Oli will now have to take a vote of confidence at the House within 30 days, failing which, an attempt to form a government under Article 76 (5) of the Constitution would be initiated.
The political stalemate comes at a time when the country is experiencing its worst COVID-19 surge with acute shortages of health facilities and oxygen for patients.
Prachanda has been making efforts to garner support from the opposition Nepali Congress and Janata Samajbadi parties in an apparent bid to oust K P Sharma Oli from power.
The ruling Nepal Communist Party was a post-poll marriage of convenience of their individual parties for power in 2018.
Nepalese President Bidya Devi Bhandari on Sunday dissolved the House of Representatives and announced dates for mid-term elections.