We study how workforce composition and labor cost affect the recovery of financially distressed firms. We use China’s 2008 Labor Contract Law (LCL) as a laboratory, which increases the cost for a firm to lay off its workers. Post LCL, financially distressed firms decelerate the layoff rate of less skilled employees and avoid mass layoffs. The inability to offload low-quality labor is particularly pronounced among distressed firms located in regions with stringent law enforcement, employer-friendly courts, or having more labor unrest. Non-SOE firms suffer more than their SOE counterparts. Following an increase in the cost to restructure their workforce, distressed firms with an ex-ante larger share of less skilled employees experience a higher cost of debt financing and lower ROA growth; they speed up assets sales and cut wages to a greater extent. Consequently, labor-intensive firms, especially those with a lower-quality workforce, have a significantly lower survival rate and are more likely to turn into zombie firms. These firms take longer to recover and suffer from productivity setbacks. The delay in financial recovery leads to a shift in the firm’s workforce composition, exacerbating the departure of highly skilled employees. Our findings highlight the mechanism by which labor costs can hinder a firm’s ability to emerge from financial distress.