In life, the Hydrotherapy Ghosts were patients at the Vannacutt Psychiatric Institute for the Criminally Insane. Dr. Vannacutt attempted hydrotherapy on them by having them thrown into a pool filled with freezing water, but the hydrotherapy patients drowned in the pool.
After the hydrotherapy patients were killed in the asylum, the Baphomet Idol kept their ghosts bound to the building, along with the ghosts of everyone else who died in the facility. The Idol apparently also kept the hydrotherapy patients' souls trapped in the pool where they drowned and forced them to constantly relive their deaths.
When Ariel, Paul, Kyle and Dr. Hammer are passing through the hydrotherapy room, Kyle is pushed by Desmond into a large pool which dominates the chamber. Ariel jumps in after Kyle to save him; instead, both find themselves trapped in the pool. The Hydrotherapy Ghosts then appear to Kyle and Ariel, in the form of waterlogged corpses, which suddenly spring to life and attack the two.
One of the Hydrotherapy Ghosts grabs Ariel and shows her a vision of how it died. When Kyle forces the ghost away from Ariel, it attacks him instead...dragging him underwater to his death. Ariel is saved by Paul and Dr. Hammer, who use a chain to lift her out of the pool before the ghosts can kill her as well.
The Hydrotherapy Ghosts were presumably freed from the house hours later when Ariel removed the Baphomet Idol from the building.