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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 25, 2004

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 Annual Report on Form 10-K or any amendment to this Annual Report on 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 the voting stock held by non-affiliates of the registrant as of June 26, 2004 was $9,780,420,908.

As of February 25, 2005, the registrant had 275,352,620 shares of common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of Medco Health Solutions, Inc.’s Proxy Statement for its 2005 Annual Meeting are incorporated by reference in this Annual Report on Form 10-K in response to Part III (Items 10 through 14).

MEDCO HEALTH SOLUTIONS, INC.

ANNUAL REPORT ON FORM 10-K

TABLE OF CONTENTS

PART I

Item 1. Business.

Overview

We are one of the nation’s largest pharmacy 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. Our programs and services help our clients moderate the cost and enhance the quality of the prescription drug benefits they offer to their members. We accomplish this by providing pharmacy benefit manager (“PBM”) services through our own mail order pharmacies and our national networks of retail 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. We have been an independent, publicly traded enterprise since we were spun off by Merck & Co., Inc., (“Merck”) on August 19, 2003. From November 18, 1993 through the spin-off, we were a wholly-owned subsidiary of Merck.

When “Medco,” “we,” “us” and “our” are used, 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 drugs and the introduction of new prescription medications. Our business model is designed to reduce the level of prescription drug cost increases, known as drug trend. The average drug trend for our clients’ plans that include both retail and mail order prescriptions amounted to 8.5% in 2004, 10.2% in 2003 and 12.9% in 2002. We help moderate this trend primarily by obtaining competitive discounts and rebates from pharmaceutical manufacturers, securing discounts from retail pharmacies, applying our sophisticated utilization management programs and efficiently administering prescriptions dispensed through our mail order pharmacies. We further contain costs for our clients and their members by encouraging the use of medically appropriate generic drugs through our generic education and substitution programs. Between 2005 and 2008, patents are expected to expire on brand-name drugs that generate aggregate U.S. sales of approximately $30 billion, representing a significant opportunity for further drug trend reduction.

In 2004, our mail order pharmacies dispensed 87.7 million prescriptions, approximately equal to the number of mail order prescriptions dispensed by the combined mail order operations of our two largest PBM competitors. 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.

The advanced technologies we have developed are instrumental to our ability to drive growth, improve service and reduce costs. Our technology platform is designed to seamlessly integrate prescription management in both mail order and retail 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 order processing pharmacies with our automated dispensing pharmacies in Willingboro, New Jersey and Las Vegas, Nevada. 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. Our Internet and integrated voice-response phone technologies allow members to enroll for mail order service, submit a refill or renewal mail order prescription for processing, track the status of their mail order prescription, and locate in-network retail pharmacies in their area, along with other features. Advanced imaging technology enables service representatives to access an online image of a member’s prescription to address a member’s needs more efficiently. Our data center links our mail order pharmacy operations, including our call center pharmacies, the retail pharmacies in our networks, and our websites. The data center enables us to efficiently receive, process and administer claims and dispense prescription drugs with speed and accuracy. We have also deployed companywide reliability and change management and implementation 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 client-oriented solutions within our information systems.

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Our proprietary Internet solutions improve client and member service by facilitating prescription ordering and by providing important healthcare information and an efficient means of communication. We support distinct websites for clients, members and pharmacists that provide critical benefit information and interactive tools aimed at facilitating compliance with benefit plan goals and simplifying benefit administration. In 2004, we processed approximately 17 million prescription orders through our member website, a 25% increase over 2003.

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:

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We have also been actively engaged in supporting the Medicare discount card program, and through our own Medco card and cards that are co-sponsored with our clients, we have provided prescription coverage and savings to over 900,000 Medicare members in 2004. We will continue to support this card program in 2005, and we are preparing to participate in the Medicare Part D program commencing in 2006, although there can be no assurance at this time that we would be able to do so on commercially acceptable terms.

