It is 1980, and chalk artist Sonny Malone is dissatisfied with his sidewalk mural and determines to kill himself. On Mount Olympus, Clio, the youngest and perkiest of the Greek Muses, convinces her six sisters to travel to Venice Beach to inspire Sonny. Zeus's rules require that Muses must always be disguised from mortals. Clio has the idea to wear roller skates, leg warmers, and sport an Australian accent, and the other muses agree. Clio changes her name to something contemporary: "Kira". Quickly and easily inspired, Sonny decides that he can combine all the arts into one spectacular entertainment: a roller disco.


Two of Clio's sisters, Melpomene and Calliope, are jealous that Clio (although the youngest) is the leader of the Muses and that Zeus had promised "Xanadu" to Clio, although no one knows exactly what that entails. So they plot to discredit Clio and cause her banishment by tricking her into breaking one of Zeus's rules: a Muse must not fall in love with a mortal, so they will curse Kira and Sonny to fall in love.


Meanwhile, Sonny finds a good location for the roller disco, a long-abandoned theater in the Fairfax district of Los Angeles called "Xanadu." He visits hard-hearted real estate mogul Danny Maguire in his posh office in downtown Los Angeles and tries to convince him to donate the theater for the roller disco, because it would bring the arts to the Fairfax district and drive up real estate values. But Danny scoffs, even though he had plans to open the theater himself, once upon a time. Danny is eventually convinced and agrees to let Sonny try.

Sonny finds Kira and tells her the good news. It is then that the evil sisters work their curse, and shoots Kira and Sonny with Cupids arrows of love. Kira is soon overwhelmed with guilt over her loving feelings and of having created her own art (a hand-drawn picture) alongside Sonny – both violations of Zeus's restrictions on the Muses.


With the help of some of the muses, Kira and Sonny fix up the old theater, and Danny agrees to go ahead with the opening. Clio realizes that she is falling in love with Sonny and tells him that she must leave. But the evil sisters are not finished. Now they offer Danny piles of money if he will tear down the theater and build condos. Danny can't resist and tells Sonny that the deal is off.  Kira sets off for Mount Olympus to receive her punishment from Zeus for falling in love.

Sonny, realizing he does love Kira, resolves to fight Zeus himself to save her.  He climbs Mount Olympus to meet the gods and learn the true meaning of "Xanadu."