MP3 is an audio-specific format that was designed by the Moving Picture Experts Group as part of its MPEG-1 standard and later extended in MPEG-2 standard. The first MPEG subgroup - Audio group was formed by several teams of engineers at Fraunhofer IIS, University of Hannover, AT&T-Bell Labs, Thomson-Brandt, CCETT, and others. MPEG-1 Audio (MPEG-1 Part 3), which included MPEG-1 Audio Layer I, II and III was approved as a committee draft of ISO/IEC standard in 1991, finalised in 1992 and published in 1993 (ISO/IEC 11172-3:1993). Backwards compatible MPEG-2 Audio (MPEG-2 Part 3) with additional bit rates and sample rates was published in 1995 (ISO/IEC 13818-3:1995).

The use in MP3 of a lossy compression algorithm is designed to greatly reduce the amount of data required to represent the audio recording and still sound like a faithful reproduction of the original uncompressed audio for most listeners. An MP3 file that is created using the setting of 128 kbit/s will result in a file that is about 11 times smaller[note 1] than the CD file created from the original audio source. An MP3 file can also be constructed at higher or lower bit rates, with higher or lower resulting quality.

The compression works by reducing accuracy of certain parts of sound that are deemed beyond the auditory resolution ability of most people. This method is commonly referred to as perceptual coding. It uses psychoacoustic models to discard or reduce precision of components less audible to human hearing, and then records the remaining information in an efficient manner.

This technique is often presented as relatively conceptually similar to the principles used by JPEG, an image compression format. The specific algorithms, however, are rather different: JPEG uses a built-in vision model that is very widely tuned (as is necessary for images), while MP3 uses a complex, precise masking model that is much more signal dependent.

The MP3 lossy audio data compression algorithm takes advantage of a perceptual limitation of human hearing called auditory masking. In 1894, Alfred Marshall Mayer reported that a tone could be rendered inaudible by another tone of lower frequency. In 1959, Richard Ehmer described a complete set of auditory curves regarding this phenomenon. Ernst Terhardt et al. created an algorithm describing auditory masking with high accuracy. This work added to a variety of reports from authors dating back to Fletcher, and to the work that initially determined critical ratios and critical bandwidths.

The psychoacoustic masking codec was first proposed in 1979, apparently independently, by Manfred R. Schroeder, et al. from AT&T-Bell Labs in Murray Hill, NJ, and M. A. Krasner both in the United States. Krasner was the first to publish and to produce hardware for speech (not usable as music bit compression), but the publication of his results as a relatively obscure Lincoln Laboratory Technical Report did not immediately influence the mainstream of psychoacoustic codec development. Manfred Schroeder was already a well-known and revered figure in the worldwide community of acoustical and electrical engineers, but his paper was not much noticed, since it described negative results due to the particular nature of speech and the linear predictive coding (LPC) gain present in speech. Both Krasner and Schroeder built upon the work performed by Eberhard F. Zwicker in the areas of tuning and masking of critical bands, that in turn built on the fundamental research in the area from Bell Labs of Harvey Fletcher and his collaborators. A wide variety of (mostly perceptual) audio compression algorithms were reported in IEEE's refereed Journal on Selected Areas in Communications. That journal reported in February 1988 on a wide range of established, working audio bit compression technologies, some of them using auditory masking as part of their fundamental design, and several showing real-time hardware implementations.

The immediate predecessors of MP3 were "Optimum Coding in the Frequency Domain" (OCF), and Perceptual Transform Coding (PXFM). These two codecs, along with block-switching contributions from Thomson-Brandt, were merged into a codec called ASPEC, which was submitted to MPEG, and which won the quality competition, but that was mistakenly rejected as too complex to implement. The first practical implementation of an audio perceptual coder (OCF) in hardware (Krasner's hardware was too cumbersome and slow for practical use), was an implementation of a psychoacoustic transform coder based on Motorola 56000 DSP chips.

MP3 is directly descended from OCF and PXFM. MP3 represents the outcome of the collaboration of Karlheinz Brandenburg, working as a postdoc at AT&T-Bell Labs with James D. (JJ) Johnston of AT&T-Bell Labs, collaborating with the Fraunhofer Society for Integrated Circuits, Erlangen, with relatively minor contributions from the MP2 branch of psychoacoustic sub-band coders.

MPEG-1 Audio Layer 2 encoding began as the Digital Audio Broadcast (DAB) project managed by Egon Meier-Engelen of the Deutsche Forschungs- und Versuchsanstalt für Luft- und Raumfahrt (later on called Deutsches Zentrum für Luft- und Raumfahrt, German Aerospace Center) in Germany. The European Community financed this project, commonly known as EU-147 (or Eureka 147), from 1987 to 1994 as a part of the EUREKA research program. MUSICAM Audio Coding was developed as part of the Eureka 147 project and has been subject to the standardization process within the ISO/Moving Pictures Expert Group (MPEG).

As a doctoral student at Germany's University of Erlangen-Nuremberg, Karlheinz Brandenburg began working on digital music compression in the early 1980s, focusing on how people perceive music. He completed his doctoral work in 1989 and became an assistant professor at Erlangen-Nuremberg. While there, he continued to work on music compression with scientists at the Fraunhofer Society (in 1993 he joined the staff of the Fraunhofer Institute).