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                                                                    EXHIBIT 10.5

                             EMPLOYMENT AGREEMENT

     Employment Agreement dated as of November 4, 1997 between Dennis G.
Johnston (the "Executive") and Paragon Health Network, Inc., a Delaware
corporation (the "Company").

     WHEREAS, the Company desires to employ the Executive as President, Hospital
Services Division, and the Executive desires to accept such employment, for the
term and upon the other conditions hereinafter set forth; and

     WHEREAS, as a condition of entering into this Agreement, the Executive
agrees to waive the Executive's rights, if any, against the Company and any
predecessor company (including GranCare, Inc.) under (i) any employment
agreement and (ii) any other plan, arrangement or agreement of any kind that
provides any form of severance payments; and

     WHEREAS, the parties desire to enter into this Agreement setting forth the
terms and conditions of the employment relationship of the Executive with the
Company;

     NOW, THEREFORE, the parties agree as follows:

     1.   Employment. The Company hereby employs the Executive, and the
          ----------
Executive hereby accepts employment with the Company, upon the terms and subject
to the conditions set forth herein.

     2.   Term. This Agreement shall commence on the date hereof (the "Effective
          ----
Date") and continue for the three-year period (the "Term") terminating on the
third anniversary of the Effective Date, or upon the Executive's earlier death,
disability or other termination of employment pursuant to Section 11; provided,
however, that commencing on the second anniversary of the Effective Date and on
each anniversary thereafter, the Term shall automatically be extended for one
additional year unless, not later than 90 days prior to any such anniversary,
either party hereto shall have notified the other party hereto in writing that
such extension shall not take effect.

     3.   Position. During the Term, the Executive shall serve as President,
          --------
Hospital Services Division of the Company or in such other executive position in
the Company as the Executive shall approve.

     4.   Duties and Reporting Relationship. During the Term, the Executive
          ---------------------------------
shall, on a full time basis, use his skills and render services to the best of
his abilities in supervising and conducting the operations of the Company and
shall not engage in any other business activities except with the prior written
approval of the Board of Directors of the Company (the "Board") or its duly
authorized designee. The Executive shall also perform such other executive and
administrative duties (not inconsistent with the position of President, Hospital
Services Division) as the Executive may reasonably be expected to be capable of
performing on behalf of the Company, as may from time to time be authorized or
directed by the Board. The Executive
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agrees to be employed by the Company in all such capacities for the Term,
subject to all the covenants and conditions hereinafter set forth.

     5.   Place of Performance. The Executive shall perform his duties and
          --------------------
conduct his business at offices of the Company located in Dallas, Texas, except
for required travel on the Company's business.

     6.   Salary and Annual Bonus.
          -----------------------

          (a)  Base Salary. The Executive's base salary hereunder shall be
               -----------
     $325,000 a year, payable monthly and prorated for any partial year of
     employment. The Board shall review such base salary at least annually and
     make such adjustment from time to time as it may deem advisable, but the
     base salary shall not at any time be less than $325,000 a year.

          (b)  Annual Bonus. The Company shall provide the Executive with an
               ------------
     opportunity to earn upon achievement of target performance, an annual bonus
     equal to sixty percent (60%) of his base salary (the "Target Bonus"), with
     a minimum bonus of between fifty percent (50%) of Target Bonus upon
     achievement of threshold performance and an opportunity to earn up to one
     hundred fifty percent (150%) of the Target Bonus for performance in excess
     of the targets.

          (c)  Execution Bonus. On the Effective Date, the Company shall pay to
               ---------------
     the Executive $500,000 (subject to any applicable payroll or other taxes
     required to be withheld) and, if the Executive is still employed by the
     Company on the third anniversary of the date of this Agreement, the Company
     shall pay to the Executive an additional amount of $250,000 (subject to any
     applicable payroll or other taxes, required to be withheld).

     7.   Vacation, Holidays and Sick Leave. During the Term, the Executive
          ---------------------------------
shall be entitled to paid vacation, paid holidays and sick leave in accordance
with the Company's standard policies for its executive vice presidents.

     8.   Business Expenses. The Executive shall be reimbursed for all ordinary
          -----------------
and necessary business expenses incurred by him in connection with his
employment upon timely submission by the Executive of receipts and other
documentation as required by the Internal Revenue Code and in conformance with
the Company's normal procedures.

     9.   Pension and Welfare Benefits. During the Term, the Executive shall be
          ----------------------------
eligible to participate fully in all health benefits, insurance programs,
pension and retirement plans and other employee benefit and compensation
arrangements available to vice presidents of the Company generally.

     10.  Stock Options The Company, pursuant to the terms of its stock option
          -------------
plan, may grant to the Executive, stock options to purchase a number of shares
of common stock.

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     11.  Termination of Employment.
          -------------------------

          (a)  General. The Executive's employment hereunder may be terminated
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     without any breach of this Agreement only under the following
     circumstances.

