Sunday's election in the central state of Hesse saw both the CDU and the Social Democrats lose significant ground amid gains for both the Greens and the Alternative for Germany party.
Merkel is expected to finish out the rest of her three year term as chancellor.
Merkel's surprise news comes after the CDU and its junior federal coalition partner the Social Democrats (SPD) suffered heavy losses in an election in the state of Hesse on Sunday.
Merkel rounded up all her decisions in one sentence - that she will not stand for any political office once her mandate as chancellor expires in 2021. Since then, both Merkel and her CSU allies have been criticized for their management of the influx. However, the CDU's share of the vote fell by more than 11 points, to 27% - marking the worst result for the party since 1962.
The ruling parties' poor outcome, which follows similar results in Bavaria earlier this month, meant the government had to agree a new "roadmap" or give up the ghost, an SPD spokeswoman said. He was tapped years ago as a potential successor to Chancellor Merkel and has been a constant challenger within her party.
She said her decision to not seek re-election was aimed at allowing the government to focus on the tasks ahead, and it will also allow her party CDU to prepare for the future.
Others include two state premiers Armin Laschet and Daniel Guenther, who carry weight after recently leading the CDU to victory in regional elections. Any decline in Merkel's political stature is likely to be seen by investors as a loosening of the fiscal discipline that became a hallmark of her tenure, during which she demanded austerity and economic overhaul in return for bailouts in countries such as Greece.
She said Monday that it's "time to start a new chapter".
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"She was genuinely sad and not at all bitter and asked that the discussion about her succession be conducted in a kind manner", the source said, adding that Merkel's words were greeted with a standing ovation.
Die Welt reporter Robin Alexander said the path could now be clear for Merkel's chosen heir, CDU general secretary Annegret Kramp-Karrenbauer, to take the reins if no other credible candidate emerges by December.
Merkel has dragged the CDU to the political center, dropping military conscription and abruptly accelerating the shutdown of Germany's nuclear power plants following Japan's Fukushima disaster in 2011.
In an attempt to rein Mr Spahn in, Ms Merkel this year named him health minister - a thorny portfolio that brings a lot of work and few headlines.
Merkel has loomed large on the European stage since 2005, helping guide the EU through the euro zone crisis and opening Germany's doors to migrants fleeing war in the Middle East in 2015 - a move that still divides the bloc and Germany.
Thomas Heilmann, a CDU member of the Bundestag, said the party's elected officials were relieved by Merkel's choice.