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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 27, 2003

Commission File Number: 1-31312

MEDCO HEALTH SOLUTIONS, INC.

(Exact Name of Registrant as Specified in Its Charter)

Registrant’s Telephone Number, Including Area Code: 201-269-3400

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

Securities registered pursuant to Section 12(g) of the Act: None

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 ¨

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 an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes ¨ No x

The aggregate market value of the voting stock held by non-affiliates of the registrant as of March 18, 2004 was $8,900,731,908, based on the closing price of the registrant’s common stock on such date. There was no trading market for the registrant’s common stock as of the last business day of the registrant’s most recently completed second fiscal quarter.

As of March 18, 2004, the registrant had 270,950,743 shares of common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of Medco Health Solutions, Inc.’s Proxy Statement for its 2004 Annual Meeting are incorporated by reference in this Annual Report on Form 10-K in response to Part III (Items 10 through 14).

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MEDCO HEALTH SOLUTIONS, INC.

ANNUAL REPORT ON FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 27, 2003

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PART I

Overview

We are one of the nation’s largest prescription benefit managers, and we provide sophisticated programs and services for our clients and the members of their prescription benefit plans, as well as for the physicians and pharmacies the members use. We were acquired as a wholly-owned subsidiary of Merck & Co., Inc., (“Merck”) on November 18, 1993, and were spun off as a separate publicly traded enterprise on August 19, 2003. Our programs and services help our clients control the cost and enhance the quality of the prescription drug benefits they offer to their members. We accomplish this by providing prescription benefit management (“PBM”) services through our national networks of retail pharmacies and our own mail order pharmacies. We have a large number of clients in each of the major industry categories, including Blue Cross/Blue Shield plans; managed care organizations; insurance carriers; third-party benefit plan administrators; employers; federal, state and local government agencies; and union-sponsored benefit plans.

When we use “Medco,” “we,” “us” and “our,” we mean Medco Health Solutions, Inc., a Delaware corporation, and its consolidated subsidiaries.”

We operate in a competitive market in which clients seek to control the growth in the cost of providing prescription drug benefits to their members. Prescription drug costs have risen considerably over the past several years, largely as a result of inflation of brand-name products and the introduction of new products produced by pharmaceutical manufacturers. These prescription drug cost increases, known as drug trend, have garnered significant attention in the United States as they contribute significantly to the rise in the national cost of healthcare. Our business model is designed to reduce this level of drug trend, primarily by obtaining competitive discounts and rebates from pharmaceutical manufacturers, obtaining competitive discounts from retail pharmacies and efficiently administering prescriptions filled through our mail order pharmacies. In 2003, our network of mail order pharmacies filled approximately 78 million prescriptions, exceeding the number of mail order prescriptions filled by the mail order operations of our three largest competitors combined. We believe that our ability to consistently deliver high-quality service while effectively managing drug costs for our clients and their members has made us a market leader.

We seek to contain costs for our clients and their members by encouraging the use of medically appropriate generic drugs through our generic education and substitution programs. Our high-quality service, advanced technology and cost containment initiatives enabled us to limit the average drug trend for plans that include both retail and mail order to 10.2% in 2003, 12.9% in 2002 and 14.0% in 2001, compared to the national average of an estimated 13.4% in 2003, 15.3% in 2002 and 17.3% in 2001, as reported by the Centers for Medicare & Medicaid Services, or CMS.

The advanced technology and infrastructure we have developed is instrumental to our ability to drive growth, improve service and reduce costs. Our technology platform seeks to seamlessly integrate prescription management and processing with our client and member services. The cornerstone of our mail order technology is our single networked platform which connects prescription ordering functions at our prescription processing facilities with our automated dispensing pharmacies in Las Vegas, Nevada and Willingboro, New Jersey. At our specialized call center pharmacies, our experienced service representatives and consulting pharmacists use advanced technology to speed service and provide members personalized prescription and health information. For example, interactive voice recognition technology allows members to enroll for mail order service, process prescription orders, track the status of their orders, or locate in-network retail pharmacies in their area. Advanced imaging technology enables service representatives to access an online image of a member’s prescription to service that member more efficiently. Our data center links our dispensing and call center pharmacies, the retail pharmacies in our networks and our websites. As a result, our data center enables us to receive, process and administer claims and dispense prescription drugs efficiently. We have also deployed companywide reliability and change management programs that help drive excellence in execution across our operations, reducing our time to market with new capabilities and increasing our ability to implement error-free updates and customer oriented solutions to our systems.

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We also seek to improve client and member service and prescription ordering by providing important healthcare information and an efficient means of communication through our proprietary Internet solutions. For clients, members and pharmacists, we support distinct websites that provide critical benefit information and interactive tools aimed at facilitating compliance with benefit plan goals and simplifying benefit administration. In 2003, we processed 13.8 million patient prescription orders through our member website, a 27% increase over 2002.

Our innovative and flexible programs and services have enabled us to deliver effective drug trend management for our clients while, we believe, improving the quality of care for members. Our services focus on:

From 1999 to 2003, our net revenue increased on average approximately 20% per year. In 2003, we administered approximately 532 million prescriptions; had net revenues of approximately $34 billion and net income of more than $425 million; and had earnings before interest income/expense, taxes, depreciation and amortization, or EBITDA, of approximately $1,036 million. See Note 6 under Item 6, “Selected Financial Data” for a further description of EBITDA and a table that reconciles net income to EBITDA. Our net income is driven by our ability to earn rebates and negotiate favorable discounts on prescription drugs from pharmaceutical manufacturers; negotiate competitive client pricing, including rebate sharing terms; and provide services in a cost-efficient manner.

