After the completion of Spyro: Year of the Dragon in 2000, Insomniac Games stepped away from the series to develop Ratchet & Clank, while Sony Computer Entertainment and Universal Interactive Studios ended their publishing partnership. Universal retained ownership of the Spyro IP and was later absorbed into Havas Interactive (later known as Vivendi Universal), which announced plans to make a new Spyro game for PlayStation 2, Xbox, PC, and Game Boy Advance. Development was split between the Californian companies Check Six Studios, which handled programming and design, and Equinoxe Digital Entertainment, which produced the game's artwork.

Lead designer Joel Goodsell believed the next-generation console jump called for a new direction. At first, Universal rejected a pitch for a darker interpretation of the series with steampunk-inspired visuals, and a different pitch centered on the villains Gnasty Gnorc and Ripto teaming up against Spyro. They eventually approved Goodsell's more ambitious pitch inspired by action RPGs, featuring 25 expansive levels, a central town and interconnected overworld, and changing seasonal environments. The PlayStation 2 version was announced in February 2002, with a Nintendo GameCube version announced in July; these were the only two versions to see release.

As pressure rose to meet the 2002 holiday release window, both developers moved into a shared office in Venice, California to improve collaboration, but faced major technical and financial issues. The game suffered from low frame rates despite repeatedly scaled-back visuals and content, while Check Six faced cash-flow problems that resulted in delayed paychecks. Goodsell recalled that he departed from the project as a result of intensely conflicting leadership between Universal and Check Six. This included one incident where according to developer Jack Mamais, Check Six co-founder Brent Oster allegedly attempted to choke a programmer who disagreed with a suggestion he made, resulting in Oster's firing. Series composer Stewart Copeland realized that he no longer wanted to work on the series upon seeing promo materials built around a country-and-western theme that, in his view, no longer resembled Spyro or the series' original creative vision.

The game ultimately became the only title completed by both Check Six and Equinoxe before they shut down. Check Six was working on Aliens: Colonial Marines before cancellation, while Equinoxe was working on an undisclosed prototype for Nintendo that they chose to stop funding early in development.