Overview

Advocat Inc. provides long-term care services to nursing center patients in eight states, primarily in the Southeast and Southwest. Our centers provide a range of health care services to their patients and residents. In addition to the nursing, personal care and social services usually provided in long-term care centers, we offer a variety of comprehensive rehabilitation services as well as nutritional support services. As of March 31, 2012, our continuing operations consist of 47 nursing centers with 5,445 licensed nursing beds. We own 9 and lease 38 of our nursing centers included in continuing operations.

Strategic operating initiatives. Our key strategic operating initiatives include improving skilled mix in our nursing centers by enhancing our registered nurse coverage and adding specialized clinical care. The investments in nursing and clinical care were conducted in concert with additional investments in nursing center based marketing representatives to develop referral and managed care relationships. These investments have attracted and are expected to continue to attract quality payor sources for patients covered by Medicare, managed care as well as certain private pay individuals. These marketing and nurse coverage efforts have already enabled us to improve our Medicare rate by bringing in additional referrals of higher acuity patients.

Another strategic operating initiative was to implement Electronic Medical Records (“EMR”). We completed the implementation of Electronic Medical Records in all our nursing centers in December 2011.

As part of our strategic operating initiatives we have accelerated our program for improving our physical plants. Since 2005, we have been completing strategic renovations of certain facilities that improve quality of care and profitability. We plan to continue these nursing center renovation projects and accelerate this strategy using the knowledge obtained in the first few years of this program. Our strategic operating initiatives will also include pursuing and investigating opportunities to acquire, lease or develop new facilities, focusing primarily on opportunities within our existing areas of operation.

We are incurring expenses in connection with these initiatives, as described in “Results of Operations.” These investments in business initiatives have increased our operating expenses during 2012 and 2011 as well as the latter portion of 2010 and while we expect the increases to be on a lower scale, we expect to see additional costs over the next year. We have already experienced increased acuity and rate per day which continue to contribute to our increases in revenue. We expect to continue this trend in the future.

Basis of Financial Statements. Our patient revenues consist of the fees charged for the care of patients in the nursing centers we own and lease. Our operating expenses include the costs, other than lease, professional liability, depreciation and amortization expenses, incurred in the operation of the nursing centers we own and lease. Our general and administrative expenses consist of the costs of the corporate office and regional support functions. Our interest, depreciation and amortization expenses include all such expenses across the range of our operations.

Critical Accounting Policies and Judgments

A “critical accounting policy” is one which is both important to the understanding of our financial condition and results of operations and requires management’s most difficult, subjective or complex judgments often involving estimates of the effect of matters that are inherently uncertain. Actual results could differ from those estimates and cause our reported net income or loss to vary significantly from period to period. Our critical accounting policies are more fully described in our 2011 Annual Report on Form 10-K.

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Revenue Sources

We classify our revenues from patients and residents into four major categories: Medicaid, Medicare, managed care, and private pay and other. Medicaid revenues are composed of the traditional Medicaid program established to provide benefits to those in need of financial assistance in the securing of medical services. Medicare revenues include revenues received under both Part A and Part B of the Medicare program. Managed care revenues include payments for patients who are insured by a third-party entity, typically called a Health Maintenance Organization, often referred to as an HMO plan, or are Medicare beneficiaries who assign their Medicare benefits to a managed care replacement plan often referred to as Medicare replacement products. The private pay and other revenues are composed primarily of individuals or parties who directly pay for their services. Included in the private pay and other are patients who are hospice beneficiaries as well as the recipients of Veterans Administration benefits. Veterans Administration payments are made pursuant to renewable contracts negotiated with these payors.

The following table sets forth net patient and resident revenues related to our continuing operations by payor source for the periods presented (dollar amounts in thousands):

The following table sets forth average daily skilled nursing census by payor source for our continuing operations for the periods presented:

Consistent with the nursing home industry in general, changes in the mix of a center’s patient population among Medicaid, Medicare, managed care, and private pay and other can significantly affect the profitability of the center’s operations.

Health Care Industry

The health care industry is subject to numerous laws and regulations of federal, state and local governments. These laws and regulations include, but are not necessarily limited to, matters such as licensure, accreditation, government health care program participation requirements, reimbursement for patient services, quality of resident care and Medicare and Medicaid fraud and abuse. Over the last several years, government activity has increased with respect to investigations and allegations concerning possible violations by health care providers of fraud and abuse statutes and regulations as well as laws and regulations governing quality of care issues in the skilled nursing profession in general. Violations of these laws and regulations could result in exclusion from government health care programs together with the imposition of significant fines and penalties, as well as significant

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repayments for patient services previously billed. Compliance with such laws and regulations is subject to ongoing government review and interpretation, as well as regulatory actions in which government agencies seek to impose fines and penalties. The Company is involved in regulatory actions of this type from time to time.

