Private companies, voluntary groups and independent schools could educate pupils who have been excluded from schools in England.
The name "pupil referral units" is to be scrapped - and new providers will be invited to raise standards.
The plan calls for earlier intervention - including making efforts to identify problem children in primary school.
Schools Secretary Ed Balls says there must be a "radical transformation" of learning outside mainstream classes.
Mr Balls has set out a root and branch reform of provision for excluded and disruptive pupils - in an attempt to raise the low performance of the current system.
'Studio schools'
At present, only 1% of youngsters in pupil referral units achieve the basic level of five good GCSEs.
PUPIL REFERRAL UNITS
These units are also much more expensive than mainstream classes - costing £15,000 per pupil per year, more than three times as much as an ordinary secondary school place.
The proposals set out in the White Paper, Back on Track, call for a more innovative range of alternatives, including "studio schools" for vocational training and schemes from the private and voluntary sector.
The shake-up would mark an "end to a penal and low-education approach," said Mr Balls.
The Prince's Trust has already expressed an interest in taking part in one of 10 pilot schemes, which will receive £26.5m in government funding.
Mr Balls has not ruled out profit-making companies - pointing to the private companies involved in secure training centres - and said he would be "enthusiastic" to have the participation of independent schools.
The proposals would see the closure of failing referral units - and the requirement for a more effective replacement, either from the state, private or voluntary sector.
There will be an emphasis on early intervention, which is likely to mean an increase in the number of children, particularly primary school pupils, passing through these referral units - for shorter periods of time.
Psychiatric help
"Often primary heads and teachers are the best early indicator of things going wrong," said Mr Balls.
"A child with a special educational need or a sibling who has been involved with crime - those are very substantial risk factors. We can identify all of those risk factors at primary school," he said.
"We would like to be intervening at a much earlier stage and using alternative provision before you get into the world of exclusions at all."
Sir Alan Steer, who has been advising the government on pupil behaviour, says all referral units should have a psychiatric nurse or psychiatric social worker.
There will also be greater scrutiny of standards, with the expectation that pupils' achievement and attendance should be monitored and a guarantee of an adequate curriculum for pupils.
But Jerry Glazier from the National Union of Teachers, who teaches at a pupil referral unit in Essex, said the union was opposed to the trend of involving private companies in education.
"We think it's absolutely crucial that local authorities work with their own resources, with schools, to provide the best quality provision and I'm unconvinced that a private provider will be able to do that effectively.
"There are some excellent pupil referral units across the country - those need to be extended, that provision needs to be strengthened, local authorities and government need to commit themselves to more resources, and then I think we will see stepped improvements."
However, the general secretary of the Association of School and College Leaders said it was irrelevant whether the referral centres were run by the public or private sector, as quality was the key consideration.
"What we want is high-quality provision and I don't think there should be any pre-supposition that either the public sector or the private sector is the only place in which that high-quality provision can be provided," said John Dunford.
Disruption
But Dr Dunford said permanent exclusion should not be the only way for young people to access alternative provision.
"The goal should be earlier intervention for those in danger of exclusion, with PRUs working with the local school behaviour partnerships to devise family support and educational strategies that match the young person's needs."
Michael Gove, the Shadow Secretary of State for Children, Schools and Families, highlighted that Conservative leader David Cameron had called for more involvement from the voluntary sectory last year.
“I'm glad that Ed Balls now accepts this is right. However, we should be tackling this problem at the source. Many children suffer because they've not been taught to read properly.
"We need tried and tested reading schemes in primary schools to stop children going off the rails in the first place," said Mr Gove.
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