The former Hornets assistant will step into the head manager's role after Mackay took the job at Cardiff City and club owner Laurence Bassini is delighted with the board's decision.
"I'm delighted that the Board - Graham Taylor, Stuart Timperley and David Fransen - have been able to add their experience and influence to the decision to appoint Sean as our new manager," Bassini told the club's official website.
"For me, this appointment is very much in keeping with 'The Watford Way' of doing things - and that's an ethos I'm growing more familiar with as time goes on.
"It's important we've appointed someone who has a real feeling for what this club is about. I'm very glad we've been able to reach this point now."
39-year old Dyche was Macaky's assistant since July 2009 at Vicarage Road and was also a player there for three years in between 2002 and 2005.