Social Development Minister Paula Bennett says the cancellation of a person's benefit for failing a drugs test would be a last resort.
The details of the Government's second phase of welfare reforms will go before Cabinet in the next few weeks.
Ms Bennett says the changes are likely to include graduated sanctions for beneficiaries who refuse to apply for a job because they are asked to take a drug test or who fail a pre-employment drug test.
She says benefits could be cut by up to 50%, or cancelled if the beneficiary is unwilling to be drug-free.
Ms Bennett says the Government would much rather work with people than implement sanctions if they have not met their welfare obligations.
Legislation to enable the sanctions, as well as other social obligations for beneficiaries such as ensuring that children go to school, will be introduced to Parliament in the next few months.
The changes are expected to come into effect in July 2013.
Prime Minister John Key defended moves to cancel payments to beneficiaries who refuse work opportunities because of their drug use.
Mr Key says there are obligations on beneficiaries - and one of them is that they be available for work.
"A beneficiary that can work and will, therefore, be on the Jobseeker Support benefit should work if work is made available to them.
"If they are refusing to go and apply for a job which they know would require a drug test - and the reason they're refusing is because they know they would fail that drug test because of use of recreational drugs - that's quite wrong in my view."
Mr Key says taxpayers do not expect to subsidise the drug habits of beneficiaries.
The Labour Party says the Government should be helping beneficiaries off drugs, not cutting their support.
Social development spokesperson Jacinda Ardern says cutting benefits is short-sighted and will do nothing to help beneficiaries who have a drug problem.
"Those working in the community on drug and alcohol programmes will tell you they're desperately under-funded and under-resourced.
"I would certainly applaud the Government if it is proposing focusing on addressing the nub of the issue, but to date there's been no evidence that that's a part of their plan."
The Green Party says the Government should not be threatening beneficiaries with losing their benefits.
Co-leader Metiria Turei says it should be focused on supporting people to find work, not punishing them.