The SARS-CoV-2 papain-like protease (PLpro) is a target for antiviral drug development. It is essential for processing viral polyproteins for replication and functions in host immune evasion by cleaving ubiquitin (Ub) and ubiquitin-like protein (Ubl) conjugates. While highly conserved, SARS-CoV-2 and SARS-CoV PLpro have contrasting Ub/Ubl substrate preferences. Using a combination of structural analyses and functional assays, we identify a molecular sensor within the S1 Ub-binding site of PLpro that serves as a key determinant of substrate specificity. Variations within the S1 sensor specifically alter cleavage of Ub substrates but not of the Ubl interferon-stimulated gene 15 protein (ISG15). Significantly, a variant of concern associated with immune evasion carries a mutation in the S1 sensor that enhances PLpro activity on Ub substrates. Collectively, our data identify the S1 sensor region as a potential hotspot of variability that could alter host antiviral immune responses to newly emerging SARS-CoV-2 lineages.