Water wheels used for power generation are applied to tailwater and ultra-low head sites. In this research, the VOF method and the standard k-ε turbulence model are utilized to predict the performance and transient flow fields of water wheels. The numerical results show a reasonable agreement with the experimental data. This work aims at improving the performance and increasing the internal fluid stability of the water wheel, based on the entropy production approach to research the detailed distribution of energy loss in the water wheel for power generation under the clearance effects between blades and hub. Under the same rotational speed, it is indicated that by setting appropriate clearance, the performance of the water wheel can be elevated by 8.7%, targeted elimination of vortical flow, improving flow adaptability, attenuating to a great extent of the backwater phenomenon, and reducing the fatigue damage of the hub and blade. Further, the interaction mechanism of vorticity–pressure which will induce irreversible energy loss of the water wheel under different clearance effects is investigated. Therefore, this research indicates that the entropy method can provide a theoretical reference and engineering guidance for the targeted optimization of water wheels.