<PAGE>
                                                        Exhibit 8.5
 
                  FIRST FEDERAL BANK, A FEDERAL SAVINGS BANK
                     EMPLOYEE SEVERANCE COMPENSATION PLAN


                                 PLAN PURPOSE

     The purpose of this First Federal Bank, a Federal Savings Bank Employee
Severance Compensation Plan is to assure the services of employees of the Bank
in the event of a Change in Control.  The benefits contemplated by the Plan
recognize the value to the Bank of the services and contributions of the
employees of the Bank and the effect upon the Bank resulting from the
uncertainties of continued employment, reduced employee benefits, management
changes and relocations that may arise in the event of a Change in Control.  The
Board believes that the Plan will also aid the Bank in attracting and retaining
the highly qualified individuals who are essential to its success and that the
Plan's assurance of fair treatment of the Bank's employees will reduce the
distractions and other adverse effects on employees' performance in the event of
a Change in Control.

                                   ARTICLE I
                             ESTABLISHMENT OF PLAN

     1.1   Establishment of Plan
           ---------------------

     As of the Effective Date of the Plan as defined herein, the Bank hereby
establishes an employee severance compensation plan to be known as the First
Federal Bank, a Federal Savings Bank Employee Severance Compensation Plan."  The
purposes of the Plan are as set forth above.

     1.2   Application of Plan
           -------------------

     The benefits provided by this Plan shall be available to all employees of
the Bank, who, at or after the Effective Date, meet the eligibility requirements
of Article III, except for those officers of the Bank who have entered into, or
who enter into in the future, and continue to be subject to, an employment or
change in control agreement with the Employer.

     1.3   Contractual Right to Benefits
           -----------------------------

     This plan establishes and vests in each Participant a contractual right to
the benefits to which each Participant is entitled hereunder in the event of a
Change in Control, enforceable by the Participant against the Employer, the
Bank, or both.  The Plan does not provide, and should not be construed as
providing, benefits of any kind to any employee except in the event of a Change
in Control and, in the event of a Change in Control, only upon the involuntary
or voluntary termination of an employee in the manner contemplated herein.
<PAGE>
 
                                  ARTICLE II
                         DEFINITIONS AND CONSTRUCTION

     2.1   Definitions
           -----------

     Whenever used in the Plan, the following terms shall have the meanings set
forth below.

     "Annual Compensation" of a Participant means and includes all wage and
salary paid (including accrued amounts) by an Employer as consideration for the
Participant's service during the 12-month period ending on the last day of the
month preceding the date of a Participant's termination pursuant to Section 4.2.
For purposes of this Plan, a Participant's "Monthly Compensation" shall equal
one-twelfth of a Participant's Annual Compensation as determined in accordance
with this paragraph.

     "Bank" means First Federal Bank, a Federal Savings Bank or any successor as
provided for in Article VII hereof.

     "Board" means the Board of Directors of the Bank.

     "Change in Control" shall mean an event deemed to occur if and when (a) an
offeror other than the Corporation purchases shares of the stock of the
Corporation or the Bank pursuant to a tender or exchange offer for such shares,
(b) any person (as such term is used in Sections 13(d) and 14(d)(2) of the
Exchange Act) is or becomes the beneficial owner, directly or indirectly, of
securities of the Corporation or the Bank representing twenty-five percent (25%)
or more of the combined voting power of the Corporation's or the Bank's then
outstanding securities, (c) the membership of the board of directors of the
Corporation or the Bank changes as the result of a contested election, such that
individuals who were directors at the beginning of any twenty-four (24) month
period (whether commencing before or after the date of adoption of this Plan) do
not constitute a majority of the Board at the end of such period, or (d)
shareholders of the Corporation or the Bank approve a merger, consolidation,
sale or disposition of all or substantially all of the Corporation's or the
Bank's assets, or a plan of partial or complete liquidation.  If any of the
events enumerated in clauses (a) - (d) occur, the Board shall determine the
effective date of the change in control resulting therefrom, for purposes of the
Plan.

     "Company" means First Capital, Inc., an Indiana corporation, the holding
company of the Bank.

     "Disability" means the permanent and total inability by reason of mental or
physical infirmity, or both, of an employee to perform the work customarily
assigned to him.  Additionally, a medical doctor selected or approved by the
Board must advise the Board that it is either not possible to determine if or
when such Disability will terminate or that it appears probable that such
Disability will be permanent during the remainder of said employees lifetime.

     "Effective Date" means the date the Plan is approved by the Board of the
Bank, or such other date as the Board shall designate in its resolution
approving the Plan.
<PAGE>
 
     "Employer" means (i) the Bank or (ii) a subsidiary of the Bank or a parent
company of the Bank which has adopted the plan pursuant to Article VI hereof.

