The official Wafa news agency said the move was intended to prepare for general elections planned later this year. Prime Minister Salam Fayyad now has six weeks to name a new Cabinet.
President Mahmoud Abbas accepted Fayyad's decision after the Cabinet meeting.
Abbas' Palestinian Authority has announced a series of dramatic moves following mass protests that ousted rulers in Egypt and Tunisia over the past month. The protests have spurred calls for democracy throughout the Middle East, a region dominated by monarchs and autocratic leaders.
The Palestinians are also dealing with the fallout from embarrassing media leaks about past peace talks with Israel. Together with deadlock in peace efforts with Israel, these developments have put pressure on Abbas to press forward with reforms.
The Palestinian government said over the weekend that it would hold long-overdue general elections later this year, weeks after saying it would hold local elections in July.
The chief peace negotiator, Saeb Erekat, also resigned in response to the leaks broadcast by the Al-Jazeera satellite channel, which detailed far-reaching concessions that his government was prepared to make to Israel to form a future Palestinian state.
Palestinian spokesman Ghassan Khatib said Fayyad's Cabinet reshuffle had been planned for weeks.
"It's not tied to the new changes in the region," Khatib said.
The Wafa statement said the new Cabinet will help implement Fayyad's plan to build Palestinian institutions in preparation for eventual independence, and to prepare for parliamentary and presidential elections.
A Fayyad aide said his boss was expected to include members of Abbas' Fatah party in the Cabinet, members of smaller Palestinian factions, as well as independent technocrats. Fayyad is a U.S.-educated economist.
The aide spoke on condition of anonymity because negotiations had not begun.
The new Cabinet will oversee the affairs of Palestinians in the West Bank, where the Western-backed government has partial self-rule.
The other territory that Palestinians want for their future state - the Gaza Strip, which lies on the other side of Israel - has been ruled by the militant Islamic group Hamas since it overran Abbas loyalists in 2007.
Hamas has rejected Abbas' reforms and says it will not allow elections to take place in Gaza. Its leaders argue that the two rivals must reconcile before returning to the ballot box.
"This is silly theater," said Hamas official Fawzi Barhoum. He accused Abbas of trying to fool people into thinking that genuine reform was underway.