In the opening scene, Fred Madison (Bill Pullman) is a saxophonist who is seen sitting in his house one morning, smoking a cigarette, looking disheveled when the intercom from the front door of his house buzzes. Over the intercom, a distorted man's voice says: "Dick Laurent is dead". When Fred looks out a window, police sirens are heard in the distance, but the streets outside his house are empty.
Fred then plays his saxophone at a nightclub that night where his wife Renee (Patricia Arquette) does not join him. Fred's performance at the Club Luna is insanely over the top. He calls his house during a break, but she does not answer (several different phones at the house are seen to be ringing). Arriving home later, Fred sees Renee asleep in bed. Fred apparently suspects that Renee may be cheating on him.
The next morning, there is a mysterious package that arrives on the front doorstep containing a videotape. A very quiet Renee doesn't mention the tape, but Fred sees it and demands that they watch it (thinking it may be a sex tape of her). The tape only displays a 20-second image of the outside of their home. The releaved Renee tells a perplexed Fred that the tape "might have been from a real estate agent".
One night Fred tries to make love to Renee, but gives up in failure. She tells him it is okay. He tells her about a dream he had: she was crying out for him, "Fred, where are you?" But he couldn't find her and says that he saw someone in bed that looked like her but wasn't her. When she screams in bed, he seems to wake up, but when he turns to look at Renee, it is not her and now he wakes up for real. The person he sees is a man with greenish-weird makeup and a dark wig that looks like Renee's hair. (It is the first time we see the "mystery man," whom Fred meets again, as explained below.)
As the days pass, another tape arrives, showing the interior of their house and even shows them in bed sleeping. Fred and Renee call the police and two detectives, Al and Ed (John Roselius and Louis Eppolito), watch the video. The two cops recommend Fred and Renee resume using their security system, and search the house for signs of forced entry. One of the departing the cops say "We'll keep watch over the house. We'll do the best we can" having neither found nor resolved anything.
That evening, Fred and Renee go out to a party held by Andy (Michael Massee) a band manager friend of Renee. Renee is getting drunk and stumbles into Andy's arms while pleading with Fred to get her another drink. A frustrated Fred goes to the bar for a drink where he meets a strange looking Mystery Man in Black (Robert Blake), who tells Fred that if they met before and that he is at his house right now. Fred phones his house and the voice of the Mystery Man answers at the house while he's standing right in front of Fred. Fred walks away and asks Andy who the Mystery Man is and is told that he is a friend of Dick Laurent. Both Renee and Andy glance at each other with concern when Fred mentions that Dick Laurent is dead (clearing hiding something between them). Fred then forcibly grabs Renee and they leave the party.
Driving home, Fred asks Renee questions about Andy and of her past connection to him, which Renee avoids answering. Arriving back at their house, Fred looks around first and finds no one around. While Renee prepares herself for bed by taking off her makeup in the bathroom, Fred walks around the dark cavern-like house and finds himself standing in front of a dark hallway resembling a vortex that leads seemingly to a unknown destination. Fred walks down the dark hallway that seemingly goes on for hundreds of feet and disappears, and he finds himself staring at a mirror reflection of himself. Renee walks out of the bedroom and stands at the base of the dark hallway and calls out for Fred, as in the dream he told her about. A minute later, shortly before Fred emerges from the darkness of the long hallway, we see a shadow moving through another part of the house.
The next morning, another tape arrives and Fred watches it alone. To his horror it contains gory images of him killing Renee. He is then arrested for her murder. Fred is next shown being beaten in an interrogation room by the same two detectives, Al and Ed, who accuse him of killing his wife. A terrified Fred claims that he didn't kill Renee. But seconds later he becomes confused and immediately says to the detectives, "Tell me I didn't kill her!"
Tried, found guilty and sentenced to death, Fred is locked away on death row in prison for the murder of Renee (a crime he continues to deny committing). Shortly after arriving, Fred is plagued by frequent headaches and is perplexed by strange visions of the Mystery Man, a burning cabin in the desert, and a strange other man driving down a dark highway. He is brought out of his cell once by the guards and to the prison infirmary complaining of "massive headaches" and he cannot sleep. The prison doctor gives Fred some sedatives and has the guards take him back to his cell.
