Kindred Healthcare (KND)

Equity-Based Compensation

Consideration of Annual Equity Awards

The Company uses equity-based compensation as a key component of its overall executive compensation strategy. Such awards provide a direct and long-term link between the results achieved for the Company’s shareholders and the total direct compensation provided to the Named Executive Officers. Stock-based compensation is designed to retain the Named Executive Officers through time-based vesting conditions and to motivate them to enhance the value of the Common Stock by aligning the financial interests of the Named Executive Officers with those of the Company’s shareholders. Equity-based compensation also provides an effective incentive for management to create shareholder value over several years since the full benefit of this element of compensation is primarily realized as a result of appreciation in the price of the Common Stock.

Historically, the Committee has awarded both stock options and restricted stock to the Named Executive Officers. When evaluating equity-based compensation, the Committee considers the accounting costs associated with the form of equity award. Generally, the Committee believes that a mixture of equity awards between stock options and restricted stock is the most appropriate method to achieve the Company’s compensation strategies in relation to the total cost to the Company and is consistent with the equity allocation trends of the peer group. The Committee believes that equity awards provide incentives to the Named Executive Officers to grow the Company’s stock price since the full benefit of these awards cannot be achieved unless the value of the Common

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Stock increases. In addition, the Committee generally has used stock options, which vest over several years, and service-based restricted stock to promote retention of the Named Executive Officers and to build their ownership stake in the Company.

In 2007, the Committee awarded only restricted stock. The Committee decided to grant only restricted stock to maximize the compensation value of the awards while minimizing the impact on share dilution and avoiding accounting charges associated with the KPS Spin-off. See “Adjustment of Stock Options in Connection with the KPS Spin-off.” The use of restricted stock also allowed the Named Executive Officers and other equity participants to participate in the dividend associated with the KPS Spin-off.

While the Committee does not have a formal policy with respect to the timing of grants of equity-based awards in connection with the release of material non-public information, the Committee generally considers issues raised by the timing of award grants when making such awards. Stock options are awarded at the closing price of the Company’s Common Stock on the NYSE on the date of grant. The Committee does not grant options with an exercise price that is less than the closing price of the Common Stock on the NYSE on the grant date and it does not grant stock options that are priced on a date other than the grant date.

The amount of equity awarded to the Named Executive Officers is based upon a number of factors. First, the Committee considers an overall assessment of the Company’s performance and the equity granting practices of other companies in the healthcare industry and its peer group. In addition, the Committee considers information prepared by Mercer with respect to the form of the equity awards and the relative costs. Based on this assessment, the Committee then establishes an aggregate pool of potential equity awards for all participants in the equity-based incentive plan, including the Named Executive Officers.

Following the establishment of the aggregate pool of potential equity awards, the Committee considers benchmarks by position from the peer group in evaluating potential awards to the Named Executive Officers. The Chief Executive Officer also provides an assessment to the Committee of the overall level of performance for the other Named Executive Officers. The Committee then considers the overall performance of the Named Executive Officer and his actual and potential contribution to the Company’s growth and long-term performance in determining individual awards. The assessment of actual and potential contribution is based upon the Committee’s subjective evaluation of each Named Executive Officer in light of various operational and strategic challenges and opportunities facing the Named Executive Officer during the relevant year. Based on these assessments, the Committee ranks each Named Executive Officer in one of three award levels—high, middle or low. These award levels are converted to a multiple of base salary, generally within the relevant benchmark, and awards are made from the Company’s aggregate pool of available equity awards established by the Committee.

The Committee granted restricted stock to the Named Executive Officers in April 2007. After evaluating the performance of the Company, the Committee established an aggregate pool of approximately 421,000 shares for potential equity awards to all participants, which represented between the 25^th and 50^th percentile of the peer group. The Committee determined that the Company’s performance supported an aggregate pool at the 50^th percentile but elected to reduce the size of the pool due to the costs of the awards and to reduce the dilutive effect of these shares on shareholder equity given the Company’s capital structure. The size of the 2007 aggregate pool was less than the Company’s historic annual “run rate” (shares subject to awards made under the Company’s equity plan as a percentage of the total shares outstanding) and was below the 2007 median for the peer group.

