Mineralized biomaterials are promising for use in bone tissue engineering. Culturing osteogenic cells in such materials will potentially generate biological bone grafts that may even further augment bone healing. Here, we studied osteogenic differentiation of human mesenchymal stem cells (MSC) in an alginate hydrogel system where the cells were co-immobilized with alkaline phosphatase (ALP) for gradual mineralization of the microenvironment. MSC were embedded in unmodified alginate beads and alginate beads mineralized with ALP to generate a polymer/hydroxyapatite scaffold mimicking the composition of bone. The initial scaffold mineralization induced further mineralization of the beads with nanosized particles, and scanning electron micrographs demonstrated presence of collagen in the mineralized and unmineralized alginate beads cultured in osteogenic medium. Cells in both types of beads sustained high viability and metabolic activity for the duration of the study (21 days) as evaluated by live/dead staining and alamar blue assay. MSC in beads induced to differentiate in osteogenic direction expressed higher mRNA levels of osteoblast-specific genes (RUNX2, COL1AI, SP7, BGLAP) than MSC in traditional cell cultures. Furthermore, cells differentiated in beads expressed both sclerostin (SOST) and dental matrix protein-1 (DMP1), markers for late osteoblasts/osteocytes. In conclusion, Both ALP-modified and unmodified alginate beads provide an environment that enhance osteogenic differentiation compared with traditional 2D culture. Also, the ALP-modified alginate beads showed profound mineralization and thus have the potential to serve as a bone substitute in tissue engineering.