Kristen Parker (Patricia Arquette) falls asleep and dreams of a young girl running into an old, condemned house, which bears resemblance to Nancy's house. As Kristen follows the little girl, she begins to realize that she's in trouble. She finds the girl in a boiler room. As she hears someone walking above them, the little girl exclaims, "Freddy's home!" Kristen then grabs the girl and flees from Freddy. After gaining some ground on the madman, she then realizes that the little girl she is carrying is nothing more than a decomposing skeleton. She wakes and goes to the bathroom. While using the sink, the taps come alive and hold Kristen's hands, Freddy appears in the mirror and slashes her wrists with his glove, showing that Kristen was still in a dream. Her mother mistakes this incident as a suicide attempt, because when Kristen awakes she is holding a razor blade to her own wrist.
Kristen is placed in Westin Hills, a psychiatric hospital. When a nurse tries to sedate her, Kristen fights back and cuts one of the orderlies, Max (Laurence Fishburne), with a scalpel. As she backs into a corner chanting a rhyme she heard in her dreams, new staff member Nancy Thompson (Heather Langenkamp) suddenly appears in the room and finishes it for her. Nancy soon realizes that Freddy is not dead, and that Kristen and the other patients, Joey (Rodney Eastman), who cannot speak, Taryn (Jennifer Rubin), an ex addict, Kincaid (Ken Sagoes), a tough kid with behavioral problems, Phillip (Bradley Gregg), a talented sculptor, Jennifer (Penelope Sudrow), a wannabe actress, and Will (Ira Heiden), who is confined to a wheelchair because of an earlier suicide attempt, and is an avid fan of the Wizard Master, a character from a strategy-based board game, are the "last of the Elm Street children" – the last remaining children of the vigilantes who killed Freddy.
Dr. Neil Gordon (Craig Wasson), the main psychiatrist who looks after the kids, and Nancy go to a restaurant where Nancy reveals some information regarding her past experiences and explains that she knows what the children are going through. It is revealed that Nancy has been taking an experimental dream suppressant, Hypnocil, which Nancy suggests using with the children to ensure their safety. Due to the drug not yet receiving FDA approval, Neil is extremely reticent.
Kristen has another terrifying dream in which Freddy attacks her in the form of a giant worm like creature, Kristen reveals a latent ability to bring others into her dreams by bringing Nancy into the dream to assist her. Nancy enters the room from a mirror, and seeing Kristen in peril, uses a shard of glass to stab the Freddy-worm in the eye. Freddy recoils from the wound and recognizes Nancy, he attempts to attack, but Kristen takes Nancy and herself out of the dream. Nancy sees the potential of Kristen's ability to put Freddy down for good.
While Phillip is sleeping, one of the sculpted figures in his room transforms into Freddy, cuts Phillips arms and legs down the center, and leads Phillip out of the room by using his arteries as puppet strings. Kincaid, who is sleeping in the next bed, awakens and notices Phillip moving, but thinks that he is just sleepwalking again. Freddy is somehow able to allow Phillip to walk through locked doors and other obstacles in his path and leads him to the top of one of the nearby towers. Meanwhile in another room, Joey and Will were taking shifts staying awake to protect each other when Joey notices Phillip at the top of the tower. Joey rushes to Will and after dragging Will to the window to show him Phillip leaning dangerously over the ledge, Will tells Joey to get help. Joey attempts to alert the others by stealing a lunch tray from a nurse and bangs it on the doors to the rooms of the other children. The kids all converge in Will's and Joey's room and scream as loud as they can to try to awaken Phillip and get him away from the ledge. Freddy then cuts the "puppet strings" and Phillip falls to his death as the other childern watch in horror. The medical staff rule this as a suicide due to Phillip's propensity for sleepwalking, but the kids refuse to believe this since they could see that Phillip was awake and aware of his own impending death.
The kids are now even more terrified of sleeping. Max enters the T.V. room and tells Jennifer she needs to go to sleep, Jennifer pleads with him to let her stay up which he does. As Jennifer starts to fall asleep, she lights an old ciggarette then stubs her cigarette on her arm to wake herself up. When she falls asleep the actress on T.V. (Zsa Zsa Gabor) is killed by Freddy, then the television distorts. As she goes to investigate, two metal arms and Freddy's head appear out of the T.V. He hoists her up and exclaims the famous line "Welcome to Prime Time, Bitch!" before ramming her head into the TV, killing her.
