My personal inclination is to let a player know that their character is hallucinating, if not all PCs are affected, but to strictly enforce the effects of hallucination afterwards, should the player choose to try to function anyways. I'm assuming that these aren't what's called "veridical hallucinations" -- false perceptions indistinguishable from reality -- but are more like hypnagogic or psychedelic hallucinations, where you know you are hallucinating, but that doesn't mean you can function normally.
The way I figure it, hallucination effects will cause the following problems:
- Always surprised;
- Can't read magical or mundane texts;
- There's a random noise behind every door, and secret doors are everywhere;
- When trying to draw a weapon or other item, you only succeed in taking out the correct item on a 5+ on 1d6;
- Unlike Confusion, you can choose whether to attack or not, but the target will be random if you do attack.
That's pretty basic, but the real "problem" is inspiration for what the victim perceives instead of reality. The idea I had yesterday (inspired by Nethack) was: use the last letter of the name of whatever the victim discovers as the first letter of the replacement word. "You see a cat holding a book standing in front of a large rock." Based on that description, what would you do?