include all amounts paid to full- and part-time employees, including all related costs of benefits provided to employees. It also includes amounts paid for contract labor. Supplies expense includes all costs associated with supplies used while providing patient care. These costs include pharmaceuticals, needles, bandages, food, and other similar items.

Significant Changes in Regulations Governing IRF Reimbursement

As discussed in Item 1, Business, “Sources of Revenues,” changes in regulations governing IRF reimbursement have combined to create a challenging operating environment for our inpatient division. One of these changes occurred on May 7, 2004, when the United States Centers for Medicare and Medicaid Services (“CMS”) issued a final rule stipulating revised criteria for qualifying as an IRF under Medicare. This rule, known as the “75% Rule,” has created significant volume volatility in our inpatient division. We also continue to experience Medicare payment updates that have led to reduced unit pricing applicable to our IRFs.

The 75% Rule, as revised, generally provides that to be considered an IRF, and to receive reimbursement for services under the IRF-PPS methodology, 75% of a facility’s total patient population must require treatment for at least one of 13 designated medical conditions. As a practical matter, this means that to maintain our current level of revenue from our IRFs we will need to reduce the number of non-qualifying patients treated at our IRFs and replace them with qualifying patients, establish other sources of revenues at our IRFs, or both. The Deficit Reduction Omnibus Reconciliation Act of 2005, signed by President Bush on February 8, 2006 as Public Law 109-171, extended the phase-in schedule for the 75% Rule by one year and delayed implementation of the 65% compliance threshold until July 1, 2007.

On August 1, 2006, CMS released a final rule that updates the IRF-PPS for the federal fiscal year 2007 (covering discharges occurring on or after October 1, 2006 and on or before September 30, 2007). Although the final rule includes an overall market basket update of 3.3%, this market basket update is offset by a 2.6% reduction in standard payment rates. We estimate that the final rule will modestly increase our inpatient segment’s net Medicare revenues by approximately $5 million per quarter for federal fiscal year 2007 as compared to federal fiscal year 2006.

combined these changes will decrease our inpatient division’s Net operating revenues by approximately $0.5 million per quarter for calendar year 2007 as compared to calendar year 2006.

The combination of volume volatility created by the 75% Rule and lower unit pricing resulting from IRF-PPS and Physician Fee Schedule changes reduced our Net operating revenues in 2006. Thus far, we have been able to partially mitigate the impact of the 75% Rule on our inpatient division’s operating earnings by implementing the mitigation strategies discussed in Item 1, Business, “Inpatient Division.”

Change in Ownership of Facilities

As noted earlier in this Item, we were involved in a legal dispute regarding the lease of Braintree Rehabilitation Hospital in Braintree, Massachusetts and New England Rehabilitation Hospital in Woburn, Massachusetts. In 2005, a judgment was entered against us that upheld the landlord’s termination of our lease of these two facilities and placed us as the manager, rather than the owner, of these two facilities. Accordingly, our inpatient segment’s 2006 and 2005 results of operations include only the $4.0 million and $5.4 million management fee we earned for operating these facilities on behalf of the landlord during the nine months ended September 30, 2006 and the year ended December 31, 2005, respectively. In 2004, the results of operations of these two inpatient facilities were included in our inpatient segment’s results of operations on a gross basis. This segment’s Net operating revenues and operating earnings were negatively impacted by approximately $106.3 million and $3.6 million, respectively, in 2005 as a result of the change in ownership of these two facilities. In September 2006, we completed the transition of these two facilities to the landlord.

For additional information, see Note 25, Contingencies and Other Commitments, to our accompanying consolidated financial statements.

Other Notable Events of 2006

During 2006, the following other notable events occurred within our inpatient segment:

•

In April 2006, HealthSouth Ridge Lake Hospital, our 40-bed long term acute care hospital in Sarasota, Florida, received its license approval.

•

In June 2006, we opened HealthSouth Rehabilitation Hospital of Petersburg, a 40-bed rehabilitation facility in Petersburg, Virginia.

