However, the decree does include an exemption for firms whose guards work inside compounds used by foreign embassies and non-governmental organisations even though Karzai's office said last week there would be no exceptions.
Karzai has repeatedly called for the banning of private security companies, saying they undermine government security forces.
The decision to disband the firms is linked to Karzai's ambitious project to take over all security responsibility from foreign forces by 2014.
Waheed Omer, Karzai's spokesman, gave notice last week that the president intended to act over private security firms, calling it "a serious programme that the government of Afghanistan will execute".
"It's not about regulating the activities of private security companies, it's about their presence, it's about the way they function in Afghanistan ... all the problems they have created," Omer said.
Omer said more than 50 private security companies, roughly half of them Afghan and the other half international, employ 30,000 to 40,000 armed personnel in Afghanistan.
"Since [Afghan security forces] are not quite at the stages of capability and capacity to provide all the security that is needed, private security companies are filling a gap"
The US military on Monday said it supported the plan and was tightening oversight of its own armed contractors in the meantime.
"Certainly we understand President Karzai's statements that he is determined to dissolve private security companies," Brigadier General Margaret Boor, head of a new task force to better regulate and oversee private security operations, said.
"We are committed to partnering with the government in meeting that intent," she said.
About 26,000 armed security contractors work with the US government in Afghanistan, including 19,000 with the US military, Boor said.
The majority of military contractors protect convoys, though some also provide base
security, Major Joel Harper, a spokesman for Nato forces, said.
Karzai has said such responsibilities should fall to either enlisted military or police, though it is unclear how soon Afghan forces would be ready to take on additional jobs.
Boor said private contractors were still needed to keep development projects and military operations running.
"Since the Afghan army and the Afghan police are not quite at the stages of capability and capacity to provide all the security that is needed, private security companies are filling a gap,'' Boor said.
Al Jazeera's Hoda Abdel-Hamid, reporting from Kabul, said the conduct of private security personnel had caused "a lot of uproar among the Afghan population".
"Their behaviour has always been questioned. Many of them were involved in accidents on highways where innocent Afghan civilians were killed," she said.
"[To ban those firms] is certainly a move that will be widely accepted by the Afghan people and it's certainly a move that comes at a very good time for the Afghan president.
"Parliamentary elections are expected to be held here next month and certainly this is a move that could could garner some support for the president."
Contractors in Afghanistan have been in the spotlight on several occasions.
In February, US senate investigators said the contractor formerly known as Blackwater hired violent drug users to help train the Afghan army and declared "sidearms for everyone'', even though employees were not authorised to carry weapons.
The allegations came as part of an investigation into the 2009 shooting deaths of two Afghan civilians by employees of the company, now known as Xe.