The guidance, published on Wednesday, says it is a common misunderstanding that the move towards increased procurement and contracting means there is no longer a role for grants.
It says contracts "should not inappropriately replace grant funding" and grants are particularly appropriate for organisations that care for people with long-term conditions.
Kevin Curley, chief executive of local infrastructure group Navca, described the guidance as "a very welcome early Christmas present".
"I have argued strongly that grants are a key part of intelligent commissioning," he said. "A healthy local third sector needs a mix of funding that includes grants alongside contracts and donations. I am really encouraged that the Department of Health has listened to this argument and understood it.
"Local charities and community groups should make sure they get hold of a copy of this paper. It is a powerful tool we can use to challenge local commissioners who say they will not or cannot use grants."