          (b)  Death or Disability.
               -------------------

               (i)  The Executive's employment hereunder shall automatically
     terminate upon the death of the Executive.

               (ii) If, as a result of the Executive's incapacity due to
     physical or mental illness, the Executive is unable to perform the
     essential functions of his job for any one hundred eighty (180) days
     (whether or not consecutive) during any eighteen (18) month period, and no
     reasonable accommodation can be made that will allow Executive to perform
     his essential functions, the Company may terminate the Executive's
     employment hereunder for any such incapacity (a "Disability").

          (c)  Termination by the Company. The Company may terminate the
               --------------------------
     Executive's employment hereunder at any time, whether or not for Cause. For
     purposes of this Agreement, "Cause" shall mean (i) the failure or refusal
     by the Executive to perform his duties hereunder (other than any such
     failure resulting from the Executive's incapacity due to physical or mental
     illness), which has not ceased within ten (10) days after a written demand
     for substantial performance is delivered to the Executive by the Company,
     which demand identifies the manner in which the Company believes that the
     Executive has not performed such duties, (ii) the engaging by the Executive
     in willful misconduct or an act of moral turpitude which is materially
     injurious to the Company, monetarily or otherwise (including, but not
     limited to, conduct which violates Section 15 hereof) or (iii) the
     conviction of the Executive of, or the entering of a plea of nolo
     contendere by, the Executive with respect to, a felony.

          (d)  Termination by the Executive. The Executive shall be entitled to
     terminate his employment hereunder (A) for Good Reason, (B) if his health
     should become impaired to an extent that makes his continued performance of
     his duties hereunder hazardous to his physical or mental health, provided
     that the Executive shall have furnished the Company with a written
     statement from a qualified doctor to such effect and provided, further,
     that, at the Company's request, the Executive shall submit to an
     examination by a doctor selected by the Company and such doctor shall have
     concurred in the conclusion of the Executive's doctor or (C) without the
     Executive's express written consent, any failure by the Company to comply
     with any material provision of this Agreement, which failure has not been
     cured within ten (10) days after notice of such noncompliance has been
     given by the Executive to the Company. For purposes of this Agreement,
     "Good Reason" shall mean the occurrence following a Change in Control
     during the term of this Agreement, of any one of the following acts by the
     Company, or failures by the Company to act, unless, in the case of any act
     or failure to act described

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     below, such act or failure to act is corrected prior to the Date of
     Termination specified in the Notice of Termination given in respect
     thereof:

               (i)    any material diminution in the Executive's authorities or
          responsibilities (including reporting responsibilities) which were in
          effect immediately prior to the Change in Control or from his status,
          title, position or responsibilities (including reporting
          responsibilities) which were in effect following a Change in Control
          pursuant to the Executive's consent to accept any such change; the
          assignment to him of any duties or work responsibilities which are
          inconsistent with such status, title, position or work
          responsibilities; or any removal of the Executive from, or failure to
          reappoint or reelect him to any of such positions, except if any such
          changes are because of Disability, retirement, death or Cause ;

               (ii)   a reduction by the Company in the Executive's base salary
          or Target Bonus as in effect on the date hereof or as the same may be
          increased from time to time except for across-the-board salary
          reductions similarly affecting all senior executives of the Company
          and all senior executives of any Person (as defined in Section
          11(h)(i) below) in control of the Company provided in no event shall
          any such reduction reduce the Executive's base salary below $325,000;

               (iii)  the relocation of the Executive's office at which he is to
          perform his duties, to a location more than fifty (50) miles from the
          location at which the Executive performed his duties prior to the
          Change in Control, except for required travel on the Company's
          business to an extent substantially consistent with his business
          travel obligations prior to the Change in Control;

               (iv)   the failure by the Company, without the Executive's
          consent, to pay to the Executive any portion of the Executive's
          current compensation;

               (v)    the failure by the Company to continue to provide the
          Executive with benefits substantially similar in value to the
          Executive in the aggregate to those enjoyed by the Executive under any
          of the Company's pension, life insurance, medical, health and
          accident, or disability plans in which the Executive was participating
          immediately prior to the Change in Control, unless the Executive
          participates after the Change in Control in other comparable benefit
          plans generally available to senior executives of the Company and
          senior executives of any Person in control of the Company;

               (vi)   any purported termination of the Executive's employment
          which is not effected pursuant to a Notice of Termination satisfying
          the requirements of Section 11(f) below; for purposes of this
          Agreement, no such purported termination shall be effective.

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The Executive's continued employment for 6 months following any act or failure
to act constituting Good Reason hereunder without the delivery of a Notice of
Termination shall constitute consent to, and a waiver of rights with respect to,
such act or failure to act.

