The move comes two days after the Patriots dropped a 41-33 decision to the Philadelphia Eagles in Super Bowl LII in Minneapolis. McDaniels' hire is one day removed after the Detroit Lions named New England defensive coordinator Matt Patricia as their head coach.
McDaniels will be formally introduced by the Colts during a news conference Wednesday. He replaces Chuck Pagano, who was fired on Dec. 31 after six seasons.
The 41-year-old McDaniels goes from guiding Tom Brady and the high-octane Patriots to a team that struggled mightily without quarterback Andrew Luck, who missed all of last season while recovering from right shoulder surgery in January 2017.
Indianapolis also has the third overall pick in the 2018 NFL Draft in April after finishing 4-12 last season.
McDaniels will begin his second stint as a head coach. He was fired during his second year with the Denver Broncos, with whom he posted an 11-17 mark during the 2009-10 seasons.
McDaniels has captured five Super Bowl titles in New England after joining Bill Belichick's staff in 2001.
McDaniels began his NFL coaching career as a personnel assistant for the Patriots in 2001. He became a defensive assistant two years later before being named quarterbacks coach in 2004 and offensive coordinator in 2005.
McDaniels made a brief stop with the then-St. Louis Rams as their offensive coordinator in 2011 before returning for a second stint with the Patriots in the same position in 2012.
In his nine seasons as Patriots offensive coordinator, McDaniels had six top-10 rankings in total offense.