Dragon Slayer laid the foundations for the action role-playing game genre, influencing future series like Ys. Xanadu was an early real-time action RPG with full-fledged character statistics, and it introduced several innovative gameplay mechanics, such as the Karma morality system, individual experience for equipped items, a heavy emphasis on puzzle-solving, equipment that changes the player character's visible appearance, food that is consumed slowly over time and is essential for keeping the player character alive, magic that can be used to attack enemies from a distance, and training facilities to improve various statistics. It also introduced a platformer-style side-scrolling view, including the ability to jump. The side-scrolling view is used during exploration and switches to the overhead view of its predecessor during battle, while certain rooms also use an overhead view. This gameplay is credited as a precursor to the development of the metroidvania genre.

The game begins with the player directly in control of the protagonist, with little to no introduction. To progress, one must speak with the king, who gives the player the bare essentials and a small amount of cash to train. After selecting which attributes to raise, the player must navigate of the city and into the vast underground complex. Finding this exit is the first of many puzzles the player will encounter, though the game is not a puzzle game but a role-playing video game with puzzle game and adventure game elements.

The protagonist can move left and right, climb down ladders, jump, cast equipped spells, enter doors, or use equipped items. Similar to Falcom's own later Ys series, damage is done by walking directly into the enemy; however, unlike with Ys, in Xanadu it doesn't matter which part of the target's body the player character runs into.