In a literal sense the story takes place in old New York, in (as Irving announces in the very first sentence) the Catskill Mountains overlooking the Hudson River. As is typical of early Romantic literature, the setting is a picturesque one. Writers from this period loved to describe the beauty of nature, as a counterpoint to the artificiality of the urban milieu that was becoming increasingly dominant in both Europe and America at that time. But this specific literary tendency was also a reaction against the eighteenth-century Enlightenment and its emphasis upon man and man's works, his progress, his advancement and his overcoming of Nature in creating a modern world based on science and achievement. Irving, like the German Romantic writers who preceded and influenced him, seems to revel in the natural world for the beauty of the words he's able to use in describing it:
They [the Catskills] are a branch of the great Appalachian family, and are seen away to the west of the river, swelling up to a noble height, and lording it over the surrounding country. Every change of season, every change of weather, indeed, every hour of the day, produces some change in the magical hues and shapes of these mountains.
The Catskills are called "fairy mountains," befitting the fairy-tale atmosphere of the story, typically so for the early nineteenth century, in which writers reinterpreted the past and the magical, mysterious features of the pre-modern world they sought to recreate. Yet all of this is a metaphor for the action that takes place within Rip van Winkle's mind. In his sojourn on the mountain we have no way of knowing how much of what he experiences is real and how much is imaginary. The strange traveler dressed in "antique Dutch fashion," the men playing ninepins looking like "the figures in an old Flemish painting," are projections of Rip's soul, of the dreamer within him who wishes to escape the tedious real world in which he's henpecked by his wife, and where he doesn't fit in with the times as they march forward inexorably.
That march forward is what passes Rip by during his long sleep. The setting remains the same after he awakens—the same in a topographic or geographic sense, that is, since he's still in the Catskill region of New York. But now New York is part of a new country, the United States. So in a way what he experiences is a transference from the old milieu—and the even older one in which his dreamer's mind has plunged him—into a modern, transformed world. The story is a kind of parable about man's inability to remain apart from the dynamic process of human life, though Nature is implicitly the one constant that stands apart from the ceaseless changes created by man, and which Rip is alienated by. Thus the setting in the beautiful mountains and the Hudson Valley are one with Rip, even while human activity exists in a different realm.