Born at Mårbacka (now in Sunne Municipality) an estate in Värmland in western Sweden, Lagerlöf was the daughter of Lieutenant Erik Gustaf Lagerlöf and Louise Lagerlöf née Wallroth. The couple's fourth child, she was born with a hip injury. An early sickness left her lame in both legs, although she later recovered. She was a quiet child, more serious than others her age, with a deep love of reading. The sale of Mårbacka following her father's illness in 1884 had a deep impact on her development.

Lagerlöf worked as a country schoolteacher in Landskrona for nearly 10 years while honing her story telling skills, with particular focus on the legends she had learned as a child. Through her studies at the Royal Women's Superior Training Academy in Stockholm, Lagerlöf reacted against the realism of contemporary Swedish language writers such as August Strindberg. She began her first novel, Gösta Berling's Saga, while working as a teacher in Landskrona. Her first break as a writer came when she submitted the first chapters to a literary contest, and won a publishing contract for the whole book. She received financial support from Fredrika Limnell, who wished to enable her to concentrate on her writing.

In 1894 she met Sophie Elkan, also a writer, who became her friend and companion, and, judging from the letters between them that survive, with whom she fell deeply in love. Over many years, Elkan and Lagerlöf critiqued each other's work. Lagerlöf wrote of Elkan's strong influence on her work, often disagreeing sharply with the direction Lagerlöf wanted to take in her books.

By 1895, she gave up her teaching to devote herself to her writing. She and Elkan, with the help of proceeds from Gösta Berlings Saga and a scholarship and grant, traveled to Italy. There, a legend of a Christ Child figure that had been replaced with a false version inspired Lagerlöf's novel, Antikrists mirakler, where she explored the interplay between Christian and socialist moral systems.

She moved in 1897 to Falun, and there met Valborg Olander, who became her literary assistant, friend, and associate. Elkan's jealousy of Olander was a complication in the relationship. Olander, a teacher, was also active in the growing woman suffrage movement in Sweden.

In 1900, Lagerlof visited the American Colony in Jerusalem, which became the inspiration for her book by that name.

Most of her stories were set in Värmland, though a trip through continental Europe inspired such works as her The Miracles of the Antichrist, set in Sicily.

Many of Lagerlöf's works have been adapted to cinema. Already during the 'Golden Age' of Swedish silent cinema her works were used in film by Victor Sjöström, Mauritz Stiller and other Swedish cinema pioneers. Sjöström's retelling of Lagerlöf's tales about rural Swedish life, in which his camera recorded the detail of traditional village life and the Swedish landscape, provided the basis of some of the most poetic and memorable products of early silent cinema. Jerusalem was adapted in 1996 into an internationally acclaimed motion picture.

In 1909 Selma Lagerlöf won the Nobel Prize "in appreciation of the lofty idealism, vivid imagination and spiritual perception that characterize her writings". But the decision was preceded by harsh internal power struggle within the Swedish Academy. In 1914 she also became a member of the Swedish Academy, the body that awards the Nobel Prize in literature. At the start of World War II, she sent her Nobel Prize medal and gold medal from the Swedish Academy to the government of Finland to help raise money to fight the Soviet Union. The Finnish government was so touched that it raised the necessary money by other means and returned her medal to her. In 1928, she received an honorary doctorate from the University of Greifswald's Faculty of Arts.

Two hotels are named after her in Östra Ämtervik in Sunne, and her home, Mårbacka, is preserved as a museum. Since 1992, her portrait has been featured on the Swedish 20 krona banknote.