1
                   U. S. SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549

                                 FORM 10-KSB

       Annual report pursuant to Section 13 or 15(d) of the Securities
                             Exchange Act of 1934

                 For the fiscal year ended December 31, 1995

                       Commission file number: 1-13738

                           PSYCHEMEDICS CORPORATION
            (exact name of registrant as specified in its charter)

             Delaware                                      58-1701987
- ---------------------------------------------   -------------------------------
(State or other jurisdiction of incorporation   (I.R.S. Employer Identification
          or organization)                                     No.)

1280 Massachusetts Ave., Cambridge, MA                  02138
- -----------------------------------------             ---------     
(Address of principal executive offices)              (Zip Code)

       Registrant's telephone number, including area code: 617-868-7455

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

                        Common Stock, $.005 Par Value
                         -----------------------------
                               (Title of class)

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

   Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.

                                YES (X) NO ( )

   Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-B 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-KSB or any amendment to
this Form 10-KSB ( )

        The registrant's revenue for the year ended December 31, 1995 was
$10,110,934.

   On March 22, 1996 the aggregate market value of the voting stock held by
non-affiliates of the registrant was $71,292,876 and 19,752,868 shares of Common
Stock, $.005 par value, were outstanding at such date.

                     DOCUMENTS INCORPORATED BY REFERENCE
                     -----------------------------------

Part III - Portions of the Registrant's Proxy Statement relative to the 1996
Annual Meeting of Stockholders to be held on May 7, 1996.
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                                     PART I

Item 1.   Business
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GENERAL

Psychemedics Corporation ("the Company") is a Delaware corporation organized on
September 24, 1986 to provide testing services for the detection of abused
substances through the analysis of hair samples. The Company's testing methods
utilize a patented technology for performing immunoassays on enzymatically
dissolved hair samples with confirmation testing by gas chromatography/mass
spectrometry ("GC/MS").

The Company's first application of its patented technology is a testing service
which screens for the presence of certain drugs of abuse in hair. The
application of radioimmunoassay procedures using hair differs from the more
widely used application of radioimmunoassay procedures using urine samples. The
Company's tests provide quantitative information which indicates the approximate
amount of drug ingested as well as historical data which can show a pattern of
individual drug use over a period of time. This information is useful to
employers in both applicant and employee testing, to physicians, treatment
professionals, law enforcement agencies, to the insurance industry and to other
individuals and entities engaged in any business where drug use is an issue. The
Company provides commercial testing and confirmation by GC/MS using industry
accepted practices for cocaine, marijuana, PCP, methamphetamine, and opiates. In
addition, the Company has developed a test for methadone for use in the
treatment industry.

Testing services are currently performed at the Company's laboratory at 5832
Uplander Way, Culver City, California. The Company's services are marketed under
the name RIAH[Registered Trademark] (Radioimmunoassay of Hair), a registered 
service mark.

DEVELOPMENT OF RADIOIMMUNOASSAY OF HAIR

The application of special radioimmunoassay procedures to the analysis of hair
was initially developed in 1978 by the founders of the Company, Annette
Baumgartner and Werner A. Baumgartner, Ph.D. The Baumgartners demonstrated that
when certain chemical substances enter the bloodstream, the blood carries them
to the hair where they become "entrapped" in the protein matrix in amounts
roughly proportional to the amount ingested. The Company's drugs of abuse
testing procedure involves washing the hair sample to clean it of surface
contaminants and then subjecting the cleaned hair sample to the Company's unique
proprietary process which involves the direct analysis of liquefied hair samples
by radioimmunoassay procedures utilizing special reagents and antibodies. The
antibodies detect the presence of a specific drug or metabolite in the liquefied
hair sample by reacting with the drug present in the sample solution and an
added radioactive analog of the drug. The resulting antibody-drug complex is
precipitated and analyzed. The amount of drug present in the sample is inversely
proportional to the amount of radioactive analog in the precipitate. Depending
upon both the length of hair and the hair growth rate (hair grows approximately
1.3 centimeters per month), the Company is able to provide historical
information on drug use by the person from whom the sample was obtained. Another
testing option involves sectional analysis of the hair sample. In this
procedure, the hair is sectioned lengthwise to approximately correspond to
certain time periods. The sections are

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then labeled by time period, which allows the Company to provide trend
information on drug use. When quantitative results of this test are reported and
compared to dose correlation graphs, information is provided about the
individual's approximate drug usage during the period being tested.

VALIDATION OF THE COMPANY'S PROPRIETARY TESTING METHOD

The process of analyzing human hair for the presence of drugs using the
Company's patented method has been the subject of over fifty scientific field
studies since 1990. Results from the studies that have been published or
accepted for publication in scientific journals are generally favorable to the
Company's technology. These studies were performed with the following
organizations: Citizens for a Better Community Court, Columbia University, Koba
Associates-DC Initiative, Harvard Cocaine Recovery Project, Hutzel Hospital, ISA
Associates (Interscience America)-NIDA Workplace Study, University of
California-Sleep State Organization, Maternal/Child Substance Abuse Project,
Matrix Center, National Public Services Research Institute, Narcotic and Drug
Research Institute, San Diego State University-Chemical Dependency Center,
Spectrum Inc., Stapleford Centre (London), Task Force on Violent Crime
(Cleveland, Ohio); University of Miami-Department of Psychiatry, University of
Miami-Division of Neonatology, University of South Florida-Operation Par Inc.,
University of Washington, VA Medical Center-Georgia, U.S. Probation Parole-Santa
Ana. The above studies include research in the following areas: prenatal,
treatment evaluation, workplace drug use, and the criminal justice system. Many
of the studies have been funded by the National Institute of Justice or the
National Institute on Drug Abuse ("NIDA").

An additional independent evaluation of the technology, favorable to the
Company's services, has been performed by submission of blind samples by Dr.
Robert DuPont, President of the Institute of Behavior and Health, Inc., the
first Director of the National Institute on Drug Abuse and presently Chairman of
the Company's Scientific Advisory Board. Some of the Company's customers have
also completed their own testing to validate the Company's proprietary hair
testing method as a prelude to utilizing the Company's services. These studies
have consistently confirmed the Company's superior detection rate. When the
results from utilizing the Company's patented hair testing method were compared
to urine results in side-by-side evaluations, 5 to 10 times as many drug abusers
were accurately identified with the Company's proprietary method. In addition to
these studies, the Company is now performing testing for over 600 clients.

During 1995, the Company's patented method was applied as a research tool in
several new investigative areas, including: a study on the effects of cocaine
use during pregnancy by the National Institute of Drug Abuse; a collaborative
research study on drug abuse by juvenile arrestees and homeless populations by
Cleveland State University and the University of South Florida; a study of brain
function in cocaine-exposed infants by the Neurological Institute at Columbia
University; and further research on drug abuse and treatment in criminal justice
populations in Texas, Louisiana, California, Oregon and Massachusetts.

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ADVANTAGES OF USING THE COMPANY'S PATENTED METHOD

The Company asserts that hair testing using its patented method confers
substantive advantages relative to existing means of drug detection through
urinalysis. Although urinalysis testing can provide accurate drug use
information, the scope of the information is short-term and is generally limited
to the type of drug ingested within a few days of the test. Studies published in
many scientific publications including NIDA RESEARCH MONOGRAPH and the JOURNAL
OF FORENSIC SCIENCES have indicated that cocaine, PCP, opiates, and
methamphetamine disappear from urine within 72 to 96 hours of use, and that
marijuana typically takes a week or more.

In contrast to urinalysis testing, hair testing using the Company's patented
method provides long-term historical drug use information resulting in a
significantly wider "window of detection." This "window" may be three months or
longer depending on the length of the hair sample. The Company's standard test
offering, however, uses a 3.9 centimeter length; therefore, it measures use for
approximately the previous 90 days.

This wider window of detection enhances the detection efficiency of hair
analysis, particularly in pre-employment testing. Hair testing not only
identifies more drug users, but also uncovers patterns and severity of drug use,
information most helpful in determining the scope of an individual's involvement
with drugs and serves as a deterrent against the use of drugs. Hair testing
using the Company's patented method greatly reduces the incidence of "false
negatives" associated with evasive measures typically encountered with
urinalysis testing. Urinalysis test results are impacted adversely by excessive
fluid intake prior to testing as well as adulteration of the sample. Moreover, a
drug user who abstains from use for a few days prior to urinalysis testing can
usually escape detection. Hair testing is effectively free of these problems as
it cannot be thwarted by evasive measures typically encountered with urinalysis
testing. It is also attractive to customers since sample collection is typically
performed under close supervision yet is less intrusive and embarrassing for
test subjects.

Hair testing using the Company's patented method (with GC/MS confirmation)
further reduces the prospects of error in conducting drug detection tests.
Urinalysis testing is more susceptible to problems such as "evidentiary false
positives" resulting from passive drug exposure (e.g. poppy seeds.) In the event
a positive urinalysis test result is challenged based on passive exposure, the
only remedy is a newly collected sample. Depending on the drug usage of the
forewarned individual prior to the date of the newly collected sample, a re-test
may yield a negative result when using urinalysis testing because of temporary
abstention. In contrast, when the Company's hair testing method is offered on a
repeat hair sample the individual suspected of drug use cannot as easily affect
the results because historical drug use data remain locked in the hair fiber.

