The report, Extraordinary Lives, by the Social Work Inspection Agency (SWIA) finds that too many looked-after children are denied access to good health and education services and opportunities for a stable home life.
However, it also argues that, with the right support, looked-after children can overcome childhood adversity and lead successful lives, particularly where they are supported by adults who believe in them and have the skills to help them.
Around 200 young people and adults with first-hand experience of the care system were consulted for the report, which is part of SWIA's programme of thematic inspections.
The report, launched at a Time to Care conference held at Strathclyde University, concludes that councils must improve how they act as "parents".
It urges chief executives to report annually on what they have helped their looked-after children to achieve.
The report also says all authorities should nominate an elected member to act as a champion for looked-after children, as well as appointing a senior manager to co-ordinate the provision of these services throughout the authority.
Alexis Jay, SWIA's chief inspector, said: "This report highlights what is working well and identifies areas where improvements are needed. It makes suggestions - for councils, health boards, voluntary organisations and the Executive - setting out how they can improve outcomes for looked-after children.
"These provide a framework for change that will build successful futures for more of Scotland's looked-after children."
The report adds: "It is a paradox that much care away from home, which is intended to make up for early disadvantages and losses, ends up compounding rather than alleviating children's difficulties.
"Children and young people can do well and many return to their families.
Those who remain looked after can progress to a fulfilled adult life. The challenge faced by carers of looked-after children is to break the paradox; being looked after should always enhance children's education, health, leisure and life chances."
The inspectors point to stable placements with good relationships, a positive experience of school, support from adults to develop their life skills and career plans, and support in maintaining friendships and relationships as important factors in giving Scotland's 11,000 children in care a positive experience.
They also say there must be careful preparation for independence and the same sort of social, emotional and financial support that typical parents might provide for their own children.
The report's supporting documents include Celebrating Success, a study of what helps looked-after children to be happy and succeed. It also includes case studies from looked-after children. One of them, Alison, said: "The people here have really helped me through a lot of things and help me trust people again. I've been very disappointed in the past."
leader 20 Extraordinary Lives: A Review of Services for Looked-after Children in Scotland and the other documents are available on the SWIA website at www.swia.gov.uk