Financial information concerning our business segments and geographic regions for each of 2003, 2002 and 2001 is set forth in Part II, Items 5, 6, 7, 7A and 8 of this Annual Report on Form 10-K.

Industry Overview

Prescription drugs are the fastest growing component of healthcare costs in the United States. According to CMS, drug expenditures in the United States totaled over $184.1 billion during 2003; the cost of prescription drugs is expected to rise on average approximately 10.9% per year over the next ten years; and total expenditures could reach 15.5% of all healthcare costs by 2013, up from 11.0% in 2003.

We believe the key drivers of drug trend include:

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Increased generic substitution is partially offsetting the rise in drug spend. Between 2004 and 2007, patents are expected to expire on brand-name drugs representing about $38 billion in annual sales in the United States, based on the current release schedule. Generic substitution for drugs on which patents have expired is a significant factor in moderating drug spend, especially as efforts by payors, such as our clients, and generic drug manufacturers have led to an acceleration of generic drug substitution following the end of a branded drug’s marketing exclusivity.

PBMs emerged in the early 1980s, primarily to provide cost-effective drug distribution and claim processing for the healthcare industry. The PBM industry developed with the explosive growth of healthcare costs in the 1990s, as sponsors of benefit plans sought to more aggressively contain their costs. PBMs offered ways to influence both supply and demand. On the supply side, PBMs could leverage their buying power to secure manufacturer and distributor rebates and purchase discounts, as well as generating preferential discounts from retail pharmacies. On the demand side, PBMs could educate physicians on preferential prescribing options of formularies, and apply various clinical techniques to encourage members of health plans to implement more cost-effective usage habits, such as the use of less-expensive generic drugs, without jeopardizing their drug therapy.

Areas of potential growth for the PBM industry include increased use of available programs and services by existing clients, as well as entry or expansion in the specialty drugs, information services and health management markets. For example, we believe there is an opportunity to substantially increase the use of mail order pharmacies by members who use maintenance medications to treat chronic medical conditions. Mail order pharmacies currently fill only approximately 13.2% of total prescription drug sales in the United States, an increase from approximately 12.9% in 2002. Favorable demographics and increasing mail order capabilities should enable this trend to continue.

We believe that future growth within the PBM industry will also be driven by penetration into untapped categories of the overall U.S. prescription drug market, such as Medicare. The PBM industry is expected to benefit from the Medicare drug benefit that will initially take the form of a discount card program, and is expected to be introduced in mid-2004. The landmark legislation to modernize Medicare with a prescription drug benefit estimated at more than $530 billion over the next 10 years will enable us to more widely offer our market-based tools to America’s senior citizens.

Business Strategy

Our vision is to be an effective force in moderating healthcare costs for our clients and supporting improved patient care through the appropriate use of prescription drugs. Our strategy depends on our ability to understand both the common and unique needs of our customers, our ability to develop scalable yet flexible capabilities and solutions that are affordable for our clients and profitable for us, through our execution of the following:

Deliver high-quality client and member service. Our success in attracting and retaining clients depends on our ability to deliver high-quality client and member service. We assign a team to each of our clients that includes experienced clinical, financial and information technology specialists, all of whom are intimately aware of the needs of that specific client and industry category. A critical element of the service we offer clients is the development, implementation and management of a customized plan design that meets the client’s particular objectives. Our client teams work in consultation with each client and use our proprietary software tools to model the effects of different plan designs based on the client’s historical drug-use data. This allows clients to better analyze their options and helps them develop a plan design best suited to their needs. By capitalizing on the advanced technology and infrastructure we have developed, our individualized prescription drug benefit plan solutions enable us to deliver high-quality service to our clients and their members.

We also offer a wide range of clinical services. For example, since many plan designs cover drugs for only some of the conditions for which they may be prescribed, we have put in place rules that reduce the number of coverage determinations that pharmacists must make. These rules increase efficiency because pharmacists need to question fewer patients and physicians about their reasons for using a particular drug before filling a prescription. In addition, our integrated technology platform is capable of alerting members, pharmacists and physicians to potential negative drug interactions, drug recalls, allergy sensitivities or otherwise inappropriate pharmaceutical use. We regularly review our clinical services data and report to clients on our performance. We also use these reviews as an opportunity to identify drug utilization problems and suggest appropriate solutions.

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Our specialized call center pharmacies offer clients, members, pharmacists and physicians access 24 hours a day, seven days a week to service representatives and consulting pharmacists. As of February 1, 2004, we had approximately 300 pharmacists and approximately 2,600 service representatives who work in our seven call center pharmacies. In addition, our website contains tools and information that can be used by clients, members, pharmacists, physicians and the general public.

Take advantage of our significant technology investments to drive growth, improve service and reduce costs. Our technology platform offers the opportunity to enhance productivity and reduce costs for us and for our clients, provides more convenience for clients and their members and, we believe, improves overall patient care. A critical benefit of this technology platform is that it allows us to create and execute increasingly complex prescription drug benefit programs and services. Our mail order pharmacy service enables our professional pharmacists to focus on meeting the needs of our members and increases service efficiency by routing prescriptions electronically to the most appropriate pharmacies for processing and dispensing, including primarily our two highly automated dispensing pharmacies. Our technology platform also includes our data center, which enables us to provide sophisticated reporting and analysis to our clients. Our data center also helps us receive and process prescriptions and analyze data concerning drug utilization. Our specialized call center pharmacies use advanced technology to speed service and provide members personalized prescription and health information. Advanced Internet capabilities provide us with significant opportunities to improve services in e-commerce, as well as the ability to deliver timely, accurate and personalized health information to our members at a substantially lower cost than traditional communication methods. We have also implemented a suite of web-based applications for clients that provide sophisticated reporting, analytical and communications capabilities to enable them to manage more effectively the prescription drug benefits they provide.

