TxtC is an unusual bifunctional cytochrome P450 that is able to perform sequential aliphatic and aromatic hydroxylation of the diketopiperazine substrate thaxtomin D in two distinct sites to produce thaxtomin A. Though the X-ray structure of TxtC complexed with thaxtomin D revealed a binding mode for its aromatic hydroxylation, the preferential hydroxylation site is aliphatic C14. It is thus intriguing to unravel how TxtC accomplishes such two-step catalytic hydroxylation on distinct aliphatic and aromatic carbons and why the aliphatic site is preferred in the hydroxylation step. In this work, by employing molecular docking and molecular dynamics (MD) simulation, we revealed that thaxtomin D could adopt two different conformations in the TxtC active site, which were equal in energy with either the aromatic C20-H or aliphatic C14-H pointing toward the active Cpd I oxyferryl moiety. Further ONIOM calculations indicated that the energy barrier for the rate-limiting hydroxylation step on the aliphatic C14 site was 9.6 kcal/mol more favorable than that on the aromatic C20 site. The hydroxyl group on the monohydroxylated intermediate thaxtomin B C14 site formed hydrogen bonds with Ser280 and Thr385, which induced the l-Phe moiety to rotate around the Cβ-Cγ bond of the 4-nitrotryptophan moiety. Thus, it adopted an energetically favorable conformation with aromatic C20 adjacent to the oxyferryl moiety. In addition, the hydroxyl group induced solvent water molecules to enter the active site, which propelled thaxtomin B toward the heme plane and resulted in heme distortion. Based on this geometrical layout, the rate-limiting aromatic hydroxylation energy barrier decreased to 15.4 kcal/mol, which was comparable to that of the thaxtomin D aliphatic hydroxylation process. Our calculations indicated that heme distortion lowered the energy level of the lowest Cpd I α-vacant orbital, which promoted electron transfer in the rate-limiting thaxtomin B aromatic hydroxylation step in TxtC.