<PAGE>
 
                          UNITED STATESUNITED 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 SEPTEMBER 30, 1997

                                       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 OCTOBER 30, 1997, THE REGISTRANT HAD 8,386,250 SHARES OF COMMON STOCK
                                  OUTSTANDING.
<PAGE>
 
                                     INDEX


                         OPTICAL SENSORS INCORPORATED



PART I.  FINANCIAL INFORMATION

         ITEM 1.  FINANCIAL STATEMENTS (UNAUDITED)

           Balance Sheets - September 30, 1997 and December 31, 1996

           Statements of Operations - Three months ended September 30, 1997 and
                                      1996
                                      Nine months ended September 30, 1997 and
                                      1996

           Statements of Cash Flows - Nine months ended September 30, 1997 and
                                      1996

           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
                         (A Development Stage Company)

                                 Balance Sheets

<TABLE>
<CAPTION>
                                                              SEPTEMBER 30,        DECEMBER 31, 
                                                                   1997                1996    
                                                            -----------------------------------
                                                               (Unaudited)            (Note)   
<S>                                                         <C>                    <C>         
ASSETS                                                                                         
Current assets:                                                                                
  Cash and cash equivalents                                    $ 19,574,431        $ 30,134,800
  Accounts receivable                                                49,538              91,040
  Inventories                                                     1,758,870             931,917
  Prepaid expenses and other current assets                         254,593             200,731
                                                            -----------------------------------
Total current assets                                             21,637,432          31,358,488
                                                                                               
Property and equipment:                                                                        
  Equipment under capital lease                                     255,942                 ---
  Research and development equipment                                427,141             292,488
  Leasehold improvements                                            255,890             199,211
  Furniture and equipment                                           105,708              77,895
  Marketing equipment                                               805,440             344,448
  Production equipment                                              249,066             167,635
                                                            -----------------------------------
                                                                  2,099,187           1,081,677
  Less accumulated depreciation                                    (799,265)           (488,043
                                                            -----------------------------------
                                                                  1,299,922             593,634
Other assets:                                                                                  
  Patents                                                           424,961             328,630
  Other assets                                                       79,425              88,445
                                                            -----------------------------------
                                                                    504,386             417,075
                                                            -----------------------------------
Total assets                                                   $ 23,441,740        $ 32,369,197
                                                            ===================================
                                                                                               
LIABILITIES AND SHAREHOLDERS' EQUITY                                                           
Current liabilities:                                                                           
   Accounts payable                                            $    442,853        $    740,804
   Employee compensation                                            362,956             577,228
   Other liabilities and accrued expenses                             2,340               1,541
   Current portion of long term debt                                 53,242                 ---
                                                            -----------------------------------
Total current liabilities                                           861,391           1,319,573
                                                                                               
Long-term debt, net current maturities                              188,644                 ---
                                                                                               
Commitments                                                                                    
                                                                                               
SHAREHOLDERS' EQUITY                                                                           
Convertible Preferred Stock, par value $.01         
 per share:                                                                                    
     Authorized shares--5,000,000                                                                   
     Issued and outstanding shares-- 0                                  ---                 ---
Common Stock, par value $.01 per share:                                                        
  Authorized shares--30,000,000                                                                
  Issued and outstanding shares 1997--8,386,250 and                                            
   1996--8,341,497                                                   83,863              83,415
Additional paid-in capital                                       67,054,945          66,974,345
Deficit accumulated during the development stage                (44,198,815)        (35,215,362
Deferred compensation                                              (303,288)           (547,774
Note receivable from officer                                       (245,000)           (245,000
                                                            -----------------------------------
Total shareholders' equity                                       22,391,705          31,049,624
                                                            -----------------------------------
Total liabilities and shareholders' equity                     $ 23,441,740        $ 32,369,197
                                                            =================================== 
</TABLE>

Note:  The balance sheet at December 31, 1996 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
                         (A Development Stage Company)

                           Statements of Operations
                                  (Unaudited)

<TABLE>
<CAPTION>
                                                                                                              CUMULATIVE    
                                                                                                             MAY 23, 1989  
                                                        THREE MONTHS ENDED          NINE MONTHS ENDED       (INCEPTION) TO 
                                                           SEPTEMBER 30                SEPTEMBER 30          SEPTEMBER 30, 
                                                  -------------------------------------------------------                  
                                                        1997          1996          1997          1996           1997      
                                                  ------------------------------------------------------------------------ 
<S>                                                 <C>           <C>           <C>           <C>             <C>          
Net sales                                           $    23,840   $    51,330   $   104,406   $    98,251     $    267,474 
Cost of good sold                                       928,901       335,663     1,850,523       991,913        3,219,744 
                                                  ------------------------------------------------------------------------ 
Gross margin                                           (905,061)     (284,333)   (1,746,117)     (893,662)      (2,952,270)
                                                                                                                           
Operating  expenses:                                                                                                       
  Research and development                            1,066,785     1,288,373     4,023,963     4,422,422       29,046,829 
  Selling, general and administrative                 1,350,405     1,152,491     4,209,586     2,759,593       15,230,545 
                                                  ------------------------------------------------------------------------ 
Operating loss                                       (3,322,251)   (2,725,197)   (9,979,666)   (8,075,677)     (47,229,644)
                                                                                                                           
Interest expense                                         (5,565)          ---        (5,565)          ---         (146,950)
Interest income                                         292,411       449,438     1,001,775     1,131,962        3,177,779 
                                                  ------------------------------------------------------------------------
                                                                                                                           
Net loss                                            $(3,035,405)  $(2,275,759)  $(8,983,456)  $(6,943,715)    $(44,198,815)
                                                  ========================================================================
                                                                                                                           
Net loss per common share                                 $(.36)        $(.27)       $(1.07)       $(1.02)                 
                                                  =======================================================                  
                                                                                                                           
Shares used in calculation of net loss per share      8,382,297     8,307,346     8,369,151     6,827,056                  
                                                  =======================================================                   
</TABLE>

See accompanying notes.

