Allogeneic mesenchymal stem cells (allo-MSCs) have potent regenerative and immunosuppressive potential and are being investigated as a therapy for osteoarthritis; however, little is known about the immunological changes that occur in allo-MSCs after ex vivo induced or in vivo differentiation. Three-dimensional chondrogenic differentiation was induced in an alginate matrix, which served to immobilize and potentially protect MSCs at the site of implantation. We show that allogeneic differentiated MSCs lost the ability to inhibit T-cell proliferation in vitro, in association with reduced nitric oxide and prostaglandin E2 secretion. Differentiation altered immunogenicity as evidenced by induced proliferation of allogeneic T cells and increased susceptibility to cytotoxic lysis by allo-specific T cells. Undifferentiated or differentiated allo-MSCs were implanted subcutaneously, with and without alginate encapsulation. Increased CD3(+) and CD68(+) infiltration was evident in differentiated and splenocyte encapsulated implants only. Without encapsulation, increased local memory T-cell responses were detectable in recipients of undifferentiated and differentiated MSCs; however, only differentiated MSCs induced systemic memory T-cell responses. In recipients of encapsulated allogeneic cells, only differentiated allo-MSCs induced memory T-cell responses locally and systemically. Systemic alloimmune responses to differentiated MSCs indicate immunogenicity regardless of alginate encapsulation and may require immunosuppressive therapy for therapeutic use.