The story opens with a flashback of Rocky's rematch against Clubber Lang, where Rocky defeated Clubber Lang to regain his title.
Three years later. Ivan Drago (Dolph Lundgren), a highly intimidating 6- foot 4-inch, 261 pound Russian Soviet boxer, arrives in America with his wife Ludmilla (Brigitte Nielsen), a 1980 Olympic gold medal swimmer, his manager Nicolai Koloff (Michael Pataki), and a team of trainers headed by grizzled Russian coach Igor Rimsky (George Rogan), and the Cuban assistant coach Manuel Vega (James "Cannonball" Green) to challenge the best U.S. fighters. His manager shows off the hi-tech equipment which aids in improving Drago's performance, demonstrating Drago throwing punches at a machine that measures superhuman level, at 1850 psi. Motivated by patriotism and an innate desire to prove himself after his retirement from boxing, Apollo Creed (Carl Weathers) is desperate to step back into the ring in an exhibition bout against Drago. A press conference is held to publicize the bout, which begins on affable terms (despite Apollo talking down to his opponent) but quickly changes when Apollo is accused of being a "has been" by Drago's manager. Livid, Apollo loses his temper and tells Drago they'll "finish this in the ring" before abruptly leaving the conference and an unfazed Drago.
Rocky (Sylvester Stallone) has reservations, but trains Apollo for the fight which is supposed to be an exhibition match in Las Vegas. On the evening of the boxing match, the opening act is a huge patriotic event complete with James Brown singing "Living in America". At the start of the fight, Apollo puches at Drago, which he brushes off and it soon turns serious though, as Drago beats Apollo mercilessly. Apollo is in dire straits as the first round is over. Rocky and Apollo's trainer Duke (Tony Burton) plead with him to give up, but Apollo refuses to do so, and tells Rocky not to stop the fight no matter what. The second round starts just as the first ended. Rocky considers throwing in the towel but honors Apollo's wish. It turns out to be a tragic decision as Drago ultimately kills the former champion by literally beating Apollo to death. Drago displays no sense of remorse commenting: "If he dies... he dies."
Incensed by Drago's cold indifference, Rocky decides to avenge Apollo's death by agreeing to relinquish his title and fight Drago in Russia on Christmas Day in an unsanctioned bout in Moscow, USSR. Supported by Duke and his brother-in-law Paulie (Burt Young), he flies to Krasnoyarsk, Soviet Union, to train. To prepare for the fight, Drago uses expensive and very high tech equipment and (implied) use of anabolic steroids. Rocky, on the other hand uses a very basic, spartan approach: he throws logs, chops down trees, jogs in thick snow daily and climbs a mountain. When Adrian (Talia Shire) shows up unexpectedly to give Rocky her support after initially refusing to travel to Russia, the two settle their differences.
Much like the Apollo boxing match, Drago is introduced with an elaborate, patriotic ceremony that puts the boorish attending Soviet audience squarely on the side of Drago, leaving Rocky fiercely booed. In contrast to his fight with Apollo, Drago immediately goes on the offensive, repeatedly pounding Rocky and casually shrugging off his punches. After a pulverizing first round, Rocky comes back toward the end of the second and lands a strong shot that cuts Drago just below his left eye. While Drago is visibly shaken, Rocky is fired up and goes on the offensive, pummeling Drago until, after the bell rings numerous times, Balboa is pulled off his opponent. Drago punches Rocky in revenge after putting him in a headlock, and Balboa lifts up and slams Drago to the ground, their managers splitting up the fight. The commentators say it's like a street fight. While Duke and Paulie cheer Rocky for his heroism, they remind him that Drago is not a machine, but a man. Ironically, Drago comments that Rocky "is not human, he is like a piece of iron" with his own corner reprimanding him for being "weak" in comparison to the "small American."
At this point, the fight becomes a fierce battle of wills between the two boxers. Drago, for the most part, holds the upper hand but his confidence drops due to Rocky's seemingly limitless endurance, allowing Rocky to get in under his guard and deliver his own attack. By the 14th round, the previously hostile Soviet crowd has been won over by Rocky's determination and is cheering him on. Koloff, fearing retribution from the Soviet General Secretary (who resembles Mikhail Gorbachev), goes over to Drago and berates his performance, fiercely urging him to win. Drago's response is to pick up Koloff by the throat with a single hand and throw him to the ground, and adamantly proclaim that he fights only for himself.
In the 15th (final) round of the fight, Rocky and Drago trade punch after punch with Rocky eventually knocking Drago out to the shock of the crowd and the Soviet General Secretary. Victorious, Rocky is swarmed as the crowd floods the ring, lifting Rocky onto their shoulders and draping him in the American flag. A bloody and battered Rocky gives a victory speech, acknowledging the initial and mutual disdain between himself and the once hostile crowd as much as the disdain between Russians and Americans, how they've come to respect and admire each other during the course of the fight which he also says is better than war between their two countries, and how everybody can "change." The General Secretary stands and passionately applauds Rocky and his aides follow suit. Rocky ends his speech by wishing his son a Merry Christmas, and throws his arms into the air in victory as the crowd applauds.