In this paper, a diabatic compressed air energy storage system fueled by a natural gas/hydrogen mixture that integrates heating and power generation is proposed. A comprehensive thermodynamic analysis has been conducted to identify the key factors influencing system performance and elucidate the detailed formation and distribution patterns of irreversible losses when utilizing a hydrogen-natural gas blend as fuel in the proposed system. The research results indicate that increasing the hydrogen blending ratio from 0.5 to 1 lead to greater enhancements in roundtrip efficiency (∼1.08% vs. ∼0.33%), exergy efficiency (∼3.88% vs. ∼1.15%), and energy density (∼1.24% vs. ∼0.42%) compared to an increase from 0 to 0.5. The combustor suffers the largest exergy destruction proportion, with a notable reduction in exergy destruction achieved through increased hydrogen blending. System performance benefits significantly from higher combustor outlet temperatures and expansion ratios at various hydrogen blending ratios. The rate of change in exergy efficiency (∼42.76% vs. ∼83.17%) and energy density (∼58.83%) demonstrates an inverse correlation with the varied parameters (1100–1500K, 4–8), except for the rate of change in energy density (∼6.76%), which displays a positive relationship with the combustor outlet temperature. Notably, a significant decrease in the rate of change in roundtrip efficiency (∼1.87% vs. ∼6.64%) is observed within a specific parameter range (1400–1500K, 5–6). Sensitivity analysis identifies the combustor outlet temperature as the most influential factor in enhancing system performance, consistently showing positive effects of the hydrogen blending ratio.