          (e)  Voluntary Resignation. Should the Executive wish to resign
               --------------------- 
     from his position with the Company or terminate his employment for other
     than Good Reason during the Term, the Executive shall give sixty (60) days
     written notice to the Company ("Notice Period"), setting forth the reasons
     and specifying the date as of which his resignation is to become effective.
     During the Notice Period, the Executive shall cooperate fully with the
     Company in achieving a smooth transition of the Executive's duties and
     responsibilities to such person(s) as may be designated by the Company. The
     Company reserves the right to accelerate the Date of Termination by giving
     the Executive notice and payment of amounts due to the Executive under
     Section 6(a) and, to the extent applicable, Section 6(b) for the balance of
     the Notice Period. The Company's obligation to continue to employ the
     Executive or to continue payment of the amounts described in the preceding
     sentence shall cease immediately if: (1) the Executive has not satisfied
     his obligations to cooperate fully with a smooth transition or (2) the
     Company has grounds to terminate the Executive's employment immediately for
     Cause. If the Executive terminates his employment for other than Good
     Reason within twelve (12) months from the Effective Date, the Executive
     shall be obligated to refund the amount that was received under Section
     6(c) of this Agreement.

          (f)  Notice of Termination. Any purported termination of the
               ---------------------
     Executive's employment by the Company or by the Executive shall be
     communicated by written Notice of Termination to the other party hereto in
     accordance with Section 19. "Notice of Termination" shall mean a notice
     that shall indicate the specific termination provision in this Agreement
     relied upon and shall set forth in reasonable detail the facts and
     circumstances claimed to provide a basis for termination of the Executive's
     employment under the provision so indicated.

          (g)  Date of Termination. "Date of Termination" shall mean (i)
               -------------------  
     if the Executive's employment is terminated because of death, the date of
     the Executive's death, (ii) if the Executive's employment is terminated for
     Disability, the date Notice of Termination is given, (iii) if the
     Executive's employment is terminated pursuant to Subsection (c), (d) or (e)
     hereof or for any other reason (other than death or Disability), the date
     specified in the Notice of Termination which shall not be less than sixty
     (60) days from the date such Notice of Termination is given.

          (h)  Change in Control. For purposes of this Agreement, a
               -----------------
     Change in Control of the Company shall have occurred if

               (i)  any "Person" (as defined in Section 3(a)(9) of the
          Securities Exchange Act of 1934 (the "Exchange Act") as modified and
          used in Sections 13(d) and 14(d) of the Exchange Act (other than (1)
          the Company or any of its subsidiaries, (2) any trustee or other
          fiduciary holding securities under an employee benefit plan of the
          Company or any of its subsidiaries, (3) an

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          underwriter temporarily holding securities pursuant to an offering of
          such securities, (4) any corporation owned, directly or indirectly, by
          the stockholders of the Company in substantially the same proportions
          as their ownership of the Company's common stock or (5) Apollo
          Management, LP, any of its affiliates and any investments funds
          managed by it (collectively, "Apollo"))), is or becomes the
          "beneficial owner" (as defined in Rule 13d-3 under the Exchange Act),
          directly or indirectly, of securities of the Company representing more
          than 50% of the combined voting power of the Company's then
          outstanding voting securities;

               (ii)   during any period of not more than two (2) consecutive
          years, not including any period prior to the date of this Agreement,
          individuals who at the beginning of such period constitute the Board,
          and any new director (other than a director designated by a person
          (other than Apollo) who has entered into an agreement with the Company
          to effect a transaction described in clause (i), (iii), or (iv) of
          this Section 1l(h)) whose election by the Board or nomination for
          election by the Company's stockholders was (A) made pursuant to the
          Stockholders Agreement affecting the Company dated November 4, 1997 or
          (B) approved by a vote of at least two-thirds (2/3) of the directors
          then still in office who either were directors at the beginning of the
          period or whose election or nomination for election was previously so
          approved, cease for any reason to constitute at least a majority
          thereof;

               (iii)  the stockholders of the Company approve a merger or
          consolidation of the Company with any other corporation, other than
          both (A) a merger or consolidation which would result in the voting
          securities of the Company outstanding immediately prior thereto
          continuing to represent (either by remaining outstanding or by being
          converted into voting securities of the surviving or parent entity)
          50% or more of the combined voting power of the voting securities of
          the Company or such surviving or parent entity outstanding immediately
          after such merger or consolidation or (B) a merger or consolidation in
          which no person acquires 50% or more of the combined voting power of
          the Company's then outstanding securities;

               (iv)   the stockholders of the Company approve a plan of complete
          liquidation of the Company or an agreement for the sale or disposition
          by the Company of all or substantially all of the Company's assets (or
          any transaction having a similar effect) other than such a sale or
          disposition to Apollo; or .

               (v)    the approval of a sale, spin off, merger, liquidation or
          other transaction which results in a disposition of or transfer of
          substantially all of the assets of the Hospital Services Division (the
          "Division") or one or more subsidiaries which hold substantially all
          of the Division's assets.

