Mr O'Keeffe told the Dáil that there was a legal impediment in providing the grant to Protestants.
"If a case is taken by one of the Catholic schools, my advice from the Attorney General's office is that it would be extremely difficult to defend it," he said.
The Minister, who has repeatedly defended the cut against a barrage of criticism, is to meet the Protestant bishops within the next fortnight to discuss the issue.
But the Opposition condemned his defence of the cut and Seymour Crawford (FG, Cavan-Monaghan) said "it is extremely dangerous for the Minister to suggest that a legal case will be taken against him if does not break an agreement that has been in place for 40 years".
He described the controversial decision to cut the €2.8 million grant as "unbelievable. We are trying to cement a peace process, especially in the Border areas, yet schools are being put under pressure".
Critics of the move insist the grant allowed disadvantaged children to attend fee-paying schools with a Protestant ethos and that it was part of a decades-old formal agreement with the State.
The Government however has insisted that the commitment is to provide a €6.25 million block grant, which remained in place, to the 21 fee-paying Protestant schools "that no other fee-paying schools are receiving".
Olivia Mitchell (FG, Dublin South) said it was unlikely after 40 years that a Catholic school would take a case. She asked if the legal advice was obtained before or after the Budget. Mr O'Keeffe said "that advice has been in place for some time".
Former taoiseach Bertie Ahern would never have allowed the grant to be cut, she said.
"He would have been alert to the sensitivity of the issue and he would certainly have realised that its import goes way beyond educational considerations, important as they are."
Fine Gael education spokesman Brian Hayes said the grant cut would put many fee-paying Protestant schools outside the larger cities "to the wall".
Labour education spokesman Ruairi Quinn accused Mr O'Keeffe of "undermining a principle that we cherished in the South when north of the Border there was bigotry and oppression of a kind that we prized ourselves on condemning".
Mr O'Keeffe said he was well aware the cut would cause serious difficulty, but "I must also bear in mind what is equitable and right".
Charles Flanagan (FG, Laois-Offaly) accused the Minister of "intimidating a minority sector", but the Minister retorted that "trying to stir up emotions is typical of Deputy Flanagan".
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(Source: IT)