TREM2 is an innate immune receptor expressed by microglia in the adult brain. Genetic variation in the TREM2 gene has been implicated in risk for Alzheimer’s disease and frontotemporal dementia, while homozygous TREM2 mutations cause a rare leukodystrophy, Nasu-Hakola disease (NHD). Despite extensive investigation, the role of TREM2 in NHD pathogenesis remains poorly understood. Here, we investigate the mechanisms by which a homozygous stop-gain TREM2 mutation (p.Q33X) contributes to NHD. Induced pluripotent stem cell (iPSC)-derived microglia (iMGLs) were generated from two NHD families: three homozygous TREM2 p.Q33X mutation carriers (termed NHD), two heterozygous mutation carriers, one related non-carrier, and two unrelated non-carriers. Transcriptomic and biochemical analyses revealed that iMGLs from NHD patients exhibited lysosomal dysfunction, downregulation of cholesterol genes, and reduced lipid droplets compared to controls. Also, NHD iMGLs displayed defective activation and HLA antigen presentation. This defective activation and lipid droplet content were restored by enhancing lysosomal biogenesis through mTOR-dependent and independent pathways. Alteration in lysosomal gene expression, such as decreased expression of genes implicated in lysosomal acidification (ATP6AP2) and chaperone mediated autophagy (LAMP2), together with reduction in lipid droplets were also observed in post-mortem brain tissues from NHD patients, thus closely recapitulating in vivo the phenotype observed in iMGLs in vitro. Our study provides the first cellular and molecular evidence that the TREM2 p.Q33X mutation in microglia leads to defects in lysosomal function and that compounds targeting lysosomal biogenesis restore a number of NHD microglial defects. A better understanding of how microglial lipid metabolism and lysosomal machinery are altered in NHD and how these defects impact microglia activation may provide new insights into mechanisms underlying NHD and other neurodegenerative diseases.