In March 2010, significant legislation concerning health care and health insurance was passed, including the “Patient Protection and Affordable Care Act”, (“Patient Protection Act”) along with the “Health Care and Education Reconciliation Act of 2010” (“Reconciliation Act”) collectively defined as the “Legislation.” We expect this Legislation to impact our Company, our employees and our patients and residents in a variety of ways. Some aspects of these new laws are immediate while others will be phased in over the next ten years when all mandates become effective. This Legislation significantly changes the future responsibility of employers with respect to providing health care coverage to employees in the United States. Two of the main provisions of the Legislation become effective in 2014 whereby most individuals will be required to either have health insurance or pay a fine and employers with 50 or more employees will either have to provide minimum essential coverage or will be subject to additional taxes. We have not estimated the financial impact of the Legislation and the costs associated with complying with the increased levels of health insurance we will be required to provide our employees and their dependents in future years. We expect the Legislation will result in increased operating expenses.

We also expect for this Legislation to continue to impact our Medicaid and Medicare reimbursement as well, though the exact timing and level of that impact is currently unknown. We anticipate that many of the provisions of the Legislation may be subject to further clarification and modification through the rule making process. The Legislation expands the role of home based and community services, which may place downward pressure on our sustaining population of Medicaid residents.

Medicare and Medicaid Reimbursement

A significant portion of our revenues are derived from government-sponsored health insurance programs. Our nursing centers derive revenues under Medicaid, Medicare, managed care, private pay and other third party sources. We employ specialists in reimbursement at the corporate level and use third party services to monitor regulatory developments, to comply with reporting requirements and to ensure that proper payments are made to our operated nursing centers. It is generally recognized that all government-funded programs have been and will continue to be under cost containment pressures, but the extent to which these pressures will affect our future reimbursement is unknown.

Medicare

Effective October 1, 2011, Medicare rates were reduced by a nationwide average of 11.1%, the net effect of a reduction to restore overall payments to their intended levels on a prospective basis and the application of a 2.7% market basket increase and a negative 1.0% productivity adjustment required by the Patient Protection Act. The final CMS rule also adjusts the method by which group therapy is counted for reimbursement purposes and, for patients receiving therapy, changes the timing of reassessment for purposes of determining patient RUG categories. These October 2011 Medicare reimbursement changes decreased our Medicare revenue and our Medicare rate per patient day. The new regulations also resulted in an increase in costs to provide therapy services to our patients.

The Budget Control Act of 2011 (“BCA”), enacted on August 2, 2011, increased the United States debt ceiling and linked the debt ceiling increase to corresponding deficit reductions through 2021. The BCA also established a 12 member joint committee of Congress known as the Joint Select Committee on Deficit Reduction (“Super Committee”). The Super Committee’s objective was to create proposed legislation to reduce the United States federal budget deficit by $1.5 trillion for fiscal years 2012 through 2021. Part of the BCA required this legislation to be enacted by December 23, 2011 or approximately $1.2 trillion in domestic and defense spending reductions would automatically begin

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January 1, 2013, split between domestic and defense spending. As no legislation was passed that would achieve the targeted savings, payments to Medicare providers are potentially subject to these automatic spending reductions, limited to not more than a 2% reduction. At this time it is unclear how this automatic reduction may be applied to various Medicare healthcare programs. Reductions to Medicare reimbursement from the BCA could have a material adverse effect on our operating results and cash flows.

The Medicare Payment Advisory Commission (MedPAC) recently recommended that Congress provide no payment update in the coming fiscal year, beginning October 1, 2012, for skilled nursing center care. With an expected increase in the costs to care for our patients, a freeze in our Medicare rate will likely further negatively impact our operating results and cash flows.

Therapy Services . There are annual Medicare Part B reimbursement limits on therapy services that can be provided to an individual. The limits impose a $1,870 per patient annual ceiling on physical and speech therapy services, and a separate $1,870 per patient annual ceiling on occupational therapy services. CMS established an exception process to permit therapy services in certain situations and we provide services that are reimbursed under the exceptions process. The exceptions process has been extended several times, most recently by the Middle Class Tax Relief and Job Creation Act of 2012 which extended this exception process through December 31, 2012. It is unknown if any further extension of the therapy cap exceptions will be included in future legislation. If the exception process is discontinued, it is expected that the reimbursement limitations will reduce therapy revenues and negatively impact our operating results and cash flows.

On November 2, 2010, CMS released a final proposed rule as part of the Medicare Physician Fee Schedule (“MPFS”) that was effective January 1, 2011. The policy impacts the reimbursement we receive for Medicare Part B therapy services in our facilities. The policy provides that Medicare Part B pay the full rate for the therapy unit of service that has the highest Practice Expense (PE) component for each patient on each day they receive multiple therapy treatments. Reimbursement for the second and subsequent therapy units for each patient each day they receive multiple therapy treatments is reimbursed at a rate equal to 75% of the applicable PE component.

