Critically acclaimed developer Double Fine, creator of such eccentric delights as Brutal Legend and Stacking, surprised the world when it announced that it was working on a Sesame Street game. But studio founder and game industry legend Tim Schafer grew up loving the series – which he saw as a comedy sketch show, rather than an educational establishment.

Once Upon a Monster, a sort of interactive story book in which gamers help a series of monsters get in touch with their emotions, is not your average yawn-inducing "edutainment" nightmare; it's a funny, visually stunning mini-game collection, making fine use of the Kinect controller.

In part two of our interview with the game's project leader, Nathan Martz, we talk abut the challenges of introducing children (and their parents) to physical controls, and tricky problem of how scary kids' stories can be.

So, Once Upon a Monster is a physical game aimed at very young children. Did you need to think carefully about the amount of physical exertion required in every task?
We've been focus testing this game since our early prototypes, and it's not the kids who get tired, it's the adults – we have to be more concerned about the parents! The game is structured as a series of chapters and we've designed them to be self-contained: after 30 minutes of play you can put it down. The chapters themselves are broken up into activities and between every activity you turn the page and the game progresses at the speed you want it to. So we've built in breaks every 3-5 minutes.

The chapters are themed around different emotions, aren't they?
Emotions are used as broad themes. Shyness is one – we have a monster who's had a great idea but is too shy to carry it out so you help him. We have a chapter about bravery and about being yourself – and those two concepts are interwoven. We have a really fun one about music and dancing where we use the band as a metaphor for family, recognising that everyone has a different role and appreciating people who are often unappreciated in a family.

Besides Sesame Street, what were some of the influences on Once Upon a Monster, in terms of communicating stories and characters to children?
Two of my personal favourites are Pocoyo and a series of short bumpers done for Nickolodean called Purple and Brown – they're two blob creatures, kind of the Beavis and Butthead of claymation, but all of their communication is non-verbal and they're really, really funny. They have a wide variety of emotions, even though they're very simple characters. And in Pocoyo, all the characters are very expressive and can tell whole stories without speaking.

Another thing for me, and this is more of an anti-influence – very often in games and movies when you see monsters, they're just adults with fur. They speak English, they have jobs, they spend monster bucks at the monster mart, it's not a very fresh take. Part of the magic of monsters – and this goes back to Where the Wild Things Are – is that they have their own logic, their own rules.

Fictionally, the two biggest influences are Never-Ending Story – the idea of a living story that you can enter and shape – and also Winnie the Pooh, which shares this idea of self-contained stories set in a magical world that you enter and interact with.

Have you been able to infuse the story with any of Double Fine's characteristic wit?
It's interesting you should mention wit, because one of the things about Cookie Monster is, he's extremely erudite – he has the grammar of a caveman but the vocabulary of a professor. A lot of his humour is based around simple grammar and funny, adult words.

Has this project taught you any universal lessons about game design?
Learning how to create a new IP – for me and a lot of the team it's our first time doing that. Of course, we're fortunate to have Tim's guidance, but we learned a lot about what makes compelling characters and environments. There are some things we've tried that are pretty risky that I've been very pleased with, like having our monsters unable to speak English – they can communicate vocally, but just emotions not concepts. It's very easy to create a game where a monster will say "blah, blah, blah" and Elmo replies, "What's that, Marco? Did you say…" But there are more clever ways to write a scene where a monster communicates and you just know what they're trying to say.

We've learned a tremendous amount about co-op especially intergenerational co-op – how to design games to be accessible and forgiving, and embracing this whole Kinect idea of, if you think you are doing the action correctly, you are – that's a massive lesson. And there's the key Kinect maxim: physical is fun. Anything you do in Kinect, the more physical you make it, the sillier it is, the more fun it is to do. And the other thing is, it's just as much fun to watch as it is to play. It's really pleasing to watch people who are into the game and feel happy.

And what has been the most challenging element of Kinect?
Two-player co-op is hard! With two players on the same screen, there are so many things you just haven't thought of that are really hard. Every idea has to run this crazy obstacle course.

Do you think you'll be releasing DLC?
Well, the game is broken up into chapters and these are fairly modular. For a variety of reasons we didn't want a game that felt like it had a beginning and an end and once you'd played through it you were done with it. Kids have their favourite stories that they come back to again and again, and we wanted the game to have that kind of compelling quality. In some respects, it feels like an anthology, a collection of stories, and it's designed to be extendible; it's a book without an end. So provided the opportunity is right, we're looking forward to extending these possibilities and exploring this more.

Ultimately, do you feel more responsible toward this audience than you have done with previous Double Fine games?
One of my favourite quotes is from the English author, G.K. Chesterton. He was writing in the early 20th century when there was a lot of debate about what was appropriate for children, and he wrote, "Fairy tales don't tell children that dragons exist, children know that dragons exist – fairy tales tell children that dragons can be killed." This game isn't about slaying monsters, but philosophically, there's some of that spirit – through the power of fiction you can help people understand what is possible.

So we could be geeky and say that play is effectively life's own tutorial level…
Yeah, it's funny, When we were doing some usability tests with parents and kids we saw a lot of occasions, especially early on, where the kid would struggle with the mechanic and the parent would step up their game to compensate. I was like, man, parents are really great dynamic difficulty systems! That's what a lot of parenting is about – just put in a very dorky game developer-centric way.

• Once Upon a Monster is out on Xbox 360 in October, published by Warner Bros