Nayib Bukele, the President of the Central American country, has announced that the cryptocurrency will be used to fund the project.
The new city will be circular to represent the shape of a large coin and will be built in the region of La Union. The site will take advantage of the Conchagua volcano's geothermal energy to power Bitcoin mining.
Addressing a raucous crowd at a promotional event at the weekend, Bukele promised that the planned new city would "include everything".
He said: "Residential areas, commercial areas, services, museums, entertainment, bars, restaurants, airport, port, rail - everything devoted to Bitcoin."
Bukele did not provide any dates for the construction or completion of the city, but did estimate that the public infrastructure would cost around 300,000 Bitcoins.
The president added that no income taxes would be levied in the city and only VAT would be in force.
Bukele said that half of the revenue gained from this would be used to "build up the city" with the rest being used to keep the streets "neat and clean".
El Salvador recently became the first country to use Bitcoin as legal tender but the move led to large-scale protests due to fears that the cryptocurrency would bring instability and inflation to the impoverished country.
The government presented the measure as a way to boost economic development and jobs and it means that businesses, when possible, are now obliged to accept the digital coins as payment.
The move divided El Salvador because of the volatile nature of Bitcoin - which has risen and fallen dramatically over the past year.