The plans, outlined in a letter to parliament by Immigration Minister Rita Verdonk, come amid a heated debate about how to improve the integration of the country's big immigrant population following the murder of an outspoken filmmaker.
Theo van Gogh, who had angered many of the Netherlands' one millions Muslims with a film critical of Islam, was killed on 2 November.
A 26-year-old Dutch-Moroccan has been charged with his murder.
"The aim of the system is that everybody who wants to live for a long time in the Netherlands sufficiently masters the Dutch language to be able to participate in society," Verdonk said on Tuesday. "They must also know enough about how society works."
Verdonk said anybody who had less than eight years schooling in the Netherlands would have to take the test, including Dutch people.
About 18% of the Dutch population of 16 million is of recent foreign descent.
"The aim of the system is that everybody who wants to live for a long time in the Netherlands sufficiently masters the Dutch language to be able to participate in society. They must also know enough about how society works"
The minister had originally only wanted to target immigrants from outside the European Union but changed the criteria to years of schooling to avoid charges of discrimination.
Those exempt from the test include those with certain diplomas, those older than 65 and EU citizens.
The government said it would ask the European Commission whether it could oblige Turkish immigrants to take the test.
She said the individual would bear the cost of taking the exam, although people could claim most of it back if they pass. The scheme is expected to cost the government about $350 million a year.
New arrivals would have up to five years to pass the test or risk a fine of 400 euros and possible implications for their continued residency in the country.