<PAGE>
 
                                 UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                   FORM 10-Q


                                   (Mark One)

[X]  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
     ACT OF 1934 
     For the quarter ended March 31, 1999

                                       or

[ ]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
     EXCHANGE ACT OF 1934 
     For the transition period from _______________ to _______________

                         Commission File Number: 0-27600


                          OPTICAL SENSORS INCORPORATED
             (Exact name of registrant as specified in its charter)


               Delaware                                  41-1643592
     (State of other jurisdiction of                  (I.R.S. Employer
     incorporation or organization)                  Identification No.)


     7615 Golden Triangle Drive, Suite A, Minneapolis, Minnesota 55344-3733
     (Address of principal executive offices)                    (Zip Code)

        Registrant's telephone number, including area code (612) 944-5857


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. [X] Yes [ ] No

     As of May 3, 1999, the Registrant had 8,841,123 shares of Common Stock
outstanding.
<PAGE>
 
                                      Index


                          OPTICAL SENSORS INCORPORATED



Part I.    Financial Information

           Item 1. Financial Statements (Unaudited)

               Balance Sheets - March 31, 1999 and December 31, 1998

               Statements of Operations - Quarters ended March 31, 1999 and
               March 31, 1998

               Statements of Cash Flows - Quarters ended March 31, 1999 and 
               March 31, 1998

               Notes to Financial Statements

           Item 2. Management's Discussion and Analysis of Financial Condition 
                   and Results of Operations


Part II.   Other Information

           Item 6. Exhibits and Reports on Form 8-K



                                       1
<PAGE>
 
                          Optical Sensors Incorporated

                                 Balance Sheets

<TABLE>
<CAPTION>

                                                             March 31, 1999   December 31, 1998
                                                             --------------   -----------------
                                                              (Unaudited)          (Note)
<S>                                                           <C>                <C>        
Assets
Current assets:
   Cash and cash equivalents                                 $5,418,313          $ 8,079,871
   Accounts receivable                                           41,349              162,858
   Inventory                                                  1,706,410            1,846,294
   Prepaid expenses and other current assets                    103,721               99,610
                                                             ----------          ------------
Total current assets                                          7,269,793           10,188,633
                                                                                
Property and equipment:                                                         
   Leased Equipment                                           1,073,438            1,017,953
   Research and development equipment                           740,444              740,444
   Leasehold improvements                                       351,079              339,614
   Furniture and equipment                                      158,450              148,621
   Marketing equipment                                        1,004,840            1,004,840
   Production equipment                                         461,077              460,118
                                                             ----------          ------------
                                                              3,789,328            3,711,590
   Less accumulated depreciation                             (2,116,896)          (1,866,074)
                                                             ----------          ------------
                                                              1,672,432            1,845,516
Other assets:                                                                   
   Patents                                                      521,829              513,547
   Other assets                                                  16,278               16,833
                                                             ----------          ------------
                                                                538,107              530,380
                                                             ==========          ============
Total assets                                                 $9,480,332          $12,564,529
                                                             ==========          ============
                                                                                
Liabilities and shareholders' equity
Current liabilities:                       
   Accounts payable                                          $  208,880          $   353,563
   Employee compensation                                        465,200              441,917
   Other liabilities and accrued expenses                         3,912               29,714
   Obligations under capital lease, current portion             274,670              260,319
                                                             ----------          ------------
Total current liabilities                                       952,662            1,085,513
                                                                                
Obligations under capital lease, less current portion           470,113              494,909
                                                                                
Shareholders' equity                                                            
Convertible Preferred Stock, par value $.01 per share:                          
   Authorized shares--5,000,000 
Common Stock, par value $.01 per share:                                                  
   Authorized shares--30,000,000                                                
   Issued and outstanding shares 1999--8,841,123 and                            
     1998--8,829,401                                             88,411               88,294
Additional paid-in capital                                   69,332,400           69,317,467
Accumulated deficit                                         (61,330,660)         (58,366,050)
Deferred compensation                                           (32,594)             (55,604)
                                                             ----------          ------------
Total shareholders' equity                                    8,057,557           10,984,107
                                                             ==========          ============
Total liabilities and shareholders' equity                   $9,480,332          $12,564,529
                                                             ==========          ============
</TABLE>
                                                                            
Note: The balance sheet at December 31, 1998 has been derived from the audited
financial statements at that date but does not include all of the information
and footnotes required by generally accepted accounting principles for complete
financial statements.

See accompanying notes.

                                       2
<PAGE>
 
                          Optical Sensors Incorporated

                            Statements of Operations
                                   (Unaudited)




<TABLE>
<CAPTION>
                                                              Three Months Ended
                                                          March 31,          March 31,
                                                            1999               1998
                                                       ------------       ------------
<S>                                                    <C>                <C>        
Net Sales                                              $    59,960        $   165,373
Cost of goods sold                                         745,088            557,371
                                                       ------------       ------------
Gross Margin                                              (685,128)          (391,998)

Operating Expenses:
   Research and development expenses                       968,775            974,515
   Selling, general and administrative expenses          1,362,131          1,508,351
                                                       ------------       ------------
Operating loss                                          (3,016,034)        (2,874,864)

Interest expense                                           (23,665)           (22,628)
Interest income                                             74,425            228,271
Other  income                                                  664                257
                                                       ------------       ------------
                                                            51,424            205,900
                                                       ------------       ------------

Net loss                                               $(2,964,610)       $(2,668,964)
                                                       ============       ============

Net loss per common share:
Basic and diluted                                      $      (.34)       $      (.31)
                                                       ============       ============

Shares used in calculation of net loss per share         8,837,932          8,718,090
                                                       ============       ============
</TABLE>


See accompanying notes.


