As far as I've been playing it, you enter combat against a monster, and make the Horror check. Before you attempt the combat check, you decide to use the Flute, and automatically "defeat" all monsters on your spot. For all intents and purposes, "defeat" is effectively the same as "pass a combat check against."
I don't see any issues with the Rat Thing. You're not actually making any combat check, so you're not subject to its ability. You're using the Flute instead of making a combat check, and you're handling all the Flute's victims as though you had passed a combat check against them. Passing a combat check against a Rat-Thing simply means you take it as a trophy.