•

We broke ground on a new 40-bed IRF in Fredericksburg, Virginia.

•

In October 2006, we closed a transaction to sell Cedar Court Rehabilitation Hospital in Melbourne, Australia, and related assets (“Cedar Court”), to Epworth Foundation and ING Management Limited. The Cedar Court assets included a 74-bed rehabilitation hospital and outpatient center, a stand alone rehabilitation facility at the Oasis Leisure Center, and an occupational medicine rehabilitation therapy business. Cedar Court is included in discontinued operations in our accompanying consolidated financial statements.

•

In August 2006, we completed a business consolidation agreement with TMC HealthCare in Tucson, Arizona to provide rehabilitation services. Under the agreement, HealthSouth Rehabilitation Institute of Tucson now provides rehabilitation and therapy services historically provided at El Dorado Hospital in Tucson and select TMC outpatient therapies.

•

The lease associated with Central Georgia Rehabilitation Hospital in Macon, Georgia expired on September 30, 2006 and was not extended. This facility included 58 rehabilitation beds and an outpatient rehabilitation satellite facility.

•

In November 2006, we reached an agreement to close a competitor’s 48-bed IRF in Wichita Falls (Texas) and consolidated its patients to our existing 63-bed IRF.

None of the above events or transactions, individually or in the aggregate, is expected to have a material impact on the results of operations, financial position, or cash flows of our inpatient segment or to HealthSouth on a consolidated basis.

Net Operating Revenues

Our inpatient segment’s Net operating revenues for 2006 were 2.5% lower than 2005. The decrease was primarily due to a reduction of non-compliant case volumes due to the continued phase-in of the 75% Rule. In 2005, our IRFs were required to operate at a 50% minimum qualifying patient mix threshold under the 75% Rule. In 2006, the minimum qualifying patient mix threshold increased to 60% causing further reductions of non-compliant case volumes. Our inpatient segment also experienced a decrease in outpatient volumes due to the decrease in our inpatient volumes, changes in patient-program mix, shortages in therapy staffing, and continued competition from physicians offering physical therapy services within their own offices. Certain regulatory pricing changes implemented as of October 1, 2005 also negatively impacted Net

operating revenues for the first three quarters of 2006. However, we were able to mitigate a portion of these unit price reductions by achieving an approximate 6.0% compliant case growth during 2006 compared to 2005. This compliant case growth also increased the acuity of our patients year over year.

Our inpatient segment’s Net operating revenues declined by 10.6% from 2004 to 2005. The change in ownership of our Braintree and Woburn facilities contributed to approximately $106.3 million, or 50.5%, of the decline. The remainder of the decrease in Net operating revenues was due to declining volumes. Excluding the impact of the change in ownership of the Braintree and Woburn facilities, discharges were approximately 7.5% lower than 2004 due to the continued phase-in of the 75% Rule and the majority of our facilities moving to the 50% phase. Our inpatient segment also experienced a 10.5% decrease in outpatient volumes (excluding the impact of the change in ownership) due to continued competition from physicians offering physical therapy within their own offices, as well as the decrease in our inpatient volumes. Due to this continued competition from physicians and resulting decrease in outpatient visits, we evaluated our outpatient satellites sites and closed 22 sites during 2005. Declining volumes were offset slightly by favorable pricing from Medicare during the first nine months of 2005 due to the Medicare market basket adjustment of 3.1% that was received from Medicare in October 2004 for their fiscal year 2005. However, the IRF-PPS Final Rule, as discussed above, negatively impacted our fourth quarter earnings by approximately $10.0 million. Human capital constraints in key clinical positions (therapists and nurses) at some of our hospitals also negatively impacted volumes as facilities managed volumes within these constraints.

Operating Expenses

Salaries and Benefits

Salaries and benefits comprised over 59% of inpatient’s operating expenses in each year.