                                       3
<PAGE>
 
                          Optical Sensors Incorporated
                         (A Development Stage Company)

                            Statements of Cash Flows
                                  (Unaudited)

<TABLE>
<CAPTION>
                                                                                                               CUMULATIVE   
                                                                                                              MAY 23, 1989 
                                                                                     NINE MONTHS ENDED       (INCEPTION) TO
                                                                                       SEPTEMBER 30           SEPTEMBER 30,
                                                                                    1997           1996           1997       
                                                                                ------------------------------------------- 
<S>                                                                             <C>            <C>           <C>            
OPERATING ACTIVITIES                                                                                                        
Net loss                                                                        $ (8,983,456)  $(6,943,715)    $(44,198,815)
Adjustments to reconcile net loss to net cash used in                                                                       
 operating activities:                                                                                                      
     Loss on write-off of research and development equipment                                                        133,919 
     Loss on write-off of prepaid royalties                                                                         135,201 
     Write-down of Inventory                                                         500,000                        500,000 
     Depreciation and amortization                                                   325,210        80,436          960,114 
     Amortization of deferred loss on sale leaseback                                                                 11,196 
     Deferred compensation amortization                                              244,486       467,587        1,876,405 
     License fee financed with long-term debt                                                                       193,700 
     Issuance of Common Stock for services                                                                           37,091 
     Issuance of Common Stock in lieu of interest payments on                                                               
      notes payable                                                                                                  35,412 
     Issuance of warrants in connection with debt and lease                                                                 
      financings                                                                      13,574         3,016           77,671 
     Issuance of options in connection with consulting services                                                      55,690 
     Changes in operating assets and liabilities:                                                                           
         Accounts receivable                                                          41,502       (69,017)         (49,538)
         Inventories                                                              (1,326,953)     (598,294)      (2,258,870)
         Prepaid expenses and other assets                                          (155,158)      191,513         (772,555)
         Accounts payable and accrued expenses                                      (511,424)      430,761          808,149 
                                                                                ------------------------------------------- 
     Net cash used in operating activities                                        (9,852,219)   (6,437,713)     (42,455,230)
                                                                                                                            
INVESTING ACTIVITIES                                                                                                        
Proceeds from disposal of equipment                                                                                  46,947 
Purchases of property and equipment                                               (1,017,510)      (80,227)      (2,722,039)
                                                                                -------------------------------------------
Net cash used in investing activities                                             (1,017,510)      (80,227)      (2,675,092)
                                                                                                                            
FINANCING ACTIVITIES                                                                                                        
Proceeds from sale leaseback                                                                                        283,030 
Net proceeds from issuance of Common Stock                                            67,474    34,001,096       35,112,150 
Net proceeds from issuance of Preferred Stock                                                                    27,290,155 
Reimbursement to founder and shareholder                                                                             (3,500)
Reductions on long-term debt                                                         (14,056)                    (1,410,950)
Proceeds from notes payable                                                          255,942                      3,433,868 
                                                                                -------------------------------------------
Net cash provided by financing activities                                            309,360    34,001,096       64,704,753 
                                                                                ------------------------------------------- 
                                                                                                                            
Increase (decrease) in cash and cash equivalents                                 (10,560,369)   27,483,156       19,574,431 
Cash and cash equivalents at beginning of period                                  30,134,800     5,394,721              --- 
                                                                                ------------------------------------------- 
Cash and cash equivalents at end of period                                      $ 19,574,431   $32,877,877     $ 19,574,431 
                                                                                ------------------------------------------- 
</TABLE>

See accompanying notes.

                                       4
<PAGE>
 
                          Optical Sensors Incorporated
                         (A Development Stage Company)

                            Statements of Cash Flows
                                  (Unaudited)


                              September 30, 1997


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 and nine month periods ended September
30, 1997 are not necessarily indicative of the results that may be expected for
the year ended December 31, 1997. For further information, refer to the
financial statements and footnotes thereto included in the Optical Sensors
Incorporated 1996 Annual Report to Shareholders incorporated by reference into
the Annual Report on Form 10-K for the year ended December 31, 1996.

NOTE B - NET LOSS PER SHARE

Net loss per share is computed using the weighted average number of common
shares outstanding during the period.  Common equivalent shares from stock
options and warrants are excluded from the computation as their effect is
antidilutive.  In February 1997, the Financial Accounting Standards Board (FASB)
issued FASB Statement No. 128, "Earnings Per Share."  This Statement replaces
the presentation of primary earnings per share (EPS) with basic EPS and also
requires dual presentation of basic and diluted EPS for entities with complex
capital structures.  This Statement is effective for the fiscal year ended
December 31, 1997.  For the three and the nine month periods ended September 30,
1997, there is no difference between basic earnings per share under Statement
No. 128 and net loss per share as reported.

