It's Christmas Eve 1971, and the Chapman family - father, mother, and two sons, Billy, age 5, and infant Ricky - are traveling in their station wagon along desolate Utah roads, with the radio for company. They arrive at their destination, a state mental hospital, where they visit Grandpa. Grandpa is severely mentally ill, and while not dangerous, he can't take care of himself. He doesn't seem to even realize he has visitors. The father and mother, with little Ricky, go off to discuss things with the doctors, leaving Billy momentarily alone with Grandpa. As soon as they are alone, Grandpa turns his head and smiles, and starts talking to Billy. He tells him "the truth" about Santa Claus: that Santa will only leave presents for boys and girls who have been good all year; those who haven't, Santa punishes instead. Billy is terrified, because he hasn't been good all year and he knows it. Grandpa returns to his trance before the rest of the family returns to collect Billy for the return trip home. It's after dark by the time they get started.
On the way home, Billy, having taken Grandpa's words to heart, asks his mother if Santa Claus ever punished her when she was little. The mother is visibly upset by this question, and taken aback when Billy tells her that Grandpa told him the story. She pronounces Grandpa a silly old fool, which disturbs Billy even more. He had been taught it was naughty to say bad things about old people, and Santa Claus might punish his mother for it.
Meanwhile, not too far away, a man in a Santa Claus suit robs a gas station at gunpoint, and kills the clerk when he tries to fight back. He leaves with only $31, swearing as he gets into his getaway car, which we see later broke down. The Chapman family has the misfortune to meet him when they drive up to him on the highway, thinking he is on his way to a party when he had car trouble. Billy is terrified, thinking Santa has come to punish him, and his worst fears are borne out when the man pulls his pistol, intending to steal the station wagon. The father slams the car into reverse trying to escape, but the man shoots him dead, and the car crashes into the ditch. Billy runs out of the car to hide in the bushes while the Santa drags his mother out of the car and rips her clothes off, intending to rape her. The mother fights back, and the Santa, further enraged, changes his mind and kills her with a switchblade instead. Then, with Ricky crying in the background, the Santa stands by the side of the road, looking for Billy, saying "Where are you, you little bastard?"
Now it is near Christmas in 1974. We see that the boys both survived, but we aren't told if the killer was ever caught. Billy, now 8, and Ricky, now 3 or maybe 4, live at a Catholic orphanage. Billy's gruesome Christmas drawing gets him into trouble, and he is sent to his room by the Mother Superior while the other children play outside. She discusses the case with the younger nun, Sister Margaret, who was teaching the class. Margaret realizes that Billy remembers what he saw, is mentally unstable and gets worse every Christmas, but the tyrannical Mother Superior believes that Billy was too young to remember and she can beat the thoughts out of him. Margaret goes to release Billy from his room, believing that getting outside will do him good, and knowing that Billy will improve after Christmas. Billy walks down the hallway, but is distracted when he hears noises coming from a closed room. Peeping through the keyhole, he sees two of the orphanage's older residents, in their teens, naked and having sex. He has a flashback to the murders, remembering his mother being forcibly stripped by the Santa Claus. Mother Superior catches him there and throws him aside before entering the room to punish the teenagers with her belt.
Billy goes outside to play, but the Mother Superior soon comes back for him to punish him, brushing aside Margaret's protests that she gave him permission to go outside. The Mother Superior explains to Billy that the teenagers he saw were being naughty, and they were punished, and that he would now be punished himself for leaving his room. Mother Superior whips him with the belt and sends him to bed. Later, Billy has a nightmare about the murders and runs into the hallway screaming, and Mother Superior catches him and punishes him again by tying him to the bed.
On Christmas morning, the orphanage has a man in a Santa Claus suit come by, and of course Billy is terrified of him. Mother Superior drags him kicking and screaming to Santa, and he punches Santa in the face and runs back to his room. Soon Mother Superior comes to administer even more punishment...
Now it is spring 1984. We see Sister Margaret, ten years older but looking much the same, talking to the manager of a toy store, Mr. Sims. Sims is reluctant to hire Billy, who just turned 18 and is ready to leave the orphanage and enter the real world, but changes his mind when he meets Billy, who has grown tall and strong, just what Sims needs for the warehouse. Billy starts the new job and for the first few months, it works out well for him. Besides him and Sims, there is Mrs. Randall, the assistant manager, Andy, the warehouse clerk, and Pamela, a girl who helps in the store. But Christmas comes eventually, and few places are more into it than toy stores. Billy is upset, especially by the Santa Claus imagery, and it affects his work. Andy, who shamelessly sucks up to Sims but is verbally abusive to his co-workers when Sims is not around, yells at Billy about it.
Shortly before Christmas, Sims has a problem. The guy whose job was to play Santa Claus in the store hurt himself, and the only replacement available was Billy. So they dress Billy up as Santa Claus and the next day, the parents shopping at the store remark of how good he is with the children - in fact, he frightened them into silence with his warnings of punishment, believing that's what Santa Claus does. On Christmas Eve, just before closing time, Sister Margaret calls the store to see how Billy is getting along, it being his worst time of year and all. When Andy tells her that he is dressed as Santa Claus, she realizes that this was a very bad idea, and she sets out to go there. It will be awhile before she arrives.
