The decision will go into effect within several months, said Wim van der Weegen, a Justice Ministry spokesman.
"The problem with mushrooms is that their effect is unpredictable," he said, and shops caught selling them will be closed.
Marijuana and hashish are technically illegal in the Netherlands, but police do not bother to prosecute people for possession of small amounts, and it is sold openly in designated cafes.
Possession of "hard" drugs like cocaine, LSD and Ecstasy is illegal. Mushrooms will fall somewhere in the middle.
"We're not talking about a non-prosecution policy, but we'll be targeting sellers" Van der Weegen said.
Psilocybin, the main active chemical in the mushrooms, has been illegal under international law since 1971. However, fresh, unprocessed mushrooms continued to be sold legally in the Netherlands along with herbal medicines in so-called "smart-shops," on the theory that it was impossible to determine how much of the naturally occurring substance any given mushroom contains.
Van der Weegen said that was also the reason the system proved unworkable: "It's impossible to estimate what amount will have what effect."
Calls for a re-evaluation arose after Gaelle Caroff, a 17-year-old visiting from France, from a building in Amsterdam in March after eating psychedelic mushrooms.
Caroff's parents blamed their daughter's death on hallucinations brought on by the mushrooms, though the teenager had suffered from psychiatric problems in the past. Photographs of her youthful face were splashed across newspapers around the country.
Since Caroff's death other dramatic stories involving mushrooms have been reported in the Dutch press:
"It's a shame, the media really blew this up into a big issue," said Chloe Collette, owner of the FullMoon smart-shop in Amsterdam.
She said all the incidents had involved the use of multiple drugs - against the advice of sellers - but it was the mushrooms that were blamed.
"Used in the right way, there's no problem with mushrooms: The biggest problem is with alcohol, in my opinion."
Most mushrooms sold in Amsterdam are sold to tourists, and the city's liberal drug policies and legalized prostitution are major tourist attractions.
In May, the country's health minister, Ab Klink, undertook a study of the problems and called for suggestions from the industry and Amsterdam's city government.
Murat Kucuksen, whose farm Procare supplies about half the psychedelic mushrooms on the Dutch market, said he stood to lose several million euros invested in setting up his legal growing facilities.
He predicted the trade will move underground, prices will rise, and dealers will sell dried mushrooms or LSD as a substitute, with no guidance for tourists.
"So you'll have a rise in incidents but they won't be recorded as mushroom-related, and the politicians can declare victory," he said.