DISADVANTAGES OF HAIR TESTING

There are some disadvantages of hair testing as compared to drug detection
through urinalysis. Because hair starts growing below the skin surface, drug
ingestion evidence does not appear in hair above the scalp until five to seven
days after use.

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Thus, hair testing is not suitable for use in "for cause" testing such as is
done in connection with an accident investigation. It does, however, provide a
drug history which can complement urinalysis information in "for cause" testing.

Currently, radioimmunoassay testing using hair samples under the Company's
patented method is only practiced by Psychemedics Corporation. The absence of
widespread familiarity and use of hair testing may adversely impact the
Company's revenue growth.

The Company's prices for its tests are generally somewhat higher than prices for
comparable tests using urinalysis, but the Company believes that its superior
detection rates provide more value to the customer. This pricing policy could,
however, adversely impact the growth of the Company's sales volume.

PATENTS

In December 1987, Dr. Werner A. Baumgartner, the Company's founder and Director
of Research and Development, with the assistance of the Company's patent
counsel, filed the first in a series of patent applications in the U.S. Patent
and Trademark Office on his inventions relating to radioimmunoassay using hair.
In 1994, U.S. Patent No. 5,324,642 (the "642 Patent") was issued to the Company.
This is a broad patent for the universal drug extraction procedure and
immunoassay technology for the detection of drugs in hair specimens. In 1995,
the Company was granted an additional patent covering Dr. Baumgartner's
inventions pertaining to the immuno chemical screening assay for marijuana,
which is the most difficult drug to detect. Dr. Baumgartner has continued his
research, and the Company has pending two additional patent applications in the
U.S. Patent and Trademark Office with respect to his inventions relating to
procedures using hair. The Company believes that additional patents will be
granted as a result of Dr. Baumgartner's pending patent applications although
there can be no assurance that any such additional patents will be granted.

Pursuant to an agreement dated January 1987, Werner A. Baumgartner and Annette
Baumgartner granted to the Company an exclusive royalty-free worldwide license
of all of their rights in and to their inventions relating to radioimmunoassay
using hair.

Most of Dr. Baumgartner's research on the inventions covered by the 642 patent
was conducted while he was employed by the Veteran's Administration Hospital
("VA"). Dr. Baumgartner has, therefore, also granted to the U.S. government, for
all Governmental purposes, a nonexclusive, irrevocable, royalty-free license to
use the basic invention during the term of the patent with respect to such
invention.

Certain aspects of the Company's hair analysis method are based on trade secrets
owned by the Company. The Company's ability to protect the confidentiality of
these trade secrets is dependent upon the Company's internal safeguards and upon
the laws protecting trade secrets and unfair competition. In the event that
patent protection or protection under the laws of trade secrets were not
sufficient and the Company's competitors succeeded in duplicating the Company's
products, the Company's business could be materially adversely affected.

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TARGET MARKETS

1.  Industry

The Company has focused its primary marketing efforts on the private sector. The
Company believes that the market for job applicant and employee testing will
yield the most immediate beneficial impact to the business of the Company and
assist in establishing a regular client base.

The number of businesses using drug testing to screen job applicants and
employees has increased significantly in the last eight years. The 1995 American
Management Association (AMA) survey indicated that 78% of surveyed firms were
engaged in some form of drug testing, a 261% increase since the initial AMA
survey in 1987. The prevalence of drug screening programs reflects a growing
concern that drug use contributes to employee health problems and costs
(increased absenteeism, reduced productivity, etc.) and in certain industries,
safety hazards. It has been estimated that the cost to industry in terms of
health care costs and lost productivity is at least $60 billion annually.

The principal criticism of employee drug screening programs centers on the
effectiveness of the testing program. Most private sector screening programs use
urinalysis. Such programs are susceptible to evasive maneuvers and the inability
to obtain identical repeat samples in the event of a challenged result.

Moreover, many employers, to accommodate concerns of their employees and to
avoid infringement of employee privacy rights, conduct their programs on a
pre-announced schedule, thereby providing an opportunity for many drug users to
abstain in order to escape detection.

The Company presents its patented hair analysis method to potential clients as a
better technology well suited to employer needs. Field studies and actual client
results support the accuracy and effectiveness of the Company's patented
technology and its ability to detect even casual drug use. The historical aspect
of the Company's patented method as well as the Company's ability to provide
correlation of the measured drug with approximate amount of ingestion, furnish
an employer with greater flexibility in assessing the scope of an applicant's or
an employee's drug problem.

The Company provides clients confirmation of positive results through GC/MS. The
use of GC/MS is an industry accepted practice used to confirm positive drug test
results of an initial screen. In an employment setting, GC/MS confirmation is
typically used prior to the taking of any disciplinary action against an
employee. The Company offers its clients a five-drug screen with GC/MS
confirmation of cocaine, PCP, marijuana, methamphetamine, and opiates.

2. Home Use

In 1995, the Company began marketing "PDT-90", its hair testing service to
parents concerned about drug use by their children. It allows parents to collect
a small sample from their child in the privacy of the home and have it tested
for drugs of abuse by the Company. The PDT-90 testing service uses the same
patented method that is used with the Company's workplace testing service. The
Company commenced a marketing campaign in the third quarter of 1995 for the new
service.

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3.  Medical

The Company has developed a medical market for its proprietary hair testing
method consisting mostly of testing services for use by treatment professionals
for drug recovery programs and prenatal care.

In the drug treatment area, the Company's patented method can be used by
treatment professionals to obtain reliable background information on drug use,
information most critical in structuring an individual's recovery program. With
present drug detection tests, this information is obtained from self-reporting,
an approach generally deemed unreliable for various reasons, including
reluctance to discuss the nature of one's drug habit, memory failure, and
unknown substance purity. As a follow-up to a rehabilitation process, the
Company's patented method can provide additional support by generating feedback
to individual physicians, psychiatrists and therapists on the success of their
methods. The utility of the Company's technology in monitoring recovery after
discharge from employee assistance programs has been demonstrated by the
Company's customers. The Company's recently developed methadone test can also
assist treatment professionals in their treatment efforts.

The Company has engaged in, and continues to engage in, studies supporting the
utility of its patented hair analysis method in the evaluation of drug use
during pregnancy and the corresponding treatment of newborns. Studies are under
way at Hutzel Hospital, University of Washington, Columbia University,
University of Miami, National Public Services Research Institute, University of
California-Sleep State Organization and Maternal/Child Substance Abuse Project.
The Company expects that these cost-benefit and application studies will
demonstrate the utility of its proprietary screen in the prenatal market.

SALES AND MARKETING

The Company markets its drug testing services primarily through its own direct
sales force. The Company's in-house efforts are supplemented by a limited
network of independent sales representatives who are thoroughly trained by the
Company. For both its business-to-business and consumer direct services, the
Company has undertaken an integrated marketing campaign to enhance the market
presence within each respective segment.

COMPETITION

The Company competes directly with numerous commercial laboratories which test
for drugs through urinalysis testing. Most of these laboratories, such as
Laboratory Corporation of America, SmithKline Beecham Clinical Laboratories and
MetPath, Inc. have substantially greater financial resources, market identity,
marketing organizations, facilities, and numbers of personnel than the Company.
The Company has been steadily increasing its base of corporate customers and
believes that future success with new customers is dependent on the Company's
ability to communicate the advantages of implementing a drug program utilizing
the Company's patented hair analysis method.

The Company's ability to compete is also a function of pricing. The Company's
prices for its tests are generally somewhat higher than prices for comparable
tests using urinalysis. However, the Company believes that its superior
detection rates,

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coupled with the customer's ability to test less frequently due to hair
testings' wider window of detection (approximately 90 days verses approximately
three days with urinalysis) provide more value to the customer. This pricing
policy could, however, lead to slower sales growth for the Company.

The Company is not aware of any other laboratories with a hair analysis
technology that is comparable in effectiveness to the Company's proprietary
procedures. The Company is aware of two laboratories which operate in certain
limited employment testing markets and which purport to test hair samples using
a method, which the Company presumes, includes the use of a form of immunoassay
procedures. The Company, however, does not believe that effective immunoassay
testing of hair samples is currently feasible on a commercial basis without
using the Company's unique patented method.

GOVERNMENT REGULATION

The Company is licensed as a Clinical Laboratory by the State of California as
well as certain other states. All tests are performed according to the standards
established by the Clinical Laboratories Improvement Act and the College of
American Pathologists. Presently there are no other regulations required for the
operation of a clinical laboratory in the State of California.

