diff --git a/src/compiler/resolutionCache.ts b/src/compiler/resolutionCache.ts
index aecc6989891..25545c0efbc 100644
--- a/src/compiler/resolutionCache.ts
+++ b/src/compiler/resolutionCache.ts
@@ -323,19 +323,17 @@ namespace ts {
             let dir = getDirectoryPath(getNormalizedAbsolutePath(failedLookupLocation, getCurrentDirectory()));
             let dirPath = getDirectoryPath(failedLookupLocationPath);
 
+            // If directory path contains node module, get the most parent node_modules directory for watching
+            while (dirPath.indexOf("/node_modules/") !== -1) {
+                dir = getDirectoryPath(dir);
+                dirPath = getDirectoryPath(dirPath);
+            }
+
             // If the directory is node_modules use it to watch
             if (isNodeModulesDirectory(dirPath)) {
                 return { dir, dirPath };
             }
 
-            // If directory path contains node module, get the node_modules directory for watching
-            if (dirPath.indexOf("/node_modules/") !== -1) {
-                while (!isNodeModulesDirectory(dirPath)) {
-                    dir = getDirectoryPath(dir);
-                    dirPath = getDirectoryPath(dirPath);
-                }
-                return { dir, dirPath };
-            }
 
             // Use some ancestor of the root directory
             if (rootPath !== undefined) {
diff --git a/src/harness/unittests/tsserverProjectSystem.ts b/src/harness/unittests/tsserverProjectSystem.ts
index 06e2beeaaa6..2f875456e06 100644
--- a/src/harness/unittests/tsserverProjectSystem.ts
+++ b/src/harness/unittests/tsserverProjectSystem.ts
@@ -2399,6 +2399,43 @@ namespace ts.projectSystem {
             checkWatchedDirectories(host, watchedRecursiveDirectories, /*recursive*/ true);
 
         });
+
+        it("Failed lookup locations are uses parent most node_modules directory", () => {
+            const file1: FileOrFolder = {
+                path: "/a/b/src/file1.ts",
+                content: 'import { classc } from "module1"'
+            };
+            const module1: FileOrFolder = {
+                path: "/a/b/node_modules/module1/index.d.ts",
+                content: `import { class2 } from "module2";
+                          export classc { method2a(): class2; }`
+            };
+            const module2: FileOrFolder = {
+                path: "/a/b/node_modules/module2/index.d.ts",
+                content: "export class2 { method2() { return 10; } }"
+            };
+            const module3: FileOrFolder = {
+                path: "/a/b/node_modules/module/node_modules/module3/index.d.ts",
+                content: "export class3 { method2() { return 10; } }"
+            };
+            const configFile: FileOrFolder = {
+                path: "/a/b/src/tsconfig.json",
+                content: JSON.stringify({ files: [file1.path] })
+            };
+            const files = [file1, module1, module2, module3, configFile, libFile];
+            const host = createServerHost(files);
+            const projectService = createProjectService(host);
+            projectService.openClientFile(file1.path);
+            checkNumberOfProjects(projectService, { configuredProjects: 1 });
+            const project = projectService.configuredProjects.get(configFile.path);
+            assert.isDefined(project);
+            checkProjectActualFiles(project, [file1.path, libFile.path, module1.path, module2.path, configFile.path]);
+            checkWatchedFiles(host, [libFile.path, module1.path, module2.path, configFile.path]);
+            checkWatchedDirectories(host, [], /*recursive*/ false);
+            const watchedRecursiveDirectories = getTypeRootsFromLocation("/a/b/src");
+            watchedRecursiveDirectories.push("/a/b/src", "/a/b/node_modules");
+            checkWatchedDirectories(host, watchedRecursiveDirectories, /*recursive*/ true);
+        });
     });
 
     describe("Proper errors", () => {