Spaniard Gracia, 52, who led the Hornets to the 2019 FA Cup final, has agreed what Leeds described on Tuesday as a "flexible" contract to replace Marsch, who was sacked just over two weeks ago.
Leeds slipped into the relegation zone for the first time this season after Saturday's defeat at Everton and face bottom club Southampton, in what should be Gracia's first game in charge, at Elland Road on Saturday.
Leeds had been hoping to make a swift announcement, but missed out on several top targets.
A club statement read: "Leeds United are delighted to announce the club have agreed terms with Javi Gracia to become men's first-team head coach, subject to obtaining a work permit.
"The experienced 52-year-old has agreed a flexible contract at Elland Road."
Under-21s boss Michael Skubala had been placed in temporary charge, overseeing two Premier League games in the space of five days against Manchester United - a 2-2 draw and a 2-0 home defeat - and a 1-0 loss at Everton.
Gracia spent 20 months in charge of Watford before he was sacked in September 2019. He steered them to 11th place and to the FA Cup final, which they lost 6-0 to Manchester City.
He had previously won promotion to the Spanish top flight with Almeria in 2013 and, after a brief spell at Osasuna, led unfashionable Malaga to consecutive top-10 LaLiga finishes.
After a stint in Russia with Rubin Kazan, he replaced Marco Silva at Watford in January 2018 and most recently retained the Qatar Stars League title with Al Sadd, having succeeded Xavi as head coach in 2021.
Leeds' hunt for Marsch's replacement had met with several setbacks. Talks with former Ajax boss Alfred Schreuder broke down, Rayo Vallecano blocked a move for Andoni Iraola and Arne Slot opted to stay at Feyenoord after he was approached.
Initial target Carlos Corberan signed a new contract with West Brom, while it was reported in Argentina that former River Plate boss Marcel Gallardo ruled himself out of the running.
Leeds, two points from safety, are winless in 10 league matches. They will go bottom if they lose to Southampton.
Leeds added: "The club hope Gracia's first game in charge of the Whites will be Saturday's Premier League clash against Southampton at Elland Road, subject to obtaining the necessary work permissions."
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