The 37-year-old replaces Brendan Rodgers, who left Vicarage Road to join Reading earlier this month, and says he is delighted to finally get the chance to be in charge after gaining experience as a coach.
Mackay, who had spells as a player at Celtic, Norwich and West Ham, had a five-game spell as caretaker manager after Adrian Boothroyd's departure in November.
"I'm absolutely delighted to get the job. I've been planning for a few years with the aim of eventually becoming a first-team manager," Mackay told the Watford website.
"I couldn't have had any better grounding than I have had at Watford over the last four years or so in the various roles I have undertaken.
"Now I'm looking forward to the future and I can't wait for pre-season to begin so we can get to work on the training pitch."
Hornets chairman Jimmy Russo believes Mackay's transition from the coaching staff to the top job should be a smooth one.
He said: "Malky has all the attributes to be a good manager, he has great leadership skills and, crucially, gives us continuity at the club.
"He inherits a good set-up and I'm sure he can build on that."