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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 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 28, 2003

Commission File Number: 0-26137

drugstore.com, inc.

(Exact Name of Registrant as Specified in its Charter)

13920 Southeast Eastgate Way, Suite 300 Bellevue, Washington 98005

(425) 372-3200

(Address, including zip code, and telephone number, including area code, of registrant’s Principal Executive Offices)

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, par value $0.0001 per share

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 registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x    No ¨

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. ¨

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x    No ¨

The aggregate market value of Common Stock held by non-affiliates of the registrant was approximately $391,649,235 as of June 29, 2003.

As of March 1, 2004, the number of shares of the registrant’s Common Stock outstanding was 78,269,088.

DOCUMENTS INCORPORATED BY REFERENCE

The information required by Part III of this annual report, to the extent not set forth in this annual report, is incorporated by reference from the registrant’s definitive proxy statement relating to the registrant’s annual meeting of stockholders to be held on June 10, 2003, which definitive proxy statement shall be filed with the Securities and Exchange Commission within 120 days after the end of the fiscal year to which this annual report relates.

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drugstore.com, inc.

FORM 10-K

For the Fiscal Year Ended December 28, 2003

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PART I

This annual report on Form 10-K and the documents incorporated into this annual report by reference contain forward-looking statements based on our expectations, estimates and projections as of the date of this filing. Actual results may differ materially from those expressed in forward-looking statements. See the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Special Note Regarding Forward-Looking Statements” in Part I, Item 7 of this annual report.

Overview

drugstore.com, inc. is a better way to shop for health & beauty and a leading online provider of health, beauty, wellness, personal care, vision and pharmacy solutions. Located on the Internet at www.drugstore.com, the drugstore.com^™ Web store sells health, beauty, wellness, personal care, sexual well-being and pharmacy products. We also sell prestige beauty products through our Web site located at www.beauty.com, which is also accessible through the drugstore.com Web site. As of April 28, 2003, we expanded our offering to include customized nutritional supplement programs sold through our wholly owned subsidiary, Custom Nutrition Services, Inc., or CNS, through Web sites located at www.DrWeilVitaminAdvisor.com, www.zoneprofiler.com and www.pritikin@home.com. In addition, as of December 8, 2003, we began selling contact lenses and other vision products through our wholly owned subsidiary International Vision Direct Corp., or Vision Direct^™, through Web sites located at www.visiondirect.com, www.lensmart.com and www.lensquest.com. As of March 1, 2004, our customer base was approximately five million customers worldwide.

We operate primarily in the United States and Canada, but our products are available to consumers worldwide. We were incorporated in April 1998, commercially launched our Web site at www.drugstore.com on February 24, 1999, and completed our initial public offering in July 1999. Our business has evolved over time into new product offerings and solutions and, after the acquisition of Vision Direct, we now operate and manage our business in four segments: over-the-counter, or OTC (also referred to as non-pharmaceutical), mail-order pharmacy, local pick-up pharmacy, and vision. In fiscal year 2003, OTC accounted for 44% of our consolidated revenues, mail-order pharmacy 20%, local pick-up pharmacy 35% and vision 1%. Additional information regarding our business segments can be found in the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of this annual report and in Note 12 of our consolidated financial statements included in Part IV, Item 15 of this annual report.

As used in this annual report, “drugstore.com,” “we,” “our” and similar terms refer to drugstore.com, inc. and its subsidiaries, unless the context indicates otherwise.

Our Market Opportunity

Overall spending on health and wellness products, beauty aids and prescription drugs in the United States exceeded $273 billion in 2003, according to the National Association of Chain Drug Stores. Within this group, prescription drugs is the largest and fastest growing category, representing nearly $180 billion in sales in 2003. This segment is expected to grow by 11 to 12% annually through 2005. Mail-order pharmacy continues to be one of the fastest-growing segments of the pharmacy industry, as companies and individuals embrace mail-order pharmacies in an attempt to control escalating prescription drug costs. The ophthalmic pharmaceutical segment is growing rapidly as well. Spending in this segment is currently at $5.4 billion and growing by 9% per year. Over 35 million people in the United States wear contact lenses.

The Internet is an important channel for consumers to purchase products and services. The number of Web users in the United States and worldwide has increased significantly since the launch of our Web site in 1999, to over 476 million users at the end of December 2003. Retail e-commerce sales in the United States exceeded $55 billion in 2003 (up 26% from 2002) and are anticipated to grow 19% a year over the next five years, to

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nearly $230 billion by 2008. We believe that the Internet is an ideal medium for selling health, beauty, wellness, personal care, vision and pharmacy products, many of which are lightweight and easy to ship and require replenishment. In addition, consumers seeking these products frequently desire privacy with respect to their purchase. Our business model also offers the convenience of making purchases from the comfort of home or office. The combination of Internet usage trends and the size and Internet compatibility of our product categories create what we believe is a significant opportunity both domestically and abroad.

