Without the New Union party, Mr Paksas could no longer control a parliamentary majority.
"To form a stable majority within the coalition I see the only option is for the prime minister to resign," Mr Paksas told journalists.
President Valdas Adamkus accepted Mr Paksas' resignation from hospital where he is being treated for suspected appendicitis.
He has appointed the current Economy Minister, Eugenijus Gentvilas, as caretaker prime minister.
Coalition
The government was plunged into crisis on Monday when six cabinet ministers from the New Union party withdrew from the coalition, calling for Mr Paksas' removal.
They said they could no longer work with Mr Paksas and his Liberal Union party as they had too many differences over economic policy, particularly the prime minister's drive for privatisation.
Without the New Union party, Mr Paksas could no longer control a parliamentary majority.
"We agreed that the government, after the recalling of six ministers, is de facto not capable of acting," said Mr Paksas announcing his resignation.
He had hoped President Adamkus would appoint the current Finance Minister, Jonas Lioginas, as the interim prime minister, but Mr Gentvilas had been tipped for the job.
After narrowly surviving a censure motion in parliament on Tuesday, Mr Paksas indicated he would be ready to negotiate over his premiership if this would save the coalition.
But there is speculation that the opposition Social Democrats may now form an alliance with the New Union.
Mr Paksas, a former stunt pilot champion and the ex-mayor of the capital, Vilnius, came to power in last year's general elections with promises to help stimulate the economy.
He pledged to lower taxes and cut red tape but the disagreements with his coalition partners have frustrated his plans.