We continue to encourage physician adoption of electronic prescribing, which involves physicians using hand-held or desktop computer technology and prescription writing software applications to write prescriptions for their patients. We believe that linking the physician electronically with the PBM’s patient-specific health and benefit information and the dispensing pharmacist will improve patient safety, enhance the quality of care and lead to improved patient satisfaction and convenience. Electronic prescribing may also reduce costs for plan sponsors by improving the speed and accuracy of ordering prescriptions, reducing medication errors and adverse drug events, and increasing formulary compliance and selection of generic medications. Physicians are also likely to benefit from electronic prescribing because it will reduce post patient visit prescription rework and improve the quality of patient care by giving physicians real-time access to a patient’s plan guidelines and prescription history to prevent adverse drug interactions and duplication of therapy. We believe that a universal channel is needed to provide an industry standard for the secure, electronic exchange of prescription information. In 2001, we formed RxHub with AdvancePCS and Express Scripts, Inc. to help develop this capability. RxHub has created a standardized electronic prescribing platform, enabling physicians who use electronic prescribing technology to link to pharmacies, PBMs and health plans. In addition, we have alliances with several point-of-care vendors that allowed us to process approximately 2.7 million electronic prescriptions in 2003.

Actively pursue sources of growth from new clients and increased use of our value-added services, including our mail order pharmacies. We believe our high-quality service model, including our market-facing groups designed to address the special needs of our customers, and drug trend management track record will enable us to continue to attract new clients in all client categories, from large Blue Cross/Blue Shield plans, managed care organizations and insurance carriers, through our Systemed clients in the small and mid-size client market.

We also believe we have an opportunity to increase our mail order volume substantially. Of a potential user base of over 20 million members who use maintenance medications to treat chronic medical conditions and whose plans offer them the option of using retail or mail order, only approximately 5 million members currently use mail order. We will continue to seek to convert members who currently use retail pharmacies for maintenance medications to our mail order service. Filling a prescription through our mail order pharmacy reduces costs to our clients by increasing formulary compliance and, where appropriate, generic substitutions. We believe that our mail

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order pharmacy increases member satisfaction due to, among other things, the convenience of receiving a 90-day supply of a drug instead of the 30-day supply generally dispensed by retail pharmacies, as well as the typical annual cost savings associated with reduced co-payments.

We offer our clients a comprehensive suite of cost-management programs and services, which include prescriber management products and RationalMed, our proprietary service that analyzes patients’ prescription, medical and laboratory records to determine whether a prescription drug could be harmful. Through the use of these products and services, several of our significant clients limited their drug trend to less than 10% in 2003.

We are expanding our specialty pharmacy offerings to our clients, as further discussed below, and expect to participate in the Medicare prescription benefit program. We anticipate that this new benefit program will enable Medco to extend to America’s senior citizens the market-based tools that we have successfully used to manage drug spending in the private sector.

Selectively form strategic alliances and expand into complementary, adjacent markets. While our principal focus has been to expand our business through internal growth, we have also made targeted acquisitions and entered into strategic alliances. For example, as new and expensive biotech drugs are introduced into the market, we will continue to invest in our specialty pharmacy programs, such as through our own Specialty Care Pharmacy in Ohio, or through collaboration with business partners, such as our strategic alliance with Accredo Health, Inc. (“Accredo”) announced in February 2004. The specialty pharmacy market is currently estimated at $20 billion in annual U.S. sales and is expected to double to $40 billion over the next 3 years, and through our collaboration with Accredo in the role as a preferred retail and mail order provider of a select group of specialty drug therapies, combined with our core specialty capabilities, we are well positioned to reduce our clients’ specialty drug cost in the future. We intend to continue to expand into new markets and selectively form alliances and make targeted acquisitions to complement our internal growth.

Competitive Advantages

We believe we have several competitive advantages that enable us to deliver enhanced service to clients and their members while effectively managing drug trend for our clients at levels significantly below the national average.

We believe our competitive advantages include the following:

We have a highly automated mail order pharmacy service. Our pre-eminent mail order pharmacy service automates the prescription filling process using proprietary software, much of which we have developed in-house, and advanced robotics technology. At our mail order pharmacies, we can accept a prescription for processing, determine whether the prescribed drug is on a plan’s formulary and work with physicians to substitute less expensive clinically equivalent generic drugs for brand-name drugs, fill the prescription and deliver it by mail or courier to a member. These capabilities create a distinct cost advantage for us and our clients, while enhancing member convenience.

In 2003, our mail order pharmacies filled more prescriptions than the combined mail service operations of our three largest competitors. The accuracy of prescriptions dispensed from these facilities, which use our patented technology, exceeds the highest industry quality standard. Each of these two automated pharmacies has the individual capacity to dispense over 1.0 million prescriptions per week. Our weekly average mail order prescription volume was approximately 1.5 million in 2003.

Our investments in technology are reducing costs and providing enhanced client and member service. We have designed our technology to anticipate and respond quickly to client, member, physician and pharmacist needs and to reduce costs. We have invested in a new generation of technology to allow our specialized call center pharmacies to provide faster service and enhance the access our service representatives have to member information. Our integrated voice-response phone system allows members to enroll for mail order service, submit a mail order

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prescription for processing, track the status of their mail order prescription or locate an in-network retail pharmacy in their area.

