This paper presents a systematic design approach for a sensor-embedded “smart” ball bearing. An embedded acoustic emission sensor is used as part of a condition monitoring system to provide self-diagnostic capabilities to the bearing. Integration of the sensor involved a structural modification to the bearing raceway and the configuration of a miniaturized acoustic emission sensing element. The design parameters were the size, geometry, location and material properties of the sensing element as well as the dimensions of the bearing raceway modification in which the sensor is embedded. A combination of analytical and coupled-field finite element models were used in the design process. The raceway was analyzed by evaluating the stress and deflection of the bearing, and the embedded sensor was analyzed in terms of its frequency response. This work shows how both analytical and finite element modeling methodologies can be combined effectively in the development of a smart mechanical component with improved fault detection capabilities.