Tractions exerted by cells on the extracellular matrix (ECM) are critical in many important physiological and pathological processes such as embryonic morphogenesis, wound healing, and cancer metastasis. Three-dimensional Traction Microscopy (3DTM) is a tool to quantify cellular tractions by first measuring the displacement field in the ECM in response to these tractions, and then using this measurement to infer tractions. Most applications of 3DTM have assumed that the ECM has spatially-uniform mechanical properties, but cells secrete enzymes that can locally degrade the ECM. In this work, a novel computational method is developed to quantify both cellular tractions and ECM degradation. In particular, the ECM is modeled as a hyperelastic, Neo-Hookean solid, whose material parameters are corrupted by a single degradation parameter. The feasibility of determining both the traction and the degradation parameter is first demonstrated by showing the existence and uniqueness of the solution. An inverse problem is then formulated to determine the nodal values of the traction vector and the degradation parameter, with the objective of minimizing the difference between a predicted and measured displacement field, under the constraint that the predicted displacement field satisfies the equation of equilibrium. The inverse problem is solved by means of a gradient-based optimization approach, and the gradient is computed efficiently using appropriately derived adjoint fields. The computational method is validated in-silico using a geometrically accurate neuronal cell model and synthetic traction and degradation fields. It is found that the method accurately recovers both the traction and degradation fields. Moreover, it is found that neglecting ECM degradation can yield significant errors in traction measurements. Our method can extend the range of applicability of 3DTM.