diff --git a/pkg/devcontainer/config/extends.go b/pkg/devcontainer/config/extends.go
index dee5196c8..f8382dc16 100644
--- a/pkg/devcontainer/config/extends.go
+++ b/pkg/devcontainer/config/extends.go
@@ -122,8 +122,9 @@ func parseDevContainerJSONFileWithVisited(
 	}
 	devContainer.Origin = absPath
 
-	// Recursively resolve extends
+	// Recursively resolve extends — substitute variables in refs first
 	if !devContainer.Extends.IsEmpty() {
+		devContainer.Extends = substituteExtendsRefs(devContainer.Extends, absPath)
 		declaringDir := filepath.Dir(absPath)
 		parent, err := resolveExtendsArray(ctx, devContainer.Extends, declaringDir, visited)
 		if err != nil {
diff --git a/pkg/devcontainer/config/extends_test.go b/pkg/devcontainer/config/extends_test.go
index 18e89113f..5493ae153 100644
--- a/pkg/devcontainer/config/extends_test.go
+++ b/pkg/devcontainer/config/extends_test.go
@@ -678,6 +678,96 @@ func TestExtendsRef_MarshalJSON(t *testing.T) {
 	}
 }
 
+func TestExtends_VarSub_LocalEnv(t *testing.T) {
+	tmpDir := t.TempDir()
+	subDir := filepath.Join(tmpDir, ".devcontainer")
+	// #nosec G301 -- test directory
+	if err := os.MkdirAll(subDir, 0o750); err != nil {
+		t.Fatal(err)
+	}
+
+	writeJSON(t, subDir, "parent.json", `{
+		"image": "ubuntu:22.04",
+		"remoteUser": "dev"
+	}`)
+
+	t.Setenv("DEVSY_TEST_EXTENDS_DIR", subDir)
+
+	childPath := writeJSON(t, subDir, "devcontainer.json", `{
+		"extends": "${localEnv:DEVSY_TEST_EXTENDS_DIR}/parent.json",
+		"name": "child-with-env"
+	}`)
+
+	cfg, err := ParseDevContainerJSONFile(childPath)
+	if err != nil {
+		t.Fatal(err)
+	}
+	if cfg.Name != "child-with-env" {
+		t.Errorf("expected name 'child-with-env', got %q", cfg.Name)
+	}
+	if cfg.Image != "ubuntu:22.04" {
+		t.Errorf("expected image inherited from parent, got %q", cfg.Image)
+	}
+	if cfg.RemoteUser != "dev" {
+		t.Errorf("expected remoteUser 'dev', got %q", cfg.RemoteUser)
+	}
+}
+
+func TestExtends_VarSub_LocalWorkspaceFolder(t *testing.T) {
+	tmpDir := t.TempDir()
+	subDir := filepath.Join(tmpDir, ".devcontainer")
+	// #nosec G301 -- test directory
+	if err := os.MkdirAll(subDir, 0o750); err != nil {
+		t.Fatal(err)
+	}
+
+	writeJSON(t, tmpDir, "base-config.json", `{
+		"image": "node:20",
+		"remoteUser": "node"
+	}`)
+
+	// ${localWorkspaceFolder} should resolve to the parent of .devcontainer
+	childPath := writeJSON(t, subDir, "devcontainer.json", `{
+		"extends": "${localWorkspaceFolder}/base-config.json",
+		"name": "workspace-ref"
+	}`)
+
+	cfg, err := ParseDevContainerJSONFile(childPath)
+	if err != nil {
+		t.Fatal(err)
+	}
+	if cfg.Name != "workspace-ref" {
+		t.Errorf("expected name 'workspace-ref', got %q", cfg.Name)
+	}
+	if cfg.Image != "node:20" {
+		t.Errorf("expected image 'node:20', got %q", cfg.Image)
+	}
+}
+
+func TestExtends_VarSub_MissingEnvResolvesToEmpty(t *testing.T) {
+	tmpDir := t.TempDir()
+	subDir := filepath.Join(tmpDir, ".devcontainer")
+	// #nosec G301 -- test directory
+	if err := os.MkdirAll(subDir, 0o750); err != nil {
+		t.Fatal(err)
+	}
+
+	// Ensure the env var is unset
+	t.Setenv("DEVSY_TEST_NONEXISTENT_VAR", "")
+	_ = os.Unsetenv("DEVSY_TEST_NONEXISTENT_VAR")
+
+	childPath := writeJSON(t, subDir, "devcontainer.json", `{
+		"extends": "${localEnv:DEVSY_TEST_NONEXISTENT_VAR}/parent.json",
+		"name": "missing-env"
+	}`)
+
+	// Missing env var resolves to empty string, resulting in an invalid path
+	_, err := ParseDevContainerJSONFile(childPath)
+	if err == nil {
+		t.Fatal("expected error when env var resolves to empty and path is invalid")
+	}
+}
+
 func strPtr(s string) *string {
 	return &s
 }
diff --git a/pkg/devcontainer/config/parse.go b/pkg/devcontainer/config/parse.go
index d81aeb977..0e92bfee2 100644
--- a/pkg/devcontainer/config/parse.go
+++ b/pkg/devcontainer/config/parse.go
@@ -8,6 +8,7 @@ import (
 	"os"
 	path2 "path"
 	"path/filepath"
+	"runtime"
 	"strings"
 	"unicode/utf8"
 
@@ -97,8 +98,11 @@ func ParseDevContainerJSONFile(jsonFilePath string) (*DevContainerConfig, error)
 	}
 	devContainer.Origin = path
 
-	// Resolve extends before applying legacy transforms
+	// Resolve extends before applying legacy transforms.
+	// Variable substitution must be applied to extends paths first so that
+	// ${localEnv:X}, ${localWorkspaceFolder}, etc. resolve before path lookup.
 	if !devContainer.Extends.IsEmpty() {
+		devContainer.Extends = substituteExtendsRefs(devContainer.Extends, path)
 		visited := map[string]bool{path: true}
 		declaringDir := filepath.Dir(path)
 		parent, err := resolveExtendsArray(
@@ -284,6 +288,35 @@ func Convert(from any, to any) error {
 	return json.Unmarshal(out, to)
 }
 
+// substituteExtendsRefs applies variable substitution to extends path strings
+// so that ${localEnv:X}, ${localWorkspaceFolder}, etc. are resolved before the
+// extends resolver attempts to open the referenced files.
+func substituteExtendsRefs(refs ExtendsRef, configFilePath string) ExtendsRef {
+	localWorkspaceFolder := filepath.Dir(filepath.Dir(configFilePath))
+	env := ListToObject(os.Environ())
+	isWindows := runtime.GOOS == "windows"
+	if isWindows {
+		newEnv := map[string]string{}
+		for k, v := range env {
+			newEnv[strings.ToLower(k)] = v
+		}
+		env = newEnv
+	}
+
+	subCtx := &SubstitutionContext{
+		LocalWorkspaceFolder: localWorkspaceFolder,
+		Env:                  env,
+	}
+
+	result := make(ExtendsRef, len(refs))
+	for i, ref := range refs {
+		result[i] = ResolveString(ref, func(match, variable string, args []string) string {
+			return replaceWithContext(isWindows, subCtx, match, variable, args)
+		})
+	}
+	return result
+}
+
 func ParseKeyValueFile(filename string) ([]string, error) {
 	f, err := os.Open(filename)
 	if err != nil {