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In 1848, von Gudden earned his doctorate from the University of Halle and became an intern at the asylum in Siegburg under Carl Wigand Maximilian Jacobi (1775–1858). From 1851 to 1855 he worked as a psychiatrist under Christian Friedrich Wilhelm Roller (1802–1878) in the mental asylum at Illenau in Baden, then from 1855 to 1869, served as director of the mental institution (Unterfränkische Landes-Irrenanstalt) in Werneck. In 1869 he was appointed director of the Burghölzli Hospital, as well as professor of psychiatry at the University of Zürich. In 1872 he was appointed Obermedicinalrath and director of the Upper Bavarian Kreis-Irrenanstalt (district mental asylum), located in Munich. Shortly afterwards, he became a professor of psychiatry at the University of Munich.
Gudden made many contributions in the field of neuroanatomy, especially in his work of mapping and describing the paths, connections, origins/termini and neuroanatomical centers of cranial and optic nerve networks. The commissural fibers of the optic tract are called the commissure of Gudden in his honor, and he is credited for developing a specialized microtome for sectioning the brain for pathological study. Among his well-known students and assistants are Emil Kraepelin (1856–1926), Franz Nissl (1860–1919), Auguste-Henri Forel (1848–1931), Sigbert Josef Maria Ganser (1853–1931) and Oskar Panizza (1853–1921).
As director of mental institutions, Gudden advocated a no-restraint policy, humane treatment of the mentally ill, communal social interaction amongst patients, and a well-trained medical staff. These were considered innovative, if not revolutionary ideas concerning mental health treatment in the mid-19th century.
Gudden was a respected psychiatrist in Germany and was appointed personal physician to King Ludwig II of Bavaria.