UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

(Mark One)

þ		ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES AND EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2005

OR

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                                           to                                          

Commission File No. 001-13489

NATIONAL HEALTHCARE CORPORATION

(Exact name of registrant as specified in its Corporate Charter)

Delaware		52-205747 2
(State of Incorporation)		(I.R.S. Employer I.D. No.)

100 Vine Street
Murfreesboro, Tennessee 37130
(Address of principal executive offices)
Telephone Number: 615-890-2020

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

Title of Each Class Shares of Common Stock		Name of Each Exchange on which Registered American Stock Exchange

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

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

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

Indicate by check mark whether the registrant (a) 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 þ No o

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Act).

Large accelerated filer o            Accelerated filer þ            Non-accelerated filer o

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

The aggregate market value of Common Stock held by non-affiliates on June 30, 2005 (based on the closing price of such shares on the American Stock Exchange) was approximately $195 million. For purposes of the foregoing calculation only, all directors, named executive officers and persons known to the Registrant to be holders of 5% or more of the Registrant’s Common Stock have been deemed affiliates of the Registrant. The number of shares of Common Stock outstanding as of March 10, 2006 was 12,283,738.

Documents Incorporated by Reference

The following documents are incorporated by reference into Part III, Items 10, 11, 12, 13 and 14 of this Form 10-K:

The Registrant’s definitive proxy statements for its 2006 shareholder’s meeting.

 

 

PART 1
	Item 1. Business
	Item 1A. Risk Factors
	Item 1B. Unresolved Staff Comments
	Item 2. Properties
	Item 3. Legal Proceedings
	Item 4. Submission of Matters to a Vote of Security Holders
PART II
	Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
	Item 6. Selected Financial Data
	Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 7a. Quantitative and Qualitative Disclosures about Market Risk
	Item 8. Financial Statements and Supplementary Data
	Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
	Item 9A. Controls and Procedures
	Item 9B. Other Information
PART III
	Item 10. Directors and Executive Officers of the Registrant
	Item 11. Executive Compensation
	Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
	Item 13. Certain Relationships and Related Transactions
	Item 14. Principal Accountant Fees and Services
PART IV
	Item 15. Exhibits and Financial Statement Schedules
SIGNATURES
EXHIBIT INDEX
Ex-10.15 Amendment No.1 to Master Operating Lease
Ex-10.16 Amendment No.2 to Master Operating Lease
Ex-10.17 Amendment No.3 to Master Operating Lease
Ex-10.18 Amendment No.4 to Master Operating Lease
Ex-10.19 Amendment No.1 Master Agreement to Lease
Ex-10.20 Amendment No.2 Master Agreement to Lease
Ex-10.21 Amendment No.3 Master Agreement to Lease
Ex-10.22 Amendment No.4 Master Agreement to Lease
Ex-10.23 Amendment No.5 Master Agreement to Lease
Ex-13 Financial Statement Schedules
Ex-23.1 Consent of Independent Registered Public Accounting Firm
Ex-23.2 Consent of Independent Registered Public Accounting Firm
Ex-31.1 Section 302 Certification of the CEO
Ex-31.2 Section 302 Certification of the PFO
Ex-32 Section 906 Certification of the CEO & PFO

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Table of Contents

			the designated sports medicine provider for Middle Tennessee State University in Murfreesboro, Tennessee. Our rates for these services are competitive with other market rates.
	C.		Medical Specialty Units. We require all our centers to participate in the Medicare program, and have expanded our range of offerings by the creation of center-specific medical specialty units such as our Alzheimer’s disease care units and subacute nursing units.
	D.		Pharmacy Operations. At year end, we operated four regional pharmacy operations (one in east Tennessee, one in central Tennessee, one in South Carolina, and one in Missouri). These pharmacy operations operate out of a central office and supply (on a separate contractual basis) pharmaceutical services and supplies which were formerly purchased by each center from local vendors. Pharmacy reimbursement under Medicare has also been shifted from direct billing by the pharmacy to a negotiated rate structure between skilled nursing centers and the pharmacy, with the skilled nursing centers Medicare reimbursement being based upon a prospective rate not related to actual patient pharmaceutical usage. Our pharmacy operations currently serve approximately 50 long-term care centers.
	E.		Assisted Living Projects. We presently own, lease or manage 22 assisted living projects, 11 of which are located within the physical structure of a long-term health care center or retirement complex. Assisted living units provide basic room and board functions for the elderly with the on-staff availability to assist in minor medical needs on an as needed basis. Development of new units has been discontinued due to existing market conditions.
	F.		Managed Care Contracts. We operate three Tennessee and one South Carolina regional contract management offices, staffed by experienced case managers who contract with managed care organizations (MCO’s) and insurance carriers for the provision of subacute and other medical specialty services within a regional cluster of our owned and managed centers. Managed care patient days were 41,320 in 2003, 44,409 in 2004 and 47,358 in 2005.
	G.		Hospice. In 2003 we entered into a partnership agreement with Caris HealthCare in order to develop hospice programs in selected market locations. Nine locations in Tennessee are now open with two additional locations due to open in 2006.
	H.		Homecare Programs. Our 30 homecare programs (one homecare program closed in 2005) have decreased their total number of visits from 506,530 in 2004 to 504,188 in 2005. Many of our homecare patients are previously discharged from our long-term health care centers. The reimbursement for homecare services under the Medicare program provides for a prospective pay system. Under the homecare prospective payment system, we receive a prospectively determined amount per patient per 60 day episode as defined by Medicare guidelines.

      Other Revenues. We generate revenues from management, accounting and financial services to third party long-term care, assisted living and independent living centers, from administrative and advisory services to NHI and NHR (which are health care real estate investment trusts), from insurance services to our managed centers, from dividends and other realized gains on securities and from interest income. In fiscal 2005, 12.1% of our net revenues were derived from such other sources. The significant other sources of revenues are described as follows:

A.

Insurance Services. NHC owns a Tennessee domestic licensed insurance company. The company is licensed in several states and provides workers’ compensation coverage to the majority of NHC operated and managed facilities in addition to other nursing homes, assisted living and retirement centers. A second wholly owned insurance subsidiary is licensed in the Cayman Islands and provides general and professional liability coverage in substantially all of NHC’s owned and managed centers. This company elects to be taxed as a domestic subsidiary. We also self-insure our employees’

			(referred to as “partners”) health insurance benefit program at a cost we believe is less than a commercially obtained policy. Finally, we operate a long-term care insurance division, which is licensed to sell commercially underwritten long-term care policies. NHC’s revenues from insurance services totaled $23.6 million in 2005.
	B.		Management, Accounting and Financial Services. We provide management services to long-term health care centers, assisted living centers and independent living centers operated by third party owners. We typically charge 6% of the managed centers’ revenues as a fee for these services. Additionally, we provide accounting and financial services to other long-term care or related types of entities who typically have been or are in the process of being transferred from bankrupt organizations or from entities operating in states with economically unreasonable liability insurance premiums into the hands of small operators or not-for-profit entities. No management services are provided to these entities. As of December 31, 2005, we perform management services for 27 centers and accounting and financial services for 37 centers. NHC’s revenues from management, accounting and financial services totaled $24.7 million in 2005.
	C.		Service Agreement with Management Advisory Source, LLC. In 1991, we formed National Health Investors, Inc. as a wholly-owned subsidiary. We then transferred to NHI certain healthcare facilities owned by NHC and distributed the shares of NHI to NHC’s shareholders. The distribution had the effect of separating NHC and NHI into two independent public companies. As a result of the distribution, all of the outstanding shares of NHI were distributed to the then NHC investors. NHI is listed on the New York Stock Exchange.
			Until November 1, 2004, we had an Advisory Agreement with NHI whereby we provided to NHI services related to investment activities and day-to-day management and operations. During 2004 and 2003, our compensation under the NHI Advisory Agreement was $2,383,000 and $2,597,000, respectively.
			Effective November 1, 2004, NHC’s Advisory Agreement with NHI was terminated. On that date, Management Advisory Source, LLC (“Advisors”), a new unrelated company formed by Mr. W. Andrew Adams, undertook to provide advisory services to NHI. Mr. Adams served as NHI’s President and Board Chairman and as NHC’s Chief Executive Officer and Board Chairman prior to November 1, 2004. Effective November 1, 2004 and to enhance independence from NHC, Mr. Adams resigned as NHC’s Chief Executive Officer and terminated his managerial responsibilities with NHC. Mr. Adams remains on the NHC Board as Chairman, focusing on strategic planning, but will have no management involvement with NHC.
			Effective November 1, 2004, NHC, through its wholly-owned subsidiary, Tennessee Management Advisory Source, LLC (“THA”) has entered into an agreement to provide financial, accounting, data processing and administrative services to Advisors. Under the agreement, THA provides to Advisors and, at the request of Advisors, to NHI, services related to accounting, data processing, administration and evaluation of investments. THA’s role under the agreement is that of advisor and service provider, and THA in no way assumes responsibility for accounting, administrative, or investment decisions which are to be made by Advisors or NHI.
			The term of the agreement is through December 31, 2005 and thereafter from year to year. However, either party may terminate the agreement at any time without cause upon 90 days written notice.
			For our services under the agreement, we are entitled to compensation of $1,250,000 per year, payable monthly and annually inflated by 5%. NHC earned approximately $1,250,000 in 2005 and $397,000 in 2004 under the terms of the advisory agreement.

	D.		Advisory Services to National Health Realty, Inc. In 1997, we formed National Health Realty, Inc., as a wholly-owned subsidiary. We then transferred to NHR certain healthcare facilities then owned by NHC and distributed the shares of NHR to NHC’s shareholders. The distribution had the effect of separating NHC and NHR into two independent public companies. As a result of the distribution, all of the outstanding shares of NHR were distributed to the then NHC investors. NHR is listed on the American Stock Exchange.
			We have entered into an Advisory Agreement with NHR whereby services related to investment activities and day-to-day management and operations are provided to NHR by NHC as Advisor. The Advisor is subject to the supervision of and policies established by NHR’s Board of Directors. The Advisory Agreement expired December 31, 2003 and thereafter is renewed from year to year unless earlier terminated. Either party may terminate the Advisory Agreement at any time on 90 days written notice. The Advisory Agreement may be terminated for cause at any time.
			On August 1, 2005, concurrent with the lease extensions, the Advisory Agreement was revised to provide that beginning for the year 2005 for our services under the Advisory Agreement, we are entitled to annual compensation equal to the greater of (1) 2.5% of NHR’s gross consolidated revenues or (2) $500,000. It was also clarified that NHR (and not NHC) is to bear all of its own corporate costs such as directors’ and officers’ insurance, audit fees, etc.
			Prior to the August 1, 2005 restatement, the Advisory Agreement had provided that for our services under the Advisory Agreement, we were entitled to annual compensation of the greater of 2% of our gross consolidated revenues or the actual expenses incurred by us. During 2005, 2004, and 2003, compensation under the Advisory Agreement was $508,000, $411,000 and $476,000, respectively.
	E.		Principal Office. We maintain our home office staff in Murfreesboro, Tennessee in a building owned by a limited partnership, which is 69.7% owned by NHC.

Long-Term Health Care Centers

     The health care centers operated by our subsidiaries provide in-patient skilled and intermediate nursing care services and in-patient and out-patient rehabilitation services. Skilled nursing care consists of 24-hour nursing service by registered or licensed practical nurses and related medical services prescribed by the patient’s physician. Intermediate nursing care consists of similar services on a less intensive basis principally provided by non-licensed personnel. These distinctions are generally found in the long-term health care industry although for Medicaid reimbursement purposes, some states in which we operate have additional classifications, while in other states the Medicaid rate is the same regardless of patient classification. Rehabilitative services consist of physical, speech, and occupational therapies, which are designed to aid the patient’s recovery and enable the patient to resume normal activities.