                                       3
<PAGE>
 
                          Optical Sensors Incorporated

                            Statements of Cash Flows

                                  (Unaudited)

<TABLE>
<CAPTION>
                                                                      Three Months Ended
                                                                  March 31,      March 31,
                                                                    1999           1998
                                                                 -----------    ----------
<S>                                                              <C>           <C>         
Operating activities
Net loss                                                         $(2,964,610)  $(2,668,964)
Adjustments to reconcile net loss to net cash used in
   operating activities:
     Depreciation and amortization                                   294,860       210,813
     Deferred compensation amortization                               23,010        41,547
     Amortization of warrants in connection with debt and lease
       financings                                                      2,775         4,321
     Changes in operating assets and liabilities:
         Receivables                                                 121,509       (65,765)
         Inventories                                                 110,826      (192,293)
       Prepaid expenses and other assets                             (26,818)     (160,562)
       Accounts payable and accrued expenses                        (147,202)       90,769
                                                                 -----------    ----------
Net cash used in operating activities                             (2,585,650)   (2,740,134)

Investing activities
Purchases of property and equipment                                  (22,253)     (139,222)
                                                                 -----------    ----------
Net cash used in investing activities                                (22,523)     (139,222)


Financing activities
Net proceeds from issuance of Common Stock                            12,275     2,218,534
Proceeds (payments) on long-term debt and lease obligations          (65,930)      (42,181)
                                                                 -----------    ----------
Net cash provided by (used in) financing activities                  (53,655)    2,176,353
                                                                 -----------    ----------

(Decrease) in cash and cash equivalents                           (2,661,558)     (703,003)
Cash and cash equivalents at beginning of period                   8,079,871    17,101,130
                                                                 ===========    ==========
Cash and cash equivalents at end of period                       $ 5,418,313   $16,398,127
                                                                 ===========    ==========
</TABLE>

Supplementary Disclosure of Non-Cash Transactions: During the three months ended
March 31,1999 and March 31,1998, the Company acquired property and equipment of
$55,485 and $95,509, respectively, under capital lease obligations.

See accompanying notes.

                                       4
<PAGE>
 
                          Optical Sensors Incorporated

                          Notes to Financial Statements
                                   (Unaudited)

                                 March 31, 1999

Note A - Basis of Presentation

The accompanying unaudited condensed financial statements have been prepared in
accordance with generally accepted accounting principles for interim financial
information and with the instructions to Form 10-Q and Article 10 of Regulation
S-X. Accordingly, they do not include all of the information and footnotes
required by generally accepted accounting principles for complete financial
statements. In the opinion of management, all adjustments (consisting of normal
recurring accruals) considered necessary for a fair presentation have been
included. Operating results for the three month period ended March 31, 1999 are
not necessarily indicative of the results that may be expected for the year
ending December 31, 1999. For further information, refer to the financial
statements and footnotes thereto included in the Optical Sensors Incorporated
Annual Report on Form 10-K for the year ended December 31, 1998. Certain
reclassifications of 1998 amounts have been made to conform with the 1999
presentation.

Note B - Net Loss Per Share

Basic and diluted net loss per common share is computed using the weighted
average number of common shares outstanding during the period. Options and
warrants were outstanding during the quarters ended March 31, 1999 and 1998, but
were not included in the computation of diluted net loss per common share
because the effect would be antidilutive. All earnings per share amounts for all
periods have been presented, and where necessary, restated to conform to the
Statement 128 requirements.


                                       5
<PAGE>
 
Management's Discussion and Analysis of Financial Condition and Results of
Operations

Overview

Since October 1998, Optical Sensors Incorporated (the "Company"), has been
focussing its resources on development and commercialization of the CapnoProbe,
which is a handheld device with a carbon dioxide ("CO2") probe that is slipped
under the tongue like a thermometer. It non-invasively measures the tissue CO2
of the mucous membrane in the mouth - a sensitive measure that can indicate
early clinical shock, even when traditional vital signs may still appear
relatively normal, as in compensated shock cases. Generalized inadequacy of
tissue perfusion is the hallmark of clinical shock. Diagnosis of shock may be
difficult in its early stages when the signs and symptoms are masked by the
body's natural compensatory mechanisms that preserve blood supply to vital
organs by reducing blood flow to other organs. If treatment is delayed to the
point that the body's compensatory systems can no longer maintain adequate
circulation and vital tissue perfusion, the consequences can be disastrous for
the patient. To date, there has been no rapid, low-cost, noninvasive method to
objectively determine when a patient has inadequate tissue perfusion and is in
early shock.

In December 1998, the Company filed a 510(k) application for FDA clearance of
the CapnoProbe as a Class II medical device. Prototype versions of the
CapnoProbe system are currently being evaluated at clinical sites in the United
States. The Company has completed set up of one manufacturing pod for manual
assembly of the prototype probes and finished preliminary plans for automated
probe assembly. The Company currently estimates that the CapnoProbe product will
be available for commercialization in the first quarter of 2000.

Prior to January 1999, the Company had also been actively marketing its
SensiCath system, a patient-connected, on-demand arterial blood gas ("ABG")
monitoring system, which provides precise and accurate ABG results within 60
seconds without exposure to potentially infectious blood or depleting the
patient's blood supply (the "SensiCath System"). ABG tests measure oxygen,
carbon dioxide and acid-base in a sample of blood taken from a patient's artery.
Because of the Company's need to conserve resources, in January 1999, the
Company significantly reduced its workforce, suspended direct sales activities
and product cost reduction programs for the SensiCath System and reduced
associated expenses. The Company recognized approximately $300,000 in employee
severance costs for the first quarter of 1999 related to the workforce
reduction. The Company also exercised its right to convert Instrumentation
Laboratory Company ("IL") to a non-exclusive distributor of the SensiCath System
in January 1999, and is currently pursuing termination of the IL distribution
agreement. Since that time, IL has not placed any material orders for the
SensiCath, and the only sales of the SensiCath have been to existing customers
who have continued to order SensiCath sensors. Accordingly, the Company does not
expect meaningful sales of the SensiCath System in the future. The Company
currently has approximately 30 employees.


                                       6
<PAGE>
 
In January 1999, the Company also announced that it had engaged Volpe Brown
Whelan & Company, LLC, to serve as financial advisor to the Company. The Company
is working with Volpe Brown Whelan to explore strategic alternatives. Currently,
the Company is actively pursuing a sale of the Company as a whole, as well as
the separate sale of its two product lines and its intellectual property
portfolio.


