Document:

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                                                                    EXHIBIT 10.6

                              EMPLOYMENT AGREEMENT
                              --------------------

          This EMPLOYMENT AGREEMENT is made as of the 28th day of January, 2002
(the "Effective Date"), by and between Kindred Healthcare Operating, Inc., a
Delaware corporation (the "Company"), and Paul J. Diaz (the "Executive").

                              W I T N E S S E T H:
                              - - - - - - - - - -

          WHEREAS, the Executive is employed by the Company, a wholly-owned
subsidiary of Kindred Healthcare, Inc. ("Parent"), and the parties hereto desire
to provide for the terms of Executive's employment by the Company; and

          WHEREAS, the Company has determined that it is in the best interests
of the Company to enter into this Agreement.

          NOW, THEREFORE, in consideration of the premises and the respective
covenants and agreements contained herein, and intending to be legally bound
hereby, the Company and Executive agree as follows:

          1. Employment. The Company hereby agrees to employ Executive and
             ----------
Executive hereby agrees to be employed by the Company on the terms and
conditions herein set forth. The initial term of this Agreement shall be for a
one-year period commencing on the Effective Date. The term shall be
automatically extended by one additional day for each day beyond the Effective
Date that the Executive remains employed by the Company until such time as the
Company elects to cease such extension by giving written notice of such election
to the Executive (the "Term"). In such event, the Agreement shall terminate on
the first anniversary of the effective date of such election notice.

          2. Duties. Executive is engaged by the Company as its President and
             ------
Chief Operating Officer. The Executive will have the same titles with the
Parent.

          3. Extent of Services. Executive, subject to the direction and control
             ------------------
of the Board of Directors (the "Board"), shall have the power and authority
commensurate with his executive status and necessary to perform his duties
hereunder. During the Term, Executive shall devote his entire working time,
attention, labor, skill and energies to the business of the Company, and shall
not, without the consent of the Company, be actively engaged in any other
business activity, whether or not such business activity is pursued for gain,
profit or other pecuniary advantage. Notwithstanding the foregoing, it shall not
be a breach or violation of this Agreement for the Executive to (i) serve on
corporate, civic or charitable boards or committees, or (ii) manage personal
investments, so long as such activities do not reasonably interfere with or
reasonably

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detract from the performance of the Executive's responsibilities to the Company
in accordance with this Agreement.

          4. Compensation. As compensation for services hereunder rendered,
             ------------
Executive shall receive during the Term:

          (a) A base salary ("Base Salary") of Six Hundred Thousand Dollars
     ($600,000) per year payable in equal installments in accordance with the
     Company's normal payroll procedures. Executive may receive increases in his
     Base Salary from time to time, as approved by the Board.

          (b) In addition to Base Salary, Executive will be eligible to receive
     bonuses and other incentive compensation as the Board may approve from time
     to time, including participation in the Company's annual incentive bonus
     plan and its long-term incentive plan. For purposes of calculating awards
     under the annual incentive bonus plan and the long-term incentive plan
     only, Executive's initial hire date shall be deemed to be January 1, 2002.
     For purposes of computing Executive's bonuses in 2002, Executive shall be
     eligible (i) to earn a target bonus of 60% and a maximum bonus of 75% under
     the Company's annual incentive program based on goals established by the
     executive compensation committee of the Board of Directors; and (ii) to
     earn a bonus up to 90% of Base Salary under the Company's long-term
     incentive plan.

          5. Benefits.
             --------

          (a) Executive shall be entitled to participate in any and all pension
     benefit, welfare benefit (including, without limitation, medical, dental,
     disability and group life insurance coverages) and fringe benefit plans
     from time to time in effect for officers of the Company and its affiliates
     following the Company's standard waiting periods, if any.

          (b) On the Effective Date, the Executive shall be granted 100,000
     options to purchase common stock of the Parent pursuant to the Kindred
     Healthcare, Inc. 2001 Stock Option Plan (the "Plan"). Executive shall be
     eligible for additional grants of options under the Plan, any successor
     Plan thereto, in such amounts and subject to such terms and conditions as
     determined by the Board of Directors or Committee of the Board appointed
     under the Plan. Executive shall also be entitled to participate in other
     bonus, stock option, or other incentive compensation plans of the Company
     and its affiliates in effect from time to time for officers of the Company.

          (c) Executive shall be entitled to four weeks of paid vacation each
     year. The Executive shall schedule the timing of such vacations in a
     reasonable manner.

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     The Executive may also be entitled to such other leave, with or without
     compensation, as shall be mutually agreed by the Company and Executive.

          (d) Executive may incur reasonable expenses for promoting the
     Company's business, including expenses for entertainment, travel and
     similar items. The Company shall reimburse Executive for all such
     reasonable expenses in accordance with the Company's reimbursement policies
     and procedures.

          (e) The Company shall reimburse all reasonable travel and relocation
     expenses incurred by Executive in accordance with the Company's standard
     relocation policy. Until July 28, 2002, the Company will reimburse
     Executive for all reasonable travel and living expenses incurred by
     Executive. Any reimbursements under this Section 5(e) upon which Executive
     is subject to tax shall be "grossed up" to cover all federal and state
     taxes so that Executive retains an after-tax amount equal to his
     reimbursable expenses.

          (f) If Executive is not promoted to the Chief Executive Officer of the
     Company and the Parent on or before the second anniversary of the Effective
     Date, Executive shall be credited immediately with an additional two years
     of vesting of all outstanding stock option awards, such vesting shall be in
     addition to any accelerated vesting which may occur under this Agreement or
     otherwise.

          (g) While this Agreement is in effect, the Company shall provide the
     Executive with (i) director's and officer's liability insurance coverage;
     (ii) life insurance for which the Executive may designate the beneficiary
     or beneficiaries; and (iii) long-term disability insurance, consistent with
     the benefits provided to the Company's executive officers.