                                       5
<PAGE>
 
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS

OVERVIEW

Optical Sensors Incorporated (the "Company") has developed the SensiCath System,
a patient-attached, 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").  The SensiCath System utilizes a disposable,
fiberoptic sensor device (the "SensiCath Sensor") connected to a small modular
instrument that can be configured to integrate with bedside monitoring systems
or to serve as a stand-alone monitor.

The SensiCath System is currently available in two configurations.  The first
configuration of the SensiCath System combines the SensiCath Sensor with a
module (the "OnlineABG Module") that plugs into bedside monitors manufactured by
Marquette Medical Systems, Inc. ("Marquette").  The second configuration of the
SensiCath System consists of the SensiCath Sensor, the OnlineABG Module and the
Company's OpticalCAM ABG monitor (the "OpticalCAM") that can be used as a
stand-alone monitoring device or can interface with bedside monitors supplied by
other manufacturers of patient monitoring equipment.  Currently, the OpticalCAM
is able to interface with patient monitoring systems sold by Hewlett-Packard
Company and SpaceLabs Medical, Inc.  The two configurations of the SensiCath
System give the Company access to over 80 percent of the monitored critical care
beds in the United States.

The Company completed product development of the initial configuration of the
SensiCath System in June 1995 and received 510(k) clearance to market the
SensiCath System from the FDA in January 1996.  The Company completed
development of the OpticalCAM in September 1996 and received 510(k) clearance to
market the OpticalCAM from the FDA in January 1997.  In April 1997, the Company
received 510(k) clearance to market from the FDA for the expanded use of the
SensiCath Sensor from 72 to 144 hours and from 100 to 200 ABG measurements.  The
extended use of the SensiCath Sensor enables the Company's customers the ability
to realize additional cost savings for their high acuity patients.

In May of 1997,  the Company voluntarily initiated an action to recover all
customer inventory  of SensiCath Sensors due to unanticipated interference with
pH readings in certain patient applications.  The interfering agent, called
bilirubin, is elevated in patients that have underdeveloped or failing livers.
At the same time, the Company notified the FDA of its action to recover all
customer inventory of sensors.  In July 1997, the FDA notified the Company that
voluntary action was classified as a product recall.  The Company has complied
with all requirements of  the FDA recall action and retrieved all sensors from
customers. In addition, the Company has developed an enhanced sensor which will
reduce interference with pH readings to a clinically acceptable level and which
the Company believes will be compatible with its existing manufacturing
equipment and processes.  The enhanced sensor also includes upgrades in
supporting software and a streamlined calibration process.  Laboratory tests of
the enhanced sensor indicate that it meets the Company's performance
specifications.  The Company has 

                                       6
<PAGE>
 
initiated patient-attached evaluations of the enhanced sensor at clinical
reference sites and has begun validation of manufacturing processes for the
enhanced sensor. Assuming successful completion of these actions, the Company
expects the enhanced sensor to be commercially released in the fourth quarter of
1997.

RESULTS OF OPERATIONS

Net sales in the third quarter of 1997 decreased $27,490 or 54% from $51,330  in
the third quarter in 1996 to $23,840 in the third quarter of 1997.   Net sales
for the nine month period ended September 30, 1997 increased $6,155 or 6% from
$98,251 in the nine month period ended September 30, 1996 to $104,406 in the
nine month period ended September 30, 1997.  Sales decreased for the quarter due
to the Company's action to retrieve sensors in May 1997.  The Company does not
anticipate generating any significant revenues until after the enhanced sensor
is commercially released, which is currently expected to begin in the fourth
quarter of 1997.

Costs of products sold in the third quarter of 1997 increased $593,238 or 177%
from $335,663 in the third quarter in 1996. Cost of products sold for the nine
month period ended September 30, 1997 increased $858,610 or 87% from $991,913
for the nine month period ended September 30, 1996. A total of $500,000 of the
increase for the third quarter and the nine months ended September 30, 1997
represents a write-down of OpticalCAM inventories to estimated market value.
During the third quarter, the Company implemented marketing strategies to
reduce customer selling prices of its OpticalCAM as part of the commercial
introduction of the enhanced SensiCath System in the fourth quarter of 1997.
The amount of the write-down reflects the difference between the Company's
estimated average customer selling price of the OpticalCAM monitor and
OnlineABG module and the cost of OpticalCAM monitor and OnlineABG module
inventories currently on hand or on order. The major component of cost of
products sold, excluding the writedown, for both the third quarter and year to
date is manufacturing infrastructure costs necessary for anticipated future
sales levels. The cost of manufacturing infrastructure, which was established
to its current level in the latter part of 1996, accounted for the majority of
the increase in cost of products sold that was not related to the write-down
of OpticalCAM inventory. The Company expects an improving relationship between
sales and cost of product sold once sales volumes begin to increase. The
Company believes it has the capacity to increase production levels to
approximately 50,000 sensors per year without materially increasing
manufacturing infrastructure costs.