Salaries and benefits grew from 46.6% of Net operating revenues in 2005 to 48.3% of Net operating revenues in 2006. This increase resulted from increased labor costs during a year of declining unit pricing within our inpatient segment. As noted earlier in this Item, shortages of therapists and nurses have caused us to raise salaries to retain current employees and to increase our utilization of higher-priced contract labor to properly care for our patients. In addition, as a result of our efforts to comply with the 75% Rule, we are increasingly treating higher acuity patients, which has resulted in increased labor costs in our inpatient segment.

Salaries and benefits decreased by $116.2 million, or 12.3%, from 2004 to 2005 primarily as a result of the change in facility ownership discussed above and fewer full-time equivalents due to the decline in volumes. The change in ownership of our Braintree and Woburn facilities contributed approximately $66.1 million, or 56.9%, to the decrease. Full-time equivalents, excluding the employees of the Braintree and Woburn facilities, declined by 8.7% from 2004 to 2005 which more than offset the increase in average Salaries and benefits per full-time equivalent due to merit and market rate adjustments. However, excluding the impact of the change in facility ownership discussed above, Salaries and benefits as a

percent of Net operating revenues remained consistent from 2004 to 2005, approximating 46.7% and 46.6%, respectively. The segment’s ability to maintain this ratio while experiencing a 5.6% decline in Net operating revenues (excluding the impact of the change in facility ownership) is evidence of our facilities’ ability to adjust staffing levels to accommodate changing volumes.

Supplies

Supplies expense decreased by $1.4 million, or 1.3%, from 2005 to 2006 due to the decline in volumes. From 2004 to 2005, Supplies expense decreased by $13.3 million, or 11.2%. Approximately $6.2 million of the decrease was due to the change in ownership of our Braintree and Woburn facilities. The remainder was due to the decline in volumes during 2005.

As noted earlier in this Item, as a result of our efforts to comply with the 75% Rule, our inpatient segment is increasingly treating higher acuity patients, which has resulted in increased supply costs for the segment. These increased supply costs are occurring in a flat or declining unit pricing environment. As a result, our inpatient segment’s Supplies expense is increasing as a percent of Net operating revenues.

Provision for Doubtful Accounts

Our Provision for doubtful accounts increased from 2.3% of Net operating revenues in 2005 to 2.9% of Net operating revenues in 2006. The installation and implementation of new collections software and processes within our inpatient segment negatively impacted collection activity during 2006, but we believe this distraction and negative impact will be temporary. From 2004 to 2005, the segment’s Provision for doubtful accounts as a percent of Net operating revenues remained flat, approximating 2.3% in each year.

All Other Operating Expenses

From 2005 to 2006, all other operating expenses decreased by 7.7% due primarily to the reduction in volumes discussed above. All other operating expenses for 2006 included approximately $8.9 million in fees paid to a consulting firm for process standardization of billing and collection procedures and assistance with technology enhancements with installation of upgraded patient accounting systems. We do not expect to incur similar fees in 2007. All other operating expenses for 2006 also included a $0.3 million impairment charge related to long-lived assets at a facility experiencing declining cash flows from operations. We determined the fair value of the impaired long-lived assets based on the assets’ estimated fair value using valuation techniques that included discounted future cash flows and third-party appraisals. During 2006, all other operating expenses decreased from 23.1% of Net operating revenues in 2005 to 21.9% of Net operating revenues due primarily to decreased insurance costs during 2006 based on current claims history.

From 2004 to 2005, all other operating expenses decreased by 7.1% due to the change in facility ownership and the reduction in volumes discussed above. However, all other operating expenses increased from 22.3% of Net operating revenues in 2004 to 23.1% of Net operating revenues in 2005 due primarily to a $1.3 million impairment charge recorded as a result of continued negative cash flows experienced by one of our facilities in Texas. We determined the fair value of the impaired long-lived assets based on the assets’ estimated fair value using valuation techniques that included discounted future cash flows and third-party appraisals.

