Kingston Falls is a small, economically depressed town in the northeastern U.S. that had been hit hard by the loss of jobs in the 70s and 80s. Many of the people were out of work. One such person was Rand Peltzer, a middle-aged man who we see in Chinatown in New York looking for a Christmas present for his son Billy as the movie opens. Rand had become an inventor of dubious skills. He made a little money selling his usually-unreliable inventions, but it was Billy, who had a job as a bank teller, who was keeping the family just barely above water.
Rand hoped to sell one of his inventions to the proprietor of a junk store in Chinatown, but he became interested in a little furry creature he found in the back. The elderly proprietor refused to sell the creature, but his teenage grandson, knowing that their family also was desperate for money, sold the creature to Rand without his grandfather's knowledge or consent. The boy told Rand three important rules for care of the creature, but did not elaborate on why they were important.
We then meet Billy, who can't get his car started one cold December morning. He gives up after awhile, and talks to his friend Pete, and then to another family friend, Mr. Futterman, who had also lost his job some while back. Mr. Futterman knows that American goods, which he produced a few years earlier, are built like a tank and the best in the world, and he is highly distrustful of cheaper, lower-quality imports (including Billy's car) that cost him his job. Billy goes to his job at the bank on foot, his dog Barney in tow, and just barely makes it on time.
While he is at work, he is visited by Mrs. Deagle, a bitter, mean-spirited old woman who owns much property in town, and her stranglehold on it exacerbates many of the people's financial distress. Mrs. Deagle tells Billy that his dog destroyed one of her lawn ornaments, but would rather have the dog put down than be paid for the damages. The dog, sensing that something is up, jumps out from under Billy's desk and frightens Mrs. Deagle. The bank manager, Mr. Corbin, yells at Billy for bringing his dog to work, but lets him keep his job.
After work, Billy stops by the bar, where he sees one of his co-workers, Kate, whom he is interested in romantically, has a part time side job at the bar. He returns home and talks to his mother, just before his father Rand, gets home from his trip to Chinatown. Rand has the creature, a "mogwai", which he has named Gizmo, and since a living creature can't wait until Christmas, Rand gives him the present a few days early. After the flash from a camera frightens the creature, Rand remembers to tell his son the three rules: The creature did not like bright light and would be killed by sunlight. They must never give the creature any water, either to drink or a bath. And they must never feed it after midnight.
The next day, Billy sees his friend Pete again, and they play with Gizmo, but Pete accidentally knocks over a glass of water and gets Gizmo wet. Gizmo goes into convulsions and five tiny furballs pop out of his back. The furballs grow, and a few minutes later, they develop into creatures just like Gizmo: he has reproduced. He goes to tell his father about it, and his father immediately starts thinking about how he might make money selling them. Pete wants to take a creature home, but Billy thought it best to take one to the local school and have the science teacher examine it first. Once there, he puts a single drop of water on the creature, and one new creature emerges. The teacher, fascinated, keeps it for examination, and Billy leaves.
Billy discovers that the new creatures' personalities are markedly different from Gizmo's. Gizmo is friendly and playful, but the new creatures are mean, nasty, and destructive. One of them has a white mohawk, which Billy names Stripe, is the leader of the new pack. Stripe tries to bite Billy's hand when he goes to pet it. That evening, Billy finds his dog Barney hanging from some Christmas lights outside. He immediately suspects Mrs. Deagle, but there were no footprints anywhere outside. Rand tells Billy that he would take Barney with him when he goes to an upcoming inventors' convention, where he hoped to peddle his wares some more.
Later, Billy stops by the bar again, and sees Kate persuade a very drunk, dejected Mr. Futterman to walk home instead of driving. Billy walks Kate home, and on the way, she tells him that she dislikes Christmas, but gets defensive when he asks why. Just as they arrive at Kate's place, Billy asks her out, and she accepts.