The drugstore.com Solution

Our business strategy is to offer our customers a superior shopping experience over other solutions in our market category. We attract and retain our customers by emphasizing the following key attributes of our store:

Convenience.    Our user-friendly online store may be reached from wherever the shopper has Internet access, such as the shopper’s home or office. Further advantages offered by our online stores include:

Selection.    We believe that we offer the largest selection of drugstore products available on the Internet. We do not have the shelf display space limitations that bricks-and-mortar stores do. We believe we offer a significantly broader range of products, and also greater depth within each product category, than are available in a traditional chain drugstore. For example, we offer customized nutritional supplement programs recommended by Dr. Andrew Weil in addition to the broad selection of products offered through our nutritional and wellness store, and we are the only online retailer that offers nutrition and wellness products from General Nutrition Companies, Inc., or GNC. Our customers are able to buy drugstore products, prestige brands, salon hair care, and other specialty items with a single check-out.

Information.    We provide a broad array of interactive tools and information on our Web sites to help consumers to make informed purchasing decisions. This information is generated in-house, by third-party expert sources, and through our customer review feature, by customers themselves. Consumers can either access the

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information directly through a number of content features on our Web sites, or get free help from our customer care representatives and experts by contacting them by e-mail or by telephone at 1-800-DRUGSTORE, or 1-800-VISIONDIRECT for assistance with vision products. Our information services include:

Communication.    We can communicate with customers on a regular basis through the convenience of e-mail. We offer the following means of communication with our store:

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Value.    Through the combination of shopping convenience, product selection, information, communication, competitive pricing, and promotional programs, we believe we offer our customers superior value over the typical retail solution. We believe we can save our customers time and money. For more information regarding our merchandising, pricing and marketing strategies, see the section entitled “How We Merchandise and Market” below.

Privacy.    When shopping at a physical store, many shoppers feel embarrassed or uncomfortable buying items that may reveal personally sensitive aspects of their health or lifestyle to store personnel or other shoppers. Shoppers at the drugstore.com Web store avoid these problems by shopping from the privacy of their home or office and are able to ask a drugstore.com pharmacist questions that they may otherwise feel uncomfortable asking in a public place.

Business Segments

We offer products in four business segments: OTC, mail-order pharmacy, local pick-up pharmacy and vision. We sell products both through a multi-store format under the drugstore.com store umbrella and, for certain products, through separate subsidiary Web sites. We adjust and update our store offering and content throughout the year in response to market trends, consumer demand and vendor introduction and advertisement of new products.

OTC

We offer over 18,000 non-prescription health, beauty, wellness, personal care and sexual well-being products. Our primary OTC stores on the drugstore.com Web site include medicine cabinet, beauty and spa, nutrition and wellness, personal care, household, and sexual well-being, in addition to a variety of specialty stores such as Dr. Weil Recommends, GNC Live Well and the Natural Store. In addition, we sell prestige beauty products and customized nutritional supplements through our subsidiary Web sites.

Medicine Cabinet.    The medicine cabinet category includes OTC remedies, such as digestion aids, diabetes supplies, cough, cold, allergy and pain relief medications, first aid products, medical devices for home healthcare and other health-related products. Representative brands in our medicine cabinet category include Prilosec, Advil, Tylenol, Pepcid, Bausch & Lomb and Metamucil.

Beauty and Spa.    The beauty and spa category includes cosmetics, fragrances, home spa products and a variety of skin care products. The beauty category can be broadly classified into two subcategories: prestige beauty products, which consumers generally find in department stores, beauty specialty stores or spas and salons, and mass-market beauty products. Representative brands in our prestige beauty product category include LORAC, Sue Devitt Studios, Calvin Klein, and tarte, in addition to anti-aging products such as Basic Research’s StriVectin. Representative brands in our mass-market beauty product category include philosophy, Neutrogena, Olay, Revlon and L’Oreal.

Nutrition and Wellness.    The nutrition and wellness category includes nutritional foods and supplements, exercise, diet and weight loss products, massage and relaxation products, and sports nutrition products.

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Representative brands in our wellness product category include Nature Made, Twinlab, Natrol, Nature’s Way, Atkins, EAS, Gaiam, HoMedics and DreamTime. We are also the exclusive online retailer of GNC Live Well products.

