Foreign airlines will be able to buy up to 49 percent of Air India under new rules approved by the government on Wednesday to boost the debt-laden flag carrier.
Once the country's monopoly airline, Air India has slowly lost market share to new low-cost private players in one of the world's fastest-growing airline markets.
The government said last June it was open to selling a stake in the state-owned airline, which has developed a reputation for delays, cancellations and poor service.
On Wednesday the cabinet rubber-stamped plans to allow foreign airlines to invest up to 49 percent in Air India, subject to government approval.
That was part of a series of moves to relax restrictions on foreign investment.
Prime Minister Narendra Modi's right-wing government has sought to encourage foreign companies to invest in India since coming to power in 2014.
The cabinet also cleared plans to automatically allow 100 percent foreign investment in single-brand retailers. Previously, this required special government approval.
Air India ran losses for nearly a decade after a botched merger in 2007 and has debts of around $7.67 billion according to government figures.
It has received a $5.8 billion in bailout funds from the government but still needs more working capital to turn it around.
India has the world's fastest growing passenger airline industry, expanding at an annual rate of around 20 percent.
Experts say India's aviation sector holds vast untapped potential, with just 100 million of its 1.2 billion people taking to the skies in 2016.