diff --git a/CHANGELOG.md b/CHANGELOG.md
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--- a/CHANGELOG.md
+++ b/CHANGELOG.md
@@ -7,6 +7,14 @@ The format is based on [Keep a Changelog](https://keepachangelog.com/en/1.0.0/).
 
 ## [Unreleased]
 
+### Fixed
+- **SDK Agent Spatial Awareness**: Added working directory (CWD) context propagation
+  - SDK agent now receives `<tool_cwd>` element with each tool execution
+  - Prevents false "file not found" reports when files exist in different repositories
+  - Enables accurate path matching between requested and executed paths
+  - Works with all models (Haiku, Sonnet, Opus) - no premium workaround needed
+  - See `docs/CWD_CONTEXT_FIX.md` for technical details
+
 
 ## [5.4.0] - 2025-11-09
 
diff --git a/docs/CWD_CONTEXT_FIX.md b/docs/CWD_CONTEXT_FIX.md
new file mode 100644
index 00000000..24b5ddc5
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+++ b/docs/CWD_CONTEXT_FIX.md
@@ -0,0 +1,164 @@
+# CWD Context Fix - Technical Documentation
+
+## Overview
+
+This fix adds working directory (CWD) context propagation through the entire claude-mem pipeline, enabling the SDK agent to have spatial awareness of which directory/repository it's observing.
+
+## Problem Statement
+
+Previously, the SDK agent would:
+- Search wrong repositories when analyzing file operations
+- Report "file not found" for files that actually exist
+- Lack context about which project was being worked on
+- Generate inaccurate observations due to spatial confusion
+
+## Solution
+
+The CWD information now flows through the entire system:
+
+```
+Hook Input (cwd) → Worker API (cwd) → SessionManager (cwd) → SDK Agent (tool_cwd)
+```
+
+## Data Flow
+
+### 1. Hook Layer (`save-hook.ts`)
+```typescript
+export interface PostToolUseInput {
+  session_id: string;
+  cwd: string;  // ← Captured from Claude Code
+  tool_name: string;
+  tool_input: any;
+  tool_response: any;
+}
+```
+
+The hook extracts `cwd` and includes it in the worker API request:
+```typescript
+body: JSON.stringify({
+  tool_name,
+  tool_input,
+  tool_response,
+  prompt_number,
+  cwd: cwd || ''  // ← Passed to worker
+})
+```
+
+### 2. Worker Service (`worker-service.ts`)
+```typescript
+const { tool_name, tool_input, tool_response, prompt_number, cwd } = req.body;
+
+this.sessionManager.queueObservation(sessionDbId, {
+  tool_name,
+  tool_input,
+  tool_response,
+  prompt_number,
+  cwd  // ← Forwarded to queue
+});
+```
+
+### 3. Session Manager (`SessionManager.ts`)
+```typescript
+session.pendingMessages.push({
+  type: 'observation',
+  tool_name: data.tool_name,
+  tool_input: data.tool_input,
+  tool_response: data.tool_response,
+  prompt_number: data.prompt_number,
+  cwd: data.cwd  // ← Included in message queue
+});
+```
+
+### 4. SDK Agent (`SDKAgent.ts`)
+```typescript
+content: buildObservationPrompt({
+  id: 0,
+  tool_name: message.tool_name!,
+  tool_input: JSON.stringify(message.tool_input),
+  tool_output: JSON.stringify(message.tool_response),
+  created_at_epoch: Date.now(),
+  cwd: message.cwd  // ← Passed to prompt builder
+})
+```
+
+### 5. Prompt Generation (`prompts.ts`)
+```typescript
+return `<tool_used>
+  <tool_name>${obs.tool_name}</tool_name>
+  <tool_time>${new Date(obs.created_at_epoch).toISOString()}</tool_time>${obs.cwd ? `
+  <tool_cwd>${obs.cwd}</tool_cwd>` : ''}  // ← Included in XML
+  <tool_input>${JSON.stringify(toolInput, null, 2)}</tool_input>
+  <tool_output>${JSON.stringify(toolOutput, null, 2)}</tool_output>
+</tool_used>`;
+```
+
+## SDK Agent Prompt Changes
+
+The init prompt now includes a "SPATIAL AWARENESS" section:
+
+```
+SPATIAL AWARENESS: Tool executions include the working directory (tool_cwd) to help you understand:
+- Which repository/project is being worked on
+- Where files are located relative to the project root
+- How to match requested paths to actual execution paths
+```
+
+## Example Usage
+
+When a user executes a read operation in `/home/user/my-project`:
+
+```xml
+<tool_used>
+  <tool_name>ReadTool</tool_name>
+  <tool_time>2025-11-10T19:18:03.065Z</tool_time>
+  <tool_cwd>/home/user/my-project</tool_cwd>
+  <tool_input>
+  {
+    "path": "src/index.ts"
+  }
+  </tool_input>
+  <tool_output>
+  {
+    "content": "export default..."
+  }
+  </tool_output>
+</tool_used>
+```
+
+The SDK agent now knows:
+1. The operation happened in `/home/user/my-project`
+2. The file `src/index.ts` is relative to that directory
+3. Which repository context to search when generating observations
+
+## Testing
+
+8 comprehensive tests validate the CWD propagation:
+
+```bash
+npx tsx --test tests/cwd-propagation.test.ts
+```
+
+All tests verify:
+- Type interfaces include `cwd` fields
+- Hook extracts and passes `cwd`
+- Worker accepts and forwards `cwd`
+- SDK agent includes `cwd` in prompts
+- End-to-end flow is correct
+
+## Benefits
+
+1. **Spatial Awareness**: SDK agent knows which directory/repository it's observing
+2. **Accurate Path Matching**: Can verify if requested paths match executed paths
+3. **Better Summaries**: Won't search wrong repositories or report false negatives
+4. **Works with All Models**: Even Haiku benefits from correct context (no need for Opus workaround)
+
+## Backward Compatibility
+
+- `cwd` is optional in all interfaces (`cwd?: string`)
+- Missing `cwd` values are handled gracefully (defaults to empty string)
+- Existing observations without `cwd` continue to work
+- No database migration required (CWD is transient, not persisted)
+
+## Related Issues
+
+Fixes issue #73 (CWD context missing from SDK agent)