Sebastian obtains it in the first chapter, grabbing it off of a hanging body beneath the hospital, and uses it to free himself from his bonds. The knife is only used when performing stealth kills against Haunted and potentially other enemies. During gameplay, Sebastian can only use the knife when performing a stealth kill, otherwise the weapon is rendered useless and cannot be used during combat. Despite this, however, Sebastian may occasionally use the knife for other purposes, such as prying old lithographs from the walls in Chapter 7.
Sadist (Chapter 1): If a sneak attack is executed on the Sadist during the first chapter, Sebastian will silently stab him from behind in the upper back, right around the shoulder/neck. This will not kill him, and he will get back up and kill Sebastian unless he is able to quickly find a hiding spot. If he is sneak attacked a few more times he will die, which is an excellent method of obtaining a large sum of Green Gel early on.
Sadist (Chapters 3, 6, and 15): During these chapters Sebastian will actually engage in combat with the Sadist, and can make excellent use of the knife, with the right tactics. In order to stealth attack the Sadist during these chapters, Sebastian will need a Flash Bolt, which will blind the Sadist for a period of time, allowing for Sebastian to crouch down and stab him straight into the belly. This will only bring him to his knees, however, and must be done three or four times, if those are the only weapons you plan to use on him. Combined with other weapons, one can easily make short work of the fight. Take note, however, that if the player finishes the Sadist off with a sneak kill during Chapter 3, they will earn the Knife beats Chainsaw achievement. It can only be done on New Game+, as the player won't acquire the Flash Bolt until later in the game.
Haunted (Stealth Kill): From Chapter 2 onward, the player can seize the opportunity and stealth kill any Haunted they come across, so long as they are unaware of Sebastian's presence, it always instantly kills them, regardless of whatever headwear they have on. The same applies to fat Haunted. After stabbing them in the head, Sebastian gently rests their body onto the ground. The knife will not work on AlterEgo's, however, as they have two heads.
Haunted(Bottle Throw): If the player picks up an empty bottle, and throws it directly at a Haunted's face, they will stumble about for a few seconds, giving the player a chance to stab them up through the underside of their jaw, killing them instantly. The same applies to fat haunted. This is an excellent method of taking out Haunted with gray iron masks, which are impervious to bullets. Note that sneak killing a Haunted after throwing a bottle at them earns the Bloody Bar Brawl achievement.
Haunted (Flash Bolt): If the player fires a Flash Bolt at a group of Haunted, it will will blind them, allowing Sebastian to either stab them through the underside of their jaw, or stab them in the back of the head. Sebastian's head-stab motion is much more swift if he does it with a flash bolt rather than doing it sneakily, as he simply yanks the knife out, and doesn't crouch down to rest the body.
Trauma: While it is a hard maneuver, Trauma can actually be stealth attacked, and will die after two of them. Because they are so large, Sebastian will actually leap up onto their backs, and stab them in the back of the neck. After they throw him off, it takes them a few seconds to get back up, allowing for Sebastian to escape and hide, and wait for another opportunity. Good locations for this are Chapter 11 in the mannequin factory, or Chapter 14 (only on Nightmare difficulty) in the tunnel with one of the fuse box wires, which is normally filled with AlterEgo's. Flash Bolts will not work on Trauma, as they have no face.
Centipedes: During the boss fight with Heresy, he will spawn numerous white centipedes that will wrap themselves around Sebastian's leg. After two or three knife slashes, they will explode into gore.
Barbed Wire Traps: The Keeper is known for leaving barbed wire traps out that capture unwary victims, ensnaring their legs until he comes to kill them. Fortunately for Sebastian, he has a knife, which cuts through the barbed wire in two or three slashes, breaking it.
The in-game Model Viewer's description of the knife goes as follows: "A survival knife found stuck into a dead body beneath the hospital. Apart from a sneak kill, taking on monsters with this is suicide."
Even though it can be seen being used to attack Haunted head-on in a pre-release screenshot for the game, you cannot use the knife in actual combat. The only use for the Knife is to stealth kill enemies.
The knife strongly resembles a KABAR combat knife, which is used by the Marines.