In 2004, we administered approximately 503 million prescriptions; had net revenues in excess of $35 billion and net income of more than $481 million; and reported earnings before interest income/expense, taxes, depreciation and amortization, or EBITDA, of approximately $1,244 million. See Note 7 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 generate favorable discounts on generic prescription drugs dispensed in our mail order pharmacies, earn rebates and discounts on brand-name drugs; negotiate competitive client pricing including rebate sharing terms, administrative fees and price discounts; and provide services in a cost-efficient manner.

Business segment and geographic region information for each of 2004, 2003 and 2002 is set forth in Part II, Items 7, 7A and 8 of this Annual Report on Form 10-K.

Industry Overview

PBMs emerged in the early 1980s, primarily to provide cost-effective drug distribution and claim processing for the healthcare industry. The PBM industry developed along with the significant 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 purchase discounts and rebates from manufacturers and discounts from distributors, as well as generating discounts from retail pharmacies. On the demand side, PBMs could educate physicians on prescribing more cost-effective alternatives, and apply various clinical techniques to encourage client membership to implement improved utilization habits, such as the use of less-expensive generic drugs and mail order, without jeopardizing their drug therapy.

Areas of potential growth for the PBM industry include increased participation in available programs and services by existing clients, with a particular focus on mail order, as well as increased focus on the dispensing of specialty drugs and participation in the Medicare Part D benefit. 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.

Prescription drugs continue to be a rapidly growing component of healthcare costs in the United States. We believe the key contributors to drug trend include drug price inflation, significant advances in pharmaceutical and biotechnology research and development, the introduction of product line extensions and increased patient awareness.

Increased generic substitution is a key element of programs to reduce drug trend. Between 2005 and 2008 patents are expected to expire on brand-name drugs representing approximately $30 billion in annual sales in the United States, based on the current estimated release schedule. The majority of these expirations are expected to occur between 2006 and 2008. Generic substitution for drugs on which patents have expired is a significant factor in moderating drug trend. Initiatives by generic drug manufacturers combined with our ability to yield significant generic substitution within a short period of time has led to an acceleration of generic drug substitution following the end of a brand-name drug’s patent protection.

Business Strategy

Upon becoming an independent company in August 2003, Medco’s leadership team outlined a strategy for growth. The first steps in the execution of this strategy included a focus on further improving Medco’s core processes and drug trend management capabilities, the implementation of a client-centric organization dedicated to meeting the needs of our diverse client base, as well as maintaining a well-governed public enterprise. We enhanced Medco’s systems development processes through improved change management and implementation programs and reliability protocols, and continued enhancement to our integrated single-platform systems architecture. We also continued to strive to become a leader in transparency with our clients and the investing public by disclosing information on rebates earned and shared with clients.

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The next phase of Medco’s strategy will focus on leadership in innovation in a drive to increase Medco’s differentiation from other PBM’s. Medco’s strategy will rely on the following:

In order for the execution of our strategy to be successful, we must respond to both the common and unique needs of our clients, and we must develop scalable yet flexible capabilities and solutions that are affordable for our clients and profitable for us. This will include delivering high quality client and member service; leveraging our significant technology investments to drive growth, improving service and reducing costs; active pursuit of sources of growth from new clients and increased use of our value-added services, including our mail order pharmacies; and selectively making acquisitions, forming strategic alliances, and expanding into complementary, adjacent markets.

We believe we have several competitive advantages that enable us to deliver enhanced service to clients and their members while effectively managing drug trend. These advantages include our highly automated mail order pharmacy capability; our investments in other systems technologies, including the Internet; our extensive value-added programs and services offerings; and our comprehensive generic substitution programs that save our clients and their members money.

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

Products 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.

Plan Design

Our client teams take a consultative approach to assisting clients in their development and implementation of plan designs that suit their specific needs. Each client has access to the skills of various Medco professionals, including 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, mail order initiatives, drug coverage and exclusion, and cost-share options and generic drug utilization initiatives, as well as applicable state and federal laws.

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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. One such tool is Medco’s EXPERxT Advisor^TM, which provides real-time plan design modeling capability for our clients. Clients can use the output from these models to judge the impact of specific plan design elements before they are implemented. In addition, the introduction of our Client Solution Centers in 2004 allows us to use videoconferencing technology to make Medco experts directly available to our clients, and to respond to clients more effectively. Our Client Solution Centers have helped us establish a new paradigm of client service.

