The narrator inexplicably finds himself in a grim and joyless city, the "grey town", which is either Hell or Purgatory depending on how long one stays there. He eventually finds a bus for those who desire an excursion to some other place (and which eventually turns out to be the foothills of Heaven). He enters the bus and converses with his fellow passengers as they travel. When the bus reaches its destination, the passengers on the bus— including the narrator — are gradually revealed to be ghosts. Although the country is the most beautiful they have ever seen, every feature of the landscape (including streams of water and blades of grass) is unyieldingly solid compared to themselves: it causes them immense pain to walk on thegrass, and even a single leaf is far too heavy for any to lift.
Shining figures, men and women whom they have known on Earth, come to meet them, and to urge them to repent and enter Heaven proper. They promise that as the ghosts travel onward and upward, they will become more solid and thus feel less and less discomfort. These figures, called "spirits" to distinguish them from the ghosts, offer to assist them in the journey toward the mountains and the sunrise.
Almost all of the ghosts choose to return instead to the grey town, giving various reasons and excuses. Much of the interest of the book lies in the recognition it awakens of the plausibility and familiarity, along with the thinness and self-deception, of the excuses that the ghosts refuse to abandon, even though to do so would bring them to "reality" and "joy forevermore". An artist refuses, arguing that he must preserve the reputation of his school of painting; a bitter cynic predicts that Heaven is a trick; a bully ("Big Man") is offended that people he believes beneath him are there; a nagging wife is angry that she will not be allowed to dominate her husband in Heaven. One man corrupted on Earth by lust, which takes the form of an ugly lizard, permits an angel to kill the lizard and is saved.
The narrator is met by the writer George MacDonald, whom he hails as his mentor, just as Dante did when encountering Virgil in the Divine Comedy ; and MacDonald becomes the narrator's guide in his journey, just as Virgil became Dante's. MacDonald explains that it is possible for a soul to choose to remain in Heaven despite having been in the grey town; for such souls, the goodness of Heaven will work backwards into their lives, turning even their worst sorrows into joy, and changing their experience on Earth to an extension of Heaven. Conversely, the evil of Hell works so that if a soul remains in, or returns to, the grey town, even its happiness on Earth will lose its meaning, and its experience on Earth would have been Hell. Few of the ghosts realize that the grey town is, in fact, Hell. Indeed, it is not that much different from the life they led on Earth: joyless, friendless and uncomfortable. It just goes on forever, and gets worse and worse, with some characters whispering their fear of the "night" that is eventually to come.
According to MacDonald, while it is possible to leave Hell and enter Heaven, doing so implies turning away (repentance); or as depicted by Lewis, embracing ultimate and unceasing joy itself.
In answer to the narrator's question, MacDonald confirms that what is going on is a dream. The use of chess imagery as well as the correspondence of dream elements to elements in the narrator's waking life is reminiscent of Alice's Adventures in Wonderland and Through the Looking-Glass .
The narrator discovers that the vast grey town and its ghostly inhabitants are minuscule to the point of being invisible compared with the immensity of Heaven and reality. This is illustrated in the encounter of the blessed woman and her husband: she is surrounded by gleaming attendants while he shrinks down to invisibility as he uses a collared tragedian— representative of his self-punishing emotional blackmail of others — to speak for him.
Toward the end, the narrator expresses the terror and agony of remaining a ghost in the advent of full daybreak in Heaven, comparing the weight of sunlight to having large blocks fall on one's body (at this point falling books awaken him). This parallels that of the man with his dream of judgment day in the House of the Interpreter of The Pilgrim's Progress . The book ends with the narrator awakening from his dream of Heaven into the unpleasant reality of wartime Britain, in conscious imitation of The Pilgrim's Progress , the last sentence of the "First Part" of which is: "So I awoke, and behold, it was a Dream."