The area was first explored in 1853 by Captain John W. Gunnison of the United States Army. Gunnison was on an expedition for the Corps of Topographical Engineers to locate a suitable pass through the Rocky Mountains.
The North Fork Valley was inhabited by the Ute people until 1880, when the Ute Indian Reservation was closed by the federal government following the infamous Meeker Massacre.
Following the closure of the reservation, the site was settled in 1880 by Samuel Wade and William Clark, who had accompanied Enos Hotchkiss to the area. The town was officially incorporated in 1902 and had its first election in July of that year. The peony roots that Samuel Wade brought with him to Colorado in 1881 inspired him to submit the Latin name for peony, Paeonia, as a town name. The post office would not allow the extra vowel, so "Paeonia" became "Paonia". The full name of the flower is Paeonia mascula.
Paonia is located in eastern Delta County at 38°52′03″N 107°35′33″W. It is situated on the North Fork Gunnison River ("North Fork River"), about 10 miles (16 km) northeast of (upstream from) neighboring Hotchkiss. It lies near the head of the North Fork Valley, an area about 150 miles (240 km) by air southwest of Denver. The valley lies at the foot of 11,396-foot (3,474 m) Mount Lamborn to the southeast and the Grand Mesa to the northwest.
Colorado State Highway 133 touches the northwest boundary of Paonia as the highway runs up the North Fork Valley; it leads southwest 9 miles (14 km) to Hotchkiss and northeast 58 miles (93 km) over McClure Pass to Carbondale.
According to the United States Census Bureau, the town of Paonia has a total area of 0.85 square miles (2.2 km2), all of it land.