In the car, Shawn and Gus pass by a group of people participating in the "Zombie Fun Run." They arrive at a gas station and Shawn goes in to get some snacks. While Shawn is in the convenience store, Gus falls asleep in the car and has a nightmare about zombies attacking him, one of them being Curt Smith from Tears for Fears.
Gus awakes to find himself in an office belonging to a dream therapist named Dr. Simpson. He instructs Gus to lie back down and to tell him all about the nightmares he's been having. Gus recounts his zombie nightmare and the therapist asks him what he thinks it means. Gus thinks it was fueled by his relationship with Emmanuelle ending. The therapist agrees that Gus' fear of abandonment is the beating heart of his anxiety, but he believes Shawn is the one causing it, not Emmanuelle. After Shawn left Gus in the car at the gas station, the nightmare started and everyone within it died or was dead already. The therapist believes Gus needs Shawn to feel whole. Gus isn't so sure.
Gus enters the Psych office and Shawn asks him how dream therapy went. Gus lies and says the nightmares are being fueled by Emmanuelle. Just then, a cable installation worker named Zach Eikleberry pops in asking Shawn and Gus to help find out who his wife Gretchen is having an affair with. He thinks it could be someone she works with. Shawn and Gus agree to help him figure out the truth, so all three hop in Zach's van and head out.
Zach has to take care of a cable installation appointment first, and Shawn and Gus are there to tag along. Zach drives them to a creepy-looking house and Gus is immediately freaked out by it. Zach goes inside to do his job and Shawn leaves to take a pee. Gus is left alone, and he slips into another nightmare. After a mysterious man comes to the van asking for a ride, Gus frantically runs into the creepy-looking house to get away. The inside of the house resembles the house in "The Texas Chainsaw Massacre" and Shawn and Zach are nowhere to be found. Suddenly, a giant man in a mask comes in and grabs a screaming Gus.
Gus wakes to find himself in the dream therapy office again. Dr. Simpson points out that Gus started to have the nightmare when Shawn left him alone in the van. There could be a pattern here. Gus, again, thinks this is a ridiculous theory. Dr. Simpson offers another. He tells Gus that he's having these nightmares because Gus thinks that working with Shawn is eventually going to get him killed. Dr. Simpson then reveals a recording of Gus talking in his sleep, shouting Shawn's name in fear. Gus is taken aback.
Later at the police station, Gus is desperately trying to get a hold of Emmanuelle on the phone. Shawn tells him to stop, and they approach Lassiter asking for work on a case because Zach the cable guy can’t afford to pay them for their services. Lassiter says things have become uncharacteristically quiet around the SBPD since he's become chief and Brannigan has become his head detective. Lassiter doesn't have a case for Shawn and Gus to work on.
With nothing else to do, Shawn and Gus agree to further assist Zach even though he can't afford to pay them upfront. They head to Gretchen's place of business, a school where she's a teacher. Shawn and Gus think the man she's having an affair with could be the P.E. teacher, Coach Derrik Bagg. While they wait in the dimly lit gym to talk to Coach Bagg, they spot a creepy-looking janitor mopping the floor. Bagg is ready to see them, so they head into his office and find out Bagg used to play pro ball. Shawn notices a few items in the office that lead him to believe that Bagg is a big gambler. Shawn also notices a post-it note from Gretchen telling him to meet her Monday at 4 o'clock. Shawn and Gus leave Bagg's office and get lost and somehow end up in the school's creepy boiler room. They hear screams and then see a lone dodgeball slowly roll into view. Shawn bails, telling Gus to follow him, but Gus loses him. Moments later, Gus finds himself locked in the boiler room with a group of possessed-looking school children staring at him with threatening eyes. This horrific display starts to escalate and Gus tries to save himself but he can't.
Suddenly, Gus is back in the dream therapy office asleep on the couch while Shawn and Dr. Simpson observe him. Gus wakes up and scolds Shawn for leaving him, and Shawn is utterly confused. Dr. Simpson tells Shawn that Gus' nightmares are not all about Emmanuelle, but are all about Shawn. Shawn tries to make sense of this but can't and calls Dr. Simpson a fraud. But Gus realizes there is some truth to Dr. Simpson's theory and admits to Shawn that he doesn't think Shawn has his back anymore; not like he used to. Things have changed. Dr. Simpson agrees and says that things aren't always what they appear to be. This statement triggers a flashback for Shawn. He reassess the clues gleaned from the school and realizes that Gretchen wasn't cheating on her husband with Coach Bagg; she was teaching him how to read. Just then, Shawn gets a call from Betsy telling him that Coach Bagg was beaten to death and that Zach was arrested for his murder. It turns out Betsy overheard Shawn and Gus talking about their domestic case involving Zach and decided to investigate on her own. She found a threatening letter from Zach to Coach Bagg at the crime scene, then followed him to a bowling alley and found even more threatening letters.