     Each health care center has a licensed administrator responsible for supervising daily activities, and larger centers have assistant administrators. All have medical directors, a director of nurses and full-time registered nurse coverage. All centers provide physical therapy and most have other rehabilitative programs, such as occupational or speech therapy. Each facility is located near at least one hospital and is qualified to accept patients discharged from such hospitals. Each center has a full dining room, kitchen, treatment and examining room, emergency lighting system, and sprinkler system where required. Management believes that all centers are in compliance with the existing fire and life safety codes.

     We provide centralized management and support services to NHC operated health care nursing centers. The management and support services include operational support through the use of regional vice presidents and regional nurses, accounting and financial services, cash management, data processing, legal, consulting and services in the area of rehabilitative care. Many personnel are employed by our administrative services affiliate, National Health Corporation, which is also responsible for overall services in the area of personnel, loss control, insurance, education and training. We reimburse the administrative services contractor by paying all the costs of personnel employed for our

benefit as well as a fee. National Health Corporation (National) is wholly owned by the National Health Corporation Employee Stock Ownership Plan and provides its services only to us.

     We provide management services to centers operated under management contracts and offsite accounting and financial services to other owners, all pursuant to separate contracts. The term of each contract and the amount of the management fee or accounting and financial services fee is determined on a case-by-case basis. Typically, we charge 6% of net revenues for our management contracts and specific item fees for our accounting and financial service agreements. The initial term of the contracts range from two years to ten years. In certain contracts, we maintain a right of first refusal should the owner desire to sell a managed center.

     All health care centers we operate are licensed by the appropriate state and local agencies. All except five are certified as providers for Medicaid patients, and all are certified as Medicare providers. Certification of advised centers is the prerogative of the provider/owner. All licensed nursing homes, assisted living and homecare offices are subject to state and federal licensure and certification surveys. These surveys, from time to time, may produce statements of deficiencies. In response to such a statement, if any, the staff at each center would file a plan of correction and any alleged deficiencies would be corrected. Presently, none of our leased and managed facilities are operating under material statements of deficiencies. We have a significant monetary bonus program for employees attached to passing these surveys with few or no deficiencies.

Health Care Center Construction

     In May 2004, we completed construction and opened a new health care facility in Franklin, Tennessee, which has 160 long-term care beds (the license for 47 of these beds came from an existing facility) and 46 assisted living units. Furthermore, we completed the construction of a 30 long-term care bed addition in Murfreesboro, Tennessee in August 2004.

     During 2005, we began construction of a 30 bed addition to an existing long-term care facility located in Farragut, Tennessee and a 60 bed addition to an existing long-term care facility located in Mauldin, South Carolina. Both of these additions are to facilities that we lease from NHR. We estimate that the costs of the additions will be approximately $10,700,000, and we have incurred accumulative cost of approximately $2,243,000 at December 31, 2005. In addition, we started renovations at a facility we lease from NHI located in Lewisburg, Tennessee. We anticipate the cost of the renovations will be approximately $1,344,000, and we have incurred accumulated cost of approximately $1,216,000. Construction of bed additions is expected to begin in 2006 at two additional centers at an expected cost of $11,025,000. Also during 2006, we will apply for Certificates of Need for additional beds in our markets and also evaluate the feasibility of expansion into new markets by building health care centers that provide services exclusively to private paying patients.

Occupancy Rates

     The following table shows certain information relating to occupancy rates for our continuing owned, leased, and debt guaranteed managed long-term health care centers:

		Year Ended December 31
		2005				2004				2003
Overall census			94.0	%			93.9	%			93.9	%

     Occupancy rates are calculated by dividing the total number of days of patient care provided by the number of patient days available (which is determined by multiplying the number of licensed beds by 365 or 366).

Termination of Florida Health Care Center Operations

     Unable to obtain liability insurance in the state of Florida (but not elsewhere), we elected to discontinue our Florida long-term health care center operations on September 30, 2000. At that time in Florida we operated two owned skilled nursing facilities and thirteen leased facilities of which three were freestanding assisted living facilities, and we had management contracts with nine facilities owned by third parties. Our former Vice President of Operations and his staff in the state of Florida resigned in August 2000. These individuals, plus additional Florida based outside investors, formed new entities and entered into a series of new leases on the thirteen leased properties and our two owned properties, which leases are for a five-year term. The leases have currently been extended through December 31, 2010. We sold the current assets and current liabilities and leased our furniture, fixtures and leasehold improvements of our owned and leased Florida facilities to the same group of entities. Additionally, and with the consent of the third party owners, the Florida management contracts were assigned to other entities primarily owned and controlled by our former Vice President of Operations. These transactions closed on September 30, 2000, with an effective date of October 1, 2000. New licenses were issued for the respective operators as of that day. Although our obligations for rent payments owed on leased centers remain in effect due to a master lease, we are receiving a credit for lease payments made by the new providers, which were current as of December 31, 2005. Through the master lease agreement, we still maintain a right of first refusal with NHI and NHR to purchase any of the Florida facilities should NHI or NHR receive an offer from an unrelated party.

Assisted Living Units

     We presently lease or own 10 and manage 12 assisted living units, 11 of which are located within the physical structure of a long-term health care center or retirement center and 11 of which are freestanding. In 2005, the rate of occupancy was 89.2%. Assisted living units provide basic room and board functions for the elderly with the on-staff availability to assist in minor medical needs on an as needed basis. Certificates of Need are not necessary to build these projects and we believe that overbuilding has occurred in some of our markets.

Retirement Centers

     Our four leased and two managed retirement centers offer specially designed residential units for the active and ambulatory elderly and provide various ancillary services for our residents, including restaurants, activity rooms and social areas. In most cases, retirement centers also include long-term health care facilities, either in contiguous or adjacent licensed health care centers. Charges for services are paid from private sources without assistance from governmental programs. Retirement centers may be licensed and regulated in some states, but do not require the issuance of a Certificate of Need such as is required for health care centers. We have, in several cases, developed retirement centers adjacent to our health care properties with an initial construction of 40 to 80 units and which units are rented by the month; thus these centers offer an expansion of our continuum of care. We believe these retirement units offer a positive marketing aspect of our health care centers.

     We have one managed and one leased retirement center which are “continuing care communities”, where the resident pays a substantial endowment fee and a monthly maintenance fee. The resident then receives a full range of services — including nursing home care - without additional charge.

     Our managed continuing care community, the 137 unit Richland Place Retirement Center, was opened in January, 1993 and is fully occupied. We opened the leased 58 unit AdamsPlace in Murfreesboro, Tennessee during 1998 and during 2002 expanded it to 93 units.

Homecare Programs

     Our home health programs (we call them homecare) provide nursing and rehabilitative services to individuals in their residences and are licensed by the Tennessee, South Carolina and Florida state governments and certified by the federal government for participation in the Medicare program. Each of our 31 Medicare certified homecare programs is managed by an administrator and under the clinical direction of a registered nurse, with speech, occupational and

physical therapists either employed by the program or on a contract basis. Homecare visits decreased to 504,188 in 2005 from 506,530 visits in 2004. Medicare reimbursement for homecare services is paid under a prospective payment system. Under this payment system, we receive a prospectively determined amount per patient per 60 day episode of care as defined by Medicare guidelines.

Regulation

     Long term health care centers are subject to extensive federal, state and in some cases, local regulatory, licensing, and inspection requirements. These requirements relate, among other things, to the adequacy of physical buildings and equipment, qualifications of administrative personnel and nursing staff, quality of nursing provided and continued compliance with laws and regulations relating to the operation of the centers. In all states in which we operate, before the facility can make a capital expenditure exceeding certain specified amounts or construct any new long-term health care beds, approval of the state health care regulatory agency or agencies must be obtained and a Certificate of Need issued. The appropriate state health planning agency must determine that a need for the new beds or expenditure exists before a Certificate of Need can be issued. A Certificate of Need is generally issued for a specific maximum amount of expenditure and the project must be completed within a specific time period. There is no advance assurance that we will be able to obtain a certificate of need in any particular instance. In some states, approval is also necessary in order to purchase existing health care beds, although the purchaser is normally permitted to avoid a full scale certificate of need application procedure by giving advance written notice of the acquisition and giving written assurance to the state regulatory agency that the change of ownership will not result in a change in the number of beds or the services offered at the facility.

     While there are currently no significant legislative proposals to eliminate certificates of need pending in the states in which we do business, deregulation in the certificate of need area would likely result in increased competition among nursing home companies and could adversely affect occupancy rates and the supply of licensed and certified personnel.

HIPAA Compliance

     The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) has mandated an extensive set of regulations to standardize electronic patient health, administrative and financial data transactions, and to protect the privacy of individually identifiable health information.

     The Company has a HIPAA Task Force and designated privacy and security officers. The privacy requirements contained in HIPAA regulations were presented to every employee and are presented on a continuing basis to new hires during the orientation process. Privacy notices are posted in each facility, and are provided to every new admission. The Company uses a standard Business Associate Agreement with vendors and providers.

     The Company has identified information inflow and outflow throughout the organization and has implemented the appropriate security safeguards to be HIPAA-compliant. Failure to comply with HIPAA could result in fines and/or penalties that could have a material adverse effect on us.

Sources of Revenue

     Our revenues are primarily derived from our health care centers. The source and amount of the revenues are determined by (i) the licensed bed capacity of our health care centers, (ii) the occupancy rate of the centers, (iii) the extent to which the rehabilitative and other skilled ancillary services provided at each center are utilized by the patients in the centers, (iv) the mix of private pay, Medicare and Medicaid patients, and (v) the rates paid by private paying patients and by the Medicare and Medicaid programs.

     The following table sets forth sources of net patient revenues from health care centers and homecare services for the periods indicated:

Private Revenue Sources

     Private paying patients, private insurance carriers and the Veterans Administration generally pay on the basis of the center’s charges or specifically negotiated contracts. We attempt to attract an increased percentage of private and Medicare patients by providing rehabilitative services and increasing the marketing of those services through market areas and “Managed Care Offices”, of which seven were open at year end. These services are designed to speed the patient’s recovery and allow the patient to return home as soon as is practical. In addition to educating physicians and patients to the advantages of the rehabilitative services, we have also implemented incentive programs which provide for the payment of bonuses to our regional and center personnel if they are able to obtain private and Medicare goals at their centers.

Government Health Care Reimbursement Programs

Medicare

     The federal health insurance program for the elderly is Medicare (Title 18 of the Social Security Act), which is administered by the United States Department of Health and Human Services (HHS), Centers for Medicare and Medicaid Services (CMS), formerly HCFA.

     Medicare is a health insurance program for people age 65 or older, people under age 65 with certain disabilities, and people of all ages with End-Stage Renal Disease (permanent kidney failure requiring dialysis or a kidney transplant). Medicare is segmented in different parts:

•		Part A Hospital Insurance – covers inpatient care in hospitals, including critical access hospitals, and skilled nursing facilities (not custodial or long-term care). It also helps cover hospice care and some home health care. Beneficiaries must meet certain conditions to get these benefits.
•		Part B Medical Insurance – covers physician services, therapy, enteral, urological, ostomy, tracheostomy, durable medical equipment, and some home health care. Services must be medically necessary for reimbursement by the program.
•		Part C Medicare Advantage Program — a managed care option for Medicare beneficiaries.
•		Part D Prescription Drug Coverage — a new Medicare prescription drug coverage option that beginning January 1, 2006 is available to all Medicare beneficiaries. Medicare Prescription Drug Coverage is insurance provided by private companies. Beneficiaries select their company and pay a premium for coverage.

Medicaid

     State programs for medical assistance to the indigent are known as Medicaid (Title XIX of the Social Security Act). These programs are operated by state agencies which adopt their own medical reimbursement methodology and standards, but which are entitled to receive supplemental funds from the federal government if the state plan is approved

by CMS. Medicaid is the federal-state matching program in all states in which we operate. Medicaid plans vary sometimes significantly from state to state. Variations include reporting forms, rate setting time frames, funding levels, and coverage requirements for patients, etc. Generally all Medicaid plans set an annual reimbursement daily rate known as a per diem. Typically, the Medicaid per diem is based upon historical data and trended with a cost of living (inflation) factor. Several state plans are case-mix (acuity) based similar to the Medicare Prospective Payment System (PPS). Medicaid reimbursement is subject to state budgetary constraints.

