Previously, Australia's aid agency chose the supplier and distributor for the medicines, but this year that process was handled by PNG.
In June, the PNG Government removed a crucial quality-control criteria and later awarded the contract to a local company that PNG doctors say supplies sub-quality drugs from China.
Doctors say the distribution of ineffective medicine could cost lives.
Presenter: Liam Cochrane
Speakers: Dr Glen Mola, treasurer of the Medical Society of PNG, DFAT spokesperson
Three years ago, a corruption scandal within Papua New Guinea's health system left hospitals running out of drugs and prompted the PNG Government to ask for Australia's help in stocking health centres.
For two years, the International Dispensary Association supplied medical kits to almost 3,000 health facilities across Papua New Guinea.
Dr Glen Mola, treasurer of the Medical Society of PNG, says the IDA did a good job getting the medicine to health clinics in remote parts of PNG.
The person who contracted to distribute the medicine didn't get paid unless they could take a digital photograph of the medicine arriving at the actual health facility at a time and a date that was verified by the health facility.
But the arrangement was always going to be temporary and this year the PNG Government took responsibility for procuring the 2014 supply of medical kits.
Australia agreed to keep funding the program - provided the tender process was transparent.
But days after the closing date for tenders, an official at the Ministry for Health told bidders that an internationally-recognised quality-management accreditation - known as ISO 9001 - was no longer required.
The company that won the tender - Borneo Pacific - does not have the ISO 9001 accreditation.
But the company does have a history in PNG.
Dr Glen Mola.
Borneo Pacific are a company that have been in PNG for a couple of decades and they have a reputation. And many of us are very concerned because of past performance.
Borneo Pacific is the largest supplier of drugs from the North China Pharmaceutical Group.
A survey of antibiotics in PNG in 2011, found all four samples provided by North China Pharmaceutical Group were sub-standard, with one probably a fake drug.
What's more, the Borneo Pacific bid was nine million Australian dollars more than the firm which successfully delivered the kits for the past two years.
Australia's Department of Foreign Affairs and Trade released this statement about its funding of the medical kits:
This [funding] was conditional on the Government of PNG purchasing the kits from a pharmaceutical's firm which met international drug quality standards, through a fair, transparent international tender process. Unfortunately, these conditions were not met and the Australian Government will not fund the distribution of the medical kits resulting from this tender process.
The ABC understands the PNG Government has set aside money in next year's budget to pay Borneo Pacific for the medical kits and the drugs are expected to arrive in May and June.
Dr Glen Mola, from the Medical Society of PNG says the distribution of quality drugs in these medical kits is a matter of life or death.
If the health workers don't receive the medicine they need to treat the patients, well then the patients die! It's not like in Australia, perhaps in other countries, where the patient can go just to a different facility or go to see a different doctor or something, when you're in a rural or remote area of Papua New Guinea, your health centre is the only health facility for your community - there's no alternative.
Australia's decision to walk away from the deal is another blow to the credibility of PNG's claims to be battling corruption and improving services.
The ABC's efforts to contact the Papua New Guinea Health Minister were unsuccessful and there's been no response to a request for comment from the PNG Prime Minister's office.