Parental mental illness can be linked to reduced family functioning, which is associated with more conflicts, less adaptability and cohesion as well as a disorganized pattern of everyday planning. Concurrently, family functioning is an important moderator for the influence of parental mental disorders on the development of the children. Consequently, the current study addresses the correlation of family functioning in families with mentally ill parents and the psychological health of the children. The sample consists of 67 mentally ill parents. Both parents and therapists completed questionnaires related to family functioning and the psychological health of the children. Family functioning was rated as dysfunctional in 38% of the families. The psychological health of the children was classified as clinical or subclinical in 43% of the cases. 52% of the children were rated to have no psychological problems. In families with good family functioning, children were assessed to have less psychological problems than in families with poor functioning. Children outside the clinical range lived in families with good family functioning and vice versa. Significant positive correlations were found between the FB-A scales, the CBCL/4-18 syndrome scales and the CBCL/4-18 total score. Results indicate that family functioning and psychological health of children in families with mentally ill parents correlate closely and represent potential targets for future family interventions.