The prologue and epilogue are narrated by 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 neurologist 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, told Rutherford his story (which Rutherford recorded in a manuscript), and then slipped away again.
Rutherford gives the neurologist his manuscript, which 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 due to 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 mountain range.
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 because she wants 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. The High Lama then dies. Conway contemplates the events.
Hours after the High Lama dies, Conway is outside still pondering the events while in the moonlight. Mallinson then grabs him by the arm and tells Conway he has arranged to leave the valley with porters and Lo-Tsen. Barnard and Brinklow have decided to stay. The porters and Lo-Tsen are waiting for him five kilometers outside the valley, but he cannot traverse the dangerous route alone, so he convinces Conway to go along and assist him. Conway is caught, divided between the two worlds. Ultimately, because of his love for the boy, he decides to join Mallinson. 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. The narrator wonders whether Conway can find his way back to his lost paradise.