Operating Earnings

Operating earnings of our inpatient segment decreased during 2006 due primarily to continued volume decline, as discussed above, as well as increased labor costs without a proportionate increase in pricing. In addition, operating earnings of our inpatient segment were negatively impacted by fees paid to a consulting firm for process standardization and technology assistance (as discussed above), which also resulted in an increase in our inpatient segment’s Provision for doubtful accounts based on current collection activities and payment trends. However, as noted above, we believe this distraction and negative impact to our Provision for doubtful accounts will be temporary.

Approximately $3.6 million of the decrease in operating earnings from 2004 to 2005 was due to the change in ownership of our Braintree and Woburn facilities. The remainder was due to the declining volumes experienced by the segment and the reimbursement challenges presented by the 75% Rule.

Surgery Centers

We operate one of the largest networks of ASCs in the United States. As of December 31, 2006, we provided these services through the operation of our network of 144 freestanding ASCs and 3 surgical hospitals in 35 states, with a concentration of centers in California, Texas, Florida, North Carolina, and Alabama.

Our ASCs provide the facilities and medical support staff necessary for physicians to perform nonemergency surgical procedures. For 2004 through 2006, this segment’s operating results were as follows:

	For the year ended December 31,
	2006	2005	2004
	(Dollars In Millions)
Surgery Centers
Net operating revenues	$ 737.0	$ 755.5	$ 794.3
Operating expenses*	643.7	670.2	706.0
Operating earnings	$ 93.3	$ 85.3	$ 88.3

Cases (in thousands)	572.4	607.1	684.1

Full time equivalents (actual amounts)	3,942	4,302	4,442

During the years ended December 31, 2006, 2005, and 2004, our surgery centers segment derived its Net operating revenues from the following payor sources:

	For the year ended December 31,
	2006	2005	2004
Medicare	18.4%	18.1%	17.9%
Medicaid	3.3%	3.2%	2.7%
Workers' compensation	9.6%	10.6%	10.8%
Managed care and other discount plans	59.9%	58.3%	55.7%
Other third-party payors	3.2%	3.5%	0.1%
Patients	4.3%	5.0%	11.2%
Other income	1.3%	1.3%	1.6%
Total	100.0%	100.0%	100.0%

Our commercial revenues, which are included in “Other third-party payors” in the above chart, increased by approximately $25 million from 2004 to 2005. We believe this increase is the result of an increase in out-of-network cases that yield higher net patient revenue per case. The number of plastic surgery cases performed by our centers decreased by approximately 7% from 2004 to 2005. As a result, net patient revenues from cases where the patient has primary financial responsibility decreased from 2004 to 2005.

The number of cases performed by our ASCs is a key metric utilized by the segment to regularly evaluate its performance. The segment’s primary operating expenses include Salaries and benefits and Supplies. Salaries and benefits represent the most significant costs to the segment and include all amounts paid to full- and part-time employees, as well as all related costs of benefits provided to employees. It also includes amounts paid for contract labor. Supplies expense includes all costs associated with medical supplies used while providing patient care at our ASCs. Such costs include sterile disposables, pharmaceuticals, implants, and other similar items.

Like most other ASCs, the majority of our centers are owned in partnership with surgeons and other physicians who perform procedures at the centers. As existing physician partners retire or change geographic location, it is important that the surgery centers segment periodically provide other physicians with opportunities to purchase ownership interests in our ASCs. Our ability to resyndicate our partnerships is a key success factor for our surgery centers segment.

In 2006, our focus within our surgery centers segment was on resyndication activities in existing centers, portfolio rationalization, and operational improvements. During the latter part of 2006, we began to see margin expansion through improved revenues and labor and supply cost management initiatives, including the standardization of non-physician preference items. However, this margin expansion was negatively impacted by an increase in minority interests from our resyndication efforts. We believe, however, that our resyndication efforts helped stabilize our portfolio of surgery centers and will add value to the segment over time.