Other Payors

     Some of our nursing centers generate revenues from the United State Veterans Administration for providing services to veterans.

     Some of our nursing centers care for hospice patients that are placed by various hospice companies. NHC has a fifty percent ownership interest in Caris HealthCare, a hospice company. Hospice care provides a comprehensive set of services coordinated by an interdisciplinary team to provide for the needs of terminally ill patients. Hospice companies reimburse our centers based on an agreed upon per diem, and then the hospice bills the Medicaid or Medicare program.

Medicare and Medicaid Participation by Our Centers

     All health care centers, owned, leased or managed by us are certified to participate in Medicare. Health care centers participating in Medicare are known as SNFs (Skilled Nursing Facilities). All but five of our affiliated nursing centers participate in Medicaid. All of our homecares (Home Health Agencies) participate in Medicare which comprises over 95% of their revenue. Homecares also participate in Medicaid.

     During the fiscal year, each nursing center receives payments from Medicare and, if participating, from Medicaid. We record as receivables the amounts we expect to receive under the Medicare and Medicaid programs and record into profit or loss any differences in amounts actually received at the time of interim or final settlements. Adjustments have not had a material adverse effect within the last three years.

Certifications and Participation Requirements; Efforts to Impose Reduced Payments

     Changes in certification and participation requirements of the Medicare and Medicaid programs have restricted, and are likely to continue to restrict further, eligibility for reimbursement under those programs. Failure to obtain and maintain Medicare and Medicaid certification at our nursing centers would result in denial of Medicare and Medicaid payments which would likely result in a significant loss of revenue. In addition, private payors, including managed care payors, increasingly are demanding that providers accept discounted payments resulting in losses for specific patients. Efforts to impose reduced payments, greater discounts and more stringent cost controls by government and other payors are expected to continue. For the fiscal year ended December 31, 2005, we derived 35% and 37% of our net patient revenues from the Medicare and Medicaid programs, respectively. Any reforms that significantly limit rates of reimbursement under the Medicare and Medicaid programs could have a material adverse effect on our profitability. We are unable to predict what reform proposals or reimbursement limitations will be adopted in the future or the effect such changes will have on our operations. No assurance can be given that such reforms will not have a material adverse effect on us.

Medicare Legislation and Regulations

Skilled Nursing Facilities (SNFs)

      SNF PPS — Medicare is uniform nationwide and reimburses nursing centers under a fixed payment methodology named the Skilled Nursing Facility Prospective Payment System (SNF PPS). PPS was instituted as mandated by the Balanced Budget Act of 1997. PPS became effective for our nursing centers effective January 1, 1999. PPS is an acuity based classification system that uses nursing and therapy indexes adjusted by geographical wage indexes to calculate per

diem rates for each Medicare patient. Payment rates are updated annually and are generally increased each October when the federal fiscal year begins. The acuity classification system is named RUGs (Resource Utilization Groups III). SNF PPS as implemented had an adverse impact on our industry and our business by decreasing payments materially. Refinements in the form of temporary add-ons provided some relief until October 1, 2002. Annual market basket (inflationary) increases have continued to improve payments since that time.

     On July 28, 2005, the Centers for Medicare and Medicaid Services (CMS) issued a final rule updating the SNF PPS and consolidated billing provisions. The rule updates the per-diem payment rates under the SNF PPS for federal fiscal year (FY) 2006.

     Effective October 1, 2005, PPS rates were increased by a 3.1% annual inflation update factor. Revenues for the fourth quarter of 2005 reflected the continuation of the temporary add-on payments. We estimate that the positive revenue effect of the CMS final rule was $650,000 for the fourth quarter of 2005.

     Including inflation, total Medicare payments to all providers in FY 2006 as projected by CMS will be the same as total payments made to providers in FY 2005. However, the final rule will cause a redistribution of payments among providers. This is accomplished by refinements expanding the Resource Utilization Groups (RUGs) from 44 RUG groups to 53 RUG groups and by eliminating temporary rate add-ons. The elimination of temporary add-ons has always been tied to the long awaited RUG refinement. RUG refinement increases the case mix weight that applies to both nursing and non-ancillary therapy ancillary costs. This is a permanent change in the PPS methodology. Excluding the 3.1% annual inflation update factor which we expect to be offset by our own costs increases, RUG refinement is expected to reduce our Medicare payment rates approximately $13 per patient day beginning January 1, 2006, thereby reducing 2006 revenues and pre-tax income by approximately $4.6 million.

      Medicare Bad Debts — The Deficit Reduction Act (DRA) of 2005 mandates the reduction of bad debt payments (which are included in Medicare payments) to skilled nursing facilities over a three year phase in period. The first year, FY 2006, reduction would be 10% or $430,000. Year two would be a 20% reduction with year three and beyond holding at a 30% reduction similar to inpatient hospitals.

      Prescription Drugs – Medicare Part D — On December 8, 2003, the Congress enacted the Medicare Prescription Drug, Improvement, and Modernization Act (MMA) of 2003. This landmark legislation will have a significant effect on the long term care business. Medicaid patients were in the past billed to state Medicaid formularies for reimbursement with varying payment methodologies. Under Part D, private insurance companies contract with Medicare to provide this coverage for Medicare beneficiaries. Nursing centers generally contract with a pharmacy to provide drugs for their patients.

     Under Part D the pharmacy will be billing multiple companies for each nursing center serviced versus one state Medicaid formulary. For Medicare Part A patients, drug costs and charges will continue to be consolidated with their inpatient claims under Part A. Patients not on Medicare Part A or Medicaid may enroll in Medicare Part D plans that require pharmacy billing.

     Most of our nursing centers are serviced by owned regional pharmacies. There is substantial financial risk related to this legislation. Some insurance plans may not pay as much for drugs as Medicaid formularies have in the past. There could be gaps in coverage under these plans resulting in non-covered drugs and increased bad debts. Also, billing changes may impact the way drugs are purchased, increasing inventories and expense. There more likely than not will be a period of adjustment to insurance plans. We formed a team of pharmacists and other qualified individuals early on to study, network, develop, and administrate our implementation plan. We anticipate that modifications to our system in both personnel and computer systems may be necessary to remain profitable in this volatile area.

      Therapy - Therapy caps went into effect on January 1, 2006. The DRA of 2005 provides an exception process under which additional services could be approved when medically justified. Therapy caps are increased to $1,740 per patient per calendar year for Physical/Speech and Occupational therapy. The financial impact of therapy caps is not measurable at this time. The effect to our business may or may not be significant.

Homecares (HHAs)

     Medicare is uniform nationwide and reimburses homecares under a fixed payment methodology named the Prospective Payment System (HH PPS). PPS was instituted as mandated by the Balanced Budget Act of 1997. PPS became effective for our homecares effective October 1, 2000. Generally, Medicare makes payment under the HH PPS on the basis of a national standardized 60-day episode payment, adjusted for case mix and geographical wage index. Payment rates are updated annually and generally increased each October when the federal fiscal year begins. The acuity classification system is named HHRGs (Home Health Resource Groups).

     On December 8, 2003, the Congress enacted the Medicare Prescription Drug, Improvement, and Modernization Act (MMA) of 2003. As a result, payments to home health agencies increased by 2.3% beginning on January 1, 2004. Effective April 1, 2005 the rural add-on of 5% was eliminated causing a 3% decrease in revenues to all providers.

     The Deficit Reduction Act (DRA) of 2005 mandates the home health payment rate for 2006 would be frozen. HHAs serving rural beneficiaries would see a one-year five percent add-on payment under the legislation. The rural add-on payment would provide for a 2.5% increase in total payments or, for our homecare operations, approximately $1.2 million in FY 2006 due to a significant number of our homecares serving rural counties.

Medicaid Legislation and Regulations

     State Medicaid plans subject to budget constraints are of particular concern to us given the repeal of the Boren Amendment by the Balance Budget Act of 1997. The Boren Amendment provided fair reimbursement protection to nursing facilities. Changes in federal funding and pressure on certain provider taxes coupled with state budget problems have produced an uncertain environment. Industry studies predict the Medicaid crisis will continue with a state required contribution to Medicare Part D and anticipated budget deficits. States will more likely than not be unable to keep pace with nursing center inflation. States are under pressure to pursue other alternatives to long term care such as community and home-based services.

     In Tennessee, annual Medicaid rate increases have been delayed in 2005 due to submission of a new plan to CMS. The new plan substitutes a new funding methodology called Certified Patient Expenditures (CPE) for inter-governmental transfers (IGT). In effect our rates in Tennessee have been frozen for a year and a half. In Missouri, Medicaid rates were cut effective April 1, 2005. Missouri Medicaid was unable to fund expected rebasing of FY 2001 audited cost reports. In South Carolina, Medicaid has continued to fund and set new rates as usual effective October 1, 2005.

Competition

     In most of the communities in which we operate health care centers, there are other health care centers with which we compete. We own, lease or manage (through subsidiaries) 74 long-term health care facilities located in 10 states. Each of these states are certificate of need states which generally requires the state to approve the opening of any new long-term health care facilities. There are hundreds of operators of long-term health care facilities in each of these states and no single operator, including us, dominates any of these state’s long-term health care markets, except for some small rural markets which might have only one long-term health care facility. In competing for patients and staff with these centers, we depend upon referrals from acute care hospitals, physicians, residential care facilities, church groups and other community service organizations. The reputation in the community and the physical appearance of our health care centers are important in obtaining patients, since members of the patient’s family generally participate to a greater extent in selecting health care centers than in selecting an acute care hospital. We believe that by providing and emphasizing rehabilitative as well as skilled care services at our centers, we are able to broaden our patient base and to differentiate our centers from competing health care centers.

     Our homecares compete with other home health agencies (HHA’s) in most communities we serve. Competition occurs for patients and employees. Our homecares depend on hospital and physician referrals and reputation in order to maintain a health census.

     As we expanded into the assisted living market, we monitored proposed or existing competing assisted living centers. Our development goal is to link our health care centers with our assisted living centers, thereby obtaining a competitive advantage for both.

     We experience competition in employing and retaining nurses, technicians, aides and other high quality professional and non-professional employees. In order to enhance our competitive position, we have an educational tuition loan program, an American Dietetic Association approved internship program, a specially designed nurse’s aide training class, and we make financial scholarship aid available to physical therapy vocational programs. We support the Foundation for Geriatric Education. We also conduct an “Administrator in Training” course, 24 months in duration, for the professional training of administrators. Presently, we have six full-time individuals in this program. Four of our six regional vice presidents and 46 of our 73 health care center administrators are graduates of this program.

     We experience competition in providing management and accounting services to other long-term health care providers. Those services are provided primarily to owners with whom we have had previous involvement through ownership or through our relationship with NHI. Our insurance services are provided primarily to centers for which we also provide management and accounting services.

     Our employee benefit package offers a tuition reimbursement program. The goal of the program is to insure a well trained qualified work force to meet future demands. While the program is offered to all disciplines, special emphasis has been placed on supporting students in nursing and physical therapy programs. Students are reimbursed at the end of each semester after presenting tuition receipts and grades to management. The program has been successful in providing a means for many bright students to pursue a formal education.

Employees

     As of December 31, 2005, our Administrative Services Contractor plus our managed centers had approximately 11,000 full and part time employees, who we call “Partners”. No employees are represented by a bargaining unit. We believe our current relations with our employees are good.

Investor Information

     We maintain a worldwide web site at www.nhccare.com. We publish to this web site our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and press releases. We do not necessarily have these filed the same day as they are filed with the SEC or released to the public, but rather have a policy of placing these on the web site within two (2) business days of public release or SEC filing.