Research and development costs for the third quarter of 1997 decreased $221,588
or 17% from $1,288,373 in the third quarter of 1996.  Research and development
costs  for the nine month period ended September 30, 1997 decreased $398,459 or
9% from $4,422,422 for the nine month period ended September 30, 1996.
Decreased spending for both the quarter and nine month periods resulted from
lowered clinical research activities as the SensiCath System reached development
maturity and lower costs relating to development of the OpticalCAM.  The
majority of research and development activities in the third quarter of 1997
continued to be directed towards the sensor enhancements described above.  The
Company anticipates returning its efforts 

                                       7
<PAGE>
 
to development of new sensors to measure additional blood analytes and other
product enhancements after validation of manufacturing processes for the
enhanced sensor are completed. Selling, general and administrative expenses in
the third quarter of 1997 increased $197,914 or 17% from $1,152,491 in the third
quarter of 1996. 

Selling, general and administrative expenses for the nine month
period ended September 30, 1997 increased $1,449,993 or 53% from $2,759,593. The
increase is attributable primarily to organizational expansion of sales and
marketing and product positioning activities beginning the latter half of 1996.
During late 1996, the Company completed the initial hiring of its sales and
marketing staff to support product positioning and initial product launch
activities. Salaries and benefits for the expanded sales and marketing staff and
travel expenses related to sales and marketing activities accounted for a
significant portion of the increase in selling, general and administrative
expenses in the third quarter and the nine months ended September 30, 1997 from
the same periods in 1996. The Company expects to operate through the balance of
1997 without materially increasing its selling, general and administrative
expenses from the current level.

Net interest income in the third quarter of 1997 decreased $162,592 from
$449,438 in the third quarter of 1996.  Net interest income for the nine month
period ended September 30, 1997 decreased  $135,752 from $1,131,962  for the
nine month period ended September 30, 1996.  The decrease in net interest income
in the third quarter of 1997 is due to declining cash balances of proceeds from
the Company's initial public offering,  which was completed in the first quarter
of 1996.  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 $3,035,405  for the quarter ended September
30, 1997, compared to a net loss of $2,275,759  for the quarter ended September
30, 1996.  The Company incurred a net loss of $8,983,456 for the nine months
ended September 30, 1997, compared to a net loss of $6,943,715 for the nine
months ended September 30, 1996.  As of September 30, 1997, the Company had an
accumulated deficit of $44,198,815.  The increase in the net loss was primarily
due to the increase in operating expenses and the inventory write-down described
above.  The Company anticipates that its operating losses will continue for the
foreseeable future because it plans to expend substantial resources in funding
sales and marketing activities, commercial manufacturing, and research and
development.  Except for historical information contained herein, the
disclosures in this report are forward looking statements which could be
affected by certain risks and uncertainties, including: successful completion
of patient attached evaluations and validation of the manufacturing processes
of the enhanced SensiCath Sensor; market acceptance of the SensiCath System;
increasing sales to customers of major manufacturers of patient monitoring
systems; actions taken and alternative products introduced or marketed by the
Company's competitors; actions related to future regulatory matters; and
continued supply of instrumentation and other key components for which the
Company relies on sole suppliers. Certain of these risks are described in more
detail in the Company's Annual Report on Form 10-K for the year ended December
31, 1996.

                                       8
<PAGE>
 
LIQUIDITY AND CAPITAL RESOURCES

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.  The Company's Common Stock is
quoted on the Nasdaq National Market under the symbol "OPSI."

The Company's cash and cash equivalents were $19,574,431 and $30,134,800 at
September 30, 1997 and December 31, 1996, respectively. The Company incurred
cash expenditures for the nine months ended September 30, 1997 of $9,852,219 for
operations and $1,017,510 for capital expenditures.  The capital equipment
expenditures were principally for the acquisition of OpticalCAM monitors and
OnlineABG Modules for demonstration and marketing purposes and for tooling for
production of OpticalCAM monitors. In addition, the Company incurred cash
expenditures of approximately $1.3 million to increase its inventory position
for the nine month period ended September 30, 1997.  The majority of the
inventory increase (prior to the write-down described above) related to the
purchase of OpticalCAM monitors and OnlineABG Modules  to be used for rental,
promotional and resale purposes.  A substantial portion of the inventory level
at September 30, 1997 consisted of key components, OpticalCAM monitors and
OnlineABG Modules for which the Company relies on sole suppliers.

As of September 30, 1997, the Company had commitments outstanding for
approximately $520,000 to purchase additional OpticalCAM monitors and OnlineABG
Modules. As of September 30, 1997 the Company had no material commitments
outstanding for tooling and equipment.

SensiCath(R) and OpticalCAM/TM/ are trademarks of the Company. OnlineABG/TM/ is
a trademark of Marquette Medical Systems, Inc.