In April 2007, the Committee granted annual awards of restricted Common Stock to the Named Executive Officers from the aggregate pool. The number of shares of restricted Common Stock granted in April 2007 were as follows: Mr. Diaz–71,139 shares; Mr. Lechleiter–15,502 shares; Mr. Kuntz–35,569 shares; Mr. Battafarano–16,276 shares; and Mr. Bowen–24,961 shares. These shares will vest in four equal annual installments beginning on the first anniversary of the date of grant.

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As noted above, the individual awards are also based on the Committee’s subjective evaluation of the Named Executive Officer’s performance. The Committee determined that Messrs. Diaz, Lechleiter, Kuntz and Battafarano had performed at the middle range. The Committee determined that Mr. Bowen had performed at the high range.

In making this grant, the Committee considered the performance of Mr. Diaz in leading the Company’s businesses through continued reimbursement instability, while maintaining improvements in employee turnover and quality measures. The Committee also noted Mr. Diaz’s efforts to resolve the last remaining issues associated with the Company’s 2001 reorganization. Mr. Diaz also facilitated additional external growth and has positioned the Company’s portfolio for future growth. Likewise, Messrs. Lechleiter and Kuntz played key roles in the Company’s growth through acquisitions and organic development projects. They also made considerable efforts in connection with the KPS Spin-off.

With respect to Mr. Battafarano, the Committee believed that the Company’s hospital division continued to perform well despite a rapidly changing reimbursement environment. In addition, Mr. Battafarano oversaw significant growth in patient admissions and achieved meaningful reductions in overhead. Under his direction, the Hospital Division also continued to improve on several of its quality measures and maintained high customer satisfaction.

In evaluating Mr. Bowen’s performance, the Committee noted that the Health Services Division had made significant improvements in quality measures and in its human resource outcomes. Mr. Bowen’s efforts facilitated successful growth in the division as well as new program development. In addition, the Health Services Division has experienced improved census and operating margins under his leadership.

As described above, the Committee granted these awards of restricted stock based upon its subjective evaluation that the number of shares and terms were appropriate and desirable considering the foregoing contributions of the Named Executive Officers to the Company and the Committee’s desire to award total direct compensation that is competitive within its peer group. The Committee also considered the retention benefits of awarding restricted stock.

Other Equity Awards

During 2007, the Committee also addressed two significant compensation issues outside of its normal review cycle. In February 2007, the Committee considered and approved changes to the employment agreement for Mr. Kuntz. In addition, the Committee considered and approved bonuses to certain Named Executive Officers and other key employees in recognition of their service on the KPS Spin-off. In connection with these compensation discussions, the Committee granted equity awards to Messrs. Kuntz and Diaz. These matters are described in more detail under “Employment and Other Agreements—Mr. Kuntz” and “Compensation Associated with the KPS Spin-off,” respectively.

Equity-Based Compensation

The Company uses equity-based compensation as a key component of its overall executive compensation strategy. Such awards provide a direct and long-term link between the results achieved for the Company’s shareholders and the total direct compensation provided to the Named Executive Officers. Stock-based compensation is designed to retain the Named Executive Officers through time-based vesting conditions and to motivate them to enhance the value of the Common Stock by aligning the financial interests of the Named Executive Officers with those of the Company’s shareholders. Equity-based compensation also provides an effective incentive for management to create shareholder value over several years since the full benefit of this element of compensation is primarily realized as a result of the appreciation in the price of the Common Stock.

The Company does not currently have a security ownership policy for its Named Executive Officers. However, the Committee may consider adopting a formal security ownership policy for its Named Executive Officers

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following the completion of the proposed spin-off of its pharmacy division. The Committee generally does not take into consideration equity awards granted in previous years when evaluating awards for the current year.

Consistent with prior years, the Committee awarded both stock options and restricted stock in 2006. When evaluating equity-based compensation, the Committee considers the accounting costs associated with the form of equity award and believes that the current mixture of equity awards between stock options and restricted stock is an appropriate method to achieve the Company’s compensation strategies in relation to the total cost to the Company and is consistent with the equity allocation trends of the peer group. The Committee believes that stock options and restricted stock provide incentives to the Named Executive Officers to grow the Company’s stock price since the full benefit of these awards cannot be achieved unless the value of the Common Stock increases. In addition, the Committee uses stock options, which vest over several years, and service-based restricted stock to promote retention of the Named Executive Officers and to build their ownership stake in the Company.