We offer extensive value-added programs and services to our clients and their members. Our flexible programs and services enable us to deliver effective drug trend management for our clients while, we believe, improving the quality of care for their members. Our services focus on:

Our Pharmacy and Therapeutics Committee and Medical Advisory Board play an integral role in creating and administering our value-added programs and services. Our Pharmacy and Therapeutics Committee and Medical Advisory Board make decisions independently of us, and are each comprised of a distinguished independent group of clinicians. The Pharmacy and Therapeutics Committee guides us in maintaining a consistent and therapeutically appropriate approach to the clinical content of certain programs and services, including, for example, the development of formularies and coverage criteria. Our Medical Advisory Board reviews and evaluates the clinical relevance, quality and effectiveness of all our health management programs and services.

Our comprehensive generic substitution programs save our clients money. The substitution of medically appropriate generic drugs for brand-name drugs helps contain client and member prescription drug costs. Generic drugs save both clients and their members money because they are less expensive and generally require lower co-payments than brand-name drugs. Our Generics First^® program offers participating physicians the opportunity to obtain free generic samples and information on the value of generic drugs, and educates physicians and members

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about the cost savings as well as the availability of generic therapeutic equivalents and alternatives to brand-name drugs. Other aspects of our integrated generics strategy include alerting physicians to the availability of medically appropriate generic substitutes and substituting generic drugs as soon as legally permissible, generally when the marketing exclusivity on the brand-name drug ends. For example, within one month of a generic equivalent becoming available for Prinivil^®, we achieved a substitution rate of approximately 90% for prescriptions filled by our mail order pharmacies, and within two weeks of a generic equivalent becoming available for Glucophage^®, we achieved a substitution rate of over 91% for prescriptions filled by our mail order pharmacies. Between 2004 and 2007, patents are expected to expire on brand-name drugs that generate aggregate U.S. sales of approximately $38 billion.

We have a deep and experienced management team. Our management team has extensive experience in the PBM and healthcare industries and has established long-standing relationships with key constituents.

See “—Competition” below for a description of competition in the PBM industry.

Programs and Services

To support our efforts to control prescription drug costs for our clients while supporting the appropriate use of prescription drugs, we offer a wide range of programs and services that help manage the cost, quality and administration of the prescription drug benefits that our clients offer to their members. These programs and services are targeted at our key constituencies: clients, members, pharmacies and physicians.

Plan Design

Over the years, our customer teams have refined a consultative approach for helping clients develop and implement different plan designs. We assign each client a team that includes experienced clinical, financial and information technology specialists. Each client’s success in achieving the business objectives of its pharmacy benefit ultimately depends on the benefit plan design. These designs take into account formulary, pharmacy management, drug coverage and exclusion and cost-share options, as well as applicable state and federal laws. We also work closely with clients to determine how to introduce plan design changes to maximize member acceptance.

As an integral part of this consultative approach, our account teams use proprietary software tools that we have developed to model the effects of different plan designs based on historical data. Clients can then judge the impact of specific components before they are implemented. We provide a broad range of plan designs and the ability to customize plan design.

The following are descriptions of key plan design elements:

Formulary choice. A formulary is a list of preferred drugs from which our clients’ members and their physicians can choose. Our independent Pharmacy and Therapeutics Committee reviews drugs for formulary inclusion and exclusion based on clinical considerations. Clients can choose from one of our existing formularies or we will assist them in designing their own customized formulary. Our goal is to give members access to clinically appropriate drugs, while helping clients control plan costs. We look for client savings by focusing on lower-cost products and attractive rebates and discounts.

Generic options. Because generic drugs typically cost substantially less than brand-name drugs, generic equivalents can be an important part of a plan design. Clients can realize plan savings by implementing effective generic substitution incentive programs, such as differential co-payment plans that require members to pay for the difference between the cost of a brand-name drug and a less expensive, generic substitute.

Mandatory mail. Our mandatory mail programs combine plan design features and communications to encourage our clients’ members to use mail order for maintenance prescriptions, which patients generally take over a protracted period of time. The programs increase the use of mail order, providing substantial savings for our clients through better prescription pricing and superior generic substitution performance. Also, our clients’

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members benefit from lower annual co-payments, superior dispensing accuracy and 24 hour-a-day pharmacist availability.

Pharmacy networks. Our clients can realize plan savings by carefully selecting a retail pharmacy network and making use of our mail order service. In selecting a retail pharmacy network, clients generally consider the number and location of pharmacies in the network, the competitiveness of the reimbursement plan that the network offers and the quality of service and care provided to plan members.

Coverage rules. Coverage rules govern the conditions under which drugs are covered, aligned with each client’s benefit philosophy. In concert with our clinical experts, a client may set up a combination of coverage conditions establishing the quantity, dose and number of days’ supply of medication, the length of time for a therapy, and particular medical conditions that the plan will or will not cover. Our Coverage Management WorkStation software then helps clients, or us on their behalf, to efficiently administer coverage rules.

Cost-share decisions. Cost-share decisions also are aligned with a client’s benefit philosophy and govern the relative share of a drug therapy’s cost that is paid by the member. A number of cost-share options exist, including multi-tiered co-payment, percentage co-payments and payments for the difference between the cost of a brand-name drug and a less-expensive, generic equivalent. When properly structured, cost sharing can encourage members to make more cost-effective prescription drug choices.

Plan limitations and exclusions. Our clinical experts work with clients to determine appropriate limitations and exclusions on coverage of some medications, including many associated with lifestyle choices. For example, some clients will exclude coverage of impotence or baldness medications and treatments.

Clinical Management

Increases in the utilization rate of prescription drugs typically account for a significant portion of the rise in drug trend. Increased utilization rates are attributable to, among other things, the commercialization of new drugs and increased patient awareness and demand. We capitalize on our clinical expertise and advanced information technology infrastructure to help reduce client costs in a medically appropriate way, while striving to improve safety and the quality of care for members. We do this by developing action-oriented clinical programs and services based on clinical rationale reviewed by our Pharmacy and Therapeutics Committee. Once developed, these programs are integrated into a client’s pharmacy benefit plan. To monitor our success with these programs, we regularly consult with clients, review their clinical and financial data, and report to clients on the success of our actions on their behalf.

