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                                                                   EXHIBIT 10.40

                              EMPLOYMENT AGREEMENT

         AGREEMENT, made as of December 16, 1998 by and between MEDCATH
INCORPORATED a North Carolina corporation (the "Company") and DENNIS I. KELLY
("Executive").

                                    RECITALS

         In order to induce Executive to serve as the Senior Vice President -
Development of the Company, the Company desires to provide Executive with
compensation and other benefits on the terms and conditions set forth in this
Agreement.

         Executive is willing to accept such employment and perform services for
the Company, on the terms and conditions hereinafter set forth.

         It is therefore hereby agreed by and between the parties as follows:

         1.       Employment.

         1.1      Subject to the terms and conditions of this Agreement, the
Company agrees to employ Executive during the term hereof as its Senior Vice
President - Development. In his capacity as the Senior Vice President -
Development of the Company, Executive shall report to the Chief Executive
Officer ("CEO") of the Company and shall have the customary powers,
responsibilities and authorities of a senior vice president - development for
corporations of the size and character of the Company, as it exists from time to
time, and as are assigned by the CEO.

         1.2      Subject to the terms and conditions of this Agreement,
Executive hereby accepts employment with the Company commencing on January 15,
1999, and agrees to devote his full working time and efforts, to the best of his
ability, experience and talent, to the performance of services, duties and
responsibilities in connection therewith. Executive shall perform such duties
and exercise such powers, commensurate with his position, as the CEO shall


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from time to time delegate to him on such terms and conditions and subject to
such restrictions as the board of directors of the Company (the "Board") may
reasonably from time to time impose.

         1.3      Nothing in this Agreement shall preclude Executive from
engaging, so long as, in the reasonable determination of the Board, such
activities do not interfere with his duties and responsibilities hereunder, in
charitable and community affairs, from managing any passive investment made by
him in publicly traded equity securities or other property (provided that no
such investment may exceed 5% of the equity of any entity or, without prior
notice to the Board and subject to Section 13(b) hereof, from serving as a
member of boards of directors or as a trustee of any other corporation,
association or entity.

         2.       Term of Employment. Executive's term of employment under this
Agreement shall commence on January 15, 1999 and, subject to the terms hereof,
shall terminate on the earlier of (i) September 30, 2002 (the "Termination
Date") or (ii) termination of Executive's employment pursuant to this Agreement;
provided, however, that, unless earlier terminated as a result of Executive's
termination of employment, this Agreement shall automatically renew for one
additional year following the Termination Date unless, at least 90 days prior to
the Termination Date, Executive provides written notice to the Company of his
intention not to continue his employment with the Company for such additional
year; provided, further, that (A) any other termination of employment by
Executive (other than for death, Permanent Disability or Good Reason) may only
be made upon 90 days prior written notice to the Company and any termination of
employment by Executive for Good Reason may only be made upon 30 days prior
written notice to the Company and (B) any termination of employment by the
Company for any reason may only be made upon 30 days prior written notice to
Executive.

         3.       Compensation.

         3.1      Salary. The Company shall pay Executive a base salary ("Base
Salary") at the rate of $200,000 per annum for the year commencing on the
beginning of Executive's term of employment hereunder. Base Salary shall be
adjusted annually at the discretion of the Board but


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in no event shall Base Salary be reduced nor be less than the median base salary
for a comparable position at corporations of similar size and character as the
Company, as it exists from time to time, and, as increased, shall constitute
"Base Salary" hereunder. Base Salary shall be payable in accordance with the
ordinary payroll practices of the Company.

