The review, the most comprehensive for 20 years, is likely to be compared to the controversial changes proposed for the police force in the Sheehy report.
Ministers confirmed that it could lead to some grades being abolished and others being given higher pay for higher qualifications.
Jeremy Hanley, the Minister for the Armed Forces, confirmed in a written answer in the Commons that a major independent review of service career and manpower structures, including terms and conditions of service, was being planned.
He said it would 'ensure that we have arrangements which are appropriate to the early part of the 21st century'.
The Government is planning a review team comprising an independent chairman and three or four independent members. The study will last about a year and the names will be revealed shortly.
The review is part of the cost-saving 'Front Line First' scrutiny. It will be separate from the annual review of pay by the Armed Forces Pay Review Body, which Mr Hanley said would make recommendations in its normal way for the pay round next January.
The review team will be given carte blanche to report back on the structure of the pay grades. Ministers are already preparing to merge the posts of chaplain for the three services, and more streamlining of roles is expected.
But ministers also expect the team to look at detailed changes to allowances for the armed forces. These include removal costs, and additional payments for flying, the cost of living in London, extra pay for serving in Northern Ireland and separation allowances - paid to married personnel to compensate them for the stress of separation.
The Government was forced to back down over recommendations of performance-related pay and fixed-term contracts for the lower ranks in the police under the Sheehy report. The armed services already have short-term contracts and there could be a row if ministers seek to impose performance-related pay on its fighting arm, although the system has been introduced for civilian staff.
Senior officers in the armed forces were awarded increases of 2.75 per cent from April but the Cabinet refused to implement the pay rises of up to 4.4 per cent recommended by the pay review for the lower ranks in the armed forces.
It was the only one of the five pay review body reports not to be implemented in full. The Cabinet decided that this could not be afforded and agreed to pay an increase of 3.6 per cent in two stages.