     "Expiration Date" means a date ten (10) years from the Effective Date
unless earlier terminated pursuant to Section 8.2 or extended pursuant to
Section 8.1.

     "Just Cause" shall means termination because of Participant's personal
dishonesty, incompetence, willful misconduct, any breach of fiduciary duty
involving personal profit, intentional failure to perform stated duties, willful
violation of any law, rule or regulation (other than traffic violations or other
similar offenses) or any final cease-and desist order.

     "Payment" means the payment of severance compensation as provided in
Article IV hereof.

     "Participant" means an employee of an Employer who meets the eligibility
requirements of Article III.

     "Plan" means this First Federal Bank, a Federal Savings Bank Employee
Severance Compensation Plan.

     2.2   Applicable Law
           --------------

     The laws of the State of Indiana shall be controlling law in all matters
relating to the Plan to the extent not preempted by Federal law.

 
     2.3   Severability
           ------------

     If a provision of this Plan shall be held illegal or invalid, the
illegality or invalidity shall not affect the remaining parts of the Plan and
the Plan shall be construed and enforced as if the illegal or invalid provision
had not been included.

                                  ARTICLE III
                                  ELIGIBILITY

     3.1   Participation
           -------------

     The term "Participant" shall include all employees of an Employer who have
completed at least one (1) year of service with the Employer at the time of any
termination pursuant to Section 4.2 herein.  For purposes of this Plan, "years
of service" shall include all years of employment with Bank in which an employee
was credited with at least 500 actual hours of service and "years of service"
shall be determined without regard to any break in service.  In addition, the
term "Participant" shall, without regard to years of service, include each
employee who is a vice president, assistant vice president or manager  of the
Bank.  Notwithstanding the foregoing, an employee who has entered into and
continues to be covered by an individual employment contract or change in
control agreement with an Employer shall not be entitled to participate in this
Plan.
<PAGE>
 
     3.2   Duration of Participation
           -------------------------

     A Participant shall cease to be a Participant in the Plan when the
Participant ceases to be an employee of an Employer, unless such Participant is
entitled to a Payment as provided in the Plan.  A Participant entitled to
receipt of a Payment shall remain a Participant in this Plan until the full
amount of such Payment has been paid to the Participant.

                                  ARTICLE IV
                                   PAYMENTS

     4.1   Right to Payment
           ----------------

     A Participant shall be entitled to receive from his or her Employer a
Payment in the amount provided in Section 4.3 if a Change in Control occurs and
if, within one (1) year thereafter, the Participant's employment by an Employer
shall terminate for any reason specified in Section 4.2.  A Participant shall
not be entitled to a Payment if termination occurs by reason of death, voluntary
retirement, voluntary termination other than for the reasons specified in
Section 4.2, Disability or for Just Cause.

     4.2   Reasons for Termination
           -----------------------

     Following a Change in Control, a Participant shall be entitled to a Payment
in accordance with Section 4.3 if employment by an Employer is terminated,
voluntarily or involuntary, for any one or more of the following reasons:

           (a)   The Employer reduces the Participant's base salary or rate of
compensation as in effect immediately prior to the Change in Control, or as the
same may have been increased thereafter.

           (b)   The Employer materially changes Participant's function, duties
or responsibilities which would cause the Participant's position to be one of
lesser responsibility, importance or scope with the Employer than immediately
prior to the Change in Control.

           (c)   The Employer requires the Participant to change the location of
the Participant's job or office, so that such Participant will be based at a
location more than thirty-five (35) miles from the location of the Participant's
job or office immediately prior to the Change in Control provided that such new
location is not closer to Participant's home.

           (d)   The Employer materially reduces the benefits and perquisites
available to the Participant immediately prior to the Change in Control;
provided, however, that a material reduction in benefits and perquisites
generally provided to all employees of the Bank on a nondiscriminatory basis
shall not trigger a Payment pursuant to this Plan.

           (e)   A successor to the Employer fails or refuses to assume the
Employer's obligations under this Plan, as required by Article VII.
<PAGE>
 
           (f)   The Employer, or any successor to the Employer, breaches any
other provisions of this Plan.

           (g)   The Employer terminates the employment of a Participant at or
after a Change in Control other than for Just Cause.

     4.3   Amount of Payment
           -----------------

           (a)   Each Participant who was a vice president of the Bank
immediately prior to the effective date of the Change in Control and entitled to
a Payment under this Plan shall receive from the Bank a lump sum cash payment
equal to the Participant's Annual Compensation.

           (b)   Each Participant who was an assistant vice president or manager
of the Bank immediately prior to the effective date of the Change in Control and
entitled to a Payment under this Plan shall receive from the Bank a lump sum
cash payment equal to seventy-five (75) percent of the Participant's Annual
Compensation.

