A man who claims to be Santa Claus (Douglas Seale) arrives at the Orlando International Airport in Florida. Ernest P. Worrell (Jim Varney) is working as a taxi driver. He takes a passenger to the airport, but speeds and the passenger falls out of the taxi. Ernest later picks up Santa Claus, who tells Ernest that he is on his way to inform a local celebrity named Joe Carruthers (Oliver Clark) that he has been chosen to be the new Santa Claus. Carruthers hosts a children's program named Uncle Joey's Treehouse in the Orlando area similar to Mister Rogers' Neighborhood with emphasis on manners and integrity with the catchphrase "They never get old. They always stay new. Those three little words, Please and Thank You.".

While they are driving, a runaway teenage girl (Noelle Parker) who says she is named Harmony Starr joins Ernest and Santa in the cab. When they get to their destination, Santa possesses no legal currency (only play money), so in his giving Christmas spirit, Ernest lets him ride for free. The decision gets Ernest fired from his job. Back at the taxi garage, Ernest discovers that Santa left his magic sack behind in the cab, and Ernest begins a quest to find the old man and return it to him.

Santa arrives at the Orlando Children's Museum to talk to Joe, but is interrupted and rebuffed by Joe's agent Marty Brock. Marty misunderstands Santa's name, thinking he said "Mr. Santos," and continues to call him by that name, even when Santa tells him his real name. Santa begins to worry as he then discovers he lost his sack, and becomes more discouraged as he realizes he is becoming forgetful in his old age (he's 151 years old, indicating he was born in 1837). Joe does not believe Santa's story and Marty has Santa arrested. Meanwhile, Ernest goes over to his friend Vern's house to put up a Christmas tree, much to Vern's distress (as with the original commercials that first introduced Ernest, the audience never sees Vern's face and only his point of view). Ernest poses as Astor Clement, an employee of the governor and Harmony as the governor's niece Mindy, and the two help Santa escape from jail by convincing the police chief that Santa believing that he is Santa Claus is "infectious insanity" and he must be taken to solitary confinement. Ernest disguises himself as an Apopka snake rancher (Lloyd Worrell from Knowhutimean? Hey Vern, It's My Family Album) who sneaks Santa into a movie studio and speaks to a security guard about delivering the snakes to people who direct horror films. Meanwhile, Marty presses Joe to quit his children's job, shave his beard, and instead land a part in a horror film titled Christmas Slay a movie about an alien which terrorizes a bunch of children on Christmas Eve which offends Santa so deeply he punches the director in the eye.

Santa tracks down Joe at his home, but Joe finally tells Santa, "Thanks...no thanks." Later on, however, Joe is overcome by conscience when the director of the movie wants him to use foul language, which he refuses to say in front of the kids on the set.

Ernest and Harmony (whose real name is later revealed by Santa to be Pamela Trenton) discover the magic power of Santa's sack, and immediately Pamela starts to abuse it. She steals the sack, and attempts to run away yet again. On Christmas Eve, however, her conscience prevails, and she rushes back to find Ernest and Santa and return the sack.

Eventually, Joe hunts down Santa on Christmas Eve and accepts the job. For the first year, however, Ernest gets to drive the sleigh. The film ends with, "Merry Christmas To All And To All A Good Night," followed by a sleigh dash that spells, KnowWhatIMean?, one of Ernest's catchphrases.