Personal Care.    The personal care category includes products related to hair, body and shaving, oral hygiene, baby and feminine needs. Representative brands carried in our personal care product category include Gillette, Colgate, Johnson & Johnson, Rogaine and Pampers.

Household.    The household category offers a wide selection of household products, including healthy and aromatherapeutic cleaning products and other cleaning solutions, small household appliances and healthy home products, such as air and water purification systems. Representative brands include Caldrea, Method, Seventh Generation, OxiClean, Shark, Tanita, BlueAir and SlantFin.

Sexual Well-Being.    The sexual well-being category offers both information and a wide selection of sexual well-being products, all provided in an environment where customers can explore their sexual wellness needs in the privacy of their own home. We provide a wide range of adult consumer shopping choices, from novelty to relationship building products to individual pleasure and relaxation products. Representative brands include Kama Sutra, Astroglide, Lover’s Choice, Shunga and Vibratex. In January 2003, we acquired the domain name sexualwellbeing.com to more effectively market the products in this category.

Dr. Weil Recommends.    The Dr. Weil Recommends store provides consumers with information, resources, and a selection of health and wellness products personally recommended by Dr. Andrew Weil. In addition to purchasing health and wellness products, customers can take the Vitamin Advisor questionnaire to obtain a personalized recommendation for vitamin supplements based on Dr. Weil’s research and sign up for daily or weekly e-mail newsletters from Dr. Weil.

Natural Store.    The natural store category features a broad selection of natural products, including those products without artificial coloring or flavoring, synthetic fragrance or other unnecessary chemicals and/or products from companies with environmentally-conscious and cruelty-free policies. The Natural Store features many of the top natural brands on the market, including Burt’s Bees, Tom’s of Maine, Zia Natural Skincare, 7th Generation, New Chapter, Boiron and Clif Bar.

Nutritional Products.    Our GNC Live Well Store is dedicated to GNC nutritional products and other products typically sold in GNC stores. We are currently the exclusive distributor of GNC brand products on the Internet, and will continue to be the exclusive online distributor until July 2005. We also provide personalized nutrition services to consumers in the form of an online assessment of an individual’s specific nutritional supplement needs, and deliver the personalized vitamins, minerals, herbs, and supplements in pharmaceutical-grade, daily dose packages (CustomPaks^™). In addition to providing CustomPaks for consumers purchasing vitamin supplements through our Dr. Weil Recommends store, our subsidiary CNS is the exclusive online distributor of CustomPaks for Dr. Andrew Weil at www.DrWeil.com, Dr. Barry Sears at www.zonediet.com, and The Pritikin Longevity Center at www.Pritikin.com.

Mail-Order Pharmacy and Local Pick-up Pharmacy

We divide the pharmacy product category into two business segments: mail-order pharmacy and local pick-up pharmacy. Our mail-order pharmacy segment covers the prescription drugs and supplies delivered to customers through our mail order facility, and our local pick-up pharmacy business segment covers the prescriptions picked up by customers at Rite Aid stores. New prescriptions may be ordered on the drugstore.com Web site for mail-order delivery. Refill prescriptions that have previously been filled at a Rite Aid store or through our mail order facility may be mailed to the customer or picked up by the customer at any one of the approximately 3,400 Rite Aid stores nationwide. Although most prescriptions are ordered through the drugstore.com Web site, we also accept orders to fill prescriptions by telephone at 1-800-DRUGSTORE.

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Product Offering.    We are a full-service pharmacy stocking over 4,800 prescription drugs. Our pharmacy product offering consists primarily of prescription medications for chronic illnesses and needs, such as high blood pressure, diabetes, osteoporosis, depression, hair loss and birth control.

The pharmacy services at the drugstore.com online pharmacy are provided by experienced professionals using sophisticated information technologies. We employ licensed pharmacists who ensure private, personal customer service and we are licensed to fill prescriptions in all 50 states in the United States. We have also received VIPPS certification from the National Association of Boards of Pharmacy, or NABP, a coalition of state pharmacy boards. The voluntary VIPPS program sets standards for Internet pharmacies and informs the public of those online pharmacies that are fully licensed and in compliance with state pharmacy laws and the NABP’s pharmacy practice standards.

Filling Prescriptions.    We accept prescriptions only from licensed health care providers. We do not prescribe medications or otherwise practice medicine. We focus on dispensing medications used by consumers on a chronic basis. For acute care needs, when a customer has a single episode of a short-term illness or an exacerbation of a chronic condition requiring immediate attention in the form of antibiotics or pain medications, we recommend that customers pick up their prescriptions from a local pharmacy. This is because the treatment of acute care needs are extremely time sensitive and the delivery time required for online purchases could be too long to meet the customer’s needs. Because there are increased risks associated with the dispensing of opiates, depressants, stimulants and other controlled substances classified as Schedule II pharmaceuticals, such as fraud, illegal resale and special storage, shipping and handling requirements, we dispense Schedule II pharmaceuticals only to patients who use pharmacy benefit managers, or PBMs, for which we act as the mail-order pharmacy provider. Like traditional retail and mail service pharmacies, we accept, verify and cross-check prescriptions.

