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Two unemployed brothers, Bob and Doug McKenzie (Rick Moranis and Dave Thomas), place a live mouse in a beer bottle in an attempt to blackmail the local beer store into giving them free Elsinore beer, but are told to take up the matter at the Elsinore brewery instead. After presenting the mouse to management at the brewery, the brothers are given jobs on the bottling line inspecting the bottles for mice.
Meanwhile, the evil Brewmeister Smith (Max von Sydow) is perfecting a secret plan to take over the world by placing a mind-control drug in Elsinore beer which, while rendering the consumer docile, also makes him or her attack others when certain musical tones are played. Smith tests this adulterated beer on patients of the neighbouring Royal Canadian Institute for the Mentally Insane, which is connected to the brewery by underground tunnels.
Bob and Doug learn the former brewery owner John Elsinore has recently died under mysterious circumstances and his daughter, Pam (Lynne Griffin), has been given full control of the Elsinore brewery. While exploring the massive brewery, they find a shuttered cafeteria containing an old Galactic Border Patrol video game which supernaturally reveals that Brewmeister Smith murdered John Elsinore and that Pam's bumbling Uncle Claude (Paul Dooley) was deeply involved. Additionally, while poking around the brewery, Bob recognizes an employee as one-time hockey great Jean "Rosie" LeRose (Angus MacInnes), who suffered a career-ending nervous breakdown and has fallen under Smith's control.
Eventually, Bob and Doug wander into Brewmeister's operations room while he is away, and Doug takes a floppy disk containing video of John Elsinore's murder (thinking it is a "new wave EP" and not realizing the importance of its contents). Smith and Claude tranquilize the brothers and arrange to frame them for murder, concealing Pam and her father's friend, Henry Green, in beer kegs in the back of their sabotaged van, and instruct the brothers to deliver the kegs to a party. The brothers are unable to stop and crash the van into Lake Ontario, but all survive, Pam with apparent memory loss, and the brothers are arrested.
When put to trial, Bob and Doug's antics cause the judge to declare them insane, and he puts them under Brewmeister Smith's care at the asylum. Rosie soon finds them and helps them escape, and they later find Pam and rescue her as well. Rosie, having figured out Brewmeister's plan, foments an uprising among the brainwashed mental-patient test subjects. The brothers separate for the first time in their lives, with Doug helping Rosie to overpower Brewmeister Smith (the spirit of John Elsinore, possessing the electrical system at the brewery, then impales him with lightning). However, Smith has locked Pam and Bob into a brewery tank, filling it with beer; they escape this possible death when Bob consumes all the beer (expanding to a cartoonish size).
John Elsinore's ghost warns them that Smith has already shipped tainted beer to Oktoberfest and tells her to stop them. The police accompany the brothers back to their house to retrieve their dog, Hosehead, to invade the party. Enticed by promises of free beer and sausages, Hosehead leaps into the air and flies over the city like Superman. He crashes into the tent at the celebration and, mistaken for a skunk, frightens people away from the tainted beer. In the end, the McKenzie Brothers save the day and Pam and Rosie find true love with each other. As for the contaminated beer, Bob and Doug are allowed to haul away the lot to apparently try to drink it all.