Madsen was born in Chicago, Illinois, the daughter of Elaine (née Melson), an Emmy-winning poet, producer and playwright who often works for PBS, and Calvin Madsen, a fireman. Madsen's mother left a career in corporate business to pursue a writing career. Madsen's brother is actor Michael Madsen. Her paternal grandparents were Danish and her mother has Irish and Native American ancestry. Madsen is a graduate of New Trier High School in Winnetka, Illinois.

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 -- a key role in one version, greatly diminished in another -- 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. As beauty queen Dixie Lee Boxx, she was the sexy romantic interest of minor-league baseball manager Cecil "Stud" Cantrell (William Petersen in the made-for-cable Long Gone (1987). A couple of provocative film appearances followed: 1990's The Hot Spot with Don Johnson directed by Dennis Hopper, and the equally steamy Third Degree Burn with Treat Williams. She was also co-host of the TV series Unsolved Mysteries in 1999, the show's final season on CBS.

Madsen turned in a solid performance in a small but key role in the Francis Ford Coppoladrama The Rainmaker (1997) starring Matt Damon. Film critic Roger Ebert said that Madsen had a "strong scene", while reviewer James Berardinelli noted that "the supporting cast is solid, with turns from... Virginia Madsen as a witness for the plaintiff". Madsen had spent more than twenty years in minor films before her breakout critically acclaimed performance in Sideways (2004). The role catapulted her onto the fabled Hollywood A-list. Her first major role after Sideways was opposite Harrison Fordin Firewall. She later appeared in Robert Altman's A Prairie Home Companion, in a key role as the angel. She co-starred with Jim Carrey in The Number 23 and Billy Bob Thorntonin The Astronaut Farmer; both films opened in North America on February 23, 2007.

Madsen has made numerous television appearances including: Star Trek: Voyager, CSI: Miami, Dawson's Creek, The Practice, Frasier, Moonlighting, and other series. She starred opposite Ray Liotta in CBS's short-lived crime drama Smith.

When Madsen arrived in Hollywood, she was engaged to actor Billy Campbell. She married actor Danny Huston in 1989 and they divorced in 1992. Madsen also had a relationship with actor Antonio Sabato Jr. with whom she had a son, Jack, in 1994. Her brother is actor Michael Madsen. Madsen has Heterochromia, a genetic trait resulting in different pigmentation of the eyes. Madsen has one green eye, and one half-green, half-brown eye.