The recession has tightened the belt on Google's long-standing reputation for pampering its employees, having also cut down on the number of restaurants offering free meals on the staff campus.
In an e-mail memo, Google asked its employees to "dogfood" the phone, referring to the Silicon Valley practice of "eating your own dogfood" when products are first tested out by staff.
The e-mail also said: "The holiday bonus is a Google tradition -- it's a great way to thank everyone for their hard work. In the past, we've done this in cash. This year, we've decided to give Googlers a different kind of present -- a Dream phone."
The G1 was released in October with Google's open source operating platform to rival Apple's iPhone.
Since its release it has sold over 1m handsets, with mixed tech reviews given online. Apple's iPhone 3G sold 1m handsets in three days.
The free phones will be given out to staff in the US, Europe, Canada, Australia, Singapore and Japan, covering about 85% of Google's employees, or 20,000 staff.
In countries where the G1 will not operate, such as China and India, staff will be given around $400 (£275) cash instead.
Google's Christmas gift will be of little solace to its Silicon Valley counterparts, many of whom have a murky future in 2009.
Technology blog Techcrunch estimates 113,000 have lost their jobs in the sector so far this year as many start-ups have folded to economic pressures.
Google, on the other hand, is far from being in the red despite a recent slow in growth. This year the company has posted turnover in excess of $21bn (£13.6bn).