Services.    We seek to provide a high level of responsiveness and customer support. In addition to our Ask Your Pharmacist feature, drug price index, our extensive drug information database, specialized customer care features, and refill reminders, our pharmacy services include:

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Generic Insider.    We notify customers if a branded drug becomes available in generic form or if a prescription drug becomes available in a non-prescription form available over the counter.

Insurance/PBM relationships.    We serve both cash-paying pharmacy customers and customers with insurance coverage. Through our relationships with insurance companies, PBMs, and Rite Aid Corporation, or Rite Aid, we are able to obtain insurance reimbursement coverage for many insured prescriptions filled through the drugstore.com pharmacy. For example, as a result of our relationship with Rite Aid, we are able to fill prescriptions for a majority of customers with pharmacy benefits covered by a plan accepted by Rite Aid. We participate in the retail pharmacy networks of many PBMs, including Advance PCS, Aetna US Healthcare, Inc., Caremark Inc. and Express Scripts, Inc. In addition, we act as a mail-order pharmacy service provider for a number of PBMs, under which we dispense medications in supplies of 90 days or more. These PBMs provide their clients with prepaid mailing envelopes addressed to the drugstore.com pharmacy, to make it easy and convenient to send prescriptions to us.

We also expect to participate in prescription drug discount card programs to be established under the new federal Medicare legislation. This prescription discount card legislation, which goes into effect in June 2004, provides for the development and administration of discount card programs offering discounts off the retail price of prescription drugs reimbursed by Medicare. PBMs, insurance companies and others are currently applying to the federal government for approval to offer a prescription drug discount card program. We expect to participate in the networks of PBMs that are approved to offer a discount card program, and two PBMs that have applied have asked us to participate as their drug discount card vendor of choice.

Payment.    Customers may pay for their prescriptions by credit card or by entering insurance information that shows that they are covered by a managed care organization, insurance plan or PBM with whom we have a contract. During 2003, approximately 95% of the prescriptions in our local pick-up pharmacy segment and approximately 25% of the prescriptions in our mail-order pharmacy segment were paid for by insurance plans, with the balance reflecting prescriptions filled for customers who paid for the prescriptions directly. We accept checks for payment by customers who use PBMs for which we act as the mail-order pharmacy provider.

Vision

We sell prescription contact lenses and other vision products through our subsidiary Vision Direct, through Web sites located at www.visiondirect.com, www.lensmart.com, and www.lensquest.com, as well as by telephone at 1-800-VISIONDIRECT.

Product Offering.    We provide our customers with a broad assortment of contact lenses, including popular brands manufactured by Johnson & Johnson, Ciba Vision, Bausch and Lomb, OSI/American Hydron and CooperVision. We also sell reading glasses and contact lens cases. We believe that we offer these products at a substantial price savings over eye care practitioners, national optical chains and many online competitors.

Prescription Verification.    We adhere to the prescription verification guidelines defined in the U.S. federal Fairness to Contact Lens Consumers Act, which became effective in February 2004. In accordance with this law, we ask the patient’s eye care professional to verify the prescription before we ship an order, and allow eight

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business hours for the eye care professional to reply to our verification request. If the eye care professional indicates that the prescription is invalid, we cancel the order and notify the customer. If the eye care professional approves the prescription or does not respond to our verification request within eight business hours, we ship the order to the customer. If, at any time after we ship an order, the eye care practitioner notifies us that the prescription is invalid, we will notify the customer of this result and the reason the prescription is invalid.

Services.    We offer a convenient process for customers to reorder from their accounts and automatic shipments based on a customer’s delivery preferences.

How We Merchandise and Market

Merchandising

We believe that the breadth and depth of our product selection, together with the flexibility and convenience of our online store and the range of useful shopping services we provide, enables us to pursue a strong merchandising strategy.

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Marketing

Our marketing and promotion strategy is designed to build brand recognition, increase customer traffic to our store, add new customers, build strong customer loyalty, maximize repeat purchases and develop incremental revenue opportunities. We intend to continue to use the unique capabilities of the Internet as a means to encourage traffic to, and repeat purchases from, our Web sites. Our advertising campaigns are focused on frequently visited Internet portals, health-related Web sites and other frequently visited Web sites, search engines and associated Web sites, and direct-to- consumer marketing programs using e-mail. We also extend our market presence through our associates program, which enables associated Web sites to make our products and services available to their audiences through a link to our Web site.

