Abstract: Abstract: It’s increasingly important for China to establish a new domestic market system based on functional division of labor among cities, in order to face the challenges of foreign technologies decoupling to realize its technology independence and sovereignty, and to accelerate the development of a unified domestic market with a new growth pattern with internal economic circulation domination. However, few studies focus on the measurement of functional division of labor in urban. And fewer researches empirically test the relationship between digital economy and urban functional division of labor, especially lacking quantitative analysis of transaction efficiency as a mediation mechanism. With the improved measurement methods of functional division of labor and transaction efficiency in cities, it empirically analyzes the effect path of digital economy on functional division of labor through higher transaction efficiency adopting the two-way fixed effect model and threshold model of the panel data from 2011 to 2019 in Chinese prefecture level cities. The results present that: the functional division of labor in urban shows an upward trend with fluctuations from 2011 to 2019. There are obvious regional differences in functional division of labor in Chinese urban agglomerations including Yangtze River Delta, Pearl River Delta, Beijing-Tianjin-Hebei Metropolitan Region, Middle Reaches of the Yangtze River and the group cities region around Chengdu and Chongqing, with highest in Pearl River Delta. The direct effect illustrate that functional division of labor in urban has been improved with the development of digital economy. The mechanism test reveals that digital economy could the level of functional division of labor in urban driven by optimized transaction efficiency. Further research indicates that there is a double threshold effect between digital economy and functional division of labor in urban on the basis of transaction efficiency. Compared with extant research, the marginal contributions of this paper cover the following areas. Firstly, it puts forward a new method to measure the functional division of labor in urban, and compares the functional division of labor among five major urban agglomerations in China, furthering research on indicators for measuring the functional division of labor at city level. Second, the positive impact of the digital economy on the functional division of labor in urban was illustrated using data at urban level, enriching the quantitative analysis on functional division of labor enabled by digital technologies. Finally, it has verified the mediation effect of transaction efficiency between digital economy and urban division of labor. Therefore, it is necessary to establish a new domestic functional division of labor network through digital technology based on existing regional division of labor as soon as possible, and to formulate differentiated regional development strategies based on the functional positioning in the domestic division of labor network and the local resource endowments. What’s more, it’s recommended to make full use of digital technology to bolster technological and institutional transaction efficiency in order to develop a network of functional division of labor in urban for a unified domestic market.