Changes in the Reimbursement Environment for ASCs

Our surgery centers segment faces a changing reimbursement environment. For example, the Deficit Reduction Act of 2005 caps payments for ASC procedures in 2007 to the lesser of the ASC or hospital outpatient prospective payment system (“OPPS”) payment rate. In addition, on August 8, 2006, CMS issued a proposed rule that would substantially change Medicare reimbursement for ASC procedures. The proposed rule would revise ASC payment rates to be based on 221 Ambulatory Payment Classifications currently used to categorize procedures under OPPS and would tentatively set calendar year 2008 ASC payment rates at 62% of applicable OPPS payment rates subject to a phase in period whereby payments during the first year would equal a blend of the existing and proposed rates. Beginning in 2010, the ASC conversion factor would be updated by the consumer price index for urban consumers. The proposed rule would also expand the list of ASC approved procedures beginning in 2008. CMS proposes to phase in the new payment system over two years.

On November 1, 2006, CMS released changes to the ASC approved procedure list and ASC payment rates, effective January 1, 2007. Twenty-one procedures are being added to the ASC approved procedure list. Payments for 275 procedures will be capped at the OPPS rate. We estimate that the 2007 final rule will decrease our surgery centers division’s Net operating revenues by approximately $1.4 million in 2007. This final rule, which also includes 2007 OPPS payment rates, does not cover changes to the ASC payment system that will take effect in 2008. If the final rule relating to the 2008 ASC payment system changes results in downward adjustment to ASC reimbursement rates or limits the expansion of covered surgical procedures, it could have a material adverse effect on our business, financial position, results of operations, and cash flows.

Net Operating Revenues

As a result of our resyndication activities, certain surgery centers may become equity method investments rather than consolidated entities as a result of changes in control of the applicable centers. These types of changes will decrease Net operating revenues when the change in control occurs. During 2006, two surgery centers became equity method investments rather than consolidated entities. During 2005, five surgery centers became equity method investments rather than consolidated entities. The timing of these changes in each year effect the extent of the impact to Net operating revenues in each year.

Approximately $16.1 million of the decrease in Net operating revenues from 2005 to 2006 is due to surgery centers that became equity method investments rather than consolidated entities during these periods. An additional $9.2 million of the decrease is due to six facility closures that did not qualify as discontinued operations. During 2006, Net operating revenues were also negatively impacted by continued market competition and physician turnover, but these volume declines were offset by favorable pricing.

Declining volumes was the primary contributor to the decrease in Net operating revenues from 2004 to 2005. Although the majority of this decrease is due to the limited resyndication activities that took place from 2003 through the first half of 2005, approximately $25.6 million of the decrease is due to the change of five surgery centers that became equity method investments rather than consolidated entities during 2005. The Net operating revenues lost through volume declines were partially offset by a shift in case mix to ophthalmology cases which generate higher average net revenue per case. Net operating revenues in 2005 were also negatively impacted by a decrease in rental income associated with subleases that were terminated during the year.

Operating Expenses

Salaries and Benefits

In each year, Salaries and benefits represent approximately 37% of our surgery centers segment’s operating expenses.

Salaries and benefits decreased from 33.0% of Net operating revenues in 2005 to 32.6% of Net operating revenues in 2006. This decrease was due to a reduction in full-time equivalents that primarily resulted from facilities that became equity method investments rather than consolidated entities and facility closures and a reduction in workers’ compensation premiums (before the impact of minority interest) due to lower headcount, recent claims history, and updated actuarial calculations.

Salaries and benefits decreased by 2.8% from 2004 to 2005 due primarily to a reduction in full-time equivalents year over year due to the decline in the number of cases performed by our surgery centers and the segment’s focus to improve operational performance and productivity. However, efforts to reduce full-time equivalents were not made quickly enough. Therefore, declining case volumes coupled with annual merit increases and market adjustments increased Salaries and benefits from 32.3% of Net operating revenues in 2004 to 33.0% of Net operating revenues in 2005.

