Schapelle Corby, 34, was convicted in 2005 of smuggling 4.1 kilograms (nine pounds) of marijuana and is serving a 20-year jail sentence at the overcrowded Kerobokan prison on Indonesia's Bali island.
The prison houses murderers and paedophiles and has also been hit by outbreaks of violence, including in February when it was taken over for several days by rioting prisoners after a gang stabbing.
"The Ministry of Justice and Human Rights has given its recommendation to the Indonesian president that clemency be granted to Schapelle Corby," the ministry official told AFP, on condition of anonymity.
He gave no other details, such as when a decision could be expected.
The president has the final decision on clemency, and if he agrees Corby could be given a reduced sentence or even released.
Corby filed a clemency appeal about two years ago, when her lawyers said she should be released on humanitarian grounds because of mental illness.
Her lawyer Iskandar Nawing told AFP on Wednesday that Corby had been driven insane at Kerobokan, one of Indonesia's most notorious prisons, whose 1,000 inmates include 60 foreigners, 12 of whom are Australian.
"Corby deserves clemency due to her mental illness," Nawing said. He added that an Australian psychiatrist had "examined her in prison some time ago and found that she has gone insane."
"Before submitting our recommendation to the presidency we made some surveys in the prison to know her condition," the ministry official said, without elaborating on Corby's physical or mental health.