Billy and Ricky live at St. Mary's Orphanage when their parents was killed by a Killer Santa in 1971 at Christmas Eve.
Billy, who is 8 years old, is sent to his room for drawing a picture of a bloody Santa Claus and a decapitated reindeer. Later, Sister Margaret tells Billy to come outside and help build a snowman the children are making.
Billy get ready to go outside, but before he goes outside, he sees an older boy and girl starting to have sex. Mother Superior thrashes the older children and she gets mad at Billy for leaving his room.
She asks what he saw upstairs which Billy responds, "Nothing, Mother Superior." Mother Superior then asks Billy if he knew what they were doing, then Billy says, "No, Mother Superior," which Mother Superior responds with a simple "Good."
Mother Superior then explains to Billy, "What they were doing was something very, very naughty. They thought they could do it without being caught. But when we do something naughty, we are always caught, and then we are punished."
She also reminded Billy, "Punishment is absolute. Punishment is necessary. Punishment is good." Billy reluctantly agrees.
Mother Superior then told Billy that he left his room, to which he reluctantly admits to having done, then Mother Superior replies in a very stern voice, "Very, very naughty," while Sister Margaret looks on with sympathy for Billy.
Mother Superior then takes Billy to his room, where she spanks him with a belt while laying on a chair. Then she tells Billy, "Now go to bed. And stay there."
That night, traumatized by the day's events, Billy has nightmares about the murderer dressed as Santa Claus and the murder of his parents, so he wakes up screaming in terror and horror.
Then, Billy runs out of his room only to be caught by Mother Superior, who ties his arms to his bed while he struggles to get free to no avail.
Christmas morning, 1974: The orphanage kids line up to sit on Santa's lap. Billy, terrified by the sight of him, is forced to join in or face his punishment.
Finding himself face-to-face with his worst nightmare, Billy wiggles free and punches Santa in the face, giving him a bloody nose which Santa says, "What the Hell's wrong with that kid?".
Billy flees to his room and starts having a panic attack, as he mumbles: "I'm sorry. I didn't mean to be naughty. Don't punish me. Please." The bedroom door opens and Billy is shocked and scared as Mother Superior comes in, and says in an angry voice, "William!"
Ten years later, Spring, 1984: Billy, who is now 18 years old, is hired as a stockboy at Ira's Toy Store, thanks to Sister Margaret. Things go well until the Christmas decorations begin to appear, including images of Santa Claus.
After Billy leaves, Sister Margaret goes inside and sees Mrs. Randall's body and runs out, screaming.
The next day on Christmas morning, Police Captain Richards tallies the night's murders, attributed by witnesses to Santa Claus. Sister Margaret tells the Captain she suspects Billy is the culprit because of his history.
She deduces that his next attack will likely be at the orphanage. A police car is dispatched to the orphanage, where the officer named Officer Barnes sees Santa trudging towards the building.
When Santa does not respond so his orders to halt, Officer Barnes shoots him. When the fake beard is pulled away, Officer Barnes realizes it isn't Billy but old hard-of-hearing Father O'Brien.
Billy then appears, says "Punish!", and kills Officer Barnes by striking his axe in Officer Barnes' chest. A child then lets Billy into the orphanage, believing him to be Santa.
Billy approaches the now-wheelchair bound Mother Superior and she tells Billy in a stern voice, "THERE IS NO SANTA CLAUS!" Billy then becomes furious, raises his axe to kill Mother Superior, and shouts out "NAUGHTY!" in an angry voice, while Mother Superior closes her eyes awaiting her death.
But before he can strike, Captain Richards shoots Billy in the back twice, making him collapse to the ground. Before he dies, he weakly turns his head to the horrified children, and says in a weak and dying voice, "You're safe...now. Santa Claus...is gone."
Then Billy dies, while Sister Margaret looks at the dead Billy very sadly. Ricky, who still lives in the orphanage, looks at the axe near his dead brother's body, then stares sulkishly upset at Mother Superior while she curiously looks at Ricky with a confusing, rude, and sulky look upon his face, and Ricky quietly snarls, "Naughty..." in a very threatening voice, indicating that he will kill Mother Superior.