Gracia signed an 18-month contract when he replaced Marco Silva in January and the extension would see him remain in charge at Vicarage Road until the end of the 2020/21 campaign.
Since then he has masterminded an impressive start to the Premier League campaign with his side sitting comfortably in eighth.
Gracia will become the first boss at Watford to sign a contract extension since Malky Mackay in 2011.
Watford visit Southampton in their final league game before the international break on Saturday.