     We also maintain the following documents on the web site:

	•		The NHC Code of Ethics and Standards of Conduct. This has been adopted for all employees of our Administrative Services Contractor, officers and directors of the Company. The website will also disclose whether there have been any amendments or waivers to the Code of Ethics and Standards of conduct. To date there have been none.
	•		Information on our “NHC Valuesline”, which allows our staff and investors unrestricted access to our Corporate Compliance Officer, executive officers and directors. The toll free number is 800-526-4064 and the communications may be incognito, if desired.
	•		The NHC Restated Audit Committee Charter.
	•		The NHC Compensation Committee Charter.
	•		The NHC Nomination and Corporate Governance Committee Charter

     We will furnish, free of charge, a copy of any of the above documents to any interested investor upon receipt of a written request.

Item 1A.		Risk Factors

     You should carefully consider the risk factors set forth below, as well as the other information contained in this Annual Report on Form 10-K. The risks described below are not the only risks facing us. Additional risks and uncertainties that are not currently known to us or that we currently deem to be immaterial may also materially and adversely affect our business operations. Any of the following risks could materially adversely affect our business, financial condition or results of operations.

Risks Relating to Our Company

      We depend on reimbursement from Medicare, Medicaid and other third-party payors and reimbursement rates from such payors may be reduced. — We derive a substantial portion of our revenue from third-party payors, including the Medicare and Medicaid programs. For the twelve months ended December 31, 2005, we derived approximately 61% of our net revenues from the Medicare, Medicaid and other government programs. Third-party payor programs are highly regulated and are subject to frequent and substantial changes. Changes in the reimbursement rate or methods of payment from third-party payors, including the Medicare and Medicaid programs, or the implementation of other measures to reduce reimbursements for our services has in the past, and could in the future, result in a substantial reduction in our revenues and operating margins. Additionally, net revenue realizable under third-party payor agreements can change after examination and retroactive adjustment by payors during the claims settlement processes or as a result of post-payment audits. Payors may disallow requests for reimbursement based on determinations that certain costs are not reimbursable or reasonable because additional documentation is necessary or because certain services were not covered or were not reasonable and medically necessary. There also continue to be new legislative and regulatory proposals that could impose further limitations on government and private payments to health care providers. In some cases, states have enacted or are considering enacting measures designed to reduce their Medicaid expenditures and to make changes to private health care insurance. We cannot assure you that adequate reimbursement levels will continue to be available for the services provided by us, which are currently being reimbursed by Medicare, Medicaid or private third-party payors. Further limits on the scope of services reimbursed and on reimbursement rates could have a material adverse effect on our liquidity, financial condition and results of operations. It is possible that the effects of further refinements to PPS that result in lower payments to us or cuts in state Medicaid funding could have a material adverse effect on our results of operations. See Item 1, “Business — Government Health Care Reimbursement Programs” and “Medicare Legislation and Regulations” and “Medicaid Legislation and Regulations”.

      We conduct business in a heavily regulated industry, and changes in, or violations of, regulations may result in increased costs or sanctions that reduce our revenue and profitability. — In the ordinary course of our business, we are regularly subject to inquiries, investigations and audits by federal and state agencies to determine whether we are in compliance with regulations governing the operation of, and reimbursement for, skilled nursing, assisted living and independent living facilities, hospice, home health agencies and our other operating areas. These regulations include those relating to licensure, conduct of operations, ownership of facilities, construction of new and additions to existing facilities, allowable costs, services and prices for services. In particular, various laws, including federal and state anti-kickback and anti-fraud statutes, prohibit certain business practices and relationships that might affect the provision and cost of health care services reimbursable under federal and/or state health care programs such as Medicare and Medicaid, including the payment or receipt of remuneration for the referral of patients whose care will be paid by federal governmental programs. Sanctions for violating the anti-kickback and anti-fraud statutes include criminal penalties and civil sanctions, including fines and possible exclusion from governmental programs such as Medicare and Medicaid.

     In addition, the Stark Law broadly defines the scope of prohibited physician referrals under federal health care programs to providers with which they have ownership or other financial arrangements. Many states have adopted, or are considering, legislative proposals similar to these laws, some of which extend beyond federal health care programs, to prohibit the payment or receipt of remuneration for the referral of patients and physician referrals regardless of the

source of the payment for the care. These laws and regulations are complex and limited judicial or regulatory interpretation exists. We cannot assure you that governmental officials charged with responsibility for enforcing the provisions of these laws and regulations will not assert that one or more of our arrangements are in violation of the provisions of such laws and regulations.

     The regulatory environment surrounding the long-term care industry has intensified, particularly for larger for-profit, multi-facility providers like us. The federal government has imposed extensive enforcement policies resulting in a significant increase in the number of inspections, citations of regulatory deficiencies and other regulatory sanctions, including terminations from the Medicare and Medicaid programs, denials of payment for new Medicare and Medicaid admissions and civil monetary penalties. If we fail to comply, or are perceived as failing to comply, with the extensive laws and regulations applicable to our business, we could become ineligible to receive government program reimbursement, be required to refund amounts received from Medicare, Medicaid or private payors, suffer civil or criminal penalties, suffer damage to our reputation in various markets or be required to make significant changes to our operations. We are also subject to federal and state laws that govern financial and other arrangements between health care providers. These laws often prohibit certain direct and indirect payments or fee-splitting arrangements between health care providers that are designed to induce the referral of patients to a particular provider for medical products and services. Possible sanctions for violation of any of these restrictions or prohibitions include loss of eligibility to participate in reimbursement programs and/or civil and criminal penalties. Furthermore, some states restrict certain business relationships between physicians and other providers of health care services. Many states prohibit business corporations from providing, or holding themselves out as a provider of, medical care. From time to time, we may seek guidance as to the interpretation of these laws; however, there can be no assurance that such laws will ultimately be interpreted in a manner consistent with our practices. In addition, we could be forced to expend considerable resources responding to an investigation or other enforcement action under these laws or regulations. Furthermore, should we lose licenses or certifications for a number of our facilities as a result of regulatory action or otherwise, we could be deemed in default under some of our agreements, including agreements governing outstanding indebtedness. We also are subject to potential lawsuits under a federal whistle-blower statute designed to combat fraud and abuse in the health care industry. These lawsuits can involve significant monetary awards to private plaintiffs who successfully bring these suits.

     We have established policies and procedures that we believe are sufficient to ensure that our facilities will operate in substantial compliance with these anti-fraud and abuse requirements. While we believe that our business practices are consistent with Medicare and Medicaid criteria, those criteria are often vague and subject to change and interpretation. Aggressive anti-fraud actions, however, have had and could have an adverse effect on our financial position, results of operations and cash flows. See Item 1, “Business Government Health Care Reimbursement Programs”.

     We face additional federal requirements that mandate major changes in the transmission and retention of health information. HIPAA was enacted to ensure, first, that employees can retain and at times transfer their health insurance when they change jobs, and second, to simplify health care administrative processes. This simplification includes expanded protection of the privacy and security of personal medical data and requires the adoption of standards for the exchange of electronic health information. Among the standards that the Secretary of Health and Human Services has adopted pursuant to HIPAA are standards for the following: electronic transactions and code sets, unique identifiers for providers, employers, health plans and individuals, security and electronic signatures, privacy and enforcement. Although HIPAA was intended to ultimately reduce administrative expenses and burdens faced within the health care industry, we believe that implementation of this law has resulted and will continue to result in additional costs. Failure to comply with HIPAA could result in fines and penalties that could have a material adverse effect on us. See Item 1, “Business - HIPAA Compliance”.

     We are unable to predict the future course of federal, state and local regulation or legislation, including Medicare and Medicaid statutes and regulations, or the intensity of federal and state enforcement actions. Our failure to obtain or renew required regulatory approvals or licenses or to comply with applicable regulatory requirements, the suspension or revocation of our licenses or our disqualification from participation in certain federal and state reimbursement programs, or the imposition of other harsh enforcement sanctions could have a material adverse effect upon our operations and financial condition.

      Significant legal actions, which are commonplace in our industry, could subject us to increased operating costs and substantial uninsured liabilities, which would materially and adversely affect our liquidity and financial condition. — As is typical in the health care industry, we are subject to claims that our services have resulted in resident injury or other adverse effects. We, like our industry peers, have experienced an increasing trend in the frequency and severity of professional liability, workers’ compensation, and health insurance claims and litigation asserted against us. In some states in which we have significant operations, insurance coverage for the risk of punitive damages arising from professional liability claims and/or litigation may not, in certain cases, be available due to state law prohibitions or limitations of availability. We cannot assure you that we will not be liable for punitive damage awards that are either not covered or are in excess of our insurance policy limits. We also believe that there have been, and will continue to be, governmental investigations of long-term care providers, particularly in the area of Medicare/Medicaid false claims, as well as an increase in enforcement actions resulting from these investigations. Insurance is not available to cover such losses. Any adverse determination in a legal proceeding or governmental investigation, whether currently asserted or arising in the future, could have a material adverse effect on our financial condition.

     Due to the rising cost and limited availability of professional liability, workers’ compensation and health insurance, we are largely self-insured on all of these programs and as a result, there is no limit on the maximum number of claims or amount for which we or our insured subsidiary can be liable in any policy period. Although we base our loss estimates on independent actuarial analyses using the information we have to date, the amount of the losses could exceed our estimates. In the event our actual liability exceeds our estimates for any given period, our results of operations and financial condition could be materially adversely impacted. In addition, our insurance coverage might not cover all claims made against us. If we are unable to maintain our current insurance coverage, if judgments are obtained in excess of the coverage we maintain, if we are required to pay uninsured punitive damages, or if the number of claims settled within the self-insured retention currently in place significantly increases, we could be exposed to substantial additional liabilities. We cannot assure you that the claims we pay under our self-insurance programs will not exceed the reserves we have set aside to pay claims. The number of claims within the self-insured retention may increase.

      Recent legislation and the increasing costs of being publicly owned are likely to impact our future consolidated financial position and results of operations. — In connection with the Sarbanes-Oxley Act of 2002, we are subject to rules requiring our management to report on the effectiveness of our internal controls over financial reporting, and further requiring our independent auditor to attest similarly to such effectiveness. If we fail to have effective internal controls and procedures for financial reporting in place, we could be unable to provide timely and reliable financial information which could, in turn, have an adverse effect on our business, results of operations, financial condition and cash flows.

     Significant regulatory changes, including the Sarbanes-Oxley Act and rules and regulations promulgated as a result of the Sarbanes-Oxley Act, have increased, and in the future are likely to further increase, general and administrative costs. In order to comply with the Sarbanes-Oxley Act of 2002, the listing standards of the American Stock exchange, and rules implemented by the Securities and Exchange Commission (SEC), we have had to hire additional personnel and utilize additional outside legal, accounting and advisory services, and may continue to require such additional resources. Moreover, in the rapidly changing regulatory environment in which we now operate, there is significant uncertainty as to what will be required to comply with many of the new rules and regulations. As a result, we may be required to spend substantially more than we currently estimate, and may need to divert resources from other activities, as we develop our compliance plans.

      New accounting pronouncements or new interpretations of existing standards could require us to make adjustments in our accounting policies that could affect our financial statements. — The Financial Accounting Standards Board, the SEC, or other accounting organizations or governmental entities issue new pronouncements or new interpretations of existing accounting standards that sometimes require us to change our accounting policies and procedures. Future pronouncements or interpretations could require us to change our policies or procedures and have a significant impact on our future statements.