                                       9
<PAGE>
 
PART II.   OTHER INFORMATION

ITEM 6.   EXHIBITS AND REPORTS ON FORM 8-K

(a)  The following exhibit is included herein:

     (27)  Financial Data Schedule

(b)  Reports on Form 8-K

     None

                                       10
<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    November 5, 1997            /s/ Sam B. Humphries
                                  -----------------------------
                                        Sam B. Humphries
                              President and Chief Executive Officer
                                  (Principal Executive Officer)
 
 
Date    November 5, 1997            /s/ Wesley G. Peterson
                                  -----------------------------
                                        Wesley G. Peterson
                            Chief Financial Officer, Vice President of
                             Finance and Administration and Secretary
                            (Principal Financial and Accounting Officer)
 

                                       11
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UNITED STATESUNITED 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 SEPTEMBER 30, 1997

                                       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 OCTOBER 30, 1997, THE REGISTRANT HAD 8,386,250 SHARES OF COMMON STOCK
                                  OUTSTANDING.
INDEX

                         OPTICAL SENSORS INCORPORATED

PART I.  FINANCIAL INFORMATION

         ITEM 1.  FINANCIAL STATEMENTS (UNAUDITED)

           Balance Sheets - September 30, 1997 and December 31, 1996

           Statements of Operations - Three months ended September 30, 1997 and
                                      1996
                                      Nine months ended September 30, 1997 and
                                      1996

           Statements of Cash Flows - Nine months ended September 30, 1997 and
                                      1996

           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
                         (A Development Stage Company)

                                 Balance Sheets
SEPTEMBER 30,        DECEMBER 31, 
                                                                   1997                1996    
                                                            -----------------------------------
                                                               (Unaudited)            (Note)
ASSETS                                                                                         
Current assets:                                                                                
  Cash and cash equivalents                                    $ 19,574,431        $ 30,134,800
  Accounts receivable                                                49,538              91,040
  Inventories                                                     1,758,870             931,917
  Prepaid expenses and other current assets                         254,593             200,731
                                                            -----------------------------------
Total current assets                                             21,637,432          31,358,488
                                                                                               
Property and equipment:                                                                        
  Equipment under capital lease                                     255,942                 ---
  Research and development equipment                                427,141             292,488
  Leasehold improvements                                            255,890             199,211
  Furniture and equipment                                           105,708              77,895
  Marketing equipment                                               805,440             344,448
  Production equipment                                              249,066             167,635
                                                            -----------------------------------
                                                                  2,099,187           1,081,677
  Less accumulated depreciation                                    (799,265)           (488,043
                                                            -----------------------------------
                                                                  1,299,922             593,634
Other assets:                                                                                  
  Patents                                                           424,961             328,630
  Other assets                                                       79,425              88,445
                                                            -----------------------------------
                                                                    504,386             417,075
                                                            -----------------------------------
Total assets                                                   $ 23,441,740        $ 32,369,197
                                                            ===================================
                                                                                               
LIABILITIES AND SHAREHOLDERS' EQUITY                                                           
Current liabilities:                                                                           
   Accounts payable                                            $    442,853        $    740,804
   Employee compensation                                            362,956             577,228
   Other liabilities and accrued expenses                             2,340               1,541
   Current portion of long term debt                                 53,242                 ---
                                                            -----------------------------------
Total current liabilities                                           861,391           1,319,573
                                                                                               
Long-term debt, net current maturities                              188,644                 ---
                                                                                               
Commitments                                                                                    
                                                                                               
SHAREHOLDERS' EQUITY                                                                           
Convertible Preferred Stock, par value $.01         
 per share:                                                                                    
     Authorized shares--5,000,000                                                                   
     Issued and outstanding shares-- 0                                  ---                 ---
Common Stock, par value $.01 per share:                                                        
  Authorized shares--30,000,000                                                                
  Issued and outstanding shares 1997--8,386,250 and                                            
   1996--8,341,497                                                   83,863              83,415
Additional paid-in capital                                       67,054,945          66,974,345
Deficit accumulated during the development stage                (44,198,815)        (35,215,362
Deferred compensation                                              (303,288)           (547,774
Note receivable from officer                                       (245,000)           (245,000
                                                            -----------------------------------
Total shareholders' equity                                       22,391,705          31,049,624
                                                            -----------------------------------
Total liabilities and shareholders' equity                     $ 23,441,740        $ 32,369,197
                                                            ===================================
Note:  The balance sheet at December 31, 1996 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
                         (A Development Stage Company)

                           Statements of Operations
                                  (Unaudited)
CUMULATIVE    
                                                                                                             MAY 23, 1989  
                                                        THREE MONTHS ENDED          NINE MONTHS ENDED       (INCEPTION) TO 
                                                           SEPTEMBER 30                SEPTEMBER 30          SEPTEMBER 30, 
                                                  -------------------------------------------------------                  
                                                        1997          1996          1997          1996           1997      
                                                  ------------------------------------------------------------------------
Net sales                                           $    23,840   $    51,330   $   104,406   $    98,251     $    267,474 
Cost of good sold                                       928,901       335,663     1,850,523       991,913        3,219,744 
                                                  ------------------------------------------------------------------------ 
Gross margin                                           (905,061)     (284,333)   (1,746,117)     (893,662)      (2,952,270)
                                                                                                                           
Operating  expenses:                                                                                                       
  Research and development                            1,066,785     1,288,373     4,023,963     4,422,422       29,046,829 
  Selling, general and administrative                 1,350,405     1,152,491     4,209,586     2,759,593       15,230,545 
                                                  ------------------------------------------------------------------------ 
Operating loss                                       (3,322,251)   (2,725,197)   (9,979,666)   (8,075,677)     (47,229,644)
                                                                                                                           
Interest expense                                         (5,565)          ---        (5,565)          ---         (146,950)
Interest income                                         292,411       449,438     1,001,775     1,131,962        3,177,779 
                                                  ------------------------------------------------------------------------
                                                                                                                           
Net loss                                            $(3,035,405)  $(2,275,759)  $(8,983,456)  $(6,943,715)    $(44,198,815)
                                                  ========================================================================
                                                                                                                           
Net loss per common share                                 $(.36)        $(.27)       $(1.07)       $(1.02)                 
                                                  =======================================================                  
                                                                                                                           
Shares used in calculation of net loss per share      8,382,297     8,307,346     8,369,151     6,827,056                  
                                                  =======================================================
See accompanying notes.

