The year is 1980. Somewhere along the beach in Venice, California, Sonny Malone becomes frustrated with the mural he has painted of the nine muses of Greek mythology. After he storms off in frustration, the Muses come to life ("I'm Alive") and Sonny's Muse, Kira (a.k.a. Clio), hatches a plan to inspire Sonny to artistic greatness.

Kira disguises herself as a regular mortal from Australia and arrives at the Santa Monica pier just in time to rescue Sonny. Kira begins her work ("Magic"), and Sonny reveals his dream to open a roller disco.

Inspiring Sonny brings Kira one step closer to being granted the gift of Xanadu. This infuriates sister Muses, Melpomene and Calliope, who hatch a plan to curse Kira so that she falls in love with the mortal Sonny, something that is strictly forbidden ("Evil Woman").

Sonny and Kira meet again in front of a rundown theater and receive a sign that things are coming together to fulfill Sonny's dream ("Suddenly"). Sonny meets with Danny, the owner of the theater, who is not interested in Sonny's plan until Kira enters and reminds him of someone he knew long ago ("Whenever You're Away from Me"). In a flashback, we learn that Kira once came to Danny in the guise of a Southern belle, Kitty, and inspired him to build the old theater.

Melpomene and Calliope hide in the abandoned theater and await the arrival of Kira and Sonny so they can curse them and make them fall in love. Danny and Sonny run into each other at the theater, which is named Xanadu, and share their individual visions for its restoration ("Dancin'"). Danny agrees to give Sonny the theater if he can fix it up by the end of the day. Kira arrives, and they begin planning, providing Melpomene and Calliope with the moment for which they have been waiting ("Strange Magic").

Left with only one hour to restore the theater, the Muses enter and help with the job ("All over the World"). With the theater restored, Danny is back in show business, and Sonny's dreams are coming true. The two of them admire the Xanadu sign while Kira receives a message from Zeus (via Hermes), reminding her of the rules by which she must live. Realizing her feelings, Kira tries to leave, but Sonny begs her to stay ("Don't Walk Away"). Kira gets away, and her evil sisters talk Danny into selling them the theater.

Kira returns to Venice Beach to re-enter the mural, having failed in her quest to inspire Sonny and achieve Xanadu for herself. Confronted by her sisters and Sonny, the truth comes out, and she leaves, flying back to Mount Olympus on the back of Pegasus ("Suspended in Time").

Kira is brought before Zeus, Aprhodite, Thetis and Hera to answer for what she has done. Zeus proclaims his sentence, but the others beg his mercy ("Have You Never Been Mellow"). Zeus pardons Kira, and Sonny arrives at Mount Olympus to profess his love. Zeus decrees that Kira shall return to Earth as a mortal to be with Sonny. He grants her the gift of Xanadu ("Xanadu").