Woody plants have been increasing in many woodland and savanna ecosystems owing to land use changes in recent decades. We examined the effects of encroachment by the indigenous shrub Leptospermum scoparium (Myrtaceae) on herb-rich Eucalyptus camaldulensis woodlands in southern Australia. Species richness and compositional patterns were examined under the canopy of L. scoparium and in surrounding open areas to determine the species most susceptible to structural changes. Richness was significantly lower in areas of moderate to high L. scoparium cover (>15%), suggesting that a threshold shrub cover caused major change in this ecosystem. Shrubs were associated with a significant reduction in above-ground biomass of the ground-layer flora and a significant shift in community composition. The few species that were positively associated with high L. scoparium cover were also common in the woodland flora; no new species were recorded under the shrub canopy. Important environmental changes associated with L. scoparium cover were decreased light availability and increased litter cover, which were likely a consequence of encroachment. Leptospermum scoparium cover was also associated with greater surface soil moisture, which may be a consequence of increased shading under the shrub canopy or indicate favourable soil conditions for L. scoparium establishment. Reductions in species richness and abundance of the germinable seed bank were found in soil samples taken from under L. scoparium. With ongoing recruitment of L. scoparium and consequent increases in shrub cover, ground-layer diversity in these species-rich woodlands should continue to decline over time.