Emergency services were called to conduct a welfare check at a home in Croydon, 9 km west of central Sydney, shortly after 5 p.m. on Monday, Xinhua reported.
Police officers arrived at the scene and found the body of a man, believed to be in his 50s, with stab wounds.
A 32-year-old man was arrested at the scene and taken to a nearby police station.
Superintendent Christine McDonald told reporters on Monday night that the deceased man's injuries were "horrific" and that it was "too late" for ambulance paramedics to save him.
"This is a gruesome crime," she said.
McDonald said that police believe from preliminary investigations that it was a drug deal "gone horribly wrong."
A crime scene was established at the home and an investigation has been launched into the circumstances surrounding the incident.