Mesenchymal stem cells (MSCs) represent a great therapeutic promise in pre-clinical models of osteoarthritis (OA), but many questions remain as to their therapeutic mechanism of action: engraftment versus paracrine action. Encapsulation of human MSCs (hMSCs) in sodium alginate microspheres allowed for the paracrine signaling properties of these cells to be isolated and studied independently of direct cellular engraftment. The objective of the present study was to quantitatively assess the efficacy of encapsulated hMSCs as a disease-modifying therapeutic for OA, using a medial meniscal tear (MMT) rat model. It was hypothesized that encapsulated hMSCs would have a therapeutic effect, through paracrine-mediated action, on early OA development. Lewis rats underwent MMT surgery to induce OA. 1 d post-surgery, rats received intra-articular injections of encapsulated hMSCs or controls (i.e., saline, empty capsules, non-encapsulated hMSCs). Microstructural changes in the knee joint were quantified using equilibrium partitioning of a ionic contrast agent based micro-computed tomography (EPIC-μCT) at 3 weeks post-surgery, an established time point for early OA. Encapsulated hMSCs significantly attenuated MMT-induced increases in articular cartilage swelling and surface roughness and augmented cartilaginous and mineralized osteophyte volumes. Cellular encapsulation allowed to isolate the hMSC paracrine signaling effects and demonstrated that hMSCs could exert a chondroprotective therapeutic role on early stage OA through paracrine signaling alone. In addition to this chondroprotective role, encapsulated hMSCs augmented the compensatory increases in osteophyte formation. The latter should be taken into strong consideration as many clinical trials using MSCs for OA are currently ongoing.