A substantial number of states regulate drug testing. The scope and nature of
such regulation varies greatly from state to state. In some states, a clinical
laboratory such as the Company is required to satisfy certain requirements as a
precondition to the laboratory's certification or right to perform drug testing
services with respect to specimens taken in such state. The legislation or
regulations in other states will, in some instances, limit testing to certain
matrixes ("matrix" refers to the substance, blood, urine, hair, etc., which is
tested for the presence of drugs). The Company seeks, through participation in
the legislative and regulatory process, to influence the legislative and
regulatory agencies of those few states whose statutes have been interpreted to
not include the testing of hair.

In August 1995, the United States Food and Drug Administration ("FDA") issued a
Warning Letter to the Company pertaining to PDT-90, the drug testing service
which the Company introduced in July 1995 as a testing service for parents
concerned about drug use by their children. The FDA claimed that the collection
envelope the Company distributed as part of the PDT-90 testing service
constituted a "medical device" under the Federal Food Drug and Cosmetic Act, as
amended (the "FDC Act"), and that, because the Company did not seek the approval
or permission of the FDA to market the envelope, it was therefore adulterated
and misbranded under the FDC Act.

In its response, the Company stated its position that the collection envelope is
not a medical device under the FDC Act. However, in order to expeditiously
resolve the matter with the FDA, the Company submitted a 510(k) premarket
notification to the FDA on September 27, 1995 seeking a determination from the
FDA that the collection envelope is substantially equivalent to collection
envelopes which previously received 510(k) premarket clearance and were
currently being commercially marketed. In November 1995, the FDA issued a "Not
Substantially Equivalent" ("NSE") determination in response to the Company's
510(k) submission and classified PDT-90 as a Class III device under the FDC Act.

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In December 1995, the Company filed suit against the FDA in the United States
Court of Appeals for the First Circuit seeking to overturn the FDA's NSE
determination. In March 1996, the FDA agreed to withdraw the Warning Letter and
the NSE determination in exchange for the Company's dismissal of its suit
against the FDA. The FDA also confirmed its decision not to actively regulate
PDT-90 and not to pursue enforcement action on any of the grounds contemplated
in the Warning Letter.

SCIENTIFIC ADVISORY BOARD

The Company has established a Scientific Advisory Board which consults with
management of the Company to examine and evaluate the progress of the Company's
research and development activities, to promote independent validation studies
of the Company's patented hair analysis method technology, and to assist in
accelerating acceptance of the technology in both the public and private
sectors. Members of the Scientific Advisory Board are compensated at the rate of
$1,000 per day for each meeting attended plus reimbursement for out-of-pocket
expenses. The Chairman of the Scientific Advisory Board is Dr. Robert DuPont.
Dr. DuPont's career has included numerous positions in the psychiatric and
substance abuse field, including Director, Special Action Office for Drug Abuse
Prevention - The White House; the first Director, National Institute on Drug
Abuse; President, American Council for Drug Education; and President, Phobia
Society of America. Dr. DuPont has received several national awards and
presently serves as President: Institute for Behavior and Health, Inc.; Vice
President, Bensinger, DuPont and Associates, a national drug and alcohol abuse
consulting firm; and he maintains a private practice in psychiatry. Dr. DuPont
has also been granted options to acquire shares of the Company's common stock.
Other members of the Scientific Advisory Board are Edward C. Senay, M.D., a
Professor in the Department of Psychiatry at the University of Chicago, and
Arthur McBay, Ph.D., a Forensic Toxicologist and former Professor of Pharmacy at
the University of North Carolina.

RESEARCH AND DEVELOPMENT

The Company is continuously engaged in research and development activities.
During the years ended December 31, 1995, 1994 and 1993, $436,385, $406,345 and
$352,784, respectively, were expended for research and development.

The Company's research includes "controlled studies" to determine the advantages
of hair testing in the medical, forensic and criminal justice markets. The
Company has also furnished technical assistance to several distinguished
independent researchers whose studies have been funded through government
grants. Many such studies are currently in progress. The Company continues to
conduct its own research toward the development of new inventions, services and
products derived from the Company's patented technology.

SOURCES AND AVAILABILITY OF RAW MATERIALS

Since its inception, the Company has purchased raw materials for its laboratory
services from outside suppliers. The most critical of these raw materials are
the antibodies and radio-labeled drugs. If suitable radio-labeled drugs become

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unavailable, or available only at prohibitive cost, the Company would have to
allocate sufficient resources to produce its own radio-chemical supplies. The
Company estimates that it would have to expend approximately $200,000 for
capital additions to produce its own supply. Thereafter, direct costs for such
raw materials would likely decrease.

PRINCIPAL CUSTOMER

The Company's major customer, Blockbuster Entertainment Group ("Blockbuster"), a
division of Viacom, Inc., accounted for approximately 21% of the Company's drug
testing sample volume and approximately 18% of the Company's revenue during the
year ended December 31, 1995. The Company's agreement with Blockbuster is
terminable at will by either party and the loss of Blockbuster as a customer
could have a material adverse effect on the Company. However, the Company
believes that its relations with Blockbuster are satisfactory.

EMPLOYEES

As of December 31, 1995, the Company had 79 full-time equivalent employees, of
which four full-time employees were in research and development. None of the
Company's employees is subject to collective bargaining agreements.

Item 2.   Properties.
- ---------------------

The Company maintains its corporate office and northeast sales office at 1280
Massachusetts Avenue, Cambridge, Massachusetts; the office is leased through
September 1998.

The Company leases 18,000 square feet of space in Culver City, California, for
sales, customer service and laboratory purposes. This facility is leased through
December 31, 1997 with an option to renew for an additional five years.

Item 3.   Legal Proceedings.
- ----------------------------

The Company's dispute with the Food and Drug Administration is described above
under Business Government Regulation. The Company is involved in various other
suits and claims in the ordinary course of business. The Company does not
believe that the disposition of any such suits or claims will have a material
adverse effect on the continuing operations or financial position of the
Company.

Item 4.   Submission of Matters To Vote of Security Holders.
- ------------------------------------------------------------

Not applicable.

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                                     PART II

Item 5.   Market for Registrant's Common Equity and Related Shareholder
- -----------------------------------------------------------------------
          Matters.
          --------

The Company's common stock has been traded on the American Stock Exchange under
the symbol "PMD" since April 27, 1995. Prior to such date, the stock was traded
on the NASDAQ Small-Cap Market under the symbol "PCMC". The following table sets
forth for the periods indicated the range of prices for the Company's common
stock as reported by the National Quotation Bureau, Inc. (through April 26,
1995) and as reported by the American Stock Exchange thereafter. As of March 22,
1996, there were 549 recordholders of the Company's common stock.

Calendar Period                           High                      Low
- ---------------                         ----------                 ------
                                                              
1995
- ----
First Quarter                            3 7/16                     2 1/2
Second Quarter                           3 3/8                      2 5/8
Third Quarter                            9                          3 3/8
Fourth Quarter                           6                          4 3/4

1994
- ----
First Quarter                            4 1/6                      2
Second Quarter                           4                          3 1/8
Third Quarter                            4 1/8                      3 1/6
Fourth Quarter                           3 15/16                    2 7/8

The Company has paid no cash dividends on its common stock and does not intend
to pay cash dividends in the foreseeable future.

Item 6.  Management's Discussions and Analysis of Financial Condition
- -------------------------------------------------------------------
         and Results of Operations.
         --------------------------

The following Selected Financial Data for the years ended December 31, 1995,
1994 and 1993 have been derived from the financial statements of the Company as
audited by Arthur Andersen LLP, the Company's independent public accountants.
This Selected Financial Data should be read in conjunction with, and is
qualified in its entirety by reference to, the financial statements and related
notes thereto included elsewhere in this Report.

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                                                    As of and for the Periods Ended
                                                    -------------------------------
                                                  (In thousands except per share data)
                                                              December 31,
                                                  ------------------------------------

                                                 1995               1994            1993
                                                 ----               ----            ----

Revenue ............................            $10,111            $8,734          $6,576

Gross profit .......................              5,407             5,037           3,886

Income from operations .............              1,301             1,742             987

Net income .........................              1,559             1,831             953

Net income per common and common  
  equivalent share .................                .07               .09             .05

REVENUE

The year ended December 31, 1995 was another record year for revenue. Revenue
was $10,110,934 in 1995 as compared to $8,734,156 in 1994 and $6,575,553 in
1993, representing an increase of 16% in 1995 and 33% in 1994. These increases
were due primarily to the addition of new clients and expanded volume from
existing clients in targeted industries such as gaming, manufacturing, service,
retail and mining. Revenue included $1,822,000, $2,059,000 and $1,283,000 from
Blockbuster in 1995, 1994 and 1993, respectively. The decrease in revenue
attributable to Blockbuster in 1995 was due to both lower volume of testing and
a reduced selling price. There can be no assurance that Blockbuster's testing
volume and the Company's resulting revenue derived from Blockbuster will reach
the same levels in 1996 as in 1995.