          (i)  Return of Property. When the Executive ceases to be employed by
               ------------------
     the Company, the Executive will promptly surrender to the Company all
     Company property, including without limitation, all records and other
     documents obtained by him or

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     provided, however, that the Executive may retain copies of such documents
     as necessary for the Executive's personal records for federal income tax
     purposes.

     12.  Compensation During Disability; Death or Upon Termination.
          ---------------------------------------------------------

          (a)  During any period that the Executive fails to perform his duties
     hereunder as a result of incapacity due to physical or mental illness
     ("Disability Period"), the Executive shall continue to receive his base
     salary at the rate then in effect for such period until his employment is
     terminated pursuant to Section 1l(b)(ii) hereof, provided that payments so
     made to the Executive during the Disability Period shall be reduced by the
     sum of the amounts, if any, payable to the Executive with respect to such
     period under disability benefit plans of the Company or under the Social
     Security disability insurance program, and which amounts were not
     previously applied to reduce any such payment.

          (b)  If the Executive's employment is terminated by his death or
     Disability, the Company shall pay (i) any base salary due to the Executive
     under Section 6(a) through the date of such termination and (ii) an amount
     equal to the Target Bonus he would have received for the fiscal year that
     ends on or immediately after the Date of Termination, assuming the Company
     achieved the lowest target level for which a bonus is paid under the plan
     described in Section 6(b), prorated for the period beginning on the first
     day of the fiscal year in which occurs the Date of Termination through the
     Date of Termination. In addition, if the Executive's employment is
     terminated by his death, the Company shall continue to pay to his estate
     his salary for an additional six months at the rate then in effect.

          (c)  If the Executive's employment is terminated by the Company for
     Cause or by the Executive for other than Good Reason, the Company shall pay
     the Executive his base salary through the Date of Termination at the rate
     in effect at the time Notice of Termination is given, and the Company shall
     have no further obligations to the Executive under this Agreement.

          (d)  If following a Change in Control (A) the Company terminates the
     Executive's employment without Cause, or (B) the Executive terminates his
     employment for Good Reason, then

               (i)  the Company shall pay the Executive his base salary through
          the Date of Termination at the rate in effect at the time Notice of
          Termination is given and all other unpaid amounts, if any, to which
          the Executive is entitled as of the Date of Termination under any
          compensation plan or program of the Company, at the time such payments
          are due;

               (ii) in lieu of any further salary payments to the Executive for
          periods subsequent to the Date of Termination, the Company shall pay
          as liquidated damages to the Executive an aggregate amount equal to
          the product of (A) the

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          sum of (1) the Executive's base salary at the rate in effect of the
          Date of Termination and (2) the average of the annual bonuses actually
          paid to the Executive by the Company with respect to the two (2)
          fiscal years which immediately precede the year of the Term which the
          Date of Termination occurs provided if there was bonus or bonuses paid
                                     --------
          to the Executive with respect only to one fiscal year that immediately
          precedes the year within the Term in which the Date of Termination
          occurs, then such single year's bonus or bonuses shall be utilized in
          the calculation pursuant to this clause (2), provided, further, that
                                                       --------  -------
          for purposes of this Agreement, if the Date of Termination occurs
          before the end of the first fiscal year that ends after the Effective
          Date, the amount of the bonus paid by the Company to the Executive
          shall be deemed to be the Target Bonus and (B) the number two and one-
          half (2.5);

               (iii)  the Company shall pay the Executive an amount equal to the
          prorated Target Bonus that would have been paid for the period
          beginning on the first day of the fiscal year in which the Date of
          Termination occurs;

               (iv)   the Company shall continue coverage for the Executive, on
          the same terms and conditions as would be applicable if the Executive
          were an active Employee, under the Company's life insurance, medical,
          health and similar welfare benefit plans (other then group disability
          benefits) for a period of thirty-six (36) months. Benefits otherwise
          receivable by the Executive pursuant to this Section 12(d)(iv) shall
          be reduced to the extent comparable benefits are actually received by
          the Executive from a subsequent employer during the period during
          which the Company is required to provide such benefits, and the
          Executive shall report any such benefits actually received by him to
          the Company; and

               (v)    the payments provided for in this Section 12(d) (other
          than Section 12(d)(iv)) shall be made not later than the thirtieth
          (30th) day following the Date of Termination, provided, however, that
          if the amounts of such payments, and the limitation on such payments
          set forth in Section 16 hereof, cannot be finally determined on or
          before such day, the Company shall pay to the Executive on such day an
          estimate, as determined in good faith by the Company, of the minimum
          amount of such payments to which the Executive is clearly entitled and
          shall pay the remainder of such payments (together with interest at
          the rate provided in section 1274(b)(2)(B) of the Code (as defined in
          Section 16)) as soon as the amount thereof can be determined but in no
          event later than the sixtieth (60th) day after the Date of
          Termination. In the event that the amount of the estimated payments
          exceeds the amount determined by the Company within six (6) months
          after payment to have been due, such excess shall constitute a loan by
          the Company to the Executive, payable no later than the thirtieth
          (30th) business day after demand by the Company (together with
          interest at the rate provided in section 1274(b)(2)(B) of the Code).
          At the time that payments are made under this Section 12(d), the
          Company shall provide the Executive with a written statement setting
          forth the manner in which such payments were calculated and the basis
          for such calculations including, without limitation, any opinions or
          other advice the

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          Company has received from outside counsel, auditors or consultants
          (and any such opinions or advice which are in writing shall be
          attached to the statement).

