Madsen was born in Chicago, Illinois, and is of Danish, Irish and Native American descent. She is also an alumna of New Trier High School. She was born in 1961, but her year of birth was erroneously disseminated in the media as 1963.

Audiences first caught a glimpse of Madsen 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 school girl who fell in love with a boy from a prison camp in Duncan Gibbons' 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. There appeared to be a trend (Fire, Hot, Burn) in names.

In 2004 she gave a critically acclaimed performance in Sideways, which garnered her Academy Award and Golden Globe nominations as well as a Broadcast Film Critics Award win for Best Supporting Actress.

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

When Madsen arrived in Hollywood she was engaged to actor Billy Campbell. She was married to Danny Huston from 1989 to 1992. She later had a relationship with actor Antonio Sabato Jr., which in 1994 produced a son, Jack.