Overview

This Management's Discussion and Analysis (MD&A) section is intended to help the reader understand ResCare's financial performance and condition. MD&A is provided as a supplement to, and should be read in conjunction with, our Consolidated Financial Statements and the accompanying notes. All references in this MD&A to "ResCare", "our company", "we", "us", or "our" mean Res-Care, Inc. and, unless the context otherwise requires, its consolidated subsidiaries. The individual sections of MD&A are:

† Our Business - a general description of our business and revenue sources.

† Application of Critical Accounting Policies- a discussion of accounting policies that require critical judgments and estimates.

† Results of Operations - an analysis of our consolidated results of operations for the periods presented including analysis of our operating segments.

† Financial Condition, Liquidity and Capital Resources - an analysis of cash flows, sources and uses of cash and financial position.

† Contractual Obligations and Commitments - a tabular presentation of our contractual obligations and commitments for future periods.

Our Business

We receive revenues primarily from the delivery of residential, training, educational and support services to various populations with special needs. As of December 31, 2008, we had three reportable operating segments: (i) Community Services, (ii) Job Corps Training Services and (iii) Employment Training Services. Management's discussion and analysis of each segment is included below. Further information regarding our segments is included in the Notes to Consolidated Financial Statements.

Revenues for our Community Services operations are derived primarily from state Medicaid programs, other government agencies, commercial insurance companies and from management contracts with private operators,

generally not-for-profit providers, who contract with state government agencies and are also reimbursed under the Medicaid program. Our services include social, functional and vocational skills training, supported employment and emotional and psychological counseling for individuals with intellectual or other disabilities. We also provide respite, therapeutic and other services to individuals with special needs and to older people in their homes. These services are provided on an as-needed basis or hourly basis through our periodic in-home services programs that are reimbursed on a unit-of-service basis. Reimbursement varies by state and service type, and may be based on a variety of methods including flat-rate, cost-based reimbursement, per person per diem, or unit-of-service basis. Generally, rates are adjusted annually based upon historical costs experienced by us and by other service providers, or economic conditions and their impact on state budgets. At facilities and programs where we are the provider of record, we are directly reimbursed under state Medicaid programs for services we provide and such revenues are affected by occupancy levels. At most facilities and programs that we operate pursuant to management contracts, the management fee is negotiated with the provider of record. Through ResCare HomeCare, we also provide in-home services to seniors on a private pay basis. We are concentrating growth efforts in the home care private pay business to further diversify our revenue streams.

We operate vocational training centers under the federal Job Corps program administered by the DOL through our Job Corps Training Services operations. Under Job Corps contracts, we are reimbursed for direct facility and program costs related to Job Corps center operations, allowable indirect costs for general and administrative costs, plus a predetermined management fee. The management fee takes the form of a fixed contractual amount plus a computed amount based on certain performance criteria. All of such amounts are reflected as revenue, and all such direct costs are reflected as facility and program costs. Final determination of amounts due under Job Corps contracts is subject to audit and review by the DOL, and renewals and extension of Job Corps contracts are based in part on performance reviews.

We operate job training and placement programs that assist disadvantaged job seekers in finding employment and improving their career prospects through our Employment Training Services operations. These programs are administered under contracts with local and state governments. We are typically reimbursed for direct facility and program costs related to the job training centers, allowable indirect costs plus a fee for profit. The fee can take the form of a fixed contractual amount (rate or price) or be computed based on certain performance criteria. The contracts are funded by federal agencies, including the DOL and DHHS.

Application of Critical Accounting Policies

Our discussion and analysis of the financial condition and results of operations are based upon our Consolidated Financial Statements, which have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts and related disclosures of commitments and contingencies. We rely on historical experience and on various other assumptions that we believe to be reasonable under the circumstances to make judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates.

We believe the following critical accounting policies involve the more significant judgments and estimates used in the preparation of our Consolidated Financial Statements. Management has discussed the development, selection, and application of our critical accounting policies with our Audit Committee.