Results of Operations

Net sales in the first quarter of 1999 decreased $105,413 or 64% from $165,373
in the first quarter in 1998 to $59,960 in the first quarter of 1999. The
decrease in sales is the result of OSI's suspension of direct sales and support
activities of the SensiCath System in January 1999. Sales for the quarter
consisted of SensiCath disposable products ordered by existing customers. No new
customer sales were made nor were any OpticalCAM instruments sold during the
quarter. The Company did not receive any material orders from IL in the quarter
and does not expect meaningful sales of the SensiCath System in the future.

Costs of products sold in the first quarter of 1999 increased $187,717 to
$745,088 or 34% from $557,371 in the first quarter in 1998. The increased cost
of products sold was directly related to decreased cost absorption into
inventories, costs for suspension of production activities and layoffs of
personnel. Manufacturing personnel levels were reduced by 62% during the first
quarter of 1999. Remaining fixed overhead costs and costs of personnel that
remain in support of CapnoProbe activities and maintenance of SensiCath
technologies are expected to average approximately $500,000 per quarter for the
foreseeable future.


Research and development costs for the first quarter of 1999 decreased $5,740 to
$968,775 or 1% from $974,515 in the first quarter of 1998. Research and
development efforts during the quarter were directed towards product development
and regulatory activities for the CapnoProbe. Research and development staffing
was reduced by approximately 25% in the first quarter of 1999. However, outside
CapnoProbe development costs are expected to offset personnel savings until the
fourth quarter of 1999. Accordingly, research and development expenses are
expected to remain at approximately the same levels for the next several
quarters as CapnoProbe development efforts are completed. The Company
anticipates that research and development expenses will decline by the fourth
quarter of 1999 by approximately an additional 15%, primarily due to a reduction
in personnel. Under the July 1998 license agreement with ICCM, the Company
expects to pay $300,000 in minimum royalties in 1999. The minimum royalty
payments will be recorded as research and development expenses because no
CapnoProbe sales are anticipated in 1999. The Company is obligated to pay ICCM a
customary royalty equal to a percentage of sales, which varies depending on the
selling price to the customer of the CapnoProbe. However, the Company does not
currently expect to have any commercial sales of the CapnoProbe in 1999.



                                       7
<PAGE>
 
Selling, general and administrative expenses in the first quarter of 1999
decreased $146,220 or 10% to $1,362,131 from $1,508,351 in the first quarter of
1998. Substantially all sales and marketing activities related to the SensiCath
product line were suspended during the first quarter of 1999. Accordingly, the
Company expects selling, general and administrative expenses to decrease by up
to 50% for the balance of 1999, not including expenses which might result from
its activities in securing a corporate merger, distribution partner or sale of a
portion or all of the Company. Selling, general and administrative expenses
consist primarily of the cost of CapnoProbe marketing clinical activities,
ongoing administrative activities and costs of maintaining the Company's public
status.

Net interest income in the first quarter of 1999 decreased $154,883 to $50,760
from $205,643 in the first quarter of 1998. The decrease in net interest income
in the first quarter of 1999 is due to declining cash balances. The Company
expects interest income to continue to decline in future periods as it uses cash
for operations.

Since its inception, the Company has experienced significant operating losses.
The Company incurred a net loss of $2,964,610 for the quarter ended March 31,
1999, compared to a net loss of $2,668,964 for the quarter ended March 31, 1998.
As of March 31, 1999, the Company had an accumulated deficit of $61,330,660. The
Company anticipates that its operating losses will continue for the foreseeable
future. Except for historical information contained herein, the disclosures in
this report are forward looking statements. See "Certain Important Factors".


Liquidity and Capital Resources

To date, the Company has financed its operations primarily through the sale of
equity securities. From inception through December 31, 1995, the Company raised
net proceeds of $30,400,000 from private equity financings and stock option
exercises. In the first quarter of 1996, the Company completed an initial public
offering of 2,875,000 shares of Common Stock. The net proceeds to the Company
from the public offering were approximately $33,916,000. In January 1998, the
Company sold 441,203 shares of Common Stock to IL, which represented 4.99% of
the Company's outstanding Common Stock following completion of the transaction,
at a price of $5.00 per share (which is equal to the closing market price on the
date before signing of the agreement) for a total price of $2,206,015. The
proceeds from the sales of stock have been used to fund costs of producing
products and for the operating expenses described above and capital expenditures
described below. The Company's Common Stock is quoted on the Nasdaq National
Market under the symbol "OPSI."

The Company granted IL and its affiliates certain pre-emptive rights to
participate in future sales of equity securities by the Company, and certain
demand and incidental registration rights under a registration rights agreement
previously entered into by the Company and shareholders that purchased shares of
stock in private transactions prior to the Company's initial public offering in
February 1996. IL is prohibited from selling or otherwise transferring its
shares of Common Stock for a period of one year, except to an affiliate or
pursuant to the exercise of its registration 


                                       8
<PAGE>
 
rights. IL and its affiliates are also subject to certain standstill provisions
for a period of five years that prohibit them from (a) acquiring more than 5.0%
of the Company's outstanding Common Stock, (b) entering into a voting agreement
with respect to the shares IL purchased from the Company, (c) participating in
any proxy solicitation or becoming a participant in an election contest, or (d)
joining a group for the purpose of acquiring, holding, voting or disposing of
shares of Common Stock.


The Company's cash and cash equivalents were $5,418,313 and $8,079,871 at March
31, 1999 and December 31, 1998, respectively. The decrease in the Company's cash
balance is due to the operating losses described above. The Company incurred
cash expenditures for the three months ended March 31, 1999 of $2,585,650 for
operations and $22,253 for capital expenditures. A substantial portion of the
inventory level at March 31, 1999 consisted of key components, OpticalCAM
monitors and ABG Modules for which the Company relies on sole suppliers.

The Company has contracts to purchase minimum quantities of instrumentation and
other sole source inventory items with an outstanding aggregate commitment of
approximately $900,000 in 1999 and 2000. The Company also has a potential
$500,000 obligation payable to Marquette Medical Systems, Inc. under a
previously disclosed technology purchase agreement. As of March 31, 1998, the
Company had no material commitments outstanding for tooling and equipment.