Meanwhile, Neil, begins to receive visits from a mysterious nun, who introduces herself as Sister Mary Helena. She informs Neil that Freddy Krueger was born in the abandoned wing of the same hospital, Westin Hills, after one hundred maniacs raped his mother, Amanda Krueger. She was a staff member who was accidentally locked inside over the Christmas holidays, and that when he was killed Krueger was never properly buried and must be laid to rest in consecrated ground.
Nancy convinces Neil to try an experimental hypnosis to put the kids and themselves into a deep sleep and then has Kristen attempt to pull them into her dream. After attempting this, it appears that it has failed and they prepare to try again. Joey notices an attractive nurse outside the room who proceeds to seduce him. She leads him to one of the empty rooms and lays him on the bed. She then turns into Freddy who holds Joey captive in the dream world while at the same time rendering him comatose in the real world. Dr. Carver (Paul Kent), fires Neil and Nancy due to those incidents.
Nancy, knowing that while under the care of a more strict psychiatrist the kids will be in great danger, goes to see her father, Lt. Donald Thompson. She makes an impassioned plea to him which ultimately falls on deaf ears due to his alcoholism. Neil tells her to go back to the hospital to help the kids whilst Neil forces Lt. Thompson to help him find Freddy's remains and bury them, stopping at a church to collect Holy water and a crucifix. Nancy and the kids attempt a group sleep session to try and go in and free Joey and get to Kristen, who was thrown in the "quiet room" and sedated without her consent.
As soon as the kids fall asleep, Freddy separates them. He kills Taryn, by giving her an overdose of drugs. He then goes after Will, who in his dreams has the power of a wizard and is no longer confined to his wheelchair, by stabbing him through the heart with his glove. However, Kincaid, who dreams of having super strength, manages to fight his way through Freddy's barriers and reunite with Nancy and Kristen. They fall into a version of Nancy's old home. They save Joey before Freddy can kill him and Krueger reveals he gains strength from imprisoning the souls of his victims. Kincaid attempts to attack Freddy, but Freddy demonstrating how strong he has become, to the shock of Nancy, picks him up with one arm. He is about to kill Kincaid but notices something askew and disappears. Meanwhile, Neil and Lt. Thompson have found Freddy's remains in a large auto salvage yard. They begin to dig a grave when the bones come to life. Lt. Thompson attempts to attack the Freddy-skeleton but is easily beaten and thrown across the yard and impaled on the tail fin of a car, the skeleton proceeds to beat Neil with a shovel leaving him unconscious near the make shift grave.
The kids and Nancy proceed to make their way through Freddy's lair when they come to a room full of mirrors, each of the party are grabbed and pulled through except for Joey who lets out a piercing scream which shatters the mirrors and releases his friends, seemingly stopping Freddy. Nancy notices a bright light from an adjoining room and realizes it is her father's spirit. He tells her that he has crossed over and wanted to say goodbye to her. Lt. Thompson's spirit and Nancy embrace. Seconds later, Nancy is stabbed twice in the stomach by Freddy, who was impersonating her father. Knowing that the biggest threat to him has been removed, Freddy closes the door on Kincaid and Joey, and proceeds to attack Kristen. Just as he is about to kill Kristen, Nancy appears behind him, and makes Freddy stab himself with his own glove. At this precise moment, Neil, who is visibly in pain, awakens and sprinkles the holy water on Freddy's remains, causing bright light to emanate from his body. Neil uses the crucifix and completes the burial causing Krueger to disappear in a brilliant white light.
Nancy, grievously wounded, dies in Kristen's arms. At Nancy's funeral, as others are weeping in silence over the loss, Neil sees the nun that helped him. When he goes to thank her, she vanishes. He is left standing by a gravestone. On the stone there is a name, Amanda Krueger, just below that is another name, her name in Christ: Sister Mary Helena, showing that the nun was the spirit of Freddy's mother. At the end, Neil falls asleep with a toy house next to his head, and a light suddenly comes on in it.