John Murray said Odessa Carey had visited him at his garden, where he lived in the shed, last April and shown him the severed body part, after wiping blood from her arms and hands.
Prosecutors claim Carey, 36, beat her mother, also called Odessa Carey, to death at her home then cut off her head.
Newcastle Crown Court heard the 73-year-old victim's headless corpse was found on her bed at her home in Ashington.
Mrs Carey's head was found at a separate address, where Carey Jnr was found hiding in the loft.
Carey, of no fixed address, has been charged with murder but is too unwell to face trial for a criminal offence.
Jurors will decide whether Carey did the act of killing but not whether she is guilty or not guilty.
Mr Murray has told jurors Carey was at his allotment shed when he returned home from the pub and shop.
He said: "I found Odessa there. I shocked her. She mustn't have realised I would be back.
"She was in the shed, sitting on a seat.”
Mr Murray said Carey cleaned blood from both arms and hands but he couldn't see any source for the blood coming from her.
He said Carey was wearing a pink onesie, two odd socks and trainers and a blue fleece was over the back of the chair.
He added: "She was just chilling.
"She was in good fettle but tired. She kept nodding off to sleep.
"She was sat on a red bar stool. That was her perch.
"After a while she reached for the blue bag.
"I was sat right next to her."
Prosecutor Nicholas Lumley QC asked Mr Murray if Carey produced anything during their conversation and he replied: "A towel and pillow case. Then she produced a head."
Mr Murray said the head was "definitely human" and belonged to a white female.
When asked what Carey did, Mr Murray said: "She kissed it on the forehead then put it back in the bag very carefully, inside the towel and pillow case."
Mr Murray said he "didn't really know what to do" and told people at his local pub he had had a "queer day".
Mr Lumley QC has told jurors Mrs Carey, who used a mobility scooter to get around, was found dead on April 8 last year.
Mr Lumley said police went to an address in Guide Post, Northumberland, and found Carey hiding in a loft.
He added: "In a cupboard under the sink at the address in Guidepost police found a human head, wrapped in a pillow case, in a towel, inside a carrier bag."
Jurors were shown cctv of Carey carrying the bag around the streets in the days before the grim discovery.
Mr Lumley said expert findings suggest Mrs Carey had been face down on her bed when she was attacked and there was "multiple impacts" to her head which caused fractures to her face and skull.
The court heard it was the head injuries, which may have been caused with a mallet, that caused the death. Mr Lumley said Mrs Carey's head was removed after she was dead.
Mr Lumley said Carey's DNA was found on the handle of the mallet.
He added: "The head was wrapped up in the bathroom before being taken from the house."
The trial continues.