While the Committee does not have a formal policy with respect to the timing of grants of equity-based awards in connection with the release of material non-public information, the Committee generally considers issues raised by the timing of award grants when making such awards. Stock options are awarded at the closing price of the Company’s Common Stock on the NYSE on the date of grant. The Committee does not grant options with an exercise price that is less than the closing price of the Common Stock on the NYSE on the grant date and it does not grant stock options that are priced on a date other than the grant date.

The amount of equity awarded to the Named Executive Officers is based upon a number of factors. First, the Committee considers an overall assessment of the Company’s performance and the equity granting practices of other companies in the healthcare industry and its peer group. In addition, the Committee considers information prepared by Mercer with respect to the form of the equity awards and considers the relative costs. Based on this assessment, the Committee then establishes an aggregate pool of potential equity awards for all participants in the equity-based incentive plan, including the Named Executive Officers.

The Committee considers the overall performance of the Named Executive Officer and his actual and potential contribution to the Company’s growth and long-term performance in determining individual awards. In addition, the Committee considers benchmarks from the peer group in evaluating potential awards to the Named Executive Officers. The Chief Executive Officer also provides an assessment of the overall level of performance for the other Named Executive Officers. The assessment of actual and potential contribution is based upon the Committee’s subjective evaluation of each Named Executive Officer. Based on these assessments, the Committee ranks each Named Executive Officer in one of three award levels and grants equity-based awards to the participants in each level from the Company’s aggregate pool of available equity awards established by the Committee.

The Committee granted stock options and restricted stock to the Named Executive Officers in February 2006. After evaluating the performance of the Company, the Committee established an aggregate pool of approximately 750,000 shares for potential equity awards, which represented approximately the 25^th percentile of the peer group. The Committee evaluated the size of the aggregate pool and determined that the pool would not cause an excessive dilution of shareholder equity. The size of the 2006 aggregate pool was somewhat less than the Company’s annual “run rate” (shares subject to awards made under the Company’s equity plan as a percentage of the total shares outstanding) and was below the 2006 median for the peer group.

In connection with the February 2006 grant, the Committee granted stock option awards to the Named Executive Officers covering the following number of shares: Mr. Diaz—67,017 shares; Mr. Lechleiter—18,751 shares; Mr. Kuntz—23,974 shares; Mr. Battafarano—19,690 shares; and Mr. Chapman—17,356 shares. These options have an exercise price of $21.99 per share, vest in four equal annual installments beginning on the first anniversary of the date of grant and expire seven years from the date of grant. On the same date, the Committee also granted awards of restricted Common Stock to the Named Executive Officers. The number of shares of restricted Common Stock granted to the Named Executive Officers were as follows: Mr. Diaz—55,289 shares; Mr. Lechleiter—15,470 shares; Mr. Kuntz—19,779 shares; Mr. Battafarano—16,244 shares; and

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Mr. Chapman—14,319 shares. These shares will vest in four equal annual installments beginning on the first anniversary of the date of grant.

During the fall of 2006, the Committee further assessed the competitiveness of the total direct compensation paid to Mr. Diaz. The Committee considered the recommendations of Mercer which indicated that Mr. Diaz’s projected 2006 total direct compensation was well below the 2006 median for chief executive officer compensation in the peer group and the healthcare industry generally. In December 2006, the Committee awarded Mr. Diaz 44,711 shares of restricted stock in order to more closely align Mr. Diaz’s compensation with the 2006 median for chief executive officers in the peer group. These shares will vest in three equal annual installments beginning on the first anniversary of the date of grant. As noted above, the Committee also increased Mr. Diaz’s base salary effective January 1, 2007.

In making this grant, the Committee considered the performance of Mr. Diaz in leading the Company’s four businesses through significantly changing reimbursement environments, the Company’s improvements in employee turnover and quality measures, and his efforts to unlock substantial shareholder value associated with the proposed spin-off of the Company’s pharmacy division. The Committee granted this award of restricted stock based upon its subjective evaluation that the number of shares and terms were appropriate and desirable considering Mr. Diaz’s significant contributions to the Company and the Committee’s desire to award total direct compensation between the 50^th and 75^th percentiles of the peer group. The Committee also considered the retention benefits of awarding restricted stock.