The following are descriptions of key plan design elements:

Formulary Choice. A formulary is a list of plan-preferred drugs used to assist plan members and their physicians in the drug selection process. We work with our clients to develop formularies that deliver affordable access to the prescription drugs their members need to stay healthy while containing costs for our clients. Client savings are derived from our ability to support members and physicians in choosing clinically appropriate, but lower-cost alternatives, and from purchase discounts and rebates. Clients can choose from one of Medco’s standard formularies, or we can assist them in designing their own customized formulary. For standard formularies, our independent Pharmacy and Therapeutics Committee, which is further described below, reviews drugs for formulary inclusion based on clinical considerations.

Generic Options. Because generic drugs typically cost substantially less than brand-name drugs, incentives that encourage the preferential use of generic drugs, when clinically appropriate, can be an important part of a plan design. Clients can realize plan savings by implementing effective generic incentive programs in which members that choose generics instead of brand-name drugs benefit from lower co-payments.

Pharmacy Networks. Our clients can realize plan savings by carefully selecting a retail pharmacy network and by using 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.

Mail Advantage. Our Mail Advantage 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 use of mail order provides substantial savings for our clients through better prescription pricing, formulary compliance, and superior generic substitution performance. Also, our clients’ members benefit from generally lower annual co-payments, superior dispensing accuracy and greater convenience.

Coverage Rules. Coverage rules govern the conditions under which certain drugs are covered. We work with each client to understand their benefit philosophy, and make recommendations on the conditions under which certain drugs should be covered, and in what amounts. Our Coverage WorkStation software then helps clients, or us on their behalf, to efficiently administer their coverage rules.

Cost-share Decisions. Cost-share decisions govern the share of a drug’s cost that is paid by our clients or their members. We work with our clients to help them make cost-sharing decisions aligned with their benefit philosophy. A number of cost-share options exist, including tiered flat and percentage co-payments. 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 exclude coverage of treatments for impotence or baldness.

Clinical Management

We capitalize on our clinical expertise and advanced information technology infrastructure to help reduce client costs for prescription drugs in a medically appropriate manner, 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. Our Pharmacy and Therapeutics Committee and Medical Advisory Board play

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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 clinically oriented programs and services.

Once developed, these programs are integrated into a client’s pharmacy benefit plan. To monitor our success with these programs, we regularly report to clients on the success of our actions on their behalf, review their clinical and financial data, and consult with our clients to identify opportunities for improvement.

Clinical Information. We track experimental drugs and possible new indications for existing drugs while they are still in the research and development phase, as well as the timing of new generic and over-the-counter 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 provides us lead time for the development of 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 various scenarios. From the first day the new drug becomes available, we use proprietary rule-development workstations to make client-specific changes to a benefit plan’s formulary, and clinical rules to address the new drug’s utilization profile.

Clinical Programs. To help clients manage the quality of care and costs associated with prescription drugs, we offer clinical programs designed to assist providers and their members in making more cost-effective and evidence-based decisions regarding the use of prescription drugs.

We have introduced a variety of innovative clinical programs. One of these is our proprietary RationalMed service, an advanced patient safety program designed to improve patient care and lower total healthcare costs. RationalMed analyzes patients’ available prescription, inpatient and outpatient medical and laboratory records to detect medication and other safety issues, and engage physicians and pharmacists in making appropriate changes in care. Clients who participate in RationalMed can save money by reducing inappropriate and unsafe prescription use and avoiding unnecessary medical costs, including possible hospitalization. We offer RationalMed to health plans and plan sponsors, regardless of whether they are clients of our PBM business.

