Sarah Williams (Connelly) is a 15-year-old who loves playing dress-up. The movie opens with a scene of Sarah rehearsing lines from her book Labyrinth in the park. Sarah, who is trying to remember the final line of a speech in the book, loses track of time, forgetting that she must babysit her infant half-brother, Toby, that night. She runs home to find her stepmother waiting angrily for her. They quarrel, after which the stepmother leaves with Sarah's father on a date, while Sarah remains behind to babysit Toby. Here, the already furious Sarah realizes her treasured teddy bear, Lancelot, is missing from her room. Storming into Toby's room, she finds Lancelot and shouts at Toby. He begins to cry; Sarah, possibly to tease him further in revenge, begins rehearsing more lines from Labyrinth. The part of the story she cites tells of a young woman granted special powers by the King of Goblins. According to the story, the girl (whom Sarah apparently uses to represent herself) could no longer stand her life and wishes for goblins to take away her screaming baby brother. As she ends the story and turns off the light, she remarks, "I wish the goblins would come and take you away...right now". Toby suddenly stops crying. Worried, Sarah enters his room, to find that Toby has vanished.

A barn owl flutters through the opened window and transforms into Jareth, the King of Goblins (Bowie), who tells her that he has taken the baby as she had beseeched. Appalled at the realization of what she has done, Sarah begs for the return of her brother. Jareth gives her 13 hours in which to solve his great maze, called the Labyrinth, and find Toby. If she fails, Jareth will change him into a goblin and keep him forever.

The Labyrinth is not a simple maze; the pathways and openings in the walls of the maze change from time to time, and are riddled with logic-puzzles and tests. At its entrance, Sarah finds Hoggle, a curmudgeonly goblin, spraying fairies with a solution that stuns them so that they will not bite him. She bribes him with plastic jewelry to lead her through the maze. Although he eventually sides with Sarah, it is later revealed that he is a halfhearted operative deployed by Jareth. Sarah's other companions, acquired along the way, are Sir Didymus, a chivalrous, fox-like knight who rides a sheepdog called Ambrosius, lives near the Bog of Eternal Stench, and guards a bridge to uphold a sacred oath; and Ludo, a giant, furry, gentle beast she rescues from some of Jareth's goblins. Ludo has the unique ability to summon boulders by howling. Sir Didymus and his English sheepdog steed Ambrosius are the main inhabitants of the bog, along with some frogs and flies. Perhaps because he is there constantly, Sir Didymus' nose seems numb to the bog's pungency. Sir Didymus has sworn a solemn oath with his lifeblood to let no one cross the bridge leading from the bog without his permission. Sarah manages to overcome this promise by simply asking for permission to cross; being extremely polite, he grants it.

Sarah and her friends experience a variety of adventures, including an encounter with detachable-limbed revelers known as "The Fire Gang", who try to remove Sarah's head; a detour through the Bog of Eternal Stench; a stop at the Four Guards, where she must solve a Raymond Smullyan-inspired Knights and Knaves logic puzzle to avoid certain death; a junkyard-like recreation of her own bedroom; and a hallucinogen-induced masquerade ball. There, Jareth attempts to keep her until the 13th hour by dancing with her. She breaks free of his spell and makes her way into the castle beyond the goblin city. She overcomes the obstacles with logical thought, recollection of her purpose, and help from her friends. Most of the obstacles are put in her path by Jareth, who (as Sarah herself had stated to Toby) has fallen in love with her and wants her to rule by his side.

The film climaxes in Jareth's multi-dimensional, M. C. Escher-inspired castle, wherein he makes a final appeal for her to abandon her quest and stay with him. She defeats him by reciting her monologue from the beginning of the movie, including the line she could not remember: "You have no power over me". The room crumbles away, whereupon Sarah finds herself in the front hall of her home with the clock striking midnight and the barn owl (Jareth) flying away.

In Toby's room, she gives him Lancelot, then returns to her room. As Sarah clears her dressing table, she seems confused about whether she has undergone the turning point in her life between childhood and adulthood. Hoggle appears, along with Ludo and Sir Didymus, as images in the mirror. They seem to be bidding her good-bye as she leaves behind the fantasies of childhood, but remind her that they will still be available "should you need us". Sarah insists she presently needs them, whereupon they appear in her bedroom. The film closes as the Labyrinth's creatures celebrate in her room. Outside, the owl watches the party for a while, then flies away into the night.