That night, Billy is reading and the creatures are clamoring to be fed. He looks over at the clock: it's 11:35, so Billy goes and gets the creatures some fried chicken, which all the creatures devour, except Gizmo, who refuses. Meanwhile, at the school, the science teacher antagonizes the creature in his care by performing blood tests on it. After working well into the night, the teacher leaves around 2:20 a.m. He left half a sandwich on the table, which the creature can reach from his cage, and eats it.
The next day is Christmas Eve. In the morning, Rand has left with Barney for the convention. Billy asks his mother to come upstairs and look. All of the creatures have disappeared, except Gizmo. They have been replaced by soccer-ball sized cocoons, which appear inert. His mother asks if he fed them after midnight, and Billy looks over at the clock - which still reads 11:35. He checks it and discovers that the wires were deliberately chewed up, so it really was after midnight when he fed them. Oops!
In the afternoon, Rand Peltzer calls home from the convention. It was out of his league, the inventors there are far more advanced than he was, so he was going to come home early, and would be in late that night. Meanwhile, Billy and Pete meet the science teacher at the school, where the creature there has undergone a similar transformation. The teacher refers to it as the pupal stage. Afterward, the bell rings and the teacher wishes his departing students a merry Christmas and he would see them after winter break. Just around that time, the cocoons start to hatch. At the Peltzer house, a terrified Gizmo takes refuge inside a football helmet. The teacher calls Billy at the bank, telling him "they've hatched", and Billy, who is just getting off work, runs to the school. There he finds that the creature has killed the teacher and shoved his syringe (from the blood tests) into his butt. Immediately alarmed, he reaches for the phone, but a clawed hand rises up and bats him away. He follows the creature throughout the building, and gets his first look at the now vaguely-reptilian creature when it takes another swipe at him. It isn't much bigger than before, but is even more malicious, and has teeth and razor-sharp claws with which to cause havoc. The creature escapes.
Meanwhile, at the Peltzer house, the creatures have pulled Gizmo from his hiding place and are busy torturing him. Billy's mother hears sounds upstairs, and goes up with a knife to investigate. She finds nothing except the five hatched cocoons. Just then, Billy calls her from the school, warning her to leave the house immediately, but one of the creatures disconnects the phone line. Then she hears noises downstairs, goes to investigate and sees the creatures making a mess of the place. Using household items, she kills the creatures one at a time. One of them was eating out of the blender, and she switched it on, killing it. She used cooking spray to make another one retreat into the microwave, which she switched on, causing it to explode. She stabbed a third on the kitchen counter. The fourth one was hiding in the Christmas tree, and it attacked. Billy, who had just run from the school, arrived home and grabbed a sword and killed this creature, sending it headlong into the fireplace. The fifth creature, the one with the mohawk, escaped from the house.
Billy grabbed Gizmo and they tracked the creature to the YMCA, where it had broken in. The creature takes another swipe at him, and Billy is just in time to see it jump into the pool, multiplying. Billy, now hopelessly outnumbered, retreats from the YMCA; a few minutes later, thousands of little gremlins emerge.
Billy returns home and takes his mother to see a doctor, for the wounds inflicted by the fourth gremlin. Then he goes to the police station and tries to get the cops to take action, or at least warn people, but the cops think he is drunk. They refuse to do anything. The first calls are coming in about freak accidents and fires caused by the gremlins, and the cops go out to check things out, leaving Billy alone.
The gremlins are busy little creatures, and set out to destroy as much as they can. They injure a man who is putting mail in a mailbox, tamper with the electrical grid causing sparks to fly and lights to go on and off all over town. They cause car wrecks by making all the lights at an intersection green. They kill Mrs. Deagle by tampering with her stair-lift, making it go so fast it flings her out an upstairs window. They get into the Futterman's snowplow and use it to demolish half of his house, and they disable the brakes on the police car, so when the cops are going to the Futtermans', they wreck their car. Pete manages to keep the gremlins at bay from his bedroom window.
