The 88-year-old was serving a 20-year sentence after being jailed in 2006 for sexually abusing and torturing children and settlers.
He died of heart disease on Saturday, prison officials said.
Schaefer established Colonia Dignidad, a large, armed, self-sufficient German colony, in an isolated region south of Santiago in 1961 after fleeing Germany to escape child abuse charges.
The mountain colony 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 Schaefer left Chile for Argentina in August 1996 when new child abuse allegations came to light.
The colony was seized in 2005 by Chilean authorities. The same year, Schaefer was arrested in Argentina and extradited back to Chile to face child abuse charges.
Human rights abuse
Schaefer was also charged with collaborating in human rights violations commited by the regime of Augusto Pinochet, the dictator who ruled Chile between 1973 and 1990.
He was accused of allowing Chilean military agents to use Colonia Dignidad to torture political prisoners. Many of the prisoners later disappeared.
The Simon Wiesenthal Centre, a Jewish human rights organisation which helps track down Nazi war criminals, had suspected Schaefer of 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 Colonia Dignidad lived an austere life until Schaefer's arrest. They have now renamed it "Bavarian Village" and opened it to the tourist trade.
aljazeera