DIRECT COSTS AND EXPENSES

The following table sets forth the direct costs of revenue as a percentage of
revenue and general and administrative expenses, marketing and selling expenses
and research and development expenses as a percentage of revenue for the years
ended December 31:

                                               1995          1994         1993
                                               ----          ----         ----

Direct costs                                    47%           42%          41%
General and administrative expenses             18%           15%          17%
Marketing and selling expenses                  19%           18%          22%
Research and development expenses                4%            5%           5%

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Direct Costs

Direct costs for the year ended December 31, 1995 were $4,703,517 as compared to
$3,696,944 in 1994 and $2,689,835 in 1993. The increases of $1,006,573 and
$1,007,109 in 1995 and 1994, respectively, are due primarily to increases in the
volume of samples tested in each such period. The increase in direct costs as a
percentage of revenue in 1995 as compared to 1994 is primarily the result of
increases in laboratory personnel and the expansion of the Company's laboratory
in February 1995.

General and Administrative Expenses

General and Administrative Expenses were $1,795,039, $1,342,653 and $1,111,524
for the years ended December 31, 1995, 1994 and 1993, respectively. The $452,386
increase in 1995 was due primarily to the higher costs incurred by the Company
as a result of its continued growth, principally salaries and legal and
regulatory expenses. The $231,129 increase in 1994 was also due primarily to the
higher costs incurred by the Company as a result of its growth.

Marketing and Selling Expenses

Marketing and Selling Expenses for the year ended December 31, 1995 were
$1,874,862 as compared to $1,546,084 in 1994 and $1,434,508 in 1993. The
increase in 1995 of $328,778 was due primarily to increased marketing expenses
related to the introduction of "PDT-90". The $111,576 increase in 1994 as
compared to 1993 was due primarily to the increased marketing expenses.

Research and Development Expenses

Research and Development Expenses were $436,385 in 1995 as compared to $406,345
in 1994 and $352,784 in 1993. The Company continues to expand its research
efforts to develop new products and services utilizing the Company's proprietary
technology. Additional research using the Company's proprietary technology is
being conducted by outside research organizations through government-funded
studies.

OTHER INCOME (EXPENSE)

Interest income in 1995, 1994 and 1993 resulted primarily from temporary
investments of cash derived from operations, the exercise of stock options and
warrants and from the Company's various private equity placements. The decline
in interest expense in 1995 and 1994 results from the repayment of capital lease
obligations attributable to the financing of certain equipment purchase in 1993
through capital lease arrangements.

NET INCOME

Net income for December 31, 1995, 1994 and 1993 was $1,558,686, $1,831,230 and
$953,108, respectively. The decrease in 1995 was primarily due to higher direct
costs and increased general and administrative expenses. The provision for
income taxes in 1995 and 1994 represents the alternative minimum tax due, as
required by the Internal Revenue Code. The Company has total net operating loss
carryforwards at December 31, 1995 of approximately $4,973,000 available to
offset future federal taxable income.

                                       13
   14

LIQUIDITY AND CAPITAL RESOURCES

The Company's cash and investment balances at December 31, 1995 amounted to
$5,473,383. Cash generated from operations in 1995 was $1,973,362. The Company
also received $1,022,288 of net proceeds from the exercise of warrants and stock
options in 1995.

Working capital at December 31, 1995 amounted to $6,788,513 as compared to
$7,657,838 at December 31, 1994. The decrease of $869,325 during 1995 was due
primarily to repurchases of Common Stock during the year.

Management believes that the proceeds from the exercise of outstanding options
and warrants, together with future operating profits, should be adequate to fund
anticipated working capital requirements. Depending upon the Company's results
of operations, its future capital needs and available marketing opportunities,
the Company may use various financing sources to raise additional equity
capital. Such sources could include joint ventures or additional private equity
placements. There can be no assurance that such funds will be available on a
favorable basis, if at all.

The Company's capital expenditures were $1,269,118 in 1995, $528,819 in 1994 and
$785,758 in 1993. The increase in 1995 was primarily a result of expansion of
the Company's laboratory facilities. Capital expenditures for 1996 are expected
to be approximately $600,000 and are expected to be funded through cash
generated from operations and from existing cash reserves.

In December 1994, the Company's Board of Directors authorized the repurchase of
up to 1 million shares of the Company's common stock. During 1995, the Company
purchased a total of 699,387 shares of Common Stock for $2,676,793. This program
is a direct result of the Company's solid financial condition and
cash-generating capability, and it was authorized after evaluating various
alternatives to enhance long-term share owner value.

Item 7.   Financial Statements
- ------------------------------

The financial statements and financial statement schedules are incorporated by
reference in this report on pages F-1 through F-12.

Item 8.   Changes in and Disagreements with Accountants on
- ----------------------------------------------------------
          Accounting and Financial Disclosure.
          ------------------------------------

None.

                                            14
   15

                                    PART III

Item 9.   Directors and Executive Officers of the Registrant.
- -------------------------------------------------------------

Following is a list that sets forth as of March 31, 1996 the names, ages and
positions within the Company of all of the Executive Officers of the Company and
the Directors of the Company. Each such director has been nominated for
reelection at the Company's 1995 Annual Meeting, to be held on May 7, 1996.

NAME                              AGE         POSITION
- ----                              ---         --------

Raymond C. Kubacki, Jr.           51         Chief Executive
                                             Officer, President,
                                             Director

Werner A. Baumgartner, Ph.D.      60         Chairman of the
                                             Board, Director

A. Clinton Allen                  52         Vice Chairman of
                                             the Board, Director

Bruce M. Stillwell                34         Vice President,
                                             Treasurer, Controller

Donald J. Kippenberger, Ph.D.     49         Vice President-
                                             Laboratory Operations

Thomas Cairns, Ph.D., D.Sc.       55         Vice President-
                                             Technology Research
 & Development

William Thistle                   46         Vice President,
                                             General Counsel

Donald F. Flynn                   56         Director

John J. Melk                      59         Director

Frederick J. Weinert              48         Director

All Directors hold office until the next annual meeting of stockholders or until
their successors are elected. Officers serve at the discretion of the Board of
Directors.

Mr. Kubacki joined the Company in July 1991 as Director and as President and
Chief Executive Officer. During the five years prior to joining the Company, he
served as Vice President-National Accounts and Director of Sales and Marketing
for Reliance COMM/TEC Corporation, a subsidiary of Reliance Electric Co.

                                       15
   16

Dr. Baumgartner, a founder of the Company, has served as Chairman of the Board
and a Director of the Company since its organization in September 1986. Dr.
Baumgartner has served as the Company's Director of Scientific and Regulatory
Affairs since May 1989. Dr. Baumgartner received his Ph.D. in physical chemistry
in 1963 from the University of New South Wales, Sydney, Australia, and has been
engaged in physical and biophysical chemistry research since 1960, holding
research and teaching positions at University of New South Wales; Long Beach
State University; Jet Propulsion Laboratory at California Institute of
Technology; University of California, Los Angeles; and University of Southern
California. Dr. Baumgartner has been the director of the Radioimmunoassay and In
Vitro Laboratory of the Nuclear Medicine Service, Veterans Administration
Hospital, Wadsworth, Los Angeles, California, since 1976, serving in such
capacity on a part-time basis since February 1987.

Mr. Allen is Chairman and Chief Executive Officer of A.C. Allen & Company, Inc.,
a financial services consulting firm located in Cambridge, Massachusetts. Mr.
Allen currently serves as a director of The Forschner Group, Inc.; Victory
Capital LLC; the Tigera Group, Inc.; and the SweetWater Corporation. He also
serves as a director and Vice Chairman of The DeWolfe Companies, Inc. Mr. Allen
has been a director of the Company since 1989.

Dr. Kippenberger joined the Company in January 1994 as Vice President of
Laboratory Operations. From 1987 to 1990, he was the Technical Director of the
Wiesbaden Forensic Toxicology Drug Testing Laboratory, one of the U.S. Army's
largest drug testing laboratories. From 1990 to 1993 he served as the Forensic
Toxicology Consultant to the U.S. Army Surgeon General, where he directed
policy, technical operations and inspection oversight of the four U.S. Army
toxicology drug testing laboratories. Dr. Kippenberger is a National Institute
on Drug Abuse (NIDA) inspector.

Dr. Cairns joined the Company in July 1995 as Vice President of Technology
Research & Development. An authority in the field of mass spectrometry, Dr.
Cairns served as a Senior Research Scientist with the Food and Drug
Administration during his 21-year tenure with that agency. He also served on the
FDA Senior Science Counsel from 1991 to 1995 and served as Chairman of the FDA
Science Forum from 1992 to 1995. In addition, Dr. Cairns holds an academic
appointment with the University of Southern California as Adjunct Professor of
Pharmaceutical Science, School of Pharmacy, and was recently appointed Science
Advisor to the FDA.

Mr. Thistle joined the Company in September 1995 as Vice President and General
Counsel. Prior to joining the Company, he served as Associate General Counsel
for MGM Grand in Las Vegas from 1993 to 1995. From 1989 to 1993, Mr. Thistle was
Associate General Counsel for Harrah's Casino Resorts.

