The ruling left-wing coalition has reversed the previous Congress-led government's decision to shut all bars expect those in five-star hotels.
The new policy states that two and three-star hotels can now serve liquor, and new bars will be able to apply for licences.
The government said it believed in restraint and not prohibition.
Chief Minister Pinarayi Vijayan said there had been "a steep increase in substance abuse" since the restrictions were approved in 2015.
"Prohibition has not succeeded anywhere in the world. It only helped drug smugglers and bootlegging. Here [in Kerala] we are experiencing a dangerous situation of alcoholics turning to drugs and posing a threat to the society," he said.
Bars will now be allowed to remain open until 2300, instead of the earlier deadline of 2200. Lounges at domestic airports will also be allowed to serve foreign liquor.
A major part of Kerala's income comes from tourism, and experts say the ban on alcohol had badly hurt the industry.