Hannah was born in Chicago, Illinois, the daughter of Susan Wexler, a producer, and Don Hannah, a tugboat and barge company owner. Her parents divorced shortly after her birth and her mother subsequently married Jerrold Wexler, a businessman and brother of Haskell Wexler, a cinematographer. She grew up with siblings Don and Page Hannah, as well as half-sister Tanya Wexler, in Long Grove, Illinois.

Hannah is missing part of her left index finger, having lost it in an accident at age three.

Hannah became interested in movies at a young age, partly due to insomnia. She was very shy and diagnosed as borderline autistic. Hannah attended the progressive Francis W. Parker School (where she played on the soccer team) before enrolling at the University of Southern California.

Hannah made her film debut in 1978 with a brief appearance in Brian De Palma's horror film The Fury. She turned down many roles early on in her career, including the role of Emmeline Lestrange for The Blue Lagoon (that ultimately went to Brooke Shields). Her first notable role came as the acrobatic and violent replicant Pris in Ridley Scott's 1982 science fiction classic Blade Runner, in which she performed some of her own gymnastic stunts. That same year she appeared in the summer hit release Summer Lovers. She then was cast as a blonde mermaid in Ron Howard's 1984 fantasy Splash, which starred Tom Hanks and was a major financial success, establishing Hannah as a high-profile film actress.

Hannah's successes in the remainder of the 1980s ranged from Steel Magnolias and the Academy Award-winning Wall Street (for which she received her Razzie Award) to the 1986 film version of the best-seller The Clan of the Cave Bear. Also in 1986 Hannah co-starred with Robert Redford and Debra Winger in Legal Eagles. She starred in the title role of Fred Schepisi's 1987 film Roxanne, a modern retelling of Edmond Rostand's play Cyrano de Bergerac, a performance which was described as "sweet" and "gentle" by film critic Roger Ebert.

She also appeared in The Pope of Greenwich Village with co-stars Mickey Rourke and Eric Roberts and played the daughter of Jack Lemmon's character in both of the Grumpy Old Men comedies. In 1995, Hannah was chosen by Empire magazine as #96 of the "100 Manliest Stars in Film History." That year she appeared as homicidal sociopath Leann Netherwood in The Tie That Binds.

Of her most recent roles, the most memorable may be that of the one-eyed assassin Elle Driver in Kill Bill, directed by Quentin Tarantino. Her performance in this film, as well as her appearances in Speedway Junky, Northfork, Michael Radford's Dancing at the Blue Iguana, John Sayles' Casa de los Babys and Silver City, have been described by some as a comeback.

Hannah wrote, directed and produced a short film, "The Last Supper", which won an award at the Berlin Film Festival. She directed, produced and was cinematographer for the documentary Strip Notes. It aired on Channel 4 in the UK and on HBO and was about the research Hannah did for her role as a stripper in Dancing at the Blue Iguana. Hannah currently has several projects in post-production, including Shannon's Rainbow and A Closed Book.

She appeared in Robbie Williams' video for the song "Feel", portraying Williams' love interest.

Hannah's career has veered away from acting and towards board games over the last several years. In February 2010 she released her second board game called Liebrary, a board game she conceived 10 years earlier. It is a party game for three to six players, ages 12 and up in which players listen to the title and a synopsis of a real book, then write down what they think the first line to that book could be. Points are earned when other players believe that a made up first line is the true one.