Mr. Stillwell joined the Company in September 1995 as Vice President,
Controller. In January 1996, he was elected Treasurer. Prior to joining the
Company, he served in various positions including Controller for Organogenesis
Inc. from 1988 to 1995. From 1983 to 1988, Mr. Stillwell was an auditor for
Arthur Andersen LLP.

                                       16
   17

Mr. Flynn has been the sole stockholder and Chairman of the Board of Flynn
Enterprises, Inc., a financial advisory and venture capital firm, since February
1988. Mr. Flynn also was Chairman of the Board from July 1992 until February
1996 and Chief Executive Officer from July 1992 until May 1995 of Discovery
Zone, Inc., an operator of indoor entertainment and fitness facilities for
children. On March 25, 1996, Discovery Zone, Inc. filed a voluntary petition
under Chapter 11 of the U.S. Bankruptcy Code. From 1972 to December 1990, Mr. 
Flynn served in various positions with WMX Technologies, Inc. (formerly Waste 
Management, Inc.) including Senior Vice President and Chief Financial Officer.
Mr. Flynn currently serves as a director of WMX Technologies, Inc. and its 
affiliated entities, Waste Management International plc and Wheelabrator 
Technologies, Inc. Mr. Flynn has been a director of the Company since 1989.

Mr. Melk currently serves as Chairman and Chief Executive Officer of H20 Plus,
L.P., which develops and manufactures health and beauty products and distributes
them through a company-owned chain of specialty retail stores, as well as over
300 wholesale/department stores. He also serves as Chairman of MW Partners, an
investor in commercial and residential real estate investments. From 1987 to
1989, Mr. Melk was Vice Chairman of the Board of Blockbuster Entertainment
Corporation. From 1971 to 1975, Mr. Melk was Vice President of Corporate
Development for WMX Technologies and from 1975 to 1984 held the position of
President of W.M.I. International, Ltd. based in London, England. He is a
director of Republic Industries, Inc., and Extended Stay America, Inc. Mr. Melk
has been a director of the Company since 1991.

Mr. Weinert serves as President of San Telmo, Inc. (investment and international
development projects), Barrington Services Group (a business advisory firm and
commercial real estate developer), Here's Hollywood, Inc. (a Blockbuster Video
franchisee) and Vice President of H20 Plus, S.A. (a distributor of cosmetics,
bath products and fragrances in Argentina, Chile and Uruguay). From June 1989 to
February 1995 he was President of H20 Plus L.P., MW Partners, and Century
Entertainment Ltd. Previous to that he was President of Waste Management
International, Inc. from December 1983 to June 1989. For over 10 years he has
served on the Business Advisory Council for the University of Dayton and also
serves as a Director of Americas Cooperating for Health & Education. Mr. Weinert
has been a director of the Company since 1991.

Item 10.  Executive Compensation.
- ---------------------------------

The information required by this item will be set forth in the Proxy Statement
of the Company relating to the 1996 Annual Meeting of Stockholders to be held on
May 7, 1996 and is incorporated herein by reference.

Item 11.  Security Ownership of Certain Beneficial Owners and Management.
- -------------------------------------------------------------------------

The information required by this item will be set forth in the Proxy Statement
of the Company relating to the 1996 Annual Meeting of Stockholders to be held on
May 7,1996 and is incorporated herein by reference.

Item 12.  Certain Relationships and Related Transactions.
- ---------------------------------------------------------

The information required by this item will be set forth in the Proxy Statement
of the Company relating to the 1996 Annual Meeting of Stockholders to be held on
May 7, 1996 and is incorporated herein by reference.

                                       17
   18

Item 13.  Exhibits, Financial Statement Schedules, and Reports on Form 8-K.
- ---------------------------------------------------------------------------

(a) (1)  Financial Statements:                                  Page
                                                                ----
                                                               
         Report of Independent Public Accountants                F-1

         Balance Sheets as of December 31, 1995 and 1994         F-2

         Statements of Income for the Years

         Ended December 31, 1995, 1994 and 1993                  F-3

         Statements of Shareholders' Equity for the Years

         Ended December 31, 1995, 1994 and 1993                  F-4

         Statements of Cash Flows for the Years

         Ended December 31, 1995, 1994 and 1993                  F-5

         Notes to Financial Statements                           F-6

    (2)  Exhibits -    (See the Index to Exhibits included
                         elsewhere in this report)

(b)      Reports on Form 8-K

         None

                                       18
   19

                            PSYCHEMEDICS CORPORATION

                                     10-KSB

                                Index to Exhibits
                                -----------------

Exhibit                                                                   Page or
Number                            Description                             Reference
- ------                            -----------                             ---------
                                                                     
3                    Articles of Incorporation and By-Laws
                     -------------------------------------

3.1                  Certificate of Incorporation filed                    A-3 (i)
                     September 24, 1986

3.2                  Amendment to Certificate of                           A-3 (ii)
                     Incorporation filed October 29, 1986

3.3                  Amendment to Certificate of                           B-3 (c)
                     Incorporation filed July 12, 1989

3.4                  Amendment to Certificate of                           G-4
                     Incorporation filed August 7, 1990

3.5                  Amendment to Certificate of                           J-4
                     Incorporation filed May 9, 1991

3.6                  By-Laws of the Company                                A-3 (iii)

4                    Instruments Defining the Rights of Security Holders
                     ---------------------------------------------------

4.1                  Specimen Stock Certificate                            A-4

4.3                  Form of Common Stock Purchase Warrant                 H-4
                     issued to investors on December 31, 1990

4.4                  Form of Common Stock Purchase Warrant                 I-4
                     issued to investors on March 28, 1991

4.5                  Form of Common Stock Purchase Warrant                 K-4
                     issued to the Placement Agent on
                     November 27, 1991

10                   Material Contracts
                     ------------------

10.1                 License Agreement  with Werner                        A-10 (v) *
                     Baumgartner, Ph.D. and Annette Baumgartner
                     dated January 17, 1987

   20

10.2                 License Agreement with Home Office                  D-19
                     Reference Laboratory dated November 17, 1988

10.3                 License Agreement with Lifecodes                    E-19
                     Corporation dated February 24, 1989

10.4                 Employment Agreement with Werner A.                 O-10.1
                     Baumgartner, Ph.D. dated May 15, 1994

10.5                 Securities Purchase Agreement re:  sale             C-28
                     of 3,500,000 shares of Common Stock
                     and 4,200,000 Common Stock Purchase
                     Warrants dated May 15, 1989

10.6                 Amendment dated as of June 30, 1990 to              L-10.9
                     Securities Purchase Agreement dated
                     May 15, 1989

10.7                 1989 Employee Stock Option Plan,                    N-A *
                     as amended

10.8                 1989 Non-Qualified Stock Option Plan,               N-B *
                     as amended

10.9                 Purchase Agreement re:  sale of 317,220             F-28
                     shares of Common Stock, 475,949 Warrants,
                     $500,000 Convertible Subordinated Note and
                     127,479 shares of Preferred Stock dated
                     June 29, 1990

10.10                Conversion Agreement re:  conversion of             H-28
                     indebtedness (including accrued interest) 
                     and 127,479 shares of Preferred Stock (including 
                     accrued dividends) into 1,039,026 shares of Common 
                     Stock dated as of December 31, 1990

10.11                Purchase Agreement re:  sale of 810,000             I-28
                     shares of Common Stock and 810,000
                     Common Stock Purchase Warrants dated
                     March 28, 1991

10.12                1991 Non-Qualified Stock Option Plan                L-10.15 *

10.13                Employment Agreement with Raymond C.                L-10.16 *
                     Kubacki, Jr. effective July 16, 1991

10.14                Form of Purchase Agreement re:  sale                M-28.1
                     of 2,000,000 shares of Common Stock
                     dated November 27, 1991

10.15                Conversion Agreement re:  conversion                K-28.2
                     of Promissory Notes into 428,571 shares
                     of Common Stock dated November 27, 1991

   21

10.16                Lease dated October 6, 1992 with Mitchell H.          M-10.18
                     Hersch, et. al with respect to premises in

                     Culver City, California

10.17                Security Agreement dated October 6, 1992              M-10.19
                     with Mitchell H. Hersch et. al

10.18                Lease Agreement dated December 30, 1992               M-10.20
                     with General Electric Capital Corporation

10.19                Letter of Credit Agreement dated December 29,         M-10.21
                     1992 with General Electric Capital Corporation

10.20                Standby Letter of Credit dated December 29,           M-10.22
                     1992 with Brown Brothers Harriman & Co.

10.21                Employment Agreement with Donald J.
                     Kippenberger, Ph.D. dated January 1, 1994             O-10.3 *

10.22                Employment Agreement with Thomas Cairns Ph.D.,        O-10.3 *
                     D.Sc. dated July 1, 1995

23                   Consents of Experts and Counsel
                     -------------------------------

23.1                 Consent of Arthur Andersen LLP                        Filed herewith

- ------------------------------

A-   Incorporated by reference from the Registrant's Registration Statement on
     Form S-18 (File No. 33-10186 LA). The number set forth herein is the number
     of the Exhibit in said Registration Statement.

