No. 3 Squadron was formed at Point Cook, Victoria, on 19 September 1916 under the command of Major David Blake. It was one of four operational squadrons of the Australian Flying Corps, and its personnel were members of the Australian Army. Shortly afterwards, the unit embarked upon the HMAT Ulysses and sailed to England for training, before becoming the first AFC squadron deployed to France, in September 1917, equipped with the R.E.8 two-seat reconnaissance/general purpose aircraft. To avoid confusion with the British No. 3 Squadron RFC, it was known to the British military as "No. 69 Squadron RFC". This terminology was never accepted by the squadron or the Australian Imperial Force who continued to use the AFC designation regardless, and in early 1918, the British designation was dropped.
After moving to the Western Front, the squadron was initially based at Savy. In November 1917, it was assigned the role of a corps reconnaissance squadron and allocated to I Anzac Corps, which was based around Messines, and established itself at Bailleul. No. 3 Squadron would remain with I Anzac for the remainder of the war, and participated in bombing, artillery spotting and reconnaissance missions supporting ANZAC and other British Empire ground forces. Its first air-to-air victory came on 6 December 1917; by the end of the war its aircrews had been credited with another 15 German aircraft, and a total of 10,000 operational hours.
In early 1918, the collapse of Russia allowed the Germans to concentrate their strength on the Western Front, and launched a major offensive. As the Allies were pushed back, the squadron's airfield at Baileul came into range of the German guns and it was moved first to Abeele and then, as the Allies were pushed back further, it moved again to Poulainville. During the offensive, the squadron operated mainly in the Somme Valley, providing artillery observation. In April 1918, the squadron became responsible for the remains of the "Red Baron", Manfred von Richthofen, after he was shot down in its sector. Blake initially believed that one of the squadron's R.E.8s may have been responsible but later endorsed the theory that an Australian anti-aircraft machine gunner actually shot down the Red Baron. In July, the squadron undertook reconnaissance and deception operations in support of the Australian attack at Hamel, before later joining the final Allied offensive of the war around Amiens in August, flying support operations until the armistice in November. Shortly before the end of the war, the squadron began converting to the Bristol F.2 Fighter.
Following the end of hostilities, the squadron was engaged briefly in mail transport duties before being withdrawn to the United Kingdom in early 1919. It was disbanded in February and over the course of the next couple of months its personnel were repatriated back to Australia.Casualties amounted to 32 killed and 23 wounded, of which the majority were aircrew; the squadron lost 11 aircraft during the war.
In 1925, the squadron was re-formed as part of the fledgling independent Royal Australian Air Force.