If I'm not mistaken this episode is written by the incomparable Violet Welles.
It's one of my favorites among the dream sequences--too many of them tend to be pretty straightforward and that's not how people seem to dream. This had enough bizarre flavor to be creepy and yet plausible at the same time.
I don't think this sequence was in the dream compilation on the MPI tape -- I kept waiting for it since this is obviously (IMHO) one of the best if not the best of all of DS's dream sequences. Incredible that they didn't include it.