The 32-year-old Lugano brings a wealth of experience to the Hawthorns, having played in the Champions League and captained Uruguay a record 77 times, but manager Steve Clarke said that was not enough to guarantee him selection.
"I'm delighted to welcome Diego to the club," Clarke said. "He's an experienced centre-half who will increase competition in that area of the team.
"This is a tough league. You need as many good players in your squad as you can get - and Diego is undoubtedly one of those.
"Like some of the others we have here, Diego is another player who captains his country and is a leader.
"He has a real hunger and ambition to play and succeed in the Barclays Premier League and he will hopefully get a platform here to show everyone what he can do.
"However, Diego knows he's got a fight on his hands to get into the team.
"Over the past couple of seasons, Gareth McAuley and Jonas Olsson have been an established Premier League pairing with stiff competition from Gabriel Tamas and young Craig Dawson, who we believe will be a good centre-half for this club in years to come."