The Championship side, managed by former Manchester United midfielder Tom Cleverley, are currently second in the table having won all three of their games this campaign.
The teams have only met once before in this competition back in 1987, with the Blues winning 3-1 at Maine Road.
City have won the past 15 meetings between the clubs in all competitions with an astonishing aggregate of 58-8.
The Blues are also unbeaten in the past 20 meetings with the Hornets.
The highest profile encounter between the teams was when City beat Watford 6-0 in the 2019 FA Cup final with Kevin De Bruyne among the scorers that day.
Watford have seen off MK Dons (5-0) and Plymouth Argyle (2-0) to reach the last 32.
The tie will be played either the week beginning September 16 or September 23 and the date and ticket details will be confirmed in due course.
Full draw: Carabao Cup Round 3
Liverpool v West Ham
Manchester City v Watford
Arsenal v Bolton Wanderers
Manchester United v Barnsley
Wycombe Wanderers v Aston Villa
Coventry City v Tottenham
Walsall v Leicester City
Brentford v Leyton Orient
Blackpool v Sheffield Wednesday
Preston North End v Fulham
Everton v Southampton
Queens Park Rangers v Crystal Palace
Stoke City v Fleetwood Town
Brighton v Wolves
AFC Wimbledon v Newcastle United
Chelsea v Barrow
