This should ensure that investors in Hypo - not just taxpayers - help to shoulder the financial burden of winding down a bank that has sucked in €5.5 billion (US$7.5 billion) in public aid so far.
However, there are concerns that this law could drive up borrowing costs for other state-backed firms, including utilities and health agencies.
But ratings agencies, some in the financial sector and now the International Monetary Fund warn that Vienna has set a dangerous precedent which may undermine investor confidence in other state guarantees that underpin billions of euros in debt.
Guarantees from provinces and communities totaled around €77 billion at the end of 2011, mostly for commercial, or Hypo, banks under the wing of the provinces.
If investor confidence is shaken, borrowing costs may rise for these banks and for companies such as utilities and health care agencies that enjoy direct or at least implicit state backing.
The opposition parties had always argued in favour of letting the Hypo become bankrupt and there are still discussions as to whether to set up an investigation committee on that issue.
However, the government denied a bankruptcy as it would have had dramatic effects for the whole of Austria, as the €19 billion (with which Carinthia had underpinned the bank), would have had to be actually paid out.
A bankruptcy of Austria's number six bank could also have created a "domino effect" in other European countries.
Finance Minster Michael Spindelegger, head of the conservative People's Party (ÖVP), the junior partner to the centre-left Social Democrats (SPÖ), has faced a public furore over the mounting costs of dismantling Hypo Alpe Adria, which Austria had to nationalise in 2009 to avoid a collapse that would have sent a shock wave across the region.
He considered letting Hypo go bust - which would have bankrupted Carinthia given the state's unaffordable guarantees - but decided in March this path was too risky.
Instead he wants to impose losses on holders of €890 million of Carinthia-guaranteed Hypo debt and seize another €800 million from former Hypo owner BayernLB of Germany. The law could take effect in August if all goes to plan.
Spindelegger insists that Carinthia - which made millions by selling its Hypo stake to BayernLB - contribute around €500 million to Hypo's costs, which the province is fighting.
The Hypo draft legislation does not force Carinthia to contribute, as Spindelegger had originally threatened, only to relent at the last minute to allow more time for negotiations.