<PAGE>

                                                                    Exhibit 10.5

                                  KYPHON INC.

                           2002 DIRECTOR OPTION PLAN

     1.   Purposes of the Plan. The purposes of this 2002 Director Option Plan
          --------------------
are to attract and retain the best available personnel for service as Outside
Directors (as defined herein) of the Company, to provide additional incentive to
the Outside Directors of the Company to serve as Directors, and to encourage
their continued service on the Board.

          All options granted hereunder shall be nonstatutory stock options.

     2.   Definitions.  As used herein, the following definitions shall apply:
          -----------

          (a)  "Board" means the Board of Directors of the Company.
                -----

          (b)  "Code" means the Internal Revenue Code of 1986, as amended.
                ----

          (c)  "Common Stock" means the common stock of the Company.
                ------------

          (d)  "Company" means Kyphon Inc., a Delaware corporation.
                -------

          (e)  "Director" means a member of the Board.
                --------

          (f)  "Disability" means total and permanent disability as defined in
                ----------
section 22(e)(3) of the Code.

          (g)  "Employee" means any person, including officers and Directors,
                --------
employed by the Company or any Parent or Subsidiary of the Company. The payment
of a Director's fee by the Company shall not be sufficient in and of itself to
constitute "employment" by the Company.

          (h)  "Exchange Act" means the Securities Exchange Act of 1934, as
                ------------
amended.

          (i)  "Fair Market Value" means, as of any date, the value of Common
                -----------------
Stock determined as follows:

               (i)  If the Common Stock is listed on any established stock
exchange or a national market system, including without limitation the Nasdaq
National Market or The Nasdaq SmallCap Market of The Nasdaq Stock Market, its
Fair Market Value shall be the closing sales price for such stock (or the
closing bid, if no sales were reported) as quoted on such exchange or system for
the last market trading day prior to the time of determination as reported in
The Wall Street Journal or such other source as the Administrator deems
reliable;

               (ii) If the Common Stock is regularly quoted by a recognized
securities dealer but selling prices are not reported, the Fair Market Value of
a Share of Common Stock shall be the mean between the high bid and low asked
prices for the Common Stock for the last market

<PAGE>

trading day prior to the time of determination, as reported in The Wall Street
Journal or such other source as the Board deems reliable; or

               (iii) In the absence of an established market for the Common
Stock, the Fair Market Value thereof shall be determined in good faith by the
Board.

          (j)  "Inside Director" means a Director who is an Employee.
                ---------------

          (k)  "Option" means a stock option granted pursuant to the Plan.
                ------

          (l)  "Optioned Stock" means the Common Stock subject to an Option.
                --------------

          (m)  "Optionee" means a Director who holds an Option.
                --------

          (n)  "Outside Director" means a Director who is not an Employee.
                ----------------

          (o)  "Parent" means a "parent corporation," whether now or hereafter
                ------
existing, as defined in Section 424(e) of the Code.

          (p)  "Plan" means this 2002 Director Option Plan.
                ----

          (q)  "Share" means a share of the Common Stock, as adjusted in
                -----
accordance with Section 10 of the Plan.

          (r)  "Subsidiary" means a "subsidiary corporation," whether now or
                ----------
hereafter existing, as defined in Section 424(f) of the Internal Revenue Code of
1986.

     3.   Stock Subject to the Plan. Subject to the provisions of Section 10 of
          -------------------------
the Plan, the maximum aggregate number of Shares which may be optioned and sold
under the Plan is 200,000 Shares plus an annual increase to be added on the
first day of the Company's fiscal year beginning in 2003, equal to the lesser of
(i) the number of Shares granted pursuant to Options under the Plan in the prior
fiscal year or (ii) an amount determined by the Board. The Shares may be
authorized, but unissued, or reacquired Common Stock.

          If an Option expires or becomes unexercisable without having been
exercised in full, the unpurchased Shares which were subject thereto shall
become available for future grant or sale under the Plan (unless the Plan has
terminated).  Shares that have actually been issued under the Plan shall not be
returned to the Plan and shall not become available for future distribution
under the Plan.

