A report by a commission led by former Surgeon General Joycelyn Elders (pdf) finds there is no good rationale for a transgender ban. Nathaniel Frank, author of Unfriendly Fire: How the Gay Ban Undermines the Military and Weakens America, looks into the history behind it:
The ban on transgender military service is really a string of different restrictions left over from a time when anything outside a straight and narrow norm was regarded as a mystifying and dangerous difference. Defense Department medical standards disqualify applicants with “major abnormalities or defects of the genitalia such as change of sex,” as well as what the Pentagon calls “psychosexual conditions,” which include “transsexualism, exhibitionism, transvestism, voyeurism, and other paraphilias.”
The trans restrictions are embedded, for the most part, in medical regulations whose purpose is perfectly sensible: to minimize the chances that anyone who joins the military will endanger the health of the force, lose excessive duty time, or become undeployable. (They are not, interestingly, expressed in the same terms as the DADT restrictions, which presumed that openly gay troops would so disturb other service members that they would leave or that unit cohesion would suffer.) But when the commission looked into the rationale for including transgender identity and trans-related medical procedures in the list of disqualifiers to service, they made two important discoveries—that the restrictions are hugely out of date, and that there is no documented history of why they ever existed in the first place.