The move comes ahead of general elections due in April-May.
"The decision will result in the benefit of improved pay and allowances as well as rationalisation of the pay structure in case of Central Government employees and other employees included in the scope of the 7th Central Pay Commission (CPC)," an official statement said after the Cabinet meeting.
The Commission, it said, will make its recommendations within 18 months of the date of its constitution.
"It may consider, if necessary, sending interim reports on any of the matters as and when the recommendations are finalised," said the release on CPC's term of reference.
Headed by former Supreme Court Judge Ashok Kumar Mathur, the CPC has been asked to "examine, review, evolve and recommend changes that are desirable and feasible" regarding the principles that should govern the emoluments structure including pay, allowances and other facilities or benefits.
The recommendations, as per the terms of reference, have to be made while keeping in view the economic conditions in the country, need for fiscal prudence and the need to ensure that adequate resources are available for developmental expenditures and welfare measures.
The CPC's report will be applicable on Central Government employees, All India Services, personnel of the Union Territories, officers and employees of the Indian Audit and Accounts Department, Members of regulatory bodies, officers and employees of the Supreme Court and personnel of Defence Forces.
The panel has also been asked to examine the "principles which should govern the structure of pension and other retirement benefits", including revision of pension for those who have retired prior to the date of effect of these recommendations.
There are about 50 lakh central government employees, including those in defence and railways, and about 30 lakh pensioners.
The CPC has also been asked to provide the likely impact of the recommendations on the finances of the state governments (which usually adopt the recommendations with some modifications).
It has also been asked to keep in view the best global practices and their adaptability and relevance in Indian conditions while making the recommendations.
Oil Secretary Vivek Rae is full time Member of the Commission, while Rathin Roy (Director, NIPFP) is part-time Member and Meena Agarwal (OSD, Department of Expenditure) is Secretary.
Central Pay Commissions are periodically constituted to go into various issues of emoluments structure, retirement benefits and other service conditions of Central Government employees and to make recommendations on the changes required.
Prime Minister Manamohan Singh had approved setting up of the 7th Pay Commission in September 2013.
The 6th Pay Commission was implemented with effect from January 1, 2006; the fifth from January 1, 1996 and fourth from January 1, 1986.