Clinical Information. Our Department of Medical Affairs tracks prescription drugs while they are still in the research and development phase, as well as the timing of patent expirations for brand-name drugs. This allows us to anticipate how the introduction of new prescription drugs and patent expirations will impact plan design and formulary content options, and gives us lead time on developing new programs and services for clients.

Clinical Decision Support Tools. Once a new prescription drug enters the market, our physicians and pharmacists use modeling software to provide clients with projections of drug spending under different scenarios. We have the ability to make client-specific changes to a benefit plan’s formulary or clinical rules within a few days of a new product’s introduction utilizing workstations that are linked to our data infrastructure.

Clinical Programs. To help clients manage drug trend, we have clinically based programs that identify drug claims on the basis of clinical rules that our clients use for coverage criteria. These rules have the potential to reduce unnecessary costs from uncovered drug use while minimizing impact on valid claims. The clinical basis for the criteria used to develop these rules are approved by our Pharmacy and Therapeutics Committee. Clients may choose standard bundles of rules or, using our formulary consulting capabilities, they may create their own program by choosing the rules most appropriate to their plan design.

We have introduced a variety of innovative clinical programs. One of these is our proprietary RationalMed service, an advanced software tool designed to reduce unnecessary drug-induced illness and hospitalizations and

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reduce overall healthcare expenses. We offer the RationalMed service to our PBM clients and to other healthcare providers. RationalMed analyzes patients’ available prescription, inpatient and outpatient medical and laboratory records to indicate whether a prescription drug could be harmful to them. Clients who implement the RationalMed technology can save money by reducing inappropriate prescription use and avoiding unnecessary medical costs, including possible hospitalization.

Drug Utilization Reviews. We conduct drug utilization reviews, or DURs, which is a systematic evaluation of individual or group use of prescription drugs, to help clients identify and address overuse, underuse, and misuse of prescription drugs. Concurrent DUR provides real-time online decision support for pharmacists at the time they are filling prescriptions that improves quality of care while lowering drug cost by reducing inappropriate dispensing. Our DURs alert us of possible problems, such as drug-drug interactions, drug-age problems, and drug-pregnancy issues based on our patient profiles. Retrospective DUR looks at prescription use over time to help identify and change patterns of prescribing drugs that are not formulary compliant, or prescribing brand-name drugs where there may be medically appropriate generic equivalents.

Pharmacy Management

One of the core features of our PBM services is the management and administration of the process by which prescription claims are received and processed on behalf of our clients and drugs are dispensed to their members.

Retail Pharmacy Networks. We have contractual relationships with approximately 60,000 independent and chain retail pharmacies that have agreed to participate in one or more of our retail network options. A network offers members access to a choice of pharmacies while providing clients with cost savings through contracted discount rates that we negotiate with retail pharmacies. In general, these rates for brand-name drugs are at a discount to the average wholesale price of the drug, which is a standard pricing unit used in the industry. In addition, we determine a maximum allowable cost for each type of generic drug. Our retail pharmacy network agreements also include professional dispensing fees to be paid to the pharmacy. Clients generally select a retail pharmacy network based on the number and location of pharmacies in the network and the competitiveness of the discounts that the network offers. Pharmacies in a network also agree to follow our policies and procedures designed to enhance specific performance standards regarding patient safety and service levels. Our retail specialists also regularly review changes in pharmacy plan rules and clinical protocols with retail pharmacists to help foster the health of members and maximize savings for our clients. Pharmacies in the network benefit, in turn, from increased member traffic and sales.

Following standard industry practice, retail pharmacies maintain online contact with us to process prescription drug claims. We confirm a member’s eligibility, determine the co-payment, update records as required, and conduct concurrent DURs to enhance patient safety. Our retail network department is available 24 hours a day, seven days a week to answer pharmacists’ questions and provide support for processing prescription claims.

Mail Order Service. Our mail order service is the industry’s largest in terms of the number of prescriptions filled. We dispensed approximately 78 million prescriptions in 2003 through our mail order pharmacies. For maintenance medications, mail order typically reduces costs for clients through volume purchasing, increased generic dispensing and higher rebates through greater formulary compliance. Many members prefer mail order for maintenance medications because they can typically receive a 90-day supply instead of a 30-day supply as commonly dispensed by retail pharmacies. Members can place orders easily online through our member website, through our integrated voice-response phone system, or through the mail.

Our mail order pharmacy infrastructure currently consists of 10 mail order pharmacies throughout the United States, eight of which contain prescription processing cognitive service centers and four of which engage in mail order dispensing activities. In our prescription processing centers, our pharmacists focus on “front-end” pharmacy activities such as reviewing, recording and interpreting incoming prescriptions, screening for interactions based on each patient’s drug history and medical profile, resolving benefit and clinical issues with plan sponsors and physicians and then approving and routing the prescriptions to one of our four mail order dispensing pharmacies. In the four dispensing pharmacies, including our automated pharmacies in Las Vegas, Nevada and Willingboro, New

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Jersey, we focus on distribution processes such as prescription dispensing and presorting for shipment to patients by mail or courier. All ten of our mail order pharmacies are electronically networked to provide national coverage.

We have capitalized on the efficiencies created by our two automated dispensing pharmacies, and our industry-leading operational platform. This platform separates the front-end processing activities and back-end dispensing processes by converting our integrated mail order pharmacies into front-end pharmacies and concentrating most back-end activities at our two automated dispensing pharmacies. This approach allows us to optimize the value of our professional pharmacist services to meet the needs of members and ensure faster and smoother service, as well as maximize the efficiency of the dispensing function.