         3.2      Annual Bonus. In addition to his Base Salary, the Company
shall pay to Executive an annual cash bonus (the "Bonus") during the term of his
employment hereunder equal to a percentage of Executive's Base Salary (the
"Target Bonus"). The Bonus for each fiscal year of the Company will be tied to
either the Company's earnings per share as reported in its annual financial
statements excluding any extraordinary or nonrecurring items set forth therein
(the "EPS") and the annual EPS target for that year (the "EPS Target"), or such
other applicable performance targets as are established by the Board (or a
committee thereof). On or before the beginning of each fiscal year, the Board
(or a committee thereof) shall establish an EPS Target or other applicable
performance target (the "Target") for that year. At the end of each fiscal year,
Executive shall be paid a Target Bonus based upon the following formula:

                  If the Company's actual performance results equal
         80% of the Target or greater (e.g., actual EPS is 80% of the
         EPS Target or greater) (the comparative percentage of the
         actual performance results to the Target is referred to
         herein as the "Bonus Growth Percentage"), then Executive's
         Target Bonus shall be the Bonus Growth Percentage multiplied
         by 50% of Executive's Base Salary for the fiscal year then
         ended, subject to a maximum Bonus Growth Percentage of 120%.
         If the Bonus Growth Percentage is less than 80%, no Bonus
         will be earned or paid.

         3.3      Compensation Plans and Programs. Executive shall be eligible
to participate in any compensation plan or program maintained by the Company
from time to time, which compensation plans and programs are intended to be
comparable to those currently maintained by the Company, in which other senior
executives of the Company participate on terms that are intended to be
comparable to those applicable to such other senior executives.


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         4.       Employee Benefits.

         4.1      Employee Benefit Programs, Plans and Practices. The Company
shall provide Executive during the term of his employment hereunder with
coverage under all employee pension and welfare benefit programs, plans and
practices (commensurate with his positions in the Company from time to time and
to the extent permitted under any employee benefit plan) in accordance with the
terms thereof, which the Company makes available to its senior executives and
which employee pension and welfare benefit programs, plans and practices that
are intended to be comparable to those currently maintained by the Company.

         4.2      Vacation and Fringe Benefits. Executive shall be entitled to
no less than the number of business days paid vacation in each calendar year to
which Executive is currently entitled, which shall be taken at such times as are
consistent with Executive's responsibilities hereunder. In addition, Executive
shall be entitled to the perquisites and other fringe benefits currently made
available to senior executives of the Company, commensurate with his position
with the Company.

         5.       Expenses. Executive is authorized to incur reasonable expenses
in carrying out his duties and responsibilities under this Agreement, including,
without limitation, expenses for travel and similar items related to such duties
and responsibilities. The Company will reimburse Executive for all such expenses
upon presentation by Executive from time to time of appropriately itemized and
approved (consistent with the Company's policy) accounts of such expenditures.

         6.       Termination of Employment.

         6.1      Termination By the Company Without Cause or By Executive for
Good Reason. (a) The Company may terminate Executive's employment at any time
for any reason. If Executive's employment is terminated by the Company without
Cause (as defined in Section 6.4 hereof) (other than as a result of Executive's
death or Permanent Disability (as defined in Section 6.2 hereof)) or if
Executive terminates his employment for Good Reason (as defined in Section 6.1
(d) hereof) prior to the Termination Date, Executive shall receive such
payments, if


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any, under applicable plans or programs, including but not limited to those
referred to in Section 3.4 hereof, to which he is entitled pursuant to the terms
of such plans or programs. In addition, in connection with such termination
Executive shall be entitled to receive the following: (i) an amount equal to (A)
one times the Executive's Base Salary, provided that (B) if such termination
occurs at the time of and in connection with a Change of Control (as defined in
Executive's Non-Qualified Stock Option Agreement dated as of the date hereof)
which Change of Control occurs after the first anniversary of the date hereof,
then an amount equal to two times the Executive's Base Salary, in either case at
the annual rate as of the date of termination under this Section 6.1(a), payable
over the twelve month period following the Termination Date in substantially
equal installment payments and in accordance with the normal payroll practices
of the Company; (ii) a cash lump sum payment in respect of (x) accrued but
unused vacation days (the "Vacation Payment"), (y) compensation earned but not
yet paid (including any awarded but deferred Bonus payments) (the "Compensation
Payment") and (z) reasonable expenses incurred under Section 5 but not yet
reimbursed (the "Expense Payment"); and (iii) continued coverage under any
employee medical, disability and life insurance plans in accordance with the
respective terms thereof for a period ending on the earlier of (A) 12 months
after the date of termination under this Section 6.1(a) or (B) the date on which
the Executive becomes covered under comparable benefit plans of a new employer.

