Prime Minister Scott Morrison said it would be "sensible" if Australia followed the lead of Denmark and developed a colour-coded system of COVID-19 restrictions, instead of imposing hard internal border closures.
The idea has been backed by a leading infectious disease expert, who said sewage testing could play a role in whether an area is considered a green or red zone.
Speaking at a summit in Cooma on Friday, Mr Morrison said he regretted not setting national principles for state border closures earlier on in the pandemic.
Internal border closures had been one of only two areas of disagreement between national cabinet, Mr Morrison said.
"If I had my time over I think we would have spent more time on that but frankly at that point in time, we were looking at people digging mass graves in New York and we were dealing with the difficulties of building up our health systems to ensure we had enough respirators and ICUs and there was a lot of uncertainty. That's not an excuse, that's just an explanation," he said.
The government moved on Friday to extend paid pandemic leave to people who lived in border communities in NSW and South Australia but worked in Victoria. Victorians who were directed to self-isolate due to the virus in the month before the scheme was announced can also claim the payment.
The prime minister said border closures were not a permanent solution and should be opened in places of low virus infection.
"The idea that we're going to live with domestic borders until there's a vaccine is a recipe for economic ruin. That is not the plan," Mr Morrison said.
"The plan is to ensure testing, tracing, outbreak containment, strong quarantine, COVID-safe behaviors in the workplace, in the home ... that is how you live with the virus and keep people in jobs. Borders don't do that."
The AHPPC expert medical panel is developing Commonwealth guidelines for what constitutes a coronavirus hotspot.
Mr Morrison indicated he would like Australia to pursue a similar system to Denmark, which classifies countries as either "open" or "quarantine" countries based on whether it has a sufficient testing regime and there are fewer than 20 new cases per 100,000 inhabitants in one week.
Travel advice is changed from orange - avoid all non-essential travel - to yellow - travel with caution. Travellers to yellow countries do not have to quarantine for 14 days upon return home.
"Now I'm not suggesting that this is precisely what we do in Australia but hotspots are defined where there's an incidence of [below 20 new cases] per 100,000 inhabitants ... there's the clear metrics where they say this goes yellow and orange and different quarantine arrangements apply whether you can or can't go there. I think that's quite a sensible approach," Mr Morrison said.
State border closures did not prevent people from travelling from metro hotspots to regional areas, Mr Morrison noted.
"What matters is the outbreak and containing it there and as localised as possible and I think these sort of systems have to do this," Mr Morrison said.
Australian National University infectious disease expert Dr Peter Collignon endorsed this approach.
"I personally think this is what we have to do," Dr Collignon said.
"This is going to go on for the next year or two at least. We need to have some sort of objective criteria we use, which will invariably change over time, so that we can make it as safe as reasonable without having too many restrictions."
Under a colour-coded system, Dr Collignon said Melbourne would be considered red right now, while Sydney and maybe parts of Brisbane would be yellow.
He suggested sewage testing - like ANU researchers are doing to monitor potential outbreaks in Canberra - could play a role in determining whether an area needs tighter restrictions.
"If we really want to know if there's an unrecognised amount of COVID in a population, another way is to look at sewage. Two-thirds of people with COVID excrete it in their faeces so we should be able to detect it in the sewage," Dr Collignon said.
"If you start finding positive levels, it's time to tighten restrictions and do more testing. It might be you're not allowed 10 people in a restaurant anymore."
However Deputy Chief Medical Officer Dr Nick Coatsworth said defining a hotspot was not straightforward.
"Is it purely about a border issue? Is it about what a state is going to do internally?" he said.
But Dr Collignon said such a system was necessary to getting life back to some semblance of normality.
"My view is this is not going to go away, we're going to have this problem for years. The only way it's moderately going to go is away is if you have a vaccine that is effective for 90 per cent of people.
"Even if Australia rolled [a vaccine] out next year, you can't roll it out to the whole world, so you're still going to have issues with people coming to Australia with the virus. We're going to have to be a bit more objective about it."