Up to £1bn of Britain’s overseas aid budget is to be spent over the course of this parliament protecting the “national interest” by tackling the consequences of failed states such as Syria, George Osborne has proposed.

As David Cameron prepares to brief MPs on his plans to admit thousands of extra Syrian refugees, the chancellor said the government is to respond to the “sheer horror” of the crisis by embarking on a fundamental rethink of the aid budget.

In a first step, Osborne announced that the housing and living costs of the extra people will be met from the UK’s £12bn international aid budget.

The chancellor, who said the government needed to do more after the plight of refugees was highlighted by the publication of the picture of the drowned Syrian boy Aylan Kurdi, declined to say how many people Britain would take from camps in Syria’s neighbouring countries.

The Sunday Times reported that 10,000-15,000 refugees would be admitted to Britain as the government expands the vulnerable persons relocation scheme which has so far given sanctuary to just 216 people.

But Osborne also confirmed that every penny in the “uplift” in the aid budget – the automatic rises as the economy grows – would be spent on global challenges with a direct effect on Britain. The chancellor cited the current crisis as an example. The extra funds could work out at around £250m a year, leading to a total of more than £1bn over the course of this parliament.

Osborne told the Andrew Marr Show on BBC1: “The question in the spending review is not just how does our aid budget help the rest of the world, but how does it help Britain’s national interest.” He added: “But where is Britain’s national interest? It is in helping this crisis on our doorsteps and using this big commitment we’ve made as a British people to the aid budget to help.”

The chancellor answered critics who said that Britain is acting less generously than Germany, which is on course to admit 800,000 people this year, by saying the prime minister will outline far-reaching plans to help the refugees. Osborne said the aid budget would be used to help with refugees’ housing and living costs in the first year of their stay in Britain.

Ministers said this had been done before and counted as overseas development assistance, the OECD’s measure of aid spending. Osborne said: “The foreign aid budget can provide the support in the first year for these refugees, could help the local councils with things like housing costs. We will deploy the foreign aid budget to help with the costs of these refugees.”

He made clear that the UK will take refugees from Syria’s neighbouring countries as the government relaxes the criteria for the vulnerable persons relocation scheme. The scheme is currently only available to victims of torture or sexual violence and to elderly or disabled people who are unable to survive in a refugee camp.

The chancellor added: “There is a particular challenge with orphaned children. Everyone understands the human tragedy involved there. I think we have to look at what we can do for those children in need. There has been an outpouring of grief, as you might expect in Britain, towards those children.”

The government is exercising its right under the Lisbon treaty not to take part in a planned European commission quota scheme under which Britain would take 18,000 refugees, though the prime minister said he would act within the spirit of the EU. Government sources stressed that they would be driven by the right scheme rather than by any arbitrary figures.

The review of the aid budget will also include a big expansion of its reserve, known as the conflict, stability and security fund. This will allow for a more flexible response to a crisis, though aid groups will seek to ensure that the reserve, which is administered by the Foreign Office, is not used to subsidise defence spending on targeting Islamic State forces in Iraq.

Osborne likened the image of Aylan to the photograph of a young girl fleeing a napalm attack during the Vietnam war. He said: “Britain is going to approach this crisis with a head as well as a heart. In the short term we are going to take more refugees, but not in a way that encourages them on to these dangerous boats.

“In the longer term we need a fundamental rethink of our aid policy. So yes, we support reducing poverty but we also direct our additional aid spending to these failed states, to this refugee crisis, to the big threats facing Britain.”

The government said the change in aid spending would not undermine traditional projects in tackling poverty in areas such as sub-Saharan Africa. They are protected under the existing £12bn annual budget.