Supplies

Supplies expense represents approximately 26% of our surgery centers segment’s operating expenses in each year, making it important for our ASCs to appropriately manage and monitor these costs. Supply chain operations is a focus of management to improve product standardization, compliance with those standards, and consolidating market share with vendors to maximize savings opportunities. Supplies expense approximated 23.2%, 23.2%, and 23.1% of Net operating revenues in 2006, 2005, and 2004, respectively.

Provision for Doubtful Accounts

Our surgery centers segment’s Provision for doubtful accounts consistently remained between 1.7% and 2.0% of Net operating revenues in each year.

All Other Operating Expenses

From 2005 to 2006, all other operating expenses decreased by approximately 6.4%. This decrease is primarily due to the change of surgery centers from consolidated entities to equity method investments during 2006 and 2005. All other operating expenses in 2006 also include a net gain on disposal of assets of approximately $9.8 million (compared to a net loss of $1.1 million in 2005) related to various facility sales and asset disposals that occurred during the year. All other operating expenses also decreased in 2006 due to a decrease in impairment charges, year over year, as discussed below.

From 2004 to 2005, all other operating expenses decreased by approximately 8.0%. This decrease is primarily due to the change of five surgery centers from consolidated entities to equity method investments during 2005. These changes favorably impacted both Minority interest in earnings of consolidated affiliates and Equity in net income of nonconsolidated affiliates. In addition, all other operating expenses decreased due to the closure and/or sale of underperforming facilities in 2005 that did not qualify as discontinued operations. All other operating expenses in 2005 also include the recovery of equity losses from nonconsolidated affiliates.

We recorded impairment charges of $2.4 million, $3.9 million, and $2.0 million in 2006, 2005, and 2004, respectively. Facility closings and facilities experiencing negative cash flows from operations resulted in the impairment charges in each year. We determined the fair value of the impaired long-lived assets based on the assets’ estimated fair value using valuation techniques that included discounted cash flows and third-party appraisals.

Operating Earnings

The increase in 2006 operating earnings primarily related to the net gain on disposal of assets recorded during the year, as discussed above. The decrease in operating earnings from 2004 to 2005 was due to the volume declines discussed above.

Outpatient

We are one of the largest operators of free standing outpatient rehabilitation facilities in the United States. As of December 31, 2006, we provided outpatient rehabilitative health care services through 582 HealthSouth facilities. We have locations in 35 states and the District of Columbia, with a concentration of centers in Florida, Texas, New Jersey, and Missouri.

Our outpatient rehabilitation facilities are staffed by physical therapists, occupational therapists, and other clinicians and support personnel, depending on the services provided at a particular location, and we are open at hours designed to accommodate the needs of the patient population being served and the local demand for services. Our outpatient centers offer a range of rehabilitative health care services, including physical therapy and occupational therapy, with a particular focus on orthopedic, sports-related, work-related, hand and spine injuries, and various neurological/neuromuscular conditions.

On January 29, 2007, we announced that we have entered into a definitive agreement with Select Medical to sell our outpatient division for approximately $245 million in cash, subject to certain adjustments. The closing of this transaction is anticipated to occur on or before April 30, 2007, and is subject to customary closing conditions, including regulatory approval. As a result of the disposition of our outpatient division, we expect to record an approximate $120 million to $155 million pre-tax gain on disposal in the first half of 2007. See Note 3, Subsequent Event—Divestiture, to our accompanying consolidated financial statements for additional information regarding this disposition.

For 2004 through 2006, this segment’s operating results were as follows:

	For the year ended December 31,
	2006	2005	2004
	(Dollars In Millions)
Outpatient
Net operating revenues	$ 326.6	$ 371.1	$ 431.1
Operating expenses*	299.9	339.4	392.3
Operating earnings	$ 26.7	$ 31.7	$ 38.8

Visits (in thousands)	3,183.3	3,779.5	4,345.5

Full time equivalents (actual amounts)	3,131	3,815	4,568

For the years ended December 31, 2006, 2005, and 2004, outpatient’s Net operating revenues were derived from the following payor sources:

