In 1935, Indiana Jones (or Indy) narrowly escapes the clutches of Lao Che, a crime boss in Shanghai. With his eleven-year old Chinese sidekick, Short Round (or Shorty), and the nightclub singer, Willie Scott in tow, Indiana flees Shanghai on an airplane that, unknown to them, is owned by Lao. The pilots leave the plane to crash over the Himalayas, but the trio narrowly manage to escape on an inflatable boat and ride down the slopes into a raging river.
They come to Mayapore, a desolate village in northern India, where the poor villagers believe them to have been sent by the Hindu god Shiva and enlist their help to retrieve the sacred Sivalinga stone stolen from their shrine, as well as the community's children, from evil forces in the nearby Pankot Palace. During the journey to Pankot, Indy hypothesizes that the stone may be one of the five fabled Sankara stones that promise fortune and glory.
The trio receive a warm welcome from the residents of Pankot Palace (which includes the young Maharajah Zalim Singh and his representative, Pankot Palace Prime Minister Chattar Lal) and are allowed to stay the night as their guests, during which they attend a lavish banquet attended by the Maharajah. The palace rebuffs Indy's questions about the villagers' claims and his theory that the ancient Thuggee cult is responsible for their troubles. Later that night, Indy is attacked by an assassin, leading Indy, Willie, and Shorty to believe that something is amiss. They discover a series of tunnels hidden behind a statue in Willie's room and set out to explore them, overcoming a number of booby-trapped rooms along the way.
The trio eventually reach an underground temple where the Thuggee worship the Hindu goddess Kali with human sacrifice. They discover that the Thuggee, led by their evil, bloodthirsty high priest Mola Ram, are in possession of three of the five Sankara stones, and have enslaved the children (as well as the Maharajah) to mine for the final two stones, which they hope will allow them to rule the world. As Indy tries to retrieve the stones, he, Willie, and Shorty are captured and separated. Indy is whipped and forced to drink a potion called the "Blood of Kali", which places him in a trance-like state called the "Black Sleep of Kali Ma". As a result, he begins to mindlessly serve Mola.
Willie, meanwhile, is kept as a human sacrifice, while Shorty is put in the mines to labour alongside the enslaved children. Shorty breaks free and escapes back into the temple where he burns Indy with a torch, shocking him out of the trance. The Maharajah, who was also forcibly entranced by the "Blood of Kali", attempts to sabotage Indy with a voodoo doll. Shorty spars with the Maharajah, ultimately burning him to snap him out of the trance. The Maharajah then tells Short Round how to get out of the mines. While Mola escapes, Indy and Shorty rescue Willie, retrieve the three Sankara stones, and free the village children.
After a mine cart chase to escape the temple, the trio emerge above ground and are again cornered by Mola and his henchmen on a jungle canyon rope bridge on both ends over a gorge with crocodile-infested river flowing within. Using a sword stolen from one of the Thuggee warriors, Indy cuts the rope bridge in half, leaving everyone to hang on for their lives. Indy invokes an incantation to Shiva for Mola misusing his power, causing the stones to glow red hot. Two of the stones fall into the river, while the last falls into and burns Mola's hand. Indy catches the now-cool stone, while Mola falls into the river below, where he is devoured by crocodiles.
The Thuggee across then attempt to shoot Indiana with arrows, until a company of British Indian Army riflemen from Pankot arrive, having been summoned by the palace maharajah. In the ensuing firefight, over half of the Thuggee archers are killed and the remainder are surrounded and captured. Indy, Willie, and Shorty return victoriously to the village with the missing Sivalinga stone and the children. Indy states that it is still a long way to where they were originally going, and when Willie attempts to leave, Indy pulls her back and they share a kiss.