     4.   Administration and Grants of Options under the Plan.
          ---------------------------------------------------

          (a)  Procedure for Grants. All grants of Options to Outside Directors
               --------------------
under this Plan shall be automatic and nondiscretionary and shall be made
strictly in accordance with the following provisions:

               (i)   No person shall have any discretion to select which Outside
Directors shall be granted Options or to determine the number of Shares to be
covered by Options.

                                      -2-

<PAGE>

               (ii)  Each Outside Director shall be automatically granted an
Option to purchase 40,000 Shares (the "First Option") on the date on which such
person first becomes an Outside Director, whether through election by the
shareholders of the Company or appointment by the Board to fill a vacancy;
provided, however, that an Inside Director who ceases to be an Inside Director
but who remains a Director shall not receive a First Option..

               (iii) Each Outside Director shall be automatically granted an
Option to purchase 10,000 Shares (a "Subsequent Option") on the date of the
Company's annual stockholders meeting each year provided he or she is then an
Outside Director.

               (iv)  The terms of a First Option granted hereunder shall be as
follows:

                     (A)  the term of the Election Option shall be ten (10)
years.

                     (B)  the First Option shall be exercisable only while the
Outside Director remains a Director of the Company, except as set forth in
Sections 8 and 10 hereof.

                     (C)  the exercise price per Share shall be 100% of the Fair
Market Value per Share on the date of grant of the First Option.

                     (D)  subject to Section 10 hereof, the First Option shall
become exercisable as to 1/4/th/ of the Shares subject to the First Option on
each anniversary following its date of grant, provided that the Optionee
continues to serve as a Director on such dates.

               (v)   The terms of a Subsequent Option granted hereunder shall be
as follows:

                     (A)  the term of the Subsequent Option shall be ten (10)
years.

                     (B)  the Subsequent Option shall be exercisable only while
the Outside Director remains a Director of the Company, except as set forth in
Sections 8 and 10 hereof.

                     (C)  the exercise price per Share shall be 100% of the Fair
Market Value per Share on the date of grant of the Subsequent Option.

                     (D)  subject to Section 10 hereof, the Subsequent Option
shall become exercisable as to 100% of the Shares subject to the Subsequent
Option four (4) years following its date of grant, provided that the Optionee
continues to serve as a Director on such date.

               (vi)  In the event that any Option granted under the Plan would
cause the number of Shares subject to outstanding Options plus the number of
Shares previously purchased under Options to exceed the total number of Shares
reserved for issuance under the Plan, then the remaining Shares available for
Option grant shall be granted under Options to the Outside Directors on a pro
rata basis. No further grants shall be made until such time, if any, as
additional Shares become available for grant under the Plan through the
provisions of the Plan, by action of the Board,

                                      -3-

<PAGE>

by the stockholders approving an increase in the number of Shares which may be
issued under the Plan or through cancellation or expiration of Options
previously granted hereunder.

     5.   Eligibility. Options may be granted only to Outside Directors. All
          -----------
Options shall be automatically granted in accordance with the terms set forth in
Section 4 hereof.

          The Plan shall not confer upon any Optionee any right with respect to
continuation of service as a Director or nomination to serve as a Director, nor
shall it interfere in any way with any rights which the Director or the Company
may have to terminate the Director's relationship with the Company at any time.

     6.   Term of Plan. The Plan shall become effective upon the later to occur
          ------------
of its adoption by the Board or its approval by the stockholders of the Company.
It shall continue in effect for a term of ten (10) years unless sooner
terminated under Section 11 of the Plan.

     7.   Form of Consideration. The consideration to be paid for the Shares to
          ---------------------
be issued upon exercise of an Option, including the method of payment, shall
consist of (i) cash, (ii) check, (iii) other Shares, which, in the case of
Shares acquired from the Company, (x) have been owned by the Optionee for more
than six (6) months on the date of surrender, and (y) have a Fair Market Value
on the date of surrender equal to the aggregate exercise price of the Shares as
to which said Option shall be exercised, (iv) consideration received by the
Company under a cashless exercise program implemented by the Company in
connection with the Plan, or (v) any combination of the foregoing methods of
payment.

