I quite like the run-faster-with-knife-equipped effect in CS. Although it is sort of an exploit, it opens an avenue to player skill. For me, knife use would focus on being a skill-kill. So I agree with the earlier poster that it should deal major damage. And again with earlier posters that it should not be an insta-kill. I think it should be a click to switch, and another click to switch back again. (And put on mouse-wheel, if for PC.) That said, if supporting game pads you might experiment with a double-press-and-hold for knife out; release puts it away.
Will the knife collision be a sweep, a stab, or just (transient) proximity?