               (vi)   If the Executive continues to be employed by the Company
          for one (1) year after a Change of Control and has not by such time
          given Notice of Termination for Good Reason, the Executive will have
          waived his right to exercise his rights under Section 12(d) hereof
          with respect to any act or failure to act which constitutes Good
          Reason.

          (e)  If the Executive terminates his employment under clause (C)
     of Section 11(d) hereof or, prior to any Change of Control, the Company
     terminates the Executive's employment without Cause, then

               (i)    the Company shall pay the Executive his base salary
          through the Date of Termination at the rate in effect at the time
          Notice of Termination is given and all other unpaid amounts, if any,
          to which the Executive is entitled as of the Date of Termination under
          any compensation plan or program of the Company, at the time such
          payments are due;

               (ii)   the Company shall pay to the Executive the greater of
          either (A) the remaining amount of base salary owed for the Term; or
          (B) an aggregate amount equal to the sum of (1) twelve (12) months of
          the Executive's base salary at the rate in effect as of the Date of
          Termination plus (2) one (1) additional month of the Executive's base
          salary at such rate for each full year of service beyond the first
          anniversary of this Agreement, not to exceed twenty-four (24) months
          of base salary payments; such amount to be paid in substantially equal
          monthly installments during the period commencing with the month
          immediately following the month in which the Date of Termination
          occurs or in a lump sum payment, as decided by the Company;

               (iii)  the Company shall pay the Executive his Target Bonus
          prorated for the period beginning on the first day of the fiscal year
          in which occurs the Date of Termination through the Date of
          Termination;

               (iv)   the Company shall continue coverage for the Executive, on
          the same terms and conditions as would be applicable if the Executive
          were an active employee, under the Company's life insurance, medical,
          health, and similar welfare benefit plans (other then group
          disability) for a period not to exceed the number of months the
          Executive will be paid under Section 12(e)(ii) beginning on the Date
          of Termination;

               (v)    benefits otherwise receivable by the Executive pursuant to
          clause (iv) of this Section 12(e) shall be reduced to the extent
          comparable benefits are actually received by the Executive from a
          subsequent employer during the period which the Company is required to
          provide such benefits, and the Executive shall report any such
          benefits actually received by him to the Company;

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               (vi) the payments made to the Executive under Section 12(e)
          hereof will be reduced by the amount of payments provided for by any
          subsequent employer of the executive for a position obtained after the
          Date of Termination.

          (f)  If the Executive experiences a termination under Section
     12(d) or 12(e) hereof, until the Executive finds another full-time position
     or for 6 months, whichever is earlier, the Company shall provide the
     Executive with professional outplacement services of the Executive's
     choosing and shall reimburse the Executive documented incidental
     outplacement expenses directly related to the Executive's job search such
     as resume mailing, interview trips, and clerical support, subject to a
     maximum cost of $10,000 for such outplacement services and incidental
     expenses. The Executive's choice of professional outplacement services is
     subject to the Company's reasonable prior approval. If the Company has not
     approved or disapproved of the Executive's choice within ten (10) business
     days of receiving notice of such choice, the Company will be deemed to have
     given is approval. Any approval by the Company will be in writing and will
     state the basis for such disapproval. The Executive will not be entitled to
     receive cash or lieu of the professional outplacement services provided
     pursuant to this Section.

          (g)  If the Executive shall terminate his employment under clause (B)
     of Sections 11(d) or 11(e) hereof, the Company shall pay the Executive his
     base salary through the Date of Termination at the rate in effect at the
     time Notice of Termination is given, and the Company shall have no further
     obligations to the Executive under this Agreement.

          (h)  The Executive shall not be required to mitigate the amount of any
     payment provided for in this Section 12 by seeking other employment or
     otherwise, and, except as provided in Sections 12(e) hereof, the amount of
     any payment or benefit provided for in this Section 12 shall not be reduced
     by any compensation earned by the Executive as the result of employment by
     another employer or by retirement benefits.

          (i)  Release. Prior to making any payment pursuant to Sections
               -------
     12(d)(iii) and 12(d)(iv) or Sections 12(e)(ii) and 12(e)(iii), whichever is
     applicable, the Company shall have the right to require the Executive to
     sign, and the Executive hereby agrees to sign, an agreement to be bound by
     the terms of Section 15 of this Agreement and a waiver of all claims the
     Executive may have (including any claims under the Age Discrimination in
     Employment Act), and the Company may withhold payment of such amount until
     the period during which the Executive may revoke such waiver (normally
     seven days) has elapsed.

