O'Bannon attended USC Film School and lived near the Los Angeles Campus in an old two-story house affectionately called the "Menlo Manor" which he shared with other USC students (Don Jakoby, who collaborated on several screenplays with Dan including Blue Thunder; and Jeffrey J. Lee, who became a well-known Artist in Europe). Part of his student film Dark Star was filmed there, with O'Bannon co-starring as Sgt. Pinback. He spent many late nights in old Hollywood editing his and other student films. His wish was to become a Director. Dark Star was edited by O'Bannon using a 1940s Moviola.

Carpenter expanded the Dark Star short into a feature which was released in 1974 with a final budget of only US$60,000. O'Bannon served in a number of capacities, including scripting, editing and acting in one of the leading roles ("Pinback"). In 1975, Dark Star won the Golden Scroll award (the Saturn Awards' original name) for Best Special Effects.

He was attached to supervise special effects for an Alejandro Jodorowsky production of Frank Herbert's Dune, but this fell apart in 1975 and the movie was never made as the major Hollywood studios were wary of financing the picture with Jodorowsky as Director. O'Bannon's role is prominently featured in the 2013 documentary Jodorowsky's Dune. The collapse of Dune left O'Bannon broke, homeless, and dependent on friends for his survival. While living with his friend Ronald Shusett, they came up with the story for O'Bannon's career-making film Alien (1979), for which he wrote the screenplay and supervised visuals.

In 1981, O'Bannon helped create the animated feature Heavy Metal, writing two of its segments ("Soft Landing" and "B-17"). O'Bannon voiced his displeasure with his next big-budget outing, John Badham's Blue Thunder (1983), an action film about a Los Angeles helicopter surveillance team. Originally written with Don Jakoby, Blue Thunder also underwent extensive rewriting, losing some of its political content. He and Jakoby also scripted Lifeforce (1985), a movie based on Colin Wilson's novel The Space Vampires and directed by Tobe Hooper that veers from alien visitation to vampirism and an apocalyptic ending. It was not well received at the time, and was considered a box office flop. O'Bannon would again collaborate with Jakoby and Hooper for the 1986 remake Invaders from Mars. Purists considered it inferior to the 1950s original and it also performed poorly at the box office. O'Bannon also worked as a consultant for C.H.U.D., helping to create the design concept for the title creatures.

In 1985, O'Bannon moved into the director's chair with Return of the Living Dead. Like Alien, the film met with success, spawned numerous sequels, and became a cult classic.

In 1990, O'Bannon and Shusett re-teamed to make Total Recall, an adaptation of the short story "We Can Remember It for You Wholesale" by Philip K. Dick. This was a project the two had been working on since collaborating on Alien. The film earned well over US$100 million. An earlier screenplay by the duo titled Hemoglobin was also produced as the low budget feature Bleeders (1997).

O'Bannon's second directorial feature, The Resurrected (1992), was a low-budget horror effort released direct-to-video. Based on the writings of H. P. Lovecraft, it focused on a family's ancient rituals that awaken the dead. In 1995, O'Bannon received a co-writing credit for the sci-fi film Screamers adapted from the Philip K. Dick story "Second Variety", having written the initial version of the screenplay with Michael Campus in the early 1980s.

In 2001, O'Bannon was the filmmaker-in-residence at Chapman University's Dodge College of Film and Media Arts.

O'Bannon died from complications of Crohn's disease in Los Angeles on December 17, 2009. O'Bannon credited his experiences with Crohn's for inspiring the chest-bursting scene from Alien. He was survived by his son Adam and his wife, Diane.

In 2013, Dan O'Bannon's Guide to Screenplay Structure was released, co-written with Matt R. Lohr.