Valuation of Accounts Receivable

Accounts receivable consist primarily of amounts due from Medicaid programs, other government agencies and commercial insurance companies. An estimated allowance for doubtful accounts receivable is recorded to the extent it is probable that a portion or all of a particular account will not be collected. In evaluating the collectibility of accounts receivable, we consider a number of factors, including historical loss rates, age of the accounts, changes in collection patterns, the status of ongoing disputes with third-party payors, general economic conditions and the status of state budgets. Complex rules and regulations regarding billing and timely filing requirements in various states are also a factor in our assessment of the collectibility of accounts receivable. Actual collections of accounts

receivable in subsequent periods may require changes in the estimated allowance for doubtful accounts. Changes in these estimates are charged or credited to the results of operations in the period of the change of estimate. There were no material changes in our method of providing for reserves for doubtful accounts during 2008.

Insurance Losses

We self-insure a substantial portion of our professional, general and automobile liability, workers' compensation and health benefit risks. These liabilities are necessarily based on estimates and, while we believe that the provision for loss is adequate, the ultimate liability may be more or less than the amounts recorded. Provisions for losses for workers' compensation risks are based upon actuarially determined estimates and include an amount determined from reported claims and an amount based on past experiences for losses incurred but not reported. Estimates of workers' compensation claims reserves have been discounted using a discount rate of approximately 4% at December 31, 2008 and 2007. The liabilities are reviewed quarterly and any adjustments are reflected in earnings in the period known. There were no material changes to our method of providing reserves for insurance risks during 2008.

Legal Contingencies

We are party to numerous claims and lawsuits with respect to various matters. The material legal proceedings in which ResCare is currently involved are described in Item 3 of this report and Note 14 to the Consolidated Financial Statements. We provide for costs related to contingencies when a loss is probable and the amount is reasonably determinable. We confer with outside counsel in estimating our potential liability for certain legal contingencies. While we believe our provision for legal contingencies is adequate, the outcome of legal proceedings is difficult to predict and we may settle legal claims or be subject to judgments for amounts that exceed our estimates. There were no material changes to our method of providing reserves for legal contingencies during 2008.

Valuation of Long-Lived Assets

We regularly review the carrying value of long-lived assets with respect to any events or circumstances that indicate a possible inability to recover their carrying amount. Indicators of impairment include, but are not limited to, loss of contracts, significant census declines, reductions in reimbursement levels and significant litigation. Our evaluation is based on cash flow, profitability and projections that incorporate current or projected operating results, as well as significant events or changes in the reimbursement and regulatory environment. If circumstances suggest the recorded amounts cannot be recovered, the carrying values of such assets are reduced to fair value based upon various techniques to estimate fair value. During 2006, we recorded asset impairment charges totaling $1.0 million in connection with our withdrawal from the District of Columbia (District) and the State of New Mexico. These changes, which were primarily related to the write down of leasehold improvements, furniture and equipment, are reported as part of Discontinued Operations. We recorded an impairment loss of $0.3 million in the fourth quarter of 2008 related to a building operated under our Community Services segment. No asset valuation losses were recorded in 2007.

Goodwill

With respect to businesses we have acquired, we evaluate the costs of purchased businesses in excess of net assets acquired (goodwill) for impairment at least annually as of year end, unless significant changes in circumstances indicate a potential impairment may have occurred sooner. We are required to test goodwill on a reporting unit basis. We use a fair value approach to test goodwill for impairment and recognize an impairment charge for the amount, if any, by which the carrying amount of goodwill exceeds its implied fair value. Fair values are established using a weighted average of comparative market multiples in the current market conditions and discounted cash flows.

Discounted cash flow computations depend on a number of factors including estimates of future market growth and trends, forecasted revenue and costs, expected periods the assets will be utilized, appropriate discount rates and other variables. We base our fair value estimates on assumptions we believe to be reasonable, but which are unpredictable and inherently uncertain. Actual future results may differ from those estimates. In addition, we make certain judgments about the selection of comparable companies market multiplies in valuing our reporting units, as well as certain assumptions to allocate shared assets and liabilities to calculate values for each of reporting units.

No impairment loss was recognized as a result of the impairment tests in 2008 or 2006; however, a $0.3 million impairment loss was recorded in March 2007 related to the Schools component of our All Other reporting segment.

