diff --git a/crates/dev_container/src/devcontainer_manifest.rs b/crates/dev_container/src/devcontainer_manifest.rs
index 0c38538657da28..afe02b4950dafd 100644
--- a/crates/dev_container/src/devcontainer_manifest.rs
+++ b/crates/dev_container/src/devcontainer_manifest.rs
@@ -2301,10 +2301,10 @@ RUN sed -i -E 's/((^|\s)PATH=)([^\$]*)$/\1\${PATH:-\3}/g' /etc/profile || true
             let mut parsed_line = line.to_string();
             // Replace from devcontainer args first, since they take precedence
             for (key, value) in &devcontainer_args {
-                parsed_line = parsed_line.replace(&format!("${{{key}}}"), value)
+                parsed_line = expand_dockerfile_var(parsed_line, key, value);
             }
             for (key, value) in &inline_args {
-                parsed_line = parsed_line.replace(&format!("${{{key}}}"), value);
+                parsed_line = expand_dockerfile_var(parsed_line, key, value);
             }
             if let Some(arg_directives) = parsed_line.strip_prefix("ARG ") {
                 let trimmed = arg_directives.trim();
@@ -2442,6 +2442,30 @@ enum DevContainerBuildResources {
     Docker(DockerBuildResources),
 }
 
+/// Replaces occurrences of `${KEY}` and `$KEY` in `line` with `value`.
+/// Bare `$KEY` is only replaced when the character immediately after the key
+/// is not a word character (`[A-Za-z0-9_]`), so `$RUBY_VERSION2` is not
+/// partially consumed when expanding `$RUBY_VERSION`.
+fn expand_dockerfile_var(mut line: String, key: &str, value: &str) -> String {
+    line = line.replace(&format!("${{{key}}}"), value);
+    let pattern = format!("${key}");
+    let mut result = String::with_capacity(line.len());
+    let mut remaining = line.as_str();
+    while let Some(pos) = remaining.find(pattern.as_str()) {
+        result.push_str(&remaining[..pos]);
+        let after = &remaining[pos + pattern.len()..];
+        if after.starts_with(|c: char| c.is_alphanumeric() || c == '_') {
+            result.push('$');
+            remaining = &remaining[pos + 1..];
+        } else {
+            result.push_str(value);
+            remaining = after;
+        }
+    }
+    result.push_str(remaining);
+    result
+}
+
 fn find_primary_service(
     docker_compose: &DockerComposeResources,
     devcontainer: &DevContainerManifest,
@@ -5951,6 +5975,55 @@ FROM docker.io/hexpm/elixir:1.21-erlang-28.4.1-debian-trixie-20260316-slim AS de
         assert_eq!(base_image, "test_image:latest");
     }
 
+    #[gpui::test]
+    async fn test_expands_bare_dollar_args_in_dockerfile(cx: &mut TestAppContext) {
+        cx.executor().allow_parking();
+        env_logger::try_init().ok();
+        let given_devcontainer_contents = r#"
+            {
+              "name": "ruby-devcontainer",
+              "build": {
+                "dockerfile": "Dockerfile",
+              },
+            }
+            "#;
+
+        let (test_dependencies, mut devcontainer_manifest) =
+            init_default_devcontainer_manifest(cx, given_devcontainer_contents)
+                .await
+                .unwrap();
+
+        test_dependencies
+            .fs
+            .atomic_write(
+                PathBuf::from(TEST_PROJECT_PATH).join(".devcontainer/Dockerfile"),
+                // Mirrors real-world Dockerfiles that use bare $VAR instead of ${VAR}.
+                // $RUBY_VERSION2 must not be partially replaced when expanding $RUBY_VERSION.
+                r#"
+ARG RUBY_VERSION=3.4.4
+ARG RUBY_VERSION2=3.3.0
+FROM ghcr.io/rails/devcontainer/images/ruby:$RUBY_VERSION
+RUN echo $RUBY_VERSION2
+                "#
+                .trim()
+                .to_string(),
+            )
+            .await
+            .unwrap();
+
+        devcontainer_manifest.parse_nonremote_vars().unwrap();
+
+        let expanded = devcontainer_manifest
+            .expanded_dockerfile_content()
+            .await
+            .unwrap();
+
+        assert_eq!(
+            expanded,
+            "ARG RUBY_VERSION=3.4.4\nARG RUBY_VERSION2=3.3.0\nFROM ghcr.io/rails/devcontainer/images/ruby:3.4.4\nRUN echo 3.3.0"
+        );
+    }
+
     #[cfg(not(target_os = "windows"))]
     #[gpui::test]
     async fn check_for_existing_container_errors_when_multiple_match(cx: &mut TestAppContext) {