The partnership between the world's largest premium cars maker and the world's biggest automotive supplier will form a powerful counterweight to new players in the auto industry, such as hail-riding firms Uber and Didi.
Uber and Didi are also working on self-driving cars.
As consumers increasingly use smartphones to locate, hail and rent vehicles, car manufacturers and tech companies are trying to adjust to the shifting landscape in the auto industry.
The alliance will mark an end to Daimler's efforts to develop an autonomous car largely on its own.
The new partnership also moves the auto industry's aims from simply developing prototype vehicles, towards an industry-scale production of self-driving cars.
The deal between the two German firms was announced on Tuesday, but financial terms were not disclosed.
In the deal, Bosch will develop the software and algorithms needed for autonomous driving.
The deal will assist Bosch cover ground in a highly competitive independent driving system sector. Rivals Continental, Delphi and others have also invested heavily in the industry.
For car giant Daimler and Mercedes division, the deal with Bosch will help them dedicate more engineering resources at autonomous vehicles. This will accelerate the process of developing a production-ready system for autonomous vehicles by several years.
According to Daimler, the autonomous system is expected to be ready by the beginning of the next decade.
"The prime objective of the project is to achieve the production-ready development of a driving system which will allow cars to drive fully autonomously in the city," Daimler said in a statement on Tuesday.