The Coalition government will replace the public service 2 per cent wage rise cap with a floating limit tied to private sector pay increases.
It made the decision as it announced a review of performance bonuses arrangements for Australian Public Service executives.
The public sector union criticised the decision saying it is a missed opportunity for the government to take a leading role nationally on wages.
Labor said the decision meant public servants would suffer the consequences of the government's economic mismanagement.
Public servants can now negotiate remuneration rises greater than 2 per cent if private sector employers were awarding staff pay growth above that rate. It could also mean pay rises lower than 2 per cent, if economic conditions are poor and private sector wage growth is low.
It rules out the possibility that public sector wage rises could exceed wage rises in the private sector.
Assistant minister to the Prime Minister and cabinet Ben Morton announced the change which he said would bring wage rises for public servants more "in step with their fellow Australians."
"By removing the existing 2 per cent cap, the wages of Australian government employees can grow as private sector wages grow - even when private sector wages growth exceeds 2 per cent, but importantly it won't be able to exceed it, even when it dips below 2 per cent." Mr Morton said.
"This new policy means Commonwealth public sector employees will directly benefit from ensuring the government's plan to strengthen the economy, create jobs and deliver private sector wages growth succeeds."
Importantly, it was confirmed this new policy would be implemented as current agreements expire and are renegotiated. Existing arrangements will be allowed to run their course and not be impacted.
It brings to an end the controversial wage cap introduced under the Abbott government alongside a tougher bargaining policy for federal bureaucrats.
The wage ceiling is intended to link public servant pay growth more directly to economic conditions.
However, Community and Public Sector Union national secretary Melissa Donnelly said the government had missed the chance to boost the economy through wage growth.
"As our nation faces a recession and difficult economic circumstances, the Prime Minister has the power to help get the nation back on its feet; by creating good, stable jobs in the public sector, and showing leadership on wages," Ms Donnelly said.
"But by tying public sector wage outcomes to the private sector, the Morrison government is effectively abdicating its leadership role."
She said economists and even Scott Morrison as Treasurer commented that low wage growth was a drag on the economy.
"The long-term implications of this decision will be felt for years to come," she said.
ACT Senator Katy Gallagher was also scathing of the decision which she said came on the back of the job cuts to the public service and widespread outsourcing.
"After years of declining wages growth from this government's mismanagement of the economy they are now asking public servants to pay the price through lower wage increases," Senator Gallagher said.
"Labor will work through the implications of this announcement and will consult with the unions which represent the workers who stand to be affected."
Professionals Australia ACT branch director Dale Beasley said the decision brought some needed rigour to the manner in which wages were set compared to the arbitrary cap.
"But linking wage rises to the wage price index at this point will strap employees to a rollercoaster of changing conditions over the next two years," he said.
"The private sector wages index is projected to fall to 1 per cent in 2021, so public servants who come up to renegotiate their wage deals in that period will face a 'valley of death,' until the wage price index rises again"
The Coalition government deferred for six months public service wage rises due in 12 months from April 14, saying bureaucrats must share the economic burden of COVID-19.
However, last month it said it would not extend the wage freeze.
It will review performance bonus arrangements for APS executives, a decision that follows revelations last month that government business enterprise Australia Post bought Cartier watches as rewards for senior executives in 2018.
Mr Morton announced Prime Minister and Cabinet Department secretary Philip Gaetjens, Public Service Commissioner Peter Woolcott and Finance Department secretary Rosemary Huxtable would conduct the review.
"The government considers it appropriate to carefully consider the payment of bonuses to [SES level] employees," Mr Morton said
"It is the expectation of the government that where agencies have access to bonus arrangements they should exercise restraint to the furthest extent possible in keeping with community expectations."
The review will consider current bonus arrangements and aim to set clear guidance to be applied across government going forward.