In group the next morning, the kids are all upset. Kincade is annoyed, blaming Phillips death on his weakness. Dr Gordon tries to tell them that it was suicide, which the others do not believe. Taryn says it was murder. Dr Simms tells the teens that to prevent a reoccurrence all rooms will be locked at night and they will be sedated.
This freaks Kincade out, and as he gets irate, Dr. Simms beeps for security and he is sent to isolation once more. He is dragged away and despite Nancy's protests, Simms says she is going to begin sedation that night. Neil decides to prescribe Hypnocil, despite Simms reservations. Kincade is locked in the quiet room struggling to sleep.
Jennifer is watching TV as research in the common room. Max tries to make her go back to her room but seeing she is upset allows her to stay so she doesn't sleep. Taryn has been showering and is accosted by an orderly who offers her, the keys to the dispensary. She says that she doesn't do that anymore and goes to her room. Jennifer finds a cigarette, lights it and then burns her hand to keep herself awake.
She flicks through the channels, stopping on The Dick Cavett Show, which has Zsa Zsa Gabor as the guest. After a few minutes, Cavett suddenly turns into Freddy and attacks Gabor, after which the signal cuts out. Screams and the rhyme can be heard as Jennifer goes over to the TV. Arms burst out of the side of the television and grab Jennifer, before Freddy's head emerges from the top.
Freddy taunts the screaming teen: "This is it, Jennifer. your big break in TV. Welcome to Prime Time, Bitch!" He then brutally and forcefully rams her head face-first into the screen, causing an explosion of glass and sparks.
Neil watches at her funeral from a distance. The nun he saw earlier approaches him and asks him about his faith. He tells her that he saw her before and asks if Sister Mary-Helena does volunteer work at the hospital. She says she does from time to time, "When needed," and tells him that the only way to save the children is to put the unquiet spirit to rest. Nancy approaches and when he turns around the nun has disappeared.
Neil and Nancy share a meal and he sees Nancy's Malaysian dream doll which is supposed to bring good dreams. He is worried about the kids and doesn't know what to do. He can't make sense of it. Nancy wonders if he is ready to hear the truth, telling him to put everything else aside and just trust her.
In group, unofficially, Neil allows Nancy to tell the kids about Freddy. Although skeptical at first when she describes his dirty brown hat, his burnt face and the razors on his right hand they believe her. She tells them that the man is Freddy Krueger, a child murderer before he died and after, something much worse. She shares the fact that six years ago he had killed her friends and almost killed her as revenge for his death.
Their parents had burnt him alive after a mistake with a search warrant leading to his arrest caused all charges to be dropped and Krueger to go free. Although unable to believe it at first, the kids do believe it. Nancy reveals Kristen's gift and tells the others that she is the key, but they all have their own inner strengths they can harness in the dream world.
Neil tells them they are going to try a little group hypnosis. He gets them to relax and follow a pendulum as Nancy tells Kristen to take them to the dream world. At first, little seems to have changed; they are in the same room and decide to take a break before trying again. Joey wanders out of the room, spotting the young nurse he helped previously. She tells him that she wanted to talk to him alone as she really likes him.
She claims that she makes up excuses to come into the ward as he is so cute. Dr Gordon sets off a perpetual motion device and the ball bearings break away and float around the room, revealing that they are actually dreaming, despite initial appearances. Neil struggles to believe till Will stands up. In his dreams he can walk, and is "The Wizard Master," which he demonstrates by turning a ball bearing into a butterfly. Kristen is able to back flip and somersault in her dreams, Kincade is super strong, and Taryn is "beautiful and bad."
Joey is in the room with the nurse. She asks him to unzip her uniform, revealing she is topless underneath. Asking if he likes her body Joey nods enthusiastically. She pushes him back on the bed and kisses him, before biting his tongue and pulling it from his mouth. Tongues are used to bind Joeys wrists and ankles and the nurse is revealed to be Krueger.
"Feeling tongue-tied?" he asks. The mattress disappears to reveal a hell pit. At this moment the others realize that Freddy is close and he has Joey.