The change comes after a transsexual, Samart Meecharoen, filed a complaint Wednesday with the Central Administration Court, challenging the military's policy as discriminatory.
The new policy will list them as suffering from sexual identity problems.
"To avoid the possible violation of human rights and discrimination, the military will change the term of wording in conscription from being mentally ill to suffering sexual identity problems," said Maj. Gen. Phichai Pinsaikhaew, deputy chief of the military reserve command.
"The military does not mean to discriminate against these people or violate their human rights but we are trying to find the word to show that they are not fit to serve in the military," Phichai said.
Thai men over 20 must report each April for an examination to determine whether they are physically and mentally fit to serve the mandatory two years of military service.
The military said about 5 percent of the people who show up for registration are gay transvestite or transsexual. Those who dress like women are forced to strip off their female outfits and accept certificates of exemption that are stamped "due to mental disorder."
A celebrity Thai-style kickboxer who underwent surgery to become a woman, Parinya Charoenphol, complained on local television after being exempted from the military. Many say the label fuels discrimination and makes it difficult to find work, reports AP.
Thailand is a Buddhist country where homosexuals, transvestites and transsexuals those who dress like a woman or get surgery to change their sex are a regular presence on TV and in movies.