Colonia Dignidad was founded by former Nazi soldier Paul Schäfer in 1961.
The commune, which was located 350km (220 miles) south of Santiago, was run as a secretive cult and dozens of children were sexually abused there.
Hundreds of German and Chilean survivors will now be eligible for compensation.
The decision to pay the victims was made by a government commission in Berlin on Friday. A fund of €3.5m will be set aside to do so.
It comes a week after prosecutors dropped their investigation into a German doctor who worked at the commune.
A court in Chile had found Hartmut Hopp guilty of complicity in child sex abuse committed by Schäfer, but he fled to Germany before he could be jailed.
German prosecutors said there was insufficient evidence to uphold the ruling.
What was Colonia Dignidad?
Colonia Dignidad was a colony set up by Schäfer in the remote Maule area.
He ran it as a secretive cult with members living as virtual slaves and prevented from leaving by armed guards with dogs.
At its peak, 300 Germans and Chileans were living in the 137 sq km (53 sq mile) compound surrounded by wire fencing and overlooked by a watchtower with searchlights.
Children were forced to live separately from their parents and dozens were sexually abused by Schäfer.
What else happened there?
It was not just members of Schäfer’s sect who suffered abuse.
Under the military rule of Gen Augusto Pinochet, Colonia Dignidad became a clandestine detention centre. About 300 opponents of the regime were interrogated and tortured in its underground tunnels both by members of the Chilean secret police and Schäfer’s associates.
At least 100 people are thought to have been murdered there. One of those believed to have been killed at the site is US academic Boris Weisfeiler, who went hiking in Chile in 1984.
In its report, released on Friday, the German commission said Schäfer “tore families apart, abused countless children and actively collaborated with Pinochet dictatorship henchmen on torture, murder and disappearances.
“The survivors still suffer massively from the severe psychological and physical consequences after years of harm caused by violence, abuse, exploitation and slave labour,” the report read.
The compensation would be paid “exclusively out of moral responsibility and without recognition of a legal obligation,” it added.
Schäfer fled Chile in 1997 while facing a number of lawsuits over the sexual abuse of children. He was arrested in Argentina in 2005 and convicted of serial paedophilia.
He died in prison aged 88 in 2010.
Colonia Dignidad changed its name to Villa Baviera in 1991 and has become a tourist resort with a German-themed restaurant and hotel. More than 100 people, many of them former members of the commune, live at the site with many saying it is the only home they have ever known.