Medicare Part B therapy services in our centers are determined according to MPFS. Annually since 1997, the MPFS has been subject to a sustainable growth rate adjustment (“SGR”) intended to keep spending growth in line with allowable spending. Each year since the SGR was enacted, this adjustment produced a scheduled negative update to payment for physicians, therapists and other healthcare providers paid under the MPFS. Congress has stepped in with so-called “doc fix” legislation numerous times to stop payment cuts to physicians, most recently by the Middle Class Tax Relief and Job Creation Act of 2012, which stopped these payment cuts through December 31, 2012. Without the temporary fix we would have experienced an estimated 27% reduction in Medicare Part B payments. If the fix to payment cuts is discontinued, it is expected that we will see a reduction in therapy revenues that will negatively impact our operating results and cash flows.

The Middle Class Tax Relief and Job Creation Act of 2012 also resulted in a reduction of bad debt treated as an allowable cost. Medicare reimburses providers for beneficiaries’ unpaid coinsurance and deductible amounts after reasonable collection efforts at a rate between 70 and 100 percent of beneficiary bad debt. This provision reduces bad debt reimbursement for all providers to 65 percent.

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Medicaid

Several states in which we operate face budget shortfalls, which could result in reductions in Medicaid funding for nursing centers. The federal government made an effort to address the financial challenges state Medicaid programs are facing by increasing the amount of Medicaid funding available to states. Pressures on state budgets are expected to continue in the future and are expected to result in Medicaid rate reductions.

We receive the majority of our annual Medicaid rate increases during the third quarter of each year. The rate changes received in the third quarters of 2011 and 2010 were the primary contributor to our 4.6% increase in average rate per day for Medicaid patients in 2012 compared to 2011.

We are unable to predict what, if any, reform proposals or reimbursement limitations will be implemented in the future, or the effect such changes would have on our operations. For the three months ended March 31, 2012, we derived 33.1% and 50.4% of our total patient revenues related to continuing operations from the Medicare and Medicaid programs, respectively. Any health care reforms that significantly limit rates of reimbursement under these programs could, therefore, have a material adverse effect on our profitability.

We will attempt to increase revenues from non-governmental sources to the extent capital is available to do so. However, private payors, including managed care payors, are increasingly demanding that providers accept discounted fees or assume all or a portion of the financial risk for the delivery of health care services. Such measures may include capitated payments, which can result in significant losses to health care providers if patients require expensive treatment not adequately covered by the capitated rate.

Licensure and other Health Care Laws

All our nursing centers must be licensed by the state in which they are located in order to accept patients, regardless of payor source. In most states, nursing centers are subject to certificate of need laws, which require us to obtain government approval for the construction of new nursing centers or the addition of new licensed beds to existing centers. Our nursing centers must comply with detailed statutory and regulatory requirements on an ongoing basis in order to qualify for licensure, as well as for certification as a provider eligible to receive payments from the Medicare and Medicaid programs. Generally, the requirements for licensure and Medicare/Medicaid certification are similar and relate to quality and adequacy of personnel, quality of medical care, record keeping, dietary services, resident rights, and the physical condition of the center and the adequacy of the equipment used therein. Each center is subject to periodic inspections, known as “surveys” by health care regulators, to determine compliance with all applicable licensure and certification standards. Such requirements are both subjective and subject to change. If the survey concludes that there are deficiencies in compliance, the center is subject to various sanctions, including but not limited to monetary fines and penalties, suspension of new admissions, non-payment for new admissions and loss of licensure or certification. Generally, however, once a center receives written notice of any compliance deficiencies, it may submit a written plan of correction and is given a reasonable opportunity to correct the deficiencies. There can be no assurance that, in the future, we will be able to maintain such licenses and certifications for our facilities or that we will not be required to expend significant sums in order to comply with regulatory requirements. Recently, we have experienced an increase in the severity of survey citations and the size of monetary penalties, consistent with industry trends.

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We have employment agreements with certain members of management that provide for the payment to these members of amounts up to 2 times their annual salary in the event of a termination without cause, a constructive discharge (as defined), or upon a change of control of the Company (as defined). The maximum contingent liability under these agreements is approximately $1.0 million as of March 31, 2012. The terms of such agreements are from one to three years and automatically renew for one year if not terminated by us or the employee. In addition, upon the occurrence of any triggering event, those certain members of management may elect to require that we purchase equity awards granted to them for a purchase price equal to the difference in the fair market value of our common stock at the date of termination versus the stated equity award exercise price. Based on the closing price of our stock on March 31, 2012, there is no maximum contingent liability for the repurchase of the equity grants. No amounts have been accrued for these contingent liabilities.