          6. Termination of Employment.
             -------------------------

          (a) Death or Disability. Executive's employment shall terminate
              -------------------
     automatically upon Executive's death during the Term. If the Company
     determines in good faith that the Disability of Executive has occurred
     during the Term (pursuant to the definition of Disability set forth below)
     it may give to Executive written notice of its intention to terminate
     Executive's employment. In such event, Executive's employment with the
     Company shall terminate effective on the 30th day after receipt of such
     notice by Executive (the "Disability Effective Date"), provided that,
     within the 30 days after such receipt, Executive shall not have returned to
     full-time performance of Executive's duties. For purposes of this
     Agreement, "Disability" shall mean Executive shall be unable, or fail, to
     perform the essential functions of his position with or without reasonable
     accommodation, for any period of 150 days or more.

                                       3

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          (b) Cause. The Company may terminate Executive's employment during the
              -----
     Term for Cause. For purposes of this Agreement, "Cause" shall mean the
     Executive's (i) conviction of or plea of nolo contendere to a crime
                                              ---- ----------
     involving moral turpitude; or (ii) willful and material breach by Executive
     of his duties and responsibilities, which is committed in bad faith or
     without reasonable belief that such breaching conduct is in the best
     interests of the Company and its affiliates, but with respect to (ii) only
     if the Board adopts a resolution by a vote of at least 75% of its members
     so finding after giving the Executive and his attorney an opportunity to be
     heard by the Board. Any act, or failure to act, based upon authority given
     pursuant to a resolution duly adopted by the Board or based upon advice of
     counsel for the Company shall be conclusively presumed to be done, or
     omitted to be done, by Executive in good faith and in the best interests of
     the Company.

          (c) Good Reason. Executive's employment may be terminated by Executive
              -----------
     for Good Reason. "Good Reason" shall exist upon the occurrence, without
     Executive's express written consent, of any of the following events:

               (i) the Company shall assign to Executive duties of a
          substantially nonexecutive or nonmanagerial nature;

               (ii) an adverse change in Executive's status or position as an
          executive officer of the Company, including, without limitation, an
          adverse change in Executive's status or position as a result of a
          diminution in Executive's duties and responsibilities (other than any
          such change directly attributable to the fact that the Company is no
          longer publicly owned);

               (iii) the Company shall (A) materially reduce the Base Salary or
          bonus opportunity of Executive, or (B) materially reduce his benefits
          and perquisites (other than pursuant to a uniform reduction applicable
          to all similarly situated executives of the Company);

               (iv) the Company shall require Executive to relocate Executive's
          principal business office more than 30 miles from its location on the
          Effective Date; or

               (v) the failure of the Company to obtain the assumption of this
          Agreement as contemplated by Section 9(c).

     For purposes of this Agreement, "Good Reason" shall not exist until after
     Executive has given the Company notice of the applicable event within 90
     days of such event and which is not remedied within 30 days after receipt
     of written notice from Executive specifically delineating such claimed
     event and setting forth

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     Executive's intention to terminate employment if not remedied; provided,
                                                                    --------
     that if the specified event cannot reasonably be remedied within such
     30-day period and the Company commences reasonable steps within such 30-day
     period to remedy such event and diligently continues such steps thereafter
     until a remedy is effected, such event shall not constitute "Good Reason"
     provided that such event is remedied within 60 days after receipt of such
     written notice.

          (d) Notice of Termination. Any termination by the Company for Cause,
              ---------------------
     or by Executive for Good Reason, shall be communicated by Notice of
     Termination given in accordance with this Agreement. For purposes of this
     Agreement, a "Notice of Termination" means a written notice which (i)
     indicates the specific termination provision in this Agreement relied upon,
     (ii) sets forth in reasonable detail the facts and circumstances claimed to
     provide a basis for termination of Executive's employment under the
     provision so indicated and (iii) specifies the intended termination date
     (which date, in the case of a termination for Good Reason, shall be not
     more than thirty days after the giving of such notice). The failure by
     Executive or the Company to set forth in the Notice of Termination any fact
     or circumstance which contributes to a showing of Good Reason or Cause
     shall not waive any right of Executive or the Company, respectively,
     hereunder or preclude Executive or the Company, respectively, from
     asserting such fact or circumstance in enforcing Executive's or the
     Company's rights hereunder.

          (e) Date of Termination. "Date of Termination" means (i) if
              -------------------
     Executive's employment is terminated by the Company for Cause, or by
     Executive for Good Reason, the later of the date specified in the Notice of
     Termination or the date that is one day after the last day of any
     applicable cure period, (ii) if Executive's employment is terminated by the
     Company other than for Cause or Disability, or Executive resigns without
     Good Reason, the Date of Termination shall be the date on which the Company
     or Executive notified Executive or the Company, respectively, of such
     termination and (iii) if Executive's employment is terminated by reason of
     death or Disability, the Date of Termination shall be the date of death of
     Executive or the Disability Effective Date, as the case may be.

          7. Obligations of the Company Upon Termination. Following any
             -------------------------------------------
termination of Executive's employment hereunder, the Company shall pay Executive
his Base Salary through the Date of Termination and any amounts owed to
Executive pursuant to the terms and conditions of the benefit plans and programs
of the Company at the time such payments are due. In addition, subject to
Executive's execution of a general release of claims in a form substantially
similar to Exhibit A, Executive shall be entitled to the following additional
payments:

          (a) Death or Disability. If, during the Term, Executive's employment
              -------------------
     shall terminate by reason of Executive's death or Disability, the Company
     shall pay to

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     Executive (or his designated beneficiary or estate, as the case may be) the
     prorated portion of any Target Bonus (as defined below) Executive would
     have received for the year of termination of employment. Such amount shall
     be paid within 30 days of the date when such amounts would otherwise have
     been payable to the Executive if Executive's employment had not terminated.

