A baby boy, captivated by the sight of a teddy bear, crawls into Santa Claus's (Edward Asner) sack of gifts while he is delivering toys to an orphanage on Christmas Eve. Santa Claus unknowingly takes the baby back to the North Pole, where Papa Elf (Bob Newhart) volunteers to raise him. The baby was christened William but through a humorous misunderstanding is renamed Buddy (Will Ferrell). He is raised unaware of his status as a human, until his enormous size and (relatively) poor toy-making abilities lead him to ultimately find out the truth. Papa Elf reveals that Buddy was born to Walter Hobbs (James Caan) and Susan Wells and given up for adoption, and that Walter never knew of his existence. He explains how Susan later died and that Walter now works at a children's book company in New York City. Buddy sets out for a long trip to New York to find his father after saying good-bye to friends.
