SEPARATION AGREEMENT AND RELEASE


         This Separation Agreement and Release (the "Agreement") is entered into
by and between Datakey, Inc. (the "Company") and John H. Underwood  ("Employee")
effective as of January 1, 1997.


                                    RECITALS

         John H.  Underwood  has been an officer,  director  and employee of the
Company since 1983. In December 1996,  Employee  resigned as the Chief Executive
Officer of the Company  and  continued  as an  employee  of the Company  through
December 31, 1996. In consideration  of his covenants  hereunder and his release
of claims set forth  hereunder,  the  Company  has made  provisions  for certain
payments and other benefits to be paid to Employee.


                                    AGREEMENT

         NOW THEREFORE, the parties agree as follows:

         1.  Company.   Company,  as  used  herein,  means  Datakey,  Inc.,  its
successors and assigns, its subsidiaries,  and its present and former directors,
officers,  shareholders,  employees,  and agents, whether in their individual or
official capacities.

         2.  Employee.  Employee,  as used herein,  means John H.  Underwood and
anyone who has or obtains legal rights or claims through him.

         3. Resignation.  On or about December 1, 1996, Employee resigned as the
Chief Executive Officer of the Company.  He continued as a non-officer  employee
of the  Company  until  December  31,  1996,  at which  time he  resigned  as an
employee.  Employee will continue as a director of the Company at his discretion
until  the next  annual  meeting  of the  Company's  shareholders  or until  his
successor has been elected.

         4.       Agreement Not to Compete.

                  (a) Restrictive Covenant.  Employee agrees that until December
         31, 1998, he shall not,  directly or indirectly,  engage in competition
         with the  Company  in any  manner or  capacity  (e.g.,  as an  advisor,
         principal, agent, partner, officer, directors,  stockholder,  employee,
         member of any  association,  or otherwise) in any phase of the business
         which the Company is  currently  conducting  or as part of its business
         plan intends to conduct.

                  (b) Equitable  Remedies.  The monthly severance payments to be
         made to Employee  through December of 1998 as set forth in Section 5(a)
        

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         below are in part in  consideration  for  Employee's  agreement  not to
         compete. If Employee violates his agreement not to compete, the Company
         shall  have  the  right  to  terminate  his  monthly  payment  and seek
         injunctive  relief  prohibiting  Employee  from  competing  against the
         Company.

                  (c) Geographic Extent of Covenant. The obligations of Employee
         not to compete shall apply to the entire United States.

                  (d) Indirect Competition. Employee further agrees that through
         December,  1998,  he  will  not,  directly  or  indirectly,  assist  or
         encourage any other person in carrying out, directly or indirectly, any
         activity that would be  prohibited  by the above  provisions of Section
         4(a) if such activity were carried out by Employee,  either directly or
         indirectly;  and in  particular  Employee  agrees  that  he  will  not,
         directly  or  indirectly,  induce any  employee of the Company to carry
         out, directly or indirectly, any such activity.

                  (e)  Non-Solicitation.  Employee  further  agrees that through
         December  31, 1998,  he will not solicit or encourage  employees of the
         Company to terminate their employment with the Company or contact or in
         any  way   interfere  or  attempt  to  interfere   with  the  Company's
         relationship with any current or potential customers of Datakey.

                  (f)  Construction  of Agreement Not to Compete.  To the extent
         any provision of this Section 4 shall be invalid or  unenforceable,  it
         shall  be  considered  deleted  herefrom  and  the  remainder  of  such
         provision and this Section 4 shall be unaffected  and shall continue in
         full force and effect.  In  furtherance to and not in limitation of the
         foregoing,  should the duration or geographical  extent of, or business
         activities  covered by, any provision of this Section 4 be in excess of
         that which is valid and  enforceable  under  applicable  law, then such
         provision  shall be  construed to cover only that  duration,  extent or
         activities  which  are  validly  and  enforceably   covered.   Employee
         acknowledges  the  uncertainty of the law in this respect and expressly
         stipulates that this Section 4 be given the construction  which renders
         its  provisions  valid  and  enforceable  to the  maximum  extent  (not
         exceeding its expressed terms) possible under applicable laws.

