Over the last decade, there has been a steady increase in the amount of magnesium scrap sourced from manufacturing processes due to the rapidly growing market for magnesium alloys in various industries. As a result, the reuse of magnesium becomes extremely beneficial for cost reduction, natural resource preservation, and environmental protection, as it gives scrap magnesium a new lease on life. The reuse of AZ91 magnesium alloy chips for producing functionally graded composites reinforced with yttrium oxide (Y2O3) to enhance microstructure and mechanical properties was investigated in this paper. The manufacturing method for this study involves: (1) collecting and cleaning magnesium chips, (2) pre-mixing them with Y2O3 particles, (3) melting and blending the compositions using a stir casting method, and (4) finally pouring it into a centrifugal casting to produce the functionally graded composite. The microstructure of the AZ91 matrix was examined, and it indicated a well-distributed gradient of Y2O3 particles with little agglomeration. The estimated concentration of particles (which ranged from 40.35% to 32.1% area) closely matched the experimental data (which ranged from 43% ± 1.5% to 28% ± 1.5% area). The study also revealed that particle concentration had a substantial influence on the mechanical properties, with the outer zone outperforming both the middle and inner zones. In the outer zone, the gradient composite had a hardness of 106.89 ± 1.25 HV, a tensile strength of 197.39 ± 2 MPa, and a compressive strength of 335.29 ± 5 MPa. Furthermore, the findings demonstrated the feasibility of employing chip waste to make graded composites, providing a feasible technique for reusing magnesium chips created during machining procedures. This research sheds new light on the use of magnesium chips as a matrix material in the casting of functionally graded composites.