Sheedy was born in New York City and has two siblings, Patrick and Meghan. Her mother, Charlotte (née Baum), was a writer and press agent who was involved in women's and civil rights movements, and her father, John J. Sheedy, Jr., was a Manhattan-based advertising executive. Ally Sheedy's mother was Jewish and her father was of Irish Catholic descent. Her parents divorced in 1971.

Sheedy attended Columbia Grammar and Preparatory School in New York City, graduating in 1980. She started dancing with the American Ballet Theatre at age six and was planning to make it a full-time career. However, she gave up dance in favor of acting full-time. At 12-years-old, she wrote a children's book, She Was Nice to Mice; the book was published by McGraw-Hill and became a best-seller.[citation needed] On June 19, 1975, she appeared on the game show, To Tell the Truth,[citation needed] in her role as young writer.

Sheedy started acting in local stage productions as a teenager. After appearing in several made-for-television films in 1981, as well as three episodes of the television series Hill Street Blues, she made her feature film debut in Bad Boys (1983), starring Sean Penn, where she played the humiliated rape victim girlfriend of Penn's character. The 1980s were her most active period, with roles in popular films such as WarGames, The Breakfast Club, St. Elmo's Fire, Short Circuit, and Maid to Order.

Throughout most of the 1990s, Sheedy appeared in a number of television films. Her most notable film performance during this time was in High Art, a well-reviewed independent film released in 1998 about a torrid romance between two women. She identified with the character of photographer "Lucy Berliner" so much that she flew, at her own expense, to participate in an audition and has said that this character is the closest one to herself she has played. Her performance in High Art was recognized with awards from the Independent Spirit Awards, Los Angeles Film Critics Association, and the National Society of Film Critics.

In 1999, Sheedy took over the lead role in the off-Broadway production of Hedwig and the Angry Inch. She was the first female to play the part of the German transsexual "Hedwig," but her run ended early amid bad reviews.

She was reunited with Breakfast Club co-star Anthony Michael Hall when she became a special guest star on his television show The Dead Zone, in the second-season episode "Playing God," from 2003.

Sheedy has also appeared in the episode ""Leapin' Lizards" of C.S.I. in which she played a woman who murdered her boyfriend's wife while mixed up in a cult. On March 3, 2008, Sheedy was introduced as the character Sarah, in the ABC Family show Kyle XY. In 2009 she played the role of Mr. Yang on the USA tv show Psych, a role that she reprised in the March 2010 Season 4 Finale.

On April 12, 1992, Sheedy married actor David Lansbury, the nephew of actress Angela Lansbury and son of Edgar Lansbury, the producer of the original production of Godspell. The couple has a daughter, Rebecca, born in 1994. In May 2008, it was announced that Sheedy had filed for divorce.

In 1985, Sheedy was admitted to Hazelden Foundation and in the 1990s was treated for a sleeping pill addiction, an experience on which she drew for her role as a drug-addicted photographer in, High Art.