      By undertaking to provide management services, advisory services, and/or financial services to other entities, we become at least partially responsible for meeting the regulatory requirements of those entities. — We provide

management and/or financial services to health care centers, assisting living centers and independent living centers owned by third parties. At December 31, 2005, we perform management services (which include financial services) for 27 such centers and accounting and financial services for an additional 37 such centers. Furthermore, we provide advisory services to NHR, a publicly traded REIT and financial services to Management Advisory Source, LLC which company provides advisory services to NHI, a publicly traded REIT. The “Risk Factors” contained herein as applying to us may in many instances apply equally to these other entities for which we provide services. We have in the past and may in the future be subject to claims from the entities to which we provide management, advisory or financial services, or to the claims of third parties to those entities. Any adverse determination in any legal proceeding regarding such claims could have a material adverse effect on our business, our results of operation, our financial condition and cash flows.

      The cost to replace or retain qualified nurses, health care professionals and other key personnel may adversely affect our financial performance, and we may not be able to comply with certain states’ staffing requirements. — We could experience significant increases in our operating costs due to shortages in qualified nurses, health care professionals and other key personnel. The market for these key personnel is highly competitive. We, like other health care providers, have experienced difficulties in attracting and retaining qualified personnel, especially facility administrators, nurses, certified nurses’ aides and other important health care providers. There is currently a shortage of nurses, and trends indicate this shortage will continue or worsen in the future. The difficulty our skilled nursing facilities are experiencing in hiring and retaining qualified personnel has increased our average wage rate. We may continue to experience increases in our labor costs due to higher wages and greater benefits required to attract and retain qualified health care personnel. Our ability to control labor costs will significantly affect our future operating results.

     Certain states in which we operate skilled nursing facilities have adopted minimum staffing standards and additional states may also establish similar requirements in the future. Our ability to satisfy these requirements will depend upon our ability to attract and retain qualified nurses, certified nurses’ assistants and other staff. Failure to comply with these requirements may result in the imposition of fines or other sanctions. If states do not appropriate sufficient additional funds (through Medicaid program appropriations or otherwise) to pay for any additional operating costs resulting from minimum staffing requirements, our profitability may be adversely affected.

     Although we currently have no collective bargaining agreements with unions at our facilities, there is no assurance this will continue to be the case. If any of our facilities enter into collective bargaining agreements with unions, we could experience or incur additional administrative expenses associated with union representation or our employees.

      Future acquisitions may be difficult to complete, use significant resources, or be unsuccessful and could expose us to unforeseen liabilities. — We may selectively pursue acquisitions or new developments in our target markets. Acquisitions and new developments may involve significant cash expenditures, debt incurrence, capital expenditures, additional operating losses, amortization of the intangible assets of acquired companies, dilutive issuances of equity securities and other expenses that could have a material adverse effect on our financial condition and results of operations. Acquisitions also involve numerous other risks, including difficulties integrating acquired operations, personnel and information systems, diversion of management’s time from existing operations, potential losses of key employees or customers of acquired companies, assumptions of significant liabilities, exposure to unforeseen liabilities of acquired companies and increases in our indebtedness.

     We cannot assure you that we will succeed in obtaining financing for any acquisitions at a reasonable cost or that any financing will not contain restrictive covenants that limit our operating flexibility. We also may be unable to operate acquired facilities profitably or succeed in achieving improvements in their financial performance.

     We also may face competition in acquiring any facilities. Our competitors may acquire or seek to acquire many of the facilities that would be suitable acquisition candidates for us. This could limit our ability to grow by acquisitions or increase the cost of our acquisitions.

      Upkeep of healthcare properties is capital intensive, requiring us to continually direct financial resources to the maintenance and enhancement of our physical plant and equipment. — As of December 31, 2005, we leased or owned

48 skilled nursing centers, 22 assisted living centers, and four independent living centers. Our ability to maintain and enhance our physical plant and equipment in a suitable condition to meet regulatory standards, operate efficiently and remain competitive in our markets requires us to commit a substantial portion of our free cash flow to continued investment in our physical plant and equipment. Certain of our competitors may operate centers that are not as old as our centers, or may appear more modernized than our centers, and therefore may be more attractive to prospective customers. In addition, the cost to replace our existing centers through acquisition or construction is substantially higher than the carrying value of our centers. We are undertaking a process to allocate more aggressively capital spending within our owned and leased centers in an effort to address issues that arise in connection with an aging physical plant.

     If factors, including factors indicated in these “Risk Factors” and other factors beyond our control, render us unable to direct the necessary financial and human resources to the maintenance, upgrade and modernization of our physical plant and equipment, our business, results of operations, financial condition and cash flow could be adversely impacted.

      Provision for losses in our financial statements may not be adequate.— Loss provisions in our financial statements for self-insured programs are made on an undiscounted basis in the relevant period. These provisions are based on internal and external evaluations of the merits of individual claims, analysis of claims history and independent actuarially determined estimates. The external analysis is completed by a certified actuary with extensive experience in the long-term care industry. Our management reviews the methods of determining these estimates and establishing the resulting accrued liabilities frequently, with any material adjustments resulting therefrom being reflected in current earnings. Although we believe that our provisions for self-insured losses in our financial statements are adequate, the ultimate liability may be in excess of the amounts recorded. In the event the provisions for loss reflected in our financial statements are inadequate, our financial condition and results of operations may be materially affected.

      Implementation of a new information technology infrastructure could cause business interruptions and negatively affect our profitability and cash flows. — We continue to refine and implement our information technology to improve customer service, enhance operating efficiencies and provide more effective management of business operations. Implementation of the new system and software and refinement of existing software carries risks such as cost overruns, project delays and business interruptions and delays. If we experience a material business interruption as a result of the implementation of our existing or future information technology infrastructure or are unable to obtain the projected benefits of this new infrastructure, it could adversely affect us and could have a material adverse effect on our business, results of operations, financial condition and cash flows.

      If we fail to compete effectively with other health care providers, our revenues and profitability may decline.— The long-term health care services industry is highly competitive. Our skilled nursing health care centers, assisted living centers, independent living facilities, home care services and other operations compete on a local and regional basis with other nursing centers, health care providers, and senior living service providers. Some of our competitors’ facilities are located in newer buildings and may offer services not provided by us or are operated by entities having greater financial and other resources than us. Our skilled nursing facilities face competition from skilled nursing, assisted living, independent living facilities, homecare services, and other operations that provide services comparable to those offered by our skilled nursing facilities. Many competing general acute care hospitals are larger and more established than our facilities.

     The long-term care industry is divided into a variety of competitive areas that market similar services. These competitors include skilled nursing, assisted living, independent living facilities, homecare services, hospice providers and other operations. Our facilities generally operate in communities that also are served by similar facilities operated by our competitors. Certain of our competitors are operated by not-for-profit, non-taxpaying or governmental agencies that can finance capital expenditures on a tax exempt basis and that receive funds and charitable contributions unavailable to us. Our facilities compete based on factors such as our reputation for quality care; the commitment and expertise of our staff; the quality and comprehensiveness of our treatment programs; the physical appearance, location and condition of our facilities and to a limited extend, the charges for services. In addition, we compete with other long-term care providers for customer referrals from hospitals. As a result, a failure to compete effectively with respect to referrals may have an adverse impact on our business. Many of these competing companies have greater financial and other resources

than we have. We cannot assure you that increased competition in the future will not adversely affect our financial condition and results of operations.

      Possible changes in the case mix of patients as well as payor mix and payment methodologies may significantly affect our profitability.— The sources and amounts of our patient revenues will be determined by a number of factors, including licensed bed capacity and occupancy rates of our facilities, the mix of patients and the rates of reimbursement among payors. Likewise, reimbursement for therapy services will vary based upon payor and payment methodologies. Changes in the case mix of the patients as well as payor mix among private pay, Medicare and Medicaid will significantly affect our profitability. Particularly, any significant increase in our Medicaid population could have a material adverse effect on our financial position, results of operations and cash flow, especially if states operating these programs continue to limit, or more aggressively seek limits on, reimbursement rates.

      Private third-party payors continue to try to reduce health care costs. — Private third-party payors are continuing their efforts to control health care costs through direct contracts with health care providers, increased utilization review and greater enrollment in managed care programs and preferred provider organizations. These private payors increasingly are demanding discounted fee structures and the assumption by health care providers of all or a portion of the financial risk. We could be adversely affected by the continuing efforts of private third-party payors to limit the amount of reimbursement we receive for health care services. We cannot assure you that reimbursement payments under private third-party payor programs will remain at levels comparable to present levels or will be sufficient to cover the costs allocable to patients eligible for reimbursement pursuant to such programs. Future changes in the reimbursement rates or methods of private or third-party payors, including the Medicare and Medicaid programs, or the implementation of other measures to reduce reimbursement for our services could result in a substantial reduction in our net operating revenues. Finally, as a result of competitive pressures, our ability to maintain operating margins through price increases to private patients is limited.

      We are exposed to market risk due to the fact that outstanding debt and future borrowings are or will be subject to wide fluctuations based on changing interest rates. — Market risk is the risk of loss arising from adverse changes in market rates and prices such as interest rates, foreign currency exchange rates and commodity prices. Our primary exposure to market risk is interest rate risk associated with variable rate borrowings. Although we do not currently have a bank credit facility, we may be in the future as we resume development and acquisitions. Any future credit facility will provide for variable rates and if market interest rates rise, so will our required interest payments on any future borrowings under the credit facility.

     Although we currently have a modest amount of debt outstanding, we expect to borrow in the future to fund development and acquisitions. In the event we incur substantial indebtedness, this could have important consequences to you. For example, it could:

•		make it more difficult for us to satisfy our financial obligations;
•		increase our vulnerability to general adverse economic and industry conditions, including material adverse regulatory changes such as reductions in reimbursement;
•		limit our ability to obtain additional financing to fund future working capital, capital expenditures and other general corporate requirements, or to carry out other aspects of our business plan;
•		require us to dedicate a substantial portion of our cash flow from operations to payments on indebtedness, thereby reducing the availability of such cash flow to fund working capital, capital expenditures or other general corporate purposes, or to carry out other aspects of our business plan;
•		require us to pledge as collateral substantially all of our assets;
•		require us to maintain certain debt coverage and financial ratios at specified levels, thereby reducing our financial flexibility;

•		limit our ability to make material acquisitions or take advantage of business opportunities that may arise;
•		expose us to fluctuations in interest rates, to the extend our borrowings bear variable rates of interest;
•		limit our flexibility in planning for, or reacting to, changes in our business and the industry; and
•		place us at a competitive disadvantage compared to our competitors that have less debt.

     In addition, loan agreements governing our debt contain and may in the future contain financial and other restrictive covenants limiting our ability to engage in activities that may be in our long-term best interests. Our failure to comply with those covenants could result in an event of default which, if not cured or waived, could result in the acceleration of some or all of our debts.

      We are permitted to incur substantially more debt, which could further exacerbate the risks described above.— We and our subsidiaries may be able to incur substantial additional indebtedness in the future. The terms of our current debt do not completely prohibit us or our subsidiaries from incurring additional indebtedness. If new debt is added to our current debt levels, the related risks that we now face could intensify.

      To service our indebtedness, we will require a significant amount of cash, the availability of which depends on many factors beyond our control. — Our ability to make payments on and to refinance our indebtedness, including our present indebtedness , and to fund planned capital expenditures, will depend on our ability to generate cash in the future. This, to a certain extend, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control.

      We may not be able to meet all of our capital needs. — We cannot assure you that our business will generate cash flow from operations, that anticipated revenue growth and improvement of operating efficiencies will be realized or that future borrowings will be available to us in an amount sufficient to enable us to service our indebtedness or to fund our other liquidity needs. We may need to refinance all or a portion of our indebtedness on or before maturity, sell assets or curtain discretionary capital expenditures.

Item 1B.		Unresolved Staff Comments

     None

Item 2. Properties

(1)		Leased from NHR or NHI
(2)		NHC HealthCare/Fort Oglethorpe and NHC HealthCare/Fort Sanders are owned by separate limited partnerships. The Company owns approximately 80% of the partnership interest in Fort Oglethorpe and 25% of the partnership interest in Fort Sanders.