The Company believes that sufficient liquidity is available to satisfy its
operating needs through 1999. However, the Company anticipates that additional
funding will be necessary to continue operations past 1999. No assurances can be
made that the Company would be able to secure such funding.

SensiCath(R) and OpticalCAM(TM) are trademarks of Optical Sensors Incorporated.


                                       9
<PAGE>
 
Year 2000 Software Performance Exposure

     The Company has determined that the software embedded in the ABG Modules is
Year 2000 compliant and that its major internal information technology systems
are Year 2000 compliant. The Company has ancillary software programs which may
not be Year 2000 compliant. Should any of these programs require replacement,
the Company anticipates that the total cost will not exceed $50,000. The Company
does not believe this amount nor any impact on ongoing information technology
projects will have any material affect on its ongoing operations. The Company
has initiated discussions with its significant suppliers, large customers and
financial institutions to ensure that those parties have appropriate plans to
remediate Year 2000 issues where their systems interface with the Company's
systems or otherwise impact its operations. The Company is assessing the extent
to which its operations are vulnerable should those organizations fail to
properly remediate their computer systems. For those vendors that have not yet
certified year 2000 compliance and which are sole suppliers of critical product
components, the Company plans to have sufficient inventories on hand at the end
of 1999 to support its needs for at least six months. For the Company's
distributor, the Company has the ability to ship product directly to the end
customer and to invoice and collect receivables should it be necessary to do so.
The Company's Year 2000 initiative is being managed by an internal staff. While
the Company believes its planning efforts are adequate to address its Year 2000
concerns, there can be no assurance that the systems of other companies which
may impact the Company's operations will be converted on a timely basis and will
not have a material effect on the Company. The cost of the Year 2000 initiatives
is not expected to be material to the Company's results of operations or
financial position.

Certain Important Factors

     In addition to the factors identified above, there are several important
factors that could cause the Company's actual results to differ materially from
those anticipated by the Company or which are reflected in any forward-looking
statements of the Company. These factors, and their impact on the success of the
Company's operations and its ability to achieve its goals, include the
following:

o    Development and Commercialization of CapnoProbe. The Company's future
     success will depend, in part, on successful development and
     commercialization of the CapnoProbe product. The Company is in the later
     stages of developing and testing prototypes and is currently engaged human
     clinical trials of the CapnoProbe product. The Company has set up one
     manufacturing pod for manual assembly of the prototype probes and finished
     preliminary plans for automated probe assembly. The Company currently
     projects that the product will be available for commercialization in the
     first quarter of 2000. The Company has not yet established commercial
     manufacturing for the CapnoProbe. Accordingly, there can be no assurance
     that the Company will successfully develop a commercial CapnoProbe product.

o    Completion of Corporate Alliance or Business Combination. In January 1999,
     the Company announced that it had engaged Volpe Brown Whelan & Company,
     LLC, to serve 


                                       10
<PAGE>
 
     as financial advisor to the Company. The Company is working with Volpe
     Brown Whelan to explore strategic alternatives, including joint ventures,
     corporate strategic alliances, sale of the business or product lines, or
     other business combinations. The Company's future success will depend on
     its ability to complete such a strategic transaction, and there can be no
     assurance that the Company will be able to complete such a transaction.

o    Nasdaq Listing Requirements. The Company's Common Stock is currently quoted
     on the Nasdaq National Market under the symbol "OPSI." In order to be
     listed on the Nasdaq National Market, the Company must maintain total net
     tangible assets of at least $4.0 million. As of March 31, 1999, the Company
     had total net tangible assets of approximately $8.0 million. In addition,
     the closing bid price for the Company's Common Stock cannot be less than
     $1.00 per share for thirty consecutive days. If, in the future, the Company
     had less than $4.0 million in total net tangible assets but more than $2.0
     million in total net tangible assets, the Company's Common Stock would be
     eligible for quotation on the Nasdaq Small Cap Market, provided that the
     $1.00 minimum bid price requirement was met. If the Common Stock were not
     eligible for either the Nasdaq National Market or the Nasdaq Small Cap
     Market it would likely be quoted in the "over-the-counter" market and
     eligible to trade on the OTC bulletin board. If the Company's Common Stock
     traded on the OTC bulletin board, trading, if any, would be subject to the
     "penny stock" rules under the Securities Exchange Act of 1934 as amended,
     and the public trading market for the Company's Common Stock could be
     adversely affected.

o    Competition. Competition among medical device companies is intense and
     increasing. There can be no assurance that the Company's competitors will
     not succeed in developing or marketing technologies and products that are
     more effective or less expensive than the Company's products or that would
     render the Company's products obsolete or non-competitive.

o    Regulatory Approvals. The Company's ability to market its current products
     and any products that it may develop in the future requires clearances or
     approvals from the FDA and other governmental agencies, including, in some
     instances, foreign and state agencies. The process for maintaining and
     obtaining necessary regulatory clearances and approvals can be expensive
     and time consuming. There can be no assurance that the Company will be able
     to maintain or obtain necessary regulatory approvals and clearances in the
     future.




Part II.  Other Information


Item 6.   Exhibits and Reports on Form 8-K


                                       11
<PAGE>
 
(a)    The following exhibit is included herein:

       (27)Financial Data Schedule

(b)    Reports on Form 8-K

       None


                                       12
<PAGE>
 
                                   Signatures


Pursuant to the requirements 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.


