Sleep disturbance is common in schizophrenia, but its role in predicting functioning and psychotic symptoms has yet to be rigorously examined. The purpose of this study was to conduct a prospective, high-resolution examination of the relationship between nightly sleep and next-day functioning and psychotic symptoms in people with a diagnosis of schizophrenia. Experience sampling methodology was integrated with actigraphy and sleep diaries across 7 days in 22 patients with a diagnosis of schizophrenia. Momentary assessments of mood, psychotic symptoms, and functioning were gathered at 5 points each day following pseudorandom schedules. Multilevel modeling was performed to evaluate the links between variables. Objective and subjective sleep disturbance predicted reduced next-day functioning, which remained significant after controlling for psychotic symptom severity. Increased sleep fragmentation and reduced subjective and objective sleep efficiency predicted greater next-day auditory hallucinations, whereas increased objective sleep fragmentation and reduced subjective sleep quality predicted greater paranoia and delusions of control. Negative affect on awakening mediated a proportion of these relationships (range: 17.9–57.3%). For the first time, we show that sleep disturbance is a predictor of next-day impaired functioning and psychotic symptom severity in people with a diagnosis of schizophrenia. Therefore, interventions targeting sleep may have the potential to directly and indirectly enhance functional and symptomatic recovery in those experiencing psychosis.