     As a result of the terms of our insurance policies and our use of a wholly-owned insurance company, we have retained significant self-insured risk with respect to general and professional liability. We use independent actuaries to estimate our exposures for claims obligations (for both asserted and unasserted claims) related to exposures in excess of coverage limits, and we maintain reserves for these obligations. It is possible that claims against us could exceed our coverage limits and our reserves, which would have a material adverse effect on our financial position, results of operations and cash flows.

Nashville Fire

     On September 25, 2003, a tragic fire occurred on the second floor of a skilled nursing facility located in Nashville, Tennessee operated by one of our limited liability company subsidiaries. While the concrete and steel constructed facility complied with applicable fire safety codes, the building was not equipped with fire sprinklers. Although the fire was predominantly confined to a patient’s room, extensive smoke filled the area and caused injuries to other patients despite aggressive efforts to evacuate these patients by NHC employees, fire department personnel and other volunteers. There were sixteen patient deaths subsequent to the fire, an undetermined number of which may be related to the events of September 25, 2003.

     The fire produced extensive media coverage, specifically focused on the fact that health care centers, including hospitals, constructed prior to 1994 are not required by Tennessee law or regulations to be fully sprinkled if constructed with fire resistant materials. Irrespective of code standards, we undertook to install fire sprinklers in all of our owned and leased long-term care centers, which installation is now completed. We proactively sought to resolve any questions and/or losses with patients and their families. Of a total of 32 lawsuits filed against us, 30 have been settled. Two lawsuits are currently pending. The cases were consolidated in the Third Circuit Court for Davidson County, Tennessee. Discovery is ongoing in the remaining two cases. The Company continues to vigorously defend against the allegations in these lawsuits while seeking settlement and final resolution with the families.

     Additionally, in connection with the fire, we have incurred losses and costs associated with interruption of business, as we have closed the center. For the year ended December 31, 2004, we received or accrued $1,404,000 of insurance recoveries from third-party insurance carriers. Amounts of insurance recoveries received in 2005 are immaterial in amount when netted against the related expenses. These insurance recoveries reduced our losses and costs and were included in other operating expenses in the consolidated statements of income.

     The building involved in the fire was leased by one of our limited liability company subsidiaries from National Health Investors, Inc. (NHI). We terminated the lease during the third quarter of 2004. A provision of the lease allowed that if substantial damage occurred during the lease term, we could terminate the lease with respect to the damaged property. Under the lease, NHC had no obligation to repair the property and NHI was entitled to all insurance proceeds related to the building damage. We are obligated to continue to indemnify and hold harmless NHI from any and all demands arising from our use of the property. NHI retained the right to license the beds under the lease termination.

     Consistent with the provisions of SFAS 5, we have accrued for probable and estimatible losses related to the Nashville fire and have included our estimates of these losses in accrued risk reserves in the consolidated balance sheet. It is possible that claims against us related to the Nashville fire could exceed our estimates, which would have a material adverse effect on our financial position, results of operations and cash flows.

General Litigation

     There is certain additional litigation incidental to our business, none of which, in management’s opinion, would be material to our financial position or results of operations.

     In 2006 we are continuing to develop an active hospice program in selected areas through our partnership with the recently formed Caris Healthcare and are also exploring opportunities to expand our home health care services.

      NHI Lease Renewal — On December 27, 2005, we reached an agreement with National Health Investors, Inc. to extend our lease of 41 properties through December 31, 2021, with three additional five-year renewal options, each at fair market value. This lease extension assures our long-term use of these properties which we developed.

      NHR Lease Renewal — Effective August 1, 2005, we reached an agreement with National Health Realty, Inc. (NHR) to extend our lease of 14 properties through December 31, 2017, with an additional renewal option for 10 years at fair market value. This lease extension assures our long-term use of these properties which we developed.

      Accrued Risk Reserves — Our accrued professional liability reserves, workers’ compensation reserves and health insurance reserves totaled $70,290,000 at the end of 2005 and are a primary area of management focus. We have set aside restricted cash to fully fund our professional liability and workers’ compensation reserves. As to the tragic fire on September 25, 2003 at the Nashville skilled nursing subsidiary, we have settled 30 of the 32 lawsuits filed against the company and will continue to vigorously defend against the allegations in the lawsuits while seeking settlement and final resolution with the families.

     As to the risks of fire, we have installed fire sprinklers in all of our owned and leased long-term care centers that were not already so equipped. In addition, we have implemented a comprehensive fire safety training program at all of our centers and reviewed and modified, if necessary, our priority safety procedures.

     As to exposure for professional liability claims, we have developed for our centers performance certification criteria to measure and bring focus to the patient care issues most likely to produce professional liability exposure, including in-house acquired pressure ulcers, significant weight loss and numbers of falls. These programs for certification, which we regularly modify and improve, have produced measurable improvements in reducing these incidents. Our experience is that achieving goals in these patient care areas improves both patient and employee satisfaction. Furthermore, we are continuing efforts to identify and restructure the ownership or management of our higher risk operations and locations to eliminate NHC liability exposure.

     As to workers’ compensation claims, we have implemented programs such as safety boards, safety awards, and tracking systems for “days without a lost time accident” to bring focus to these risks at all of our locations. As to health insurance claims, we changed our health plan network provider to obtain better discounts in 2005 and we continue to evaluate our health plan design to identify opportunities for improvements and cost savings.

Application of Critical Accounting Policies

     The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates and cause our reported net income to vary significantly from period to period.

     Our critical accounting policies that are both important to the portrayal of our financial condition and results and require our most difficult, subjective or complex judgments are as follows:

      Revenue Recognition — Third Party Payors - Approximately 61% (2005), 64% (2004) , and 66% (2003) of our net revenues are derived from Medicare, Medicaid, and other government programs. Amounts earned under these programs are subject to review by the Medicare and Medicaid intermediaries. In our opinion, adequate provision has been made for any adjustments that may result from these reviews. Any differences between our estimates of settlements and final determinations are reflected in operations in the year finalized. For the cost report years 1997 and 1998, we have submitted various requests for exceptions to Medicare routine cost limitations for reimbursement. We received

preliminary intermediary approval on $14,186,000 of these requests in 2001 after settlement of outstanding litigation styled Braeuning, et al vs. National HealthCare L.P., et al. We have, in addition, made provisions of approximately $12,761,000 for other various Medicare and Medicaid issues for current and prior year cost reports. Consistent with our revenue recognition policies, we will record revenues associated with the approved requests and the other various issues when the approvals, including the final cost report audits, are assured. The three-year review period expired in 2004 for approximately $22,310,000 of the routine cost limit exceptions and this amount was recorded as revenue in 2004 even though we received no cash payments for this revenue in 2004. Adjustments of a similar nature were not significant in 2005.

      Revenue Recognition — Private Pay — For private pay patients in skilled nursing or assisted living facilities, we bill room and board in advance for the current month with payment being due upon receipt of the statement in the month the services are performed. Charges for ancillary, pharmacy, therapy and other services to private patients are billed in the month following the performance of services. All billings are recognized as revenue when the services are performed.

      Accrued Risk Reserves — We are principally self-insured for risks related to employee health insurance, workers’ compensation and professional and general liability claims. Our accrued risk reserves primarily represent the accrual for self-insured risks associated with employee health insurance, workers’ compensation and professional and general liability claims. The accrued risk reserves include a liability for reported claims and estimates for incurred but unreported claims. Our policy with respect to a significant portion of our workers’ compensation and professional and general liability claims is to use an actuary to support the estimates recorded for incurred but unreported claims. Our health insurance reserve is based on our known claims incurred and an estimate of incurred but unreported claims determined by our analysis of historical claims paid. We reassess our accrued risk reserves on a quarterly basis.

     Professional liability remains an area of particular concern to us. The entire long term care industry has seen a dramatic increase in personal injury/wrongful death claims based on alleged negligence by nursing homes and their employees in providing care to residents. As of December 31, 2005, we and/or our managed centers are defendants in 50 such claims inclusive of years 1995 through 2005. In addition, two lawsuits are currently pending relative to a September 25, 2003 fire at our Nashville LLC skilled nursing subsidiary. This litigation may still take several years to reach final resolution. There have been no additional claims asserted that are related to the events of September 25, 2003 since 2004. It remains possible that these pending matters plus potential unasserted claims could exceed our reserves, which would have a material adverse effect on our financial position, results of operations and cash flows. It is also possible that future events could cause us to make significant adjustments or revisions to these reserve estimates and cause our reported net income to vary significantly from period to period.

     We maintain insurance coverage for incidents occurring in all provider locations owned, leased or managed by us. The coverages include both primary policies and umbrella policies.

     For 2002, we maintain primary coverage through our own insurance company with excess coverage provided by a third party insurance company. For 2003-2005, we maintain both primary and excess coverage through our own insurance subsidiary. In all years, settlements, if any, in excess of available insurance policy limits and our own reserves would be expensed by us.

      Revenue Recognition — Uncertain Collections — We provide management services to certain long-term care facilities and to others we provide accounting and financial services. We generally charge 6% of net revenues for our management services and a predetermined fixed rate per bed for the accounting and financial services. Generally our policy is to recognize revenues associated with both management services and accounting and financial services on an accrual basis as the services are provided. However, there are certain of the third parties with which we have contracted to provide services and which we have determined, based on insufficient historical collections and the lack of expected future collections, that the service revenue realization is uncertain and our policy is to recognize income only in the period in which the amounts are collected. It is possible that future events could cause us to make significant adjustments or revisions to these estimates and cause our reported net income to vary significantly from period to period.

     Certain of our accounts receivable from private paying patients and certain of our notes receivable are subject to credit losses. We have attempted to reserve for expected accounts receivable credit losses based on our past experience with similar accounts receivable and believe our reserves to be adequate.

     We continually monitor and evaluate the carrying amount of our notes receivable in accordance with Statement of Financial Accounting Standards No. 114, “Accounting by Creditors for Impairment of a Loan — An Amendment of FASB Statements No. 5 and 15.” It is possible, however, that the accuracy of our estimation process could be materially impacted as the composition of the receivables changes over time. We continually review and refine our estimation process to make it as reactive to these changes as possible. However, we cannot guarantee that we will be able to accurately estimate credit losses on these balances. It is possible that future events could cause us to make significant adjustments or revisions to these estimates and cause our reported net income to vary significantly from period to period.

      Potential Recognition of Deferred Income — During 1988, we sold the assets of eight long-term health care centers to National Health Corporation (“National”), our administrative general partner at the time of the sale. The resulting profit of $15,745,000 was deferred and will be amortized into income beginning with the collection of the note receivable (up to $12,000,000) with the balance ($3,745,000) of the profit being amortized into income on a straight-line basis over the management contract period. $10,000,000 of the previously deferred income will be recognized as income at the time of and in proportion to the collection of the associated $10,000,000 note. Additional deferred income of $2,000,000 will be reported when the company no longer has an obligation to advance the $2,000,000 working capital loan. The collection (or alternatively, the offset against certain payables to National) of up to $12,000,000 of notes receivable would result in the immediate recognition of up to $12,000,000 of pretax net income. Currently, the notes are due December 31, 2007.

      Guarantees — We guarantee the debt of managed and other long-term health care centers ($9,269,000) and the debt of National and the ESOP ($7,564,000). We recorded a liability in the amount of $1,044,000 related to our guarantee of $5,000,000 of debt of six long-term health care centers in Florida. We recorded this liability based upon our estimate of the value of the underlying collateral of the loans. It is possible that future events could cause us to make significant adjustments to our estimates and liability under these guarantees and cause our reported net income to vary significantly from period to period.

      Tax Contingencies — NHC continually evaluates for tax related contingencies. Contingencies may arise where tax laws may allow for alternative interpretations or where the timing of recognition of income is subject to judgment. We believe we have adequate provisions for tax contingencies. However, because of uncertainty of interpretation by various tax authorities and the possibility that there are issues that have not been recognized by management, we cannot guarantee we have accurately estimated our tax liabilities.

