Birth by Sleep begins in the Land of Departure, where three Keyblade wielders and close friends—Terra, Aqua, and Ventus (Ven for short)—train to become Keyblade Masters under Master Eraqus. To achieve this rank, apprentices must take the Master Qualification Exam once they come of age. Terra and Aqua take this test together, but while Aqua passes the test, Terra is deemed unfit to become a Keyblade Master due to the abundant darkness in his heart. Afterward, a group of mysterious creatures called the Unversed begin to surface in other worlds, and another Keyblade Master, Xehanort, disappears without a trace. Terra is sent to destroy the Unversed and find Xehanort, who had earlier encouraged him to embrace the darkness in his heart if he desires the strength to become a Keyblade Master. Ven, meanwhile, is goaded into following Terra by Xehanort's mysterious apprentice Vanitas, against Eraqus's wishes. Aqua is dispatched by Eraqus to survey Terra and keep him from falling into darkness, as well as to bring Ven back to the Land of Departure.

Upon arriving in other worlds, Terra, Aqua, and Ventus encounter various Disney characters, new and old, fighting off hoards of Unversed along the way. Among the characters they meet is Mickey Mouse, apprentice of the sorcerer Yen Sid, who is also on a mission to destroy the Unversed. Terra ends up attracting the attention of several Disney villains, who offer him the whereabouts of Master Xehanort in exchange of assistance for their own dark agendas. Terra reasons that Xehanort is after the seven Princesses of Heart—maidens who lack darkness in their hearts—and encourages Aqua to help them strengthen the light in their hearts, hoping it will draw Xehanort out. However, Aqua and Ven grow increasingly concerned for Terra when they hear rumors of him committing sinister deeds throughout other worlds. The three briefly reunite at Radiant Garden, where Aqua meets Kairi, a young girl containing a strong and pure light in her heart, and helps strengthen her light. Aqua and Ven also confront Terra, who distances himself from them to keep them out of the way of his increasingly dangerous dark powers. Terra and Aqua try to convince Ven to return to the Land of Departure, but he refuses until he is certain Terra won't fall into darkness.

Terra and Aqua eventually find themselves at Destiny Islands where they encounter two young boys, Sora and Riku. Terra sees potential within Riku and deems him worthy of one day wielding the Keyblade, while Aqua senses strong ties with Sora and Riku to Ven and Terra, respectively. Ven, meanwhile, comes across Master Xehanort, who reveals his intentions to use Ven's heart to create a final Keyblade known as the Χ-Blade, something Xehanort says Master Eraqus had known all along. Ven returns to the Land of Departure to confront Eraqus, who tries to erase Ven to prevent Xehanort's plans from succeeding. However, Terra, who had been sent there by Xehanort, misinterprets the situation and attacks Eraqus, teleporting Ven to safety. As soon as Terra realizes his error, Xehanort kills Eraqus and tells Terra to go to the Keyblade Graveyard, leaving the Land of Departure to be consumed by darkness. At Destiny Islands, Ven once again encounters Vanitas and learns of his hazy past: Ventus was once Xehanort's apprentice, but his heart was deemed too frail for Xehanort to use him as he intended, so he extracted the darkness in Ven's heart and used it to create Vanitas. As with Terra before him, Ven is instructed by Vanitas to go to the Keyblade Graveyard. Aqua, in the meantime, learns of Eraqus's death from Yen Sid, who tells her to go to the Keyblade Graveyard as well.

Terra, Aqua, and Ventus gather at the Keyblade Graveyard, where the remains of the mysterious Keyblade War are found. Master Xehanort appears with Vanitas and reveals his plan to use the Χ-Blade to unlock Kingdom Hearts and unleash the forbidden secrets of the Keyblade War onto the various worlds, as well as to use Terra's body as a new vessel for his own heart so that he may survive long enough to see his plans come to fruition. An epic battle ensues, with Xehanort freezing Ven and Vanitas knocking Aqua unconscious. In his rage, Terra unleashes the darkness in his heart, inadvertently allowing Xehanort to unlock his own heart and successfully transfer it into Terra's body. However, Terra's sentiment continues to linger in his discarded suit of armor, which comes to life and defeats Xehanort. Ven, meanwhile, manages to thaw himself before Vanitas can kill Aqua, and discovers his dark counterpart to be the source of all Unversed. Vanitas merges with Ven, possessing him and creating the Χ-Blade. Aqua awakens under Mickey's care, and the two fight the possessed Ventus while he battles Vanitas from within. Aqua shatters the Χ-Blade as Ven destroys Vanitas, though Ven's heart is lost in the process. The destroyed Χ-Blade unleashes a burst of light, which consumes everyone present and scatters them to the corridors of space, save for Terra's armor and sentiment, which remain in the Keyblade Graveyard.

Mickey saves Aqua and Ventus and brings them to Yen Sid's tower, where Aqua learns that Ven has fallen into a deep sleep and will not awaken until his heart returns. Aqua brings Ven back to the ruins of the Land of Departure, where she discovers Master Eraqus's Keyblade and uses it to unlock the Chamber of Waking and create Castle Oblivion from the ruins. After leaving Ven within the chamber, Aqua goes to Radiant Garden where she encounters Xehanort still in Terra's body, but having lost his memories. Aqua then battles Xehanort who attempts to unlock his own heart again. Soon after, Terra's body starts sinking into darkness, but Aqua dives into the darkness and saves Terra from disappearing. She ends up getting trapped in the Realm of Darkness and beginning a journey to return to her friends. Xehanort is discovered by Ansem the Wise, ruler of Radiant Garden, and goes on to become his apprentice. Finally, Ventus's wandering heart finds its way to young Sora, merging with the young boy's heart.