Excessive grazing leads to degradation of the structure and functions of grassland ecosystems, including the loss of species with unique functional attributes. Therefore, it is necessary to discuss the species diversity of grasslands at different grazing degradation stages and the functional diversity carried by these species. We examined the species diversity and functional diversity, which were calculated based on the plant functional traits, in grasslands at four stages of degradation (undegraded, slightly degraded, moderately degraded, and intensely degraded) in the Xilin River Basin, Inner Mongolia, China. We analyzed connections of plant functional traits, species diversity, and functional diversity with the grazing gradient, as well as the relationship between species diversity and functional diversity. Our results showed that (i) different plant functional traits have different trends along the degradation gradient. With the intensification of grassland degradation, the plant species in the community gradually change from those with low nutrient utilization efficiencies, high metabolic rates, and low resistance to forage to those with high nutrient utilization efficiencies, low metabolic rates, and high resistance to forage. (ii) The species diversity indices (species richness, Shannon–Weaver index) rise significantly with the degradation gradient, and the rate of species transformation in the community increases with the degree of grassland degradation. (iii) There is a significant positive correlation between species diversity and functional diversity, and as the species diversity increases, the increase in functional diversity gradually slows down. (ⅳ) The large species diversity and low functional richness in degradation community revealed the fact that although grassland degradation increases species richness, it still releases niche space. The changes in grassland species diversity driven by human activities will enable us to better understand the rationality of human use and provide a theoretical basis for the more scientific use of grassland resources.