     The above listing is not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by generally accepted accounting principles, with no need for management’s judgment in their application. There are also areas in which management’s judgment in selecting any available alternative would not produce a materially different result. See our audited consolidated financial statements and notes thereto which contain accounting policies and other disclosures required by generally accepted accounting principles.

Results of Operations

     The following table and discussion sets forth items from the consolidated statements of income as a percentage of net revenues for the audited years ended December 31, 2005, 2004 and 2003.

     The following table sets forth the increase in certain items from the consolidated statements of income as compared to the prior period.

     Our long-term health care services, including therapy and pharmacy services, provided 90% of net patient revenues in 2005, 2004, and 2003. Homecare programs provided 10% of net patient revenues in 2005, 2004, and 2003.

     The overall census in owned, leased and managed health care centers for which we guarantee the debt for 2005 was 94.0% compared to 93.9% in 2004 and 2003.

     Approximately 63% (2005), 64% (2004), and 66% (2003) of our net revenues are derived from Medicare, Medicaid, and other government programs. As discussed above in the Application of Critical Accounting Policies section, amounts earned under these programs are subject to review by the Medicare and Medicaid intermediaries. See Application of Critical Accounting Policies for discussion of the effects that this revenue concentration and the uncertainties related to such revenues have on our revenue recognition policies.

Government Program Financial Changes

     Cost containment will continue to be a priority for Federal and State governments for health care services, including the types of services we provide.

Medicare—

     Effective October 1, 2005, PPS rates were increased by a 3.1% annual inflation update factor. Revenues for the fourth quarter of 2005 reflected the continuation of the temporary add-on payments. We estimate that the positive revenue effect of the CMS final rule was $650,000 for the fourth quarter of 2005.

     Including inflation, total Medicare payments to all providers in FY 2006 as projected by CMS will be the same as total payments made to all providers in FY 2005. However, the final rule will cause a redistribution of payments among providers. This is accomplished by refinements expanding the Resource Utilization Groups (RUGs) from 44 RUG groups to 53 RUG groups and by eliminating temporary rate add-ons. The elimination of temporary add-ons has always been tied to the long awaited RUG refinement. RUG refinement increases the case mix weight that applies to both nursing and non-ancillary therapy ancillary costs. This is a permanent change in the PPS methodology. Excluding the 3.1% annual inflation update factor, RUG refinement is expected to reduce our Medicare payment rates approximately $13 per patient day beginning January 1, 2006, thereby reducing 2006 revenues and pre-tax income by approximately $4.6 million.

     The Deficit Reduction Act (DRA) of 2005 mandates the reduction of bad debt payments, which payments are included in patient revenues, to skilled nursing facilities over a three year phase in period. The first year, FY 2006, reduction would be 10% or $430,000. Year two would be a 20% reduction with year three and beyond holding at 30% similar to inpatient hospitals.

     Payments to home health agencies increased by 2.3% effective January 1, 2005. Effective April 1, 2005 the rural add-on of 5% was eliminated causing a 3% decrease in revenues. In effect, the increase in inflation and loss of the rural add-on offset resulting in no significant increase or decrease in revenues for FY 2005.

     The Deficit Reduction Act (DRA) of 2005, if adopted as proposed, would mandate the home health payment rate for 2006 would be frozen. HHAs serving rural beneficiaries would see a one-year five percent add-on payment under the legislation. The rural add-on payment would provide for a 2.5% increase in total payments, for our homecare operations approximately $1.2 million in FY 2006 due to a significant number our homecares serving rural counties.

Medicaid—

     Tennessee annual Medicaid rate increases have been delayed in 2005 due to submission of a new plan to CMS. The new plan substitutes a new funding methodology called Certified Patient Expenditures (CPE) for inter-governmental transfers (IGT). In effect our rates in Tennessee have been frozen for a year and a half as of December 31, 2005. If approved, it is anticipated that the rate increase would be retroactive to July 1, 2005. The increase in revenue is estimated to be approximately $650,000 per quarter.

     Missouri Medicaid cut their rates effective April 1, 2005, and was unable to fund the second and third year of the expected rebasing of FY 2001 audited cost reports. The April 1, 2005 rate change reduced our revenues $145,000 in 2005. The failure to implement the rebasing decreased revenues by approximately $2,600,000 in each year since 2001.

     South Carolina Medicaid annual per diem rate increases are expected to result in additional revenues of approximately $585,000 for the next four quarters.

2005 Compared to 2004

     Results for 2005 include a 3.9% increase compared to 2004 in net revenues and a 16.6% increase in net income before income taxes.

     As indicated in the tables shown above, our patient revenues for 2005 increased $11,925,000 or 2.6% compared to 2004. However, if you exclude the $22,310,000 of prior year Medicare and Medicaid adjustments, our 2005 patient revenues increased approximately $34,235,000. We estimate that the October 2004 Medicare rate increases for skilled nursing centers and homecare programs increased our revenues by approximately $3,400,000 for the twelve months ended December 31, 2005. Our Cool Springs health care and assisted living center in Franklin, Tennessee opened in May 2004 and a 30 long-term bed addition located in Murfreesboro, Tennessee opened in August 2004. These additions, net of a decrease in revenues from beds closed elsewhere, added approximately $12,936,000 to net patient revenues. Finally, improved census mix and therapy and pharmacy billings to managed centers increased our twelve months revenues approximately $13,300,000 compared to the period last year. Patient revenue increases in 2004 included the recognition of approximately $22,310,000 of prior period Medicare and Medicaid adjustments. Prior year adjustments in 2005 were not significant.

     Other revenues this year increased $8,627,000 or 15.1% to $65,785,000. Other revenues in 2005 include management and accounting service fees of $24,684,000 ($20,504,000 in 2004) and insurance services revenue of $23,585,000 ($19,685,000 in 2004). The increase in management and accounting service fees is due in part to the recognition in 2005 of $8,416,000, of fees received in 2005 but which had been doubtful of collection in prior years. During 2005, NHC provided management, accounting and financial services for 37 facilities as compared to 40 facilities during 2004.

     The increase in insurance service revenues is due to increased premiums for professional liability insurance from our wholly-owned insurance subsidiary. The premiums charged are based on factors considering actuarially determined estimates of potential liability.

     Total costs and expenses for 2005 increased $13,917,000 or 2.9% to $495,691,000 from $481,774,000 in 2004. Salaries, wages and benefits, the largest operating costs of this service company, increased $9,374,000 or 3.4% to $285,488,000 from $276,114,000. Other operating expenses increased $598,000 or .4% to $150,160,000 for 2005 compared to $149,562,000 in 2004. Rent expense increased $1,015,000 or 2.5% to $42,049,000. Depreciation and amortization increased 12.3% to $15,463,000. Interest costs increased 17.9% to $1,531,000.

     Increases in salaries, wages and benefits are due in part to increased numbers of employees due to newly opened long-term care bed additions or facilities (approximately $4,700,000 of increase), to inflationary wage increases and to increased bonus and benefit programs compared to 2004. The increases in bonus and benefit programs result both from inflationary increases as well as from changes in the benefit programs.

     Increases in other operating costs and expenses are due in part to increases in the costs of health insurance and to increased census at our 160 long-term care beds and 46 assisted living units which opened in May 2004 and 30 long-term care beds which opened in August 2004. Increases were offset in part due to decreases in professional liability insurance and workers’ compensation insurance.

     Expenses also included a loss of $1,000,000 for the write-down of a note receivable in March, 2005. This note receivable is due from a 120-bed long-term health care center in Missouri that we manage. As a result of increased operating costs and the lack of increase in reimbursement rates, the cash flows of this center declined and the center has not made a principal payment on this note since December 31, 2001. Based on an analysis consistent with the provisions of Statement of Financial Accounting Standards No. 114, “Accounting by Creditors for Impairment of a Loan — an Amendment of FASB Statements No. 5 and 15”, we concluded that a write-down of $1,000,000 was required. We continue to monitor closely our other notes receivable from centers to which we provide management or accounting services.

     Rent expense increased primarily due to increases in percentage rent to NHR and NHI. The increase was offset in part due to terminated leases for an 80-bed long-term health care center and a 124-bed long-term health care center in 2004.

     The increase in interest costs is primarily due to recording capitalized interest of approximately $230,000 for construction projects financed internally in the nine month period ended December 31, 2004. The weighted average interest rate for our debt increased to 7.3% in 2005 from 5.7% in 2004.

2004 Compared to 2003

     Results for 2004 include a 10.4% increase compared to 2003 in net revenues and a 20.3% increase in net income before income taxes.

     As indicated in the tables shown above, our patient revenues for 2004 increased $41,930,000 or 9.9% compared to 2003. This increase reflects improved Medicaid and private pay rates. Medicare rate improvements in the fourth quarter increased our revenues by approximately $650,000. Improvements in Medicare rates granted through annual updates effective October 1, 2003 and 2004 have restored rates to pre-October 2002 levels. Our patient revenues were also increased by approximately $22,310,000 of Medicare and Medicaid adjustments from prior years. Our newly opened Cool Springs health care and assisted living center in Franklin, Tennessee, net of revenues from beds closed elsewhere, added revenue of approximately $4,436,000.

     Other revenues in 2004 increased $7,035,000 or 14.0% to $57,158,000. Other revenues in 2004 include management and accounting service fees of $20,504,000 ($14,299,000 in 2003) and insurance services revenue of $19,685,000 ($17,427,000 in 2003). The increase in management and accounting service fees is due in part to the recognition in 2004 of $5,706,000, including $2,938,000 from National, of fees received in 2004 but which had been doubtful of collection in prior years. During 2004, NHC provided management, accounting and financial services for 40 facilities as compared to 42 facilities during 2003.

     The increase in insurance service revenues is due to increased premiums for professional liability insurance from our wholly-owned insurance subsidiary. The premiums charged are based upon actuarially determined estimates of potential liability.

     Total costs and expenses for 2004 increased $42,197,000 or 9.6% to $481,774,000 from $439,577,000 in 2003. Salaries, wages and benefits, the largest operating costs of this service company, increased $22,250,000 or 8.8% to $276,114,000 from $253,864,000. Other operating expenses increased $19,846,000 or 15.3% to $149,562,000 for 2004 compared to $129,716,000 in 2003. Rent expense decreased $503,000 or 1.2% to $41,034,000. Depreciation and amortization increased 11.2% to $13,765,000. Interest costs decreased 37.5% to $1,299,000.

     Increases in salaries, wages and benefits are due in part to increased numbers of employees due to newly opened long-term care beds and increased utilization in therapy and homecare services and to increased bonus and benefit programs compared to 2004. The increases in bonus and benefit programs result both from inflationary increases as well as from changes in the benefit programs.

     Increases in other operating costs and expenses are due in part to increases in the costs of professional liability insurance, workers’ compensation insurance and health insurance. Newly opened long-term care bed additions or facilities and higher utilization of our therapy and homecare services also contributed to the increases.

     Decreased interest expense is primarily due to our $16,791,000 prepayment of long-term debt in December 2003 and $327,000 in May 2004. The weighted average interest rate for our debt increased to 5.7% in 2004 from 5.2% in 2003.

Liquidity, Capital Resources and Financial Condition—

      Sources and Uses of Funds — Our primary sources of cash include revenues from the healthcare and senior living facilities we operate, insurance services, management services and accounting services. Our primary uses of cash include salaries, wages and other operating costs of our home office and the facilities we operate, the cost of additions to and acquisitions of real property, rent expenses, debt service payments (including principal and interest) and dividend distributions. These sources and uses of cash are reflected in our Consolidated Statements of Cash Flows and are discussed in further detail below. The following is a summary of our sources and uses of cash flows (dollars in thousands):

      Operating Activities — Net cash provided by operating activities for the year ended December 31, 2005, was $63,839,000 as compared to $20,295,000 for 2004. Cash provided by operating activities for the current year is composed of net income plus depreciation and increases in various accrued current liabilities including accrued risk reserves, tax refund and accrued payroll offset partially by increases in accounts receivable and decreases in accrued liabilities including amounts due third party payors which are payables to Medicare and Medicaid intermediaries. Depreciation increased due primarily to the completion of construction and placing in service a healthcare center located in Franklin, Tennessee and an addition to an existing healthcare center located in Murfreesboro, Tennessee.

