One year after the events of the second film, Kristen Parker is scolded by her mother Elaine to go to bed after staying up all night making a papier-mâché house. Kristen objects but obeys her mother. As she dreams, she is stalked in her model, which is revealed to be 1428 Elm Street, the home of Nancy Thompson and Jesse Walsh. Running from him, she wakes up in her own bed again and realizes it was a dream. The stalker, who is revealed as Freddy Krueger, then appears to her when she goes to wash her face and proceeds to slash her wrists with his claws. Elaine walks in, and Freddy makes the attack appear as a suicide attempt and has her admitted to the hospital for help. Going into hysterics after an attempt to sedate her, Kristen is calmed when Nancy Thompson, a newly hired member of the hospital staff arrives and earns her trust by finishing Freddy’s nursery rhyme.
Nancy is introduced to the rest of the ward; Philip, a skilled puppet maker; Kincaid, a tough kid with a short temper; aspiring actress Jennifer; former drug addict Taryn; Joey, who was so traumatized by his nightmares he refuses to speak; and Will, who is bound to a wheelchair after a failed suicide attempt. Nancy works closely with Neil Gordon, who is very invested and attached to the kids. After Kristen calls on a long-forgotten ability to bring Nancy into her dream, she is inspired that they need to work together to defeat Freddy, but their fears go unheard by the hospital staff. The following night, Philip is mistaken for sleepwalking when Freddy turns him into a living puppet and he is led up into the towers above the ward and sent falling to his death in front of the others, afterward, Jennifer is killed after Freddy possesses a TV and smashes her head into it. Neil begins to lose hope, but meets a nun named Mary Helena who warns him that the unquiet bones must be laid to rest. Nancy suggests using Hypnocil; an experimental drug designed to prevent dreaming, Neil refuses initially, but when Kincaid is sent to the quiet room for sedation he changes his mind.
Nancy lets the survivors in on Freddy’s past, and through group hypnosis they enter a shared dream and discover their dream powers, but Joey is lured away and captured by Freddy, rendering his body comatose in the real world. These actions and the prescription of Hypnocil get Neil and Nancy fired by the administrator Dr. Carver. Mary Helena appears to Neil again and tells him of Freddy’s origin; the bastard son of a hundred maniacs, whose mother was raped by lunatics when she was locked in the asylum for the holidays by accident. Realizing that his bones must be buried properly, Nancy and Neil approach her father Don Thompson who is the only man who would know where they were hidden. Nancy is called back to the hospital due to Kristen’s outbreak that she was gone causing her to be sent to the quiet room, while Neil convinces Don to help him find Freddy’s bones. She, Kincaid, Taryn and Will enter group hypnosis to unite with Kristen in the dream, but Freddy quickly separates them. He kills Taryn with a heroin overdose, and Will by cutting out his heart while the others reunite. They are led down to Joey and rescue him, but discover that the souls Freddy has collected have made him stronger. Sensing that his bones are being disturbed, Freddy leaves the dream world and possesses his skeleton. He kills Don and injures Neil before returning to the dream world. He tries to separate the group again, but Joey unlocks his dream power and shatters the mirrors Freddy was using, freeing the others from his grasp, and they believe the battle to be over. Don appears before Nancy and tells her he’s crossed over, they embrace in their last goodbyes, but he turns into Freddy before stabbing and mortally wounding Nancy.
Neil awakens and finally buries Freddy’s bones and consecrates the remains, destroying Freddy and saving Kristen. As Nancy dies in her arms, Kristen promises to send her off into a beautiful dream forever. At the funeral service, Neil sees Mary Helena again and rushes to meet her, but only discovers the gravestone of Amanda Krueger, who was also called Sister Mary Helena. That night, Neil sleeps peacefully in his bed with Nancy’s Malaysian dream doll on his dresser along with the papier-mâché house, when suddenly the lights come on in the house.