While the gold standard for inducing mesenchymal stem cell (MSC) chondrogenesis utilizes pellet culture, most tissue engineering strategies for cartilage regeneration encapsulate MSCs as single cells, partially due to the technical challenge to homogeneously encapsulate cell pellets in three-dimensional (3D) hydrogels. It remains unclear whether encapsulating MSCs as single cell suspension or cell aggregates in 3D hydrogels would enhance MSC-based cartilage formation. In this study, we determined that the optimal size of MSC micropellets (μPellets) that can be homogeneously encapsulated in hydrogels with high cell viability is 100 cells/pellet. Using optimized μPellet size, MSCs were encapsulated either as single cell suspension or μPellets in four soft hydrogel formulations with stiffness ranging 3-6 kPa. Regardless of hydrogel formulations, single cell encapsulation resulted in more neocartilage deposition with improved mechanical functions over μPellet encapsulation. For single cell encapsulation, polyethylene glycol (PEG) hydrogels containing chondroitin sulfate led to the most cartilage matrix deposition, with compressive modulus reaching 211 kPa after only 21 days, a range approaching the stiffness of native cartilage. The findings from this study offer valuable insights on guiding optimal method design for MSCs and hydrogel-based cartilage regeneration. The optimized μPellet encapsulation method may be broadly applicable to encapsulate other stem cell types or cancer cells as aggregates in hydrogels. Impact Statement While the gold standard for inducing mesenchymal stem cell (MSC) chondrogenesis utilizes pellet culture, it remains unclear whether encapsulating MSCs as cell pellets in three-dimensional hydrogels would enhance MSC-based cartilage formation. In this study, we determined the optimal size of MSC micropellet (μPellet) that can be homogeneously encapsulated in hydrogels with high cell viability. Unexpectedly, single cell encapsulation resulted in more robust new cartilage formation than μPellet encapsulation. Furthermore, tuning hydrogel formulation led to rapid cartilage regeneration with stiffness approaching that of native cartilage. The findings from this study would facilitate clinical translation of MSCs and hydrogel-based therapies for cartilage regeneration with optimized parameters.