The game was first announced at E3 1996 in Atlanta, Georgia. Internal company hopes were high during the development cycle. Tony Hsieh, project lead on Masters of Teräs Käsi, felt that it "[would] be hard to go wrong". While promoting the game in an issue of Star Wars Insider, writer Jack Lyon stated: "Short attention span Star Wars freaks will surely dig Masters of Teräs Käsi, LucasArts' first fighting game." Tekken was cited as one of the main influences on the game. A backstory was developed in which Darth Vader uses a mysterious master of Teräs Käsi, Arden Lyn, to eliminate high-ranking members of the rebellion in hand-to-hand combat. Development of the game took approximately 19 months according to lead artist Craig Rundels. Softimage was used for character creation. It was the first LucasArts title developed for the PlayStation. "No one had programmed a game on the PlayStation [...] We were learning the hardware, how to make art on it, how to program on it while we were developing Teräs Käsi." A demo was released on disc in the third issue of Official U.S. PlayStation Magazine.
The motion capture facilities and software of LucasFilm partner Industrial Light & Magic (ILM) were used to generate the animation for the characters. The varying heights of the characters presented issues during development, and developers had to find ways to adjust the collision detection based on the opponent. To create the character's reactions to hits, the motion capture data was supplemented with hand-drawn animation. Each character was made up of at least 1,200 polygons. In developing the button combo system the staff wanted buttons to have context with the character's movements. "We want to make it so that when you hit the left button, you really hit with your left arm in a combo."
The character Arden Lyn was created specifically for the game. The character's design was initially much more androgynous than how she appears in the final game. Some obscure characters, such as Jodo Kast, were included in the game for no more reason than that a member of the development team liked the character and was able to build a compelling model. Gammorean guard Thok had previously had a film appearance within Jabba's palace in Star Wars: Episode VI – Return of the Jedi. Hoar was another new character created for the game. He was later given additional backstory, including ties to characters in Star Wars: Episode II – Attack of the Clones and the video game Star Wars: Jedi Knight: Dark Forces II. In an interview with Destructoid, Capcom's Seth Killian mentioned that Star Gladiator was originally pitched as a Star Wars fighting game. Ultimately the pitch did not succeed and LucasArts instead developed Masters of Teräs Käsi. To promote the game, Star Wars: The Official Magazine ran a contest in June 1998 in which a black console with the Star Wars: Masters of Teräs Käsi logo on the top was given out.