There are a large number of high-value heritage sites in the historic villages preserved in the mountainous areas of southern China. These sites are exposed to major fire risks due to their compact layout and wooden building materials. By improving the fire risk assessment method for engineering (FRAME), we proposed a dynamic fire risk assessment method for compact historic villages. On one hand, a balance between universality and pertinence was established regarding the assessment indexes and weighting system by integrating general factors with unique regional factors. On the other hand, a connecting link between prescriptive fire codes and performance-based design adjustments was established through the cyclic operation path of assessment-intervention-reassessment. Xiaozhai village, which has experienced serious fire incidents, was selected as an example. Its original fire risk, established fire interventions, actual fire results, and optimized fire protection plan were compared and analyzed to validate the effectiveness and reliability of the assessment method. This study reveals the correlation between various factors of the village and building fire risk. Among these factors, building proximity, traditional customs, and fire protection layout, which are not included in the original FRAME, have a significant impact on fire risk. The results of this study can serve as a reference for fire prevention in historic villages with similar characteristics worldwide. Additionally, the proposed methodology can provide insights into the development of fire risk assessment methods for various types of historical settlements, thus promoting the sustainable development of built heritage in these settlements.