As per his last wishes, Merchant, who died in London Wednesday, was buried at the Bada Kabrastan in Marine Lines in south Bombay.
Merchant's death was the second major blow for India's entertainment industry in a single day, with film star-turned-politician Sunil Dutt also passing away due to a heart attack earlier Wednesday in Mumbai.
Merchant's funeral procession, which began at 4 p.m., was accompanied by many Bollywood personalities, friends and relatives.
Film director Shyam Benegal, Shashi Kapoor - who acted in several of Merchant's films - actor Om Puri, lyricist Javed Akhtar and media critic Anil Dharkar were among those who were present at the burial ceremony.
Merchant's body was brought to the city by an Air-India flight. The plane, scheduled to arrive at 12.20 pm, was delayed and landed at the Chattrapati Shivaji Airport at around 1 pm.
The body was first taken to a relative's house in the Mumbai Central neighbourhood, where friends and relatives paid homage.
Merchant last visited India and his office in Colaba in January last year to promote his film "Le Divorce". He then announced another film with singer Tina Turner, which was slated to go on the floors in November last year but had been delayed.
Kapoor said he was "deeply saddened by the departure of an old friend."
"I spoke to him a couple of days ago. He seemed fine," Kapoor told reporters, adding that "Merchant was a workaholic. Nothing gave him more satisfaction than doing a good job."
Merchant died at the Queen Elizabeth Hospital in London on due to an ulcer burst in the abdomen. He had reportedly been suffering from stomach ailments for some time and had undergone surgery for abdominal ulcers.
Merchant only recently shot for his film "The White Countess" in China with Ralph Fiennes.
Born on December 25, 1936 in Bombay, as the city was then called, Merchant and his partner James Ivory revived interest in celluloid period dramas.
Merchant lived and worked for most of his life in the West, completing his education at New York University where he earned his Masters Degree in Business Administration.
Merchant's first film was a theatrical short, "The Creation of Woman", which was nominated in 1961 for an Academy Award and was an official entry from the US in the Cannes Film Festival that year. While en route to the festival, Merchant met James Ivory and they agreed to form a partnership.
"The Householder", with Shashi Kapoor in the lead, was Merchant-Ivory first feature length film and the first Indian film to be distributed worldwide by a major American company, Columbia Pictures.
More Indian features, including "Shakespearewallah", "The Guru", and "Bombay Talkies" followed.
Over the years, Merchant-Ivory Productions made more than 40 films - garnering 31 Oscar nominations. The team won six Oscars, including four for best picture.
The duo made Oscar-winning period films such as "Howards End", "A Room With a View" and "The Remains of the Day".
"The Mystic Masseur", based on the novel by Nobel laureate V.S. Naipaul, was Merchant's latest work as a director and was released in 2002.
Merchant was also the author of several books, including "Florence", "The Proprietor", "The Screenplay" and the "Story Behind the Film" and the best-selling "Passionate Meals for Fearless Cooks and Adventurous Eaters".