          (b) Good Reason; Other than for Cause. If, during the Term, the
              ---------------------------------
     Company shall terminate Executive's employment other than for Cause (but
     not for Disability), or the Executive shall terminate his employment for
     Good Reason:

               (1) Within 14 days of Executive's Date of Termination, the
          Company shall pay to Executive (i) the prorated portion of the Target
          Bonus for Executive for the year in which the Date of Termination
          occurs, and (ii) an amount equal to two times the sum of the
          Executive's Base Salary and Target Bonus as of the Date of
          Termination.

          For purposes of this Agreement: "Target Bonus" shall mean the full
          amount of the targeted annual incentive bonus that would be payable to
          the Executive, assuming the targeted performance criteria on which
          such annual incentive bonus is based were deemed to be satisfied, in
          respect of services for the calendar year in which the date in
          question occurs.

               (2) For a period of two years following the Date of Termination,
          the Executive shall be treated as if he had continued to be an
          Executive for all purposes under the Parent's Health Insurance Plan
          and Dental Insurance Plan; or if the Executive is prohibited from
          participating in such plan, the Company or Parent shall otherwise
          provide such benefits. Following this continuation period, the
          Executive shall be entitled to receive continuation coverage under
          Part 6 of Title I or ERISA ("COBRA Benefits") treating the end of this
          period as a termination of the Executive's employment if allowed by
          law.

               (3) For a period of two years following the Date of Termination,
          Parent shall maintain in force, at its expense, the Executive's life
          insurance in effect under the Parent's Voluntary Life Insurance
          Benefit Plan as of the Date of Termination.

               (4) For a period of two years following the Date of Termination,
          the Company or Parent shall provide short-term and long-term
          disability insurance benefits to Executive equivalent to the coverage
          that the Executive would have had if he had remained employed under
          the disability insurance plans applicable to Executive on the Date of
          Termination. Should Executive become disabled during such period,

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          Executive shall be entitled to receive such benefits, and for such
          duration, as the applicable plan provides.

               (5) To the extent not already vested pursuant to the terms of
          such plan, the Executive's interests under the Parent's Retirement
          Savings Plan shall be automatically fully (i.e., 100%) vested, without
          regard to otherwise applicable percentages for the vesting of employer
          matching contributions based upon the Executive's years of service
          with the Company.

               (6) Parent may adopt such amendments to its executive benefit
          plans, if any, as are necessary to effectuate the provisions of this
          Agreement.

               (7) Executive shall be entitled to an additional two years of
          vesting for purposes of all outstanding stock option awards and
          restricted stock awards and other similar equity compensation awards.
          Executive will have an additional two years following the Date of
          Termination in which to exercise any stock options but not to exceed
          the lives of such options.

               (8) Following the Executive's Date of Termination, the Executive
          shall receive the computer which Executive is utilizing as of the Date
          of Termination.

          (c) Cause; Other than for Good Reason. If Executive's employment shall
              ---------------------------------
     be terminated for Cause or Executive terminates employment without Good
     Reason (and other than due to such Executive's death) during the Term, this
     Agreement shall terminate without further additional obligations to
     Executive except as otherwise provided under this Agreement or under any of
     the Company's benefit plans and programs.

          (d) Death after Termination. In the event of the death of Executive
              -----------------------
     during the period Executive is receiving payments pursuant to this
     Agreement, Executive's designated beneficiary shall be entitled to receive
     the balance of the payments; or in the event of no designated beneficiary,
     the remaining payments shall be made to Executive's estate.

          (e) If the Company is unable to provide the Executive with any
     benefits required hereunder by reason of the termination of the Executive's
     employment pursuant to this Section 7, then the Company shall pay the
     Executive cash equal to the value of the benefit that otherwise would have
     accrued for the Executive's

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     benefit under the plan, for the period during which such benefits could not
     be provided under the plans, said cash payments to be made within 45 days
     after the end of the year for which such contributions would have been made
     or would have accrued.

          8. Disputes. Any dispute or controversy arising under, out of, or in
             --------
connection with this Agreement shall, at the election and upon written demand of
either party, be finally determined and settled by binding arbitration in the
City of Louisville, Kentucky, in accordance with the National Employment
Arbitration rules and procedures of the American Arbitration Association, and
judgment upon the award may be entered in any court having jurisdiction thereof.
The Company shall pay all costs of the arbitration and all reasonable attorneys'
and accountants' fees of the Executive in connection therewith, including any
litigation to enforce any arbitration award.

          9. Successors.
             ----------

          (a) This Agreement is personal to Executive and without the prior
     written consent of the Company shall not be assignable by Executive
     otherwise than by will or the laws of descent and distribution. This
     Agreement shall inure to the benefit of and be enforceable by Executive's
     legal representatives.

          (b) This Agreement shall inure to the benefit of and be binding upon
     the Company and its successors and assigns.

          (c) The Company shall 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, or any
     business of the Company for which Executive's services are principally
     performed, to assume expressly 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. As used this Agreement,
     "Company" shall mean the Company as hereinbefore defined and any successor
     to its business and/or assets as aforesaid which assumes and agrees to
     perform this Agreement by operation of law, or otherwise.

          10. Other Severance Benefits. Executive hereby agrees that in
              ------------------------
consideration for the payments to be received under paragraph 7(b) of this
Agreement, Executive waives any and all rights to any payments or benefits under
any severance plans or arrangements of the Company or their respective
affiliates that specifically provide for severance payments, other than the
Change in Control Severance Agreement between the Company and Executive dated
January 28, 2002 (the "Change in Control Severance Agreement"); provided that
                                                                --------
any payments otherwise payable to Executive under paragraph 7(b) shall be offset
by any payments payable under the Change in Control Severance Agreement.

