The head of the Student Loans Company will have tax and National Insurance payments deducted from his £182,000 pay package in future, ministers say.
Ed Lester had not been added to the SLC payroll when given a two-year contract in January 2011, BBC Newsnight said.
He was paid through a private firm - an arrangement agreed with tax chiefs.
But while Mr Lester's pay will now be taxed "at source", Labour's Margaret Hodge warned the door remained open for future public sector tax avoidance.
Her party had asked an "urgent question" on the matter, following the BBC Newsnight and Exaro News investigation.
It forced Chief Secretary to the Treasury Danny Alexander, who signs off civil service salaries above £142,500, to come to the Commons.
He told MPs he was "not aware... of any tax benefit to the individual concerned" when approving the salary level, which he claimed he had "reduced significantly".
He said official guidance said public sector organisations should "avoid using tax advisers and avoidance schemes".
In light of Mr Lester's case, he had asked the Treasury to review the "appropriateness of allowing public sector appointees to be paid through this mechanism".
"I have also asked the Treasury officer of accounts to write to all accounting officers across Whitehall to remind them that all appointments should, in line with existing guidance, consider the wider cost of lost revenue to the Exchequer when considering value for money."
All departments would carry out an internal audit by the end of March, he said, and would include pay deals agreed under the previous Labour government.
But Labour's Margaret Hodge, who chairs the influential public accounts committee, said Mr Alexander appeared to have left the door open to future tax avoidance schemes.
She quoted a letter he sent to senior civil servants saying public sector organisations should "consult its usual Treasury contacts and HMRC before going ahead" with proposals using tax avoidance.
Mrs Hodge told Newsnight: "He is not ruling it out in the way that I inferred from what he said in the House today."
She added: "We've got to understand the role he played in agreeing to the particular circumstances."
Labour MP Nick Brown had earlier said it was "reassuring" to hear that income tax and NI would from now be deducted from Mr Lester's pay. He said such practices had a "demoralising and corrosive effect" on the wider public sector.
He also asked what fees were being paid to the private service company through which Mr Lester was paid and whether the cabinet secretary, prime minister or business secretary had agreed to the "controversial" arrangements.
Shadow business minister Labour's Shabana Mahmood said at a time the economy was "flatlining... the news that ministers approved the contract of a senior official, which allowed tax and National Insurance to be avoided, shows just how out of touch they are".
According to Freedom of Information documents disclosed to BBC Newsnight from the Department for Business, Innovation and Skills (BIS) SLC chairman Ed Smith wrote to Universities Minister David Willetts to get approval for Mr Lester's contract in December 2010.
The letter states that the deal was "subject to ratification with HMRC on the extension of their current concession".
Mr Willetts replied a week later, telling Mr Smith: "The terms of the appointment that you proposed in your letter of 15 December 2010 have been agreed by the chief secretary to the Treasury."
Mr Alexander was repeatedly pressed by Labour MPs on what ministers knew about the tax arrangements and told them he was "not made aware" of any tax benefit to Mr Lester.
He said the terms and conditions were "negotiated by the appointing department" - in this case BIS - and he had simply agreed the salary level because it was over £142,500.
Earlier Business Secretary Vince Cable said Mr Lester was "an exceptionally useful individual who has helped to turn round that organisation [the Student Loans Company]".
He added: "The arrangements under which the negotiations took place involved substantial value for money for the taxpayer, a tax cut by the individual and we will pursue matters of public concern on the tax issues."
But Conservative MP Richard Bacon said there had been "too much of this going on" and quoted former Tory leader Lord Howard saying "special rules for special groups breed anger and division".
Fellow Conservative backbencher David Nuttall pointed out that tax avoidance was legal - unlike tax evasion.
Mr Alexander agreed but added that the government was taking "strong action" to deal with both.
Mr Lester was appointed interim chief executive in May 2010, following months of chaos at the SLC.
BBC Newsnight reported that he was recruited through the specialist recruitment agency Penna plc, and requested the daily fee for his work as a consultant of £900 to be paid without tax or National Insurance contributions (NIC) deducted - which was agreed with HM Revenue and Customs.
In January 2011, he was appointed on a two-year contract but retained the terms of his temporary employment, instead of being added to the payroll.
Before his employment was finalised, the terms of his remuneration were brought to the attention of Universities Minister David Willetts and Cabinet Secretary Sir Gus O'Donnell, who sought clarification about the cost of employing Mr Lester, and the tax arrangements, before approving his appointment.