The third choice for intersex or transgender people means they no longer have to have reassignment surgery to have their passport changed to their preferred sex.
Instead, with a letter from a doctor, they can have their passport marked with an X (instead of M or F for male or female), under new guidelines aimed at removing discrimination.
An Australian senator, Louise Pratt - whose partner was born female and is now identified as a man - said the reform was a huge step forward.
"There have been very many cases of people being detained at airports by immigration in foreign countries simply because their passports don't reflect what they look like," she told Australian radio, the Telegraph reports.
"It's very distressing, highly inconvenient and frankly sometimes dangerous."
Robert McClelland, Australia's Attorney General, said the changes, which come into effect immediately, meant transgendered or intersex people would find traveling much easier.
"Most people take for granted the ability to travel freely and without fear of discrimination," he said. "This measure will extend the same freedoms to sex and gender-diverse Australians."
Applicants will need a letter from their doctor confirming their status and it is still not possible to change birth certificates without reassignment surgery.
Connor Montgomery, who has undergone hormone treatment, and lives as a man, welcomed the reform but said the right to change a birth certificate was also important.
"You know, having that little bit of paper, to some people it seems insignificant but for us it is so important, it feels like the last missing piece of the jigsaw," he said, ABC reports.