                                    OPTICAL SENSORS INCORPORATED



Date  May 6, 1999
                                    --------------------------------------------
                                               /s/ Paulita M. LaPlante
                                        President and Chief Executive Officer
                                            (Principal Executive Officer)


Date  May 6, 1999
                                    --------------------------------------------
                                               /s/ Wesley G. Peterson
                                     Chief Financial Officer, Vice President of
                                      Finance and Administration and Secretary
                                    (Principal Financial and Accounting Officer)



                                       13
[{"type": "10-Q", "sequence": "1", "description": "FORM 10-Q", "secsgml_size_bytes": 35107}]
{"company-data": {"conformed-name": "OPTICAL SENSORS INC", "cik": "0000907658", "assigned-sic": "3841", "irs-number": "411643592", "state-of-incorporation": "DE", "fiscal-year-end": "1231"}, "filing-values": {"form-type": "10-Q", "act": "34", "file-number": "000-27600", "film-number": "99611695"}, "business-address": {"street1": "7615 GOLDEN TRIANGLE DRIVE", "street2": "STE A", "city": "EDEN PRARIE", "state": "MN", "zip": "55344", "phone": "6179445857"}, "mail-address": {"street1": "7615 GOLDEN TRIANGLE DR STE A", "city": "EDEN PRAIRIE", "state": "MN", "zip": "55344"}}
UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                   FORM 10-Q

                                   (Mark One)

[X]  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
     ACT OF 1934 
     For the quarter ended March 31, 1999

                                       or

[ ]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
     EXCHANGE ACT OF 1934 
     For the transition period from _______________ to _______________

                         Commission File Number: 0-27600

                          OPTICAL SENSORS INCORPORATED
             (Exact name of registrant as specified in its charter)

               Delaware                                  41-1643592
     (State of other jurisdiction of                  (I.R.S. Employer
     incorporation or organization)                  Identification No.)

     7615 Golden Triangle Drive, Suite A, Minneapolis, Minnesota 55344-3733
     (Address of principal executive offices)                    (Zip Code)

        Registrant's telephone number, including area code (612) 944-5857

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. [X] Yes [ ] No

     As of May 3, 1999, the Registrant had 8,841,123 shares of Common Stock
outstanding.
Index

                          OPTICAL SENSORS INCORPORATED

Part I.    Financial Information

           Item 1. Financial Statements (Unaudited)

               Balance Sheets - March 31, 1999 and December 31, 1998

               Statements of Operations - Quarters ended March 31, 1999 and
               March 31, 1998

               Statements of Cash Flows - Quarters ended March 31, 1999 and 
               March 31, 1998

               Notes to Financial Statements

           Item 2. Management's Discussion and Analysis of Financial Condition 
                   and Results of Operations

Part II.   Other Information

           Item 6. Exhibits and Reports on Form 8-K

                                       1
Optical Sensors Incorporated

                                 Balance Sheets
March 31, 1999   December 31, 1998
                                                             --------------   -----------------
                                                              (Unaudited)          (Note)
Assets
Current assets:
   Cash and cash equivalents                                 $5,418,313          $ 8,079,871
   Accounts receivable                                           41,349              162,858
   Inventory                                                  1,706,410            1,846,294
   Prepaid expenses and other current assets                    103,721               99,610
                                                             ----------          ------------
Total current assets                                          7,269,793           10,188,633
                                                                                
Property and equipment:                                                         
   Leased Equipment                                           1,073,438            1,017,953
   Research and development equipment                           740,444              740,444
   Leasehold improvements                                       351,079              339,614
   Furniture and equipment                                      158,450              148,621
   Marketing equipment                                        1,004,840            1,004,840
   Production equipment                                         461,077              460,118
                                                             ----------          ------------
                                                              3,789,328            3,711,590
   Less accumulated depreciation                             (2,116,896)          (1,866,074)
                                                             ----------          ------------
                                                              1,672,432            1,845,516
Other assets:                                                                   
   Patents                                                      521,829              513,547
   Other assets                                                  16,278               16,833
                                                             ----------          ------------
                                                                538,107              530,380
                                                             ==========          ============
Total assets                                                 $9,480,332          $12,564,529
                                                             ==========          ============
                                                                                
Liabilities and shareholders' equity
Current liabilities:                       
   Accounts payable                                          $  208,880          $   353,563
   Employee compensation                                        465,200              441,917
   Other liabilities and accrued expenses                         3,912               29,714
   Obligations under capital lease, current portion             274,670              260,319
                                                             ----------          ------------
Total current liabilities                                       952,662            1,085,513
                                                                                
Obligations under capital lease, less current portion           470,113              494,909
                                                                                
Shareholders' equity                                                            
Convertible Preferred Stock, par value $.01 per share:                          
   Authorized shares--5,000,000 
Common Stock, par value $.01 per share:                                                  
   Authorized shares--30,000,000                                                
   Issued and outstanding shares 1999--8,841,123 and                            
     1998--8,829,401                                             88,411               88,294
Additional paid-in capital                                   69,332,400           69,317,467
Accumulated deficit                                         (61,330,660)         (58,366,050)
Deferred compensation                                           (32,594)             (55,604)
                                                             ----------          ------------
Total shareholders' equity                                    8,057,557           10,984,107
                                                             ==========          ============
Total liabilities and shareholders' equity                   $9,480,332          $12,564,529
                                                             ==========          ============
Note: The balance sheet at December 31, 1998 has been derived from the audited
financial statements at that date but does not include all of the information
and footnotes required by generally accepted accounting principles for complete
financial statements.

See accompanying notes.

                                       2
Optical Sensors Incorporated

                            Statements of Operations
                                   (Unaudited)
Three Months Ended
                                                          March 31,          March 31,
                                                            1999               1998
                                                       ------------       ------------
Net Sales                                              $    59,960        $   165,373
Cost of goods sold                                         745,088            557,371
                                                       ------------       ------------
Gross Margin                                              (685,128)          (391,998)

Operating Expenses:
   Research and development expenses                       968,775            974,515
   Selling, general and administrative expenses          1,362,131          1,508,351
                                                       ------------       ------------
Operating loss                                          (3,016,034)        (2,874,864)

Interest expense                                           (23,665)           (22,628)
Interest income                                             74,425            228,271
Other  income                                                  664                257
                                                       ------------       ------------
                                                            51,424            205,900
                                                       ------------       ------------

Net loss                                               $(2,964,610)       $(2,668,964)
                                                       ============       ============

Net loss per common share:
Basic and diluted                                      $      (.34)       $      (.31)
                                                       ============       ============

Shares used in calculation of net loss per share         8,837,932          8,718,090
                                                       ============       ============
See accompanying notes.

