McDiarmid was born in Carnoustie. He became a theatre aficionado when he was five years old, when his father took him to see an act by the name of Tommy Morgan in a theatre located in Dundee. In 2001 he stated, "It sort of fascinated me, and it also scared me. All those lights, all that make-up. I said to myself, 'I don't know what this is, but I want it.'"

However, fearing his father's disapproval, McDiarmid attended the University of St Andrews, where he received an M.A. in psychology. Soon after, he decided to pursue a career in the theatre instead, and took acting training courses at the Royal Scottish Academy of Music and Drama in Glasgow.

In 1968, McDiarmid received a gold medal for his work. This would later prove to be the first of many recognitions given to him for his work in the theatre. McDiarmid claimed he became its recipient "by doing all the boring jobs you have to do when you are young, to eke out an existence."

McDiarmid is renowned for his work in British theatre, having won plaudits as an actor and director from a wide variety of sources. He has starred in a variety of Shakespearean plays, including Hamlet (1972), The Tempest (1974, 2000), Much Ado About Nothing (1976), The Merchant of Venice (1984), and King Lear (2005). While at the Almeida, he directed plays such as Venice Preserv'd (1986) and Hippolytus (1991).

One theatrical performance of note is his portrayal of Harry Hackamore in Sam Shepard's play Seduced. By McDiarmid's own description, Hackamore was a Howard Hughes-type character. To play the part, he was made-up in prosthetics, including a false beard and long fingernails, to resemble Hackamore.

McDiarmid was only 37 at the time, and this convinced George Lucas and Richard Marquand that he could convincingly play a much older character in extreme cinematic close-up, which helped him land the role of Palpatine.

From 1990 until 2001, McDiarmid and Jonathan Kent served as the artistic directors of the Almeida Theatre, located in Islington, London. In 1998 they shared the Special Evening Standard Award for Theatrical Achievement of the Year. Their tenure was marked by a string of highly successful performances involving 'big name' actors usually seen in films such as Kevin Spacey and Ralph Fiennes.

Though McDiarmid believes himself to be first and foremost a stage actor, he is happy to work in a film for the right part. After a minor part in the film Dragonslayer, McDiarmid was cast by George Lucas in Return of the Jedi as Emperor Palpatine, the principal villain.

Sixteen years after appearing in Return of the Jedi, he reprised the role as a younger Senator and Chancellor in the Star Wars prequel films. He attributes the opportunity to reprise his role to having been much younger than his character the first time he played the part.

The prequels had him play two faces to his character; he re-created his diabolical interpretation of Palpatine from Return of the Jedi when playing Darth Sidious, the Chancellor's Sith alter ego, but created an attractive, pleasant, and seductive character in Palpatine's public persona.

While he had previously achieved little recognition for this role, due to the extensive prosthetics used for the character which made him unrecognisable, he received widespread attention and critical acclaim for his expanded role in the prequels.

In the 2004 re-release of The Empire Strikes Back, a brief scene between Darth Vader and a hologram of Emperor Palpatine was updated to have him depicted by McDiarmid (the Emperor was originally voiced by Clive Revill for that scene, and visually depicted by superimposing the eyes of a chimpanzee on the face of an old woman). With this addition to The Empire Strikes Back, McDiarmid has now appeared in every film version in which Palpatine appears.

McDiarmid took an early role as Mickey Hamilton, a killer intent on avenging the death of his wife and child in The Professionals for Granada TV. He played the role of police detective Porfiry Petrovich in the BBC's 2002 TV adaptation of Fyodor Dostoevsky's Crime and Punishment, also starring in an episode of Inspector Morse several years earlier, as murderous conman Hugo DeVries. In 2003 McDiarmid took the role of the Stuart statesman Edward Hyde, in the BBC series Charles II: The Power and The Passion.

In 2005, he portrayed the part of Satan in the 41 part BBC Four radio drama based on John Milton's Paradise Lost, which was subsequently re-broadcast on BBC7. Recently, he played the writer and pioneer of policing, Henry Fielding, in the Channel 4 historical drama series City of Vice.