We perform drug utilization review (DUR), which is a systematic evaluation of individual and population use of prescription drugs, to identify and address over-use, under-use, and misuse of prescription drugs. We use patient profiles to perform DUR to alert pharmacists and physicians to possible issues, such as drug-drug interactions, drug-age problems, drug-pregnancy issues and opportunities to consider alternate therapies including generics and formulary preferred drugs. Concurrent DUR provides real-time online decision support for pharmacists at the time they are filling prescriptions and improves quality of care while lowering drug cost by reducing inappropriate dispensing. Retrospective DUR looks at prescription use over time to help identify and change patterns of prescribing and utilization that fail to comply with drug utilization guidelines, that are not formulary compliant, or that entail the prescribing of brand-name drugs where there may be medically appropriate generic equivalents.

We have rule-based programs that identify drug claims requiring physician review to determine whether the use or amount of certain drugs can be covered under our clients’ benefit plans. These programs reduce unnecessary costs from uncovered drug use while minimizing the impact on valid claims. The clinical basis for the criteria used to develop these rules is approved by our Pharmacy and Therapeutics Committee. Clients may choose to accept our recommendations for managing the benefit plan, or work with us to create their own program by choosing the rules optimally suited to their plan philosophy.

Health Education. We offer health education programs to health plans and plan sponsors to help their members with certain chronic conditions, better understand their conditions and comply with their prescribed drug therapies. Enrolled members receive educational information and clinical support through toll-free telephone access. 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 disease, and diabetes. Clients benefit by having an informed membership that obtains better care and potentially avoids complications and higher medical costs in the future.

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

Pharmacy Management

One of the core features of our PBM services is the management of prescription claims for our clients’ members.

Mail Order Service. Our mail order service is the industry’s largest in terms of the number of prescriptions dispensed. We dispensed approximately 88 million prescriptions in 2004 through our mail order pharmacies. For maintenance medications, mail order typically reduces costs for clients as a result of Medco’s purchasing scale, increased generic dispensing and higher rebates through enhanced formulary compliance. Many members prefer mail order for maintenance medications because they can receive up to a 90-day supply instead of a 30-day supply as commonly dispensed by retail pharmacies, and members also benefit from generally lower co-payments at mail order and the convenience of receiving their prescriptions in the mail. Members can place first-fill, refill and renewal orders through the mail. In addition, members can access resources necessary for first-fill prescription orders and can place refill or renewal orders easily online through our member website or through our integrated voice-response phone system.

Our mail order pharmacy infrastructure consists of nine mail order pharmacies throughout the United States, some of which provide multiple functions. Eight of the pharmacies engage in prescription order processing activities, four of the pharmacies engage in prescription dispensing activities, and one engages in special care pharmacy 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 highly automated pharmacies in Willingboro, New Jersey and Las Vegas, Nevada, we focus on distribution processes such as prescription dispensing and pre-sorting for shipment to patients by mail or courier. All nine of our mail order pharmacies are electronically networked into our integrated systems platform. This approach to mail order operations 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.

Our special care pharmacy located in our Columbus, Ohio facility is dedicated to the processing of specialty drug orders and the associated dispensing. Our recently announced agreement to acquire Accredo is expected to provide significant additional capacity in the specialty pharmacy area.

Retail Pharmacy Networks. We have contractual relationships covering 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. 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 DUR to enhance patient safety. Representatives from our retail network function are available 24 hours a day, seven days a week to answer pharmacists’ questions and provide support for processing prescription claims.

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Call Center Pharmacies. We operate five 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 assist physicians in reducing costs through dose optimization, generic substitution and the interchange from non-formulary compliant drugs to clinically equivalent formulary compliant drugs.

We have on a limited basis outsourced some call handling capabilities to third-party vendors, including the management of inbound calls from retail pharmacies. Additionally, we have initiated work-at-home programs on a limited basis where appropriate for certain of our call center and pharmacy employees.

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 focuses on reducing our clients’ drug trend 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 scheduled to lose their patent protection. When patents for brand-name drugs expire, we act quickly to encourage physicians and members to use the new generic equivalent.

Our Generics First^® program encourages the use of generics, where medically appropriate, among thousands of physicians across the country. Higher-utilization physicians 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.

