Toni Anne Ludgate, 75, went missing in late August in the holy town of Puttaparthi in Andhra Pradesh state where she was working at an ashram for popular Hindu guru Sai Baba.
The security guard at the apartment building where she was living and two others appeared in court on Saturday on initial charges of strangling her for several hundred dollars and burying her body in fields.
"The watchman has confessed to the crime," deputy police superintendent P. Srinivas told AFP from Puttaparthi.
"He has even showed us the place where he and his friends buried the body," Srinivas said.
Ludgate's remains were exhumed on Saturday by police, before she was cremated in a traditional Hindu ceremony at the request of her family, local media reported.
She had given the security guard 30,000 rupees ($488) as rent but he only passed on 10,000 rupees to the landlord. When she asked for the money back a few days later, the guard and his friends killed her, the reports said.
Srinivas said police became suspicious after the guard himself lodged a missing person's report but officers then found discrepancies in this statements.
"The watchman himself had registered a complaint saying Ludgate was missing in order to mislead the police," Srinivas said.
Srinivas said police have been in contact with Ludgate's family as well as with officials at the Australian High Commission (embassy) over the investigation.