Call Center Pharmacies. We operate seven call center pharmacies, each of which is licensed as a pharmacy in the state in which it is located and is staffed by service representatives and pharmacists. Personnel at our call center pharmacies are available to answer questions and provide information and support to members 24 hours a day, seven days a week, for members using either our mail order service or our retail pharmacy network. Our call center pharmacies also provide information and services to physicians and pharmacists who service our clients’ members. Service representatives and pharmacists at our call center pharmacies use advanced imaging technology and other Internet capabilities to access prescription and health information when providing service to members and encourage physicians to reduce costs through dose optimization, generic substitution and the interchange of formulary compliant drugs for non-formulary compliant drugs.

Health Management Programs

We offer a series of Positive Approaches^® health management programs as part of our prescription drug benefit package to help members with certain chronic conditions better understand their conditions and comply with their prescribed drug therapies. Enrolled members receive educational and behavioral interventions, including letters and phone calls, as well as clinical support through toll-free hotlines. We focus on illnesses that have high prevalence rates and high impact on clients in terms of drug and medical costs. These illnesses include asthma, cardiovascular problems, depression and diabetes. Clients benefit through lower or avoided medical costs.

Our Partners for Healthy Aging^® initiative focuses on older members and supports older adults with literature and drug information printed in easy-to-read, large type and with customer service representatives specially trained in senior health issues.

Physician Services

Motivating physicians to prescribe more cost-effective medications is a key objective of a number of our initiatives, including our Physician Service Center, integrated generics strategy featuring our Generics First^® education and sampling program, Physicians Practice Summary Program and Point-of-Care On-line Connectivity Program.

Physician Service Center. Our Physician Service Center provides a single toll-free number for physicians and office staff to call one of our specially trained and dedicated staff of pharmacists and service representatives who can answer questions relating to patients and their prescription drug benefits. The center is further supported by physicians in our Department of Medical Affairs. The center assists in improving physicians’ understanding of formularies, generics and utilization management. Typically, the center also fields general questions about our company and our clinical products and services, handles requests for educational or promotional materials, and routes calls to other experts in our company if more in-depth information is required. Our integrated communication platform includes a physician fax platform that analyzes and routes faxes to expedite resolution of physician inquiries regarding formulary compliance and other programs and services.

Integrated Generics Strategy. Our integrated generics strategy seeks to reduce our clients’ drug spend by increasing the use of generic medications, when clinically appropriate, in place of more expensive, brand-name medications. The strategy encompasses generic education, substitution, and interchange programs, as well as a host of other activities, including careful tracking of brand-name drugs about to lose their exclusivity. When patents for brand-name drugs expire, we act quickly to encourage physicians and members to use the new generic equivalent.

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For example, when the blood pressure medication Vasotec^® lost patent protection, our mail order pharmacies moved quickly to substitute the new generic equivalent, enalapril. In our mail order pharmacy business, generic conversions from Vasotec^® reached approximately 90% within one month of enalapril’s availability, providing savings to our clients. In our mail order pharmacy business, generic conversions from Prinivil^®/Zestril^® reached approximately 90% within one month of generic lisinipril’s availability, providing savings to our clients.

Introduced late in 2000, our Generics First^® program has been encouraging the use of generics, where medically appropriate, among approximately 20,000 physicians across the country. Of these physicians, approximately 3,500 receive periodic face-to-face informational visits from our specially trained pharmacists who discuss clinical guidelines for generics and facilitate the ordering of free samples of commonly prescribed generic medications from manufacturers. These pharmacists also provide educational brochures on the benefits of generics for patients in office waiting areas and exam rooms. As part of this program, in 2003, approximately 700 physicians nationwide participated in an innovative web-based educational program that provides online Generics First^® clinical and cost education.

Physician Practice Summary Program. Through our Physician Practice Summary Program, we are able to track physician prescribing histories and report summary and comparative data to both physicians and clients. This information, combined with meetings with physicians, is useful in encouraging physicians to improve the cost effectiveness of their prescribing.

Point-of-Care On-line Connectivity Program. More than 11,000 physicians are enabled with our point-of-care, or POC, electronic prescribing program. During 2003, these physicians submitted approximately 2.7 million prescriptions using electronic prescription writing tools. Key objectives of the strategy include improved accuracy of information transmitted to the pharmacy and enhanced patient safety. Physicians gain real-time access to a patient’s plan guidelines and prescription history to help prevent drug interactions and duplicate therapies. Physicians also benefit from electronic prescribing because it simplifies the prescription process and, we believe, improves the quality of patient care.

We work closely with a variety of handheld and PC based POC providers in recruiting new physician users. We also encourage the use of an open-access system to ensure that standardized solutions are available for varying physician office requirements. In February 2001, we formed RxHub LLC with AdvancePCS and Express Scripts, Inc. RxHub created a standardized electronic prescribing platform, enabling physicians to use electronic prescribing technology to link to pharmacies, PBMs and health plans.

Web-Based Services

We believe our web-based services are the most advanced and comprehensive in the PBM industry. Not only do we offer what we believe is the industry’s leading consumer website for members, we also offer client and pharmacist sites with interactive tools aimed at improving compliance with plan goals, simplifying benefit administration, and providing critical benefit and medical information.

Member-Oriented Web Services. Our member Internet capabilities are focused on keeping members informed about their prescription drug coverage while encouraging them to use safe, effective therapies that comply with their plan’s provisions.