	For the year ended December 31,
	2006	2005	2004
Medicare	12.8%	14.4%	12.6%
Medicaid	0.8%	0.8%	0.6%
Workers' compensation	23.1%	23.2%	24.7%
Managed care and other discount plans	53.0%	50.4%	49.9%
Other third-party payors	5.7%	5.9%	6.6%
Patients	0.5%	0.9%	1.2%
Other income	4.1%	4.4%	4.4%
Total	100.0%	100.0%	100.0%

The number of visits patients make to our centers is a key metric utilized by the segment to regularly evaluate its performance. Outpatient’s Net operating revenues include revenues from patient visits, as well as revenues generated from trainers and management contracts. Outpatient has contracts with schools, municipalities, and other parties around the country to provide physical therapists and/or athletic trainers for various events. Outpatient also receives management and administrative fees for facilities it manages, but does not own. Trainer income, management fees, and administrative fees comprise the majority of the segment’s other income.

The segment’s most significant operating expense is Salaries and benefits, which includes all amounts paid to full- and part-time employees at our centers, as well as all related costs of benefits provided to employees. Due to the nature of the services provided by our outpatient centers, Supplies expense does not represent a significant portion of the segment’s operating expenses, unlike our other business segments.

Our outpatient segment participates in a slower growing, lower margin business than our other operating segments. Due to regulatory changes, physicians that once referred business to us are now treating patients at their own facilities. Due to the relatively low barriers to entry associated with an outpatient facility, our outpatient segment continues to face increased competition from physician-owned physical therapy sites. The segment is also facing an industry-wide shortage of physical therapists. To combat the shortage, our outpatient segment implemented key incentive plans to help recruit and retain therapists. These incentive plans have begun to reduce therapist turnover rates and have increased the segment’s overall clinical productivity.

In 2006, our facility rationalization and marketing initiatives within our outpatient segment began to improve the segment’s operating results. However, while our current exposure to competition from physician-owned physical therapy sites is less than it was in 2005 as a result of our initiatives to diversify our referral sources, we continued to be negatively impacted by continued competition from physician-owned physical therapy sites in 2006. We were also negatively impacted by the annual per-beneficiary limitations on Medicare outpatient therapy services.

Changes in the Reimbursement Environment for Outpatient Services

Our outpatient segment faces a changing reimbursement environment. The Balanced Budget Act of 1997 changed the reimbursement methodology for Medicare Part B therapy services from cost based to fee schedule payments. It also established two types of annual per-beneficiary limitations on outpatient therapy services provided outside of a hospital outpatient setting: (1) a $1,500 cap for all outpatient therapy services and speech language pathology services; and (2) a $1,500 cap for all outpatient occupational therapy services, as adjusted for inflation (per beneficiary per year caps are set at $1,740 for calendar year 2006 and $1,780 for calendar year 2007). These therapy caps are subject to certain exceptions relating to medically necessary services for calendar year 2006 and 2007. These therapy caps have had a negative impact on our Net operating revenues.

On November 1, 2006, CMS issued a final rule that will update the payment methodology under the Physician Fee Schedule beginning January 1, 2007. Specifically, the rule would update the work RVUs based on the five-year review required under statute, implement a new payment methodology for practice expense relative value units and apply a negative budget neutrality adjustment to the work relative value units. These changes, combined with a 5% reduction to the payment conversion factor under the Physician Fee Schedule, will result in lower reimbursement to us for outpatient services.

combined changes will decrease our outpatient division’s Net operating revenues by approximately $0.5 million per quarter for calendar year 2007 as compared to calendar year 2006.

Net Operating Revenues

From 2004 to 2006, patient visits to our outpatient facilities decreased by over 1.1 million visits. This decreased volume negatively impacted Net operating revenues by approximately $56.0 million and $53.7 million in 2006 and 2005, respectively. Management attributes the volume decline in each year to continued competition from physician-owned physical therapy sites, the nationwide physical therapist shortage, and closures of underperforming facilities that did not qualify as discontinued operations. In addition, the volume decrease from 2005 to 2006 is also due to the annual per-beneficiary limitations on Medicare outpatient therapy services that became effective on January 1, 2006.

