Saunders, who only took charge in January, learned his fate after a meeting with chief executive Jez Moxey on Monday. Saunders's assistant Brian Carey is also leaving his post.
A club statement read: "We have now begun a recruitment process, which, in conjunction with the board, will be managed by head of football development & recruitment Kevin Thelwell.
"The club will now take as long as is necessary to make this crucial appointment and there will be no publicly communicated timescales.
"Wolves would like to thank Dean and Brian for their efforts in what has been a very difficult period for everyone, and wish them both the very best for the future."
Losing key players, including Sylvan Ebanks-Blake to injury, may have been a mitigating factor in Wolves winning only five of his 20 games in charge, but Saunders's team selection and tactics failed to curry favour with many supporters.
After dropping out of the Premier League last season, Stale Solbakken was entrusted with ensuring a revival in fortunes. But he was unable to halt the downward spiral and was replaced by Saunders after just six unhappy months.
Their demotion to the third tier, where they will play for the first time since 1989, was confirmed after the 2-0 defeat at Brighton on Saturday.
Wolves owner Steve Morgan sacked Mick McCarthy, who had spent five-and-a-half years in charge, in February last year with the club struggling at the bottom end of the Premier League.
McCarthy's assistant Terry Connor was appointed until the end of that season, but Wolves were relegated to the Championship with three games remaining.
Connor was sacked the following July and Solbakken, who had lost his job at Cologne the previous month, was charged with guiding Wolves straight back to the top flight.
But the Norwegian made little impact at Molineux and, after just half a season, with the club lying 18th in the Championship in January, he too was sacked and replaced two days later by Saunders.
Former Liverpool and Aston Villa striker Saunders, who began his managerial career at Wrexham, took over as Doncaster manager in September 2011.
He was unable to halt Doncaster's slide into League One last season, but galvanised the South Yorkshire club and steered them into second place in the table before leaving to take charge of Wolves.
Doncaster secured an instant return to the Championship with victory at Brentford on the final day of the season under Brian Flynn, who has since stood down as Rovers manager.