Our member website provides members a broad set of features and capabilities, including:

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Our member website was the first Internet pharmacy site to be certified by the National Association of Boards of Pharmacy. The site processed more than 13.8 million prescription orders in 2003. The site also handled more than 49.7 million member service inquiries in 2003.

Client-Oriented Web Services. Our client website, an extranet introduced in 2001, provides clients online access to our proprietary tools for reporting, analyzing and modeling data, clinical- and decision-support, plan administration, including eligibility and claims reviews, the latest industry news, and easy submission and tracking of service requests. Clients who conduct their own member service can use our client website to update eligibility data and counsel members on all aspects of their pharmacy benefit, formularies, co-payments and coverage provisions, including the location of network retail pharmacies. Clients also can view detailed, consolidated claims for retail and mail order service and issue prior-authorization approval. We can tailor access to the specific needs of different users who play a role in managing the pharmacy benefit within the client organization, thereby limiting access to information to those who are authorized to view it.

Pharmacist-Oriented Web Services. Our Pharmacist Resource Center is an online service for retail pharmacies that participate in our national networks. This service provides pharmacists with the latest news on new benefit plans, plan design changes, pricing information, drug recalls and alerts, as well as online access to our pharmacy services manual. Pharmacists can check patient eligibility, determine coverage and review claims status for plan members. The center also gives participating pharmacies e-mail access to our pharmacy services help desk.

Contractual Relationships

Our net revenues are principally derived from contracting with clients to provide prescription drugs to their members through our mail order pharmacies and our networks of contractually affiliated retail pharmacies. Our client contracts provide that a client will pay for drugs dispensed to its members at specified discounts to average wholesale prices, plus the applicable dispensing fee. Both the specified discounts to average wholesale prices and the applicable dispensing fee vary based on whether the drug dispensed is a brand-name drug or generic drug and whether the prescription is filled through a mail order or retail pharmacy. Clients may also pay an administrative fee per prescription filled for services we provide. These services comprise claims processing, eligibility management, benefits management, pharmacy network management and other related customer services. Client contracts generally provide that we will share with clients formulary rebates received from pharmaceutical manufacturers. Additionally, many of our contracts with clients contain provisions that specify minimum levels of service we will provide to the client and associated penalties if we do not meet these levels.

Our contracts with pharmaceutical manufacturers provide us with rebates and fees for prescription drugs dispensed through our mail order pharmacies and retail pharmacies participating in our networks of contractually affiliated retail pharmacies, as well as discounts for prescription drugs we purchase and dispense from our mail order pharmacies. We typically purchase generic drugs directly from generic manufacturers pursuant to informal agreements and understandings under which we will provide the generic manufacturer with the right to be the exclusive supplier to our mail order pharmacies so long as such manufacturer’s prices remain competitive. Rebates and fees are predominantly equal to a percentage of the aggregate dollar value of all of a particular drug that we dispensed, based on the manufacturer’s published wholesale price for that drug. Rebates and fees are invoiced to the pharmaceutical manufacturer and paid to us on a quarterly basis. Although most rebates are payable on a product by product basis, some pharmaceutical manufacturers have agreed to pay rebates in respect of any given client only if all of the specified products of the manufacturer are included on that client’s formulary. Our contracts typically provide for two types of rebates:

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Formulary rebates are typically calculated based on an agreed percentage of the aggregate wholesale price of all prescriptions dispensed for clients, which include the applicable pharmaceutical products on their formularies and do not subject such products to restrictions which are not applicable to competing branded products. Market share rebates, a type of performance based rebate, are contingent upon us achieving the contractually specified market share level for a particular drug for all of our clients. We generally share a portion of rebates with our clients based on the provisions of the applicable client contract, and may also guarantee a minimum rebate per prescription dispensed to the client’s members. For a further discussion of the rebates we receive, see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Use of Estimates and Critical Accounting Policies—Critical Accounting Policies”.

In addition to contracts with clients and pharmaceutical manufacturers, we have contractual relationships with independent and chain retail pharmacies that have agreed to participate in one or more of our retail networks. These retail pharmacies agree to fill prescriptions for our clients’ members at discounted prices and, in exchange, we pay them for the contracted cost of drugs they dispense, net of co-payments, and an agreed upon professional fee for filling each prescription and performing eligibility and benefit management and other services.

Clients

We have clients in a broad range of industry categories, including various Blue Cross/Blue Shield plans; managed care organizations; insurance carriers; third-party benefit plan administrators; employers; federal, state and local government agencies; and union-sponsored benefit plans. For the fiscal year ended December 27, 2003, our ten largest clients based on revenue accounted for approximately 46% of our net revenues, including UnitedHealth Group, our largest client, which represented approximately $6,100 million, or 18%, of our net revenues. In January 2004, we announced an early renewal agreement to provide pharmacy benefit administrative services to UnitedHealth Group effective January 1, 2004, for an initial five-year term. The agreement may be extended for three additional years through 2011 at UnitedHealth Group’s option. No other client accounted for 10% or more of our net revenue in this period. Our failure to retain key clients or satisfy contractual provisions with key clients could adversely affect our financial condition, business and results of operations, including the impairment or accelerated amortization of intangible assets associated with the value of our customer relationships at the time of our acquisition by Merck and pushed down to our balance sheet.

Many of our contracts with clients contain provisions that guarantee the level of service we will provide to the client or the minimum level of rebates or discounts the client will receive. Many of our client contracts also include guaranteed cost savings. An increase in drug costs, if the result is an overall increase in the cost of the drug plan to the client, may prevent us from satisfying contracts with guaranteed cost savings or minimum levels of rebates or discounts. Additionally, these clients may be entitled to performance penalties or the right to terminate their contracts with us if we fail to meet a service or cost guarantee we provide to them. Clients that are party to these types of contracts represented, in aggregate, over 90% of our net revenues in 2003.

