He said he wanted the "best people in their fields" from inside and outside government involved and a "wider public engagement exercise" over the summer.
He attacked Labour's "centre knows best approach" and record on borrowing.
Shadow chancellor Alistair Darling warned of "scaremongering" and said Labour acted to support the economy.
'Collegiate approach'
Mr Osborne has been explaining how the coalition government will make decisions on reducing public spending over a four-year period from 2011.
He said the new Office for Budgetary Responsibility would produce its first independent assessment of "the growth forecast and other forecasts" next Monday.
The Budget on 22 June will set out overall spending plans but he outlined plans for further consultation on the best way to make savings over the summer, ahead of the autumn spending review which will set limits for every department.
Every spending programme would face "probing questions", he said - including whether it was essential, could be done cheaper or could be delivered by the private or voluntary sector.
He pledged to involve people from inside and outside government in a consultation over the summer including think tanks, pressure groups and people working in front line services.
Civil servants as well as head teachers, police officers, nurses and others would be asked to contribute, he said.
"What we want to do is make sure that all political parties, that the brightest and best brains across Whitehall and the public sector, that voluntary groups, think tanks, trade unions that members of the public are all engaged in the debate and discussion about how collectively we deal with the problem - after all it is our collective national debt," he said.
'Axe factor'
A cabinet committee, dubbed a "star chamber" is to be set up to oversee the process would be staffed by ministers with smaller departmental budgets - with others being allowed to join when they had tackled their own allocation of funds.
BBC
political correspondent Laura Kuenssberg said effectively ministers would be asked to sit in judgement on their colleagues and on the progress they were making.
Each secretary of state will be asked to appoint a minister with responsibility over the next three months for driving a "value for money agenda".
Mr Osborne said tackling the £156bn deficit was "the great national challenge of our generation".
He pledged to try to protect the most vulnerable and regions which have been heavily dependent on the public sector.
The chancellor suggested that under Labour PM Tony Blair departmental budgets were agreed between him and the then chancellor Gordon Brown and handed down to ministers.
"We are going to have a more collegiate approach," Mr Osborne said.
But the idea was criticised by SDLP MP Mark Durkan as an "Axe Factor approach to government".
And shadow chancellor Alistair Darling replied that unemployment was half that of the 1980s and repossessions were half those of the 1990s recession.
He said: "The reason our economy is growing and the reason our borrowing is coming down is because we in common with other countries, as part of an international consensus, were prepared to take action to save our economy going into recession - and every single one of those measures was opposed by him when he was shadow chancellor."
He also called for "reasoned and restrained" debate and warned about damaging investors' confidence.
"If you run around scaremongering and raising all sorts of fears it could have the perverse effect of turning markets against us," he said.
'Shocking indictment'
On Monday Prime Minister David Cameron warned said in a speech the economic situation was "even worse than we thought" and dealing with the deficit would affect "our whole way of life".
The Conservative-Lib Dem coalition government has already outlined plans for £6.2bn of cuts this financial year.
Meanwhile, in a parliamentary debate, former City minister Lord Myners said he had been frustrated by the "flawed thinking" on the economy among his colleagues in the Labour government.
He argued there was "nothing progressive" about running up huge public debt and urged the coalition to crack down on "considerable waste" in spending.
Financial Secretary to the Treasury Mark Hoban said Lord Myners had "admitted what we have been arguing all along" and his comments represented a "shocking indictment of the previous government's record".
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There are many ways for savings in the public sector without some draconian sackings.
1.The retirement age of Policemen and Firemen after 30 years service means that they can retire at 48 on a pension, is a ridiculous position and as there input to a pension is totally inadequate to what they receive over the next35/40 years is totally unsustainable
2. Why should senior public servants receive pensions paid for by the public in excess of £50,000. Making that a maximum should be immediately introduced. If they wish a a higher pension than thet should pay for it out of their own pockets as the private sector has to do from day 1.
3. As universities are screaming for increase in fees otherwise service will be cut, How can the Chnacellors and Vice Chancellors plus senior lectureres justify salaries in excess of £200,000 per year. I thought teaching was a profession of choice and sacrifice?? And as they are only at work 6months in the year how can they justify those salaries.
4. More control of working practices in the public sector, why should the public sector employee be suspended on full Pay for any length of time whilst investigations are undertaken due to Maladministration or the equivalent , we know of examples where they have been on Garden leave with full pay for up to 3 and four years.
5. We know of 1 employee in DEFRA who was given 2 weeks compassionate leave because "HIS DOG HAD DIED
These are just a few examples that waste millions of pounds over a year, it seems to be endemic in the public sector, they seem to forget that they are there to serve the public not to take advantage of them. Everytime anyone talks about cuts their answer is that front line services will suffer. Rubbish, if they just looked at their own working practices the front line services would not suffer and would be far more cost effective,
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Chancellor George Osborne has promised to limit spending cuts on the most vulnerable and on areas heavily dependent on the public sector as he outlined his framework for future spending decisions today.
Speaking during Treasury questions in the House of Commons today, Osborne promised the government would also deliver its guarantee that health spending would increase in real terms in each year of the Parliament.
The spending review, which will be published this autumn, will set departmental budgets for the years 2011-12 to 2014-15, and Osborne said this would go far beyond the first round of £6bn of cuts announced for this year.
He insisted the government was committed to tackling the deficit and restoring debt to a sustainable path by reducing public sector spending instead of by increasing taxes.
The spending review framework sets out how the Treasury will require departments to submit their initial plans to deliver their priorities before Parliament's summer recess and demonstrate that they meet a tough new set of criteria to deliver value for money.
The framework also sets out how there will be a period of external engagement between the government and all sectors of society and establishes a new "star chamber" to ensure that every department's spending plans are challenged to ensure that they deliver more for less.
It also said that the spending review would take into account initial conclusions from the commission on long-term care, due to be set up shortly to examine the future funding of adult social care.
Osborne said: "This is the great national challenge of our generation: after years of waste, debt and irresponsibility, to get Britain to live within its means. It is a time to rethink how government spends our money."
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