                                       8

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          11. Withholding. All payments to be made to Executive hereunder will
              -----------
be subject to all applicable required withholding of taxes.

          12. No Mitigation. Executive shall have no duty to mitigate his
              -------------
damages by seeking other employment and, should Executive actually receive
compensation from any such other employment, the payments required hereunder
shall not be reduced or offset by any such compensation. Further, the Company's
and Parent's obligations to make any payments hereunder shall not be subject to
or affected by any setoff, counterclaims or defenses which the Company or Parent
may have against Executive or others.

          13. Notices. Any notice required or permitted to be given under this
              -------
Agreement shall be in writing and shall be deemed to have been duly given when
delivered or sent by telephone facsimile transmission, personal or overnight
couriers, or registered mail with confirmation or receipt, addressed as follows:

          If to Executive:
          ---------------
          Paul J. Diaz

          If to Company:
          -------------
          Kindred Healthcare Operating, Inc.
          680 South Fourth Avenue
          Louisville, KY  40202
          Attn: General Counsel

          14. Waiver of Breach and Severability. The waiver by either party of a
              ---------------------------------
breach of any provision of this Agreement by the other party shall not operate
or be construed as a waiver of any subsequent breach by either party. In the
event any provision of this Agreement is found to be invalid or unenforceable,
it may be severed from the Agreement and the remaining provisions of the
Agreement shall continue to be binding and effective.

          15. Entire Agreement; Amendment. This instrument, the
              ---------------------------
Change-in-Control Severance Agreement and the Non-Qualified Stock Option Grant
Agreement dated January 28, 2002 contain the entire agreement of the parties
with respect to the subject matter hereof and supersedes all prior agreements,
promises, covenants, arrangements, communications, representations and
warranties between them, whether written or oral with respect to the subject
matter hereof. No provisions of this Agreement may be modified, waived or
discharged unless such modification, waiver or discharge is

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agreed to in writing signed by Executive and such officer of the Company
specifically designated by the Board.

          16. Governing Law. This Agreement shall be construed in accordance
              -------------
with and governed by the laws of the State of Delaware.

          17. Headings. The headings in this Agreement are for convenience only
              --------
and shall not be used to interpret or construe its provisions.

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

          19. Indemnification. The Company shall indemnify, defend and hold the
              ---------------
Employee harmless from and against any liability, damages, costs and expenses
(including attorneys' fees) in connection with any claim, cause of action,
investigation, litigation or proceeding involving him by reason of his having
been an officer, director, employee or agent of the Company, except to the
extent it is judicially determined that the Employee was guilty of gross
negligence or willful misconduct in connection with the matter giving rise to
the claim for indemnification. This indemnification shall be in addition to and
shall not be substituted for any other indemnification or similar agreement or
arrangement which may be in effect between the Employee and the Company or may
otherwise exist. The Company also agrees to maintain adequate directors and
officers liability insurance, if applicable, for the benefit of Employee for the
term of this Agreement and for five years thereafter.

                                       10

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

                                  KINDRED HEALTHCARE OPERATING, INC.

                                  By:/s/ Richard A. Schweinhart
                                     -------------------------------------------
                                     Richard A. Schweinhart
                                     Senior Vice President
                                      and Chief Financial Officer

                                  For purposes
                                  of  Section 7 and as  guarantor  of  Company's
                                  obligations  under this Agreement

                                  KINDRED HEALTHCARE, INC.

                                  By:/s/ Richard A. Schweinhart
                                     -------------------------------------------
                                     Richard A. Schweinhart
                                     Senior Vice President
                                      and Chief Financial Officer

                                  /s/ Paul J. Diaz
                                  ----------------------------------------------
                                  Paul J. Diaz

                                       11

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                                    Exhibit A

          Employee Acknowledgment and Release. Employee expressly acknowledges
          -----------------------------------
that the payments hereunder include consideration for the settlement, waiver,
release and discharge of any and all claims or actions arising from Employee's
employment, the terms and conditions of Employee's employment, or Employee's
termination of employment with the Company, including claims of employment
discrimination, wrongful termination, unemployment compensation or any claim
arising under law or equity, express or implied contract, tort, public policy,
common law or any federal, state or local statute, ordinance, regulation or
constitutional provision.

               (a) The claims released and discharged by Employee include, but
are not limited to, claims arising under Title VII of the Civil Rights Act of
1964, as amended; the Civil Rights Act of 1991; The Older Workers Benefit
Protection Act ("OWBPA"); the Age Discrimination in Employment Act of 1967
("ADEA"), as amended; the Americans with Disabilities Act ("ADA"); the Fair
Labor Standards Act; the Employee Retirement Income and Security Act of 1974, as
amended; the National Labor Relations Act; the Labor Management Relations Act;
the Equal Pay Act of 1963; the Pregnancy Discrimination Act of 1978; the
Rehabilitation Act of 1973; workers' compensation laws; Kentucky Wage and Hours
Laws, claims before the Kentucky Commission for Human Rights and Kentucky
Revised Statutes sections 341 et seq.

               (b) Employee recognizes that by signing this Agreement, he may be
giving up some claim, demand or cause of action which he now has or may have,
but which is unknown to him.

               (c) Employee agrees not to file any charges, complaints, lawsuits
or other claims against the Company that relate in any manner to the Employee's
employment or the resignation or termination of Employee's employment with the
Company.

               (d) Employee expressly waives any present or future claims
against the Company for alleged race, color, religious, sex, national origin,
age or disability discrimination or harassment under Title VII of the Civil
Rights Act of 1964, as amended; the Civil Rights Act of 1991; the Equal Pay Act
of 1963; the Americans with Disabilities Act; the Family Medical Leave Act; the
Age Discrimination in Employment Act of 1967; the Older Workers Benefit
Protection Act; the Rehabilitation Act of 1973; or any other federal or state
law protecting against such discrimination or harassment.