     Amounts due to third party payors, which are payable to Medicare and Medicaid intermediaries decreased $22,705,000 in 2004 due to the recognition of revenue related to the expiration of the review period for routine limit cost exception requests which were originally approved in 2001. The increase in other current liabilities and accrued risks reserves accounted for $11,705,000 in 2005 and $13,734,000 in 2004 of the cash provided by operating activities. If the risks materialize as expected, which may not be finally known for several years, they will require the use of our restricted cash.

      Investing Activities — Cash used in investing activities totaled $20,038,000 for the year ended December 31, 2005, as compared to $8,573,000 used in investing activities for the year ended December 31, 2004. Cash used for property and equipment additions was $16,992,000 for the year ended December 31, 2005 and $22,741,000 in the comparable period in 2004. Investments in notes receivable totaled $2,197,000 in 2005 compared to $7,972,000 in 2004. Cash provided by net collections of notes receivable was $163,000 in 2005 compared to net collections in notes receivable in 2004 of $21,905,000. Cash used in the purchase of marketable securities was $1,168,000 in 2005 compared to $218,000 in 2004.

     Construction costs included in additions to property and equipment includes $2,243,000 for partial construction of a 30 bed addition to an existing long-term care facility located in Farragut, Tennessee and a 60 bed addition to an existing long-term care facility located in Mauldin, South Carolina. An additional $1,338,000 is for partial construction of a kitchen renovation at an existing health care center located in Lewisburg, Tennessee. Approximately $2,000,000

is for the installation of fire sprinklers for which we completed installation at all of our owned and leased centers that were not already so equipped. The remaining $11,411,000 of additions to property and equipment were for capital improvements at our 49 leased or owned centers.

     Investments in notes receivable in 2004 includes our $7,376,000 investment in $15,000,000 (face value) of tax exempt bonds, related to a facility for which we previously guaranteed the debt.

      Financing Activities — Net cash used in financing activities totaled $23,532,000 for the year ended December 31, 2005 compared to $15,020,000 in 2004. Payments on debt were $2,257,000 in 2005 compared to $3,817,000 in 2004. Increases in restricted cash totaled $16,335,000 compared to $9,947,000 in the prior year. Dividends paid to shareholders for the year were $6,721,000 compared to $4,379,000 in 2004. Collections of receivables from the exercise of stock options totaled $-0- compared to $16,000 in 2004. Proceeds from the issuance of common stock, primarily from the exercise of stock options, total $1,426,000 compared to $3,017,000 in the prior period.

     The increase in restricted cash is due primarily to the cash reserved for our accrued risk reserves, including professional liability claims, workers’ compensation claims and health insurance claims, net of cash paid out for those claims.

Table of Contractual Cash Obligations

     Our contractual cash obligations for periods subsequent to December 31, 2005 are as follows:

     The guaranteed debt of $1,044,000 represents our estimated obligation under a loan guarantee to a long-term health care center. We have guaranteed debt obligations of certain other entities totaling approximately $16,833,000. These guarantees are not included in the table above because we do not anticipate material obligations under these commitments.

     NHC has entered into agreements to complete construction of leasehold improvements at three long-term health care facilities. At December 31, 2005, we are obligated on construction contracts in the amount of approximately $7,932,000.

     Our current cash on hand, marketable securities, short-term notes receivable, operating cash flows, and as needed, our borrowing capacity are expected to be adequate to meet these contractual obligations and to finance our operating requirements, growth and development plans.

     We started paying quarterly dividends in the second quarter of 2004 and anticipate the continuation of dividend payments as approved quarterly by the Board of Directors.

Off Balance Sheet Arrangements and Debt Guarantees

     In addition to our primary debt obligations, which are included in our consolidated financial statements, we have guaranteed the debt obligations of certain other entities. Those guarantees, which are not included as debt obligations in our consolidated financial statements, total $16,833,000 at December 31, 2005 and include $9,269,000 of debt of managed and other long-term health care centers and $7,564,000 of debt of National and the ESOP.

     The $9,269,000 of guarantees of debt of managed and other long-term health care centers relates to debt obligations of seven long-term health care centers to which we provide management or accounting services. We have agreed to guarantee these obligations in order to obtain management or accounting services agreements. For this service, we charge an annual guarantee fee of 0.5% to 2.0% of the outstanding principal balance guaranteed, which fee is in addition to our management or accounting services fee. All of this guaranteed indebtedness is secured by first mortgages, pledges of personal property, accounts receivable, marketable securities and, in certain instances, the personal guarantees of the owners of the facilities.

     The $7,564,000 of guarantees of debt of National and the ESOP relates to senior secured notes held by financial institutions. The total outstanding balance of National and the ESOP’s obligations under these senior secured notes is $12,198,000. Of this obligation, $4,634,000 has been included in our debt obligations because we are a direct obligor on this indebtedness. The remaining $7,564,000, which is not included in our debt obligations because we are not a direct obligor, is due from NHI to National and the ESOP. Additionally, under the amended terms (dated March 31, 2005) of these note agreements, the right of the lending institutions to require NHC to purchase the notes at par value under a guaranty and contingency purchase agreement has been removed.

     The $4,634,000 of senior secured notes payable and the $7,564,000 guarantee described above have cross-default provisions with other debt of National and the ESOP. We currently believe that National and the ESOP are in compliance with the terms of their debt agreements.

     As of December 31, 2005, our maximum potential loss related to the aforementioned debt guarantees and financial guarantees is $16,833,000 which is the outstanding balance of our guarantees. We have accrued approximately $1,044,000 for potential losses as a result of our guarantees.

     We have no outstanding letters of credit. We may or may not in the future elect to use financial derivative instruments to hedge interest rate exposure in the future. At December 31, 2005, we did not participate in any such financial investments.

Debt Cross Defaults—

     The $4,634,000 senior secured notes and an additional $1,486,000 senior notes (repaid in 2004) were borrowed from National. National obtained its financing through the ESOP. As we are a direct obligor on this debt, it has been reported as a liability owed by us to the holders of the debt instruments rather than as a liability owed to National and the ESOP.

     Through a guarantee agreement, our $4,634,000 senior secured notes and our $7,564,000 guarantee described above have cross-default provisions with other debt of National and the ESOP. We currently believe that National and the ESOP are in compliance with the terms of their debt agreements.

New Accounting Pronouncements—

     On December 16, 2004, the FASB issued FASB Statement No. 153, Exchanges of Nonmonetary Assets — An Amendment of APB Opinion No. 29 . Statement 153 amends APB Opinion No. 29, Accounting for Nonmonetary Transactions , that was issued in 1973. The amendments made by Statement 153 are based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged. Further, the

amendments eliminate the narrow exception for nonmonetary exchanges of similar productive assets and replace it with a broader exception for exchanges of nonmonetary assets that do not have “commercial substance”. Previously, Opinion 29 required that the accounting for an exchange of a productive asset for a similar productive asset or an equivalent interest in the same or similar productive asset should be based on the recorded amount of the asset relinquished. The provisions in Statement 153 are effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005, and as such, the Company is unable to assess the impact on the financial statements. Early application is permitted and companies must apply the standard prospectively. The Company has adopted Statement 153 effective July 1, 2005. The future effect of Statement 153 on the Company’s financial statements will depend on whether the Company enters into certain non-monetary transactions.

     In December 2004, the FASB issued SFAS No. 123(R), Share-Based Payment. SFAS No. 123(R) replaces SFAS No. 123, Accounting for Stock-Based Compensation , and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees . SFAS No. 123(R) requires compensation costs related to share-based payment transactions to be recognized in the financial statements over the period that an employee provides service in exchange for the award. SFAS No. 123(R) is effective for Company beginning January 1, 2006. The Company does not expect the adoption of this pronouncement to have a significant impact on the Company’s financial statements. However, we expect to record compensation expense relative to our stock options.

     In May 2005, the FASB issued FASB Statement No. 154, Accounting for Changes and Error Corrections . This new standard replaces APB Opinion No. 20, Accounting Changes and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements . Statement 154 requires that a voluntary change in accounting principle be applied retrospectively with all prior period financial statements presented on the new accounting principle, unless it is impracticable to do so. Statement 154 also provides that (1) a change in method of depreciating or amortizing a long-lived nonfinancial asset be accounted for as a change in estimate (prospectively) that was effected by a change in accounting principle, and (2) correction of errors in previously issued financial statements should be termed a “restatement”. The new standard is effective for accounting changes and correction of errors made in fiscal years beginning after December 15, 2005. The Company does not expect the adoption of this pronouncement to have a significant impact on the Company’s financial statements.

Impact of Inflation—

     Inflation has remained relatively low during the past three years. However, rates paid under the Medicare and Medicaid programs do not necessarily reflect all inflationary changes and are subject to cuts unrelated to inflationary costs. Therefore, there can be no assurance that future rate increases will be sufficient to offset future inflation increases in our labor and other health care service costs.

Item 7a. Quantitative and Qualitative Disclosures about Market Risk.

INTEREST RATE RISK

     Our cash and cash equivalents consist of highly liquid investments with a maturity of less than three months. As a result of the short-term nature of our cash instruments, a hypothetical 10% change in interest rates would have minimal impact on our future earnings and cash flows related to these instruments.

     Approximately $19.3 million of our notes receivable bear interest at fixed interest rates. As the interest rates on these notes receivable are fixed, a hypothetical 10% change in interest rates would have no impact on our future earnings and cash flows related to these instruments.

     Approximately $2.7 million of our notes receivable bear interest at variable rates (generally at the prime rate plus 2%). Because the interest rates of these instruments are variable, a hypothetical 10% change in interest rates would result in a related increase or decrease in interest income of approximately $16,000.

     As of December 31, 2005, $10.3 million of our long-term debt and debt serviced by other parties bear interest at fixed interest rates. Because the interest rates of these instruments are fixed, a hypothetical 10% change in interest rates would have no impact on our future earnings and cash flows related to these instruments. The remaining $5.7 million of our long-term debt and debt serviced by other parties bear interest at variable rates. Because the interest rates of these instruments are variable, a hypothetical 10% change in interest rates would result in a related increase or decrease in interest expense of approximately $27,000.

     We do not currently use any derivative instruments to hedge our interest rate exposure. We have not used derivative instruments for trading purposes and the use of such instruments in the future would be subject to strict approvals by our senior officers.

EQUITY PRICE RISK

     We consider the majority of our investments in marketable securities as available for sale securities and unrealized gains and losses are recorded in stockholders’ equity in accordance with Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities”. The investments in marketable securities are recorded at their fair market value based on quoted market prices. Thus, there is exposure to equity price risk, which is the potential change in fair value due to a change in quoted market prices. Hypothetically, a 10% increase in quoted market prices would result in a related 10% increase in the fair value of our investments in marketable securities of $5,366,000 and a 10% reduction in quoted market prices would result in a related 10% decrease in the fair value of our investments in marketable securities of approximately $5,366,000.

Item 8. Financial Statements and Supplementary Data.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders of National HealthCare Corporation

We have audited the accompanying consolidated statements of income, cash flows and stockholders’ equity of National HealthCare Corporation for the year ended December 31, 2003. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated results of operations and cash flows of National HealthCare Corporation for the year ended December 31, 2003 in conformity with U.S. generally accepted accounting principles.

/s/ Ernst & Young LLP

Nashville, Tennessee
February 9, 2004

The accompanying notes to consolidated financial statements are an integral part of these consolidated statements.