The national commissioner will investigate the deaths of more than 400 defence personnel since 2001, and report back within 18 months.
The permanent role requires new legislation, but an interim chief will work out of the Prime Minister’s department immediately.
The PM said the inquiry would be able to keep evidence private, unlike a royal commission.
“I think we’ve come up with a much better way that brings everybody together,” he said.
The decision comes after federal Opposition leader Anthony Albanese backed calls for a commission.
Mr Albanese endorsed the public campaign after meeting with Julie-Ann Finney, whose son David died by suicide earlier this year.
While making clear he would have preferred a royal commission, Mr Albanese welcomed the alternative as a necessary step.
“We don’t want the perfect to be the enemy of the good here,” he told reporters in Canberra.
“Labor will approach this issue in a positive way and join with the government in participating in this process.”
The suicide rate for ex-servicemen is 18 per cent higher than the broader population and ex-servicewomen are twice as likely to take their own lives as other Australian women.
The government will spend $40 million to set up the office of the commissioner.
Apart from investigating past and new deaths, the commissioner will also make recommendations to improve mental health and wellbeing.
The watchdog will deliver an annual report to parliament to assess the reduction of suicide risk factors.
Liberal backbencher Phillip Thompson, himself a veteran, said he looked forward to the inquiry delivering tangible solutions.
“Every day I wake up and I remember my mates that have been killed on operations and my friends that have died by suicide,” he said.
“I’m sick of it, veterans are sick of it and the family members are absolutely sick and tired of burying our loved ones and now this is the action.”
The government will also establish a veteran family advocate alongside the new commissioner role to communicate with veterans and their families and help develop related policy.
VETERAN SUICIDE COMMISSION EXPLAINED
An independent commissioner will investigate all suspected suicides among defence personnel and veterans.
• Unlike a one-off royal commission, the role of the commissioner will be ongoing.
• It will be able to call witnesses, compel evidence and take action against people who do not co-operate.
• The commission will sit within the attorney-general’s department.
• An interim report will be handed down within 12 months, before an annual report is delivered to federal parliament each year.
• An initial $40 million will support the commissioner, but this could be increased.
• A family advocate will also be appointed within the Department of Veteran’s Affairs.
– With AAP