In protein-protein interaction (PPI) networks, functional similarity is often inferred based on the function of directly interacting proteins, or more generally, some notion of interaction network proximity among proteins in a local neighborhood. Prior methods typically measure proximity as the shortest-path distance in the network, but this has only a limited ability to capture fine-grained neighborhood distinctions, because most proteins are close to each other, and there are many ties in proximity. We introduce diffusion state distance (DSD), a new metric based on a graph diffusion property, designed to capture finer-grained distinctions in proximity for transfer of functional annotation in PPI networks. We present a tool that, when input a PPI network, will output the DSD distances between every pair of proteins. We show that replacing the shortest-path metric by DSD improves the performance of classical function prediction methods across the board.