B-   Incorporated by reference from the Registrant's Annual Report on Form 10-K
     for the fiscal year ended June 30, 1989. The number set forth herein is the
     number of the Exhibit in said Report.

C-   Incorporated by reference from the Registrant's Current Report on Form 8-K
     filed May 30, 1989. The number set forth herein is the number of the
     Exhibit in said Report.

D-   Incorporated by reference from the Registrant's Quarterly Report on Form
     10-Q for the quarter ended December 31, 1988. The number set forth herein
     is the number of the Exhibit in said Report.

E-   Incorporated by reference from the Registrant's Quarterly Report on Form
     10-Q for the quarter ended March 31, 1989. The number set forth herein is
     the number of the Exhibit in said Report.

F-   Incorporated by reference from the Registrant's Current Report on Form 8-K
     filed July 2, 1990. The number set forth herein as the number of the
     Exhibit in said Report.

   22

G-   Incorporated by reference from the Registrant's Quarterly Report on Form
     10-Q for the Quarter ended September 30, 1990 as amended by a First
     Amendment on Form 8 filed December 15, 1990. The number set forth herein is
     the number of the Exhibit in said Form 8.

H-   Incorporated by reference from the Registrant's Current Report on Form 8-K
     filed January 8, 1991. The number set forth herein is the number of the
     Exhibit in said Report.

I-   Incorporated by reference from the Registrant's Current Report on Form 8-K
     filed April 3, 1991. The number set forth herein is the number of the
     Exhibit in said Report.

J-   Incorporated by reference from the Registrant's Quarterly Report on Form
     10-Q for the quarter ended June 30, 1991. The number set forth herein is
     the number of the Exhibit in said Report.

K-   Incorporated by reference from the Registrant's Current Report on Form 8-K
     filed December 2, 1991. The number set forth herein is the number of the
     Exhibit in said Report.

L-   Incorporated by reference from the Registrants Annual Report on Form 10-K
     for the fiscal year ended December 31, 1991. The number set forth herein is
     the number of the Exhibit in said Report.

M-   Incorporated by reference from the Registrants Annual Report on Form 10-KSB
     for the fiscal year ended December 31, 1992. The number set forth herein is
     the Exhibit in said Report.

N-   Incorporated by reference from the Registrant's 1996 Annual Proxy
     Statement. The letter set forth herein is the letter of the Exhibit in said
     Proxy Statement.

O-   Incorporated by reference from the Registrant's Current Report on Form 10-Q
     for the quarter ended June 30, 1995. The number set forth herein is the
     number of the Exhibit in said Report.

*-   Represents a management contact or compensatory plan in which a director or
     a named executive officer of the registrant participates.
   23

                                   SIGNATURES

Pursuant to the requirements of Sections 13 or 15 (d) of the Securities Exchange
Act of 1934, the registrant has duly caused this Report to be signed on its
behalf by the undersigned, thereunto duly authorized.

                                  PSYCHEMEDICS CORPORATION

                                  By: /s/ Raymond C. Kubacki, Jr.
                                      ---------------------------
                                  Raymond C. Kubacki, Jr.
                                  President and Chief Executive Officer

Date:     March 26, 1996

Pursuant to the requirements of the Securities Exchange Act of 1934, this Report
has been signed below by the following persons on behalf of the Registrant and
in the capacities and on the dates indicated.

/s/ Raymond C. Kubacki, Jr.                     March 26, 1996
- -------------------------------------
Raymond C. Kubacki, Jr.
President and Chief Executive
Officer, Director
(Principal Executive Officer)

/s/ Bruce M. Stillwell                          March 26, 1996
- -------------------------------------
Vice President, Treasurer, Controller
(Principal Financial Officer)

/s/ Werner A. Baumgartner, Ph.D.                March 26, 1996
- -------------------------------------
Werner A. Baumgartner, Ph.D.
Director

/s/ A. Clinton Allen                            March 26, 1996
- -------------------------------------
A. Clinton Allen
Director

/s/ Donald F. Flynn                             March 26, 1996
- -------------------------------------
Donald F. Flynn
Director

/s/ John J. Melk                                March 26, 1996
- -------------------------------------
John J. Melk
Director

/s/ Frederick J. Weinert                        March 26, 1996
- -------------------------------------
Frederick J. Weinert
Director

                                       19
   24

                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To Psychemedics Corporation:

We have audited the accompanying balance sheets of PSYCHEMEDICS CORPORATION (a
Delaware corporation) as of December 31, 1995 and 1994, and the related
statements of income, shareholders' equity and cash flows for each of the three
years in the period ended December 31, 1995. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. 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 audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Psychemedics Corporation as of
December 31, 1995 and 1994, and the results of its operations and its cash flows
for each of the three years in the period ended December 31, 1995, in conformity
with generally accepted accounting principles.

                                                             ARTHUR ANDERSEN LLP

Boston, Massachusetts
February 20, 1996

                                       F-1
   25
                           PSYCHEMEDICS CORPORATION

                                 BALANCE SHEETS

                                                                     DECEMBER 31,
                                                              ------------------------
                                                                  1995        1994
                                                              -----------  -----------
                                                                             
                            ASSETS
CURRENT ASSETS:
   Cash and cash equivalents                                  $   193,787  $   544,776
   Short-term investments                                       5,279,596    6,120,453
   Receivables                                                  1,722,770    1,417,701
   Laboratory supplies                                            253,216      188,703
   Prepaid expenses and other current assets                       72,247       79,687
                                                              -----------  -----------
      Total current assets                                      7,521,616    8,351,320
                                                              -----------  -----------

EQUIPMENT AND LEASEHOLD IMPROVEMENTS:
   Office furniture and equipment                                 585,411      371,068
   Laboratory equipment and leasehold improvements              3,521,569    2,466,794
                                                              -----------  -----------
                                                                4,106,980    2,837,862

   Less: Accumulated depreciation and amortization              1,864,398    1,291,684
                                                              -----------  -----------
                                                                2,242,582    1,546,178
                                                              -----------  -----------

OTHER ASSETS - NET                                                453,295      392,224

                                                              ===========  ===========
                                                              $10,217,493  $10,289,722
                                                              ===========  ===========

             LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
   Current portion of obligations under capital leases        $    16,459  $   153,942
   Accounts payable                                               466,412      303,562
   Accrued expenses                                               250,232      235,978
                                                              -----------  -----------
      Total current liabilities                                   733,103      693,482
                                                              -----------  -----------

OBLIGATIONS UNDER CAPITAL LEASES,
   net of current portion                                               -       16,031
                                                              -----------  -----------

COMMITMENTS (Note 6)

SHAREHOLDERS' EQUITY:
   Preferred stock, $.005 par value; authorized 1,000,000
     shares; none outstanding                                           -            -
   Common stock, $.005 par value; authorized 50,000,000
     shares; issued and outstanding 20,288,280 and
     19,510,879 shares in 1995 and 1994, respectively             101,441       97,554
   Paid-in capital                                             15,728,033   14,709,632
   Accumulated deficit                                         (3,668,291)  (5,226,977)
   Treasury stock, at cost; 699,387 shares in 1995             (2,676,793)           -
                                                              -----------  -----------
      Total shareholders' equity                                9,484,390    9,580,209
                                                              -----------  -----------
                                                              $10,217,493  $10,289,722
                                                              ===========  ===========

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

                                      F-2
   26

                            PSYCHEMEDICS CORPORATION

                              STATEMENTS OF INCOME

                                                         YEARS ENDED DECEMBER 31,
                                                -----------------------------------------
                                                   1995           1994           1993
                                                -----------    -----------    -----------

REVENUE                                         $10,110,934     $8,734,156     $6,575,553  

DIRECT COSTS                                      4,703,517      3,696,944      2,689,835
                                                -----------    -----------    -----------
   Gross profit                                   5,407,417      5,037,212      3,885,718
                                                -----------    -----------    -----------
EXPENSES:
   General and administrative                     1,795,039      1,342,653      1,111,524
   Marketing and selling                          1,874,862      1,546,084      1,434,508
   Research and development                         436,385        406,345        352,784
                                                -----------    -----------    -----------
                                                  4,106,286      3,295,082      2,898,816
                                                -----------    -----------    -----------
    Income from operations                        1,301,131      1,742,130        986,902
                                                -----------    -----------    -----------
OTHER INCOME (EXPENSE):
   Interest income                                  358,437        175,667         17,384
   Interest expense                                  (9,178)       (25,004)       (42,117)
   Miscellaneous, net                                (4,504)         4,537          5,939
                                                -----------    -----------    -----------
                                                    344,755        155,200        (18,794)
                                                -----------    -----------    -----------
INCOME BEFORE PROVISION
FOR INCOME TAXES                                  1,645,886      1,897,330        968,108

