The Blue Lagoon was accidentally formed in 1976 during operation at the nearby geothermal power plant. In the years that followed, people began to bathe in the unique water and apply the silica mud to their skin. Those with psoriasis noticed an incredible improvement in their condition. Over the years, Blue Lagoon has been innovative in harnessing this gift of nature to develop different spa services and products. Today, Blue Lagoon is recognized as one of the wonders of the world.

The lagoon is a man-made lagoon which is fed by the water output of this nearby power plant and is renewed every 2 days. Superheated water is vented from the ground near a lava flow and used to run turbines that generate electricity. After going through the turbines, the steam and hot water passes through a heat exchanger to provide heat for a municipal water heating system. Then the water is fed into the lagoon for recreational and medicinal users to bathe in.

The warm waters are rich in minerals like silica and sulphur .The water temperature in the bathing and swimming area of the lagoon averages 37–39 °C (98–102 °F). The Blue Lagoon also operates a Research and Development facility to help find cures for other skin ailments using the mineral-rich water.