Under the deal, Baosteel is to take over its smaller competitor Wuhan Iron and Steel.
Both companies are majority-owned by the state.
The announcement comes as Beijing tries to overhaul the steel industry, one of the country's bloated state sectors.
The merger will create a new company, China Baowu Iron and Steel Group. Based on data from 2015, the two firms together have an annual production of about 60 million tonnes a year, which would make it the country's largest steelmaker.
Globally, it would be second only to Luxembourg-based ArcelorMittal.
Baosteel's net profit tumbled 83% to 1bn yuan ($150m) last year, while Wuhan lost 7.5bn yuan, a sharp drop from its 1.3bn yuan net profit in 2014.
Steel demand in China, as well as worldwide, has slumped in the past year as the country's economic growth has slowed.
The resulting overproduction has seen steelmakers around the world suffer huge losses. China has been accused of price dumping - selling its steel cheaply overseas in order to clear its stocks.
In April, China promised to reduce its steel output, following a crisis meeting attended by 30 nations.
Over the past 25 years, Chinese steel production has expanded hugely with output growing more than twelve-fold.
China produced more than 822 million tonnes of steel in 2014 and is expected to produce even more this year. However, projected demand for its steel in 2016 is only 672 million tonnes.
Two of China's largest steel companies have announced plans for a merger, creating the world's second largest steelmaker, as the industry struggles with global overproduction.