The partial lockdown will apply until January 10th, with companies also urged to allow employees to work from home or offer extended company holidays, under the new measures agreed by Merkel with regional leaders of Germany's 16 states on Sunday.
Alcohol sales would be banned in public places, essentially outlawing the business of mulled wine stands, which have proved popular in the days running up to Christmas.
The sale of fireworks will also be banned ahead of New Year’s Eve, while care homes will be mandated to carry out coronavirus tests.
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Germans are urged to limit their social contacts to another household, with a maximum of five people excluding children under 14 meeting at each time.
From Christmas Eve to Boxing Day, the contacts would be eased to allow gatherings with another four people excluding children, but who should be limited to close relatives or partners.
“There is an urgent need to take action,” Chancellor Angela Merkel said following a meeting with leaders of the country’s 16 federal states on Sunday.
“I would have wished for lighter measures. But due to Christmas shopping the number of social contacts has risen considerably,” she told journalists.
“The corona situation is out of control,” said Bavarian state premier Markus Söder, welcoming the tougher restrictions which he pledged to implement in his state.
Exponential growth again
Germany in November closed leisure and cultural facilities and banned indoor dining in restaurants.
The measures had helped to halt rapid growth of infections after the autumn school holidays, but numbers had plateaued at a high rate.
Over the last week however, the country's disease control agency reported that the infections trend has taken a worrying turn.
“With increasing mobility and the therefore linked additional contacts in the pre-Christmas period, Germany is now in exponential growth of infections numbers,” said the policy paper agreed by regional leaders and Merkel.
It was therefore “our task to prevent an overload of our health systems and that's why there is an urgent need to take action,” said the chancellor.
While hospitals in some regions are warning that their intensive care units are reaching capacity, huge queues of shoppers were building downtown ahead of the festive period.
The chancellor had also voiced consternation at growing groups of people gathering for drinks at mulled wine stands set up by restaurants as a substitute of the popular Christmas market fare.
Germany has imposed far less stringent shutdown rules than other major European nations after coming through the first wave of the pandemic relatively unscathed.
But Europe's biggest economy has been severely hit by a second wave with daily new infections more than three times that of the peak in the spring.
Germany recorded another 20,200 new Covid cases over the past 24 hours, reaching a total of 1,320,716 cases, according to RKI data published on Sunday.
Another 321 patients died from the disease from a day earlier, bringing the total death toll to 21,787.
Merkel's government has repeatedly said that numbers need to be brought down to 50 per 100,000 people but the rate is currently 169.1 per 100,000.
Ahead of the talks, Germany's hardest hit states have already ordered new measures. Saxony state, where in some areas incidence rates have hit 500 per 100,000, will shutter shops and schools already from Monday. A curfew will also kick in from 10pm to 6am.