During 2006, our outpatient segment was able to offset the negative revenue impact of declining volumes by achieving higher net patient revenue per visit due to its examination and elimination of managed care contracts with low reimbursement rates, an increase in manual therapy services, and the closure of underperforming facilities that did not qualify as discontinued operations.

During 2006 and 2005, non-patient revenues of our outpatient segment decreased by $2.7 million and $2.8 million, respectively, due to facility closures and contract terminations during each year.

Operating Expenses

Salaries and Benefits

Salaries and benefits represent over 61% of outpatient’s operating expenses in each year.

In 2006 and 2005, Salaries and benefits decreased by $24.7 million, or 11.6% and $28.5 million, or 11.8%, respectively, due to the closure of facilities that did not qualify as discontinued operations and a reduction in non-clinical full-time equivalents. The resulting decrease in full-time equivalents decreased Salaries and benefits by approximately $38.2 million and $39.7 million in 2006 and 2005, respectively. Decreased costs associated with fewer full-time equivalents were offset by increasing costs associated with employee benefits, contract labor, and incentives to recruit and retain physical therapists.

Provision for Doubtful Accounts

From 2004 to 2006, the Provision for doubtful accounts of our outpatient segment consistently remained between 2.0% and 4.5% of Net operating revenues.

All Other Operating Expenses

All other operating expenses decreased by approximately 16.1% from 2005 to 2006. This decrease was due to the closure of underperforming facilities that did not qualify as discontinued operations and our outpatient segment’s efforts to control expenses. These expenses in 2006 included approximately $1.0 million of impairment charges. Triggering events related to facility closings and facilities experiencing negative cash flow from operations resulted in the segment recognizing these intangible and long-lived assets impairments. We determined the fair value of the impaired assets at a facility primarily based on the assets’ estimated fair value using valuation techniques that included discounted future cash flows and third-party appraisals.

From 2004 to 2005, all other operating expenses decreased by approximately 10.1% due primarily to the closure of underperforming facilities that did not qualify as discontinued operations and a $2.7 million decrease in impairment charges year over year. Triggering events related to facility closings and facilities experiencing negative cash flow from operations resulted in the segment recognizing a $0.8 million impairment charge to long-lived assets in 2005. We determined the fair value of the impaired assets at a facility primarily based on the assets’ estimated fair value using valuation techniques that included discounted future cash flows and third-party appraisals.

Triggering events related to facility closings and facilities experiencing negative cash flow from operations resulted in the segment recognizing an impairment charge of $3.5 million related to long-lived and intangible assets in 2004. We wrote these assets down to zero, or their estimated fair value, based on expected negative operating cash flows of these facilities in future years.

Operating Earnings

Operating earnings decreased in each year due to declining volumes, as discussed above. Although management reduced total operating expenses in each year, it was not enough to offset the decline in volumes in each year.

Diagnostic

We are one of the largest operators of freestanding diagnostic imaging centers in the United States. As of December 31, 2006, we performed diagnostic services through the operation of our network of 61 diagnostic centers in 19 states and the District of Columbia, with a concentration of centers in Texas, Alabama, Florida, and the Washington D.C. area.

Our diagnostic centers provide outpatient diagnostic imaging services, including MRI, CT, X-ray, ultrasound, mammography, and nuclear medicine services, as well as fluoroscopy. We do not provide all services at all sites, although approximately 80% of our diagnostic centers are multi-modality centers offering multiple types of service. Our outpatient diagnostic procedures are performed by experienced radiological technologists. After the diagnostic procedure is completed, the images are reviewed by radiologists who have contracted with us. These radiologists prepare an interpretation which is then delivered to the referring physician.

Due to the equipment utilized when performing diagnostic services for our patients, our diagnostic segment generally has high capital costs, including costs for maintaining its equipment.

For 2004 to 2006, our diagnostic segment’s operating results were as follows:

For the year ended December 31,
2006	2005	2004