     13.  Representations and Covenants.
          -----------------------------  

          (a)  The Company represents and warrants that this Agreement has been
     authorized by all necessary corporate action of the Company and is a valid
     and binding agreement of the Company enforceable against it in accordance
     with its terms.

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<PAGE>
 
          (b)  The Executive represents and warrants that he is not a party to
     any agreement or instrument which would prevent him from entering into or
     performing his duties in any way under this Agreement. The Executive agrees
     and covenants that he will obtain, and submit to, such physical
     examinations as may be necessary to facilitate the Company obtaining an
     insurance policy for its benefit insuring the life of the Executive.

     14.  Successors: Binding Agreement.
          -----------------------------

          (a)  The Company will require any successor (whether direct or
     indirect, by purchase, merger, consolidation or otherwise) to all or
     substantially all of the business and/or assets of the Company to expressly
     assume and agree to perform this Agreement in the same manner and to the
     same extent that the Company would be required to perform it if no such
     succession had taken place.

          (b)  This Agreement is a personal contract and the rights and
     interests of the Executive hereunder may not be sold, transferred,
     assigned, pledged, encumbered, or hypothecated by him, except as otherwise
     expressly permitted by the provisions of this Agreement. This Agreement
     shall inure to the benefit of and be enforceable by the Executive and his
     personal or legal representatives, executors, administrators, successors,
     heirs, distributees, devisees and legatees. If the Executive should die
     while any amount would still be payable to him hereunder had the Executive
     continued to live, all such amounts, unless otherwise provided herein,
     shall be paid in accordance with the terms of this Agreement to his
     devisee, legatee or other designee or, if there is no such designee, to his
     estate.

     15.  Confidentiality and Non-Competition Covenants.
          ---------------------------------------------

          (a)  The Executive covenants and agrees that he will not at any time
     during or at any time after the end of the Term, directly or indirectly,
     use for his own account, or disclose to any person, firm or corporation,
     other than authorized officers, directors and employees of the Company or
     its subsidiaries, Confidential Information (as hereinafter defined) that is
     treated as trade secrets by the Company and will not at any time during or
     for a period equal to the number of payments which are being made under
     Section 12(e) hereof directly or indirectly, use for his own account, or
     disclose to any person, firm or corporation, other than authorized
     officers, directors and employees of the Company or its subsidiaries, any
     other Confidential Information. As used herein, "Confidential Information"
     of the Company means information of any kind, nature or description which
     is disclosed to or otherwise known to the Executive as a direct or indirect
     consequence of his association with the Company, which information is not
     generally known to the public or in the business in which the Company is
     engaged or which information relates to specific investment opportunities
     within the scope of the Company's business which were considered by the
     Executive or the Company during the term of this Agreement. Confidential
     Information that is treated as confidential trade secrets by the Company
     shall include, but not be limited to, strategic operating plans and
     budgets, policy and procedure manuals, computer programs, financial forms
     and information, patient or resident lists and accounts, supplier
     information, accounting forms and procedures, personnel policies,

                                       11
<PAGE>
 
     information pertaining to the salaries, positions and performance reviews
     of the Company's employees, information on the methods of the Company's
     operations, research and data developed by or for the benefit of the
     Company and information relating to revenues, costs, profits and the
     financial condition of the Company. During the Term and for a period of two
     years following the termination of the Executive's employment, the
     Executive shall not induce any employee of the Company or its subsidiaries
     to terminate his or her employment by the Company or its subsidiaries in
     order to obtain employment by any person, firm or corporation affiliated
     with the Executive.

          (b)  The Executive covenants and agrees that any information,
     materials, ideas, discoveries, techniques or programs developed or
     discovered by the Executive in connection with the performance of his
     duties hereunder shall remain the sole and exclusive property of the
     Company and, to the extent it constitutes Confidential Information, shall
     be subject to the covenants contained in the preceding paragraph.

          (c)  The Executive covenants and agrees that during the Term and, if
     the Executive's employment is terminated by the Executive for other than
     Good Reason, for a period of two (2) years following the termination of the
     Executive's employment, the Executive shall not, directly or indirectly,
     own an interest in, operate, join, control, or participate as a partner,
     director, principal, officer, or agent of, enter into the employment of, or
     act as a consultant to, in any case in which he has control or supervision
     over a significant portion of any entity of which either (A) (i) the
     principal business is the operation of one or more skilled nursing
     facilities or (ii) which operates a skilled nursing business that is
     material in relation to the Company's comparable business and (iii) in
     either case, which derives at least 10% of its skilled nursing facility
     revenue from facilities which are located within 35 miles of centers or
     facilities operated by the Company or (B) (i) whose principal business is
     operating or managing long term, acute hospital care facilities or (ii)
     which operates a long term, acute hospital care facility that is material
     in relation to the Company's or its subsidiaries' comparable business and
     (iii) in either case, which derives at least 10% of its long term, acute
     care facility revenue from facilities which are located within 35 miles of
     centers or facilities operated by the Company or its subsidiaries.
     Notwithstanding anything herein to the contrary, the foregoing provisions
     of this Section 15(c) shall not prevent the Executive from acquiring
     securities representing not more than 5% of the outstanding voting
     securities of any publicly held corporation.