Revenue Recognition

Overview: We recognize revenues as they are realizable and earned in accordance with SEC Staff Accounting Bulletin No. 104, Revenue Recognition in Financial Statements(SAB 104). SAB 104 requires that revenue can only be recognized when persuasive evidence of an arrangement exists, services have been rendered, the price is fixed or determinable and collectibility is reasonably assured.

Community Services. Revenues are derived primarily from state Medicaid programs, other government agencies, commercial insurance companies and from management contracts with private operators, generally not-for-profit providers, who contract with state agencies and are also reimbursed under the Medicaid programs. Revenues are recorded at rates established at or before the time services are rendered. Revenue is recognized in the period services are rendered. Depending upon the state's reimbursement policies and practices, management contract fees are computed on the basis of a fixed fee per individual, which may include some form of incentive payment, a percentage of operating expenses (cost-plus contracts), a percentage of revenue or an overall fixed fee paid regardless of occupancy.

Job Corps Training Services.Revenues include amounts reimbursable under cost reimbursement contracts with the DOL for operating Job Corps centers for education and training programs. Depending upon the state's reimbursement policies and practices, management contract fees are computed on the basis of a fixed fee per individual, which may include some form of incentive payment, a percentage of operating expenses (cost-plus contracts), a percentage of revenue or an overall fixed fee paid regardless of occupancy. Revenue is recognized in the period services are rendered. The contracts provide reimbursement for direct facility and program costs related to operations, allowable indirect costs for general and administrative costs, plus a predetermined management fee, normally a combination of fixed and performance-based. Final determination of amounts due under the contracts is subject to audit and review by the applicable government agencies. Revenue is recognized in the period associated costs are incurred and services are rendered.

Employment Training Services. Revenues are derived primarily through contracts with local and state governments funded by federal agencies. Revenue is generated from contracts which contain various pricing arrangements, including:
(1) cost reimbursable, (2) performance-based, (3) hybrid and (4) fixed price.

With cost reimbursable contracts, revenue is recognized for the direct costs associated with functions that are specific to the contract, plus an indirect cost percentage that is applied to the direct costs, plus a profit. Revenue is recognized in the period the associated costs are incurred and services are rendered.

Under a performance-based contract, revenue is generally recognized as earned based upon the attainment of a unit performance measure times the fixed unit price for that specific performance measure. Typically, there are many different performance measures that are stipulated in the contract that must be tracked to support the billing and revenue recognition. Revenue may be recognized prior to achieving a benchmark as long as reliable measurements of progress-to-date activity can be obtained, indicating that it is probable that the benchmark will be achieved. This requires judgment in determining what is considered to be a reliable measurement.

Revenues for hybrid contracts are generally recognized based on the specific contract language. The most common type of hybrid contract is "cost-plus," which provide for the reimbursement of direct and indirect costs with profit tied to meeting certain performance measures. Revenues for cost-plus contracts are generally recognized in the period the associated costs are incurred with an estimate made for the performance-based portion, as long as reliable measurements of progress-to-date activity can be obtained, indicating that it is probable that the benchmark will be achieved. This requires judgment in determining what is considered to be a reliable measurement.

Revenues for fixed price contracts are generally recognized in the period services are rendered. Certain of our long-term fixed price contracts may contain performance-based measures that can increase or decrease our revenue. Revenue is deferred in cases where the fixed price is not determinable as a result of these provisions.

Laws and regulations governing the government programs and contracts are complex and subject to interpretation. As a result, there is at least a reasonable possibility that recorded estimates could change by a material amount in the near term. For each operating segment, expenses are subject to examination by agencies administering the contracts and services. We believe that adequate provisions have been made for potential adjustments arising from such examinations. There were no material changes in the application of our revenue recognition policies during 2008.