PROVISION FOR INCOME TAXES                           87,200         66,100         15,000
                                                -----------    -----------    -----------
NET INCOME                                      $ 1,558,686    $ 1,831,230    $   953,108  
                                                ===========    ===========    ===========

NET INCOME PER COMMON
AND COMMON EQUIVALENT SHARE                     $      0.07    $      0.09    $      0.05
                                                ===========    ===========    ===========
WEIGHTED AVERAGE COMMON AND
COMMON EQUIVALENT SHARES OUTSTANDING             22,722,387     19,341,373     19,924,005
                                                ===========    ===========    ===========

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

                                      F-3

   27

                                                     PSYCHEMEDICS CORPORATION
                                                     ------------------------
                                                STATEMENTS OF SHAREHOLDERS' EQUITY
                                                ----------------------------------

                                                                                     
                                           COMMON STOCK                                       TREASURY STOCK
                                      ----------------------     PAID-IN     ACCUMULATED    --------------------
                                        SHARES     PAR VALUE     CAPITAL      DEFICIT       SHARES    PAR VALUE       TOTAL
                                      ----------   ---------   -----------   -----------    -------  -----------    -----------
                                                                                               
BALANCE, December 31, 1992            15,024,829    $ 75,124   $10,495,768   $(8,011,315)        --           --    $ 2,559,577
                                                                                                             
 Sale of common stock through the                                                                             
   stock option plans                     20,000         100        23,000            --         --           --         23,100
 Net income                                   --          --            --       953,108         --           --        953,108
                                      ----------    --------   -----------   -----------    -------  -----------    -----------
BALANCE, December 31, 1993            15,044,829      75,224    10,518,768    (7,058,207)        --           --      3,535,785
                                                                                                             
 Sale of common stock through the                                                                             
   exercise of warrants, net of                                                                               
   related costs                       4,216,800      21,084     3,725,555            --         --           --      3,746,639
 Sale of common stock through the                                                                             
   stock option plans                    249,250       1,246       465,309            --         --           --        466,555
 Net income                                   --          --            --     1,831,230         --           --      1,831,230
                                      ----------    --------   -----------   -----------    -------  -----------    -----------
BALANCE, December 31, 1994            19,510,879      97,554    14,709,632    (5,226,977)        --           --      9,580,209
                                                                                                             
 Sale of common stock through the                                                                             
   exercise of warrants, net of                                                                               
   related costs                         498,951       2,495       504,583            --         --           --        507,078
 Sale of common stock through the                                                                             
   stock option plans                    278,450       1,392       513,818            --         --           --        515,210
 Purchases of treasury stock                  --          --            --            --    699,387  $(2,676,793)    (2,676,793)
 Net income                                   --          --            --     1,558,686         --           --      1,558,686
                                      ----------    --------   -----------   -----------    -------  -----------    -----------
BALANCE, December 31, 1995            20,288,280    $101,441   $15,728,033   $(3,668,291)   699,387  $(2,676,793)   $ 9,484,390
                                      ==========    ========   ===========   ===========    =======  ===========    ===========

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

                                     F-4
   28
                            PSYCHEMEDICS CORPORATION

                            STATEMENTS OF CASH FLOWS

                                                                       YEARS ENDED DECEMBER 31,
                                                              ------------------------------------------
                                                                 1995             1994            1993
                                                              ------------     ----------     ----------
                                                                                            
CASH FLOWS FROM OPERATING ACTIVITIES:
  Net income                                                   $ 1,558,686     $1,831,230     $  953,108
  Adjustments to reconcile net income to net
   cash provided by operating activities:
   Depreciation and amortization                                   599,714        418,800        305,632
   Changes in assets and liabilities:
    Receivables                                                   (305,069)       (20,049)      (751,388)
    Laboratory supplies                                            (64,513)       (57,373)       (63,296)
    Prepaid expenses and other current assets                        7,440         (4,720)         7,072
    Accounts payable                                               162,850        (15,673)         4,148
    Accrued expenses                                                14,254         15,315         88,886
                                                              ------------     ----------     ----------
     Net cash provided by operating activities                   1,973,362      2,167,530        544,162
                                                              ------------     ----------     ----------

CASH FLOWS FROM INVESTING ACTIVITIES:
  Sales (purchases) of short-term investments - net                840,857     (6,120,453)             -
  Purchases of equipment and leasehold improvements             (1,269,118)      (528,819)      (375,296)
  Increase in other assets                                         (88,071)       (48,837)       (99,904)
                                                              ------------     ----------     ----------
     Net cash used in investing activities                        (516,332)    (6,698,109)      (475,200)
                                                              ------------     ----------     ----------

CASH FLOWS FROM FINANCING ACTIVITIES:
  Payments on obligations under capital leases                    (153,514)      (139,778)      (119,413)
  Net proceeds from the sale of common stock                     1,022,288      4,213,194         23,100
  Purchases of treasury stock                                   (2,676,793)             -              -
                                                              ------------     ----------     ----------
     Net cash (used in) provided by financing activities        (1,808,019)     4,073,416        (96,313)
                                                              ------------     ----------     ----------
NET DECREASE IN CASH AND CASH EQUIVALENTS                         (350,989)      (457,163)       (27,351)
CASH AND CASH EQUIVALENTS, beginning of year                       544,776      1,001,939      1,029,290
                                                              ------------     ----------     ----------
CASH AND CASH EQUIVALENTS, end of year                        $    193,787     $  544,776     $1,001,939
                                                              ============     ==========     ==========

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

                                      F-5
   29

                            PSYCHEMEDICS CORPORATION

                          NOTES TO FINANCIAL STATEMENTS

1.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The Company
- -----------

Psychemedics Corporation (the Company) was incorporated in 1986. The Company
utilizes a patented hair analysis method involving radioimmunoassay technology
to analyze human hair to detect abused substances. The founder of the Company
has granted to the Company an exclusive license to all his rights in this hair
analysis technology, including his rights to the drug extraction method (see
Note 3).

Cash and Cash Equivalents and Short-Term Investments
- ----------------------------------------------------

The Company considers all highly liquid investments with maturities of three
months or less at the time of acquisition to be cash equivalents, which consist
of money market accounts at December 31, 1995. Short-term investments have
maturities of greater than three months and consist of securities issued by the
U.S. Government at December 31, 1995.

The Company adopted Statement of Financial Accounting Standards (SFAS) No. 115,
ACCOUNTING FOR CERTAIN INVESTMENTS IN DEBT AND EQUITY SECURITIES, effective
January 1, 1994. Under SFAS No. 115, investments that the Company has the
positive intent and ability to hold to maturity are reported at amortized cost,
which approximates fair market value, and are classified as held-to-maturity.
These investments include all cash equivalents and short-term investments.

Equipment and Leasehold Improvements
- ------------------------------------

Equipment and leasehold improvements are stated at cost. Depreciation and
amortization are provided over the estimated useful lives of the assets, using
the straight-line method. The estimated useful lives of the assets are as
follows:

       Office furniture and equipment           5 to 7 years
       Laboratory equipment                     5 to 7 years
       Leasehold improvements                   5 years or life of lease if less

Other Assets
- ------------

Included in other assets are patent application costs of approximately $504,000
and $407,000 as of December 31, 1995 and 1994, respectively, which relate to the
drug extraction method. The Company is amortizing the cost of these patents over
10 years from the date of grant. The Company recorded amortization of $36,000
and $14,400 during 1995 and 1994, respectively. The Company evaluates the
realizability of its patents based on estimated cash flows to be generated from
such assets as compared to the original estimates used in measuring the assets.
To the extent impairment is identified, the Company will recognize a write-down
of the related assets. To date, no impairment has been identified.

                                       F-6
   30

Revenue Recognition
- -------------------

Revenues are recognized upon reporting drug test results to the customer.

Research and Development Expenses
- ---------------------------------

The Company charges research and development expenses to operations as incurred.

Significant Customers
- ---------------------

One customer had amounts due to the Company of approximately $330,000 and
$387,000 at December 31, 1995 and 1994, respectively. This customer accounted
for 18%, 24% and 20% of revenues during 1995, 1994 and 1993, respectively.

Management Estimates
- --------------------

The preparation of financial statements in conformity with generally accepted
accounting principles requires management 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.

Net Income per Common and Common Equivalent Share
- -------------------------------------------------

Net income per common and common equivalent share for 1995 and 1994 is based on
the weighted average number of common and common equivalent shares outstanding
as computed using the treasury-stock method. Fully dilutive net income per share
has not been presented as the difference from primary net income per share is
not significant.

Recently-Issued Accounting Standards
- ------------------------------------

During March 1995, the Financial Standards Board (FASB) issued SFAS No. 121,
ACCOUNTING FOR THE IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS
TO BE DISPOSED OF, which is effective for fiscal years beginning after December
15, 1995. During October 1995, the FASB issued SFAS No. 123, ACCOUNTING FOR
STOCK-BASED COMPENSATION, which is effective for fiscal years beginning after
December 15, 1995. The Company does not expect the adoption of these standards
to have a material effect on its financial position or results of operations.

