There are different definitions of direct and indirect costs. According to the strictest definition, only billable hours are direct costs. All other costs of employment are indirect. But at least for applications from the academia, NIH considers indirect costs of employment direct costs.

Grants are not money you can use the way you see fit. If the budget includes funds for hiring employees, you cannot use them to hire contractors. You can use the money as originally requested, return it, or apply for a permission to change the budget. You can make minor changes on your own, but not major changes such as hiring a third party to do a substantial part of the work.

There are many reasons why I wouldn't hire everyone else in my company as a contractor. One reason is that this is bad for the employee/contractor. I wouldn't be able to give that person benefits for example. I need to attract the best people to my company and that means giving them fair compensation including benefits.

Yes, PTO does go into indirect costs and can not go into direct costs. Labor is separated out by hours worked for each customer. Any PTO of time working on indirect, those hours can not be billed to a customer.

Seems likely to be a poorly chosen word in the sentence - directive or regulation might have been better.

Which law said the overhead rate had to be 50%+?