                                       3
Optical Sensors Incorporated

                            Statements of Cash Flows

                                  (Unaudited)
Three Months Ended
                                                                  March 31,      March 31,
                                                                    1999           1998
                                                                 -----------    ----------
Operating activities
Net loss                                                         $(2,964,610)  $(2,668,964)
Adjustments to reconcile net loss to net cash used in
   operating activities:
     Depreciation and amortization                                   294,860       210,813
     Deferred compensation amortization                               23,010        41,547
     Amortization of warrants in connection with debt and lease
       financings                                                      2,775         4,321
     Changes in operating assets and liabilities:
         Receivables                                                 121,509       (65,765)
         Inventories                                                 110,826      (192,293)
       Prepaid expenses and other assets                             (26,818)     (160,562)
       Accounts payable and accrued expenses                        (147,202)       90,769
                                                                 -----------    ----------
Net cash used in operating activities                             (2,585,650)   (2,740,134)

Investing activities
Purchases of property and equipment                                  (22,253)     (139,222)
                                                                 -----------    ----------
Net cash used in investing activities                                (22,523)     (139,222)

Financing activities
Net proceeds from issuance of Common Stock                            12,275     2,218,534
Proceeds (payments) on long-term debt and lease obligations          (65,930)      (42,181)
                                                                 -----------    ----------
Net cash provided by (used in) financing activities                  (53,655)    2,176,353
                                                                 -----------    ----------

(Decrease) in cash and cash equivalents                           (2,661,558)     (703,003)
Cash and cash equivalents at beginning of period                   8,079,871    17,101,130
                                                                 ===========    ==========
Cash and cash equivalents at end of period                       $ 5,418,313   $16,398,127
                                                                 ===========    ==========
Supplementary Disclosure of Non-Cash Transactions: During the three months ended
March 31,1999 and March 31,1998, the Company acquired property and equipment of
$55,485 and $95,509, respectively, under capital lease obligations.

See accompanying notes.

                                       4
Optical Sensors Incorporated

                          Notes to Financial Statements
                                   (Unaudited)

                                 March 31, 1999

Note A - Basis of Presentation

The accompanying unaudited condensed financial statements have been prepared in
accordance with generally accepted accounting principles for interim financial
information and with the instructions to Form 10-Q and Article 10 of Regulation
S-X. Accordingly, they do not include all of the information and footnotes
required by generally accepted accounting principles for complete financial
statements. In the opinion of management, all adjustments (consisting of normal
recurring accruals) considered necessary for a fair presentation have been
included. Operating results for the three month period ended March 31, 1999 are
not necessarily indicative of the results that may be expected for the year
ending December 31, 1999. For further information, refer to the financial
statements and footnotes thereto included in the Optical Sensors Incorporated
Annual Report on Form 10-K for the year ended December 31, 1998. Certain
reclassifications of 1998 amounts have been made to conform with the 1999
presentation.

Note B - Net Loss Per Share

Basic and diluted net loss per common share is computed using the weighted
average number of common shares outstanding during the period. Options and
warrants were outstanding during the quarters ended March 31, 1999 and 1998, but
were not included in the computation of diluted net loss per common share
because the effect would be antidilutive. All earnings per share amounts for all
periods have been presented, and where necessary, restated to conform to the
Statement 128 requirements.

                                       5
Management's Discussion and Analysis of Financial Condition and Results of
Operations

Overview

Since October 1998, Optical Sensors Incorporated (the "Company"), has been
focussing its resources on development and commercialization of the CapnoProbe,
which is a handheld device with a carbon dioxide ("CO2") probe that is slipped
under the tongue like a thermometer. It non-invasively measures the tissue CO2
of the mucous membrane in the mouth - a sensitive measure that can indicate
early clinical shock, even when traditional vital signs may still appear
relatively normal, as in compensated shock cases. Generalized inadequacy of
tissue perfusion is the hallmark of clinical shock. Diagnosis of shock may be
difficult in its early stages when the signs and symptoms are masked by the
body's natural compensatory mechanisms that preserve blood supply to vital
organs by reducing blood flow to other organs. If treatment is delayed to the
point that the body's compensatory systems can no longer maintain adequate
circulation and vital tissue perfusion, the consequences can be disastrous for
the patient. To date, there has been no rapid, low-cost, noninvasive method to
objectively determine when a patient has inadequate tissue perfusion and is in
early shock.

In December 1998, the Company filed a 510(k) application for FDA clearance of
the CapnoProbe as a Class II medical device. Prototype versions of the
CapnoProbe system are currently being evaluated at clinical sites in the United
States. The Company has completed set up of one manufacturing pod for manual
assembly of the prototype probes and finished preliminary plans for automated
probe assembly. The Company currently estimates that the CapnoProbe product will
be available for commercialization in the first quarter of 2000.

Prior to January 1999, the Company had also been actively marketing its
SensiCath system, a patient-connected, on-demand arterial blood gas ("ABG")
monitoring system, which provides precise and accurate ABG results within 60
seconds without exposure to potentially infectious blood or depleting the
patient's blood supply (the "SensiCath System"). ABG tests measure oxygen,
carbon dioxide and acid-base in a sample of blood taken from a patient's artery.
Because of the Company's need to conserve resources, in January 1999, the
Company significantly reduced its workforce, suspended direct sales activities
and product cost reduction programs for the SensiCath System and reduced
associated expenses. The Company recognized approximately $300,000 in employee
severance costs for the first quarter of 1999 related to the workforce
reduction. The Company also exercised its right to convert Instrumentation
Laboratory Company ("IL") to a non-exclusive distributor of the SensiCath System
in January 1999, and is currently pursuing termination of the IL distribution
agreement. Since that time, IL has not placed any material orders for the
SensiCath, and the only sales of the SensiCath have been to existing customers
who have continued to order SensiCath sensors. Accordingly, the Company does not
expect meaningful sales of the SensiCath System in the future. The Company
currently has approximately 30 employees.

