A system for testing the safety of new drugs should be introduced, with low- risk substances sold with labels detailing their risks, like cigarette packaging, members of the all-party parliamentary group for drug policy reform said.
While the supply of the most dangerous substances should remain banned, users caught in possession of a small quantity of any drug should not be penalised, the inquiry found.
The proposals are likely to irk the Prime Minister, who recently rejected calls by MPs to set up a Royal Commission to consider the decriminalisation of illegal drugs.
Presenting the inquiry findings, chairwoman Baroness Meacher, who is also the chairwoman of an NHS trust, said: "The Misuse of Drugs Act is counter-productive in attempting to reduce drug addiction and other drug harms to young people."
The remaining sections of the act in use are causing "serious risks to the many young people who are determined to experiment with drugs", the group said.
Prime Minister David Cameron has said: "I don't support decriminalisation. We have a policy which actually is working."