A confused Monk is found trespassing in the home of his late wife, Trudy, and is sent to the Medford Psychiatric Institute for two days of observation. The hospital, like Monk's scarred psyche, is currently under renovation. Monk meets the hospital's brilliant director, Dr. Morris Lancaster, as well as fellow patients John Wurster - an overly empathic, Zelig-type ("I'm a detective too!") - and Manny, a man in his thirties who still believes in Santa Claus.
Wurster tells Monk about a murder that took place at Medford four years earlier. A patient named Bill LeFrankie shot and killed Dr. Conrad Gould in the medical supply room, then stole barbiturates and died nearby of a fatal overdose. However, the gun used in the murder was never found, and Wurster confides to his "colleague" Monk that he never believed the official story. At first, Monk pays little heed to Wurster's theory.
In group therapy, Manny reports looking out his window and seeing Santa Claus hovering over the chimney the night before. Intrigued, Monk later finds what appears to be a swatch of torn red cloth dangling from the chimney. Monk soon begins to suspect a possible connection between what Manny saw on the roof and Dr. Gould's murder. Using a newspaper clipping of the murder scene, Monk reenacts the Gould slaying, and deduces that the killer most likely wasn't a patient, but a hospital staff member. Monk begins to suspect Dr. Lancaster.
Lancaster reacts by sabotaging Monk's investigation, manufacturing evidence to "prove" Monk is crazy. His efforts are so successful, even Monk starts to believe he is wrong - until Sharona uncovers evidence that supports Monk's theory. Monk resumes his investigation.
The fact that the fishing line is missing from a fishing rod in the director's office soon completes the picture for Monk: Gould was up for the hospital directorship, Lancaster wanted the job, and he shot Gould to get it. Next, he framed a patient for the murder, and then dropped the murder weapon down an unused chimney. Now, four years later, renovation is threatening to expose the gun, so Lancaster arranged to have Manny, the Santa Claus nut, moved into a bedroom that overlooks the chimney. Lancaster then returned to the roof in a Santa Claus outfit so he could literally "go fishing" for the murder weapon, knowing Manny's reports about Santa being on the roof would be dismissed as lunacy.
Monk confronts "Santa", a.k.a. Lancaster, on the rooftop - just as Lancaster successfully recovers the handgun and points it at Monk's head. However, Sharona and the police arrive in time, and Lancaster is led away in handcuffs, leaving Monk to comment ruefully that, "Except for the murders and him trying to kill me, he was the best doctor I ever had."