               (e) Employee acknowledges that the Company has not and does not
admit that it engaged in any discrimination, wrong doing or violation of law on
the Company's part concerning Employee. Employee and the Company agree that by
entering into this Agreement no discrimination, wrong doing, or violation of law
has been

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acknowledged by the Company or assumed by Employee. Employee and the Company
further acknowledge that this Agreement is not an admission of liability.

          Confidentiality. Employee and the Company agree to keep the contents
          ---------------
and terms of this Agreement confidential and not to voluntarily disclose the
terms or amount of settlement to third parties. The only exception is that
Employee may reveal the terms of this Agreement to his spouse, attorney, tax
preparer or as otherwise required by law. The Company may reveal the terms of
this Agreement to its attorneys, accountants, financial advisors, managerial
employees, and any disclosure required by law or business necessity. In the
event that Employee breaches the confidentiality of this Agreement, Employee
understands that the Company shall have the right to pursue all appropriate
legal relief, including, but not limited to, attorneys' fees and costs.

          Public Statement. Employee further agrees not to make derogatory or
          ----------------
negative remarks or comments about the Company, its affiliates and their
respective directors, officers, shareholders, agents or employees, to any third
parties, and not to otherwise defame the Company in any manner. In the event
that Employee defames the Company, its affiliates and their respective
directors, officers, shareholders, agents or employees, Employee understands
that the Company shall have the right to pursue all appropriate legal relief,
including but not limited to, attorneys' fees and costs, and reimbursement of
all monies paid hereunder. Company agrees not to make derogatory or negative
remarks or comments about Employee to any third parties, not to otherwise defame
the Employee in any manner. In the event that the Company defames Employee,
Company understands that the Employee shall have the right to pursue all
appropriate legal relief, including but not limited to, attorneys' fees and
costs.

          Confidential Information. At no time shall Employee divulge, furnish,
          ------------------------
or make accessible to anyone any confidential knowledge or information about the
Company's businesses or operations (except as required by law or order of court
or other governmental agency) or any of the clients, patients, customers or
suppliers of the Company or with respect to any other confidential aspect of the
businesses of the Company. Employee understands and agrees that any violation of
this provision will cause the Company irreparable harm which cannot adequately
be compensated by an award of money damages. As a result, Employee agrees that,
in addition to any other remedy the Company may have, a violation of this
Agreement may be restrained by issuance of an injunction by any court of
competent jurisdiction. Employee further agrees to accept service of process by
first class or certified United States mail.

          Cooperation. Employee agrees that should the Company request
          -----------
Employee's cooperation in connection with litigation, government investigations
or other administrative or legal proceeding, Employee shall cooperate fully with
the Company or its designated agents. Employee further agrees to cooperate fully
in disclosing to the

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Company or its designated agents, any information that Employee obtained during
the course and scope of his employment with the Company, and to which other
employees of the Company were not privy.

          Disputes. Any dispute or controversy arising under, out of, or in
          --------
connection with this Agreement shall, at the election and upon written demand of
either party, be finally determined and settled by binding arbitration in the
City of Louisville, Kentucky, in accordance with the labor arbitration rules and
procedures of the American Arbitration Association, and judgment upon the award
may be entered in any court having jurisdiction thereof. Each party shall pay
their costs of the arbitration and all reasonable attorneys' and accountants'
fees incurred in connection therewith, including any litigation to enforce any
arbitration award.

          Indemnification. Nothing herein shall be construed to terminate or
          ---------------
limit the Company's indemnification obligations under paragraph 19 of Employee's
Employment Agreement dated January 28, 2002 or paragraph 10 of Employee's
Change-in-Control Severance Agreement dated January 28, 2002.

                                       14<PAGE>

                                                                    EXHIBIT 10.7

                      CHANGE-IN-CONTROL SEVERANCE AGREEMENT
                      -------------------------------------

     THIS CHANGE-IN-CONTROL SEVERANCE AGREEMENT (the "Agreement") is made as of
January 28, 2002 by and between KINDRED HEALTHCARE OPERATING, INC., a Delaware
corporation, (the "Company") and Paul J. Diaz, (the "Employee").

     RECITALS:
     ---------

     A. The Employee is employed by the Company, a wholly owned subsidiary of
Kindred Healthcare, Inc. (the "Parent").

     B. The Company recognizes that the Employee's contribution to the Company's
growth and success has been and continues to be significant.

     C. The Company wishes to encourage the Employee to remain with and devote
full time and attention to the business affairs of the Company and wishes to
provide income protection to the Employee for a period of time in the event of a
Change in Control.

     NOW, THEREFORE, in consideration of the mutual covenants contained herein
and other good and valuable consideration, the receipt and sufficiency of which
are hereby acknowledged, the parties hereto agree as follows:

     AGREEMENT:
     ----------

     1. Definitions.
        ------------

        a. "Base Salary" shall mean the Employee's regular annual rate of base
            -----------
pay in gross as of the date in question as elected under Paragraph 3(a).

        b. "Cause" shall mean the Employee's (i) conviction of or plea of nolo
            -----
contendere to a crime involving moral turpitude; or (ii) willful and material
breach by Employee of his duties and responsibilities, which is committed in bad
faith or without reasonable belief that such breaching conduct is in the best
interests of the Company, but with respect to (ii) only if the Board of
Directors of Parent (the "Board") adopts a resolution by a vote of at least 75%
of its members so finding after giving the Employee and his attorney an
opportunity to be heard by the Board.

        c. "Change in Control" The term "Change in Control" shall mean any one
            -----------------
of the following events occurring after the date of this Agreement:

<PAGE>

                 (i)   An acquisition (other than directly from Parent) of any
voting securities of Parent (the "Voting Securities") by any "Person" (as
defined in Paragraph 1(f) hereof) immediately after which such Person has
"Beneficial Ownership" (within the meaning of Rule 13d-3 under the 1934 Act) of
20% or more of the combined voting power of Kindred Healthcare, Inc.'s then
outstanding Voting Securities; provided, however, that in determining whether a
Change in Control has occurred, Voting Securities which are acquired in an
acquisition by (i) Parent or any of its subsidiaries, (ii) an employee benefit
plan (or a trust forming a part thereof) maintained by Parent or any of its
subsidiaries or (iii) any Person in connection with an acquisition referred to
in the immediately preceding clauses (i) and (ii) shall not constitute an
acquisition which would cause a Change in Control.

