The Spain international, who has played 450 times for Madrid, has won 27 trophies, including six Champions Leagues and four Spanish top-flight titles.
"Real Madrid wishes to express its gratitude and affection to one of the greatest legends of our club and world football," said Los Blancos in a statement.
Carvajal, 34, came through Madrid's La Fabrica youth academy, and after signing for Bayer Leverkusen in 2012, the Madridistas bought him back the following summer.
"Carvajal is a legend and a symbol of Real Madrid and its academy," said Real Madrid president Florentino Perez.
The defender was hoping to play for Spain at the World Cup this summer but has struggled with various injuries through a disappointing campaign and will not be called up by coach Luis de la Fuente, according to Spanish media.
Carvajal will play his last match for the club at the Santiago Bernabeu this weekend against Athletic Club in La Liga, at the end of a second straight season without a major trophy for Madrid.