Following sustained criticism and campaigning from advocates, Veterans' Affairs Minister Matt Keogh announced on Thursday the government had backed down on the measure.
In a bid to improve the budget's bottom line, the government introduced a $5000 annual limit on allied health services for veterans which was originally set to come into effect from July 2027.
This would have resulted in cutting more than $779 million over the next four years from the portfolio.
The proposal attracted widespread condemnation with the coalition, Greens and crossbench all calling for Labor to dump the cap.
Mr Keogh said the government took its "solemn obligation" to veterans very seriously.
"We brought forward a package of measures to improve access to allied health, improving the fees paid to allied health practitioners, so that they would provide better service to our veteran community," he told parliament.
"And as part of that, we also committed and did engage with the ex-service organisations, with veterans, with families ... and we committed to listen, and we did, and we heard, and we have responded."
Mr Keogh has faced calls in recent weeks to resign after he initially declined to meet with advocates over the cap.
The government was criticised after the parents of Cameron Baird, who was killed in 2013 during a deployment to Afghanistan, were told their travel allowance would be cut.
This was also overturned.
Fair Care for Veterans spokesman John Armfield, a former Navy clearance diver, thanked Mr Keogh for dumping the cap.
"This is what happens when a government listens to veterans," he said.
"The minister says he wants to keep talking to veterans and providers. We welcome that, and we'll be there.Â
"We'll also make sure whatever comes next doesn't bring the cap back under another name."
Veteran and Tasmanian senator Jacqui Lambie, alongside Greens senator David Shoebridge, successfully passed a bill in the upper house to stop any future cap being imposed on health payments.
Senator Lambie, who gave an emotional address about the healthcare barriers facing female veterans, hailed the win.
She urged veterans not to take out their anger on Mr Keogh or the department, noting the work completed on implementing key reforms from the Royal Commission into Defence and Veteran Suicide.
"I have seen more movement in the last two years since that royal commission than what I have in the whole 10 years I've bloody been up here," Senator Lambie told reporters.
"They are working hard, and there will there will be slips along the way, and that is my job to represent you guys up here."
Senator Shoebridge said there had been a "pile on" Mr Keogh, who had to deliver a three quarter of a billion dollar saving in his portfolio.
"If veterans are angry about this, and they should be, direct the anger at the people who made the decision," he said.
"This is a treasurer, prime minister decision."
Opposition defence personnel spokesman Phillip Thompson became emotional as he welcomed the government's decision, calling on Mr Keogh to apologise.
"You need to listen to those that it will affect and the sad thing is, the minister didn't do that," he told reporters.
"I know what it's like to carry a coffin. I know what it's like when your friends are no longer."
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