The Commission on Women Offenders, led by former Lord Advocate Dame Elish Angiolini, QC, claims women's prison HMP Cornton Vale in Stirling is "not fit for purpose".
She says it should be demolished to make way for a specialised prison for long-term offenders and regional units for those serving short sentences.
The report also calls for powers to be given to police and prosecutors to refer women to support services and programmes in their area as an alternative to prosecution and prison.
It suggests a "problem solving court" be piloted to deal with repeat offenders of low-level crimes with complex needs.
Justice Secretary Kenny MacAskill claimed the findings, welcomed by justice and social groups, offer a "compelling vision for the future".
He said: "This is one of the most pressing social justice issues of our time and it's vital we find a more effective way of dealing with women offenders.
"Many female offenders are vulnerable people for whom offending is a result of chaotic lifestyles, mental health difficulties and severe addiction problems. It is clear there are better solutions to stopping female reoffending than simply locking them up in Cornton Vale."
He said he would make a formal response in the summer.
Lewis Macdonald MSP, Scottish Labour's justice spokesman, said: "Our justice system is failing female offenders, their families and the very communities we seek to make safer. Prison exists to punish and rehabilitate, but too often when women are imprisoned for low-level offences it does more to punish the families left on the outside than it does to rehabilitate and reform those on the inside.
"To succeed, a new prison needs to provide a stronger focus on rehabilitation and reducing offending."
Liberal Democrat justice spokeswoman Alison McInnes MSP added: "The problems run deeper than a single prison. We need to think again about every step of the justice process and how it works for women offenders."
The eight-month review made 37 recommendations, including setting up regional units for women in existing prisons around the country to keep offenders close to their families and the local services they will use on their release.
Dame Elish, with sheriff Daniel Scullion and Dr Linda de Caestecker, director of public health at NHS Greater Glasgow, also called for a national Community Justice Service to manage offenders in the community. Local community justice centres would be created to offer services and programmes to reduce reoffending.
Dame Elish said: "For many women in Cornton Vale there's a complete lack of hope for the future. They've lost their children, they've lost their council house because they've been in prison for more than a month, they're isolated and their problems are not tackled.
"They leave prison with a £65 cheque in their pocket with their addiction issues not addressed and it simply goes to the nearest dealer and then they have five weeks without any benefits – we're setting them up to fail. We have a penal system in Scotland designed for men and largely based on a Victorian notion of punishment.
"The system needs to adapt and provide the Scottish community with effective remedies for the heartbreak caused by crime."
Susan Gallagher, deputy chief executive of Victim Support Scotland, said: "Providing support and interventions for victims and offenders like those proposed in this report will assist society and our communities as a whole and all efforts to do so must be welcomed."
Mary Beglan, service manager of the 218 project in Glasgow, which offers support to women offenders, said: "We all know the numbers of women offenders are rising, the numbers have doubled in the last 10 years, so something needs to be done and I think this offers some radical options."