The government, breaking an electoral campaign pledge, said it would instead raise pensions by 1 to 2 percent in 2013 and tap reserve funds to ease liquidity tensions around pension payments.
Spain's fiscal situation left no choice over the decision as meeting a 2012 deficit target of 6.3 percent of output was the top priority for Spanish authorities, the centre-right government said.
"It was a difficult, painful decision because it was the last thing we wanted to do, but we had no other choice," Labour Minister Fatima Banez said at a news conference following the weekly cabinet meeting.
The move was unexpected as Prime Minister Mariano Rajoy had said earlier this year that he would protect pensions, the only remaining campaign promise he had not been forced to break as Spain was dragged into the centre of the euro zone debt crisis.
When Reuters revealed the government was mulling not applying the inflation-linked review this year, Rajoy at first ruled it out, then said since September that it would be the last thing he would do to balance public finances.
Under Spanish law, pensions should be reviewed each year in line with the inflation data of November, which came out at 2.9 percent on Friday. By not applying the rule, the government will save around 3.8 billion euros and keep its EU-agreed deficit target within reach.
"This responsible decision will enable (Spain) to meet its deficit target, an indispensable objective to make sure Spain can access funding, exit the crisis and come back to growth," the government said in a statement.
As announced in September, all state pensions will rise by 1 percent as of January 2013, while pensioners who receive less than 1,000 euros a month will get an extra 1 percent increase. This will add just 1.5 billion euros to the 2013 budget.
The government also passed a new law to unlock a pensions reserve fund and increase by 4.3 billion euros the capital buffer available to pay pension cheques.
The fund, which was set up in 1997, was used for the first time this year but the government has already tapped the maximum available amount allowed per year.
Ministers had been divided on whether or not to touch the pensions because of the blow to Spain's around 9 million retired people, a source close to the government told Reuters.
But by doing so, Spain will please its European Union partners and the European Central Bank, which is opposed to inflation-linked reviews of pensions and wages.
Spain is so far on-track to meet its year-end deficit target but analysts say that local finances and higher costs for the social security system could derail Spain's efforts.