Some states - but not all - already allow schools to discriminate on the basis of sexual orientation, gender identity or relationship status.
Commonwealth laws also contain some provisions to permit faith-based schools this discretion.
"It is existing law," Prime Minister Scott Morrison told reporters on the NSW Central Coast.
"We're not proposing to change that law to take away that existing arrangement."
Former Liberal minister Phillip Ruddock, who chaired the review into religious freedoms, says the right of schools to turn away gay students and teachers should be enshrined in the Sex Discrimination Act.
"To some school communities, cultivating an environment and ethos which conforms to their religious beliefs is of paramount importance," the review says, according to Fairfax Media.
"The panel accepts their right to select, or preference, students who uphold the religious convictions of that school community."
Opposition Leader Bill Shorten says he can't believe the prime minister hasn't ruled out the "silly" proposal.
"The fact is every [child] is entitled to human dignity. We shouldn't even be having this debate," Shorten told reporters in Melbourne, demanding the government release the report.
Special Minister of State Alex Hawke strongly supported the proposal, saying it is up to individual Christian schools to negotiate their handling of gay students.
"I don't think it's controversial in Australia that people expect religious schools to teach the practice of their faith and their religion," he told Sky News.
Hawke said people of faith in Australia were under attack.
"Everyone of faith feels the pressure ... it's a constant pressure from the left of society on people of faith," he said.
The review was commissioned after the 2017 national same-sex marriage vote and handed to the Federal Government several months ago, but is yet to be released.
Social Services Minister Paul Fletcher said he and his cabinet colleagues had not seen the document.
Labor Deputy Leader Tanya Plibersek said her party was fundamentally opposed to increasing discrimination.
"As a human being and as a mother, the idea that adults would be discriminating against or rejecting children seems to me pretty awful," Plibersek said.
Gay rights activists have slammed the proposal as a shameful assault on equality.
Alex Greenwich, a NSW state MP who co-chaired the national campaign in support of same-sex marriage, is demanding the Federal Government rule it out.
"The recommendation to increase discrimination in schools against the gay teachers and students is offensive to parents, teachers and school communities," Greenwich said.
Greens education spokesperson Mehreen Faruqi said the review's recommendations are outrageous.
“Schools that discriminate against LGBTIQ+ students and teachers don’t deserve a cent of public money," she said.
“It is absolutely outrageous that we should change the law to allow religious schools across the country the right to discriminate against LGBTIQ+ children and teachers. We should be removing exemptions for religious schools from anti-discrimination laws, not expanding them.
“No school should have any right to discriminate against anyone, including the LGBTIQ+ community, let alone with public money.
“All schools should be places of learning, safety and acceptance. No student or teacher should be made to feel lesser because of religious bigotry."
The panel did not accept that businesses should be allowed to refuse services on religious grounds, such as denying a gay couple a wedding cake.
The review also found civil celebrants should not be entitled to refuse to conduct same-sex wedding ceremonies if they became celebrants after it was was legalised.