         5.       Benefits.

                  (a) Through  December 31,  1998,  Employee  shall  continue to
         receive  on a monthly  basis,  in  accordance  with  Datakey's  current
         payroll  practices,  an amount of  severance  equal to his monthly base
         salary in effect on December 31, 1996.

                  (b) The Company will continue to provide to Employee access to
         medical and health coverage, under its plans as they currently exist or
         may  hereafter  be  amended,  at Company  subsidized  rates  during the
         twenty-four  month severance pay period.  Thereafter,  Employee and his
         covered dependents will be entitled to elect to continue coverage under
         
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         COBRA to the extent it is  available.  Coverage by the Company or under
         COBRA will end on the earlier of Employee's  obtaining  new  employment
         which  gives him the ability to provide  medical  and health  insurance
         coverage for himself and his family  through his new  employer,  or the
         failure to pay any premium when due.

                  (c) The Company will expend up to $6,000 to be applied only to
         actual outplacement counseling of Employee's choice.

                  (d) Unpaid vacation benefits, if any, will be paid to Employee
         on or about January 15, 1997.

                  (b) Effective as of January 1, 1997 Employee's  vested account
         balance under the Company's  401(k) Plan and Trust shall be distributed
         to  Employee or at his  direction,  pursuant to the terms of the 401(k)
         Plan and Employee's election thereunder.

         6.  Stock  Options.  Employee  has been  granted  the  following  stock
options:  (i)  25,000  shares at an  exercise  price of $3.625  per share  which
expires on April 30, 2005 and which is vested at 16,600 shares;  and (ii) 75,000
shares at an exercise price of $5.75 per share which expires on January 12, 2002
and which is fully vested.  After the  termination  of Employee's  employment on
December 31, 1996,  Employee will have until  February 28, 1999, to exercise his
two stock options.

         7. Release of Employment  Claims.  Employee hereby releases and forever
discharges  the  Company  of and from any and all  actions  or causes of action,
suits,   debts,   claims,   complaints,   contracts   (expressed   or  implied),
controversies,  agreements,  promises,  damages,  claims  for  attorneys'  fees,
judgments, costs, disbursements, severance, compensation, vacation pay and other
benefits  (except as  specifically  provided  for in this  Agreement),  known or
unknown,  in law or equity,  Employee ever had, now has, or shall have as of the
date of this  Agreement  relating in any manner to  Employee's  employment  with
and/or  resignation  as  an  officer,  director  or  employee  of  the  Company,
including,  but not limited to, any alleged violation of any federal,  state, or
local law, regulation or ordinance prohibiting  discrimination or other unlawful
activity on the basis of race, color, creed, marital status, sex, age, religion,
national origin, sexual orientation, sexual harassment, disability, or any other
basis  (whether  arising under Title VII of the Civil Rights Act, 42 U.S.C.  ss.
2000e et seq., the Age  Discrimination  in Employment Act, 29 U.S.C.  ss. 621 et
seq.,  the Americans  With  Disabilities  Act, 42 U.S.C.  ss. 12101 et seq., the
Minnesota  Human Rights act, Minn.  Stat. ss. 363.01 et seq., or elsewhere),  or
any  alleged  obligation  created by statute or by common law  contract  or tort
theory.  Employee  releases  and  discharges  Company  not only from any and all
claims that he could make on his own behalf, but also those that may or could be
brought by any other person or organization on his behalf. Employee affirms that
as a current or former  employee he has not caused or  permitted to be filed any
charge,  complaint,  or action against Company and agrees that he will not cause
or permit  to be filed any  charge,  complaint,  or action  and that he will not
participate  with any other  party in the  filing of any  charge,  complaint  or
action on the basis of his employee status.

