Transgender inmates are now able to request a transfer to another prison which matches their identified sex instead of the sex shown on their birth certificate.
Corrections Minister Anne Tolley said this afternoon that New Zealand had decided to follow international practice by introducing a more flexible prison system for transgender inmates.
"If the sex on their birth certificate has been changed, these prisoners will be managed in accordance with their legal sex," she said.
"Transgender prisoners whose sex on their birth certificate has not been changed can apply to be moved into a prison with their identified gender."
The change followed a request from the Ombudsman, and was designed to improve prisoners' welfare while reducing the risks of victimisation and assault.
The Corrections chief executive would consider each request for a transfer on a case-by-case basis, and the policy would not apply to transgender prisoners with a record of serious sexual offences.
At present, there are nine transgender inmates in New Zealand jails.
Mrs Tolley also announced that all remand prisoners would no longer be automatically classed as high-risk.
Low-risk inmates would have a "less restrictive", individual security classification, which would allow them to get better access to rehabilitation programmes.
The Government has expanded its drug, alcohol and education programmes in an attempt to meet an ambitious goal of reducing reoffending by 25 per cent by 2017.
Green Party rainbow issues spokeswoman Jan Logie said the rule change was a "huge win" for transgender prisoners which would keep them safe from sexual assault and rape.
"I congratulate the Minister and the Government for taking another step towards making sure transsexual and transgendered people have the rights they deserve."