Diamonds in the Rough was recorded at Atlantic Recording Studios in New York City. The album's sound homed in on the Appalachian "high lonesome" influences evident on Prine's eponymous debut LP and its bluegrass instrumentation reflects Prine's fascination with early American folk and country music. The album was produced by Arif Mardin and features Prine's brother Dave on dobro, banjo, and fiddle while Steve Goodman also contributes on guitar and harmonies. In the Great Days: The John Prine Anthology liner notes, Prine tells David Fricke that the album was recorded in three days at a cost of $7,200, "including beer", and adds "I just wanted to do Diamonds the way I was used to playing music at my house with Dave and Steve. But it's taken me years to figure out how to balance those first two records. About every other record, after making a real studio or rock 'n' roll album, I'd come back and do a Diamonds in the Rough."

The material on Diamonds in the Rough strike a musical balance between infectious up-tempo hootenannies and stark, allegorical compositions with recitations that recall Hank Williams' recordings as Luke the Drifter. In an interview with Paul Zollo for Bluerailroad magazine, Prine stated that "Sour Grapes" and "The Frying Pan" were two of his earliest songwriting efforts, explaining that he "had a girlfriend whose father was a janitor. And the reason I’m telling you that is because he had access to a tape recorder, and nobody else I knew had one. They were really rare. A reel-to-reel. He got it from the language department. It was broken and he fixed it and had it at home. And I sat down and taped three songs for this girl and her sister. And the three songs were 'Frying Pan', 'Sour Grapes', and 'Twist & Shout'...Years later, I ended up marrying that girl. She was my first wife. She found the tape. It was after I had made the first album, so I put two of those songs on Diamonds in the Rough. And those were the first songs I remember writing." Prine also added that he wrote "Souvenirs" in his car, "a 65 Chevelle. Driving to the Fifth Peg. Like the 5th or 6th time playing there. I used to play there just Thursdays after they hired me. They hired me from that open stage the very first time I sang for the crowd. They invited me back a week later, and I did it again for an open stage...So about the fifth time I was driving down there I thought, God, the same people are gonna be sitting there. I better have a new song. So I wrote 'Souvenirs' in the car on the way down. And then I thought I’d come up with a melody. And I thought I had come up with a pretty sophisticated melody in my head, and I was surprised to find out it had the same three chords that all my other songs have. Really surprised. I thought I had written a jazz melody." Prine often performed "Souvenirs" with his friend and fellow songwriter Steve Goodman, who played on the original recording, and in the same interview the singer confessed, "Yeah, I can still hear him playing it. He played a back melody, so that you could barely hear the difference of who was playing. On tape or when we did it live. And I realized a large part of what he was doing was making it sound like I was playing the good part. And that’s basically the kind of guy he was."

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