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         8. Notification of Rights Pursuant to the Federal Age Discrimination in
Employment Act (29 U.S.C. ss.ss.  621-634) and Minnesota Human Rights Act (Minn.
Stat. Ch. 363).  Employee agrees that he is hereby notified that the federal Age
Discrimination in Employment Act provides that he is entitled to wait 21 days to
sign this Agreement.  The 21-day period shall begin the day following the day on
which Employee receives the Agreement. Employee acknowledges that the purpose of
the 21-day period is to provide  Employee  adequate time to consider whether the
terms of this Agreement are acceptable to him.  Employee is also hereby notified
of his right to rescind  his  release of claims  arising  under the  Federal Age
Discrimination  in Employment  Act within 7 calendar days of his signing of this
Agreement.  Employee is further  notified of his right to rescind his release of
claims  arising under the Minnesota  Human Rights Act within 15 calendar days of
his signing of this Agreement.  In order to be effective,  Employee's rescission
must be in writing and delivered by hand or mail to Gary Holland, Datakey, Inc.,
407 West Travelers Trail, Burnsville,  MN 55337-2554.  If delivered by mail, the
rescission must be postmarked within the required period,  properly addressed to
Gary Holland as set forth  above,  and sent by certified  mail,  return  receipt
requested.  Employee  understands  that if he rescinds  his release of claims as
provided for in this  paragraph,  Employee  will not  receive,  and will have to
return to Company, all benefits and payments provided for in this Agreement.

         9.  Confidentiality.  The parties agree  specifically that the contents
and terms of this  Agreement  shall  remain  confidential  except as required by
applicable  law  or  regulation   (including  of  the  Securities  and  Exchange
Commission  or of the  Nasdaq  National  Market).  However,  Employee  shall  be
entitled to discuss the matters  contained  herein with his legal and  financial
advisors  and his  immediate  family,  provided  they  also  agree to keep  this
Agreement  confidential.  Provided  further  that  Company  shall be entitled to
discuss the matters  contained herein with its legal and financial  advisers and
its management employees on a need to know basis.

         10. Non-Disparagement. Each party agrees not to disparage in any manner
the other party. Any such  disparagement  will be grounds for rescission of this
Agreement.

         11. Corporate Information.  Employee agrees that he will not remove any
proprietary  corporate  information  from the Company's  offices,  including the
office he occupied. The determination of what information is proprietary will be
in  the  discretion  of  the  Company.  Subject  to  the  foregoing,   corporate
information  shall  include,  but  not be  limited  to,  sales  plans,  customer
information,   employee  information,  business  correspondence  and  any  other
information  which is related to  Datakey,  Inc.  or its  subsidiaries  or their
businesses.  All personal property of the Employee,  property which is not owned
by or is not  proprietary or  confidential  to the Company,  will be returned to
Employee.

         12.  Assignment.  The  obligations of Employee under this Agreement may
not be assigned  by  Employee.  However,  in the event of  Employee's  mental or
physical  disability,  incapacitation  or death,  all remaining  payments  shall
continue to be made to  Employee's  spouse,  or in the event of the death of the


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Employee's spouse, the payments will be made to Employee's estate. The Company's
rights and  obligations  under this  Agreement  will inure to the benefit and be
binding upon the Company's successors and assignees.

         13.  Severability.  If a court rules that any part of this Agreement is
not enforceable,  that part may be modified by the court to make it enforceable.
The parties  expressly  agree that the  restrictions  contained in Section 4 are
reasonable and should be enforced to the maximum extent and scope possible.

         14.  Governing Law. Any disputes  arising under this Agreement shall be
governed by the laws of the State of Minnesota.

         15.  Acknowledgment  of Reading and  Understanding;  Consultation  with
Counsel;  Period to Consider  Agreement.  Employee,  by signing this  Agreement,
acknowledges and agrees that he has carefully read and understood all provisions
of this  Agreement  and that he has entered into this  Agreement  knowingly  and
voluntarily.  Employee further  acknowledges  that he has consulted with counsel
before signing this Agreement.  Employee also acknowledges that Company informed
him that he has 21 days from the receipt of this  Agreement to consider  whether
its terms are  acceptable  to him and that he has had the  benefit of the 21-day
period.  Employee  acknowledges  and  agrees  that  he  has  not  relied  on any
representations  or statements by Company,  whether oral or written,  other than
the express statements of this Agreement, in executing this Agreement.

         16. Full Agreement.  This Agreement  contains the full agreement of the
parties  and may not be  modified,  altered,  or  changed  in any way  except by
written  agreement  signed by both parties.  Except as expressly  stated in this
Agreement,  the parties agree that this Agreement  supersedes and terminates any
and all oral  and  written  prior  agreements  and  understandings  between  the
parties.

                                            DATAKEY, INC.



Dated: January 27, 1997                     By /s/ Gary R. Holland
                                            Gary Holland
                                            Chairman of the Board of Directors

Dated: February 27, 1997                    /s/ John H. Underwood
                                            John H. Underwood


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