And McGugan will now join his new team-mates on a pre-season training camp in Italy.
Watford boss Gianfranco Zola said: "Lewis is a very talented player and an excellent signing for this football club.
"He will give strength to our squad and I'm sure our supporters will be excited to see what he can do in a Watford shirt."
McGugan, who came through the Forest youth system, scored 44 goals in seven seasons as a first-team regular at the City Ground.
His move to Vicarage Road will be rubber-stamped once final medical clearance is given.