                                       6
In January 1999, the Company also announced that it had engaged Volpe Brown
Whelan & Company, LLC, to serve as financial advisor to the Company. The Company
is working with Volpe Brown Whelan to explore strategic alternatives. Currently,
the Company is actively pursuing a sale of the Company as a whole, as well as
the separate sale of its two product lines and its intellectual property
portfolio.

Results of Operations

Net sales in the first quarter of 1999 decreased $105,413 or 64% from $165,373
in the first quarter in 1998 to $59,960 in the first quarter of 1999. The
decrease in sales is the result of OSI's suspension of direct sales and support
activities of the SensiCath System in January 1999. Sales for the quarter
consisted of SensiCath disposable products ordered by existing customers. No new
customer sales were made nor were any OpticalCAM instruments sold during the
quarter. The Company did not receive any material orders from IL in the quarter
and does not expect meaningful sales of the SensiCath System in the future.

Costs of products sold in the first quarter of 1999 increased $187,717 to
$745,088 or 34% from $557,371 in the first quarter in 1998. The increased cost
of products sold was directly related to decreased cost absorption into
inventories, costs for suspension of production activities and layoffs of
personnel. Manufacturing personnel levels were reduced by 62% during the first
quarter of 1999. Remaining fixed overhead costs and costs of personnel that
remain in support of CapnoProbe activities and maintenance of SensiCath
technologies are expected to average approximately $500,000 per quarter for the
foreseeable future.

Research and development costs for the first quarter of 1999 decreased $5,740 to
$968,775 or 1% from $974,515 in the first quarter of 1998. Research and
development efforts during the quarter were directed towards product development
and regulatory activities for the CapnoProbe. Research and development staffing
was reduced by approximately 25% in the first quarter of 1999. However, outside
CapnoProbe development costs are expected to offset personnel savings until the
fourth quarter of 1999. Accordingly, research and development expenses are
expected to remain at approximately the same levels for the next several
quarters as CapnoProbe development efforts are completed. The Company
anticipates that research and development expenses will decline by the fourth
quarter of 1999 by approximately an additional 15%, primarily due to a reduction
in personnel. Under the July 1998 license agreement with ICCM, the Company
expects to pay $300,000 in minimum royalties in 1999. The minimum royalty
payments will be recorded as research and development expenses because no
CapnoProbe sales are anticipated in 1999. The Company is obligated to pay ICCM a
customary royalty equal to a percentage of sales, which varies depending on the
selling price to the customer of the CapnoProbe. However, the Company does not
currently expect to have any commercial sales of the CapnoProbe in 1999.

                                       7
Selling, general and administrative expenses in the first quarter of 1999
decreased $146,220 or 10% to $1,362,131 from $1,508,351 in the first quarter of
1998. Substantially all sales and marketing activities related to the SensiCath
product line were suspended during the first quarter of 1999. Accordingly, the
Company expects selling, general and administrative expenses to decrease by up
to 50% for the balance of 1999, not including expenses which might result from
its activities in securing a corporate merger, distribution partner or sale of a
portion or all of the Company. Selling, general and administrative expenses
consist primarily of the cost of CapnoProbe marketing clinical activities,
ongoing administrative activities and costs of maintaining the Company's public
status.

Net interest income in the first quarter of 1999 decreased $154,883 to $50,760
from $205,643 in the first quarter of 1998. The decrease in net interest income
in the first quarter of 1999 is due to declining cash balances. The Company
expects interest income to continue to decline in future periods as it uses cash
for operations.

Since its inception, the Company has experienced significant operating losses.
The Company incurred a net loss of $2,964,610 for the quarter ended March 31,
1999, compared to a net loss of $2,668,964 for the quarter ended March 31, 1998.
As of March 31, 1999, the Company had an accumulated deficit of $61,330,660. The
Company anticipates that its operating losses will continue for the foreseeable
future. Except for historical information contained herein, the disclosures in
this report are forward looking statements. See "Certain Important Factors".

Liquidity and Capital Resources

To date, the Company has financed its operations primarily through the sale of
equity securities. From inception through December 31, 1995, the Company raised
net proceeds of $30,400,000 from private equity financings and stock option
exercises. In the first quarter of 1996, the Company completed an initial public
offering of 2,875,000 shares of Common Stock. The net proceeds to the Company
from the public offering were approximately $33,916,000. In January 1998, the
Company sold 441,203 shares of Common Stock to IL, which represented 4.99% of
the Company's outstanding Common Stock following completion of the transaction,
at a price of $5.00 per share (which is equal to the closing market price on the
date before signing of the agreement) for a total price of $2,206,015. The
proceeds from the sales of stock have been used to fund costs of producing
products and for the operating expenses described above and capital expenditures
described below. The Company's Common Stock is quoted on the Nasdaq National
Market under the symbol "OPSI."

The Company granted IL and its affiliates certain pre-emptive rights to
participate in future sales of equity securities by the Company, and certain
demand and incidental registration rights under a registration rights agreement
previously entered into by the Company and shareholders that purchased shares of
stock in private transactions prior to the Company's initial public offering in
February 1996. IL is prohibited from selling or otherwise transferring its
shares of Common Stock for a period of one year, except to an affiliate or
pursuant to the exercise of its registration 

                                       8
rights. IL and its affiliates are also subject to certain standstill provisions
for a period of five years that prohibit them from (a) acquiring more than 5.0%
of the Company's outstanding Common Stock, (b) entering into a voting agreement
with respect to the shares IL purchased from the Company, (c) participating in
any proxy solicitation or becoming a participant in an election contest, or (d)
joining a group for the purpose of acquiring, holding, voting or disposing of
shares of Common Stock.

The Company's cash and cash equivalents were $5,418,313 and $8,079,871 at March
31, 1999 and December 31, 1998, respectively. The decrease in the Company's cash
balance is due to the operating losses described above. The Company incurred
cash expenditures for the three months ended March 31, 1999 of $2,585,650 for
operations and $22,253 for capital expenditures. A substantial portion of the
inventory level at March 31, 1999 consisted of key components, OpticalCAM
monitors and ABG Modules for which the Company relies on sole suppliers.