          (d)  Without limiting the right of the Company to pursue all other
     legal and equitable remedies available for violation by the Executive of
     the covenants contained in this Section 15, it is expressly agreed by the
     Executive and the Company that such other remedies cannot fully compensate
     the Company for any such violation and that the Company shall be entitled
     to injunctive relief, without the necessity of proving actual monetary
     loss, to prevent any such violation or any continuing violation thereof.
     Each party intends and agrees that if in any action before any court or
     agency legally empowered to enforce the covenants contained in this Section
     15, any term, restriction, covenant or promise contained herein is found to
     be unreasonable and accordingly

                                       12
<PAGE>
 
     unenforceable, then such term, restriction, covenant or promise shall be
     deemed modified to the extent necessary to make it enforceable by such
     court or agency. The covenants contained in Section 15 shall survive the
     conclusion of the Executive's employment by the Company.

     16.  Prohibition on Parachute Payments.
          ---------------------------------

          (a)  Notwithstanding any other provisions of this Agreement, any
     payment or benefit received or to be received by the Executive in
     connection with a Change in Control of the Company or the termination of
     the Executive's employment (whether pursuant to the terms of this Agreement
     or any other plan, arrangement or agreement with the Company, any person
     whose actions result in a Change in Control or any Person affiliated with
     the Company or such Person) (all such payments and benefits, including,
     without limitation, base salary and bonus payments, being hereinafter
     called "Total Payments") would not be deductible (in whole or in part), by
     the Company, an affiliate or any Person making such payment or providing
     such benefit as a result of section 280G of the Internal Revenue Code of
     1986, as amended (the "Code"), then, to the extent necessary to make such
     portion of the Total Payments deductible (and after taking into account any
     reduction in the Total Payments provided by reason of section 280G of the
     Code in such other plan, arrangement or agreement), (A) such cash payments
     shall first be reduced (if necessary, to zero), and (B) all other non-cash
     payments by the Company to the Executive shall next be reduced (if
     necessary, to zero). For purposes of this limitation (i) no portion o the
     Total Payments the receipt or enjoyment of which the Executive shall have
     effectively waived in writing prior to the Date of Termination shall be
     taken into account, (ii) no portion of the Total Payments shall be taken
     into account which in the opinion of tax counsel selected by the Company's
     independent auditors and reasonably acceptable to the Executive does not
     constitute a "parachute payment" within the meaning of section 280G(b)(2)
     of the Code, including by reason of section 280G(b)(4)(A) of the Code,
     (iii) such payments shall be reduced only to the extent necessary so that
     the Total Payments (other than those referred to in clauses (i) or (ii)) in
     their entirety constitute reasonable compensation for services actually
     rendered within the meaning of section 280G(b)(4)(B) o the Code or are
     otherwise not subject to disallowance as deductions, in the opinion of the
     tax counsel referred to in clause (ii); and (iv) the value of any non-cash
     benefit or any deferred payment or benefit included in the Total Payments
     shall be determined by the Company's independent auditors in accordance
     with the principles of sections 280G(d)(3) and (4) of the Code.

          (b)  If it is established pursuant to a final determination of a court
     or an Internal Revenue Service proceeding that, notwithstanding the good
     faith of the Executive and the Company in applying the terms of this
     Section 16, the aggregate "parachute payments" paid to or for the
     Executive's benefit are in an amount that would result in any portion of
     such "parachute payments" not being deductible by reason of section 280G of
     the Code, then the Executive shall have an obligation to pay the Company
     upon demand an amount equal to the sum of (i) the excess of the aggregate
     "parachute payments" paid to or for the Executive's benefit over the
     aggregate "parachute payments" that could have been paid to or for the
     Executive's benefit without any portion

                                       13
<PAGE>
 
     of such "parachute payments" not being deductible by reason of section 280G
     of the Code; and (ii) interest on the amount set forth in clause (i) of
     this sentence at the rate provided in section 1274(b)(2)(B) of the Code
     from the date of the Executive's receipt of such excess until the date of
     such payment.

     17.  Entire Agreement. This Agreement contains all the understandings
          ----------------
between the parties hereto pertaining to the matters referred to herein, and on
the Effective Date shall supersede all undertakings and agreements, whether oral
or in writing, previously entered into by them with respect thereto. The
Executive represents that, in executing this Agreement, he does not rely and has
not relied upon any representation or statement not set forth herein made by the
Company with regard to the subject matter, bases or effect of this Agreement or
otherwise.

