"We have decided to appoint Arrigo Sacchi so that he can bring his substantial experience to help make our club more professional," said club president Florentino Perez.
Perez said that Sacchi would work under former player Emilio Butragueno who would remain in his post as overall sporting director but would also occupy a position on the board as one of the club's vice-presidents.
He added that the 58-year-old Italian would be given an indefinite contract with the club.
Sacchi, who had a brief and unsuccessful spell in charge of Real's city rivals Atletico in the 1998-99 season, had been employed as technical director at Serie A strugglers Parma.
Sacchi's appointment is the latest in a succession of changes at a club that has gone into a spiral of decline since they discarded the highly successful Vicente del Bosque, who led them to two European Cups and two league titles in his three and a half seasons as first team coach.
Since then Real have gone through two more coaches in the shape of Carlos Queiroz and former player Jose Antonio Camacho, but they have been unable to add any major trophies to their collection.
Camacho threw in the towel just three matches into the present season saying he felt unable to get the best out of the squad, leaving former assistant Mariano Garcia Remon in charge.
Garcia
UNCONVINCING PERFORMANCES
At present Real lie third in the Primera Liga, 10 points behind runaway leaders Barcelona, and produced a series of unconvincing performances on their way to qualifying for the last 16 of the Champions League.
Sacchi, the man now charged with the task of turning the club around, made his name as a coach of Parma in the mid-1980's before he was snapped up by AC Milan in 1987.
In his four seasons at the San Siro, Sacchi was credited with revolutionising European football, creating a stylish side that featured the great Dutch trio of Ruud Gullit, Marco Van Basten and Frank Rijkaard, and winning successive European Cups in 1989 and 1990 and the Italian league title.
Sacchi took up the post of Italy coach in 1991, steering them to the final of the 1994 World Cup where they lost to Brazil on penalties.
But he quit two years later after a disappointing Euro 96 when the side failed to get beyond the first round.
He had an unsuccessful second spell in charge of Milan before joining Atletico Madrid in 1998, but left in mid-season complaining of exhaustion after a run of three league defeats.
He reappeared as Parma coach in January 2001, but resigned after less than a month citing stress as his reason.
Ten months later he returned to the club for a third time as technical director.
Parma, who have serious financial problems, finished in a creditable fifth place in the Serie A in the last two seasons.
But after their worst-ever start to a campaign they lie in 19th position in the standings with just 12 points from 16 games.