                  (b)      The Vacation Payment, the Compensation Payment, and
the Expense Payment shall be paid by the Company to Executive within 30 days
after the termination of Executive's employment by check payable to the order of
Executive or by wire transfer to an account specified by Executive.

                  (c)      For purposes of this Agreement, "Good Reason" shall
mean any of the following (without Executive's express prior written consent):

                  (i)      A substantial reduction by the Company of Executive's
         duties or responsibilities, other than (x) as approved by the current
         CEO of the Company (namely, Stephen R. Puckett) and (y) in connection
         with the termination of


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         Executive's employment by the Company for Cause, by Executive without
         Good Reason or as a result of Permanent Disability or Executive's
         death;

                  (ii)     A reduction by the Company in Executive's Base Salary
         or an amendment to the terms of the bonus plan in effect for senior
         executives and in which Executive participates on the date hereof which
         would adversely effect the ability of Executive to receive a Bonus
         (except that the establishment of the EPS or other performance targets
         to be set by the Board annually shall be deemed not to constitute such
         an amendment);

                  (iii)    A reduction or elimination of Executive's eligibility
         to participate in any of the Company's employee benefit plans that is
         inconsistent with the eligibility of similarly situated executives of
         the Company to participate therein; or

                  (iv)     Any relocation to a primary workplace that is more
         than fifty (50) miles from the Executive's workplace in effect as of
         the date of this Agreement.

                  (d)      With respect to (i) the payments Executive could
receive under this Section 6.1 and (ii) the provisions of the options for
capital stock of the Company granted as of the date of this Agreement (whether
as new or replacement options), the Company represents that it has received from
Welsh, Carson, Anderson & Stowe VII, L.P. and MedCath 1998 L.L.C. (holders of
more than 75% of all outstanding shares of capital stock of the Company and its
parent entities), after adequate disclosure, stockholder approval in a separate
vote to make such payments and provide for such acceleration, both of which are
made on the terms of the agreements presented to such stockholders.

                  6.2      Permanent Disability. If the Executive becomes
totally and permanently disabled (as defined in the Company's Long-Term
Disability Benefit Plan applicable to senior executive officers as in effect on
the date hereof) ("Permanent Disability"), the Company or Executive may
terminate Executive's employment on written notice thereof, and Executive shall
receive or commence receiving, as soon as practicable:

                  (i)      amounts payable pursuant to the terms of a disability
         insurance policy or similar arrangement which the Company maintains
         during the term hereof;


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                  (ii)     the Target Bonus in respect of the fiscal year in
         which his termination occurs, prorated by a fraction, the numerator of
         which is the number of days of the fiscal year until termination and
         the denominator of which is 365;

                  (iii)    the Vacation Payment, the Compensation Payment, and
         the Expense Payment; and

                  (iv)     such payments under applicable plans or programs,
         including but not limited to those referred to in Section 3.4 hereof,
         to which he is entitled pursuant to the terms of such plans or
         programs.

                  6.3      Death. In the event of Executive's death during the
term of his employment hereunder, Executive's estate or designated beneficiaries
shall receive or commence receiving, as soon as practicable:

                  (i)      the Target Bonus in respect of the fiscal year in
         which his death occurs, prorated by a fraction, the numerator of which
         is the number of days of the fiscal year until his death and the
         denominator of which is 365;

                  (ii)     any death benefits provided under the employee
         benefit programs, plans and practices referred to in Section 4.1
         hereof, in accordance with their terms;

                  (iii)    the Vacation Payment, the Compensation Payment, and
         the Expense Payment; and

                  (iv)     such payments under applicable plans or programs,
         including but not limited to those referred to in Section 3.4 hereof,
         to which Executive's estate or designated beneficiaries are entitled
         pursuant to the terms of such plans or programs.

                  6.4      Termination By the Company for Cause or By Executive
without Good Reason. (a) The Company shall have the right to terminate the
employment of Executive for Cause. In the event that Executive's employment is
terminated by the Company for Cause, as hereinafter defined, or by Executive
without Good Reason (other than as a result of the Executive's Permanent
Disability or death), prior to the Termination Date, notwithstanding any other
provision in this Agreement, the Executive shall be entitled only to the
Compensation


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Payment, the Vacation Payment, and the Expense Payment, and shall not be
entitled to any further compensation or benefits hereunder including, without
limitation, the payment of any Bonus in respect of all or any portion of the
fiscal year in which such termination occurs.

