A panel was set up in 2002 to look into why leprosy patients were quarantined up to 1996, despite the fact the disease is not highly contagious.
It found that the health ministry kept up the practice of isolation partly to secure continued funding.
The panel noted other countries stopped isolating leprosy patients in the 60s.
"Japan's policy of absolute quarantine... did not have any scientific grounds," the government panel said.
"The health ministry, in order to secure an adequate budget for treatment, emphasised the continued need for the policy of absolute isolation to the finance ministry," it said.
Doctors, who also had vested interested as the administrators of sanatoriums, did not challenge the policy, the 1,500 page report added.
The panel also criticised Japan's courts for helping the government uphold the policy and the country's media for failing to report it.
Babies killed
Earlier this year, it was reported that the government panel also found that for a period of 30 years up to at least the 1950s, the babies of hundreds of leprosy patients held in sanatoriums were deliberately killed by medical staff.
The Japanese investigators heard testimony from many former leprosy patients, who said that they were not permitted to keep their babies because the Japanese authorities feared they would pass on the disease.
The report was commissioned after a district court ruled in 2001 that the state wrongly maintained its isolation policy and ordered it to pay compensation to former leprosy patients.
The government went on to apologise to former leprosy sufferers.
Leprosy, also known as Hansen's disease, affects the nerves and can cause deformities and skin discolouration. It is not communicable once treated, and a cure was found in the 1940s.
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