In addition to our general marketing and promotion strategies, we utilize business segment-specific marketing programs and initiatives:

OTC.    We currently offer three anchor customer loyalty programs: Everyday Free Shipping, drugstore.com dollars^™ and Diamond Deals^™.

We will continue to evaluate and refine these programs, as well as other marketing strategies to drive customer orders, in our pursuit of cost effective customer acquisition and retention strategies.

Pharmacy.    We have a strategic relationship with Rite Aid to promote our Web site. For example, Rite Aid has agreed to include the drugstore.com online store and pharmacy in a significant portion of Rite Aid’s own weekly circular advertisements, as well as on shopping bags, prescription vial caps, in-store signs and permanent links from its Web site. In addition, we receive advertising benefits through our various PBM relationships.

Vision.    Our Vision Rewards program provides customers with discounts on future orders based on their past purchases. This credit is maintained in the customer’s account and applied automatically to the customer’s next purchase.

Pricing

Our goal is to offer our customers the largest assortment of health, beauty, wellness, vision and pharmacy products with value pricing. We strive to improve our operating efficiencies and to leverage our fixed costs so that we can pass along the savings to our customers in the form of lower prices and exclusive deals. We also strive to make additional cost savings opportunities known to our customers when they become available. For example, in our pharmacy store we proactively highlight lower-cost generic drug alternatives where both the customer and drugstore.com save on the price of the drug as compared to higher-priced brand name solutions. We also encourage our pharmacy customers to buy 90-day supplies of medication rather than 30-day supplies, when possible, by providing quantity price breaks as incentives. This strategy allows our customers to take

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advantage of price savings and enables us to realize fulfillment cost savings and achieve higher customer retention rates. Vision Direct offers a low price guarantee on all brands of contact lenses. In addition, we increase customer retention rates through our customer loyalty programs, such as drugstore.com Dollars, Diamond Deals and Vision Rewards, which provide lower prices for repeat customers. We believe our overall pricing strategy increases average net sales per order and leads to further operating efficiencies.

Our Target Customer

We target busy, working females between the ages of 30 and 54, many of whom are married with young children. This target customer makes the majority of her household’s buying decisions, uses online shopping as a means of maximizing the use of her time, browses multiple categories and finds online shopping a convenient, relaxing and rewarding experience. We also cater to a secondary target market of men over the age of 45 who use online shopping as a means of maximizing the use of their time and who tend to use more prescription medications as they age.

How We Serve our Customers

Order Fulfillment

All of our OTC orders and our pharmacy orders that are delivered by mail are processed from primary distribution center in New Jersey. Orders for products in our vision segment, including contact lenses, reading glasses and lens cases, are processed from our distribution center in Ferndale, Washington.

Our warehouse management system provides us with real-time data on inventory receiving and shipping, quantities and location. This enables us to notify customers about product availability on a real-time basis. In addition, we offer an order tracking system on our Web site that enables our customers to see where their order is en route, and when it is expected to be delivered. Due to the relatively short lead time required to fill orders for our products, backlog of orders is not material to our business.

When we fill a prescription at our pharmacy for mail-order delivery from our distribution center, we operate under our arrangement with Rite Aid. Our pharmacists, working together with a Rite Aid “pharmacist in charge,” perform all aspects of the prescription fulfillment process and all aspects of customer service. When a customer orders a prescription from us to be picked up at a Rite Aid store, we utilize Rite Aid as a fulfillment partner. Upon receiving and validating a customer’s order for products to be picked up, we submit order information to Rite Aid for processing and purchase the inventory from Rite Aid, which fills the order and makes it available for pick-up by the customer. Under our agreement with Rite Aid, Rite Aid adjudicates and collects insurance reimbursement payments on our behalf.

Non-prescription orders over $49 qualify for free standard shipping under our Everyday Free Shipping program. For orders under $49, we generally charge our customers a shipping charge that covers a portion of our expense of shipping. We offer a variety of shipping options, including next-day delivery for orders received during the business week. We ship anywhere in the United States that is served by United Parcel Service or the U.S. Postal Service. Vision Direct ships contact lenses and other vision products worldwide, primarily to the United States and Canada. Orders for which customers requested expedited shipping are flagged and expedited through our fulfillment processes. For non-prescription product orders, our goal is to ship within 24 hours of the time the order is placed. For prescription products, our goal is to ship as soon as the prescription has been verified and our pharmacists have completed the drug utilization reviews described above. Customers who order a refill of an existing Rite Aid or drugstore.com prescription can choose to pick up the refill at any Rite Aid store or have it delivered using one of our delivery options.