           (c)   Each Participant (other than a Participant entitled to a
benefit under Sections 4.3(a) and (b) of the Plan) entitled to a Payment under
this Plan shall receive from the Employer a lump sum cash payment equal to the
product of fifty percent (50%) of the Participant's Monthly Compensation and the
Participant's years of service (including partial years rounded up to the
nearest full month) from the Participant's date of hire through the date of
termination. Notwithstanding anything herein to the contrary, (i) the maximum
payment under this Section 4.3(c) to a Participant shall not exceed fifty
percent (50%) of the Participant's Annual Compensation and the (ii) minimum
payment under this Section 4.3(c) shall be the Participant's Monthly
Compensation (determined without regard to the Participant's period of service).

           (d)   The Participant shall not be required to mitigate damages on
the amount of the Payment by seeking other employment or otherwise, nor shall
the amount of such Payment be reduced by any compensation earned by the
Participant as a result of employment after termination of employment hereunder.

 
     4.4   Time of Payment
           ---------------

     The Payment to which a Participant is entitled shall be paid to the
Participant by the Employer or the successor to the Employer, in cash and in
full, not later than thirty (30) business days after the termination of the
Participant's employment.  If any Participant should die after termination of
the employment but before all amounts have been paid, such unpaid amounts shall
be paid to the Participant's named beneficiary, if living, otherwise to the
personal representative of behalf of or for the benefit of the Participant's
estate.
<PAGE>
 
     4.5   Suspension of Payment
           ---------------------

     Notwithstanding the foregoing, no payments or portions thereof shall be
made under this Plan, if such payment or portion would result in the Bank
failing to meet its minimum regulatory capital requirements as required by 12
C.F.R. (S)567.2.  Any payments or portions thereof not paid shall be suspended
until such time as their payment would not result in a failure to meet the
Bank's minimum regulatory capital requirements.  Any portion of benefit payments
which have not been suspended will be paid on an equitable basis, pro rata based
upon amounts due each Participant, among all eligible Participants.

                                   ARTICLE V
                    OTHER RIGHTS AND BENEFITS NOT AFFECTED

     5.1   Other Benefits
           --------------

     Neither the provisions of this Plan nor the Payment provided for hereunder
shall reduce any amounts otherwise payable, or in any way diminish the
Participant's rights as an employee of an Employer, whether existing now or
hereafter, under any benefit, incentive, retirement, stock option, stock bonus,
stock ownership or any employment agreement or other plan or arrangement.

     5.2   Employment Status
           -----------------

     This Plan does not constitute a contract of employment or impose on the
Participant's Employer any obligation to retain the Participant, to maintain the
status of the Participant's employment, or to change the Employer's policies
regarding termination of employment.

                                  ARTICLE VI
                            PARTICIPATING EMPLOYERS

     6.1   Upon approval by the Board of the Bank, this Plan may be adopted by
any subsidiary of the Bank or by the Company.  Upon such adoption, the
subsidiary or the Company shall become an Employer hereunder and the provisions
of the Plan shall be fully applicable to the employees of that subsidiary or the
Company.  The term "subsidiary" means any corporation in which the Bank,
directly or indirectly, holds a majority of the voting power of its outstanding
shares of capital stock.

                                  ARTICLE VII
                             SUCCESSOR TO THE BANK

     7.1   The Bank shall require any successor or assignee, whether direct or
indirect, by purchase, merger, consolidation or otherwise, to all or
substantially all the business or assets of the Bank, expressly and
unconditionally to assume and agree to perform the Bank's obligations under this
plan, in the same manner and to the same extent that the Bank would be required
to perform if no such succession or assignment had taken place.
<PAGE>
 
                                 ARTICLE VIII
                      DURATION, AMENDMENT AND TERMINATION

     8.1   Duration
           --------

     If a Change in Control has not occurred, this Plan shall expire as of the
Expiration Date, unless sooner terminated as provided in Section 8.2, or unless
extended for an additional period or periods by resolution adopted by the Board
of the Bank.

     Notwithstanding the foregoing, if a Change in Control occurs this Plan
shall continue in full force and effect, and shall not terminate or expire until
such date as all Participants who become entitled to Payments hereunder shall
have received such Payments in full.

     8.2   Amendment and Termination
           -------------------------

     The Plan may be terminated or amended in any respect by resolution adopted
by a majority of the Board of the Bank, unless a Change in Control has
previously occurred.  If a Change in Control occurs, the Plan no longer shall be
subject to amendment, change, substitution, deletion, revocation or termination
in any respect whatsoever.

     8.3   Form of Amendment
           -----------------

     The form of any proper amendment or termination of the Plan shall be a
written instrument signed by a duly authorized officer or officers of the Bank,
certifying that the amendment or termination has been approved by the Board.  A
proper termination of the Plan automatically shall effect a termination of all
Participants' rights and benefits hereunder.