     8.   Exercise of Option.
          ------------------

          (a)  Procedure for Exercise; Rights as a Shareholder. Any Option
               -----------------------------------------------
granted hereunder shall be exercisable at such times as are set forth in Section
4 hereof and may not be exercised for a fraction of a Share. An Option shall be
deemed to be exercised when written notice of such exercise has been given to
the Company in accordance with the terms of the Option by the person entitled to
exercise the Option and full payment for the Shares with respect to which the
Option is exercised has been received by the Company. Full payment may consist
of any consideration and method of payment allowable under Section 7 of the
Plan. Until the issuance (as evidenced by the appropriate entry on the books of
the Company or of a duly authorized transfer agent of the Company) of the stock
certificate evidencing such Shares, no right to vote or receive dividends or any
other rights as a shareholder shall exist with respect to the Optioned Stock,
notwithstanding the exercise of the Option. A share certificate for the number
of Shares so acquired shall be issued to the Optionee as soon as practicable
after exercise of the Option. No adjustment shall be made for a dividend or
other right for which the record date is prior to the date the stock certificate
is issued, except as provided in Section 10 of the Plan.

               Exercise of an Option in any manner shall result in a decrease in
the number of Shares which thereafter may be available, both for purposes of the
Plan and for sale under the Option, by the number of Shares as to which the
Option is exercised.

                                      -4-

<PAGE>

          (b)  Termination of Continuous Status as a Director. Subject to
               ----------------------------------------------
Section 10 hereof, in the event an Optionee's status as a Director terminates
(other than upon the Optionee's death or Disability), the Optionee may exercise
his or her Option, but only within three (3) months following the date of such
termination, and only to the extent that the Optionee was entitled to exercise
it on the date of such termination (but in no event later than the expiration of
its ten (10) year term). To the extent that the Optionee was not vested as to
his or her entire Option on the date of such termination, the Shares covered by
the unvested portion of the Option shall revert to the Plan. If, after
termination, the Optionee does not exercise his or her Option within the time
specified herein, the Option shall terminate, and the Shares covered by such
Option shall revert to the Plan.

          (c)  Disability of Optionee. In the event Optionee's status as a
               ----------------------
Director terminates as a result of Disability, the Optionee may exercise his or
her Option, but only within twelve (12) months following the date of such
termination, and only to the extent that the Optionee was entitled to exercise
it on the date of such termination (but in no event later than the expiration of
its ten (10) year term). To the extent that the Optionee was not vested as to
his or her entire Option on the date of termination, the Shares covered by the
unvested portion of the Option shall revert to the Plan. If, after termination,
the Optionee does not exercise his or her Option within the time specified
herein, the Option shall terminate, and the Shares covered by such Option shall
revert to the Plan.

          (d)  Death of Optionee. In the event of an Optionee's death, the
               -----------------
Optionee's estate or a person who acquired the right to exercise the Option by
bequest or inheritance may exercise the Option, but only within twelve (12)
months following the date of death, and only to the extent that the Optionee was
entitled to exercise it on the date of death (but in no event later than the
expiration of its ten (10) year term). To the extent that the Optionee was not
vested as to his or her entire an Option on the date of death, the Shares
covered by the unvested portion of the Option shall revert to the Plan. To the
extent that the Optionee's estate or a person who acquired the right to exercise
such Option does not exercise such Option (to the extent otherwise so entitled)
within the time specified herein, the Option shall terminate, and the Shares
covered by such Option shall revert to the Plan.

     9.   Non-Transferability of Options.  The Option may not be sold, pledged,
          ------------------------------
assigned, hypothecated, transferred, or disposed of in any manner other than by
will or by the laws of descent or distribution and may be exercised, during the
lifetime of the Optionee, only by the Optionee.