Customer Care

We believe that a high level of customer service and support is critical to retaining and expanding our customer base. Our customer care specialists are available 24 hours a day, 7 days a week to provide assistance

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via e-mail or telephone. We strive to answer all customer inquiries within 24 hours. Our customer care specialists handle questions about orders and how to use our Web site, assist customers in finding desired products and, for customers who choose not to transmit their credit card information over the Internet, register customers’ credit card information over the telephone. Our customer care specialists are a valuable source of feedback regarding customer satisfaction. Our Web site also contains a customer care page that outlines store policies and provides answers to frequently asked questions. In addition, our pharmacists can provide advice to customers about medication, dosage, delivery systems, common side effects and other information about prescription drugs.

We maintain customer care centers in our Bellevue, Washington headquarters and, for vision support, in Halifax, Nova Scotia, Canada. We operate toll-free telephone numbers, 1-800-DRUGSTORE and 1-800-VISIONDIRECT, through which customers can place orders and receive information.

We generally refund to customers all or a portion of the selling price, including related shipping fees if applicable, if a customer is not satisfied with the product purchased or the quality of customer service provided. Sales returns have not been significant to date.

Technology

We have implemented a broad array of services and systems for site management, product searching, customer interaction, transaction processing and order fulfillment functions, including, among other things:

These services and systems use a combination of our own proprietary technologies and commercially available, licensed technologies. We focus our internal development efforts on creating and enhancing the specialized, proprietary software that is unique to our business. To enhance the online and offline experience for our customers, we have integrated some of our information and pharmacy systems with Rite Aid’s systems. Rite Aid has granted us a nonexclusive, fully paid license to the Rite Aid systems that are integrated with our systems, subject to third-party rights to such technology.

We also have a technology license and advertising agreement with Amazon.com, Inc. under which we have mutually agreed to license to each other certain existing and future technology used in the operation of our Web sites, as long as we do not use the technology to compete with each other. We currently are not using any Amazon.com technology but could do so in the future if it would benefit us. This agreement is described below in the section entitled “Key Strategic Relationships—Amazon.com.”

Our core merchandise catalog, customer interaction, order collection, fulfillment and back-end systems are proprietary to drugstore.com but are available for use by Amazon.com under our technology license and advertising agreement with Amazon.com. The drugstore.com software platform and architecture are integrated with an Oracle database system. The systems are designed to provide real-time connectivity to the distribution center systems for both pharmacy and OTC products. These include an inventory-tracking system, a real-time order tracking system, an executive information system and an inventory replenishment system. Our Internet servers use SSL technology with Verisign-issued digital certificates to help conduct secure communications and transactions. Our systems infrastructure is hosted by Cable & Wireless (formerly Exodus Inc.) in Tukwila, Washington, which provides communication lines from multiple providers, as well as 24-hour monitoring and engineering support. Cable & Wireless has its own generators and multiple backup systems in Tukwila.

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Vision Direct uses a combination of internally developed and third-party software systems. We will integrate Vision Direct’s services and systems into drugstore.com’s services and systems during 2004.

Purchasing

OTC.    We purchase our non-pharmaceutical inventory directly from various manufacturers and distributors.

Pharmacy.    Under our agreement with Rite Aid, we are required to purchase all of our brand-name pharmaceutical products directly from McKesson Corporation through Rite Aid, unless we are able to obtain better overall terms from another vendor. We purchase our generic drugs directly from Rite Aid. Our arrangement with Rite Aid enables us to take advantage of volume discounts and credit terms obtained through Rite Aid, and therefore decreases our cost on pharmaceutical products. To date we have not been able to obtain better overall terms from any other supplier and we currently expect that McKesson and Rite Aid will continue to be our suppliers of pharmaceutical products. This purchase requirement will continue for the term of our relationship with Rite Aid.

When our customers order prescriptions through the drugstore.com Web store for pick-up at a Rite Aid store, we use Rite Aid as a fulfillment partner.

Vision.    We purchase our contact lens and vision products inventory directly from various manufacturers and other distributors. For example, we have entered into a direct buying partnership with Vistakon, a division of Johnson & Johnson Vision Care, Inc., to purchase Vistakon’s Acuvue brand of products.

