The ??359m Independent Living Fund pays out an average of ??300 a week, to help people pay for carers so they can live at home and not in a care home.
It was already shut to new applicants for this year and will now shut to new claims permanently, said the minister for disabled people, Maria Miller.
Payments to existing users are to continue until 2015.
Ms Miller said: "An independent discretionary trust delivering social care is financially unsustainable."
But Richard Hawkes, chief executive of disability charity Scope, said the decision to phase out the fund was "bemusing".
"The fund is comparatively very small and is designed to support disabled people to live at home rather than in care homes," he said.
"It's hard to see how phasing out this fund will do anything but narrow down options and push people towards greater dependence on the state."
The phased closure was described as "foolhardy and lacking in humanity" by Labour peer Lord Morris of Manchester.
Lord Morris, who was the first minister for the disabled, said: "This will not save money. If you make it harder for disabled people to live at home, it will cost more because more of them will have to be in hospitals and other places of full-time care.
"It will mean far more of them having to be in institutional care at far greater cost to the taxpayer."
The government said local authorities had a statutory responsibility to provide social care support to their residents.
And it said it remained its priority to safeguard the position of the recipients of the fund.
It said it would carry out a formal consultation next year on how best to continue to support existing users.
A fund which supports more than 21,000 people with severe disabilities is to be phased out by 2015.