Results of Operations

                                        Year Ended December 31
                                  2008           2007           2006
                                        (Dollars in thousands)

Revenues:
Community Services (1)         $ 1,109,275    $ 1,052,409    $   915,878
Job Corps Training Services        163,944        163,904        160,184
Employment Training Services       222,394        197,588        205,502
Other                               47,970         19,397         20,554
Consolidated                   $ 1,543,583    $ 1,433,298    $ 1,302,118
Operating Income:
Community Services (1)(2)      $    99,633    $   111,350    $   104,676
Job Corps Training Services         11,782         11,588         11,177
Employment Training Services        22,692         17,093         14,293
Other                                1,903          1,446          1,055
Total Operating Expenses (3)       (59,190 )      (54,313 )      (47,506 )
Consolidated                   $    76,820    $    87,164    $    83,695

Operating Margin:
Community Services (1)(2)              9.0 %         10.6 %         11.4 %
Job Corps Training Services            7.2 %          7.1 %          7.0 %
Employment Training Services          10.2 %          8.7 %          7.0 %
Other                                  4.0 %          7.5 %          5.1 %
Total Operating Expenses (3)          (3.8 %)        (3.8 %)        (3.6 %)
Consolidated                           5.0 %          6.1 %          6.4 %

Consolidated

Consolidated revenues increased $110.3 million in 2008, compared to 2007, for an increase of 7.7%. Consolidated revenues increased $131.2 million, or 10.1% in 2007 from 2006. Revenues are more fully described in the segment discussions below.

Consolidated operating income decreased 11.9% in 2008 from 2007. Operating margin decreased from 6.1% in 2007 to 5.0% in 2008. The reductions in operating income and margin were primarily related to the $20.3 million legal charge recorded in 2008 to resolve four legal matters in the Community Services segment. The 2007 consolidated operating income increased $3.5 million, or 4.1%, primarily due to acquisitions in the Community Services segment. Operating margin decreased from 6.4% in 2006 to 6.1% in 2007 primarily due to higher share-based compensation. Operating income is discussed further in the segment sections which follow.

As a percentage of total revenues, total operating expenses were 3.8% in 2008, 3.8% in 2007 and 3.6% in 2006. The 2008 and 2007 percentages were slightly higher due primarily to increases in depreciation expense.

Net interest expense increased $0.6 million in 2008, compared to 2007, due primarily to higher average debt balances. The 2007 net interest expense was $0.2 million higher than 2006.

Our effective income tax rates were 36.1%, 35.6% and 35.8% in 2008, 2007 and 2006, respectively. The 2008 effective tax rate benefited from increases in job credits, offset by an increase in valuation allowances associated with foreign operations. The 2007 effective tax rate is lower than 2006 due primarily to the impact of reversing a valuation allowance related to net operating losses due to certain tax law changes in Texas.

Community Services

Community Services revenues increased 5.4% in 2008 over 2007 due primarily to acquisition growth. In 2008, our Community Services segment acquired 13 operations with annual revenues of $56 million. Operating margin decreased from 10.6% in 2007 to 9.0% in 2008 due primarily to the $20.3 million legal charge for the resolution of four legal matters.

Revenues increased 14.9% in 2007 over 2006 due primarily to acquisitions and growth in periodic in-home services. In 2007, this segment acquired 10 operations with annual revenues of $93 million. Operating margins decreased from 11.4% in 2006 to 10.6% in 2007 as a result of higher share-based compensation (0.2%) and insurance related costs (0.3%), as well as lower overall margins associated with our 2007 Kelly Home Care Services acquisition (0.3%) and pharmacy business (0.1%).

Job Corps Training Services

Job Corps Training Services revenues remained consistent between 2008 and 2007, and increased 2.3% in 2007 over 2006. The 2007 increase was primarily due to contractual increases. Operating margins were 7.2%, 7.1% and 7.0% for 2008, 2007 and 2006, respectively. In January 2009, we were informed that the contract to operate the Pittsburgh Job Corps center had been awarded to another operator through the re-bidding process. Annual revenues for this contract were approximately $17 million. An appeal with the DOL was denied. We are in the process of determining whether to file an additional appeal with the General Accounting Office. Our contract currently expires on April 30, 2009.

