The pluripotent property of human embryonic stem cells (hESCs) makes them attractive for treatment of degenerative diseases such as diabetes. We have developed a stage-wise directed differentiation protocol to produce alginate-encapsulated islet-like cells derived from hESCs, which can be directly implanted for diabetes therapy. The advantage of alginate encapsulation lies in its capability to immunoisolate, along with the added possibility of scalable culture. We have evaluated the possibility of encapsulating hESCs at different stages of differentiation. Encapsulation of predifferentiated cells resulted in insufficient cellular yield and differentiation. On the other hand, encapsulation of undifferentiated hESCs followed by differentiation induction upon encapsulation resulted in the highest viability and differentiation. More striking was that alginate encapsulation resulted in a much stronger differentiation compared to parallel two-dimensional cultures, resulting in 20-fold increase in c-peptide protein synthesis. To elucidate the mechanism contributing to encapsulation-mediated enhancement in hESC maturation, investigation of the signaling pathways revealed interesting insight. While the phospho-protein levels of all the tested signaling molecules were lower under encapsulation, the ratio of pSMAD/pAKT was significantly higher, indicating a more efficient signal transduction under encapsulation. These results clearly demonstrate that alginate encapsulation of hESCs and differentiation to islet-cell types provides a potentially translatable treatment option for type 1 diabetes.