John Cleese based the TV sitcom on the Gleneagles Hotel in Torquay after staying there with the Monty Python team in 1973.
Churchill Retirement Living will convert the site after its plans were approved by Torbay Council.
Former owner Donald Sinclair unwittingly became the inspiration for Cleese's character Basil Fawlty.
The 41-bedroom hotel ceased trading early this year and Churchill Retirement Living applied to use the site for 36 retirement apartments.
Torbay Council's development management committee originally denied the application as they felt it was "too large and unsympathetic to the area".
A smaller, revised scheme was accepted by the council.
It will involve knocking down the three-star hotel and building 21 one-bed and 11 two-bedroom apartments, with a guest suite and two communal lounges.
Planning officers allowed the change of use of the site from tourist accommodation to residential as the former hotel was found to be "commercially unviable".
Fawlty Towers, voted number one in the British Film Institute's 100 Greatest Television Programmes in 2000, ran for just 12 episodes.
The hotel that inspired Fawlty Towers is to be knocked down and replaced with retirement flats.