In a highly unusual move, Bishop Franz-Peter Tebartz-van Elst of Limburg was ordered to leave his diocese while an investigation and audit into cost over-runs is held.
A Vatican statement said the bishop, who met the Pope on Monday to discuss the scandal in the German Church, "was currently not in a position to carry out his episcopal ministry". It said he should stay outside his diocese "for a period," and that it would be administered in his absence by a vicar-general.
The issue has proven a major embarrassment for the Pope, who has called for a more austere Church that sides with the poor and has told bishops not to live "like princes".
The Pontiff has also promised to clean up the murky finances of the Vatican's own bank and has set up a commission to advise him on whether it should be restructured or even closed.
The German media has dubbed Bishop Tebartz-van Elst the "Bishop of Bling" after an initial audit of his spending - ordered after a Vatican monitor visited Limburg last month - revealed the project cost six times more than planned.
Bishop Tebartz-van Elst has also been accused by German magistrates of lying under oath about a first-class flight to visit poverty programmes in India.
German media, citing official documents, said the residence had been fitted with a free-standing bath, a conference table and a private chapel.
The Pope's decision on the fate of the bishop was unusual because it appeared to leave him in limbo, falling somewhere between a suspension and outright dismissal.
This was apparently to buy time for the Vatican and German church leaders to review the situation in the troubled diocese along with its broader ramifications.
The story has been front page news in Germany, deeply embarrassing a church enjoying an upswing thanks to Pope Francis's popularity after years of criticism for hiding sexual abuse cases among clergy.
Bishop Tebartz-van Elst, 53, is 22 years away from official retirement age in the Church and his saga represents an extraordinary management quandary for the Vatican.
Even if he eventually steps down from the diocese of Limburg, he would retain the title and rank of bishop, meaning the Vatican would have to find another post for him somewhere.
Last week, while the Vatican and the German Church were in crisis mode over the Limburg case, Bishop Tebartz-van Elst was kept waiting for eight days in Rome before the Pope received him.
Archbishop Robert Zollitsch, head of the German bishops' conference, who met the Pope last week to discuss the Limburg scandal, had urged Bishop Tebartz-van Elst to examine his conscience over the crisis he caused in the German church.
The scandal has also put pressure on German bishops for more financial transparency in the entire Church in their country, forcing them to scrap centuries of secrecy over the reporting the value of their private endowments.
According to some media reports in Germany, the Limburg scandal has prompted more Germans to decide to formally leave the Church.