     10.  Adjustments; Dissolution; Merger or Asset Sale.
          ----------------------------------------------

          (a)  Adjustments. In the event that any dividend or other distribution
               ------------
(whether in the form of cash, Common Stock, other securities, or other
property), recapitalization, stock split, reverse stock split, reorganization,
merger, consolidation, split-up, spin-off, combination, repurchase, or exchange
of Common Stock or other securities of the Company, or other change in the
corporate structure of the Company affecting the Common Stock such that an
adjustment is determined by the Board (in its sole discretion) to be appropriate
in order to prevent dilution or enlargement of the benefits or potential
benefits intended to be made available under the Plan, then the Board shall, in
such manner as it may deem equitable, adjust the number and class of Common
Stock which may be delivered under the Plan, the purchase price per Share and
the number of Shares covered by each

                                      -5-

<PAGE>

Option which has not yet been exercised, and the number of Shares subject to
Options granted pursuant to Section 4.

          (b)  Dissolution or Liquidation. In the event of the proposed
               --------------------------
dissolution or liquidation of the Company, to the extent that an Option has not
been previously exercised, it shall terminate immediately prior to the
consummation of such proposed action.

          (c)  Merger or Asset Sale. In the event of a merger of the Company
               --------------------
with or into another corporation or the sale of substantially all of the assets
of the Company, outstanding Options may be assumed or equivalent options may be
substituted by the successor corporation or a Parent or Subsidiary thereof (the
"Successor Corporation"). If an Option is assumed or substituted for, the Option
or equivalent option shall continue to be exercisable as provided in Section 4
hereof for so long as the Optionee serves as a Director or a director of the
Successor Corporation. Following such assumption or substitution, if the
Optionee's status as a Director or director of the Successor Corporation, as
applicable, is terminated other than upon a voluntary resignation by the
Optionee, the Option or option shall become fully exercisable, including as to
Shares for which it would not otherwise be exercisable. Thereafter, the Option
or option shall remain exercisable in accordance with Sections 8(b) through (d)
above.

               If the Successor Corporation does not assume an outstanding
Option or substitute for it an equivalent option, the Option shall become fully
vested and exercisable, including as to Shares for which it would not otherwise
be exercisable. In such event the Board shall notify the Optionee that the
Option shall be fully exercisable for a period of thirty (30) days from the date
of such notice, and upon the expiration of such period the Option shall
terminate.

               For the purposes of this Section 10(c), an Option shall be
considered assumed if, following the merger or sale of assets, the Option
confers the right to purchase or receive, for each Share subject to the Option
immediately prior to the merger or sale of assets, the consideration (whether
stock, cash, or other securities or property) received in the merger or sale of
assets by holders of Common Stock for each Share held on the effective date of
the transaction (and if holders were offered a choice of consideration, the type
of consideration chosen by the holders of a majority of the outstanding Shares).
If such consideration received in the merger or sale of assets is not solely
common stock of the successor corporation or its Parent, the Administrator may,
with the consent of the successor corporation, provide for the consideration to
be received upon the exercise of the Option, for each Share subject to the
Option, to be solely common stock of the successor corporation or its Parent
equal in fair market value to the per share consideration received by holders of
Common Stock in the merger or sale of assets.

     11.  Amendment and Termination of the Plan.
          -------------------------------------

          (a)  Amendment and Termination. The Board may at any time amend,
               -------------------------
alter, suspend, or discontinue the Plan, but no amendment, alteration,
suspension, or discontinuation shall be made which would impair the rights of
any Optionee under any grant theretofore made, without his or her consent. In
addition, to the extent necessary and desirable to comply with any applicable
law, regulation or stock exchange rule, the Company shall obtain stockholder
approval of any Plan amendment in such a manner and to such a degree as
required.

                                      -6-

<PAGE>

          (b)  Effect of Amendment or Termination. Any such amendment or
               ----------------------------------
termination of the Plan shall not affect Options already granted and such
Options shall remain in full force and effect as if this Plan had not been
amended or terminated.

     12.  Time of Granting Options. The date of grant of an Option shall, for
          ------------------------
all purposes, be the date determined in accordance with Section 4 hereof.

     13.  Conditions Upon Issuance of Shares. Shares shall not be issued
          ----------------------------------
pursuant to the exercise of an Option unless the exercise of such Option and the
issuance and delivery of such Shares pursuant thereto shall comply with all
relevant provisions of law, including, without limitation, the Securities Act of
1933, as amended, the Exchange Act, the rules and regulations promulgated
thereunder, state securities laws, and the requirements of any stock exchange
upon which the Shares may then be listed, and shall be further subject to the
approval of counsel for the Company with respect to such compliance.

