The 30-year-old, who has played 62 Tests for Australia, had previously been found to have committed a "high-level breach" of the code of conduct over the posts he made in April.
Folau, a devout Christian, said on his Instagram account that "hell awaits" for "drunks, homosexuals, adulterers, liars, fornicators, thieves, atheists, idolators" in a post that remains visible.
He had previously been warned over making homophobic comments on social media in 2018, but did not face disciplinary action at the time.
Rugby Australia chief executive Raelene Castle told a press conference: "We are here to announce that Wallabies and Waratahs player Israel Folau has today been issued a sanction directing termination of his playing contract for his high-level breach of the professional players' code of conduct.
"The three-member panel of John West QC chair, Kate Eastman and John Boultbee, provided its final written decision today in relation to the code of conduct hearing over Folau's social media post on April 10, 2019.
"While Rugby Australia accepts the panel's decision directing termination of Israel Folau's contract for his high-level breach of the code of conduct, we want to stress that this outcome is a painful situation for the game.
"Rugby Australia did not choose to be in the situation, but Rugby Australia's position remains that Israel, through his actions, left us with no choice but to pursue the course of action resulting in today's outcome.
"This has been an extremely challenging period for rugby. This issue has created an unwanted distraction in an important year for the sport and for the Wallabies team.
"But our clear message for all rugby fans today is that we need to stand by our values and the qualities of inclusion, passion, integrity, discipline, respect and teamwork."
Castle said she had been in touch with players to "make it clear that Rugby Australia fully supports their right to their own beliefs, and nothing that has happened changes that.
"But when we're talking about inclusiveness in our game, we're talking abut respecting differences as well. When we say rugby is a game for all, we mean it.
"People need to feel safe and welcomed in our game regardless of their gender, race, background, religion or sexuality.
"Israel is a great rugby player and we are disappointed and saddened by the fact that he will not see out his four-year contract and commitment to the Wallabies and also with the Waratahs."
Folau has the option to lodge an appeal against the sanction.
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