Alexie was born on October 7, 1966, at Sacred Heart Hospital in Spokane, Washington. As a little child he lived on the Spokane Indian Reservation, located west of Spokane. His father, Sherman Joseph Alexie, was a member of the Coeur d'Alene tribe, and his mother, Lillian Agnes Cox, was of Colville, Choctaw, Spokane and European American ancestry. One of his paternal great-grandfathers was of Russian descent. Alexie was born with hydrocephalus, a condition that occurs when there is an abnormally large amount of cerebral fluid in the cranial cavity. He had to have brain surgery when he was six months old, and was at high risk of death or mental disabilities if he survived. Alexie's surgery was successful; he suffered no mental damage but had other side effects.

His successes in high school won him a scholarship in 1985 to Gonzaga University, a Roman Catholic university in Spokane. Originally, Alexie enrolled in the pre-med program with hopes of becoming a Doctor, but found he was squeamish during dissection in his anatomy classes. Alexie switched to law, but found that was not suitable, either. He felt enormous pressure to succeed in college, and consequently, he began drinking heavily to cope with his anxiety. Unhappy with law, Alexie found comfort in literature classes.

In 1987, he dropped out of Gonzaga and enrolled at Washington State University (WSU), where he took a creative writing course taught by Alex Kuo, a respected poet of Chinese-American background. Alexie was at a low point in his life, and Kuo served as a mentor to him. Kuo gave Alexie an anthology entitled Songs of This Earth on Turtle's Back, by Joseph Bruchac. Alexie said this book changed his life as it taught him "how to connect to non-Native literature in a new way". He was inspired by reading works of poetry written by Native Americans.

The Business of Fancydancing: Stories and Poems (1992) was well received, selling over 10,000 copies. Alexie refers to his writing as "fancydancing," a flashy, colorful style of competitive Pow wow dancing. Whereas older, traditional forms of Indian dance may be ceremonial and kept private among tribal members, the fancydance style was created by Native American veterans from World War II as a form of public entertainment. Alexie compares the mental, emotional, and spiritual outlet that he finds in his writings to the vivid self-expression of the Dancers. Leslie Ullman commented on The Business of Fancydancing in the Kenyon Review, writing that Alexie "weaves a curiously soft-blended tapestry of humor, humility, pride and metaphysical provocation out of the hard realities...: the tin-shack lives, the alcohol dreams, the bad luck and burlesque disasters, and the self-destructive courage of his characters."

Alexie published his first prose work, entitled The Lone Ranger and Tonto Fistfight in Heaven, in 1993. The book consists of a series of short stories that are interconnected. Several prominent characters are explored, and they have been featured in later works by Alexie. According to Sarah A. Quirk, The Lone Ranger and Tonto Fistfight in Heaven can be considered a bildungsroman with dual protagonists, "Victor Joseph and Thomas Builds-the-Fire, moving from relative innocence to a mature level on experience."

In his first novel, Reservation Blues (1995), Alexie revisits some of the characters from The Lone Ranger and Tonto Fistfight in Heaven. Thomas Builds-the-Fire, Victor Joseph, and Junior Polatkin, who have grown up together on the Spokane Indian reservation, were teenagers in the short story collection. In Reservation Blues they are now adult men in their thirties. Some of them are now Musicians and in a band together. Verlyn Klinkenborg of the Los Angeles Times wrote in a 1995 review of Reservation Blues: "you can feel Alexie's purposely divided attention, his alertness to a divided audience, Native American and Anglo." Klinkenborg says that Alexie is "willing to risk didacticism whenever he stops to explain the particulars of the Spokane and, more broadly, the Native American experience to his readers."

Indian Killer (1996) is a murder mystery set among Native American adults in contemporary Seattle, where the characters struggle with urban life, mental health, and the knowledge that there is a serial killer on the loose. Characters deal with the racism in the University system, as well as in the community at large, where Indians are subjected to being lectured about their own culture by white professors who are actually ignorant of Indian cultures.

In 1998 Alexie broke barriers by creating the first all-Indian movie, Smoke Signals. Alexie based the screenplay on his short story collection, The Lone Ranger and Tonto Fistfight in Heaven, and characters and events from a number of Alexie's works make appearances in the film. Smoke Signals was directed by Chris Eyre, a Cheyenne-Arapaho Indian filmmaker, and the entire production team and cast is Native American. The film tells the story of two young Indians, Victor Joseph (Adam Beach) and Thomas Builds the Fire (Evan Adams), who leave the reservation on a road trip to retrieve the body of Victor's dead father (Gary Farmer). During their journey the characters' childhood is explored via flashbacks. The film took top honors at the Sundance Film Festival. It received an 86% and "fresh" rating from the online film database Rotten Tomatoes.

