An independent inquiry says a major overhaul is needed in the system for caring for people with schizophrenia.
The Schizophrenia Commission, which was set up a year ago, says patients spend too long in "demoralised and dysfunctional" hospital wards.
Its analysis suggests the condition costs society almost £12bn a year - and treatment budgets could be spent more wisely to stop people from getting ill.
The government says mental health is one of its high priorities.
A spokesman said: "We are clear that people with mental health problems should be treated with the same high quality and dignified care as anyone else and we expect the NHS to make this happen."
The commission, which was established by the charity Rethink Mental Illness, says too much is spent on secure care - 19% of the mental health budget in England last year - with many people staying too long in expensive units.
Among the 42 recommendations, the report calls for a better use of "recovery houses" in the community, to provide an alternative to hospital admission.
The average cost of a night in a mental health in-patient bed is £321 - meaning a typical admission of 38 days costing more than £12,000.
The commission says early intervention teams, which aim to help people before their hallucinations or delusions become severe, are popular and should be extended. The report claims some teams are being cut or diluted at the moment.
Prof Sir Robin Murray from King's College London, which chaired the commission, said: "If you have psychosis and your mind is disturbed, you need a period of respite and calm.
"But especially in inner cities, you get admitted to something like a madhouse. The nurses are often overwhelmed.
"If patients have had a bad experience and then a further relapse, it's more likely they will then have to be admitted by compulsion.
"The system is pervaded by pressure. People are locked up too often and for too long.
"There's a preoccupation with risk, and the idea that this is a madman with an axe. But people with schizophrenia are actually more likely to be attacked themselves.
"There's no other condition where such an emphasis is put on the risk of an effect on other people."
The report says care of people with schizophrenia and psychosis is falling "catastrophically short".
An economic analysis for the commission highlighted an "exceptionally low" employment rate for people with schizophrenia of 7%, as well as disrupted education - because the illness often develops in young adulthood.
The authors said some of the costs of schizophrenia were unavoidable - but effective interventions, such as family therapy and making a concerted effort to find people jobs, were not being widely used.
Paul Jenkins, head of the charity Rethink Mental Illness, was also a member of the commission.
He said: "It's been over 100 years since the term 'schizophrenia' was first coined, but care and treatment are still nowhere near good enough.
"It is a scandal that in 2012 people with schizophrenia are dying 15-20 years earlier than the general population."
The report said tackling those worse chances of physical ill health would take many years, but made economic sense.
And it highlighted poor prescribing practice as another problem faced by people with schizophrenia, saying patients were not always receiving the most effective medication.
The report - titled The Abandoned Illness - concludes patients can be given hope and support, with the aim of stability or recovery.