Lufthansa will merge all of its domestic and European non-hub narrowbody operations "commercially and organisationally" with those of its low-cost operation Germanwings from 1 January 2013.
The budget carrier, acquired by Lufthansa in 2008, will take over all services outside of those to Lufthansa's Munich and Frankfurt, says the German carrier in a statement. It will be headquartered in Cologne.
No decision has yet been taken on a name for the new operation. Although media reports have suggested the division is to be called "Direct4U", an airline spokeswoman says this is nothing more than a "working title" for the project.
Around 90 aircraft will be operated by the merged business, which will include several from Eurowings - the former Germanwings parent - which will fly on the new company's behalf.
Lufthansa estimates the new business will carry in the region of 18 million passengers in its first year of operations.
Christoph Franz, chief executive and chairman of Lufthansa says: "Combining our domestic German and European point-to-point services has enormous potential to improve efficiency. Our aim is to once again fly these services profitably under the umbrella of a single company.
"This means we are continuing to offer our guests the prospect of a dense, high-quality network even outside of our Frankfurt and Munich hubs.
And our employees in these areas have the prospect of secure jobs within a company of the Lufthansa Group."
Lufthansa's move follows similar decisions from legacy rivals Iberia and Air France which are creating budget subsidiaries to stem losses in their short-haul operations.