Three former classmates from Oxford University are having drinks and reminiscing about a mutual friend, "Glory Conway." Conway had been a gifted student and athlete in college but never lived up to his promise. Rutherford says that Conway disappeared along with three other passengers in an airplane that was evacuating them from the war in Baskul to Peshawar. The airplane mysteriously vanished, and no one has heard of it or its passengers for months.

Rutherford says he came across Conway in a Roman Catholic hospital in Chung-Kiang. The two traveled together on a ship to Honolulu, but Conway left the ship suddenly. Rutherford has a manuscript that Conway dictated to him, which tells this story: Conway is one of four passengers being evacuated. The others are Roberta Brinklow, a missionary; Henry D. Barnard, an American oilman; and Captain Charles Mallinson, a British vice-consul. A night passes on the plane, and it comes to a bad landing to refuel. Mallinson notices that the plane is traveling in the wrong direction. He wants to "jump" the pilot, but the pilot is armed and they are not. They travel over a mountain range that seems as high as the ones near Mount Everest and land in a remote frontier. Conway believes they are somewhere in an unexplored region of Tibet.

The pilot dies in the landing. The four passengers survive. A group of natives lead them to a local settlement called Shangri-La. The leader of the natives, an elderly Chinese man riding in a sedan chair, becomes the passengers' guide. Shangri-La boasts a lamasery near a perfectly shaped mountain called Blue Moon. In the valley below is a settlement of people. The passengers stay in the colorful pavilions of the lamasery and speak with Chang over fine foods. They are amazed that Shangri-La has modern amenities like porcelain bathtubs. Chang explains that porters come in and out of Shangri-La with these goods. When the next porters come in a month, the four passengers may leave with them.

The four visitors enjoy the immense library, the beautiful gardens and the music of Shangri-La, with one exception. Mallinson wants to leave as soon as possible and considers himself to be kidnapped. Chang and Conway discuss the philosophy of the lamasery, which is moderation in all things. One should even be moderate in virtues like honesty and chastity. Conway finds himself falling under the spell of the tranquility and peace of Shangri-La. He is losing any sense of passion or ambition.

Meanwhile Mallinson and Barnard wonder where the monks get their money. Miss Brinklow questions their morals and wants to convert them to Christianity. Chang introduces Conway to a beautiful Manchu woman who plays the harpsichord. When Conway falls in love with the woman, Chang says any relationship with her will be only spiritual. Chang knows this from his own experience with her. She is actually very, very old, although she appears to be around twenty years.

The High Lama requests to meet Conway. He gives Conway an elaborate history of Shangri-La, which was founded by a 53-year-old friar named Father Perrault in 1734, who eventually lost contact with the Vatican. The High Lama spends all his days in clairvoyant meditation. He lost any sense of human passion by age one hundred or so. Conway correctly guesses that the High Lama is Father Perrault himself.

Barnard is revealed to be a fugitive from the law. He discovers that the townspeople in the valley are mining gold. He wants to take over the operation and split the money with Conway. He has no desire to leave Shangri-La because he will only get arrested. Miss Brinklow wishes to stay and convert the people to Christianity. That leaves only Mallinson, who is becoming more discontent every day. He is falling in love with the Manchu musician.

In an extraordinary turn of events, the High Lama meets with Conway four more times. He has never before requested a meeting until after a visitor has been in Shangri-La for at least five years, but he considers Conway worthy. At the fifth meeting he asks Conway to take over as High Lama, and then he himself falls dead. Conway finally confides the history of Shangri-La to Mallinson, who considers it all impossible nonsense. No one could live that long. Mallinson, Conway and the Manchu make their way out of Shangri-La and never intend to return.

The story returns to Rutherford and his friends. Rutherford relates his search for Conway, who disappeared on a banana boat to Fiji. He and the narrator are certain that Mallinson died and Conway went back to Shangri-La. One point is that an elderly Chinese woman brought Conway to the hospital. Could this mean that the story of Shangri-La is true?