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 practices.

e-Prescribing Connectivity Program. Through our e-Prescribing Connectivity program, physicians submit prescriptions using electronic prescription writing tools. Key objectives of the strategy include improved accuracy of information transmitted to the pharmacy, improved patient safety, and increased formulary compliance and generic usage. Physicians gain real-time access to a patient’s plan guidelines and prescription history to help prevent drug interactions and inappropriate therapies. Physicians also benefit from electronic prescribing because it simplifies the prescription process and, we believe, improves the quality of patient care.

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We work closely with a variety of handheld and personal computer based technology 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 2001, we formed RxHub LLC with AdvancePCS (now merged into Caremark Rx, Inc.) 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 sites for clients and retail pharmacists which provide 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:

Our member website was the first Internet pharmacy site to be certified by the National Association of Boards of Pharmacy. The site processed approximately 17 million prescription orders in 2004. The site also handled approximately 55 million member service inquiries in 2004.

Client-Oriented Web Services. Our client website provides clients online access to Medco’s 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 have the ability to 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 involved in managing the pharmacy benefit within the client organization, limiting access to information only to authorized individuals.

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 information 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 use this service to 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.

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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 dispensed through a mail order or retail pharmacy. Clients may also pay an administrative fee per prescription dispensed for services we provide. These services comprise claims processing, eligibility management, benefits management, pharmacy network management and other related customer services. Client contracts may also provide that we will share with clients a portion or all of the rebates received from pharmaceutical manufacturers.

Additionally, 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. 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 2004. Our clients are generally entitled to audit our compliance with their contracts and on occasion a client or former client has claimed that it overpaid us for our services based on the results of an audit.

Our contracts with pharmaceutical manufacturers provide us with rebates and fees for prescription drugs dispensed through our mail order pharmacies and retail pharmacy network, as well as discounts for prescription drugs we purchase and dispense from our mail order pharmacies. Rebates and fees are generally calculated as 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 with pharmaceutical manufacturers generally give the manufacturer the right to audit our calculation of amounts billed to them. These contracts typically provide for two types of rebates:

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. In some instances, rebates are passed back to a 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 dispense 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.

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 25, 2004, our ten largest clients based on

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revenue accounted for approximately 44% of our net revenues, including UnitedHealth Group, our largest client, which represented approximately $6,500 million, or 18%, of our net revenues. No other client accounted for 10% or more of our net revenues 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 primarily associated with the value of our client relationships at the time of our acquisition by Merck and pushed down to our consolidated balance sheets. As a result of the loss of Independence Blue Cross in 2004 and the loss of the Federal Employees Health Benefit Plan effective January 2005, as well as the loss of other clients in 2004 that were in our client base at the time of the Merck acquisition, we re-evaluated the weighted average useful life of our intangible asset. Effective as of the beginning of the 2004 fiscal year, the weighted average useful life was revised from 35 years to 23 years, with the annual intangible asset amortization expense, a non-cash item, increasing to $180 million in 2004 from $94 million in 2003.

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 our primary wholesaler, AmerisourceBergen Corp., which accounted for approximately 58% of our 2004 drug purchases, or from manufacturers. Most of the purchases from the primary wholesaler were for 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 a flexible, high quality, affordable prescription drug benefit management offering to our clients and their 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. Competitors include companies that offer pharmacy benefit management services, such as stand alone PBM companies, companies that offer pharmacy benefit management services as well as other managed care or health insurance services, companies that offer specialty pharmacy services, claims processing companies and others.

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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 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, and we take prompt corrective and disciplinary action when appropriate.

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. Eight of the pharmacies engage in order processing activities, four of the pharmacies engage in prescription dispensing activities, and one engages in special care pharmacy activities. In addition, we operate five 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

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require out-of-state mail order pharmacies to register with that state’s board of pharmacy or similar regulatory body. We have registered in every state that requires registration for the services we provide. To the extent some of these states have specific requirements for out-of-state mail order pharmacies that apply to us, we believe that we are in compliance with them. In addition, some states have proposed laws to regulate online pharmacies, and we may be subject to this legislation if it is passed.

