Davis was born in Perth and had a Catholic upbringing. She was educated at Loreto Convent and graduated from the National Institute of Dramatic Art (NIDA) in 1977.

First coming to prominence for her role as Sybylla Melvyn in the coming-of-age saga My Brilliant Career (1979), for which she won BAFTA Awards for Best Actress and Best Newcomer, she also played the lead in such Australian New Wave classics as Winter of Our Dreams (1981) (as the waif-like heroin addict) and Heatwave (1982) (as the radical tenant organizer). Her first foray into international film came in 1981 when she played the younger version of Ingrid Bergman's Golda Meir in the television docudrama A Woman Called Golda. In 1984 she was cast as Adela Quested in David Lean's final film, an adaptation of E.M. Forster's A Passage to India. Although she and Lean reportedly butted heads during the film's production, she was nominated for an Academy Award for Best Actress for her performance. She returned to Australian cinema for her next two films, Kangaroo, in which she displayed a fine affinity for accents as a German-born writer's wife, and High Tide, in which she gave what some critics believe is her finest performance as an alcoholic mother who attempts to reunite with her teenage daughter who is being raised by the paternal grandmother. She earned Australian Film Institute Awards for both roles, and a National Society of Film Critics award for High Tide's brief American theatrical run. In 1990 she played a brief cameo in Woody Allen's Alice. A busy 1991 featured acclaimed supporting roles as an ill-fated Southern ghostwriter in Joel Coen's Barton Fink, which won the Palme d'Or at the Cannes Film Festival and in David Cronenberg's well-received adaptation of the hallucinogenic novel Naked Lunch. She won an Independent Spirit Award for her lively work as mannish authoress George Sand in Impromptu and returned to E.M. Forster territory in Where Angels Fear to Tread. Finally, she earned additional awards and recognition for her performance as real-life World War II heroine Mary Lindell in the CBS Hallmark Hall of Fame presentation One Against the Wind. In 1992 she played a major role in Woody Allen's Husbands and Wives as one half of a divorcing couple. For this performance she earned an array of critics' awards as well as an Oscar and Golden Globe nominations for best supporting actress.

Later memorable Davis roles include the mysterious, schizophrenic mother of a teenager in boarding school in the well-made but little-seen On My Own (1993), the lifelong Australian Communist Party member reacting to the downfall of the Soviet Union in Children of the Revolution (1996), two more Allen films, Deconstructing Harry (1997) and Celebrity (1998), a high-strung White House Chief of Staff in Absolute Power (1997), a touching performance as a supportive mother in Swimming Upstream (2003) and colorful supporting roles in two 2006 films, The Break-Up and Marie-Antoinette.

Much of her recent work has been on television, where she has scooped up an impressive collection of Emmy Award nominations. She won her first Emmy for portraying the woman who gently coaxes rigid militarywoman Glenn Close out of the closet in Serving in Silence: The Margarethe Cammermeyer Story and she picked up subsequent nominations for her repressed Australian outback mother in The Echo of Thunder (1998), her portrayal of Lillian Hellman in Dash and Lilly (1999), her frigid society matron in A Cooler Climate (1999) and her interpretation of Nancy Reagan in the controversial biopic The Reagans (2003). She earned a second Emmy, among many other awards, for her portrayal of Judy Garland in the 2001 television biopic Life with Judy Garland: Me and My Shadows. In July 2006, she received her ninth Emmy nomination for her performance in the TV film A Little Thing Called Murder. In early 2007 she will appear opposite Sam Waterston in an episode of ABC's anthology series Masters of Science Fiction, directed by Mark Rydell.

Her stage work has been limited, and mostly confined to Australia. In the earliest stages of her career she played Juliet opposite Mel Gibson's Romeo, she also played both Cordelia and the Fool in a 1984 staging of King Lear and her 1986 assumption of the title role in Hedda Gabler was widely admired in Australia. In 2004 she starred in and co-directed Victory, as a Puritan woman determined her locate her husband's dismembered corpse. Internationally, she created the role of The Actress in Terry Johnson's Insignificance at the Royal Court in London and appeared in a brief Los Angeles production of Tom Stoppard's Hapgood in 1989.

[original research?] Davis' unwillingness to move to Hollywood has probably limited her career in some respects, but she is known in the industry as an "actor's actor". Even in her early acting years, Davis rarely appeared in conventional action films—she works best with sophisticated scripts aimed at grown-up audiences, playing against intelligent leading men such as Peter Weller, Sam Neill, Richard Dreyfuss, Geoffrey Rush, and Woody Allen. And Lewis Collins.

She has been married to actor and fellow NIDA graduate Colin Friels since 1984. They have two children, Jack and Charlotte.