Madsen was born in Chicago, Illinois to Cal Madsen, a Danish American, and Elaine, who is of Irish and Native American descent. Her brother is actor Michael Madsen. She is a graduate of New Trier High School.

Audiences first caught a glimpse of Madsen in a bit part she landed as Lisa in the teen sex comedy Class. She was cast as Princess Irulan in David Lynch's science fiction epic Dune (1984). Madsen first became popular with audiences in 1986 with her portrayal of a Catholic schoolgirl who fell in love with a boy from a prison camp in Duncan Gibbons's Fire with Fire. Other noted film appearances include 1990's The Hot Spot with Don Johnson, and the steamy Third Degree Burn with Treat Williams.

After more than twenty years, her breakout critically acclaimed performance in Sideways (2004), which garnered her Academy Award and Golden Globe nominations as well as a Broadcast Film Critics Award win for Best Supporting Actress. This role catapulted her onto the fabled Hollywood A-list. Her first major role after Sideways was opposite Harrison Ford in Firewall. She later appeared in Robert Altman's A Prairie Home Companion appearing in a key role as the angel. She also accepted a role opposite Jim Carrey in The Number 23 (scheduled for release in 2007).

She currently stars opposite Ray Liotta in CBS's new crime drama Smith, which airs Tuesday evenings.

Madsen's older brother is Michael Madsen, who is also an actor (and who has stated he refuses to see any films in which she has a nude scene). Her mother, Elaine Madsen, is an Emmy-winning writer and producer.