Recent studies have identified DAAO as a probable susceptibility gene for schizophrenia and bipolar disorder. However, little is known about how this gene affects brain function to increase vulnerability to these disorders. We examined the impact of DAAO genotype (rs3918346) on brain function in patients with schizophrenia, patients with bipolar I disorder and healthy controls. We tested the hypothesis that a variation in DAAO genotype would be associated with altered prefrontal function and altered functional connectivity in schizophrenia and bipolar disorder. We used functional magnetic resonance imaging to measure brain responses during a verbal fluency task in a total of 121 subjects comprising 40 patients with schizophrenia, 33 patients with bipolar disorder and 48 healthy volunteers. We then used statistical parametric mapping (SPM) and psycho-physiological interaction (PPI) analyses to estimate the main effects of diagnostic group, the main effect of genotype, and their interaction on brain activation and on functional connectivity. Inferences were made at p<0.05, after correction for multiple comparisons across the whole brain. In the schizophrenia group relative to the control group, patients with one or two copies of the T allele showed lower deactivation in the left precuneus and greater activation in the right posterior cingulate gyrus than patients with two copies of the C allele. This diagnosis×genotype interaction was associated with differences in the functional connectivity of these two regions with other cortical and subcortical areas. In contrast, there were no significant effects of diagnosis or of genotype in comparisons involving bipolar patients. Our results suggest that genetic variation in DAAO has a significant impact on both regional activation and functional connectivity, and provide evidence for a diagnosis-dependent pattern of gene action.