                                       3
Optical Sensors Incorporated
                         (A Development Stage Company)

                            Statements of Cash Flows
                                  (Unaudited)
CUMULATIVE   
                                                                                                              MAY 23, 1989 
                                                                                     NINE MONTHS ENDED       (INCEPTION) TO
                                                                                       SEPTEMBER 30           SEPTEMBER 30,
                                                                                    1997           1996           1997       
                                                                                -------------------------------------------
OPERATING ACTIVITIES                                                                                                        
Net loss                                                                        $ (8,983,456)  $(6,943,715)    $(44,198,815)
Adjustments to reconcile net loss to net cash used in                                                                       
 operating activities:                                                                                                      
     Loss on write-off of research and development equipment                                                        133,919 
     Loss on write-off of prepaid royalties                                                                         135,201 
     Write-down of Inventory                                                         500,000                        500,000 
     Depreciation and amortization                                                   325,210        80,436          960,114 
     Amortization of deferred loss on sale leaseback                                                                 11,196 
     Deferred compensation amortization                                              244,486       467,587        1,876,405 
     License fee financed with long-term debt                                                                       193,700 
     Issuance of Common Stock for services                                                                           37,091 
     Issuance of Common Stock in lieu of interest payments on                                                               
      notes payable                                                                                                  35,412 
     Issuance of warrants in connection with debt and lease                                                                 
      financings                                                                      13,574         3,016           77,671 
     Issuance of options in connection with consulting services                                                      55,690 
     Changes in operating assets and liabilities:                                                                           
         Accounts receivable                                                          41,502       (69,017)         (49,538)
         Inventories                                                              (1,326,953)     (598,294)      (2,258,870)
         Prepaid expenses and other assets                                          (155,158)      191,513         (772,555)
         Accounts payable and accrued expenses                                      (511,424)      430,761          808,149 
                                                                                ------------------------------------------- 
     Net cash used in operating activities                                        (9,852,219)   (6,437,713)     (42,455,230)
                                                                                                                            
INVESTING ACTIVITIES                                                                                                        
Proceeds from disposal of equipment                                                                                  46,947 
Purchases of property and equipment                                               (1,017,510)      (80,227)      (2,722,039)
                                                                                -------------------------------------------
Net cash used in investing activities                                             (1,017,510)      (80,227)      (2,675,092)
                                                                                                                            
FINANCING ACTIVITIES                                                                                                        
Proceeds from sale leaseback                                                                                        283,030 
Net proceeds from issuance of Common Stock                                            67,474    34,001,096       35,112,150 
Net proceeds from issuance of Preferred Stock                                                                    27,290,155 
Reimbursement to founder and shareholder                                                                             (3,500)
Reductions on long-term debt                                                         (14,056)                    (1,410,950)
Proceeds from notes payable                                                          255,942                      3,433,868 
                                                                                -------------------------------------------
Net cash provided by financing activities                                            309,360    34,001,096       64,704,753 
                                                                                ------------------------------------------- 
                                                                                                                            
Increase (decrease) in cash and cash equivalents                                 (10,560,369)   27,483,156       19,574,431 
Cash and cash equivalents at beginning of period                                  30,134,800     5,394,721              --- 
                                                                                ------------------------------------------- 
Cash and cash equivalents at end of period                                      $ 19,574,431   $32,877,877     $ 19,574,431 
                                                                                -------------------------------------------
See accompanying notes.

                                       4
Optical Sensors Incorporated
                         (A Development Stage Company)

                            Statements of Cash Flows
                                  (Unaudited)

                              September 30, 1997

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 and nine month periods ended September
30, 1997 are not necessarily indicative of the results that may be expected for
the year ended December 31, 1997. For further information, refer to the
financial statements and footnotes thereto included in the Optical Sensors
Incorporated 1996 Annual Report to Shareholders incorporated by reference into
the Annual Report on Form 10-K for the year ended December 31, 1996.

NOTE B - NET LOSS PER SHARE

Net loss per share is computed using the weighted average number of common
shares outstanding during the period.  Common equivalent shares from stock
options and warrants are excluded from the computation as their effect is
antidilutive.  In February 1997, the Financial Accounting Standards Board (FASB)
issued FASB Statement No. 128, "Earnings Per Share."  This Statement replaces
the presentation of primary earnings per share (EPS) with basic EPS and also
requires dual presentation of basic and diluted EPS for entities with complex
capital structures.  This Statement is effective for the fiscal year ended
December 31, 1997.  For the three and the nine month periods ended September 30,
1997, there is no difference between basic earnings per share under Statement
No. 128 and net loss per share as reported.

