Lee was born in Augsburg, Bavaria, West Germany, the daughter of an artist mother and architect father. She grew up in Boulder, Colorado, United States, where she was a graduate of Fairview High School (class of 1985). After graduating, Lee moved to Pasadena, California where she studied at the American Academy of Dramatic Arts, and later attended the North Carolina School of Arts, the National Theatre Conservatory in Denver, and the University of Colorado. After several years of studying, Lee moved to Seattle, Washington where she acted in several stage plays.
Lee is remembered by legions of David Lynch fans for her appearance as the dead Laura Palmer in the cult television series Twin Peaks. Lynch asked Lee to audition for him after seeing a publicity photo of her in Seattle from one of the plays she was starring in at the time. When the series was picked up, Lee was also given the part of Laura's cousin Maddy Ferguson later in the series (a role which was reportedly written because Lynch, impressed with her abilities, wanted to give her a fuller role on the show). She also starred in the prequel Twin Peaks: Fire Walk with Me, which elaborated on events leading up to Laura Palmer's death.
Other roles have included playing the part of Astrid Kirchherr in the 1994 movie Backbeat, a bio-pic of the early career of The Beatles opposite Stephen Dorff, the part of Liza in Gary Walkow's 1995 adaptation of Fyodor Dostoyevsky's novella Notes from Underground opposite Henry Czerny, the role of Katrina in John Carpenter's 1998 film Vampires opposite James Woods and Daniel Baldwin, and the role of Marlene Cadena in the 2003 television series Kingpin opposite Yancey Arias and Bobby Cannavale. Sheryl Lee also starred alongside Craig Sheffer in Bliss (1997). Lee starred opposite Anthony Michael Hall as the sweet but vengeful housewife Eve Robbins in the 2001 USA Cable movie Hitched.
In 2004, Lee was the original choice for the role of Mary-Alice Young on Desperate Housewives. It would have been the second time she would have played a dead character on a series; however, the producers ultimately chose to replace her with Brenda Strong.
In 2005, she played the recurring part of Ellie Harp, the biological mother of Peyton Sawyer (played by Hilarie Burton), who battles breast cancer, on the third season of the WB Network series One Tree Hill.
In 2001, she presented the I Love 1990 segment of the BBC's popular I Love 1990s series.
On stage, Lee starred on Broadway in 1992 alongside Al Pacino in Oscar Wilde's Salome as the title role, in the Circle in the Square Theatre, under the direction of Robert Allan Ackerman. The play co-starred Suzanne Bertish, Esai Morales and Arnold Vosloo.
Lee, along with several other Twin Peaks cast members, guest starred in a special Twin Peaks themed episode of Psych, Dual Spires. Other cast members reunited with Lee included Sherilyn Fenn (Audrey Horne), Dana Ashbrook (Bobby Briggs), Ray Wise (Leland Palmer), Lenny Von Dohlen (Harold Smith), Robyn Lively (Lana Budding Milford), and Catherine E. Coulson (The Log Lady). This episode marked the first time several Twin Peaks cast members have been reunited on television in almost two decades.
In 2010 she appeared in a supporting role as April in Debra Granik's Winter's Bone (which won best picture at the Sundance Film Festival in 2010). The film is about a seventeen-year-old girl (Jennifer Lawrence) in the rural Ozarks, caring for her mentally-ill mother and her younger brother and sister, when she discovers that her father put their house and land up as a bond for a court appearance, at which he failed to appear. Lee won two Awards for Best Ensemble at Detroit Film Critics Society and Gotham Awards, shared with the cast.