Donaghy was born into an Irish family and grew up in the Bronx, New York, losing both parents in early life. He studied at Fordham University and did postgraduate work at the University of Chicago, where, at 25, he edited the Chicago Review. Donaghy commented “I owe everything I know about poetry to the public library system (in New York City) and not to my miseducation at university [...] I mean, the Bronx, who knows, now it may be full of cappuccino bars and bookshops, but back in those days it wasn’t. My parents would say something like ‘go out and play in the burning wreckage until dinnertime’ and I’d make a beeline for the library.” He founded the acclaimed Irish music ensemble, Samradh Music and played the tin whistle, the bodhran and was a flute player of distinction, music echoing in the themes and forms of his writing.

In 1985, he moved to the Green Lanes area of Harringay, north London to join his partner and fellow musician, Maddy Paxman, whom he married in 2003; their son, Ruairi, was born in 1996. He joined the London poetry workshop, founded by the Belfast poet Robert Greacen and later chaired by Matthew Sweeney, whose members included Vicki Feaver, Ruth Padel, Jo Shapcott, Maurice Riordan, Eva Salzman and Don Paterson. Rapidly establishing himself on the poetry scene, he published his first full collection, Shibboleth, in 1988 which won the National Poetry Competition. Errata followed in 1993, and Conjure in 2000. Recognition came in the form of the Geoffrey Faber and Cholmondeley awards and the Whitbread and Forward prizes, among others. In 2003, he teamed up with Cyborg scientist Kevin Warwick and wrote Grimoire. He continued to play in various Irish music groups, as well as the early line-up of Lammas, the jazz/traditional crossover band led by Tim Garland and poet Don Paterson. He was a creative writing tutor for the Arvon Foundation and the Poetry Society and later ran an extension course for City University London. He wrote and reviewed for Poetry Review, Poetry, The New Yorker and The Times Literary Supplement. His poetry, influential to a younger generation of poets, is noted for for its metaphysical elegance and playfulness, and his skillful use of form.

He died suddenly of a brain haemorrhage on September 17, 2004. David Wheatley wrote in The Guardian "The death of Michael Donaghy in 2004 at the age of 50 has been one of the most deeply felt losses to the poetry world in recent years. Not since Sylvia Plath almost half a century ago had an American poet living in Britain so decisively entered the bloodstream of his times." The London Times described him as "one of the most widely respected figures on the British poetry scene and a fierce defender of poetry as a source of pleasure and truth." His forth collection Safest was published postumously in 2005 and a prose collection The Shape of the Dance in 2009.