I think it's worth pointing out that it is very likely possible to "save" the student. The argument being that the student was already pre-selected by the admission committee and hence likely to succeed, including being able to overcome their present difficulties. You also note that their performance has declined, so in the past they did perform better. Therefore the student was at some point in time capable of succeeding. A talented person does not become untalented easily, but it is not uncommon to lose motivation to apply that talent. In a situation like the one you describe, I would suggest that not squandering the talent is important enough to go to lengths in restoring the student's motivation. So I would recommend against allowing the student to wash out: The third option would be equivalent to this, and the second option as well if you feel that the independent committee is unlikely to give the student a fair chance. Moreover, sunk cost fallacy notwithstanding, much has been invested in this person already - it is best for everyone if they turned things around and succeeded, rather than failing.
Your student has already taken the correct first step of seeking counseling. You don't mention the type of counseling, but it's worth looking into support groups with other graduate students. I think the most useful thing with regards to the student recovering is being able to share the burden with other students - some people are fortunate in that they are good enough friends with others in their group or fellow students in other groups, to the point where they feel comfortable commiserating and seeking serious advice. I will go out on a limb and predict that your student does not have many good friends who are also graduate students. If your university's counseling unit provides support groups for graduate students, this can effectively bootstrap the process by getting the student to meet with peers in a confidential situation, obviating the slow and difficult process of learning to trust a new friend organically.
However, if the defense is months away, I think it is best abandoned. Some people, with proper help, can just "snap out of it" - but many cannot. Usually there is a lot of mental crud that needs to be processed for the student to go from being crushed by stress to becoming determined to overcome it. With proper support it would take about 1-2 years. If the student is really far gone, it may be advisable to take a break for a few months (such as a leave of absence). After that the student will need time to recover, and after recovering they will still need to bring their thesis up-to-date and prepare or re-prepare for the defense. I don't think you can count on all this happening in 8 months. It's certainly possible, and if you have no option of postponing the defense (such as due to funding) then it's worth a try. But if you have the luxury of time the odds improve significantly if the defense is at least a year out.
For handling the immediate situation, your university may have an Ombudsman or similar office (perhaps human resources would be the place to start) that provides advice for such situations. This may help navigate matters like negotiating with the committee.
With regards to the impact of the process, if done appropriately the impact should be positive. There's a lot of variables, such as the student's precise state, the feasibility of the goals set, and the attitude of the committee. However, there is nothing wrong with having a stick. The stick is your friend. The challenge of graduate school is great, and difficult to overcome with only a stick or only a carrot. You really need the combined effect of the two. Withholding the stick would be a disservice to the student. Of course the student must be ready for it, otherwise instead of perceiving the stick and moving away from it, they will perceive a wall of sticks surrounding them and give up entirely. This is why it's important for a counselor experienced with graduate students to work with the student first. After the student has regained some measure of stability, they may be ready for the formal process, or it may turn out not to be needed after all.
A useful thing you could provide here is to freshen up the carrot. It would seem obvious that finishing a PhD is much better than failing. But to a depressed or anxious person, impostor syndrome can paint some wild pictures of their future. They will always want to imagine themselves to be the one legendary failure. However, there are certain facts that even impostor syndrome cannot easily obscure: Statistics about unemployment for PhDs, incomes, skills, accomplishments up to now, and so on. You are in the best position to see these clearly in your student. You can approach the subject constructively by framing in terms of the student's career plans. These should be seriously considered anyways in the year preceding graduation. Likely the student feels they have no career prospects or hopes at all - but the fact is that this untrue. Even a failed graduate student still has above average skills and talents, and above average career prospects. To say "there's no job I could possibly get" is unrealistic, surely there is something, even if depressingly low status. You can start there and gradually move the target up based on rational, objective indicators such as skills, job descriptions, etc. I've heard of people bringing their resume to the university's career advisor, and saying "if I didn't do anything else, how bad would be the job I could get?" Often it is really not that bad. And then you realize you don't have to do nothing, you can do a little bit to improve your situation, and the job prospects get a lot better. And if you improve a bit more, it's even better... And that's how you end up to deciding to just finish the PhD, defend it properly and be done with it. So explicit planning of post-graduate career plans can be very helpful, possibly critical, here. Indeed, why bother finishing PhD if not for the things you would do with it after? I suspect your students has thought little about what they plan to do once they receive their PhD, they are too busy thinking about what they'll do if they fail.
Of course, this must be done with a measure of prudence. An already distressed person cannot easily have a robust discussion about career plans any time. They must be mentally prepared for it. So you have to approach the subject gently. Hopefully, you have enough experience and knowledge of the student's character to gauge this.
