The film is set in 1920s China during the warlord era, years before the Chinese Civil War. When the father of 19-year-old Songlian（Gong Li) dies leaving the family bankrupt, they marry her into the wealthy Chen family. Known in the household as the Fourth Mistress, Songlian becomes Chen's fourth wife, or rather third concubine. Upon arrival at the palatial abode, she is at first treated like royalty. She receives sensuous foot massages and brightly-lit red lanterns that herald a visit from her husband, Chen (Ma Jingwu), whose face is never clearly shown.
Songlian soon discovers that not all the concubines in the household receive the same luxurious treatment as her. The master of the house decides daily with which concubine he will spend the night and announces his choice by hanging lit lanterns outside her apartment. Whomever he chooses receives a foot massage, has a choice of select dishes, and is accorded the most attention and respect from the servants. Pitted in constant competition against each other, the three concubines constantly vie for their husband's attention and affections.
The First Mistress, Yuru (Jin Shuyuan), appears almost as old as the master himself. Having decades earlier borne him a son, she seems resigned to live out her life as the wife passed over in favor of the younger concubines. The Second Mistress, Zhuoyun (Cao Cuifen), befriends Songlian, complimenting her on her youth and beauty, and giving her an expensive gift of silk. She warns Songlian about the Third Mistress, Meishan (He Caifei), a former opera singer unable to cope with no longer being the youngest and most favored of the master's playthings. But Songlian soon discovers that it is really Zhuoyun, the Second Mistress, who is not to be trusted, and that there is truth in the description of her as having the face of a Buddha but the heart of a scorpion.
Songlian feigns pregnancy in an attempt to monopolize the master's time and at the same time actually become pregnant. Zhuoyun, however, is in league with Songlian's personal maid, Yan'er (Kong Lin). The maid finds and reveals bloodied undergarments that prove Songlian has recently menstruated and that her pregnancy is a fraud.
Feigning concern for Songlian's so-called pregnancy Zhuoyun summons the family physician Doctor Gao (Cui Zhigang), who is having an affair with Third Mistress Meishan. He examines Songlian and pronounces the pregnancy a sham. Infuriated, Master Chen orders that Songlian's lanterns be encased indefinitely in thick black canvas bags. Blaming the sequence of events on her maid, Songlian reveals to the house that Yan'er's room is filled with lit red lanterns. This makes explicit the servant’s dreams of rising in status to become mistress of the house. It is suggested earlier that Yan'er is in love with Master Chen, and that she has slept with him in the Fourth Mistress' bed.
Yan'er's punishment is to watch her lanterns burn as she kneels in the snow. In an act of defiance, she refuses to humble herself or apologize and remains kneeling in the snow the whole night until she collapses. Yan'er falls sick and ultimately dies after being taken to hospital. One of the servants tells Songlian that her late maid died with her mistress's name on her lips. Songlian had briefly attended university before the death of her father and her forced marriage. She comes to the conclusion that she is happier in solitude. She realizes that the competition among the concubines is a useless endeavor, because each woman is merely a robe that the master wears and discards on whim.
As Songlian retreats further into solitude, she begins to consider suicide, her reasoning being that dying is a better fate than living as a concubine in the Chen household. On her twentieth birthday, severely intoxicated and despondent over her bitter fate, Songlian inadvertently blurts out what she knows of the affair between Third Mistress Meishan and Doctor Gao. Zhuoyun overhears the information and catches the adulterous couple in the act.  In accordance with old customs and traditions, Meishan is dragged to a lone room on the roof of the estate and hanged to death by the master's servants.
Songlian, already in despair at the aimlessness of her life, witnesses the entire episode and is emotionally traumatized. The following summer, after the master's marriage to yet another concubine, Songlian is shown wandering around the compound in her old schoolgirl clothes, having gone completely insane.