Osteocytes reside within a heavily mineralized matrix, making them difficult to study in vivo and to extract for studies in vitro. IDG-SW3 cells are capable of producing a mineralized collagen matrix and transitioning from osteoblasts to mature osteocytes, thus offering an alternative to study osteoblast to late osteocyte differentiation in vitro. The goal for this work was to develop a 3D degradable hydrogel to support IDG-SW3 differentiation and deposition of bone extracellular matrix. In 2D, the genes Mmp2 and Mmp13 increased during IDG-SW3 differentiation and were used as targets to create a matrix metalloproteinase (MMP)-sensitive poly(ethylene glycol) hydrogel containing the peptide cross-link GCGPLG-LWARCG and RGD to promote cell attachment. IDG-SW3 differentiation in the MMP-sensitive hydrogels improved over nondegradable hydrogels and standard 2D culture. Alkaline phosphatase activity at day 14 was higher, Dmp1 and Phex were 8.1-fold and 3.8-fold higher, respectively, and DMP1 protein expression was more pronounced in the MMP-sensitive hydrogels compared to nondegradable hydrogels. Cell-encapsulation density (cells/mL of precursor) influenced the formation of dendrite-like cellular processes and mineral and collagen deposition, with 80 × 106 cells/mL of precursor performing better than 2 × 106 or 20 × 106 cells/mL of precursor, while connexin 43 was not affected by cell density. The cell density effects were more pronounced in the MMP-sensitive hydrogels over nondegradable hydrogels. This study identified that high cell encapsulation density and hydrogels susceptible to cell-mediated degradation enhanced the mineralized collagen matrix and osteocyte differentiation. Overall, a promising hydrogel is presented that supports IDG-SW3 cell maturation from osteoblasts to osteocytes in 3D.