Embedded processor-based self-test and diagnosis using the compressed test data is described for ICs having on-chip memory. Techniques for compressing the test data before the compressed test data is transferred to a device under test (DUT) are also described. A modified LZ77 algorithm can be used to compress strings of test data in which don't care bits are handled by assigning a value to the don't care bits according to a longest match in the window as the data is being encoded. The compressed test data can be decompressed at the DUT using a software program transferred by the automated test equipment (ATE) to the DUT with the compressed test data. Decompression and diagnostics can be carried out at the DUT using an embedded processor and the on-chip memory. Results from the diagnostics can be read by the ATE.