                 (ii)  The individuals who, as of December 1, 2001, constituted
the Board of Directors of Parent (the "Incumbent Board") cease for any reason to
constitute over 50% of the Board; provided, however, that if the election, or
nomination for election by Kindred Healthcare, Inc.'s stockholders, of any new
director was approved by a vote of over 50% of the Incumbent Board, such new
director shall, for purposes of this Section 1(c)(ii), be considered as though
such person were a member of the Incumbent Board; provided, further, however,
that no individual shall be considered a member of the Incumbent Board if such
individual initially assumed office as a result of either an actual or
threatened "Election Contest" (as described in Rule 14a-11 promulgated under the
1934 Act) or other actual or threatened solicitation of proxies or consents by
or on behalf of a Person other than the Board of Directors of Parent (a "Proxy
Contest"), including by reason of any agreement intended to avoid or settle any
Election Contest or Proxy Contest.

                 (iii) Consummation of a merger, consolidation or reorganization
involving Parent, unless each of the following events occurs in connection with
such merger, consolidation or reorganization:

                       (A) the stockholders of Parent, immediately before such
merger, consolidation or reorganization, own, directly or indirectly immediately
following such merger, consolidation or reorganization, over 50% of the combined
voting power of all voting securities of the corporation resulting from such
merger or consolidation or reorganization (the "Surviving Company") over which
any Person has Beneficial Ownership in substantially the same proportion as
their ownership of the Voting Securities immediately before such merger,
consolidation or reorganization;

                       (B) the individuals who were members of the Incumbent
Board immediately prior to the execution of the agreement providing for such
merger, consolidation or reorganization constitute over 50% of the members of
the board of directors of the Surviving Company; and

                       (C) no Person (other than Parent, any of its
subsidiaries, any employee benefit plan (or any trust forming a part thereof)
maintained by Parent, the Surviving Company or any Person who, immediately prior
to such merger, consolidation or reorganization had

                                      -2-

<PAGE>

Beneficial Ownership of 20% or more of the then outstanding Voting Securities)
has Beneficial Ownership of 20% or more of the combined voting power of the
Surviving Company's then outstanding voting securities.

                 (iv)  Approval by Parent's stockholders of a complete
liquidation or dissolution of Parent.

                 (v)   Approval by Parent's stockholders of an agreement for the
sale or other disposition of all or substantially all of the assets of Parent to
any Person (other than a transfer to a subsidiary of Parent).

                 (vi)  Any other event that the Board shall determine
constitutes an effective Change in Control of Parent.

                 (vii) Notwithstanding the foregoing, a Change in Control shall
not be deemed to occur solely because any Person (the "Subject Person") acquired
Beneficial Ownership of more than the permitted amount of the outstanding Voting
Securities as a result of the acquisition of Voting Securities by Parent which,
by reducing the number of Voting Securities outstanding, increases the
proportional number of shares Beneficially Owned by the Subject Person; provided
that if a Change in Control would occur (but for the operation of this sentence)
as a result of the acquisition of Voting Securities by Parent, and after such
share acquisition by Parent, the Subject Person becomes the Beneficial Owner of
any additional Voting Securities which increases the percentage of the then
outstanding Voting Securities Beneficially Owned by the Subject Person, then a
Change in Control shall occur.

             d.  "Change-in-Control Date" shall mean the date immediately
                  ----------------------
prior to the effectiveness of the Change in Control.

             e.  "Good Reason" The Employee shall have good reason to
                  -----------
terminate employment with the Company if (i) the Employee's title, duties,
responsibilities or authority is reduced or diminished from those in effect on
the Change-in-Control Date without the Employee's written consent; (ii) the
Employee's compensation is reduced; (iii) the Employee's benefits are reduced,
other than pursuant to a uniform reduction applicable to all managers of the
Company; or (iv) the Employee is asked to relocate his office to a place more
than 30 miles from his business office on the Change-in-Control Date.

             f.  "Person" shall have the meaning ascribed to such term in
                  ------
Section 3(a)(9) of the Securities Exchange Act of 1934 and used in Sections
13(d) and 14(d) thereof, including a "group" as defined in Section 13(d).

             g.  "Target Bonus" shall mean the full amount of target annual
                  ------------
incentive bonus that would be payable to the Employee, assuming the target
performance criteria on which such annual incentive bonus were deemed to be
satisfied, in respect of services for the calendar year in which the date in
question occurs.

                                       -3-

<PAGE>

              h.  "Termination of Employment" shall mean (i) the termination of
                   -------------------------
the Employee's employment by the Company other than such a termination in
connection with an offer of immediate reemployment by a successor or assign of
the Company or a purchaser of the Company or its assets under terms and
conditions which would not permit the Employee to terminate his employment for
Good Reason or otherwise during any Window Period; or (ii) the Employee's
termination of employment with the Company for Good Reason or any reason during
any Window Period.

              i.  "Window Period" shall mean either of two 30-day periods of
                   -------------
time commencing 30 days after (i) a Change in Control and (ii) one year after a
Change in Control.

