The England Under-21 international has struggled to make an impact since Antonio Conte's arrival at Stamford Bridge, with his appearances limited to just 32 minutes of Premier League action last season.
He becomes Frank De Boer's first signing since replacing Sam Allardyce as manager of the Eagles, and the 21-year-old was thrilled to move to Selhurst Park.
"I had the option of coming to Palace and I thought that it would be great for me,” he told the club's official website.
“I live not too far away, I was born in Lewisham and Palace is good club so I thought it’s a good chance to play here and be a part of the team.
"They have a very strong team and I’d like to be a part of that this season."
Loftus-Cheek has made 22 Premier League appearances to date, and will battle with the likes of Yohan Cabaye and Jason Puncheon for a place in the starting XI at Palace.