This paper examines the impact of drinking water quality and sanitation behavior on child health in rural districts of Ethiopia. Using primary household survey data and microbiological water test for Escherichia coli, use various estimation methods to quantify the impacts of water quality and sanitation behavior on diarrhea incidence among children under five years old. Results show that uncontaminated household storage water and safe child stool disposal decrease incidence of child diarrhea by 16% and 23% respectively. In contrast, neighborhood concentration of pit latrine increases incidence of child diarrhea by 12%. The latter result casts serious doubt on the assumed health and social benefits of moving from open to fixed-location defecation. Creating open defecation free communities in rural areas is not enough to achieve the desired health benefits of sanitation. To protect rural households from the risk of contracting communicable diseases, existing pit latrines should be upgraded to make them safer to use – fly-proofed and hygienic. There is a need for appropriate policy actions to improve household drinking water quality and to change people’s behavior towards safe sanitation practices. Increasing access to clean water supply and providing means for safe excreta disposal will bring significant health and social gains. Moreover, promotion of hygiene education campaigns about household water treatment, safe water storage and handling, washing hands with soaps at critical times, and adequately removing child feces from the domestic environment can also help ensure that people preserve good health in their household and their community.