In a huge upset, the seventh seed toppled the 34-year-old 6-4, 3-6, 6-4 to win her maiden major title and become the first German Grand Slam champion since Graf at the 1999 French Open.
Williams, the world number one and defending champion, had won all six previous Melbourne Park finals she had played and had also triumphed in her last eight Grand Slam deciders.
But Kerber, inspired by a good luck message from Graf, knew all the pressure was on her opponent and she mercilessly exploited her weaknesses in a thriller at Rod Laver Arena.
"The best two weeks of my life and career. I had goose bumps here on the centre court when I was playing."
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The left-handed German, whose win will see her move up from world number six to two, has had an emphasis on consistency in Melbourne, patiently building control of the point as rallies develop.
It worked well with the 28-year-old, who had never beaten a world number one before, dropping just one set en route to the final, in the opening round to Miskai Doi when she saved a match point.
"I was actually really happy for her. She's been around a really long time," said Williams.
"I think I did the best I could today. You know, would I give myself an A, No. But today this is what I could produce today.
"Maybe tomorrow I could produce something different. But that's all I can go off."
The imposing American was the overwhelming favourite, having won three of the four Grand Slam titles last year, but said she was only human.
The German faced the powerful Williams serve first up, and failed to win a point against it, reinforcing expectations that the top seed would take control.
But Kerber began finding her range and against the odds broke to go 2-1 in front.
An out-of-sorts Williams was hitting too many errors, but holding for 2-3 seemed to temporarily flip a switch in the American who broke back.
But the mistakes piled up and Kerber broke again as she dictated the baseline points.
Twenty-three unforced errors from Williams to the German's three told the story of the first set, which Kerber wrapped up in 39 minutes.
She took it into a deciding third set having made only five errors, in stark contrast to her wayward first set.
But it was Kerber who grabbed a decisive break in the third set as she reeled off a brilliant passing shot on her way to a 2-0 lead.
It went with serve until a titanic sixth game, when Williams saved four break points but couldn't save a fifth as she looped a forehand long.