In 1998, four engineers from Microsoft's DirectX team, Kevin Bachus, Seamus Blackley, Ted Hase and DirectX team leader Otto Berkes, disassembled some Dell laptop computers to construct a prototype Microsoft Windows-based video game console. The team hoped to create a console to compete with the Sony's upcoming PlayStation 2, which was luring game developers away from the Windows platform. The team approached Ed Fries, the leader of Microsoft's game publishing business at the time, and pitched their "DirectX Box" console based on the DirectX graphics technology developed by Berkes' team. Fries decided to support the team's idea of creating a Windows DirectX based console.

During development, the original DirectXbox name was shortened to Xbox. Microsoft's marketing department did not like the Xbox name, and suggested many alternatives. During focus testing, the Xbox name was left on the list of possible names to demonstrate how unpopular the Xbox name would be with consumers. However, consumer testing revealed that Xbox was preferred by far over the other suggested names and "Xbox" became the official name of the product.

The Xbox was the second console produced by an American company since the Apple Pippin ceased production in 1997, after the release of the Nuon in 2000. It Microsoft's first video game console after collaborating with Sega to port Windows CE to the Dreamcast console. Microsoft repeatedly delayed the console, which was first mentioned publicly in late 1999 during interviews with Microsoft's then-CEO Bill Gates. Gates stated that a gaming/multimedia device was essential for multimedia convergence in the new times. He has even been quoted as saying "if we do not advance, to the next generation, we will most surely fall behind our competitors (Apple)".

The Xbox was officially announced at the Game Developers Conference on March 10, 2000.Audiences were impressed by the console's technology. At the time of Gates' announcement, Sega's Dreamcast sales were diminishing and Sony's PlayStation 2 was just going on sale in Japan.

The Xbox was officially unveiled to the public by Gates and guest professional wrestler The Rock at CES 2001 in Las Vegas on January 3, 2001. Microsoft announced Xbox's release dates and prices at E3 2001 in May. Most Xbox launch titles were unveiled at E3, most notably Halo: Combat Evolved and Dead or Alive 3.

Due to the immense popularity of gaming consoles in Japan, Microsoft delayed the release of the Xbox in Europe to focus on the Japanese video game market. Although delayed, the European release proved to be more successful than the launch of the Xbox in Japan.

Some of Microsoft's plans proved effective. In preparation for its launch, Microsoft acquired Bungie and used Halo: Combat Evolved as its launch title. At the time, GoldenEye 007 for the Nintendo 64 had been one of the few hit FPS games to appear on a console, some of other ones being Perfect Dark and Medal of Honor. Halo: Combat Evolved proved a good application to drive the Xbox's sales. In 2002, Microsoft made the second place slot in consoles sold in North America. The Xbox Live service gave Microsoft an early foothold in online gaming and would help the Xbox become a relevant competitor to other sixth-generation consoles.

Popular launch games for the console included Dead or Alive 3, Amped: Freestyle Snowboarding, Halo: Combat Evolved, Fuzion Frenzy, Project Gotham Racing, and Jet Set Radio Future.