The couple will also no longer use their "Royal Highness" titles, the palace said in an announcement that sought to bring to an end turmoil in the monarchy sparked earlier this month when the couple announced they wanted to reduce their royal duties and spend more time in North America.
In recent days, the queen and her family have been working out with officials how this stepping back will work in practice for Harry, 35, and his American wife, former actress Meghan, 38.
"Harry, Meghan and Archie will always be much loved members of my family," Queen Elizabeth said in a statement issued by the palace, referring to the couple's baby son.
"I recognise the challenges they have experienced as a result of intense scrutiny over the last two years and support their wish for a more independent life."
The queen added that she was "particularly proud" of how quickly Meghan became one of the family. The couple married in May 2018 in a lavish ceremony at Windsor Castle.
A friend of Harry and Meghan said the couple felt they had been driven out.
The palace said the couple will no longer receive public funds and they will repay money spent on the refurbishment of their cottage at Windsor, west of London.
"Although they can no longer formally represent the queen, the Sussexes have made clear that everything they do will continue to uphold the values of her majesty," a Buckingham Palance spokeswoman said.
"The Sussexes will not use their HRH title as they are no longer working members of the royal family.
FUNDS
The change means Harry will give up his military patronages and his role as Commonwealth Youth Ambassador.
It was not immediately clear whether the couple could continue to use the "Sussex Royal" title for their website and branding.
While they will no longer receive public funding, Harry's father Prince Charles, the heir to the throne, will continue to offer private financial support, a royal source said.
The couple will split their time between Britain and North America, with the majority of their time in North America, the source said.
The changes will come into effect in the spring of this year, the palace said.