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Our clients are generally entitled to have us audited under their contracts with us and on occasion a client or former client has claimed that it overpaid us for our services based on the results of an audit. Payment disputes may adversely affect our results of operations if they result in refunds or the termination or non-renewal of a client contract.

Mail Order Service Suppliers

We maintain an extensive inventory in our mail order pharmacies of brand-name and generic pharmaceuticals. If a drug is not in our inventory, we can generally obtain it from a supplier within one or two business days. We purchase our pharmaceuticals either directly from manufacturers or through wholesalers. During 2003, one wholesaler, AmerisourceBergen Corp., accounted for approximately 60% of the total dollar amount of our mail order pharmaceutical purchases, most of which were brand-name pharmaceuticals. Generic pharmaceuticals are generally purchased directly from manufacturers. Except to the extent that brand-name drugs are available to the market exclusively through the manufacturer, we believe that alternative sources of supply for most generic and brand-name pharmaceuticals are readily available.

Competition

Competition in the PBM industry is intense. We compete primarily on the basis of our ability to design and administer innovative programs and services that provide high-quality, affordable prescription drug care and health management services to health plan members. We believe plan sponsors generally consider the following key competitive factors:

We compete with a wide variety of companies for business in client categories broadly defined as Blue Cross/Blue Shield plans; managed care organizations; insurance carriers; third-party benefit plan administrators; employers; federal, state and local government agencies; and union-sponsored benefit plans. Although some of our competitors focus on a limited set of client categories, we have clients in all of these categories, and we have achieved significant plan retention and actively compete for new business in all categories.

Competitors fall into the following categories:

National Competitors. We compete with large national PBMs, such as AdvancePCS, Caremark Rx, Inc. and Express Scripts, Inc. Caremark Rx, Inc. completed its acquisition of AdvancePCS on March 24, 2004. These competitors conduct business in every market category and, like us, they have national sales and account teams, mail order pharmacies and extensive technology infrastructure.

Managed Care and Insurance Companies. We also compete with several managed care organizations, Blue Cross/Blue Shield plans and insurance companies that have their own internal full-service pharmacy benefit programs. Some of these competitors have national account capabilities and, in some cases, they may have access to greater financial, purchasing or distribution resources than we have.

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Other Competitors. Because we provide a wide variety of programs and services, there are many non-PBM firms that compete with us in various aspects of our business. Some of our health management and other member services compete with similar services offered by pharmaceutical companies and by smaller firms specializing in those service markets. Other firms that focus on large-scale claims processing also compete with us.

Government Regulation

Federal and state laws and regulations govern many aspects of our business. These laws and regulations apply to our administration of prescription drug benefits and our drug and health education programs and services. In addition, the activities of our mail order pharmacies are regulated under federal and state laws applicable to the purchase, distribution and dispensing of prescription drugs. Many of our clients, including insurers and health management organizations, or HMOs, are themselves subject to extensive regulations that affect the design and implementation of prescription drug benefit plans that they sponsor. We believe we are in substantial compliance with all existing legal and regulatory requirements material to the operation of our business. However, the application of complex standards to the operation of our business creates areas of uncertainty.

We have standard operating procedures and controls designed to enhance operating efficiencies and assist in ensuring compliance with existing contractual requirements and state and federal law. We diligently monitor and audit our adherence to these procedures and controls. From time to time, we have become aware that certain employees at some of our pharmacies did not follow certain of our procedures and controls regarding the processing of prescriptions, and we have taken prompt appropriate corrective and disciplinary actions. We believe that the actions of such employees did not result in any material violations of any contract or applicable law. Nevertheless, a determination that any such contractual breaches or violations of law occurred could adversely impact existing governmental or legal proceedings or otherwise have a material adverse effect on our business, financial condition or profitability.

Numerous new healthcare laws and regulations or modifications to existing laws or regulations have been proposed at the federal and state levels. We cannot predict how courts or regulatory agencies may interpret existing laws or regulations or what additional federal or state legislation or regulatory initiatives may be enacted in the future regarding healthcare or the PBM industry. Laws and regulations in these areas will continue to evolve. Federal or state governments may impose additional restrictions or adopt interpretations of existing laws directly affecting our operations or the market for our services that could have a material adverse affect on our business, profitability, liquidity or growth prospects.

Among the federal and state laws and regulations that affect aspects of our business are the following:

Regulation of Our Pharmacy Operations. The practice of pharmacy is generally regulated at the state level by state boards of pharmacy. Our mail order pharmacy operations are located in eight states and dispense drugs throughout the United States. We have ten mail order pharmacies, eight of which contain prescription processing centers and four of which engage in mail order dispensing activities. In addition, we operate seven call center pharmacies that provide extensive support and counseling to members using either our mail order dispensing pharmacies or our retail pharmacy network. Each of our dispensing pharmacies, prescription processing centers and call center pharmacies must be licensed in the state in which it is located. Our pharmacies are located in Florida, Nevada, New Jersey, Ohio, Pennsylvania, Texas, Virginia and Washington. In some of the states where our dispensing pharmacies are located, state regulations require compliance with standards promulgated by the United States Pharmacopeia, or USP, a nonprofit organization whose members represent the healthcare professions, industry, government and academia. USP creates standards in the packaging, storage and shipping of pharmaceuticals. We believe that each of our pharmacies has the appropriate licenses required under the laws of the state in which it is located and that we conduct our pharmacy operations in accordance with the laws and regulations of these states.

Our mail order pharmacies deliver prescription drugs to the members of benefit plans sponsored by our clients in all 50 states. Many of the states into which we deliver pharmaceuticals and controlled substances have laws and regulations that require