                  (b)      As used herein, the term "Cause" shall be limited to
(i) willful misconduct by Executive involving dishonesty or breach of trust in
connection with his employment which results in a demonstrable injury (which is
other than de minimis or insignificant) to the Company, (ii) willful and
continued failure by Executive to perform his material duties with respect to
the Company or its subsidiaries, which failure continues beyond 10 days after a
written demand for substantial performance of such duties was given to Executive
by the Company, or (iii) the Executive's conviction of, or plea of nolo
contendere to, a felony. Termination of Executive pursuant to this Section 6.4
shall be made by delivery to Executive of written notice that, in the reasonable
judgment of the Board, Executive was guilty of conduct set forth in any of
clauses (i) through (iii) above and specifying the particulars thereof.

                  7.       Mitigation of Damages. Executive shall not be
required to mitigate damages or the amount of any payment provided for under
this Agreement by seeking other employment or otherwise after the termination of
his employment hereunder.

                  8.       Notices. All notices or communications hereunder
shall be in writing, addressed as follows:

                  To the Company:

                           MedCath Incorporated
                           7621 Little Avenue
                           Suite 106
                           Charlotte, North Carolina 28226
                           Attention: President


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                  with a copy to:

                           MedCath Incorporated
                           c/o Kohlberg Kravis
                               Roberts & Co.
                           2800 Sand Hill Road
                           Suite 200
                           Menlo Park, California 94025
                           (Attn: Edward A. Gilhuly)

                  with a copy to:

                           Alvin H. Brown, Esq.
                           Simpson Thacher & Bartlett
                           425 Lexington Avenue
                           New York, New York 10017

                  with a copy to:

                           Hal A. Levinson, Esq.
                           Moore & Van Allen, PLLC
                           100 N. Tryon Street, Floor 47
                           Charlotte, North Carolina 28202-4003

                  To Executive:

                           Dennis I. Kelly
                           3 Hodge Drive
                           Bridgewater, New Jersey 08807

Any such notice or communication shall be delivered by hand, by telecopy (with
machine confirmation) or by courier or sent certified or registered mail, return
receipt requested, postage prepaid, addressed as above (or to such other address
as such party may designate in a notice duly delivered as described above), and
the third business day after the actual date of mailing shall constitute the
time at which notice was given.

                  9.       Separability; Legal Fees. If any provision of this
Agreement shall be declared to be invalid or unenforceable, in whole or in part,
such invalidity or unenforceability shall not affect the remaining provisions
hereof which shall remain in full force and effect. Each


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party shall bear the costs of any legal fees and other fees and expenses which
may be incurred in respect of enforcing its respective rights under this
Agreement.

                  10.      Assignment. This contract shall be binding upon and
inure to the benefit of the heirs and representatives of Executive and the
assigns and successors of the Company, but neither this Agreement nor any rights
or obligations hereunder shall be assignable or otherwise subject to
hypothecation by Executive (except by will or by operation of the laws of
intestate succession) or by the Company, except that the Company may assign this
Agreement to any successor (whether by merger, purchase or otherwise) to all or
substantially all of the stock, assets or businesses of the Company, if such
successor expressly agrees to assume the obligations of the Company hereunder.

                  11.      Amendment. This Agreement may only be amended by
written agreement of the parties hereto.

                  12.      Nondisclosure of Confidential Information;
Non-Competition. (a) At any time during or after Executive's employment with the
Company, Executive shall not, without the prior written consent of the Company,
use, divulge, disclose or make accessible to any other person, firm,
partnership, corporation or other entity any Confidential Information (as
hereinafter defined) pertaining to the business of the Company or any of its
subsidiaries, except (i) while employed by the Company, in the business of and
for the benefit of the Company, or (ii) when required to do so by a court of
competent jurisdiction, by any governmental agency having supervisory authority
over the business of the Company, or by any administrative body or legislative
body (including a committee thereof) with jurisdiction to order Executive to
divulge, disclose or make accessible such information. For purposes of this
Section 13(a), "Confidential Information" shall mean non-public information
concerning the financial data, strategic business plans, and other non-public,
proprietary and confidential information of the Company, its subsidiaries,
Kohlberg Kravis Roberts & Co., Welsh, Carson, Anderson & Stowe VII, L.P., or
their respective affiliates as in existence as of the date of Executive's
termination of employment


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(collectively, the "Restricted Group") that, in any case, is not otherwise
available to the public (other than by Executive's breach of the terms hereof).

