Attorney-General Michaelia Cash on Monday released an exposure draft of new legislation to create a binding privacy code for social media services, data brokers and other large online operators.
All platforms would be forced to receive parental consent for users under the age of 16.
Social media companies would be required to take all reasonable steps to verify users' age and put children's best interests first when handling personal information.
There would be tougher penalties and more enforcement powers handed to the privacy regulator.
Online platforms subject to the code would need to comply with strict new privacy requirements, including new rules about children and other vulnerable groups.
The code will be developed with the Australian Information Commissioner and industry.
Organisations would face tougher requirements to be transparent about how personal information is handled.
Senator Cash said the bill would ensure Australians' privacy would be treated more carefully and transparently by online platforms.
"We know that Australians are wary about what personal information they give over to large tech companies," she said.
"Our draft legislation means that these companies will be punished heavily if they don't meet that standard."
A 2018 Headspace survey of more than 4000 people aged 12 to 25 found social media was the main reason youth mental health was worsening.
Assistant Mental Health Minister David Coleman said there was a consistent increase in signs of distress and mental ill-health among young people even before the coronavirus pandemic.
"While the reasons for this are varied and complex, we know that social media is part of the problem," he said.
"The recent leak of Facebook's own internal research demonstrates the impact social media platforms can have on body image and the mental health of young people."
Senator Cash's department also released a discussion paper on broader reforms to privacy laws.