Federal agencies further regulate our pharmacy operations. Pharmacies must register with the U.S. Drug Enforcement Administration and individual state controlled substance authorities in order to dispense controlled substances. In addition, the FDA (Food and Drug Administration) inspects facilities in connection with procedures to effect recalls of prescription drugs. The FTC (Federal Trade Commission) requires mail order sellers of goods to engage in truthful advertising and, generally, to stock a reasonable supply of the product to be sold, to fill mail orders within 30 days and to provide customers with refunds when appropriate. The U.S. Postal Service has statutory authority to restrict the transmission of drugs and medicines through the mail to a degree that could have an adverse effect on our mail service operations. The U.S. Postal Service historically has exercised this statutory authority only with respect to controlled substances. If the U.S. Postal Service restricts our ability to deliver drugs through the mail, alternative means of delivery are available to us. However, alternative means of delivery could be significantly more expensive.

Third-Party Administration and Other State Licensure Laws. Many states have licensure or registration laws governing companies that perform third-party administration, or TPA, services on behalf of others. The definition of a TPA required to register and comply with these laws varies from state to state. We have obtained licenses in each of the states in which we believe a license is required based on the benefit management services we provide in those states.

In addition, many states have laws or regulations that govern ancillary healthcare organizations, including preferred provider organizations and companies that provide utilization review and related services. The scope of these laws differs significantly from state to state, and the application of these laws to the activities of PBMs is often unclear. We have registered under these laws in states in which we have concluded, after discussion with the appropriate state agency, that registration is required. These regulations generally require annual or more frequent reporting and licensure renewals and impose other restrictions or obligations affecting PBM services. Changes in these regulations could adversely affect our business, profitability and growth prospects.

Consumer Protection Laws. Most states have consumer protection laws designed to assure that information provided to consumers is adequate, fair and not misleading. We believe that our practices conform to the requirements of state consumer protection laws. However, we may be subject to further scrutiny under these laws as they are often interpreted broadly.

Antitrust Laws. In 1999, the FTC entered an order to resolve its antitrust concerns resulting from Merck & Co., Inc.’s (“Merck”) acquisition of us in 1993. Among other things, the order requires us to maintain an open formulary that consists of drugs selected and approved by the Pharmacy and Therapeutics Committee. The order also requires that we accept, and accurately reflect on the open formulary, all concessions offered by any other manufacturer of pharmaceutical products. We and Merck also agreed pursuant to the order not to share certain proprietary or other non-public pricing information received from the other’s competitors unless such information is required for legal or auditing purposes.

Network Access Legislation. As part of our PBM services, we form and manage pharmacy networks by entering into contracts with retail pharmacies. A significant number of states have adopted legislation that may affect our ability to limit access to our retail pharmacy networks or to remove retail pharmacies from a network. This type of legislation, commonly known as “any willing provider” legislation, may require us or our clients to admit into our networks and retain any retail pharmacy willing to meet the price and other terms of our clients’ plans. To date, these statutes have not had a significant impact on our business because, for most of our clients, we administer large networks of retail pharmacies and will admit any licensed pharmacy that meets our network’s terms, conditions and credentialing criteria, including adequate insurance coverage and good standing with the relevant state regulatory authorities.

Proposals for Direct Regulation of PBMs. Legislation directly regulating PBM activities in a comprehensive manner has been introduced recently in a number of states. These legislative initiatives have the support of associations representing independent pharmacies. In addition, legislation has been proposed in some states seeking to impose fiduciary

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obligations or disclosure requirements on PBMs. If enacted in a state in a form that is applicable to the operations we conduct there, this type of legislation could materially adversely impact us. Georgia has enacted a statute requiring PBMs engaged in the practice of pharmacy to obtain a Georgia pharmacy license. Compliance with this statute has not had a material impact on us. South Dakota has enacted a statute requiring PBMs to license as TPAs and imposing certain disclosure obligations. Medco is considering the implications of these requirements on potential business in South Dakota. Maine and the District of Columbia each has enacted a statute imposing fiduciary and disclosure obligations on PBMs; however, the U.S. District Court in Maine and District of Columbia, respectively, each has preliminarily enjoined enforcement of these statutes.

