The lay-offs included 1600 Xbox workers, with more to come this year in a broader reorganisation designed to "reset" Xbox as it faces heightened competition, the company said on Monday.
"Our business today is not healthy," said a memo from Xbox CEO Asha Sharma, who took over the gaming division earlier this year.
"We are operating at margins that are 3-10x lower than comparable platform and publishing businesses."
Sharma said the industry, in which Xbox competes with Sony's PlayStation and Nintendo's Switch, is facing a severe "hardware crisis" as costs soar for console components.
Beyond the lay-offs announced on Monday, Sharma said Xbox expects another 1600 job cuts over the course of the fiscal year that began last week.
The company is also spinning off four video game development studios previously acquired by Microsoft.
Nearly three years ago, Microsoft closed a $US69 billion ($A100 billion) deal to acquire gaming giant Activision Blizzard, maker of Call of Duty and other blockbuster franchises.
The company said at the time it wanted to broaden its game development portfolio and offer a Netflix-like streaming subscription service but the strategy does not appear to have been enough to get ahead of the competition.
"While those businesses have created meaningful value, they did not grow at the pace we expected," Sharma said.
The Xbox cuts are in addition to broader Microsoft lay-offs that the software giant's chief people officer Amy Coleman tied to unspecified changes in customer needs.
"I also want to be direct that the roles eliminated today are not being replaced by AI," Coleman wrote in a blog post.
The layoffs followed voluntary buyouts that Microsoft began offering to about 8750 people in May.
More than 30 per cent of eligible workers accepted those voluntary retirement offers, Coleman said.
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