Key Strategic Relationships

Rite Aid

In June 1999, we entered into a strategic relationship with Rite Aid. Through this relationship, we have access to Rite Aid customers through the RiteAid.com Web site, which is powered by the drugstore.com Web site. All pharmacy orders processed through the drugstore.com Web site or the RiteAid.com Web site can either be shipped to the customer from our distribution center or, in the case of refills of existing drugstore.com or Rite Aid prescriptions, picked up by the customer at any of Rite Aid’s approximately 3,400 stores nationwide. In addition to providing for multi-channel delivery options, we and Rite Aid agreed to promote each other’s services both online and in other promotional materials. We also benefit from access to many of Rite Aid’s relationships with insurance and PBMs, which provides us with opportunities to meet the needs of more customers because of the availability of insurance coverage to those customers. Currently, we purchase all of our pharmaceutical inventory through Rite Aid, leveraging its volume requirements to obtain favorable pricing and credit terms. We also sell over 200 Rite Aid brand private label OTC products throughout our Web store. As a result of this agreement, Rite Aid is one of our largest suppliers.

As part of our relationship, drugstore.com agreed to certain exclusivity provisions that limit our ability to promote, or affiliate with, any other physical retail drugstore or to operate as a traditional physical drugstore, and Rite Aid agreed not to offer or sell products or services on the Internet other than through our Web site. In addition, our agreement requires us to purchase all of our pharmaceutical products through Rite Aid unless we are able to obtain better overall terms from another vendor. The agreement also contains additional provisions providing for the licensing by Rite Aid to drugstore.com of information technology systems and the integration of the information technology and pharmacy systems of the two companies. We currently use these systems to process pharmaceutical orders through our primary distribution center.

Our agreement with Rite Aid ends in 2009. In connection with this ten-year agreement, Rite Aid received 9,334,746 shares of our common stock. Rite Aid was one of our largest stockholders until 2002, when Rite Aid liquidated its holdings in our common stock.

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GNC

In June 1999, we entered into a 10-year agreement with GNC under which we became the exclusive online provider of GNC-branded products. We have the exclusive right to sell GNC’s wellness products over the Internet, including the PharmAssure brand of pharmacist-recommended vitamins and nutritional supplements, until July 2005. We have agreed that, as long as we have the exclusive right to distribute GNC’s products over the Internet, we will not promote any other retail health food store or operate a physical retail health food store. When the exclusivity provisions of the agreement terminate, we will have the nonexclusive right to sell these products for the remaining term of the agreement. As part of this relationship, we have created the GNC Live Well Store within the drugstore.com Web site, which is dedicated to selling GNC products on a consignment basis. We are entitled to retain a percentage of the gross revenues that we collect from sales of GNC products and recognize only the net amount we retain as revenues. We have also agreed with GNC to co-promote each other’s products and services in both traditional and online marketing efforts, including GNC’s placement of a link to our Web site on the GNC Web site. In connection with this relationship, GNC received 2,947,853 shares of our common stock. GNC liquidated its holdings in 2002.

Amazon.com

Effective September 19, 2003, we entered into a new e-commerce agreement with Amazon.com. Under the new agreement, we are a nonexclusive wholesaler and fulfillment provider for certain OTC products sold through the Health & Personal Care store on the Amazon.com Web site. We ship the Amazon.com orders we fulfill in Amazon.com-branded boxes from our distribution facility. The new agreement replaced our then-existing marketing agreement with Amazon.com. The initial term of this agreement ends in April 2007.

In August 1998, we entered into a technology license and advertising agreement with Amazon.com, under which we have the right to license substantially all of Amazon.com’s technology for use in our business and to receive certain technological and advertising support from Amazon.com, and Amazon.com has the right to license substantially all of our technology for use in its business. Neither party may use the other’s technology to compete against the other. Currently, neither party has licensed any technology from the other under this agreement. If we were to be acquired by a competitor of Amazon.com and Amazon.com did not vote in favor of the transaction, we would lose our rights to use Amazon.com’s technology, if we are then using any. This agreement also restricts us from promoting on our Web site any company, other than drugstore.com, that sells products or services competitive with those that Amazon.com offers or is preparing to produce or market.

Amazon.com is our largest stockholder, owning 16.8% of our outstanding stock as of December 28, 2003. Jeffrey P. Bezos, Amazon.com’s chairman of the board, president and chief executive officer, is currently serving as Amazon’s designee on our board of directors.

Competition

The market for health, beauty, wellness, vision and pharmacy products is intensely competitive and highly fragmented. We face intense competition in each of our business segments, as described below. In addition, we compete with Internet portals and online service providers that feature shopping services, such as America Online, MSN and Yahoo!, and with other online or mail-order retailers that offer products within one or more of our business segments.

