Transposable elements (TEs) have had a major influence on shaping both prokaryotic and eukaryotic genomes, largely through stochastic events following random or near-random insertions. In the mammalian immune system, the recombination activation genes1/2 (Rag1/2) recombinase has evolved from a transposase gene, demonstrating that TEs can be domesticated by the host. In this study, we uncovered a domesticated transposase, Kluyveromyces lactis hobo/Activator/Tam3 (hAT) transposase 1 (Kat1), operating at the fossil imprints of an ancient transposon, that catalyzes the differentiation of cell type. Kat1 induces mating-type switching from mating type a (MATa) to MATα in the yeast K. lactis. Kat1 activates switching by introducing two hairpin-capped DNA double-strand breaks (DSBs) in the MATa1-MATa2 intergenic region, as we demonstrate both in vivo and in vitro. The DSBs stimulate homologous recombination with the cryptic hidden MAT left alpha (HMLα) locus resulting in a switch of the cell type. The sites where Kat1 acts in the MATa locus most likely are ancient remnants of terminal inverted repeats from a long-lost TE. The KAT1 gene is annotated as a pseudogene because it contains two overlapping ORFs. We demonstrate that translation of full-length Kat1 requires a programmed -1 frameshift. The frameshift limited Kat1 activity, because restoring the zero frame causes switching to the MATα genotype. Kat1 also was transcriptionally activated by nutrient limitation via the transcription factor mating type switch 1 (Mts1). A phylogenetic analysis indicated that KAT1 was domesticated specifically in the Kluyveromyces clade of the budding yeasts. We conclude that Kat1 is a highly regulated transposase-derived endonuclease vital for sexual differentiation.