2.   SUPPLEMENTAL CASH FLOW INFORMATION

A capital lease obligation was incurred when the Company entered into a lease
for new equipment of $410,462 during the year ended December 31, 1993.

Cash paid for interest during the years ended December 31, 1995, 1994 and 1993
was $9,178, $23,630 and $39,391, respectively. Cash paid for income taxes during
the years ended December 31, 1995, 1994, and 1993 was $67,490, $16,411 and
$7,500, respectively.

                                      F-7
   31

3.   LICENSE AGREEMENTS

The Company has a royalty-free license from the founder for the proprietary
rights to the patented hair analysis technology used by the Company in its drug
testing services. The Company has two agreements to sublicense its technology,
which have not generated significant royalties to date.

4.   INCOME TAXES

The Company accounts for income taxes under SFAS No. 109, Accounting for Income
Taxes.

The Company has total net operating loss carryforwards at December 31, 1995 of
approximately $4,973,000 available to offset future federal taxable income, if
any. Approximately $2,172,000 of these losses expire in 2005, $2,223,000 in
2006, and $578,000 in 2007. These net operating loss carryforwards are subject
to review and possible adjustment by the Internal Revenue Service. In addition,
existing tax regulations contain provisions that may limit the net operating
loss carryforward that the Company may utilize in any given year in the event of
certain significant changes in ownership interest.

The provision for income taxes in the accompanying 1995, 1994 and 1993
statements of income represents the alternative minimum tax due, as required
under the Internal Revenue Code.

The components of the net deferred tax amount recognized in the accompanying
balance sheets are as follows:

                                         December 31,
                                --------------------------
                                    1995           1994
                                -----------    -----------
                                                 
Deferred tax assets             $ 1,860,000    $ 2,042,000
Valuation allowance              (1,860,000)    (2,042,000)
                                -----------    -----------
                                $         -    $         -
                                ===========    ===========

The approximate income tax effect of each type of temporary difference and
carryforward before allocation of the valuation allowance is approximately as
follows:

                                                             December 31,
                                                      ------------------------
                                                         1995          1994
                                                      ----------    ----------
                                                                     
Operating loss and credit carryforwards               $1,723,000    $1,994,000
Temporary differences                                    137,000        48,000
                                                      ----------    ----------
                                                      $1,860,000    $2,042,000
                                                      ==========    ==========

A valuation allowance is provided as it is more likely than not that some
portion of the deferred tax asset will not be realized. The decrease in the
valuation allowance in 1995 is primarily the result of the realization of tax
benefits for the current year's taxable income.

                                       F-8
   32

5.   STOCK OPTIONS AND WARRANTS

Employee Stock Option Plan
- --------------------------

Under the Company's 1989 Employee Stock Option Plan, as amended (the Plan),
2,300,000 shares of the Company's common stock are reserved for issuance to key
employees and officers of the Company. The Plan is administered by a committee
of outside directors. Under the terms of the Plan, the Company may grant
employees either incentive stock options or nonqualified stock options to
purchase shares of the Company's common stock at prices not less than fair
market value at the date of grant, as defined in the Plan. Options are
exercisable on terms to be established by the committee at its discretion.
Options are generally exercisable on a cumulative basis over the four-year
period following the date of grant and expire no later than 10 years from the
date of grant.

Nonqualified Stock Options
- --------------------------

In 1989, the Company adopted a nonqualified stock option plan for outside
members of the Board of Directors, and 200,000 shares of the Company's common
stock are reserved for issuance thereunder. Options to purchase 25,000 shares of
common stock of the Company shall be automatically granted under this plan to
each outside director of the Company upon appointment to the Board of Directors.
This plan is administered by the Board of Directors. Options are to be granted
at the fair market value at the date of grant. Options are exercisable on a
cumulative basis over the two-year period following the date of grant and expire
no later than five years from the date of grant.

In 1991, the Company adopted a nonqualified stock option plan for key employees
and consultants, and 300,000 shares of the Company's common stock were reserved
for issuance thereunder. The plan is administered by a committee of the Board of
Directors. Under the terms of the plan, the Company may grant nonqualified stock
options at option prices and terms to be determined by the committee at its
discretion and expire no later than 10 years from the date of grant.

Warrants
- --------

In connection with a private placement in 1989, the Company issued warrants that
entitled the holders to purchase an aggregate of 4,200,000 shares of the
Company's common stock at an exercise price of $.90 per share. All of these
warrants were exercised in 1994.

In connection with other private placements in 1990 and 1991, the Company issued
warrants that entitle the holders to purchase an aggregate of 1,585,951 shares
of the Company's common stock at exercise prices that range from $0.97 to $2.00
per share. In 1995, 475,951 warrants were exercised at $.096875 per share, and
23,000 warrants were exercised at $2.00 per share.

                                       F-9
   33

A summary of all stock option and warrant transactions for the years ended
December 31, 1995, 1994 and 1993 is as follows (in thousands, except per share
amounts):

                                                     1995      1994        1993
                                                 --------------------------------
                                                                
Options and warrants outstanding at
  beginning of period                               3,428       7,905       7,476

Granted                                               519         132         506

Exercised                                            (777)     (4,466)        (20)

Canceled                                               (7)       (143)        (57)
                                                 ---------   ---------   ---------

Options and warrants outstanding at
  end of period                                     3,163       3,428       7,905
                                                 =========   =========   =========
                                                          
Price range of options and warrants                 $1.34       $0.97       $0.90
  outstanding at end of period                   to $6.41    to $3.75    to $3.75

Vested options and warrants at end of
  period                                            2,447       2,662       6,830

6.   COMMITMENTS

Lease Agreements
- ----------------

The Company leases certain of its facilities and equipment under operating lease
arrangements expiring through September 1998. Total minimum lease payments,
including scheduled increases, are charged to operations on a straight-line
basis over the life of the lease. Rent expense for the years ended December 31,
1995, 1994 and 1993 was approximately $445,000, $313,000 and $259,000,
respectively.

The Company also leases certain equipment under capital leases that expire
through July 1996. Equipment under capital leases is included in laboratory
equipment and leasehold improvements in the accompanying balance sheets as
follows:

                                                 December 31,
                                             --------------------
                                                1995       1994
                                             --------    --------
                                                        
Equipment under capital leases               $433,998    $433,998
Less:  Accumulated depreciation               161,337      99,725
                                              -------    --------
                                             $272,661    $334,273
                                             ========    ========

                                      F-10
   34

At December 31, 1995, minimum commitments remaining under lease agreements were
as follows:

                                          Capital      Operating
                                          Leases        Leases       Total
                                          ------        ------       -----
                                                                
     Years ending December 31: 
              1996                        $16,459       $266,000    $282,459
              1997                              -        272,000     272,000
              1998                              -         86,000      86,000
                                          -------       --------    --------
                                          $16,459       $624,000    $640,459
                                          =======       ========    ========

Employment Agreement
- --------------------

In May 1994, the Company entered into a three-year employment agreement with an
officer of the Company requiring a minimum annual salary of approximately
$116,000, subject to certain adjustments.

7.  ACCRUED EXPENSES

Accrued expenses consist of the following:

                                                    December 31,
                                             -----------------------
                                               1995           1994
                                             --------       --------
                                                           
Accrued payroll & employee benefits          $134,159       $124,111
Accrued income taxes                           55,567         64,284
Accrued other                                  60,506         47,583
                                             --------       --------
                                             $250,232       $235,978
                                             ========       ========

                                      F-11
   35

8.   SELECTED QUARTERLY FINANCIAL DATA (Unaudited)

The following is an analysis of certain items in the accompanying statements of
income by quarter for the years ended December 31, 1995 and 1994:

                                               Income                          Net                     
                                                from             Net          Income
                              Revenue        Operations         Income       per share
                              -------        ----------         ------       ---------
                                                                    
1995
- ----
First Quarter              $ 2,321,157       $  338,619       $  403,980       $.02
Second Quarter               2,747,242          614,169          650,540        .03
Third Quarter                2,667,417          367,556          430,390        .02
Fourth Quarter               2,375,118          (19,213)          73,776        .00
                           -----------       ----------       ----------
                           $10,110,934       $1,301,131       $1,558,686       $.07
                           ===========       ==========       ==========
1994
- ----
First Quarter              $ 1,548,115       $   31,862       $   35,229       $.00
Second Quarter               2,325,143          546,546          552,722        .03
Third Quarter                2,547,508          646,581          673,289        .03
Fourth Quarter               2,313,390          517,141          569,990        .03
                           -----------       ----------       ----------
                           $ 8,734,156       $1,742,130       $1,831,230       $.09
                           ===========       ==========       ==========

                                        F-12

   1

                    CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS

As independent public accountants, we hereby consent to the incorporation of our
reports included in this Form 10-KSB into the Company's previously filed
Registration Statements File Nos. 33-41787, 33-50712, 33-45332, 33-66942 and
33-58970.

                                                ARTHUR ANDERSEN LLP

Boston, Massachusetts
March 29, 1996