Based on the classic 19th century tale by German writer/composer E.T.A. Hoffmann, the film investigates the tale's themes of obsession and madness, emphasizing expressionist imagery and theatrical style. The story relates the life of the young student Nathanael, whose childhood memories are haunted by a sinister man. As a child, Nathanael believed this dark figure to be the mythic Sandman, who puts children to sleep by stealing their eyes. When confronted by this same evil presence as an adult, he is pushed toward madness as he tries to confront his childhood fears.

In the heat of an American desert, Captain Jean Farrell arrives at a secret military installation, run by the enigmatic Doctor Harlan Jessup. Jessup is conducting 'Operation Sandman', an experiment involving a group of soldiers who have volunteered to be injected with 'the Juice', a drug which enables them to function without sleep. The team of soldiers, led by gruff and abusive 'Gunny' Riggins continually takes part in Virtual Reality scenarios whereby they face terrorists, kidnappers, guerrillas and a plethora of other situations that demand split-second timing, and undying obedience in the face of danger.

Set in a boring and bureaucratic version of NYC, Izumi and Alex go about their mundane existences while quietly refusing to give into mandates of the new dystopian society – namely undergoing a surgical treatment that renders the brain incapable of dreaming.