Billy gets in his unreliable car, and this time it starts without any problem. He goes to the bar to check on Kate, who is being held hostage by the gremlins. The gremlins have occupied the bar and are drinking beer, getting drunk, playing cards (and cheating and being caught), breakdancing, playing with the ceiling fans, and tearing stuff up as best as they can. Kate notices that they shrink away from her matches when she tries to light their cigarettes. Quick on the uptake, she picks up a camera and takes their picture, the flash each time making them cringe. She gets to the door, but is confronted by another gremlin wearing sunglasses and holding a gun. Even this gremlin is forced to retreat when the glare of Billy's headlights illuminates the bar's front window. Kate leaves with Billy. Meanwhile, Rand Peltzer is still on his way home. He stops at a gas station to call home again, but can't get through (the line is out). He does manage to bring in a little money by selling one of his inventions, a smokeless ashtray (which actually billows smoke) to the attendant. Barney barks at him, which irritates him - they still have a long drive ahead of them.
This time, the car doesn't start, so they have to run for it. They go to the bank, only to find that it too has been vandalized by the gremlins. They can hear small explosions in the distance. Kate says that now she has two reasons to dislike Christmas, and this time she tells Billy the first reason. When she was a little girl, her father disappeared without a trace on Christmas Eve. He didn't turn up on Christmas, either. He was discovered dead several days later in their chimney, where he was dressed as Santa Claus. He had been hoping to surprise Kate, but had slipped and broken his neck, and his body got stuck there.
After telling this story, they notice that calm has returned to the town, and all the lights are on. Figuring they must all be some place dark, they go to the local movie theater, where, sure enough, all the gremlins are inside watching "Snow White", and loving it. They go to the cellar and turn on the gas, and leave some burning newspapers and towels, intending to destroy the building with the creatures inside it. Just as they're leaving, the gremlins detect their presence, and go after them. Kate and Billy, who still has Gizmo, flee through the back door with the gremlins in hot pursuit, and they manage to barricade the door, trapping the gremlins inside. After a few minutes, the gas leak causes an explosion, and all the gremlins are killed.
Not all of them! Kate spots one survivor, Stripe, in the window of a Montgomery Ward's department store. He had left the theater briefly to obtain food, and saw the explosion. Determined not to let Stripe escape, Billy and Kate break into the store. Billy takes a bat and goes to look for Stripe, while Kate gets into the back rooms and starts looking for anything useful, such as lights.
Stripe uses items he finds in the store to attack Billy - a tennis ball launcher, a small crossbow, and later, a chainsaw. Kate, in the back room, finds a set of circuit breakers and starts turning stuff on randomly - the background music system, some lights, and a water fountain. Billy is using the bat to defend himself from Stripe's chainsaw when the lights come on, distracting Stripe, who has to retreat.
By this time, the first light of dawn is visible in the east. It's Christmas morning. Rand and the dog are finally getting back into town, but Barney barks at the broken window of the store and jumps out of the car and into the store. A cranky Rand parks the car and follows him.
Gizmo has left Billy's backpack and is now roaming the store, and he and Barney meet once more. Gizmo has found a toy car to drive around. They finally locate Stripe, who has discovered the water fountain, and also found Montgomery Ward's gun sale counter. Billy rushes into the garden area, with the fountain, only to find Stripe poised to reproduce again. Stripe shoots the gun, but misses. It's Gizmo to the rescue as he drives his toy car up a leaning shovel, flying through the air and striking the window shades. One of the shades rolled up all the way to the top, letting in streaming sunlight directly onto Stripe, killing it. As Billy watches, Stripe melts in a puddle of gunk and falls into the water.
Kate and Rand arrive in the room and see the mess. Stripe's decaying body jumps out of the fountain for one last scare, but he can't handle the sunlight, and collapses. They all return home.
In the evening, the Peltzers are watching the news about the destruction, where it is described as a series of unexplained accidents and fires. They are confronted by the owner of the Chinese junk shop, who knew exactly where to go once he heard the news. The Chinese man can barely conceal his disgust for television and Western society in general. He returns Rand's $200, and takes Gizmo back with him, but before he goes, he tells Billy that one day, he might be ready to become the creature's caretaker.
The movie ends with Rand's voice telling viewers that if they have any unexplained electrical or mechanical problems, they should be alert for gremlins.