The Business of Fancydancing, written and directed by Alexie in 2002, explores themes of Indian identity, cultural involvement vs blood quantum, living on the reservation or off it, and other issues around makes someone a "real Indian." The title refers to the protagonist's choice to leave the reservation and make his living performing for predominantly-white audiences. Evan Adams, who plays Thomas Builds the Fire in "Smoke Signals", again stars, now as an urban gay man with a white partner. The death of a peer brings the protagonist home to the reservation, where he reunites with his friends from his childhood and youth. The film is unique in that Alexie hired an almost completely female crew to produce the film. Many of the actors improvised their dialogue, based on real events in their lives.

Ten Little Indians (2004) is a collection of "nine extraordinary short stories set in and around the Seattle area, featuring Spokane Indians from all walks of urban life," according to Christine C. Menefee of the School Library Journal. In this collection, Alexie "challenges stereotypes that whites have of Native Americans and at the same time shows the Native American characters coming to terms with their own identities."

In 2005, Alexie became a founding board member of Longhouse Media, a non-profit organization that is committed to teaching filmmaking skills to Native American youth and using media for cultural expression and social change. Alexie has long supported youth programs and initiatives dedicated to supporting at-risk Native youth.

Flight (2007) also features an adolescent protagonist. The narrator, who calls himself "Zits," is a fifteen-year-old orphan of mixed Native and European ancestry who has bounced around the foster system in Seattle. The novel centers around experiences of the past, as Zits experiences short windows into others' lives after he is shot while committing a crime.

War Dances is a collection of short stories, poems, and short works. It won the 2010 PEN/Faulkner Award for Fiction. The collection, however, received mixed reviews.

In 2012, Arizona's HB 2281 removed Alexie's works, along with those of others, from Arizona school curriculum. Alexie's response:

Alexie is the guest Editor of the 2015 Best American Poetry.

Alexie's memoir, You Don't Have to Say You Love Me, was released by Hachette in June 2017. Claudia Rowe of The Seattle Times wrote in June 2017 that the memoir "pulls readers so deeply into the author’s youth on the Spokane Indian Reservation that most will forget all about facile comparisons and simply surrender to Alexie’s unmistakable patois of humor and profanity, history and pathos." Alexie cancelled his book tour in support of You Don't Have to Say You Love Me in July 2017 due to the emotional toll that promoting the book was taking. In September 2017, he decided to resume the tour, with some significant changes. As he related to Laurie Hertzel of The Star Tribune, “I’m not performing the book,” he said. “I’m getting interviewed. That’s a whole different thing.” He went on to add that he won’t be answering any questions that he doesn’t want to answer. “I’ll put my armor back on,” he said.

On February 28, 2018, Alexie published a statement regarding accusations of sexual harassment against him by several women, including author Litsa Dremousis with whom he'd had a consensual affair in the past and who claimed numerous women had spoken to her about Alexie's behavior. Ms. Dremousis' response initially appeared on her Facebook page and was subsequently reprinted in The Stranger for March 1, 2018. The fallout from these accusations includes the Institute of American Indian Arts renaming its Sherman Alexie Scholarship as the MFA Alumni Scholarship. The blog Native Americans in Children's Literature has deleted or modified all references to Alexie. In February 2018 it was reported that the American Library Association, which had just awarded Alexie its Carnegie Medal for You Don't Have to Say You Love Me: A Memoir, was reconsidering, and in March it was confirmed that Alexie had declined the award and was postponing the publication of a paperback version of the memoir The American Indian Library Association rescinded its 2008 Best Young Adult Book Award from Mr. Alexie for The Absolute True Diary of a Part Time Indian sending the message that his actions are unacceptable.

Alexie’s writings are meant to evoke sadness, but at the same time, he uses humor and pop culture that leave the readers with a sense of respect, understanding, and compassion. Alexie’s influences for his literary works do not rely solely on traditional Indian forms. He "blends elements of popular culture, Indian spirituality, and the drudgery of poverty-ridden reservation life to create his characters and the world they inhabit," according to Quirk. Alexie's work is laced with often startling humor. According to Quirk, he does this as a "means of cultural survival for American Indians—survival in the face of the larger American culture's stereotypes of American Indians and their concomitant distillation of individual tribal characteristics into one pan-Indian consciousness."