Lynas said phase one funding provided by the DoD will allow it and partner Blue Line to complete a detailed market and strategy study plus detailed planning and design work for the facility, with this work to be completed in the 2021 financial year.
Such a facility would be the only source of separated HRE outside China.
No details in terms of the funding for the study were disclosed.
The initiative comes during an era of increased economic and geopolitical tensions between the US and China.
Australian minister for resources, water and Northern Australia Keith Pitt described the contract as "historic".
"This is a great result for Lynas and our critical minerals sector," he said.
"Lynas has a proven track record in the processing of rare earth elements and provides the only model to-date for establishing commercially viable rare earth separation capacity outside of China.
"Our current environment has shone a spotlight on concentrated global supply chains, particularly for critical minerals.
"This milestone brings us a step closer to a secure supply chain of rare earth materials, integral to defence and industrial bases for both our countries."
Investors responded positively to the Lynas news, marking the stock up 12% to A$2.43 in late trade, capitalising the company at $1.7 billion.
The stock plumbed a low of $1.03 in March at the height of the COVID-19 market selldown.