          As a condition to the exercise of an Option, the Company may require
the person exercising such Option to represent and warrant at the time of any
such exercise that the Shares are being purchased only for investment and
without any present intention to sell or distribute such Shares, if, in the
opinion of counsel for the Company, such a representation is required by any of
the aforementioned relevant provisions of law.

          Inability of the Company to obtain authority from any regulatory body
having jurisdiction, which authority is deemed by the Company's counsel to be
necessary to the lawful issuance and sale of any Shares hereunder, shall relieve
the Company of any liability in respect of the failure to issue or sell such
Shares as to which such requisite authority shall not have been obtained.

     14.  Reservation of Shares. The Company, during the term of this Plan, will
          ---------------------
at all times reserve and keep available such number of Shares as shall be
sufficient to satisfy the requirements of the Plan.

     15.  Option Agreement. Options shall be evidenced by written option
          ----------------
agreements in such form as the Board shall approve.

                                      -7-

<PAGE>

                                                                    FIRST OPTION

                                  KYPHON INC.

                           DIRECTOR OPTION AGREEMENT

     Kyphon Inc., (the "Company"), has granted to ___________________ (the
"Optionee"), an option to purchase a total of 40,000 shares of the Company's
Common Stock (the "Optioned Stock"), at the price determined as provided herein,
and in all respects subject to the terms, definitions and provisions of the
Company's 2002 Director Option Plan (the "Plan") adopted by the Company which is
incorporated herein by reference.  The terms defined in the Plan shall have the
same defined meanings herein.

     1.   Nature of the Option.  This Option is a nonstatutory option and is not
          --------------------
intended to qualify for any special tax benefits to the Optionee.

     2.   Exercise Price. The exercise price is $__________ for each share of
          --------------
Common Stock.

     3.   Exercise of Option.  This Option shall be exercisable during its term
          ------------------
in accordance with the provisions of Section 8 of the Plan as follows:

          (i)    Right to Exercise.
                 -----------------

                 (a)  This Option shall become exercisable as to 25% of the
Optioned Stock on each anniversary of its date of grant; provided, however, that
in no event shall any Option be exercisable prior to the date the stockholders
of the Company approve the Plan and subject to Optionee continuing to be a
Director on such date.

                 (b)  This Option may not be exercised for a fraction of a
share.

                 (c)  In the event of Optionee's death, disability or other
termination of service as a Director, the exercisability of the Option is
governed by Section 8 of the Plan.

          (ii)   Method of Exercise.  This Option shall be exercisable by
                 ------------------
written notice which shall state the election to exercise the Option and the
number of Shares in respect of which the Option is being exercised. Such written
notice, in the form attached hereto as Exhibit A, shall be signed by the
                                       ---------
Optionee and shall be delivered in person or by certified mail to the Secretary
of the Company. The written notice shall be accompanied by payment of the
exercise price.

     4.   Method of Payment.  Payment of the exercise price shall be by any of
          -----------------
the following, or a combination thereof, at the election of the Optionee:

          (i)    cash;

          (ii)   check;

          (iii)  surrender of other Shares, provided Shares acquired from the
Company, (x) have been owned by the Optionee for more than six (6) months on the
date of surrender, and (y)

<PAGE>

have a Fair Market Value on the date of surrender equal to the aggregate
exercise price of the Shares as to which said Option shall be exercised; or

          (iv)   delivery of a properly executed exercise notice together with
such other documentation as the Company and the broker, if applicable, shall
require to effect an exercise of the Option and delivery to the Company of the
sale or loan proceeds required to pay the exercise price.

     5.   Restrictions on Exercise.  This Option may not be exercised if the
          ------------------------
issuance of such Shares upon such exercise or the method of payment of
consideration for such shares would constitute a violation of any applicable
federal or state securities or other law or regulations, or if such issuance
would not comply with the requirements of any stock exchange upon which the
Shares may then be listed. As a condition to the exercise of this Option, the
Company may require Optionee to make any representation and warranty to the
Company as may be required by any applicable law or regulation.

