Nato estimates for 2016 show that only five alliance members - the US, UK, Greece, Poland and Estonia - will spend a minimum of 2% of national output (GDP) on defence, which is the target.
Germany's defence spending of â‚¬37bn in 2017 will be 1.2% of GDP.
US President-elect Donald Trump says Nato allies are over-reliant on the US.
He has questioned whether the US should defend any alliance partner, under Article 5, if so many of the 28 Nato members are not paying their way. He also criticised Nato as "obsolete".
Nato Secretary-General Jens Stoltenberg has long urged alliance members to meet the 2% target.
Announcing the 2017 spending target, German Defence Minister Ursula von der Leyen said "we're moving in the right direction, but we can't do it in one year". Defence spending also rose in 2016.
Germany has for years struggled to modernise its military as it becomes more involved in Nato operations. It scrapped conscription to become a professional army in 2011 but last year said it may introduce a form of national service for civil defence.
Other Nato members have also started to increase defence spending. The alliance faces a range of security challenges, including the Islamist insurgencies in the Middle East and Africa and Russia's resurgent armed forces, accused of undermining Ukraine.
The significant areas of German defence spending in 2016 included: the Puma Infantry Combat Vehicle, new ammunition and communications equipment. There were delays to some major projects: the A400M transport plane, the Tiger attack helicopter and the NH90 transport helicopter, German n-tv news reports.
Germany plans to boost defence spending by nearly â‚¬2bn (Â£1.7bn; $2.1bn) this year - but it will remain far short of the Nato target.