     8.4   No Attachment
           -------------

           (a)   Except as required by law, no right to receive payments under
this Plan shall be subject to anticipation, commutation, alienation, sale,
assignment, encumbrance, charge, pledge, or hypothecation, or to execution,
attachment, levy, or similar process or assignment by operation of law, and any
attempt, voluntary or involuntary, to affect such action shall be null, void,
and of no effect.

           (b)   This Plan shall be binding upon, and inure to the benefit of,
each employee, the Employer and their respective successors and assigns.

                                  ARTICLE IX
                            LEGAL FEES AND EXPENSES

     9.1   All reasonable legal fees and other expenses paid or incurred by a
party hereto pursuant to any dispute or question of interpretation relating to
this Plan shall be paid or reimbursed by the prevailing party in any legal
judgment, arbitration or settlement.
<PAGE>
 
                                   ARTICLE X
                              REQUIRED PROVISIONS

     10.1  The Bank may terminate the employee's employment at any time, but any
termination by the Bank, other than Termination for Cause, shall not prejudice
employee's right to compensation or other benefits under this Agreement if the
employee is otherwise entitled to a benefit.  The employee shall not have the
right to receive compensation or other benefits for any period after termination
for Just Cause as defined in Section 2.1 hereinabove.

     10.2  If the employee is suspended and/or temporarily prohibited from
participating in the conduct of the Bank's affairs by a notice served under
Section 8(e)(3) or 8(g)(1) of the Federal Deposit Insurance Act, 12 U.S.C.
(S)1818(e)(3) or (g)(1), the Bank's obligations under this Plan to such employee
shall be suspended as of the date of service, unless stayed by appropriate
proceedings.  If the charges in the notice are dismissed, the Bank may in its
discretion (i) pay the employee all or part of the compensation withheld while
their contract obligations were suspended and (ii) reinstate (in whole or in
part) any of the obligation which were suspended.

     10.3  If the employee is removed and/or permanently prohibited from
participating in the conduct of the Bank's affairs by an order issued under
Section 8(e)(4) or 8(g)(1) of the Federal Deposit Insurance Act, 12 U.S.C.
(S)1818(e)(4) or (g)(1), all obligations of the Bank under this Plan to the
employee shall terminate as of the effective date of the order, but vested
rights of the contracting parties shall not be affected.

     10.4  If the Bank is in default as defined in Section 3(x)(1) of the
Federal Deposit Insurance Act, 12 U.S.C. (S)1818(x)(1), all obligations of the
Bank under this Plan shall terminate as of the date of default, but this
paragraph shall not affect any vested rights of the contracting parties.

     10.5  All obligations of the Bank under this contract shall be terminated,
except to the extent determined that continuation of the contract is necessary
for the continued operation of the institution, (i) by the Director of the OTS
(or his designee) or (ii) the Federal Deposit Insurance Corporation ("FDIC") at
the time the FDIC enters into an agreement to provide assistance to or on behalf
of the Bank under the authority contained in Section 13(c) of the Federal
Deposit Insurance Act, 12 U.S.C. (S)1823(c); or (ii) by the Director of the OTS
(or his designee) at the time the Director (or his designee) approves a
supervisory merger to resolve problems related to the operations of the Bank or
when the Bank is determined by the Director to be in an unsafe or unsound
condition.  Any rights of the parties that have already vested, however, shall
not be affected by such action.

     10.6  Any payments made to an employee pursuant to this Plan or otherwise
shall be conditioned upon compliance under 12 U.S.C. (S)1828(k) and any
regulations promulgated thereunder.
<PAGE>
 
                                  ARTICLE XI
                          ADMINISTRATION OF THE PLAN

     11.1  The Plan shall be administered by the Board (or, by a committee of
non-employee directors designated by the Board).  Subject to the other
provisions of the Plan, the Board shall have authority to adopt, amend, alter
and repeal such administrative rules, guidelines and practices governing the
operation of the Plan as it shall from time to time consider advisable, to
interpret the provisions of the Plan and to decide all disputes arising in
connection with the Plan. The Board may correct any defect or supply any
omission or reconcile any inconsistency in the Plan in the manner and to the
extent it shall deem appropriate to carry the Plan into effect, in its sole and
absolute discretion. The Board's decisions and interpretations shall be final
and binding. Any action of the Board with respect to the administration of the
Plan shall be taken pursuant to a majority vote or by the unanimous written
consent of its members.

     Having been adopted by its Board on December 23, 1998, this Plan is
executed by duly authorized officer of the Bank this 31/st/ day of December,
1998.

Attest


/s/Joel E. Voyles                      /s/James G. Pendleton
-----------------------------          -----------------------------------
Secretary                              James G. Pendleton
                                       Chief Executive Officer