Government officials often intern activists, dissidents and petitioners while the powerful and wealthy can abuse the system to lock up opponents, said Chinese Human Rights Defenders (CHRD).
"Those locked up for 'mental illnesses' are one of the most vulnerable groups in China," CHRD international director Renee Xia said in a report.
"Not only are they deprived of their liberty on the basis of alleged disabilities, those who violate their rights also face little legal oversight or accountability."
Those in psychiatric hospitals are subject to forced medical treatment and physical abuse such as electric shocks. Often barred from contacting family members or lawyers, they stand little chance of arguing their case in court.
The system is "highly vulnerable to abuse," the report said.
The study was prepared for the United Nations' first review next month of China's compliance with the Convention on the Rights of Persons with Disabilities, which it ratified in 2008 and which bans disability-based detention.
Those who committed the patients are often appointed as guardians, authorised to decide if those inside should be released, the report said.
By law, guardians should only be appointed if patients have been declared legally incompetent.
The Chinese national legislature's permanent Standing Committee is set at the end of the month to discuss a draft mental health law that appears to codify the status quo, CHRD said, urging a rewrite.
The report drew from evaluations of 60 cases across the country and interviews with 15 former psychiatric patients.