The Company has contracts to purchase minimum quantities of instrumentation and
other sole source inventory items with an outstanding aggregate commitment of
approximately $900,000 in 1999 and 2000. The Company also has a potential
$500,000 obligation payable to Marquette Medical Systems, Inc. under a
previously disclosed technology purchase agreement. As of March 31, 1998, the
Company had no material commitments outstanding for tooling and equipment.

The Company believes that sufficient liquidity is available to satisfy its
operating needs through 1999. However, the Company anticipates that additional
funding will be necessary to continue operations past 1999. No assurances can be
made that the Company would be able to secure such funding.

SensiCath(R) and OpticalCAM(TM) are trademarks of Optical Sensors Incorporated.

                                       9
Year 2000 Software Performance Exposure

     The Company has determined that the software embedded in the ABG Modules is
Year 2000 compliant and that its major internal information technology systems
are Year 2000 compliant. The Company has ancillary software programs which may
not be Year 2000 compliant. Should any of these programs require replacement,
the Company anticipates that the total cost will not exceed $50,000. The Company
does not believe this amount nor any impact on ongoing information technology
projects will have any material affect on its ongoing operations. The Company
has initiated discussions with its significant suppliers, large customers and
financial institutions to ensure that those parties have appropriate plans to
remediate Year 2000 issues where their systems interface with the Company's
systems or otherwise impact its operations. The Company is assessing the extent
to which its operations are vulnerable should those organizations fail to
properly remediate their computer systems. For those vendors that have not yet
certified year 2000 compliance and which are sole suppliers of critical product
components, the Company plans to have sufficient inventories on hand at the end
of 1999 to support its needs for at least six months. For the Company's
distributor, the Company has the ability to ship product directly to the end
customer and to invoice and collect receivables should it be necessary to do so.
The Company's Year 2000 initiative is being managed by an internal staff. While
the Company believes its planning efforts are adequate to address its Year 2000
concerns, there can be no assurance that the systems of other companies which
may impact the Company's operations will be converted on a timely basis and will
not have a material effect on the Company. The cost of the Year 2000 initiatives
is not expected to be material to the Company's results of operations or
financial position.

Certain Important Factors

     In addition to the factors identified above, there are several important
factors that could cause the Company's actual results to differ materially from
those anticipated by the Company or which are reflected in any forward-looking
statements of the Company. These factors, and their impact on the success of the
Company's operations and its ability to achieve its goals, include the
following:

o    Development and Commercialization of CapnoProbe. The Company's future
     success will depend, in part, on successful development and
     commercialization of the CapnoProbe product. The Company is in the later
     stages of developing and testing prototypes and is currently engaged human
     clinical trials of the CapnoProbe product. The Company has set up one
     manufacturing pod for manual assembly of the prototype probes and finished
     preliminary plans for automated probe assembly. The Company currently
     projects that the product will be available for commercialization in the
     first quarter of 2000. The Company has not yet established commercial
     manufacturing for the CapnoProbe. Accordingly, there can be no assurance
     that the Company will successfully develop a commercial CapnoProbe product.

o    Completion of Corporate Alliance or Business Combination. In January 1999,
     the Company announced that it had engaged Volpe Brown Whelan & Company,
     LLC, to serve 

                                       10
as financial advisor to the Company. The Company is working with Volpe
     Brown Whelan to explore strategic alternatives, including joint ventures,
     corporate strategic alliances, sale of the business or product lines, or
     other business combinations. The Company's future success will depend on
     its ability to complete such a strategic transaction, and there can be no
     assurance that the Company will be able to complete such a transaction.

o    Nasdaq Listing Requirements. The Company's Common Stock is currently quoted
     on the Nasdaq National Market under the symbol "OPSI." In order to be
     listed on the Nasdaq National Market, the Company must maintain total net
     tangible assets of at least $4.0 million. As of March 31, 1999, the Company
     had total net tangible assets of approximately $8.0 million. In addition,
     the closing bid price for the Company's Common Stock cannot be less than
     $1.00 per share for thirty consecutive days. If, in the future, the Company
     had less than $4.0 million in total net tangible assets but more than $2.0
     million in total net tangible assets, the Company's Common Stock would be
     eligible for quotation on the Nasdaq Small Cap Market, provided that the
     $1.00 minimum bid price requirement was met. If the Common Stock were not
     eligible for either the Nasdaq National Market or the Nasdaq Small Cap
     Market it would likely be quoted in the "over-the-counter" market and
     eligible to trade on the OTC bulletin board. If the Company's Common Stock
     traded on the OTC bulletin board, trading, if any, would be subject to the
     "penny stock" rules under the Securities Exchange Act of 1934 as amended,
     and the public trading market for the Company's Common Stock could be
     adversely affected.

o    Competition. Competition among medical device companies is intense and
     increasing. There can be no assurance that the Company's competitors will
     not succeed in developing or marketing technologies and products that are
     more effective or less expensive than the Company's products or that would
     render the Company's products obsolete or non-competitive.

o    Regulatory Approvals. The Company's ability to market its current products
     and any products that it may develop in the future requires clearances or
     approvals from the FDA and other governmental agencies, including, in some
     instances, foreign and state agencies. The process for maintaining and
     obtaining necessary regulatory clearances and approvals can be expensive
     and time consuming. There can be no assurance that the Company will be able
     to maintain or obtain necessary regulatory approvals and clearances in the
     future.

Part II.  Other Information

Item 6.   Exhibits and Reports on Form 8-K

                                       11
(a)    The following exhibit is included herein:

       (27)Financial Data Schedule

(b)    Reports on Form 8-K

       None

                                       12
Signatures

Pursuant to the requirements 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.

                                    OPTICAL SENSORS INCORPORATED

Date  May 6, 1999
                                    --------------------------------------------
                                               /s/ Paulita M. LaPlante
                                        President and Chief Executive Officer
                                            (Principal Executive Officer)

Date  May 6, 1999
                                    --------------------------------------------
                                               /s/ Wesley G. Peterson
                                     Chief Financial Officer, Vice President of
                                      Finance and Administration and Secretary
                                    (Principal Financial and Accounting Officer)

                                       13