We introduce a computational theory of situated language understanding in which the meaning of words and utterances depends on the physical environment and the goals and plans of communication partners. According to the theory, concepts that ground linguistic meaning are neither internal nor external to language users, but instead span the objective‐subjective boundary. To model the possible interactions between subject and object, the theory relies on the notion of perceived affordances: structured units of interaction that can be used for prediction (...) at multiple levels of abstraction. Language understanding is treated as a process of filtering perceived affordances. The theory accounts for many aspects of the situated nature of human language use and provides a unified solution to a number of demands on any theory of language understanding including conceptual combination, prototypicality effects, and the generative nature of lexical items.To support the theory, we describe an implemented system that understands verbal commands situated in a virtual gaming environment. The implementation uses probabilistic hierarchical plan recognition to generate perceived affordances. The system has been evaluated on its ability to correctly interpret free‐form spontaneous verbal commands recorded from unrehearsed game play between human players. The system is able to “step into the shoes” of human players and correctly respond to a broad range of verbal commands in which linguistic meaning depends on social and physical context. We quantitatively compare the system's predictions in response to direct player commands with the actions taken by human players and show generalization to unseen data across a range of situations and verbal constructions. (shrink)