As part of the agreement, Pandora will negotiate royalty rates directly with Merlin, which counts 20,000 independent labels and distributors as members, rather than paying compulsory rates set by the U.S. government.
The U.S.-only deal will also allow artists and labels to take advantage of Pandora's marketing abilities, Pandora and Merlin said.
"It's kind of a watershed, to be honest," said Tim Westergren, Pandora's founder, in an interview. "This is a strong signal to the music industry of what's ahead."
Shares of Pandora rose about 2% to $25.38 a share in midday trading.
Oakland-based Pandora typically pays blanket mandatory royalty rates, which have long been the subject of dispute between record labels and the streaming service. Neither Pandora nor Merlin would disclose terms of the deal, but said the agreement would be mutually beneficial.
"We wouldn't do a deal that would potentially see our members worse off," said Charles Caldas, Merlin's chief executive. "As a point of principle, we're not going to be licensing to a service at rates lower than what we currently get."
The agreement is a significant step for both parties, as independent artists try to figure out how to best make more money from the growing streaming music industry. Merlin, which is headquartered in London and handles digital royalties only, says the labels it represents account for 10% of the streaming music market, globally.
Royalties also have a huge effect on Pandora's business, as paying for the music it plays continues to be the company's biggest expense by far. For the first six months of 2014, the company spent $219.7 million acquiring content, while generating $413.2 million in revenue.
Shares of Pandora are down significantly from their 52-week high of $40.44 a share in March.
Wedbush Securities analyst Michael Pachter said in an email that making a direct deal with a group like Merlin could help Pandora as it tries to bring down those costs.
"It expands their offering, [is] good for consumers, and gives them some leverage with the Copyright Royalty Board as they negotiate rates going forward," he said. "Merlin gives them a large critical mass of indie labels."
Merlin's artists, including Vampire Weekend, Tom Waits and Bad Religion, could get a big marketing boost.
As part of the deal, Merlin's labels and artists will have access to data from the service, which could help them do things like promote certain tracks to users and better choose which cities to visit for live performances. Pandora and Merlin said the deal will enable members to reach listeners more directly.
Westergren said streaming music has helped independent artists by getting them exposure they can't get through traditional radio. "Terrestrial radio's tremendously difficult to get on, so Pandora's become a very important platform for independents."
The deal for the independents comes after Pandora has a suffered a publicity blow from major artists and labels complaining about the money they received from the service that counts more than 76 million active users. Major record labels sued Pandora in April over royalties from recordings made before 1972.
Westergren would not comment on possible future direct deals.
Representatives from major labels Universal Music Group, Warner Music Group and