Hugh Conway, a veteran member of the British diplomatic service, finds inner peace, love, and a sense of purpose in Shangri-La, whose inhabitants enjoy unheard-of longevity. Among the book's themes is an allusion to the possibility of another cataclysmic world war brewing. It is said to have been inspired at least in part by accounts of travels in Tibetan borderlands, published in National Geographic by the explorer and botanist Joseph Rock. The remote communities he visited, such as Muli, show many similarities to the fictional Shangri-La. One such town, Zhongdian, has now officially renamed itself Shangri La (Chinese: 香格里拉 Xiānggélǐlā) because of its claim to be the inspiration for the novel.
The book explicitly notes that, having made war on the ground, man would now fill the skies with death, and all precious things were in danger of being lost, like the lost histories of Rome ("Lost books of Livy"). It was hoped that, overlooked by the violent, Shangri-la would preserve them and reveal them later to a receptive world exhausted by war. That was the real purpose of the lamasery; study, inner peace, and long life were merely a side benefit to living there.
Conway is a veteran of the trench warfare of WWI, with the emotional state frequently cited after that war—a sense of emotional exhaustion or accelerated emotional aging. This harmonises with the existing residents of the lamasery and he is strongly attracted to life at Shangri-La.
The origin of the eleven numbered chapters of the novel is explained in a prologue and epilogue, whose narrator is a neurologist.
This neurologist and a novelist friend, Rutherford, are given dinner at Tempelhof, Berlin, by their old school-friend Wyland, a secretary at the British embassy. A chance remark by a passing airman brings up the topic of Hugh Conway, a British consul in Afghanistan, who disappeared under odd circumstances. Later in the evening, Rutherford reveals to the narrator that, after the disappearance, he discovered Conway in a French mission hospital in Chung-Kiang (probably Chongqing), China, suffering from amnesia. Conway recovered his memory and told Rutherford his story, then slipped away again.
Rutherford wrote down Conway's story; he gives the manuscript to the neurologist, and that manuscript becomes the heart of the novel.
In May 1931, during the British Raj in India, the 80 white residents of Baskul are being evacuated to (Peshawar), owing to a revolution. In the aeroplane of the Maharajah of Chandrapore are Conway, the British consul, aged 37; Mallinson, his young vice-consul; an American, Barnard; and a British missionary, Miss Brinklow. The plane is hijacked and flown instead over the mountains to Tibet. After a crash landing, the pilot dies, but not before telling the four (in Chinese, which only Conway speaks) to seek shelter at the nearby lamasery of Shangri-La. The location is unclear, but Conway believes the plane has "progressed far beyond the western range of the Himalayas towards the less known heights of the Kuen-Lun"
The four are taken there by a party directed by Chang, a postulant at the lamasery who speaks English. The lamasery has modern conveniences, like central heating; bathtubs from Akron, Ohio; a large library; a grand piano; a harpsichord; and food from the fertile valley below. Towering above is Karakal, literally translated as "Blue Moon," a mountain more than 28,000 feet high.
Mallinson is keen to hire porters and leave, but Chang politely puts him off. The others eventually decide they are content to stay; Miss Brinklow, to teach the people a sense of sin; Barnard, because he is really Chalmers Bryant (wanted by the police for stock fraud), and because he is keen to develop the gold-mines in the valley; and Conway, because the contemplative scholarly life suits him.
A seemingly young Manchu woman, Lo-Tsen, is another postulant at the lamasery. She does not speak English, but plays the harpsichord. Mallinson falls in love with her, as does Conway, though more languidly.
Conway is given an audience with the High Lama, an unheard-of honor. He learns that the lamasery was constructed in its present form by a Catholic monk named Perrault from Luxembourg, in the early eighteenth century. The lamasery has since then been joined by others who have found their way into the valley. Once they have done so, their aging slows; if they then leave the valley, they age quickly and die. Conway guesses correctly that the High Lama is Perrault, now 250 years old.
In a later audience, the High Lama reveals that he is finally dying, and that he wants Conway to lead the lamasery. Meanwhile, Mallinson has arranged to leave the valley with porters and Lo-Tsen. They are waiting for him 5 kilometers outside the valley, but he cannot traverse the dangerous route by himself, so he convinces Conway to go along and assist him. This ends Rutherford's manuscript.
The last time Rutherford saw Conway, it appeared he was preparing to make his way back to Shangri-La. Rutherford completes his account by telling the neurologist that he attempted to track Conway and verify some of his claims of Shangri-La. He found the Chung-Kiang doctor who had treated Conway. The doctor said Conway had been brought in by a Chinese woman who was ill and died soon after. She was old, the doctor had told Rutherford, "Most old of anyone I have ever seen", implying that it was Lo-Tsen, aged drastically by her departure from Shangri-La.