Kristens mother, Elaine, and Nancy meet at their house to discuss her nightmares. Elaine is very dismissive, believing Kristen is just acting out and looking for attention. She tells Nancy she has packed a suitcase of Kristens belongings and directs Nancy to her room to get them. Nancy sees the model of her old house which Kristen had been working on. Dr. Gordon looks up Hypnocil, the medication he had seen in Nancy's bag, to find that the drug is used to treat night terrors. We return to Kristen who is in bed drawing the Elm Street house.
As she begins to doze, the door to her room creaks open and the red tricycle from her previous dream wheels, leaving three bloody tire tracks. It then glows red-hot and melts on the floor. She edges out of the room and finds herself back behind the closed and locked front red door of the Elm Street house - trapped inside. Kristen finds herself in the dining room with an elegantly-set table.
A stale barbequed pig with an apple in its mouth is on the table and flies buzz around before it leaps out at her. Kristen explores and finds herself in the empty living room, devoid of furniture, the walls crumble around her and lump appears under the carpet.
A long, tubular snake-like lump with Freddy's face moves under the floor rug and bursts out of the floor. 'Snake-Freddy' catches her legs firmly in its jaw. and begins to eat it's way up Kristen's body. She screams for Nancy and we see Nancy startled from her sleep. She looks at Kristen's model which she has taken home with her and hears Kristen scream again. Nancy passes out and falls through the chair to find herself in Kristen's dream, entering through an ornate mirror in the living room.
Nancy grabs a shard of broken mirror and stabs it into the eye of the snake, causing Kristen to be regurgitated. "YOU!" Freddy hisses. As they flee, Nancy begs for Kristen to take them out of the dream. They hide behind a door and disappear as Freddy crashes through the door and Nancy awakes, back in her chair, with a cut on her hand from the mirror. The next morning Nancy brings the model to Kristen, telling her it is where she used to live. She asks if she has ever pulled anyone into her dream the way she did.
Kristen confides that when she was a child she would pull her Dad into her dreams if they were scary, allowing him to believe that they were his dreams instead. After her parents divorced, it stopped and after a while Kristen thought she had simply imagined the whole thing. Kristen asks about the man in her dreams and Nancy assures her "he is real." At group, Dr. Gordon tells the kids that it is "straight talk only" and then he and Dr. Simms introduce Nancy to the rest of the patients.
Will Stanton is the first to introduce himself. He tells Nancy he had an accident, gesturing to the wheel chair he is sitting in. Taryn White is the next to introduce herself. She admits she is going through "some very strange shit" with her dreams and that the hospital is a better alternative to Juvie hall. Taryn reveals though that he was injured in a suicide jump, not an accident. Kincade reveals that Taryn was a junkie, injecting into her arms. Jennifer Caulfield shares that she wants to be an actress on TV when she leaves the hospital. Jennifer goes on to introduce Joey who doesn't speak.
Phillip interrupts, to say that the doctors all believe their dreams are group psychosis, despite the fact they all dreamt about Freddy before they had met and as a result just seem to go around in circles. Dr. Simms tells him they will not make any progress until the teens can accept the dreams as "By products of guilt; psychological scars stemming from moral conflicts and overt sexuality." Taryn, Will and Joey play dungeons and dragons until Max comes to tell them that it is lights out. After Max and Taryn leave, it is revealed that the boys take shifts to sleep.
Nancy and Neil Gordon are getting coffee. He asks about Nancy's parents. She says her mother "Died in her sleep" and that she and her father don't have a good relationship. She tells Neil that the teens are in real physical danger from their dreams and he asks her about the Hypnocil she has been taking. He seems shocked that Nancy wants him to prescribe the drug to the kids. She confides she used to be like them, and tells Neil that their survival depends on it but he refuses.
Then, Phillip experiences a troubling and deadly dream. Freddy's face appears on the misshapen head of one of his unfinished marionette clay puppets hanging on the wall, and then generates fingers and razor-sharp claws from its right-hand stubbly appendage.
Freddy cut the puppet's strings, dropped to the floor, and grows to a full-size Freddy, at the foot of Phillip's bed. As Phillip is paralyzed on his bed, Freddy slashes large bloodless grooves down the length of each of his arms and legs. He then pulls one long strand of sinewy muscle tendon out of each incision.
Phillip is pulled out of his bed by the tendons in his arms, Freddy now controls him like a puppet. Kincade sees Phillip being manipulated out of the room, but thinking he is sleepwalking, doesn't wake him. Freddy makes Phillip walk out of the ward and up the hospital tower.
Freddy, laughing maniacally as a giant puppet-master looming above the building, lets Phillip teeter there on the edge of the window ledge. Joey sees Phillip standing at the edge of the ledge, waking Will and carrying him to the window. Joey tries to get help, banging a tray as he runs along the corridor to wake people. Will shouts from the window trying to wake Phillip. The group gathers to see Phillip fall to his death as Freddy cuts his strings.