Employment Training Services

Employment Training Services revenue increased $24.8 million in 2008 compared to 2007, due primarily to the ramping up of the Arizona and Indiana contracts and new contracts in Texas, Arkansas and South Carolina, which were partially offset by lost contracts in Florida due to certain Workforce Investment Boards taking services in-house. Operating margin improved from 8.7% in 2007 to 10.2% in 2008 due primarily to a 1% increase in margin due to improvement in performance in the New York City Back to Work contract and a 0.5% increase in margin for incentives received in the Calworks programs.

Employment Training Services revenue decreased $7.9 million in 2007 compared to 2006, due primarily to contract non-renewals and concessions in modifications to existing contracts in 2006. In particular, two significant contracts were not renewed when their terms ended shortly after they were acquired in January 2006. Operating margin

improved from 7.0% in 2006 to 8.7% in 2007 due to achieving certain performance incentives, the loss of a very low margin contract, stricter monitoring of expenses, and slightly lower share-based compensation costs.

Other

A portion of our business is dedicated to operating charter schools and international job training and placement agencies. Revenues increased $28.6 million or 147.3% from 2007 to 2008 due primarily to acquisition growth in the schools and international business. Operating margins decreased from 7.5% in 2007 to 4.0% in 2008 due primarily to integration costs associated with the international acquisitions. Revenues decreased $1.2 million from 2006 to 2007 primarily due to a lost school contract in Florida. Operating margins improved from 5.1% in 2006 to 7.5% in 2007 due to higher 2006 costs related to international job training contracts.

Discontinued Operations

Net loss from discontinued operations was $0.3 million for 2008 and 2007 and $5.3 million in 2006. Included in net loss from discontinued operations in 2006 is a pre-tax charge of $3.9 million for impaired assets and abandoned leased facilities and a pretax operational loss of $4.3 million, offset by a tax benefit of $2.9 million. The discontinued operations relate to the Community Services segment's exit from the District of Columbia and the state of New Mexico, which were effective on March 31, 2006 and October 31, 2006, respectively.

Financial Condition, Liquidity and Capital Resources

Total assets increased $79.6 million, or 9.5%, in 2008 over 2007. This increase was due primarily as a result of the acquisitions, which caused goodwill and other intangibles to increase $46.1 million from December 31, 2007.

Cash and cash equivalents were $13.6 million at December 31, 2008, compared to $10.8 million at December 31, 2007. Cash provided by operating activities for 2008 was $46.6 million compared to $85.8 million for 2007 and $36.2 million for 2006. The increase from 2006 to 2007 was primarily due to improved collection efforts in accounts receivable, as well as an increase in net income. The decrease from 2007 to 2008 was primarily related to lower net income due principally to the $20.3 million legal charge and the result of funding working capital requirements for the acquired operations.

Days revenue in net accounts receivable were 51 days at December 31, 2008 compared with 49 days at December 31, 2007 and 52 days at December 31, 2006. The increase in the number of days is due primarily to one state adopting a new voucher system and payment delays by certain insurance payors. Net accounts receivable at December 31, 2008 increased to $231.0 million, compared to $206.5 million at December 31, 2007 and $197.7 million at December 31, 2006. The increase in net accounts receivable from 2006 to 2008 is primarily due to revenue growth associated with acquisitions. Approximately 4.8%, 4.5% and 3.5% of the total net accounts receivable balance was greater than 540 days at December 31, 2008, December 31, 2007 and December 31, 2006, respectively.

Our capital requirements relate primarily to our plans to expand through selective acquisitions and the development of new facilities and programs, and our need for sufficient working capital for general corporate purposes. Since most of our facilities and programs are operating at or near capacity, and budgetary pressures and other forces are expected to limit increases in reimbursement rates we receive, our ability to continue to grow at the current rate depends directly on our acquisition and development activity. We have historically satisfied our working capital requirements, capital expenditures and scheduled debt payments from our operating cash flow and borrowing under our revolving credit facility.

The capital markets remain under duress due to the ongoing financial crisis which may impede our ability to expand and grow our business if credit conditions remain tight or our access to these markets becomes limited. State budgetary pressures from the financial crisis may put further pressure on reimbursement rates and limit our ability to receive rate increases. We expect . . .