ERISA Regulation. We provide PBM services to a number of different corporations and other sponsors of health plans. These plans are subject to ERISA (the Employee Retirement Income Security Act of 1974), which regulates employee pension benefit plans and employee welfare benefit plans, including health benefit and medical plans.

ERISA imposes duties on any person that is a fiduciary with respect to a plan that is subject to ERISA. We administer pharmacy benefit plans according to the plan design choices made by the plan sponsor. We believe that our activities are sufficiently limited that we are not a fiduciary except in those instances in which we have expressly contracted to act as a fiduciary for the limited purpose of addressing benefit claims and appeals, including our program to meet the Department of Labor regulations for claims payment and member appeals.

Since December 1997, a number of lawsuits have been filed against us, alleging that we should be treated as a “fiduciary” under ERISA and that we have breached our fiduciary obligations under ERISA in connection with our development and implementation of formularies, preferred drug listings and intervention programs. For further information on this litigation and the proposed settlement, see Note 12, “Commitments and Contingencies,” to our consolidated financial statements included in Part II, Item 8 of this Annual Report on Form 10-K.

Anti-Kickback Laws. Subject to certain exceptions, federal law prohibits the payment, offer, receipt or solicitation of any remuneration that is knowingly and willfully intended to induce the referral of Medicare, Medicaid or other federal healthcare program beneficiaries for the purchase, lease, ordering or recommendation of the purchase, lease or ordering of items or services reimbursable under federal healthcare programs. These laws are commonly referred to as anti-remuneration or anti-kickback laws. Several states also have similar laws, known as “all payor” statutes, which impose anti-kickback prohibitions on services not covered by federal healthcare programs. Sanctions for violating these federal and state anti-kickback laws may include criminal and civil sanctions and exclusion from participation in federal healthcare programs. Anti-kickback laws vary between states, and courts have rarely interpreted them. However, where courts have reviewed these laws, they have generally ruled that contracts that violate anti-kickback laws are void as a matter of public policy.

Courts, the Office of the Inspector General within the Department of Health and Human Services, or OIG, and some administrative tribunals have broadly interpreted the federal anti-kickback statute. Courts have ruled that a violation of the statute may occur even if only one of the purposes of a payment arrangement is to induce patient referrals or purchases. Among the practices that the OIG has identified as potentially improper under the statute are “product conversion programs” in which benefits are given by pharmaceutical manufacturers to pharmacists or physicians for changing a prescription, or recommending or requesting such a change, from one drug to another. These laws have been cited as a partial basis, along with the state consumer protection laws discussed above, for investigations and multi-state settlements relating to financial incentives provided by pharmaceutical manufacturers to physicians or pharmacists in connection with product conversion programs.

On April 28, 2003, the OIG issued a final voluntary guidance for pharmaceutical manufacturers to consider when developing or implementing programs to assure compliance with laws and regulations pertaining to doing business with federal healthcare programs, such as Medicare and Medicaid. The guidance raises several questions and areas of risk that manufacturers should address in reviewing their business transactions with physicians and other health professionals who influence drug prescribing, drug purchasers such as hospitals and pharmacies, group purchasing organizations and PBMs. The key areas of risk identified by the guidance include discounts and rebates, product support services tied to the purchase of products, educational grants, research funding, and other remuneration to purchasers such as upfront payments, free or reduced-price goods or payments to cover the cost of converting from a competitor’s product. The guidance encourages

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manufacturers to structure their relationships to fall within several “safe harbors” established under the anti-kickback statute or regulations whenever possible, but also acknowledges that failure to comply with a safe harbor does not mean a business arrangement is illegal. The final guidance recognizes the value of formularies and formulary support activities to promote clinically appropriate, safe, and cost-effective drug therapy. The guidance says that formulary development is unlikely to raise significant anti-kickback issues as long as decisions about clinical efficacy and appropriateness precede and are paramount to considerations of costs. The guidance states that rebates or other payments by manufacturers to PBMs that are based on or otherwise related to a PBM’s customers’ purchases potentially implicate the anti-kickback statute.

