The Shas party said it was abandoning the cabinet to protest against MPs' failure to guarantee future exemption from military service for religious students.
"Shas representatives ... find with a heavy heart that they cannot stay in the government and be a part of it," the group said in a statement, a day after the United Torah Judaism (UTJ) party also announced its walkout.
However, unlike the UTJ, a Shas spokesman said the party was not leaving the parliamentary coalition, leaving Netanyahu with a razor-thin majority.
The move means Netanyahu does not face early elections, nor does it undermine his efforts to secure a possible Gaza Strip ceasefire.
Israel's parliament starts a three-month summer recess on July 27, giving Netanyahu time to try to resolve the long-standing problem over whether ultra-Orthodox students should continue to be exempt from military service.
UTJ has seven seats in the Knesset, the 120-seat Israeli parliament, while Shas holds 11.
The issue of conscripting highly religious Israeli men into the military has been a long-standing point of tension for Netanyahu's nationalist religious coalition.
It has returned to the agenda due to the war in the Gaza Strip, with commanders warning of an urgent shortage of combat-ready soldiers.
While members of ultra-Orthodox communities have been exempt from compulsory military service for decades, the exemption expired last year, and the government did not pass a new law to cement the special status.
The Supreme Court issued a judgement last year that ultra-Orthodox Jewish men must be conscripted into military service.
Many ultra-Orthodox Jews see military service as a threat to their pious lifestyle, partly because women and men serve together.
with DPA
