Happy Action Theater is based on an idea that Double Fine's founder, Tim Schafer, had on devising a game that Lily, his two-year-old daughter (at the time), could play with.

To this, the open-ended game is a collection of eighteen different modes that allow multiple players to interact in unique ways through the Kinect cameras and motion-sensing in an augmented reality shown on the console's display, such as playing in a giant virtual ball pit or walking through simulated lava.

Happy Action Theater is an open-ended game, providing eighteen different modes that incorporate features of the Kinect motion-sensing and camera system.

[5] Schafer's idea for the approach to Happy Action Theater was partially inspired by interactive advertisements at malls which would react to people passing in from them.

[6] In following this, Happy Action Theater was developed more like a toy or playmate rather than a game, having it react to whatever the players in front of the sensor was doing without adding any conformity.

[8] Double Fine's team used a rapid prototyping concept to try out new modes, spending a few days to program the activity and then testing it out to see if it could be expanded upon.

[9] Double Fine performed internal playtesting, leaving the game running in a conference room to allow anyone passing to try it, and brought in friends and families with young children to try it out.

[8] Despite the aim for children, the Double Fine team found the game to appeal to "three-year-olds or college dorm rooms full of drunken 20-year-olds".

[10] Happy Action Theater was developed by only six people at Double Fine, compared with their four "Amnesia Fortnight" projects which had around 12 members per team.

[4] Double Fine built on their previous Kinect work from Once Upon a Monster to fully integrate the features of the hardware device into the game, and wanted to avoid any mode that could have simply been done with a camera such as the EyeToy.

[3] A further technical challenge was to create effective lighting of the players' images on the screen, such as when they are holding a simulated firework in their hand, and incorporating their shadows onto other virtual props as to provide better immersion in the game.