We believe that we substantially comply with the legal requirements imposed by these laws and regulations, and that our programs do not involve practices that the OIG has questioned. However, on September 29, 2003, the U.S. Attorney’s Office for the Eastern District of Pennsylvania filed a complaint against us alleging violations of the federal False Claims Act and asserting other legal claims. On December 9, 2003, the U.S. Attorney’s Office filed an amended complaint, which added two former employees of the Company as defendants and, among other additional legal claims, asserted a claim against the Company under the Public Contracts Anti-Kickback Act for allegedly making improper payments to health plans to induce such plans to select the Company as a PBM for government contracts. On November 17, 2004, the complaint against one of our former employees was dismissed without prejudice. The government did not re-file its complaint against this former employee. See Note 12, “Commitments and Contingencies,” to our consolidated financial statements included in Part II, Item 8 of this Annual Report on Form 10-K.

Regulation of Financial Risk Plans. Although the administration of fee-for-service prescription drug plans by PBMs is not subject to insurance regulation by the states, a few clients seek to limit their exposure in providing prescription drug benefits. In order to provide “stop-loss” insurance to our clients who seek to limit their risk under fee-for-service drug plans, we own three insurance companies: Medco Containment Insurance Company of New Jersey; Medco Containment Insurance Company of New York; and Medco Containment Life Insurance Company. These subsidiary insurance companies are licensed in 48 states and the District of Columbia and are subject to extensive regulatory requirements imposed under the insurance laws of the states in which they are domiciled as well as those in which they have obtained licenses to transact insurance business. To date, these insurance subsidiaries only underwrite risk in connection with our own PBM services and do not represent a separate line of business. Historically, we have provided services to a limited number of our clients through these insurance companies. Premiums paid to the insurance companies and the losses incurred under the insurance coverage during this period were not material to our financial results. Our plans to participate in the Medicare Part D prescription drug benefit may involve an expanded role for these three insurance companies. In that case, we would be required to comply with the extensive, detailed requirements of a variety of insurance laws and regulations.

Regulation Relating to Data Transmission and Confidentiality of Patient Identifiable Information. Dispensing of prescriptions and management of prescription drug benefits require the ability to utilize patient-specific information. Government regulation of the use of patient identifiable information has grown substantially over the past several years. At the federal level, Congress has enacted legislation, the Health Insurance Portability and Accountability Act of 1996, or HIPAA, and the Department of Health and Human Services, or HHS, has adopted extensive regulation, governing the transmission, use and disclosure of health information by all participants in healthcare delivery, including physicians, hospitals, insurers and other payers. Additionally, regulation of the use of patient identifiable information is likely to increase. Many states have recently passed or are considering laws dealing with the use and disclosure of health information. These proposals vary widely, some relating to only certain types of information, others to only certain uses, and yet others to only certain types of entities. These laws and regulations have a significant impact on our operations, products and services, and compliance with them is a major operational requirement. Regulations and legislation that severely restrict or prohibit our use of patient identifiable information could materially adversely affect our business.

HHS adopted Privacy Standards under HIPAA that require covered entities to make available certain rights to individuals, including the right to receive notice of privacy practices describing how their health information may be used or disclosed, the right to access to a copy of health information maintained by the covered entity, the right to request amendment to such health information, the right to an accounting of certain disclosures of health information, and certain rights to request restrictions on how their health information may be used or disclosed. Additionally, the Privacy Standards specifically define permitted uses and disclosures of an individual’s health information, including for purposes of treatment, payment and healthcare operations, and generally require that a covered entity obtain valid written authorization from the individual for other uses and disclosures. The Privacy Standards require covered entities to establish administrative safeguards, including appointment of a privacy official, adoption of policies and practices to assure

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compliance with the HIPAA standards and to limit use or disclosure of health information in many cases to the minimum amount necessary to accomplish an activity permitted by the Privacy Standards. Our pharmacy operations are covered entities which are directly subject to these requirements. In our role as a manager of the prescription benefit, we are a business associate of health plan clients which are covered entities subject to the Privacy Standards. We have invested considerable time and resources modifying and maintaining our systems, policies and procedures in order to comply with our obligations under the HIPAA regulations as a covered entity and maintaining capabilities to support compli