Emotional arousal, mediated by the amygdala, is known to modulate episodic memories stored by the hippocampus, a region involved in pattern separation (the process by which similar representations are independently stored). While emotional modulation and pattern separation have been examined independently, this study attempts to link the two areas of research to propose an alternative account for how emotion modulates episodic memory. We used an emotional discrimination task designed to tax pattern separation of emotional information by concurrently varying emotional valence and similarity of stimuli. To examine emotional modulation of memory at the level of hippocampal subfields, we used high-resolution fMRI (1.5 mm isotropic) of the medial temporal lobe. Consistent with prior reports, we observed engagement of the hippocampal dentate gyrus (DG) and CA3 during accurate discrimination of highly similar items (behavioral correlate of pattern separation). Furthermore, we observed an emotional modulation of this signal (negative > neutral) specific to trials on which participants accurately discriminated similar emotional items. The amygdala was also modulated by emotion, regardless of the accuracy of discrimination. Additionally, we found aberrant amygdala-hippocampal network activity in a sample of adults with depressive symptoms. In this sample, amygdala activation was enhanced and DG/CA3 activation was diminished during emotional discrimination compared to those without depressive symptoms. Depressive symptom severity was also negatively correlated with DG/CA3 activity. This study suggests a novel mechanistic account for how emotional information is processed by hippocampal subfields as well as how this network may be altered in mood disorders.