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After the success of Star Wars: Shadows of the Empire on the Nintendo 64 in 1996, LucasArts began planning a follow-up. At the time, Factor 5 was developing a game engine to create large terrain maps for their planned sequel to LucasArts' Rescue on Fractalus! After LucasArts signed a three-game exclusivity deal with Nintendo, Factor 5 was allowed to convert their work on the new Fractalus sequel into a Star Wars game instead. The game's focus would be space combat; this direction was inspired by a level of Shadows of the Empire in which the player flies a snowspeeder during the Battle of Hoth. Rogue Squadron and LucasArts production manager Brett Tosti stated, "That whole scene was actually the genesis for Rogue Squadron because everybody said, 'Why don't you do a whole game like that?' So we did." Factor 5 and LucasArts divided the game's development load. Factor 5 designed the game engine, the music, and worked closely with Nintendo, while LucasArts produced the game's content and ensured it was faithful to Star Wars canon.

Factor 5 initially pitched a concept to allow gamers to play through missions similar to the fans' favorite action sequences from the Star Wars films. This proposal was rejected, however. At that time, LucasFilm was not comfortable with video games drawing directly from the films nor would they allow original content to be incorporated alongside battles from the films. Consequently, the resulting game was almost completely set in the Star Wars Expanded Universe. The designers at LucasArts initially planned to adapt Rogue Squadron and Star Wars: X-wing Rogue Squadron, a series of books and comic books set after the years of the original film trilogy, and have the game centered around Wedge Antilles. It was later decided that the game would instead focus on Luke Skywalker and primarily take place between the events of A New Hope and The Empire Strikes Back as it was more commercially appealing.

LucasArts began developing the story and gameplay in a setting that would include characters from the films participating in new, original missions using Factor 5's terrain map engine as the base. The development team's basic design plan was to combine the free-roaming style of Rescue on Fractalus with the on-rails gameplay of Atari's Star Wars arcade game. Initially, designing and refining the individualized flight controls for the game's various vehicles was difficult for programmer Mark Haigh-Hutchinson before breaking through to find the right balance for each. In May 1998, a demo of the game was displayed at E3, but the game was so incomplete at the time that Tosti considered it a tech demo. It rendered a basic heightmap and an immobile AT-AT model, while TIE fighters lacking artificial intelligence flew and fired in a predetermined path. When "playing" the demo for audiences, Tosti followed a very specific flight path of his own to give the illusion that he was actually battling with the TIEs. Despite the demo's barebones presentation, response from gamers was largely positive. In the final build of the game, many of the enemy fighters continued to follow predetermined flight paths as calculating flight paths on the fly required too much processing power.

Late in development, the team realized that they were developing the game with a Nintendo 64 memory expansion in place at all times. Unable to run the game on a standard Nintendo 64, they began working on compression techniques to allow the game to run within the confines of the standard console. At the same time, Factor 5 also appealed to Nintendo to release the newly developed memory Expansion Pak commercially. Nintendo was reluctant, expecting the technology to be reserved solely for hardware peripherals. However, after Iguana Entertainment also wanted to use the Expansion Pak to achieve a higher display resolution for Turok 2: Seeds of Evil, Factor 5 was given the green light. Ultimately, Rogue Squadron was made to run on a standard Nintendo 64 but the Expansion Pak increases its resolution from 320 × 240 to 640 × 480.