         2.   Term. The initial term of this Agreement shall be for a three-year
              ----
period commencing on January 28, 2002 (the "Effective Date"). The Term shall be
automatically extended by one additional day for each day beyond the Effective
Date that the Employee remains employed by the Company until such time as the
Company elects to cease such extension by giving written notice of such election
to the Employee. In such event, the Agreement shall terminate on the third
anniversary of the effective date of such election notice. Notwithstanding the
foregoing, this Agreement shall automatically terminate if and when the Employee
terminates his employment with the Company other than in connection with a
Change-in-Control or two years after the Change-in-Control Date, whichever first
occurs.

         3.   Severance Benefits. If at any time following a Change in Control
              ------------------
and continuing for two years thereafter, the Company terminates the Employee
without Cause, or the Employee terminates employment with the Company either for
Good Reason or during any Window Period, then as compensation for services
previously rendered the Employee shall be entitled to the following benefits:

              a.   Cash Payment. The Employee shall be paid cash equal to
                   ------------
three times the greater of:

                   (i)  the sum of the Employee's Base Salary and Target Bonus
as of the Termination of Employment, or

                   (ii) the sum of the Employee's Base Salary and Target Bonus
as of the Change-in-Control Date.

Payment shall be made in a single lump sum upon the Employee's effective date of
termination.

              b.   Continuation of Benefits.
                   ------------------------

                   (i)  For a period of three years following the Termination
of Employment, the Employee shall be treated as if he had continued to be an
employee for all purposes under Parent's Health Insurance Plan and Dental
Insurance Plan; or if the Employee is prohibited from participating in such
plan, the Company or Parent shall otherwise provide such benefits. Following
this continuation period, the Employee shall be entitled to receive continuation

                                      -4-

<PAGE>

coverage under Part 6 of Title I or ERISA ("COBRA Benefits") treating the end of
this period as a termination of the Employee's employment if allowed by law.

                 (ii)  For a period of three years following the Termination of
Employment, Parent shall maintain in force, at its expense, the Employee's life
insurance in effect under Parent's Voluntary Life Insurance Benefit Plan as of
the Change-in-Control Date or as of the date of Termination of Employment,
whichever coverage limits are greater.

                 (iii) For a period of three years following the Employee's
Termination of Employment, the Company or Parent shall provide short-term and
long-term disability insurance benefits to Employee equivalent to the coverage
that the Employee would have had had he remained employed under the disability
insurance plans applicable to Employee on the date of Termination of Employment,
or, at the Employee's election, the plans applicable to Employee as of the
Change-in-Control Date. Should Employee become disabled during such period,
Employee shall be entitled to receive such benefits, and for such duration, as
the applicable plan provides.

              c. Retirement Savings Plan. To the extent not already vested
                 ------------------------
pursuant to the terms of such plan, the Employee's interests under the Parent's
Retirement Savings Plan shall be automatically fully (i.e., 100%) vested,
without regard to otherwise applicable percentages for the vesting of
employer-matching contributions based upon the Employee's years of service with
the Company.

              d. Plan Amendments. Parent shall adopt such amendments to its
                 ---------------
employee benefit plans, if any, as are necessary to effectuate the provisions of
this Agreement.

              e. Fringe Benefits. Following the Employee's Termination of
                 ---------------
Employment, the Employee shall receive the computer that Employee is utilizing
as of the date of such Termination of Employment. In addition, for a period of
one year following Employee's Termination of Employment, Employee shall be
entitled to be reimbursed for any legal or accounting services utilized by
Employee to minimize any personal income tax obligations arising from the Change
in Control, in an amount not to exceed $5,000.

           4. Golden Parachute Tax Reimbursement. Whether or not any payments
              ----------------------------------
are made pursuant to Section 3 above, if a Change in Control occurs at any time
and the Employee reasonably determines that any payment or distribution by the
Company or any of its affiliates to or for the benefit of the Employee, whether
paid or payable or distributed or distributable pursuant to the terms of this
Agreement or otherwise pursuant to or by reason of any other agreement, policy,
plan, program or arrangement, including without limitation any restricted stock,
stock option, stock appreciation right or similar right, or the lapse or
termination of any restriction on or the vesting or exercisablility of any of
the foregoing (individually and collectively, the "Payment"), would be subject
to the excise tax imposed by Section 4999 of the Internal Revenue Code of 1986,
as amended (the "Code") (or any successor provision thereto) by reason of being
considered "contingent on a change in ownership or control," within the meaning
of Section 280G of the Code (or any successor provision thereto), or any
interest or penalties

                                      -5-

<PAGE>

with respect to such excise tax (such excise tax, together with any such
interest and penalties, being hereinafter collectively referred to as the
"Excise Tax"), then the Company or Parent shall pay to the Employee an
additional payment or payments (individually and collectively, the "Gross-Up
Payment"). The Gross-Up Payment shall be in an amount such that, after payment
by the Employee of all taxes required to be paid by the Employee with respect to
the receipt thereof under the terms of any federal, state or local government or
taxing authority (including any interest or penalties imposed with respect to
such taxes), including any Excise Tax imposed with respect to the Gross-Up
Payment, the Employee retains an amount of the Gross-Up Payment equal to the
Excise Tax imposed upon the Payment. The Gross-Up Payment shall be paid to the
Employee within 30 days of the Company's receipt of written notice from the
Employee that such Excise Tax has been paid or will be payable at any time in
the future.

         5. No Mitigation Required or Setoff Permitted. In no event shall
            ------------------------------------------
Employee be obligated to seek other employment or take other action by way of
mitigation of the amounts payable to Employee under the terms of this Agreement,
and all such amounts shall not be reduced whether or not Employee obtains other
employment. Further, the Company's and Parent's obligations to make any payments
hereunder shall not be subject to or affected by any setoff, counterclaims or
defenses which the Company or Parent may have against Employee or others.

