Chaperone protein BiP binds to Ire1 and dissociates in response to endoplasmic reticulum (ER) stress. However, it remains unclear how the signal transducer Ire1 senses ER stress and is subsequently activated. The crystal structure of the core stress-sensing region (CSSR) of yeast Ire1 luminal domain led to the controversial suggestion that the molecule can bind to unfolded proteins. We demonstrate that, upon ER stress, Ire1 clusters and actually interacts with unfolded proteins. Ire1 mutations that affect these phenomena reveal that Ire1 is activated via two steps, both of which are ER stress regulated, albeit in different ways. In the first step, BiP dissociation from Ire1 leads to its cluster formation. In the second step, direct interaction of unfolded proteins with the CSSR orients the cytosolic effector domains of clustered Ire1 molecules.