Raul is Real's record appearance maker with 741 and their second all-time top scorer behind Cristiano Ronaldo, racking up 323 goals in 16 years while winning six La Liga titles and three Champions Leagues.
The former Spain striker, who also played for Schalke, Qatari side Al Sadd and the New York Cosmos, had been working with the Madrid's Under-18 team since March.
Zinedine Zidane was coach of Castilla before being named first-team coach in 2016 while Santiago Solari followed the same path last season before Zidane returned as head coach.
Julen Lopetegui, Vicente del Bosque and Rafael Benitez also worked at Castilla before taking the top job at the 13-times European champions.
Castilla lost out on promotion to Spain's second tier in the playoffs and Raul, 41, will be aiming to lead them out of Segunda Division B next season.
(Reporting by Richard Martin, editing by Ed Osmond)
