Schäfer, 88, a wartime Nazi corporal and medic, was taken to hospital last July with heart problems and was given respiratory assistance.
He was sentenced to 20 years in jail in May 2006 for abusing and torturing children and other settlers at the armed enclave Colonia Dignidad, or Dignity Colony.
The large, self-sufficient German colony in an isolated region south of Santiago was established by Schäfer in 1961 after he fled Germany to escape child abuse charges there.
The 13,000-hectare mountain resort, 350 kilometres south of Santiago, was home to about 300 refugees from Nazi Germany and their descendants. It was equipped with a hospital and an airport, and became a "state-within-a-state."
But the colony's leader later fled to Argentina in August 1996 after the families of the abused children filed complaints against him.
The Chilean authorities seized the property in 2005 and the Argentines arrested and deported Schäfer back to Chile.
He was also charged with collaborating in human rights abuses during the regime of former Chilean dictator Augusto Pinochet's 1973-1990, including allowing Chilean military agents to use Dignity Colony to torture political prisoners, many of whom were never found.
The Simon Wiesenthal Centre had suspected Schäfer of having connections with Nazi fugitives such as Walter Rauff, who the centre said escaped to Chile and was protected by Pinochet's regime. Rauff died in Chile in 1984.
Residents of Dignity Colony lived an austere life until Schäfer’s arrest, and they have now renamed it Bavarian Village and opened it to the tourist trade.