Labyrinth begins on a rainy afternoon, with a young girl named Sarah practicing a play in the park with her dog Merlin. An owl is watching her, seemingly with great interest, as Sarah realizes she is late, and runs home as fast as she can. Her father and stepmother are annoyed with her for being tardy, and leave for an evening of fun, with Sarah as a reluctant baby-sitter to her half-brother, Toby. Sarah is furious when she realizes her beloved stuffed bear Lancelot has been taken and given to Toby.

As she retreives it, she begins to tell the crying Toby all about the Goblin King and how the goblins will take him away. When his cries don't stop, she irrationally shouts out "I wish the goblins would take you away right now!" Moments later, he is gone, and Sarah stands before Jareth, the Goblin King. He informs her that Toby is now in his palace, and if she wishes to rescue him, she must traverse the mysterious Labyrinth within thirteen hours. If she fails, then Toby will become a goblin.

Sarah begins her quest, encountering first the strange dwarf Hoggle, who helps her into the Labyrinth itself, despite being grumpy and rude. Within the Labyrinth she finds many strange things, including a talking worm, walls that appear and disappear, and a huge monstrous creature known as Ludo, who is quite gentle and becomes Sarah's friend. She also meets the zany Fierys and noble Sir Didymus and his steed Ambrosious, and survives the perilous Bog of Eternal Stench. Appearing to interfere in her quest is Jareth, who dominates the weak Hoggle, who returns to help Sarah out from an oubliette, a dungeon-like cell, she falls into.

Due to Hoggle, Sarah is swept away into a peach-induced ballroom, where Jareth sings of what could be love, or simply trying to keep her from completing her quest. When Sarah breaks through the vision, she finds herself not far from the Goblin City, with Ludo and Sir Didymus waiting for her.

As they are attacked at the front gates by a gigantic robotic creature, they are rescued by Hoggle, who overcomes his fear and joins their company. Jareth hears of their arrival, and sends out his troops to stop them. A chase and battle ensues, which is won only by the help of Ludo's friends, the rocks. At last, Sarah and her friends reach the castle, and Sarah enters to do battle with Jareth. In a climatic scene, she declares at last that "he has no power over her", and has won Toby's freedom. She is returned home, and because of the lessons learned in her quest, is more at peace with herself, her parents, and Toby. She misses her new friends, though, and calls them to her for one last party. Outside is the white owl that is Jareth, watching sadly as he flies away into the unknown.