Elmo is playing with his blanket in his house. After he bumps his blanket on a juice cup and after drying off his blanket at the laundromat, Elmo sees Zoe feeling depressed because her father cannot take her to the zoo, so he decides to make Zoe happy again by imitating certain zoo animals (a lion, a monkey, and a pig). When Zoe sees his blanket, Elmo refuses to share, resulting in a tug-of-war that rips Elmo’s blanket. Elmo is furious and declares that Zoe is no longer his friend. Suddenly, Telly Monster inadvertently takes away the blanket while rollerskating out of control. They go around Finders Keepers and knock over a tray of drinks Ruthie is carrying. Telly hits Cookie Monster at the revolving door of Furry Arms hotel. The blanket accidentally lands in the hands of Oscar the Grouch, who drops it in his trash can after sneezing on it. Elmo drops into the bottom of Oscar’s trash can, where he finds the blanket nailed to a door. But they are both teleported to Grouchland USA, a world filled with Grouches where a greedy man named Huxley (Mandy Patinkin) steals anything he can grab including Elmo’s blanket. Elmo is determined to find his blanket and begins a journey through Grouchland. He asks a kind girl named Grizzy to help in his quest, but she later abandons him when Elmo discovers that Huxley’s house is on the top of the faraway Mount Pickanose.
Meanwhile, the Sesame Street residents are informed of Elmo’s absence and go to Grouchland to find him, with help from Oscar. When Big Bird and Zoe find a Grouch Police Officer and Big Bird asks him for help, the entire group ends up arrested as the Grouch Police Officer informs them that it is against Grouchland’s laws to ask a police officer for help and that they have the right to scream their heads off.
Meanwhile, Huxley’s sidekick Bug and the Pesties trap Elmo in a tunnel using a trap door. However, he gets out with the help of fireflies. Then, he meets the Queen of Trash (Vanessa L. Williams) in a garbage dump area. He leaves her dump by giving the queen 100 raspberries in 30 seconds. Elmo succeeds and continues walking to Huxley’s house. He is then chased by a humongous chicken named ”Tiny”, but gets away. When night comes, he stops at a rock to rest, discouraged.
When Grizzy learns of the Sesame Street friends being arrested, she tells them of Elmo’s location in Huxley’s house. Oscar the Grouch is convinced to help set things right as well as admitting that Elmo is his friend. He then convinces the Grouch Police Officer and all of the Grouches of Grouchland that even though Grouches hate cooperation, just for once they have to take a stand against Huxley from stealing any more of their trash. Taking light to this problem, the Grouch Police Officer releases the Sesame Street residents and aids them to go to Huxley’s house to fight for their trash and rescue Elmo.
A caterpillar wakes up Elmo the next morning on the rock. He gives Elmo advice to look inside his body and he’ll see that he’ll be brave. He then makes it to Huxley’s before he could make Elmo’s blanket his blanket. However, Huxley prevents Elmo from escaping by grabbing him with a claw and deciding to label them ”MINE”. Just as Elmo is about to face the fate of never seeing his friends again, the Sesame Street and the Grouchland citizens appear in time to rescue Elmo and the Pesties flee. Bug takes Elmo’s blanket from Huxley and turns against him as Elmo catapults a basket over his shoulders. Bug then gives Elmo his blanket back. Elmo is hailed a hero by the Sesame Street and Grouchland citizens and Huxley unanimously tries to change his mind about his selfishness but fails. Elmo, happy to get his blanket back, goes with his friends back to his own world and apologizes to Zoe for not sharing his blanket and hurting her feelings. Elmo says goodbye to the audience when Ernie and Bert head home as the film ends.