     18.  Amendment or Modification. Waiver. No provision of this Agreement may
          -------------------------
be amended or waived unless such amendment or waiver is agreed to in writing,
signed by the Executive and by a duly authorized officer of the Company. No
waiver by any party hereto of any breach by another party hereto of any
condition or provision of this Agreement to be performed by such other party
shall be deemed a waiver of a similar or dissimilar condition or provision at
the same time, any prior time or any subsequent time.

     19.  Notices. Any notice to be given hereunder shall be in writing and
          -------
shall be deemed given when delivered personally, sent by courier or telecopy or
registered or certified mail, postage prepaid, return receipt requested,
addressed to the party concerned at the address indicated below or to such other
address as such party may subsequently give notice of hereunder in writing:

          To Executive at:    Dennis G. Johnston
                              17321 Earthwind Drive
                              Dallas, Texas 75248

          To the Company at:  Paragon Health Network, Inc.
                              One Ravinia Drive, Suite 1500
                              Atlanta, Georgia 30346

          Any notice delivered personally or by courier under this Section 19
shall be deemed given on the date delivered and any notice sent by telecopy or
registered or certified mail, postage prepaid, return receipt requested, shall
be deemed given on the date telecopied or mailed.

     20.  Severability. If any provision of this Agreement or the application of
          ------------
any such provision to any party or circumstances shall be determined by any
court of competent jurisdiction to be invalid and unenforceable to any extent,
the remainder of this Agreement or the application of such provision to such
person or circumstances other than those to which it is so determined to be
invalid and unenforceable, shall not be affected thereby, and each provision
hereof shall be validated and shall be enforced to the fullest extent permitted
by law.

                                       14
<PAGE>
 
     21.  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.

     22.  Governing Law: Attorney's Fees.
          ------------------------------

          (a)  This Agreement will be governed by and construed in accordance
     with the laws of the State of Georgia, without regard to its conflicts of
     laws principles .

          (b)  The prevailing party in any dispute arising out of this Agreement
     shall be entitled to be paid its reasonable attorney's fees incurred in
     connection with such dispute from the other party to such dispute.

     23.  Dispute Resolution. The Executive and the Company shall not initiate
          ------------------
legal proceedings relating in any way to this Agreement or to the Executive's
employment or termination from employment with the Company until thirty (30)
days after the party against whom the claim is made ("respondent") receives
written notice from the claiming party of the specific nature of any purported
claims and the amount of any purported damages attributable to each such claim.
The Executive and the Company further agree that if respondent submits the
claiming party's claim to the CPR Institute for Dispute Resolution,
JAMS/Endispute, or other local dispute resolution service for nonbinding
mediation prior to the expiration of such thirty (30) day period, the claiming
party may not institute arbitration or other legal proceedings against
respondent until the earlier of: (a) the completion of good-faith mediation
efforts or (b) 90 days after the date on which the respondent received written
notice of the claimant's claim(s); provided, however, that nothing in this
Section 23 shall prohibit the Company from pursuing injunctive or other
equitable relief against the Executive prior to, contemporaneous with, or
subsequent to invoking or participating in these dispute resolution processes.
The Company shall pay the cost of the mediator.

     24.  Headings.  All descriptive headings of sections and paragraphs in this
          --------
Agreement are intended solely for convenience, and no provision of this
Agreement is to be construed by reference to the heading of any section or
paragraph.

     25.  Withholdings. All payments to the Executive under this Agreement shall
          ------------
be reduced by all applicable withholding required by federal, state or local tax
laws.

     26.  Counterparts.  This Agreement may be executed in counterparts, each of
          ------------
which shall be deemed an original, but all of which together shall constitute
one and the same instrument.

     27.  Release of Prior Employment Agreement.  The Executive hereby releases
          -------------------------------------
the Company and any predecessor company (including GranCare, Inc. and Living
Centers of America, Inc.) from all obligations under the employment agreement
entered into by the Executive and GranCare, Inc. dated February 12, 1997,
including any obligation to pay severance or other post-termination benefits,
which shall be upon the execution hereof terminated and of no further force or
effect; provided, however, that in no event shall this release

                                       15
<PAGE>
 
affect the Executive's rights under any grant or award under any stock option or
stock award plans of the Company and any predecessor company (including
GranCare, Inc. and Living Centers of America, Inc.).

     IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of
the date first above written.

                                   PARAGON HEALTH NETWORK, INC.


                                   BY:    /s/ Susan Thomas Whittle
                                          --------------------------------------
                                   NAME:  Susan Thomas Whittle
                                   TITLE: Senior Vice President
                                          and General Counsel 
                                                     
                                                     
                                   EXECUTIVE         
                                                     
                                   /s/ Dennis G. Johnston
                                   ---------------------------------------     
                                   Dennis G. Johnston 

                                       16