A quarter of the world's population will suffer from mental illness at some point in their lives
It says 450 million people world-wide, currently suffering from mental or neurological illnesses, are being failed by their communities, many of which have no mental health policies in place.
It says depression, which is most prevalent in poorer communities, is currently the fourth most common illness in the world.
And mental health disorders are expected to rank second behind heart disease by 2020.
Stigma and Discrimination
The report said: "We now know that large mental institutions no longer represent the best option for patients and families.
"Such institutions lead to a loss of social skills, excessive restriction, human rights violations, dependency and reduced opportunities for rehabilitation.
"Countries should move towards setting up community care alternatives in a planned manner, ensuring that such alternatives are in place even as institutions are being phased out."
The report suggests that most mental disorders could be prevented or successfully treated but government investment into the problem is woefully inadequate.
It says many countries allocate less than 1% of their total health budgets on mental health and in half the world's countries there is just one psychiatrist per 100,000 people.
And up to two-thirds of people suffering mental disorders will never seek help because of discrimination and the stigma attached to such conditions.
A quarter of countries do not have access to the three most commonly prescribed drugs used to treat schizophrenia, depression and epilepsy, it reveals.
'Labelled for life'
Dr Gro Harlem Brundtland, director-general of the WHO, said: "Mental illness is not a personal failure.
"In fact, if there is a failure, it is to be found in the way we have responded to people with mental and brain disorders.
"I hope this report will dispel long-held doubts and dogma and mark the beginning of a new public health era in the field of mental health."
Although Britain has a more progressive approach to mental health care there is still huge room for improvement and no room for complacency, said Richard Brook, chief executive of Mental Health Charity Mind.
He said: "This large-scale rejection of mental health services is a sad refelction of global mental health care.
"In Britain services are also too restrictive, offer people little choice of treatments than other medication, and leave people 'labelled' for life and burdened by discrimination and stigma.
"People in mental distress still know what helps them recover but they are not listened to and rarely have a say in their treatment."
The charity welcomed the WHO's call for patients to be treated more in the community than in mental institutions.