The team said in a statement that both parties mutually agreed to part ways.
Donovan's contract expired at season's end, and the sides decided against pursuing an extension.
"We had planned to sit down at the end of the season and discuss the best way to move forward for both of us," Thunder executive vice president and general manager Sam Presti said in a statement. "After those discussions, it became apparent that we couldn't provide him the information on the future direction of the team over the next several seasons to give him the level of clarity that he understandably desires at this stage of his career.
"Therefore, we close this chapter and reflect fondly on all that he has given to the team, organization and community. Billy will always have a place in the Thunder family."
Discussions between OKC management and Donovan were described as collaborative and realistic, sources said.
"This place will always be special to us. I will always hold this organization in the highest regard and wish the Thunder and their fans the success they deserve," Donovan said in a statement.
The reality of Oklahoma City's transition toward a rebuild made it a challenge for the two sides to find a way to continue together, sources said.
Donovan's contract expired with the Thunder's season ending in a Game 7 loss to the Houston Rockets in the first round of the Western Conference playoffs.
With reduced league revenues amid the pandemic, there remains uncertainty about how long the Thunder will continue with key veterans in place before changing course on being in playoff contention in the Western Conference.
The Bulls are expected to have interest in considering Donovan for the franchise's head coach position, sources said. Chicago is currently undergoing first-round interviews with several candidates.
Donovan signed a five-year deal with the Thunder after serving as the head coach for the University of Florida. His deal included a team option that Oklahoma City exercised early in the 2018-19 season.
Donovan was the National Basketball Coaches Association's co-coach of the year with Milwaukee's Mike Budenholzer for 2019-20. The NBA's coaches vote on the award.
In five seasons, Donovan advanced to the Western Conference finals in his first season with Kevin Durant and Russell Westbrook and reached the playoffs in each of the next four years. Donovan was 243-157 (.608) as the Thunder's head coach.
The Thunder are well equipped to execute a rebuild, with a young core of players that includes point guard Shai Gilgeous-Alexander, rookie guard Lu Dort and forward Darius Bazley. Trades that sent Paul George to the Clippers and Westbrook to the Rockets have left the Thunder in position to have 13 first-round picks and three sets of swap rights across the next seven NBA drafts.