     6.   Non-Transferability of Option.  This Option may not be transferred in
          -----------------------------
any manner otherwise than by will or by the laws of descent or distribution and
may be exercised during the lifetime of Optionee only by the Optionee. The terms
of this Option shall be binding upon the executors, administrators, heirs,
successors and assigns of the Optionee.

     7.   Term of Option.  This Option may not be exercised more than ten (10)
          --------------
years from the date of grant of this Option, and may be exercised during such
period only in accordance with the Plan and the terms of this Option.

     8.   Taxation Upon Exercise of Option.  Optionee understands that, upon
          --------------------------------
exercise of this Option, he or she will recognize income for tax purposes in an
amount equal to the excess of the then Fair Market Value of the Shares purchased
over the exercise price paid for such Shares. Since the Optionee is subject to
Section 16(b) of the Securities Exchange Act of 1934, as amended, under certain
limited circumstances the measurement and timing of such income (and the
commencement of any capital gain holding period) may be deferred, and the
Optionee is advised to contact a tax advisor concerning the application of
Section 83 in general and the availability a Section 83(b) election in
particular in connection with the exercise of the Option. Upon a resale of such
Shares by the Optionee, any difference between the sale price and the Fair
Market Value of the Shares on the date of exercise of the Option, to the extent
not included in income as described above, will be treated as capital gain or
loss.

                 [Remainder of page intentionally left blank]

                                      -2-

<PAGE>

     DATE OF GRANT:  ______________

                                             KYPHON INC.,
                                             A Delaware corporation

                                             By:_______________________________

     Optionee acknowledges receipt of a copy of the Plan, a copy of which is
attached hereto, and represents that he or she is familiar with the terms and
provisions thereof, and hereby accepts this Option subject to all of the terms
and provisions thereof.  Optionee hereby agrees to accept as binding, conclusive
and final all decisions or interpretations of the Board upon any questions
arising under the Plan.

     Dated: _________________

                                             ______________________________
                                             Optionee



                 [SIGNATURE PAGE TO DIRECTOR OPTION AGREEMENT]

                                      -3-

<PAGE>

                                   EXHIBIT A
                                   ---------

                        DIRECTOR OPTION EXERCISE NOTICE

Kyphon Inc.
1350 Bordeaux Dr.
Sunnyvale, CA 94089

Attention: Corporate Secretary

     1.   Exercise of Option. The undersigned ("Optionee") hereby elects to
          ------------------
exercise Optionee's option to purchase __________ shares of the Common Stock
(the "Shares") of Kyphon Inc. (the "Company") under and pursuant to the
Company's 2002 Director Option Plan and the Director Option Agreement (the
"Agreement").

     2.   Representations of Optionee.  Optionee acknowledges that Optionee has
          ---------------------------
received, read and understood the Agreement.

     3.   Federal Restrictions on Transfer.  Optionee understands that the
          --------------------------------
Shares must be held indefinitely unless they are registered under the Securities
Act of 1933, as amended (the "1933 Act"), or unless an exemption from such
registration is available, and that the certificate(s) representing the Shares
may bear a legend to that effect. Optionee understands that the Company is under
no obligation to register the Shares and that an exemption may not be available
or may not permit Optionee to transfer Shares in the amounts or at the times
proposed by Optionee.

     4.   Tax Consequences.  Optionee understands that Optionee may suffer
          ----------------
adverse tax consequences as a result of Optionee's purchase or disposition of
the Shares. Optionee represents that Optionee has consulted with any tax
consultant(s) Optionee deems advisable in connection with the purchase or
disposition of the Shares and that Optionee is not relying on the Company for
any tax advice.

     5.   Delivery of Payment.  Optionee herewith delivers to the Company the
          -------------------
aggregate purchase price for the Shares that Optionee has elected to purchase
and has made provision for the payment of any federal or state withholding taxes
required to be paid or withheld by the Company.

     6.   Entire Agreement.  The Agreement is incorporated herein by reference.
          ----------------
This Exercise Notice and the Agreement constitute the entire agreement of the
parties and supersede in their entirety all prior undertakings and agreements of
the Company and Optionee with respect to the subject matter hereof. This
Exercise Notice and the Agreement are governed by California law except for that
body of law pertaining to conflict of laws.