One morning, during a routine check of the cells, the prison guards are shocked to find that the man in Fred's cell is not Fred. The man is discovered to be Pete Dayton (Balthazar Getty) a young, confused auto mechanic whom the prison officials discover has a past record for auto theft. Since Pete has committed no crime aside from the auto theft five years earlier, he is released into the care of his parents Bill and Candace (Gary Busey and Lucy Butler), a former motorcycle gang couple, and he is taken home to their house in Van Nuys. At the same time, Pete is being followed by two detectives, named Hank and Lou (Carl Sundstrom and John Soiari), to find out why and how Pete ended up in Fred Madison's prison cell.
Pete goes out that evening with his friends Steve V (Giovanni Ribisi), Teddy, (Scott Coffey), Lanie (Heather Stephens) and Carl (Al Garrett) along with Pete's girlfriend Sheila (Natasha Gregson Wagner) first to a drive-in restaurant, and then to a bowling alley where they have drinks and dance in the bowling alley's bar. Sheila asks Pete about his mood and his whereabouts for the last several days. Pete avoids the question by insisting that they dance.
The next day, Pete returns to work at the garage where he is welcomed back by the owner Arnie (Richard Pryor) and his co-workers including veteran mechanic Phil (Jack Nance). Pete is called on by a certain Mr. Eddy (Robert Loggia), a charming but hot-tempered gangster, to fix his Mercedes. Mr. Eddy takes Pete for a drive where Pete witnesses him wave a tailgater (Greg Travis) on, then rams into the guy's car and he and his two cohorts attack and beat up the driver. Mr. Eddy then drops off Pete back at the garage where the two detectives, Hank and Lou, not noticing Pete leave earlier with Mr. Eddy, sees them returning. Hank identifies Mr. Eddy as a certain criminal named Dick Laurent.
Pete goes out that evening with Sheila where she questions him on his moody behavior, but lets lust sidetrack her again. Pete proceeds to have sex with Sheila in the backseat of his car while Hank and Lou continue to watch from a safe distance.
The next day, Mr. Eddy returns to the garage with his Cadillac for Pete to repair and also inside the car is a beautiful blond woman named Alice Wakefield (also Patricia Arquette), Mr. Eddy's mistress. At the end of the day, Alice returns to the garage and invites Pete out for dinner. Soon, Pete and Alice begin a secret liaison by meeting at run-down motels every night. Hank and Lou continue to keep tabs on Pete to find out what he is really up to.
As the days wear on, Pete begins experiencing a number of psychological problems with headaches, and strange streams of memory... the same type of psychological problems that Fred Madison had. When Alice phones Pete to cancel their nightly get-together, Pete instead rides his motorcycle to Sheila's house where he has rough sex with her, under the delusion that he is having sex with Alice.
Another evening or two later, after Pete comes home from work, his worried-looking parents confront him about the recent events and say that the police have been calling them to ask if Pete remembers anything from that night that he vanished. Pete continues to claim that he has no memory about the night he disappeared and ended up in Fred Madison's prison cell, except for flashes of being on the front lawn of his house with Sheila and his parents running after him. While Pete claims not to know what happened to him that night, his parents clearly do. But for some reason that is never explained, Bill and Candace refuse to tell Pete anything about what happened to him the night he vanished.
Another day later while working at the garage, Mr. Eddy pays Pete another visit where he makes an implied threat on his life by claiming that he would kill anyone whom he caught fooling around with Alice.
After work, Pete secretly goes to visit Alice after work where she tells him that she begins to fear that Mr. Eddy suspects her and Pete of seeing each other. Alice tells Pete about a plan to steal money from a friend of hers so they can leave town. Alice reveals to Pete that Mr. Eddy is actually a porno producer named Dick Laurent and she tells Pete a story about how Mr. Eddy forced her against her will to do pornographic video tapes and wants to get far away from the city as possible to start a new life with Pete. Alice explains the details of her plans. She tells Pete that on the following night, she will meet with Mr. Eddy's associate Andy (the same band manager friend of Fred and Renee's) at his house. Pete will go there and stage what will appear to be a break in and he and Alice will steal money from Andy and then leave town. Pete is wary about trusting Alice, but tells her that he will think about it.
