Work and Pensions Secretary John Hutton has unveiled plans to get one million incapacity benefit claimants back into work, saving £7bn a year.
More severely disabled people will receive a higher rate of benefit and have no obligation to look for work.
But claimants who refuse to take part in back-to-work schemes risk losing part of their benefits, Mr Hutton said.
There will also be moves to get a million older people and 300,000 single parents back into work, he said.
About 2.7m people currently claim incapacity benefit, resulting in an annual bill of £12.5bn. From 2008 it will be renamed the Employment and Support Allowance.
If one million incapacity benefit claimants return to work, the country would move closer to Labour's ambition of an 80% employment rate, Mr Hutton said as he unveiled the Welfare Reform Green Paper.
The measures include the UK-wide roll-out of the Pathways to Work initiative, currently being tested in seven regions.
The idea is to give individual counselling, training and advice to sick and disabled people to help them back to work.
It will be compulsory for claimants assessed as able to work to take part in these schemes.
Those who refuse to take part could lose as much as £10.93 a week in payments, rising to £21.86 for a second refusal.
Mr Hutton told MPs the aim was to reduce the number of new claimants, to provide greater help to those on the benefit to return to work, and to give more support to the most severely sick and disabled.
Other measures include, in a month's time, the hiring of employment advisers by GP surgeries as part of a trial scheme to help sick people return to work.
Health staff who help to keep people in work while they were ill, or assist them to return to a job, will be rewarded, under the proposals.
"Our proposals will be fair to claimants and fair to taxpayers," said Mr Hutton.
"Nine out of 10 people who came on to incapacity benefit expect to get back into work, yet if you have been on incapacity benefit for more than two years, you are more likely to retire or die than ever get another job. That cannot be right."
A third of new claimants now cite mental health problems as the reason for coming on to benefits, he said.
WHAT IS A GREEN PAPER?
It is a consultation document containing policy proposals for debate before a decision is taken on the best policy option
It contains several alternative policy options
After the consultation, ministers normally publish firm recommendations in a White Paper, which may then be put before MPs in the form of a Bill
It is thought the government wants to get the welfare reforms into a published bill and through Parliament by the end of November
Lone parents whose youngest child is at least 11 will be required to attend interviews every three months, while those on benefit for a year will have to visit a jobs adviser every six months.
Shadow work and pensions secretary Philip Hammond said that, while the Conservatives broadly welcomed the thrust of the policies, much of it had been heard before without any government action.
David Laws, the Liberal Democrat work and pensions spokesman, said setting targets was "the easy part" and that the "test" would be whether the reforms delivered in the long run.
TUC general secretary Brendan Barber gave a "guarded welcome" to the plans, but said he had "real concerns" about how they will work in detail.
Lorna Reith, of the Disability Benefits Consortium - which brings together a number of leading disability groups and health charities - said she was concerned about the sanctions contained in the proposals.
She urged ministers to concentrate on preventing people from being pushed out of the labour market in the first place.
Mr Blair is trying to win over Labour MPs concerned about the changes. Sixty-five backbenchers rebelled against planned reforms to the benefit in 1999.