                 [Remainder of page intentionally left blank]

<PAGE>

Submitted by:                           Accepted by:

OPTIONEE:                               KYPHON INC.

By:__________________________           By: _______________________________

                                        Its: ______________________________

Address:


Dated:_______________________           Dated:__________________________





              [SIGNATURE PAGE TO DIRECTOR OPTION EXERCISE NOTICE]

                                      -2-

<PAGE>

                                                               SUBSEQUENT OPTION

                                  KYPHON INC.

                           DIRECTOR OPTION AGREEMENT

     Kyphon Inc., (the "Company"), has granted to ___________________ (the
"Optionee"), an option to purchase a total of 10,000 shares of the Company's
Common Stock (the "Optioned Stock"), at the price determined as provided herein,
and in all respects subject to the terms, definitions and provisions of the
Company's 2002 Director Option Plan (the "Plan") adopted by the Company which is
incorporated herein by reference.  The terms defined in the Plan shall have the
same defined meanings herein.

     1.   Nature of the Option.  This Option is a nonstatutory option and is not
          --------------------
intended to qualify for any special tax benefits to the Optionee.

     2.   Exercise Price.  The exercise price is $__________ for each share of
          --------------
Common Stock.

     3.   Exercise of Option.  This Option shall be exercisable during its term
          ------------------
in accordance with the provisions of Section 8 of the Plan as follows:

          (i)    Right to Exercise.
                 -----------------

                 (a)  This Option shall become exercisable as to 100% of the
Optioned Stock on the 4/th/ anniversary of the date of grant; provided, however,
that in no event shall any Option be exercisable prior to the date the
stockholders of the Company approve the Plan and subject to Optionee continuing
to be a Director on such date.

                 (b)  This Option may not be exercised for a fraction of a
share.

                 (c)  In the event of Optionee's death, disability or other
termination of service as a Director, the exercisability of the Option is
governed by Section 8 of the Plan.

          (ii)   Method of Exercise.  This Option shall be exercisable by
                 ------------------
written notice which shall state the election to exercise the Option and the
number of Shares in respect of which the Option is being exercised. Such written
notice, in the form attached hereto as Exhibit A, shall be signed by the
                                       ---------
Optionee and shall be delivered in person or by certified mail to the Secretary
of the Company. The written notice shall be accompanied by payment of the
exercise price.

     4.   Method of Payment.  Payment of the exercise price shall be by any of
          -----------------
the following, or a combination thereof, at the election of the Optionee:

          (i)    cash;

          (ii)   check;

          (iii)  surrender of other Shares, provided Shares acquired from the
Company, (x) have been owned by the Optionee for more than six (6) months on the
date of surrender, and (y)

<PAGE>

have a Fair Market Value on the date of surrender equal to the aggregate
exercise price of the Shares as to which said Option shall be exercised; or

          (iv)   delivery of a properly executed exercise notice together with
such other documentation as the Company and the broker, if applicable, shall
require to effect an exercise of the Option and delivery to the Company of the
sale or loan proceeds required to pay the exercise price.

     5.   Restrictions on Exercise.  This Option may not be exercised if the
          ------------------------
issuance of such Shares upon such exercise or the method of payment of
consideration for such shares would constitute a violation of any applicable
federal or state securities or other law or regulations, or if such issuance
would not comply with the requirements of any stock exchange upon which the
Shares may then be listed. As a condition to the exercise of this Option, the
Company may require Optionee to make any representation and warranty to the
Company as may be required by any applicable law or regulation.

     6.   Non-Transferability of Option.  This Option may not be transferred in
          -----------------------------
any manner otherwise than by will or by the laws of descent or distribution and
may be exercised during the lifetime of Optionee only by the Optionee. The terms
of this Option shall be binding upon the executors, administrators, heirs,
successors and assigns of the Optionee.

     7.   Term of Option.  This Option may not be exercised more than ten (10)
          --------------
years from the date of grant of this Option, and may be exercised during such
period only in accordance with the Plan and the terms of this Option.