That same evening when Pete comes home, he is confronted by a jealous Sheila over his infidelity. Before she walks away, Sheila tries to persuade Bill and Candace to tell Pete the truth about that night. Soon afterwards, Pete receives a threatening phone call from Mr. Eddy and his associate, the Mystery Man, who make an another implied threat on his life. Frightened, Pete calls Alice and agrees to help with her plan.
The next night, Pete sneaks out of his house and away from the two detectives in their squad car. He takes a local bus and goes to Andy's house where Alice already is with Andy. Pete climbs a fence and comes in the back door that Alice has left unlocked and, while searching the house, discovers a projector of a porno film of Alice being played. He also sees a picture of the two women side by side, Alice and Renee, and asks about it. She says she is the one in blonde hair. Andy catches Pete and after a vicious struggle, Pete accidentally kills him in a bizarre accident; Andy is thrown and lands with his forehead squarely on the edge of a glass coffee table. Alice steals money and other property, and Fred and Alice flee, driving away in Andy's red sports car, but not before Pete has a nightmarish vision which implies that Alice will betray him.
Arriving at a cabin in the desert (the same cabin that was in Fred and Pete's visions) to meet with their contact, Alice looks around but finds the cabin empty. Alice tells Pete that they will have to wait for a while. Alice then seduces Pete and they have sex on a blanket beside their car. When Pete whispers to Alice over and over that he wants her, Alice replies: "you'll never have me".
When Alice gets up and walks away, stark nude, into the desert cabin, the distraught Pete stands up... and suddenly metamorphoses back into Fred Madison. Fred puts his clothes back on and searches the desert cabin. But Alice is gone and he meets the Mystery Man again with a video camera who tells Fred that Alice is actually Renee, and that Renee is a liar. Fred runs back to Andy's car and drives away with the Mystery Man videotaping and charging at him as he drives away. This suggests that the Mystery Man might be the one who made the videotapes of Fred and Renee's house. But he also seems like a supernatural character who can appear and vanish at will.... possibly even a manifestation of the devil or Death.
Fred drives to the Lost Highway Hotel, a creepy-looking nightmarish place in the middle of the desert, and sees the brunette Renee/Alice checking into a room with Mr. Eddy. Fred checks himself into another room and hears Renee and Mr. Eddy having sex in the next room. A while later, Renee leaves the room to go back to her car and drive home. After Renee leaves, Fred breaks into Mr. Eddy's room, grabs him and takes him away in his Mercedes. The Mystery Man watches from another room.
In the desert, Fred stops the car and gets out to open the trunk when Mr. Eddy emerges and attacks him. But the Mystery Man suddenly appears and gives Fred a knife to slash Mr. Eddy's throat. The Mystery Man then shows footage of Renee with Mr. Eddy watching a snuff film on a portable mini TV, which shows that Fred knows that he and Renee have been having an affair. The Mystery Man then shoots Mr. Eddy to death and whispers something inaudible to Fred. The Mystery Man disappears and Fred (now holding the gun) drives off in Mr. Eddy's Mercedes.
Back at Andy's house, all four of the detectives, Al and Ed, Hank and Lou, are investigating the crime scene with the dead Andy until one of them notices a photo of Renee, Mr. Eddy and Andy together which they see as the motivation for Fred wanting to kill Renee (Note: Alice is no longer in the photo when Pete saw her in it earlier). One detective mentions finding Pete's fingerprints all over the crime scene. One of the detective's states: "You know what I think? I think there's no such thing as a bad coincidence."
In the final scene, things come full circle as Fred, still driving Mr. Eddy's Mercedes and wearing Pete's dark clothes, drives to his house where it's revealed that he is the person who walks up to the front door of his old house, buzzes the intercom, and leaves the cryptic message, "Dick Laurent is dead", to himself in the past. The two police detectives, Al and Ed, pull up in their squad car when they see Fred standing at the front door of his old house and move in to arrest him. Seeing the detectives advancing towards him, Fred runs back to his car and drives off with the detectives in close pursuit. As it gets dark, Fred speeds down the lost highway pursued by the police as he enters a dark vortex that appears on the road and begins violent screaming fit (like ones earlier in the film). Possibly he is metamorphosing into another person....