Poundstone's family moved to Sudbury, Massachusetts when she was young (some sources incorrectly state Poundstone was born in Sudbury). Poundstone was placed in foster care in the 1970s, an experience which later led her to become a foster mother to several children.

Poundstone dropped out of high school to pursue a show business career. She worked as a stand-up comedian in Boston for a few years and then relocated to California. In 1984, Poundstone was cast in the movie Hyperspace but she did not follow through on a potential acting career. Instead she became better known as a comedian and began appearing on several talk shows. In 1989, she won the American Comedy Award for "Best Female Stand-Up Comic". In 1990, she wrote and starred in an HBO special Cats, Cops and Stuff and subsequently won a CableACE Award for the show. She worked as a political correspondent for the Tonight Show during the 1992 Presidential campaign and did the same for The Rosie O'Donnell Show in 1996. In 1993, Poundstone won a second Cable Ace Award, began writing a regular column "Hey, Paula!" for Mother Jones magazine (which lasted five years), and had a variety show The Paula Poundstone Show on ABC (which lasted only two episodes). She was a regular panelist for the game shows Hollywood Squares and To Tell the Truth.

Poundstone became a foster mother in 1993. In 1997, she adopted two children, and later a third.

On June 6, 2000, Poundstone, apparently drunk, drove her children to an ice cream parlor. Her behavior at the store was reported to the police. She later admitted she had been drinking at the time and checked herself into the Promises rehabilitation center on June 13. On June 27, she was arrested for one count of child endangerment (for driving her children while intoxicated) and three counts of committing a lewd act on a child under the age of 14. Poundstone pleaded no contest to the endangerment charge on September 12. The lewd acts charges were all dropped before her hearing and Poundstone has stated she was innocent of these charges. A judge issued an order prohibiting everyone involved in the incident from discussing any details of it. One tabloid newspaper has reported the charges derived from one of Poundstone's foster children making a false accusation against her after an argument. As a result of the case, Poundstone was placed on five years probation, was required to spend 180 days in rehabilitation, and was barred from acting as a foster mother. Poundstone was allowed supervised visits to her own children after December 5, 2001 and they were returned to her custody in late 2002.

Poundstone's career was slowed by the incident but she still continues to perform her stand-up act. She voiced Paula Small on the first five episodes of Home Movies. Also, she is currently a regular panelist on Wait Wait... Don't Tell Me!, a radio game show produced by NPR.

There have been numerous speculations about Poundstone's sexual orientation. She has a large gay and lesbian fanbase and many fans assume she is a lesbian. However, Poundstone has never publicly stated whether she is gay or straight and usually deflects questions on this issue by stating she is not currently dating anyone, male or female.

She is number 88 on Comedy Central's list of the 100 greatest standups of all time.