She was born at Château St Leonard, Boulogne, France to expatriate English parents. She was the half-sister of Eugene Lee-Hamilton, adapting her pseudonym from his surname. Although she primarily wrote for an English audience and made many visits to London, she spent the majority of her life on the continent, particularly in Italy. Her longest residence was on the hillside just outside of Florence, in the Palmerino villa, from 1889 until her death, with a brief interruption during the war. Her library was left to the British Institute of Florence and can still be inspected by visitors. In Florence she knit lasting friendships with the painter Telemaco Signorini and the learned Mario Praz, and she encouraged his love of learning and English literature. An engaged feminist, she always dressed á la garçonne, and was a member of the Union of Democratic Control. She was also a lesbian, and had long-term passionate friendships with two women, Mary Robinson and Kit Anstruther-Thomson.

She played the harpsichord well, and her appreciation of music animates her first major work, Studies of the Eighteenth Century in Italy (1880). In her preface to the second edition of 1907, she recalled her excitement as a girl when she came across a bundle of eighteenth-century music. She was so nervous that it wouldn't live up to her expectations that she escaped to the garden and listened rapturously through an open window as her mother worked out the music on the piano. Along with Pater and John Addington Symonds, she was considered an authority on the Italian Renaissance, and wrote two works that dealt with it explicitly, Euphorion (1884) and Renaissance Fancies and Studies (1895).

Her short fiction explored the themes of haunting and possession. The English writer and translator Montague Summers described Vernon Lee as "the greatest [...] of modern exponents of the supernatural in fiction." The most famous were collected in Hauntings (1890) and her story "Prince Alberic and the Snake Lady" (1895) was first printed in the notorious Yellow Book.

She was responsible for introducing the German concept of Einfühlung, or empathy into the study of aesthetics in England. She developed her own theory of psychological aesthetics in collaboration with her lover, Kit Anstruther-Thomson, based on previous work by William James, Theodor Lipps, and Karl Groos. She claimed that spectators "empathize" with works of art when they call up memories and associations and cause often unconscious bodily changes in posture and breathing.

She was also well known for her numerous essays about travel in Italy, France, Germany, and Switzerland which attempted to capture the psychological effects of places rather than to convey any particular piece of information. "The Lie of the Land", in the volume "Limbo, and other Essays", had an influence on the study of landscaping.

Like her friend and colleague Henry James, she wrote critically about the relationship between writers and their audience, pioneering the idea of critical assessment among all the arts as relating to an audience's personal response. She was a strong, though vexed, proponent of the Aesthetic movement, and after a lengthy written correspondence met the movement's effective leader, Walter Pater, in England in 1881, just after encountering his famous disciple Oscar Wilde. Her interpretation of the movement called for social action, which set her apart from Pater.