At closing time, Sims locks the store and starts the Christmas party by getting out the booze. Everyone seems to be having a good time, except Billy, still in the Santa Claus suit, who is still moody, thinking about his parents' murders. Sims, becoming more and more drunk, tries to cheer Billy up while Andy takes Pamela into the back. Billy, becoming somewhat drunk himself, believes Sims's joke that he will soon think he is Santa Claus. He walks to the back, and sees Andy becoming more aggressive with Pamela, he has ripped her shirt open. Seeing this give him another flashback to the old days, and this pushes him over the edge at last. Believing that he really is Santa Claus and has the power to punish the naughty, he steps forward and kills Andy by hanging him from a string of Christmas lights. Pamela freaks out, and Billy, believing her to be naughty as well, cuts her stomach with a utility knife. Sims, thinking he heard noises in the back, goes to investigate, and Billy kills him with a claw hammer. Mrs. Randall, realizing she is alone, goes to look for Sims, and finds him dead. She runs for the door, but it is locked. Then she goes for the phone, but Billy chases her with a double-bit axe. She hides from him, then pushes him down and takes his axe, intending to break the doors and escape. Billy picks up a bow and and shoots her with an arrow from across the room. Then he unlocks the door and leaves, axe in hand, a few minutes before Sister Margaret finally arrives to see what Billy has done.
Next, we see two policemen, incredulous that they have orders to pick up Santa Claus. They see a man in a Santa suit climbing in the second-floor window of a nearby home, and go to get him, but it turns out to be a false alarm: it was the man who lived there, intending to surprise his young daughter.
Next, we see a teenage girl named Denise, making out with her boyfriend Tommy on top of a pool table. The girl's younger sister Cindy starts walking down the stairs, anxious for Christmas to arrive and hoping to see Santa Claus. Not wanting to be seen half-naked, she tells Cindy to go back to bed lest Santa pass the house by. She does so, unhappily. Then Denise hears jingling outside, and tells her boy-friend to wait for a moment, so she can let the cat in. Denise pulls on some very short shorts, and wearing nothing else, goes to let the cat in. The cat runs inside, but then Billy shows up, dressed in the Santa suit and carrying his double-bit axe. Denise screams and slams the door shut, but Billy breaks the door down. After a brief struggle, Billy picks up Denise and impales her on the antlers of a trophy deer that was hung over the fireplace. Tommy couldn't hear the ruckus over the radio, and has been killing time playing pool. Eventually he goes up to check on Denise, finds the door broken and then finds Denise hanging on the antlers. Then he meets Billy. He puts up a better fight, but eventually Billy gets hold him and throws him from the window, where he lands on the hard ground outside, breaking his neck.
Just as Billy gets ready to leave, Cindy comes out of her room again, and she is overjoyed that she did get to meet Santa Claus. Billy asks Cindy if she's been good all year, and she insists that she has. Billy puts a "present" into the little girl's hands, the utility knife, and then he leaves. We can hear Cindy's voice, puzzled but excited, calling for her sister to tell her what she saw.
Meanwhile, two boys in the early teens are out for a late-night sled down a snowy hill. Before they start, they are set upon by two older boys who steal the sleds for themselves. The first one sleds down the hill; the second is attacked by the axe-wielding Billy halfway down. He falls sideways off the sled at the bottom of the hill, his head rolling down behind him. The other boy screams.
By morning, Billy has still not been caught. Sister Margaret, who had fallen asleep at the police station, wakes up and one of the policemen tells her the bad news, three more killings overnight. They believe that Billy will likely return to the orphanage and radio the police there to keep a lookout for a man in a Santa Claus suit. Sister Margaret tries to call the orphanage to warn them, but one of the little girls there has been playing with the phone and left it off the hook, so she only gets a busy signal. After several failed tries, she and one of the policemen set out to drive there.
One of the policemen on patrol near the orphanage does see a Santa Claus walking toward the orphanage, and gets out of the car and yells for him to stop. When the man doesn't respond, the policeman shoots him. He falls forward, dead. But we soon learn that this was a case of mistaken identity when the dead man turns out to be middle-aged. Sister Margaret instantly recognizes the description as that of Father O'Brien, who had been their Santa Claus for several years, and who could not hear the policeman because he was deaf.
The policeman apologizes to the Mother Superior, and tells her that the killer may still be coming and that he will keep watch. Over the last ten years, Mother Superior's health has declined, she is now in a wheelchair and no longer able to physically punish the children, but she is every bit as bitter and hateful. She tries to comfort the children, who have just seen Santa Claus shot dead, by leading them in singing Christmas carols, while the policeman circles the building. The children include Billy's younger brother Ricky, who was a baby at the time of the killings but is now in his early teens. The policeman makes his rounds but he is ambushed by Billy, who has finally arrived at the orphanage. Billy kills him by slamming the axe into his chest.
Billy then goes to the front door, and one of the children, overjoyed at seeing Santa apparently alive and well, lets him in. He walks toward the Mother Superior, helpless in her wheelchair, and raises the axe. Just then, the other policeman who was driving with Sister Margaret arrives and shoots Billy twice in the back. He falls forward, dying. His last words, to the children, are, "You're safe now. Santa Claus is gone." Billy's axe falls at Ricky's feet, and he appears ready to pick up where his older brother left off someday, as he looks at Mother Superior and says, "Naughty!"