"Licensing arrangements and other relevant regulations could be set up so that local authorities could control prostitution in their areas," the Home Office said in a paper that will form the basis of consultation before a decision is made about whether to amend the law.
The paper added that sex workers could also be registered and "tolerance zones" where street prostitution is allowed could be created.
Home Secretary David Blunkett said he wants to meet head-on "the devastating consequences of prostitution."
He ruled out any possibility that prostitutes under the age of 18 should no longer be treated as offenders.
"We believe there are compelling arguments for retaining this offense in respect of those under 18 to underline the message that prostitution involving children and young people is wholly unacceptable," said the consultation paper.
Official estimates suggest there are 80,000 people involved in prostitution in Britain, with four out of five of them women. More than nine out of 10 are drug users and many of them have been prostitutes since childhood.
The report said there was support for creating managed zones for prostitution in several parts of Britain, including Doncaster and Liverpool in northern England.
"In both the places it is suggested that managed areas could bring significant benefits, providing greater safety and fewer stigmas for those who engage in prostitution by choice," it said.
"What is proposed is a formalized 'red light' area, where those involved in prostitution and their users are permitted to trade in a defined area regularly monitored by the police and provided with drop-in health services and other facilities."
Home Office Minister Caroline Flint acknowledged Friday that in the Netherlands, where the idea has been tested, several zones have been closed because they didn't prove effective.
The paper suggests that a registration scheme for prostitutes may help to safeguard public health.
It cited the example of a registration scheme in Austria where call-girls must be at least 19 and have regular health checks, and may be limited to certain streets or banned from working on the streets at all.
Considering changes to the legal status of brothels would help combat businesses such as massage parlors or saunas which offer prostitution behind closed doors, the paper said.
"It has been argued that treating brothels as legitimate businesses could reduce levels of exploitation through the application of employment law and health and safety at work regulations," said the paper.
Under current law, it is not illegal for one person to operate as a prostitute from an apartment, but brothels are illegal.