                  (b)      During the period of his employment hereunder and for
one year thereafter, Executive agrees that, without the prior written consent of
the Company, (A) he will not, directly or indirectly, either as principal,
manager, agent, consultant, officer, stockholder, partner, investor, lender or
employee or in any other capacity, carry on, be engaged in or have any financial
interest in (other than an ownership position of less than 5 percent in any
company whose shares are publicly traded), any business, which is in Competition
(as hereinafter defined) with the existing business of the Company or its
subsidiaries (which business shall consist of owning or managing cardiac care
hospitals, centers or clinics, and any such business in which the Company or any
of its subsidiaries has taken concrete steps toward engaging) and (B) he shall
not, on his own behalf or on behalf of any person, firm or company, directly or
indirectly, solicit or offer employment to any person who has been employed by
the Company or its subsidiaries at any time during the 12 months immediately
preceding such solicitation.

                  (c)      For purposes of this Section 13, a business shall be
deemed to be in Competition with the Company or its subsidiaries if it is
engaged in or has taken concrete steps toward engaging in the business of owning
or managing cardiac care hospitals, centers or clinics in the United States.

                  (d)      Executive and the Company agree that this covenant
not to compete is a reasonable covenant under the circumstances, and further
agree that if in the opinion of any court of competent jurisdiction such
restraint is not reasonable in any respect, such court shall have the right,
power and authority to excise or modify such provision or provisions of this
covenant as to the court shall appear not reasonable and to enforce the
remainder of the covenant as so amended. Executive agrees that any breach of the
covenants contained in this Section 13 would irreparably injure the Company.
Accordingly, Executive agrees that the Company may, in addition to pursuing any
other remedies it may have in law or in equity, cease making any payments
otherwise required by this Agreement and obtain an injunction against Executive
from


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any court having jurisdiction over the matter restraining any further violation
of this Agreement by Executive.

                  13.      Beneficiaries; References. Executive shall be
entitled to select (and change, to the extent permitted under any applicable
law) a beneficiary or beneficiaries to receive any compensation or benefit
payable hereunder following Executive's death, and may change such election, in
either case by giving the Company written notice thereof. In the event of
Executive's death or a judicial determination of his incompetence, reference in
this Agreement to Executive shall be deemed, where appropriate, to refer to his
beneficiary, estate or other legal representative. Any reference to the
masculine gender in this Agreement shall include, where appropriate, the
feminine.

                  14.      Survivorship. The respective rights and obligations
of the parties hereunder shall survive any termination of this Agreement to the
extent necessary to the intended preservation of such rights and obligations,
including the provisions of Section 13 herein. The provisions of this Section 15
are in addition to the survivorship provisions of any other section of this
Agreement.

                  15.      Governing Law. This Agreement shall be construed,
interpreted and governed in accordance with the laws of the State of North
Carolina without reference to rules relating to conflicts of law.

                  16.      Effect on Prior Agreements. This Agreement contains
the entire understanding between the parties hereto and supersedes in all
respects any prior or other agreement or understanding between the Company or
any affiliate of the Company and Executive other than the agreements referred to
in Section 7 hereof.

                  17.      Withholding. The Company shall be entitled to
withhold from payment any amount of withholding required by law.


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                  18.      Counterparts. This Agreement may be executed in two
or more counterparts, each of which will be deemed an original.

                                       MEDCATH INCORPORATED



                                       By /s/ Stephen Puckett
                                         --------------------------------------
                                        Name:
                                        Title:



                                          /s/ Dennis I. Kelly
                                       ----------------------------------------
                                          Dennis I. Kelly


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