Osteoarthritis (OA) is a progressive and degenerative joint disease resulting in changes to articular cartilage. In focal early OA defects, autologous chondrocyte implantation (ACI) has a 2-fold failure rate due to poor graft integration and presence of inflammatory factors (e.g. Interleukin-1β). Bone marrow derived mesenchymal stem cells (MSCs) are an alternative cell source for cell-based treatments due to their chondrogenic capacity, though in vivo implantation leads to bone formation. In vivo, chondrocytes reside under an oxygen tension between 2–7% oxygen or physioxia. Physioxia enhances MSC chondrogenesis with reduced hypertrophic marker (collagen X and MMP13) expression compared to hyperoxic conditions (20% oxygen). This study sought to understand whether implantation of physioxic preconditioned MSCs improves cartilage regeneration in an early OA defect model compared to hyperoxic MSCs. Bone marrow extracted from New Zealand white rabbits (male: 5–6 months old; n = 6) was split equally for expansion under 2% (physioxia) or 20% (hyperoxia) oxygen. Chondrogenic pellets (2 × 105 cells/pellet) formed at passage 1 were cultured in the presence of TGF-β1 under their expansion conditions and measured for their wet weight and GAG content after 21 days. During bone marrow extraction, a dental drill (2.5mm diameter) was applied to medial femoral condyle on both the right and left knee and left untreated for 6 weeks. Following this period, physioxia and hyperoxia preconditioned MSCs were seeded into a hyaluronic acid (TETEC) hydrogel. Fibrous tissue was scraped and then MSC-hydrogel was injected into the right (hyperoxic MSCs) and left (physioxia MSCs) knee. Additional control rabbits with drilled defects had fibrous tissue scrapped and then left untreated without MSC-hydrogel treatment for the duration of the experiment. Rabbits were sacrificed at 6 (n = 3) and 12 (n = 3) weeks post-treatment, condyles harvested, decalcified in 10% EDTA and sectioned using a cryostat. Region of interest was identified; sections stained with Safranin-O/Fast green and evaluated for cartilage regeneration using the Sellers scoring system by three blinded observers. Physioxic culture of rabbit MSCs showed significantly shorter doubling time and greater cell numbers compared to hyperoxic culture (∗p < 0.05). Furthermore, physioxia enhanced MSC chondrogenesis via significant increases in pellet wet weight and GAG content (∗p < 0.05). Implantation of physioxic preconditioned MSCs showed significantly improved cartilage regeneration (Mean Sellers score = 7 ± 3; ∗p < 0.05) compared to hyperoxic MSCs (Sellers score = 12 ± 2) and empty defects (Sellers score = 17 ± 3). Physioxia enhances in vitro rabbit MSC chondrogenesis. Subsequent in vivo implantation of physioxia preconditioned MSCs improved cartilage regeneration in an early OA defect model compared to hyperoxic MSCs. Future studies will investigate the mechanisms for enhanced in vivo regeneration using physioxia preconditioned MSCs.