The London recruitment and retention allowance is designed to contribute to the "higher costs encountered during a permanent assignment" in London.
From 1 April, the allowance will stop for the rank of sergeant and above.
The MoD said it needed to make savings set out by the prime minister.
The change affects the British Army, Royal Navy and the Royal Air Force.
About 2,000 people will lose the allowance, said the MoD, while 3,000 at the rank of corporal or below will not.
This will provide a saving of about £2.9m a year.
Prime Minister David Cameron set out the need to reduce allowances as part of the wider Strategic Defence and Security Review, published in October 2010.
In it, he said there would be an 8% cut in the defence budget in real terms over four years.
But one serving sergeant affected by the London allowance changes, who did not wish to be identified, said: "In the forces you don't have a choice where you are posted.
"Are the MPs losing their London weighting, or the police?"
He added he was concerned for serving staff posted to London from Wales, Scotland or Northern Ireland with their families.
"It is unfair that they will be expected to pay a higher cost of living in London," he said.
Like the police, members of the armed forces are legally not allowed to strike.
A MoD spokesman pointed out that those on lower pay will still be eligible for the London allowance.
He said: "The move will ensure that the allocation of allowances is fair and appropriate to meet the needs of service personnel."
In the Army, sergeant pay starts at £30,012 per year. The London allowance provides about £120 per month.
Army staff have to pay income tax and national insurance and those who are living in private accommodation must also pay council tax.
While some staff live in barracks or Army houses, others have to rent privately.
'Painful readjustment'
HQ London District, the headquarters for all Army units within the M25 corridor, is based at Horse Guards in central London.
It includes Major Regular Units including the Household Cavalry, The King's Troop RHA and the Coldstream Guards, and also territorial units.
A summary of all the changes to allowances, released by the Ministry of Defence last year, lists 19 areas where benefits will be reduced or removed, including travel and bonuses.
The ministry said the total annual bill for allowances of £880m would be cut by £250m a year, after an "extensive review".
It said its review had "expressly not targeted those on operations".
Speaking about the allowance cuts, Andrew Robathan, Minister for Defence Personnel, Welfare and Veterans, said the government knew the changes would "require some readjustment and will be painful for some personnel".
He added: "But we are all aware of the financial difficulties currently facing the country and we have had to make hard decisions."
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