The LD-PSD measurement system is widely used in modern geometrical precision measurement, such as displacement, angle, vibration and position error detection. It adopts LD as the light source and PSD to detect the position of laser spot. In this system, such unfavorable factors as background light, dark current of PSD, environmental temperature and electromagnetic noise can reduce the accuracy of the practical measurement system and result in the phenomenon of drift. This paper presents a method of signal processing for LD-PSD system based on square-wave modulation to improve the system accuracy. The factors affecting measurement precision are analyzed and some general methods are introduced. Aiming at a typical 2-D linear displacement measuring system, the signal processing system is designed, including the LD driver and PSD signal processing and sampling module. The experimental results show that the system can effectively decreases the noise effect and has good linearity and stability.