First, understand human psychology deeply. Know what scares people on a psychological level, like the fear of losing one's mind or being betrayed. Then, create a setting that feels claustrophobic or otherworldly. The characters should be complex, with their own demons. For instance, a character who has repressed memories that start to resurface in a menacing way. Use language that is evocative and can play with the reader's emotions, making them feel as if they are in the character's shoes and experiencing the horror firsthand.
To create a truly terrifying psychological horror short story, you need to focus on the characters' minds. Make their fears and insecurities so vivid that the reader can feel them. Also, use isolation as a tool. If the character is alone in a spooky place, it amps up the horror. And don't forget about the power of suggestion. Sometimes, what you don't show can be scarier than what you do.
Use suspense. Build it up slowly by dropping hints and keeping the reader guessing. For example, don't reveal the true nature of the horror right away.