It means that it's such a strange/unusual thing to happen that you wouldn't even imagine it happening (make it up). It's used to express complete disbelief about how ridiculous something sounds. Your example is a common usage, but it is a little bit rude. Don't say it that way in front of your boss, or grandma. You can also say: "You couldn't make this up". "The government is changing its mind for the fiftieth time". "You couldn't make this up". - It's beyond belief that they could run the country this badly. "I ordered two doors to be delivered and they turned up with six radiators! Then they took them away and came back with a table. Seriously, it's ridiculous, you couldn't make this up!" "

It's an ironic expression. It really means, "You would think I'm making this up, but I'm not." You usually say that after you tell a story in which someone does something that you think is so ridiculous, crazy, or stupid that one would think it was fiction. Also calling the situation "shit" could add a more dismissive or disapproving tone, or maybe a more informal tone. I'm assuming you know that "shit" is generally considered profanity. People also say "you can't make this stuff up". The examples depend on the viewpoint of the speaker. An example to me is ---A student's mother wanted her son to be excused from taking his math test because he was tired from his basketball game the night before. When the teacher said that the son could not be excused, the mother threatened to sue the school district. You can't make this shit up! But another person might think that the mother's request is totally reasonable, so that person would not use the expression "you can't make this shit up" when talking about it.

Perhaps think of this sentence as a way that someone could say, "I'm not lying to you." Because of the given situation that they may be talking about would be too hard to make up as a lie due to how ridiculous or surreal it is. For example, imagine someone was saying something so ridiculous or weird that happened during their day. They have proof that whatever they experienced actually happened via video or something similar, then they say: "You can't make this shit up." While they are showing you the proof.