At the SBPD, Zach is brought in for questioning. A worried Gretchen is there with him trying to placate the situation. Zach claims the letters he wrote were just to blow off steam; he never meant to do any actual real harm. Shawn and Gus are upset with Betsy for stealing their case.
Shawn and Gus head to the morgue and find out from Woody that Bagg's body was bound and gagged moments before beaten. Woody also notes that Bagg's fingers were broken, but were like that a couple days before he was beaten. As Woody is speaking, Gus begins to slip back into a nightmare and starts seeing things. He imagines Bagg's body coming back to life along with the others encased at the morgue. Gus makes it out of the morgue and then finds himself in his childhood home. He sees his mom there. He hugs her and realizes it's really her that he's hugging; not a nightmarish monster in disguise. Gus tells his mom he's been having all these bad dreams because everything is changing. Gus no longer has a job and his car is destroyed. Juliet has left Santa Barbara for a job in the bay area, and Gus thinks Shawn will one day move up there to be with her, leaving Gus all alone. Gus' mom hands him some words of advice, then suddenly things start to turn creepy again. Gus knows something is amiss and starts to worry. He imagines that his mom is getting eaten by a giant monster. He runs into the living room and the place has suddenly turned into a house of horrors. Lassiter, Henry, and Betsy are there trying to ward off the monsters that are trying to get into the house. The monsters are able to break through the boards they nailed to the windows, and they start attacking Lassiter and Betsy. Henry grabs hold of Gus and they escape into a closet, but Henry ends up getting captured. Gus manages to get away, but he is stopped by the crowd of monsters who are all laughing at him, as he tried to defend himself with a three-hole punch. Gus goes to tell Shawn that everyone is dead, but when Shawn turns around, Gus sees that Shawn is now a zombie.
Just as Zombie Shawn is about to eat Gus' brains, Gus wakes to find himself in the car back at the gas station he and Shawn stopped at before. Shawn gets in the car and they head back to the SBPD. Shawn believes Coach Bagg was killed because he couldn't pay off his gambling debts. They tell Lassiter this theory, but it turns out Brannigan already beat them to the punch. They already have the suspect in custody. The case is now closed.
Later, Shawn and Gus pay a visit to Dr. Simpson during his book signing. Gus has been sleeping more soundly again, and he has Dr. Simpson to thank for it.
Back at Gus' place, he's in bed resting peacefully until a nightmare starts to creep up on him again. He calls Shawn, who then comes over with milkshakes and a movie to keep him company. Shawn tells Gus that no matter what happens, he will always be there for him, and Gus finally finds comfort.
- This episode is rated at just 6.4/10 stars on IMDb, making it the lowest-rated of the entire series. The average episode rating is 8.3/10.
- The episode title is likely a reference to the 1984 horror film "A Nightmare on Elm Street."
- In one scene, Gus picks up a three-hole punch to use as a weapon, after which all the zombies start laughing at him. This is a reference to an inside joke among the cast and crew referencing a previous season, when one of the writers made a fuss about a line regarding a "three-hole punch", which then translated into several gag tapes with the cast inserting the line "three-hole punch" and laughing hysterically.
- The original title of the episode was "Dream Therapy".
- James Roday jokingly Tweeted that "#PsychNightmare was the most fun I've ever had directing drunk..." immediately after it aired.
- The first zombie Gus sees in the field by the gas station is played by Psych creator and showrunner Steve Franks. The executive producers, writers, and members of the crew all played zombies in this scene as well.
- Curt Smith from Tears for Fears has played the role of 'himself' in a total of three Psych episodes, the first two being Shawn 2.0 and 100 Clues.
- This episode is the last and final episode shot for the entire series.
- The very last shot ever filmed on set was of Dulé Hill screaming in front of a green screen.
- It was chosen in a fan vote for one of the final episodes of Season Eight, and it won with over fifty percent of the votes, although one of the other choices was produced as well, under the episode name "Shawn and Gus Truck Things Up".
- When Gus wakes up in his mother's house he comments "papa" upon seeing a picture of Martin Sheen. This is a reference to Dulé Hill's previous series The West Wing where Sheen played President Josiah Bartlett, a surrogate father figure to Hill's character Charlie Young.
- The closing credits feature the song "They're Coming to Get You, Barbara" by the band No More Kings. It's based on a line from the movie "Night of the Living Dead".
- Henry only appears in one scene in this episode, as he is seen during Gus' nightmares.
- Dean Cameron appears in this episode. He played "Chainsaw", a student obsessed with horror classics (The Texas Chainsaw Massacre being his favorite), in the movie Summer School. In that movie he could be heard uttering the phrase "We Live!" after a successful driving instruction. This reference can be seen when they pull to an abrupt stop at the farm in his van.
- Bruce Campbell's character name in the episode (Ashford Simpson) is a reference to his character from the Evil Dead series as well as possibly a reference to an R&B singing duo. The jump scare and the reveal shot at the very end are also references to the series, using the make-up and appearance of deadites.