         6. Waiver of Other Severance Benefits. The benefits payable pursuant to
            ----------------------------------
this Agreement are in lieu of any other severance benefits which may otherwise
be payable by the Company or its affiliates to the Employee upon termination of
employment pursuant to a severance program of the Company or its affiliates
(including, without limitation, any benefits to which Employee might otherwise
be entitled under any other severance or change in control or similar agreement
previously entered into between Employee and the Company or any of its
affiliates).

         7. Disputes. Any dispute or controversy arising under, out of, or in
            --------
connection with this Agreement shall, at the election and upon written demand of
either party, be finally determined and settled by binding arbitration in the
City of Louisville, Kentucky, in accordance with the National Employment
Arbitration rules and procedures of the American Arbitration Association, and
judgment upon the award may be entered in any court having jurisdiction thereof.
The Company shall pay all costs of the arbitration and all attorneys' and
accountants' fees of the Employee in connection therewith, including any
litigation to enforce any arbitration award.

         8. Successors; Binding Agreement. This Agreement shall not be
            -----------------------------
terminated by the voluntary or involuntary dissolution of the Company or by any
merger or consolidation where the Company is not the surviving corporation, or
upon any transfer of all or substantially all of the Company's stock or assets.
In the event of such merger, consolidation or transfer, the provisions of this
Agreement shall be binding upon and shall inure to the benefit of the surviving
corporation or corporation to which such stock or assets of the Company shall be
transferred.

                                      -6-

<PAGE>

         9.  Notices.  Any notice or other communication hereunder shall be in
             -------
writing and shall be effective upon receipt (or refusal of receipt) if delivered
personally, or sent by overnight courier if signature for the receiving party is
obtained, or sent by certified or registered mail, postage prepaid, to the other
party at the address set forth below:

                       If to the Company:     Kindred Healthcare Operating, Inc.
                                              680 South Fourth Street
                                              Louisville, KY  40202
                                              Attention:  General Counsel

                       If to Employee:        Paul J. Diaz

             Either party may change its specified address by giving notice in
writing to the other.

         10. Indemnification. The Company shall indemnify, defend and hold the
             ---------------
Employee harmless from and against any liability, damages, costs and expenses
(including attorneys' fees) in connection with any claim, cause of action,
investigation, litigation or proceeding involving him by reason of his having
been an officer, director, employee or agent of the Company, except to the
extent it is judicially determined that the Employee was guilty of gross
negligence or willful misconduct in connection with the matter giving rise to
the claim for indemnification. This indemnification shall be in addition to and
shall not be substituted for any other indemnification or similar agreement or
arrangement which may be in effect between the Employee and the Company or may
otherwise exist. The Company also agrees to maintain adequate directors and
officers liability insurance, if applicable, for the benefit of Employee for the
term of this Agreement and for five years thereafter.

         11. ERISA. Many or all of the employee benefits addressed in Paragraph
             -----
3(b) and (c) exist under plans which constitute employee welfare benefit plans
("Welfare Plans") within the meaning of Section 3(1) of the Employee Retirement
Income Security Act of 1974, as amended ("ERISA"). Any payments pursuant to this
Agreement which could cause any of such Plans not to constitute a Welfare Plan
shall be deemed instead to be made pursuant to a separate "employee pension
benefit plan" within the meaning of Section 3(2) of ERISA or a "top hat" plan
under Section 201(2) of ERISA as to which the applicable portions of the
document constituting the Welfare Plan shall be deemed to be incorporated by
reference. None of the benefits hereunder may be assigned in any way.

         12. Severability.  The invalidity or unenforceability of any provision
             ------------
of this Agreement shall not affect the validity or enforceability of any other
provision, which other provision shall remain in full force and effect.

                                      -7-

<PAGE>

         13. Interpretation.  The headings used herein are for convenience only
             --------------
and do not limit or expand the contents of this Agreement. Use of any male
gender pronoun shall be deemed to include the female gender also.

         14. No Waiver.  No waiver of a breach of any provision of this
             ---------
Agreement shall be construed to be a waiver of any other breach of this
Agreement. No waiver of any provision of this Agreement shall be enforceable
unless it is in writing and signed by the party against whom it is sought to be
enforced.

         15. Survival.  Any provisions of this Agreement creating obligations
             --------
extending beyond the term of this Agreement shall survive the expiration or
termination of this Agreement, regardless of the reason for such termination.

         16. Amendments.  Any amendments to this Agreement shall be effective
             ----------
only if in writing and signed by the parties hereto.

         17. Entire Agreement.  This Agreement constitutes the entire agreement
             ----------------
of the parties with respect to the subject matter hereof.

         18. Governing Law.  This Agreement shall be interpreted in accordance
             -------------
with and governed by the law of the State of Delaware.

         19. Counterparts.  This Agreement may be executed in two or more
             ------------
counterparts, each of which shall be deemed to be an original, and all of which
together shall constitute one and the same instrument.

                                      -8-

<PAGE>

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

                                      KINDRED HEALTHCARE OPERATING, INC.

                                               /s/ Richard A. Schweinhart
                                      ------------------------------------------
                                         By:   Richard A. Schweinhart
                                               Senior Vice President
                                               and Chief Financial Officer

                                         For the purposes of Sections 3, 4, 5
                                         and 10 and as guarantor of the
                                         Company's obligations under this
                                         Agreement:

                                         KINDRED HEALTHCARE, INC.

                                               /s/ Richard A. Schweinhart
                                         ---------------------------------------
                                         By:   Richard A. Schweinhart
                                               Senior Vice President
                                               and Chief Financial Officer

                                         /s/ Paul J. Diaz
                                         ---------------------------------------
                                         Paul J. Diaz

                                      -9-

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