Sleeping can be done in any bed that isn't owned by somebody else, provided no enemies are nearby. It is not to be confused with waiting, which also passes the time but can be done without a bed.
Level-up is triggered when the character has accumulated 10 major skill increases and finds a legal bedroll or bed to sleep on without being interrupted by a random enemy encounter. Waiting will not trigger a level-up. Other than leveling up, becoming a vampire, or other quest related needs, however, there are no benefits to sleeping over waiting. The purpose of both waiting and sleeping in the game is to allow the user to pass time and recover Health, Magicka, and fatigue.
Places to sleep include:
- Your house(s) - Free once you have bought the house.
- Inns - Prices at inns vary - usually from 10-40 gold - though with the number of free beds in the game, paying for one is not needed in most cases. Beggars and other people are helpful in finding the cheapest (or most lavish, if you prefer). Inns are available in every city, in many villages, and on most major roads.
- Factions - Joining the Mages or Fighters Guild gives you a free bed in almost every town. (There's no Fighters Guild hall in the Imperial City, and you cannot get access to the Mage Quarters at the Arcane University until you have joined the Mages Guild.) Other factions may give you a free bed in a single location (Arena, Dark Brotherhood, Knights of White Stallion, the Blades, Knights of the Thorn, etc.). Note that the bedrolls in the Arena Bloodworks are free to sleep in without joining or being a member of the Arena.
- Beggars' bedrolls - Some of these are marked as "owned", but others are free.
- A few houses (such as the Abandoned Shack in the Waterfront District of Imperial City and the Skooma Den in Bravil) have no owner so the beds can be used whenever they are available.
- Bandit camps - Be careful, as these carry the greatest risk (albeit small) of being interrupted by an unfriendly creature or NPC.
- One place with a free bed to sleep in for new characters is outside the entrance of Dzonot Cave. It is just outside of the Imperial City and due south of the bridge leading to the city and is easily accessible.
- Caves, Ayleid Ruins and Forts often have beds and/or bedrolls that can be used once all enemies in the vicinity have been killed.
Sleeping has additional effects upon vampires, as does feeding on the blood of the living. These are covered in detail here.