Pharmacy.    In our mail-order pharmacy and local pick-up pharmacy segments, we compete with chain drugstores, including those with an online presence, such as Walgreens and CVS; pharmacy benefit managers, such as Medco Health Solutions, Inc.; and hospitals, health maintenance organizations, or HMOs, and mail-order prescription drug providers, many of which are or may begin offering products and services over the Internet. In addition, we face competition from other online pharmacies. Some of these pharmacies are foreign Internet pharmacies that can sell drugs at a lower price because of government subsidies. In addition, many online

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pharmacies, often referred to as “rogue” pharmacies, sell counterfeit drugs or drugs diverted from proper channels. Foreign online pharmacies and rogue online pharmacies can often sell drugs to American residents at a lower price because they do not comply with U.S. pharmacy regulations, are not subject to U.S. regulatory oversight, or both.

OTC.    Our competitors in the OTC segment can be divided into several groups: chain drugstores, such as Walgreen’s, CVS and Eckerd; mass market retailers, such as Wal-Mart, Kmart, Target and, to a certain extent, Amazon.com; warehouse clubs, such as Costco and Sam’s Club; supermarkets, such as Safeway, Albertson’s and Kroger; and, with respect to upscale health, prestige beauty and spa products, specialty retailers and major department stores, such as Nordstrom, Macy’s, Sephora and Bloomingdale’s.

Vision.    Our competitors in the vision segment include online providers of contact lenses, such as 1-800-CONTACTS, national optical chains, such as Lenscrafters and Pearle Vision, eye care professionals and mass-market retailers such as Walmart and Costco that provide prescription vision services.

We believe that there are a number of competitive factors in our market, including brand awareness and preference, company credibility, product selection and availability, convenience, price, privacy, actual or perceived value, Web site features, functionality and performance, ease of purchasing, customer service, quality and quantity of information supporting purchase decisions (such as product information and reviews), and reliability and speed of order shipment.

Government Regulation

Our business is subject to extensive federal, state and local regulations. In particular, entities engaging in the practice of pharmacy are subject to federal and state regulatory and licensing requirements. For example, pursuant to the Omnibus Budget Reconciliation Act of 1990 and related state and local regulations, pharmacists are required to offer counseling to customers, without additional charge, regarding medication, dosage, delivery systems, common side effects, adverse effects or interactions and therapeutic contraindications, proper storage, prescription refill and other information deemed significant. Entities such as the drugstore.com pharmacy that distribute “controlled substances” are also subject to the Controlled Substances Act of 1970 and regulations issued by the U.S. Drug Enforcement Administration and state laws and regulations pertaining to controlled substances. We are also subject to the Health Insurance Portability and Accountability Act of 1996, which provides standards and requirements to control the flow of health information throughout the health care system and to protect the privacy of personal health records. We also sell dietary supplements, medical devices, cosmetics, foods, drug products (prescription, OTC and homeopathic) and other consumer products that are subject to regulation by the Food and Drug Administration, or FDA, the Federal Trade Commission, or FTC, the Consumer Product Safety Commission, and state regulatory authorities, as the case may be. In addition to regulating the claims made for specific types of products, the FDA and the FTC may also attempt to regulate the format and content of Web sites that offer products to consumers.

As we expand our product and service offerings, more of our products and services will likely be subject to federal, state and foreign regulations. Regulatory requirements to which our business is subject may also expand over time. For example, Congress and federal agencies continue to scrutinize the benefits and risks of online pharmacies, focusing especially on those sites that illegally issue prescriptions and illegally sell prescription drugs. To combat the illegal issuance of prescriptions and the illegal sale of prescription drugs over the Internet, certain members of Congress have proposed additional regulation of Internet pharmacies, primarily regarding disclosure of certain identifying information on Web sites, as well as additional enforcement mechanisms and funding for such efforts. The regulations applicable to our business often require subjective interpretation, and we cannot be certain that our attempts to comply with applicable regulations will be deemed sufficient by the appropriate regulatory agencies. Violations of any regulations could result in various civil and criminal penalties, including, but not limited to, suspension or revocation of licenses or registrations, seizure of our inventory or monetary fines that could adversely affect our business, financial condition or operating results.

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We believe we are in compliance with existing federal and state requirements for pharmacy licensing and registration, with laws relating to dispensing of prescription drugs, security, record keeping and reporting of pharmacy sales, and with other applicable laws. The NABP has developed the Verified Internet Pharmacy Practice Sites, or VIPPS^®, program, which certifies that an online pharmacy is in compliance with the licensing and inspection requirements of its state and each state to which it dispenses pharmaceuticals, and other stringent criteria established by NABP to ensure good pharmacy practice. We have received VIPPS program certification.