Grace Paley was born as Grace Goodside in the Bronx; her Jewish parents, Isaac and Manya Ridnyik Goodside, had anglicized the family name from Gutseit on immigrating from Ukraine. The family spoke Russian and Yiddish along with English. The youngest of the three Goodside children (sixteen and fourteen years younger than brother and sister Victor and Jeanne, respectively), Paley was a tomboy as a child.

In 1938 and 1939, Paley attended Hunter College, then, briefly New York University, but never received a degree. In the early 1940s, Paley studied with W. H. Auden at the New School for Social Research. Auden's social concern and his heavy use of irony is often cited as an important influence on her early work, particularly her poetry. On June 20, 1942, Grace Goodside married cinematographer Jess Paley, and had two children, Nora (1949-) and Danny (1951-). They later divorced. In 1972 Paley married fellow poet (and author of the Nghsi-Altai series) Robert Nichols.

Paley was known for pacifism and for political activism. She wrote about the complexities of women's and men's lives and advocated for the betterment of life for everyone. She taught at Sarah Lawrence College. In 1980, she was elected to the National Academy of Arts and Letters and in 1989, Governor Mario Cuomo made her the first official New York State Writer. She was the Vermont State Poet Laureate from March 5, 2003 until July 25, 2007. She died at home in Thetford, Vermont at the age of 84 of breast cancer. In a May 2007 interview with Vermont Woman newspaper – one of her last – Paley said of her dreams for her grandchildren: "It would be a world without militarism and racism and greed – and where women don't have to fight for their place in the world."

Paley taught writing at Sarah Lawrence College from 1966 to 1989, and helped to found the Teachers & Writers Collaborative in New York in 1967. She also taught at Columbia University, Syracuse University and the City College of New York. Paley summarized her view of teaching during a symposium on "Educating the Imagination" sponsored by the Teachers & Writers Collaborative in 1996:

"Our idea," Paley said, "was that children—by writing, by putting down words, by reading, by beginning to love literature, by the inventiveness of listening to one another—could begin to understand the world better and to make a better world for themselves. That always seemed to me such a natural idea that I’ve never understood why it took so much aggressiveness and so much time to get it started!"

In the 1950s, Paley joined friends in protesting nuclear proliferation and American militarization. She also worked with the American Friends Service Committee to establish neighborhood peace groups, through which she met her husband Robert Nichols.

With the escalation of the Vietnam War, Paley joined the War Resisters League and came to national prominence as an activist when she accompanied a 1969 peace mission to Hanoi to negotiate the release of prisoners of war. She served as a delegate to the 1974 World Peace Conference in Moscow and in 1978, was arrested as one of "The White House Eleven" for unfurling an anti-nuclear banner (that read "No Nuclear Weapons—No Nuclear Power—USA and USSR") on the White House lawn.

After a number of rejections, Paley published her first collection, The Little Disturbances of Man (1959) with Doubleday. The collection features eleven stories of New York life, several of which have since been widely anthologized, particularly "Goodbye and Good Luck" and "The Used-Boy Raisers." The collection introduces the semi-autobiographical character "Faith Darwin" (in "The Used-Boy Raisers" and "A Subject of Childhood"), who later appears in six stories of Enormous Changes at the Last Minute and ten of Later the Same Day. Though as a story collection by an unknown author, the book was not widely reviewed, those who did review it (including Philip Roth and The New Yorker book page) tended to rate the stories highly. Despite this initial lack of publicity, The Little Disturbances of Man went on to build a sufficient following leading it to be reissued by Viking Press in 1968.

Goodbye and Good Luck was adapted as a musical by Mabel Thomas (book), Muriel Robinson (lyrics) and David Friedman (music) in 1989 and is currently being reworked.

Following the success of Little Disturbances of Man, Paley's publisher encouraged her to write a novel. After several years of tinkering with drafts, Paley abandoned the project and turned back to short fiction. Instead, with the aid of Donald Barthelme, Paley assembled a second collection of fiction in 1974, Enormous Changes at the Last Minute. This collection of seventeen stories features several recurring characters from Little Disturbances of Man (most notably the narrator "Faith," but also including Johnny Raferty and his mother), while continuing Paley's exploration of racial, gender, and class issues. The long story, "Faith in a Tree," positioned roughly at the center of the collection, brings a number of characters and themes from the stories together on a Saturday afternoon at the park. Faith, the narrator, climbs a tree to get a broader perspective on both her neighbors and the "man-wide world," and after encountering several war protesters, declares a new social and political commitment. The collection's shifting narrative voice, metafictive qualities, and fragmented, incomplete plots have led most critics to classify it as a postmodernist work.