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Mental health, which is an integral and essential part of health, has long been of little concern in China and has attracted the attention of the public. Previous studies have found that unemployment is a contributing factor affecting mental health. However, there is hardly any rigorous evidence in China thus far, and the underlying mechanism of how unemployment affects mental health is poorly understood. Using data collected from the China Family Panel Studies survey (2010–2018), we applied fixed-effects models to examine how unemployment affects residents’ mental health and the possible influencing channels. These findings support the idea that unemployment negatively affects the mental health of Chinese interviewees. Frequency of physical exercise mediates the relationship between unemployment and mental health. Further analysis revealed that medical insurance had a moderating effect on the mental health of the unemployed. The study summarizes the main findings and provides possible policy implications.