Xanadu is a powerful computer created by Donald, featured most prominently in Act III, Scene IX.
Xanadu is a machine with a very peculiar purpose: to document the creation of itself. Donald and his friends, Lula and Joseph, originally planned to develop Xanadu as a revolutionary new computer system, and used the quiet and secrecy of the Bedquilt Caverns as their workspace. However, as explained by Xanadu's simulation, they encountered strangers as they worked, and experienced setbacks. Lula and Joseph left the project, while Donald soldiered on, hiring assistants. These assistants included Weaver, Amy, and Roberta.
When the player first encounters Xanadu, it is not in working order, and can only respond with garbled text. Once the group gets it working, it presents a simulation that strongly resembles older text adventure games, with a simple verb-and-noun parser. Once Xanadu's main story is complete, it will switch over to a management-style game that explores Donald's efforts to get the computer working with his newly hired assistants. The player need not finish this simulation - only the first half of Xanadu's story is required to progress.
Xanadu is a machine of stupendous size and complexity, apparently using black mold as part of its circuitry in some unexplained way. The black mold gave the machine a strange chaotic effect, allowing its simulation to "learn," and behave in ways that its programmers did not intend. Xanadu itself does not seem to be "alive" as such, but the virtual entities inside it behave uncannily like their real-world counterparts. However revolutionary it might be, the computer is clearly dated (it resembles a PDP-1). Its main screen is a vectorscope and it outputs with a ticker-tape printer. The player can also use Shannon's transponder to fire electrical signals through the machine, but this is only a cosmetic flourish and does not actually affect its operation.
The name Xanadu draws from the name Shangdu, the capital of the Yuan Dynasty in China. In English literature, it is more famous as the topic of the poem "Kubla Khan" by Samuel Taylor Coleridge. In that work, Xanadu is a shining palace, possibly representing creativity, ambition, or the power of the human race.
Xanadu is also the name of Charles Foster Kane's mansion in the 1941 film Citizen Kane, an impossibly expensive monument to Kane's own wealth and achievements. The Xanadu estate ultimately falls into disrepair, paralleling Kane's own decline into old age and loneliness.
Additionally, Project Xanadu is a real world computer system that has been in development since the 1960's. It inspired the World Wide Web despite coming before it.
In Kentucky Route Zero, Xanadu is essentially a video game, within a video game. Moreover, it is a game that imitates text adventures, the forerunners of Kentucky Route Zero's point-and-click adventure. Xanadu, Donald, and all his assistants might therefore be seen as a commentary on the art, and the past, of game development itself. Donald is represented as a brilliant scientist, but hopelessly romantic, and with little self-determination to get out of his creative slump. Lula and Joseph, equally bright but with other goals, have left him, and now he can literally watch his work go up in smoke. Xanadu is the only remarkable thing he has left, but there is no place for it in the modern world.
Donald's assistants are more direct references to games of the past. Roberta, for instance, speaks the line "The kingdom is in peril!", making her a reference to Roberta Williams, creator of the King's Quest series.