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Three Months Ended March 31, 2012 Compared With Three Months Ended March 31, 2011

Patient Revenues

Patient revenues were $77.1 million in 2012 and 2011. Our newly opened West Virginia nursing center has received its license to operate, with its Medicare and Medicaid certification in process, and contributed $0.1 million in revenue during the first quarter of 2012 as its federal certification is in process.

The following table summarizes key revenue and census statistics for continuing operations for each period:

The average Medicaid rate per patient day for 2012 increased 4.6% compared to 2011, resulting in an increase in revenue of $1.7 million. This average rate per day for Medicaid patients is the result of rate increases in certain states and increasing patient acuity levels. The average Medicare rate per patient day for 2012 decreased 8.7% compared to 2011, resulting in a net decrease in revenue of $2.1 million. This decrease is primarily attributable to the October 1, 2011, CMS implemented Medicare rate decrease of 11.1% offset by investments we have made to improve our skilled care offerings.

Our total average daily census decreased by approximately 1.1% compared to 2011, resulting in a revenue decrease of approximately $0.6 million. We experienced an increase of $0.8 million in revenue delivery to our Medicare B patients in 2012 compared to 2011.

Operating expense

Operating expense increased to $61.5 million in 2012 from $60.9 million in 2011, an increase of $0.6 million, or 1.1%. Operating expense increased to 79.8% of revenue in 2012, compared to 78.9% of revenue in 2011.

The largest component of operating expenses is wages, which increased to $38.0 million in 2012 from $37.1 million in 2011, an increase of $0.9 million, or 2.4%. Merit and inflationary raises for personnel were approximately 4.0% for the first quarter. The extra day in February for leap year contributed $0.4 million of the wage increases.

Workers compensation insurance expense decreased approximately $0.3 million in 2012 compared to 2011. The decrease is the result of better claims experience in 2012 compared to 2011.

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Employee health insurance costs were approximately $0.4 million lower in 2012 compared to 2011. The Company is self-insured for the first $175,000 in claims per employee each year, and we experienced a lower level of claims costs during 2012. Employee health insurance costs can vary significantly from year to year, and we continually evaluate the provisions of these plans.

Our newly opened West Virginia nursing center contributed $0.4 million in additional costs.

Bad debt expense increased approximately $0.3 million in 2012 compared to 2011.

Lease expense

Lease expense increased to $5.8 million in 2012 from $5.7 million in 2011. The primary reason for the increase in lease expense was rent for lessor funded property renovations.

Professional liability

Professional liability expense was $2.3 million in 2012 compared to $1.7 million in 2011, an increase of $0.6 million. We were engaged in 39 professional liability lawsuits as of March 31, 2012, compared to 38 as of December 31, 2011. Our cash expenditures for professional liability costs of continuing operations were $1.4 million and $1.3 million for 2012 and 2011, respectively. Professional liability expense and cash expenditures fluctuate from year to year based respectively on the results of our third-party professional liability actuarial studies and on the costs incurred in defending and settling existing claims. See “Liquidity and Capital Resources” for further discussion of the accrual for professional liability.

General and administrative expense

General and administrative expenses were approximately $6.8 million in 2012 compared to $6.1 million in 2011, an increase of $0.7 million, or 12.7%. Wage costs increased by $0.4 million while costs of our strategic initiatives accounted for approximately $0.3 million, including consulting services, legal and acquisition related expenses. Performance-based incentive expense was $0.3 million lower in 2012. We also experienced an increase of approximately $0.7 million in severance costs. Our cost increases were offset by a decrease in implementation costs of Electronic Medical Records when compared to 2011.

Depreciation and amortization

Depreciation and amortization expense was approximately $1.8 million in 2012 and $1.6 million in 2011. The increase in 2012 is primarily due to depreciation and amortization expenses related to capital expenditures for additions to property and equipment, including equipment related to our EMR initiative.

Interest expense, net

Interest expense increased to $0.7 million in 2012 compared to $0.5 million in 2011. As discussed further in “Capital Resources” the increase in interest expense is partially due to the change in interest rates on our Mortgage Loan to a fixed rate of 7.07% from 4.01% and the additional $2.4 million in borrowings for capital improvements at our owned homes. The interest expense related to the new nursing center in West Virginia was responsible for $0.1 million in increased interest in 2012.

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Income (loss) from continuing operations before income taxes; income (loss) from continuing operations per common share

As a result of the above, continuing operations reported income (loss) before income taxes of $(1.9) million and $0.7 million in 2012 and 2011, respectively. The provision (benefit) for income taxes was $(0.7) million in 2012, an effective rate of 36.3% and $0.2 million in 2011, an effective rate of 35.8%. The basic and diluted income (loss) per common share from continuing operations were both $(0.24) in 2012 compared to $0.06 in 2011.

Liquidity and Capital Resources

Liquidity