The military said that 65-year-old Yehudit Weiss was discovered in a house near the hospital complex in Gaza City, adding that her family had been informed, and her body would be returned to Israel.
Ms Weiss was kidnapped from her home in Be'eri near the Gaza border during the attack on 7 October, during which 1,200 people were killed and around 240 people were taken hostage.
The Israeli military said on Friday morning that it had also recovered the body of 19-year-old Israeli Corporal Noa Marciano from “a structure adjacent to the Shifa Hospital”. Corporal Marciano's death was confirmed earlier this week.
Israel military spokesman, Rear Admiral Daniel Hagari said that intelligence had led them to the location of Corporal Marciano's body near al-Shifa. The funeral for Corporal Marciano was held on Friday In the central Israeli city of Modi'in.
Noa’s mother, Adi Marciano, said on Thursday: “It’s hard to talk about Noa in the past tense... Noa is a girl of light and love, with kind eyes that tell a story of giving, of a smile that is never-ending.” During the funeral on Friday, she wept over her daughter’s coffin.
Rear Admiral Hagari added that the military "share in the family's grief and will continue to work together with its partners in the security system to locate and return the abductees home."
Ms Weiss was hailed as a "loving full-time grandmother" according to the Bring Them Home Now group, which represents the families of hostages. She had been recovering from breast cancer when Hamas launched its deadly attack, but was without her medication when she was taken, according to the group.
Ms Weiss worked in her kibbutz's kindergartens, managed the dining room and specialised in nursing before she retired, the group said, adding she had a love for culture, sports, travelling and baking. Her husband, Shmulik, a rabbi, was killed in the Hamas assault.
In its statement, the Israeli army said that Kalashnikov rifles and rocket-propelled grenades were among the weapons discovered where her body was located.
It comes as the families of Israeli hostages and thousands of supporters marched towards Jerusalem on Friday, ramping up pressure on the government to secure their release nearly six weeks after Hamas militants abducted them and took them into Gaza.
The procession left Tel Aviv three days ago and at this point stretched a few kilometres. Police blocked off parts of the main highway as the marchers began to ascend the foothills leading to Jerusalem. They held up pictures of their loved ones, waved Israeli flags, and chanted "We won't give up, we demand the hostages' release!"
In other developments, Israel said its troops had found a tunnel shaft used by Hamas at al-Shifa.
The hospital, which contains hundreds of patients and displaced people, has been a major focus of global concern this week. Israel says Hamas has stored weapons and ammunition and is holding hostages in a network of tunnels under hospitals like alShifa, using patients and people taking shelter there as human shields. Hamas denies this.
Israel has vowed to crush Hamas in the wake of the attack across the border with Gaza. It responded with a near-continuous aerial bombardment of Gaza, which continues, and a blockade which has seen crucial supplies of fuel, water, food and medical supplies running short – or out.
Ground operations have focused on northern Gaza, and particularly Gaza City, forcing hundreds of thousands to flee southwards, even though airstrikes have also been used on areas of southern Gaza. Officials from the health ministry in Hamas-run Gaza have said more than 11,000 people have been killed since Israel’s operations began, around 40 per cent of them children.
Israel accused Hamas of preventing people from heading to the south of the Gaza Strip, which the militant group denied.
The army released a video it said showed a tunnel entrance in an outdoor area of al-Shifa. The video showed a deep hole in the ground, littered with and surrounded by concrete and wood rubble and sand. It appeared the area had been excavated. A bulldozer appeared in the background.
The army said its troops also found a vehicle in the hospital containing a large number of weapons.
The United Nations said there would be no cross-border aid operation into Gaza on Friday due to fuel shortages and a communication shutdown. For a second consecutive day on Thursday, no aid trucks arrived in Gaza due to lack of fuel for distributing relief.
World Food Programme (WFP) Executive Director Cindy McCain said nearly the entire population was in desperate need of food assistance.
"Supplies of food and water are practically non-existent in Gaza and only a fraction of what is needed is arriving through the borders," she said in a statement.
"With winter fast approaching, unsafe and overcrowded shelters, and the lack of clean water, civilians are facing the immediate possibility of starvation," Ms McCain added.
Reuters and Associated Press contributed to this report