                                       5
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS

OVERVIEW

Optical Sensors Incorporated (the "Company") has developed the SensiCath System,
a patient-attached, 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").  The SensiCath System utilizes a disposable,
fiberoptic sensor device (the "SensiCath Sensor") connected to a small modular
instrument that can be configured to integrate with bedside monitoring systems
or to serve as a stand-alone monitor.

The SensiCath System is currently available in two configurations.  The first
configuration of the SensiCath System combines the SensiCath Sensor with a
module (the "OnlineABG Module") that plugs into bedside monitors manufactured by
Marquette Medical Systems, Inc. ("Marquette").  The second configuration of the
SensiCath System consists of the SensiCath Sensor, the OnlineABG Module and the
Company's OpticalCAM ABG monitor (the "OpticalCAM") that can be used as a
stand-alone monitoring device or can interface with bedside monitors supplied by
other manufacturers of patient monitoring equipment.  Currently, the OpticalCAM
is able to interface with patient monitoring systems sold by Hewlett-Packard
Company and SpaceLabs Medical, Inc.  The two configurations of the SensiCath
System give the Company access to over 80 percent of the monitored critical care
beds in the United States.

The Company completed product development of the initial configuration of the
SensiCath System in June 1995 and received 510(k) clearance to market the
SensiCath System from the FDA in January 1996.  The Company completed
development of the OpticalCAM in September 1996 and received 510(k) clearance to
market the OpticalCAM from the FDA in January 1997.  In April 1997, the Company
received 510(k) clearance to market from the FDA for the expanded use of the
SensiCath Sensor from 72 to 144 hours and from 100 to 200 ABG measurements.  The
extended use of the SensiCath Sensor enables the Company's customers the ability
to realize additional cost savings for their high acuity patients.

In May of 1997,  the Company voluntarily initiated an action to recover all
customer inventory  of SensiCath Sensors due to unanticipated interference with
pH readings in certain patient applications.  The interfering agent, called
bilirubin, is elevated in patients that have underdeveloped or failing livers.
At the same time, the Company notified the FDA of its action to recover all
customer inventory of sensors.  In July 1997, the FDA notified the Company that
voluntary action was classified as a product recall.  The Company has complied
with all requirements of  the FDA recall action and retrieved all sensors from
customers. In addition, the Company has developed an enhanced sensor which will
reduce interference with pH readings to a clinically acceptable level and which
the Company believes will be compatible with its existing manufacturing
equipment and processes.  The enhanced sensor also includes upgrades in
supporting software and a streamlined calibration process.  Laboratory tests of
the enhanced sensor indicate that it meets the Company's performance
specifications.  The Company has 

                                       6
initiated patient-attached evaluations of the enhanced sensor at clinical
reference sites and has begun validation of manufacturing processes for the
enhanced sensor. Assuming successful completion of these actions, the Company
expects the enhanced sensor to be commercially released in the fourth quarter of
1997.

RESULTS OF OPERATIONS

Net sales in the third quarter of 1997 decreased $27,490 or 54% from $51,330  in
the third quarter in 1996 to $23,840 in the third quarter of 1997.   Net sales
for the nine month period ended September 30, 1997 increased $6,155 or 6% from
$98,251 in the nine month period ended September 30, 1996 to $104,406 in the
nine month period ended September 30, 1997.  Sales decreased for the quarter due
to the Company's action to retrieve sensors in May 1997.  The Company does not
anticipate generating any significant revenues until after the enhanced sensor
is commercially released, which is currently expected to begin in the fourth
quarter of 1997.

Costs of products sold in the third quarter of 1997 increased $593,238 or 177%
from $335,663 in the third quarter in 1996. Cost of products sold for the nine
month period ended September 30, 1997 increased $858,610 or 87% from $991,913
for the nine month period ended September 30, 1996. A total of $500,000 of the
increase for the third quarter and the nine months ended September 30, 1997
represents a write-down of OpticalCAM inventories to estimated market value.
During the third quarter, the Company implemented marketing strategies to
reduce customer selling prices of its OpticalCAM as part of the commercial
introduction of the enhanced SensiCath System in the fourth quarter of 1997.
The amount of the write-down reflects the difference between the Company's
estimated average customer selling price of the OpticalCAM monitor and
OnlineABG module and the cost of OpticalCAM monitor and OnlineABG module
inventories currently on hand or on order. The major component of cost of
products sold, excluding the writedown, for both the third quarter and year to
date is manufacturing infrastructure costs necessary for anticipated future
sales levels. The cost of manufacturing infrastructure, which was established
to its current level in the latter part of 1996, accounted for the majority of
the increase in cost of products sold that was not related to the write-down
of OpticalCAM inventory. The Company expects an improving relationship between
sales and cost of product sold once sales volumes begin to increase. The
Company believes it has the capacity to increase production levels to
approximately 50,000 sensors per year without materially increasing
manufacturing infrastructure costs.