     8.   Taxation Upon Exercise of Option.  Optionee understands that, upon
          --------------------------------
exercise of this Option, he or she will recognize income for tax purposes in an
amount equal to the excess of the then Fair Market Value of the Shares purchased
over the exercise price paid for such Shares. Since the Optionee is subject to
Section 16(b) of the Securities Exchange Act of 1934, as amended, under certain
limited circumstances the measurement and timing of such income (and the
commencement of any capital gain holding period) may be deferred, and the
Optionee is advised to contact a tax advisor concerning the application of
Section 83 in general and the availability a Section 83(b) election in
particular in connection with the exercise of the Option. Upon a resale of such
Shares by the Optionee, any difference between the sale price and the Fair
Market Value of the Shares on the date of exercise of the Option, to the extent
not included in income as described above, will be treated as capital gain or
loss.

                 [Remainder of page intentionally left blank]

                                      -2-

<PAGE>

     DATE OF GRANT:  ______________

                                        KYPHON INC.,
                                        A Delaware corporation


                                        By: __________________________________

     Optionee acknowledges receipt of a copy of the Plan, a copy of which is
attached hereto, and represents that he or she is familiar with the terms and
provisions thereof, and hereby accepts this Option subject to all of the terms
and provisions thereof.  Optionee hereby agrees to accept as binding, conclusive
and final all decisions or interpretations of the Board upon any questions
arising under the Plan.

     Dated: _________________

                                        ______________________________
                                        Optionee



                 [SIGNATURE PAGE TO DIRECTOR OPTION AGREEMENT]

                                      -3-

<PAGE>

                                   EXHIBIT A
                                   ---------

                        DIRECTOR OPTION EXERCISE NOTICE

Kyphon Inc.
1350 Bordeaux Dr.
Sunnyvale, CA 94089

Attention: Corporate Secretary

     1.   Exercise of Option.  The undersigned ("Optionee") hereby elects to
          ------------------
exercise Optionee's option to purchase ______ shares of the Common Stock (the
"Shares") of Kyphon Inc. (the "Company") under and pursuant to the Company's
2002 Director Option Plan and the Director Option Agreement (the "Agreement").

     2.   Representations of Optionee.  Optionee acknowledges that Optionee has
          ---------------------------
received, read and understood the Agreement.

     3.   Federal Restrictions on Transfer.  Optionee understands that the
          --------------------------------
Shares must be held indefinitely unless they are registered under the Securities
Act of 1933, as amended (the "1933 Act"), or unless an exemption from such
registration is available, and that the certificate(s) representing the Shares
may bear a legend to that effect. Optionee understands that the Company is under
no obligation to register the Shares and that an exemption may not be available
or may not permit Optionee to transfer Shares in the amounts or at the times
proposed by Optionee.

     4.   Tax Consequences.  Optionee understands that Optionee may suffer
          ----------------
adverse tax consequences as a result of Optionee's purchase or disposition of
the Shares. Optionee represents that Optionee has consulted with any tax
consultant(s) Optionee deems advisable in connection with the purchase or
disposition of the Shares and that Optionee is not relying on the Company for
any tax advice.

     5.   Delivery of Payment.  Optionee herewith delivers to the Company the
          -------------------
aggregate purchase price for the Shares that Optionee has elected to purchase
and has made provision for the payment of any federal or state withholding taxes
required to be paid or withheld by the Company.

     6.   Entire Agreement.  The Agreement is incorporated herein by reference.
          ----------------
This Exercise Notice and the Agreement constitute the entire agreement of the
parties and supersede in their entirety all prior undertakings and agreements of
the Company and Optionee with respect to the subject matter hereof. This
Exercise Notice and the Agreement are governed by California law except for that
body of law pertaining to conflict of laws.

                 [Remainder of page intentionally left blank]

<PAGE>

Submitted by:                           Accepted by:

OPTIONEE:                               KYPHON INC.


By: __________________________          By: _______________________________

                                        Its: ______________________________

Address:



Dated: _______________________          Dated: ______________________





              [SIGNATURE PAGE TO DIRECTOR OPTION EXERCISE NOTICE]

                                      -2-