Research and development costs for the third quarter of 1997 decreased $221,588
or 17% from $1,288,373 in the third quarter of 1996.  Research and development
costs  for the nine month period ended September 30, 1997 decreased $398,459 or
9% from $4,422,422 for the nine month period ended September 30, 1996.
Decreased spending for both the quarter and nine month periods resulted from
lowered clinical research activities as the SensiCath System reached development
maturity and lower costs relating to development of the OpticalCAM.  The
majority of research and development activities in the third quarter of 1997
continued to be directed towards the sensor enhancements described above.  The
Company anticipates returning its efforts 

                                       7
to development of new sensors to measure additional blood analytes and other
product enhancements after validation of manufacturing processes for the
enhanced sensor are completed. Selling, general and administrative expenses in
the third quarter of 1997 increased $197,914 or 17% from $1,152,491 in the third
quarter of 1996. 

Selling, general and administrative expenses for the nine month
period ended September 30, 1997 increased $1,449,993 or 53% from $2,759,593. The
increase is attributable primarily to organizational expansion of sales and
marketing and product positioning activities beginning the latter half of 1996.
During late 1996, the Company completed the initial hiring of its sales and
marketing staff to support product positioning and initial product launch
activities. Salaries and benefits for the expanded sales and marketing staff and
travel expenses related to sales and marketing activities accounted for a
significant portion of the increase in selling, general and administrative
expenses in the third quarter and the nine months ended September 30, 1997 from
the same periods in 1996. The Company expects to operate through the balance of
1997 without materially increasing its selling, general and administrative
expenses from the current level.

Net interest income in the third quarter of 1997 decreased $162,592 from
$449,438 in the third quarter of 1996.  Net interest income for the nine month
period ended September 30, 1997 decreased  $135,752 from $1,131,962  for the
nine month period ended September 30, 1996.  The decrease in net interest income
in the third quarter of 1997 is due to declining cash balances of proceeds from
the Company's initial public offering,  which was completed in the first quarter
of 1996.  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 $3,035,405  for the quarter ended September
30, 1997, compared to a net loss of $2,275,759  for the quarter ended September
30, 1996.  The Company incurred a net loss of $8,983,456 for the nine months
ended September 30, 1997, compared to a net loss of $6,943,715 for the nine
months ended September 30, 1996.  As of September 30, 1997, the Company had an
accumulated deficit of $44,198,815.  The increase in the net loss was primarily
due to the increase in operating expenses and the inventory write-down described
above.  The Company anticipates that its operating losses will continue for the
foreseeable future because it plans to expend substantial resources in funding
sales and marketing activities, commercial manufacturing, and research and
development.  Except for historical information contained herein, the
disclosures in this report are forward looking statements which could be
affected by certain risks and uncertainties, including: successful completion
of patient attached evaluations and validation of the manufacturing processes
of the enhanced SensiCath Sensor; market acceptance of the SensiCath System;
increasing sales to customers of major manufacturers of patient monitoring
systems; actions taken and alternative products introduced or marketed by the
Company's competitors; actions related to future regulatory matters; and
continued supply of instrumentation and other key components for which the
Company relies on sole suppliers. Certain of these risks are described in more
detail in the Company's Annual Report on Form 10-K for the year ended December
31, 1996.

                                       8
LIQUIDITY AND CAPITAL RESOURCES

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.  The Company's Common Stock is
quoted on the Nasdaq National Market under the symbol "OPSI."

The Company's cash and cash equivalents were $19,574,431 and $30,134,800 at
September 30, 1997 and December 31, 1996, respectively. The Company incurred
cash expenditures for the nine months ended September 30, 1997 of $9,852,219 for
operations and $1,017,510 for capital expenditures.  The capital equipment
expenditures were principally for the acquisition of OpticalCAM monitors and
OnlineABG Modules for demonstration and marketing purposes and for tooling for
production of OpticalCAM monitors. In addition, the Company incurred cash
expenditures of approximately $1.3 million to increase its inventory position
for the nine month period ended September 30, 1997.  The majority of the
inventory increase (prior to the write-down described above) related to the
purchase of OpticalCAM monitors and OnlineABG Modules  to be used for rental,
promotional and resale purposes.  A substantial portion of the inventory level
at September 30, 1997 consisted of key components, OpticalCAM monitors and
OnlineABG Modules for which the Company relies on sole suppliers.

As of September 30, 1997, the Company had commitments outstanding for
approximately $520,000 to purchase additional OpticalCAM monitors and OnlineABG
Modules. As of September 30, 1997 the Company had no material commitments
outstanding for tooling and equipment.

SensiCath(R) and OpticalCAM/TM/ are trademarks of the Company. OnlineABG/TM/ is
a trademark of Marquette Medical Systems, Inc.

                                       9
PART II.   OTHER INFORMATION

ITEM 6.   EXHIBITS AND REPORTS ON FORM 8-K

(a)  The following exhibit is included herein:

     (27)  Financial Data Schedule

(b)  Reports on Form 8-K

     None

                                       10
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    November 5, 1997            /s/ Sam B. Humphries
                                  -----------------------------
                                        Sam B. Humphries
                              President and Chief Executive Officer
                                  (Principal Executive Officer)
 
 
Date    November 5, 1997            /s/ Wesley G. Peterson
                                  -----------------------------
                                        Wesley G. Peterson
                            Chief Financial Officer, Vice President of
                             Finance and Administration and Secretary
                            (Principal Financial and Accounting Officer)
 

                                       11