Croydon-born Watson - who turns 21 next week - started his career at West Ham United before leaving the Premier League club in 2020 to join Derby.
He began his career at Pride Park with the Under 23s, but then moved into the senior squad and made his league debut for Derby as a late substitute in a convincing 4-0 win over Birmingham City in December 2020.
He was a regular feature on the bench and made a handful of appearances as a substitute before making his first league start against Brentford in March 2021.
Having attended an England Under-15 training camp previously, Watson was capped twice by the Republic of Ireland at U18 level and his good form with the Rams led to his inclusion in the Ireland U21 squad in the same month. He has since played a further four times for his country.
Under Wayne Rooney in the Championship last season he made three starts, as well as two appearances in the EFL Cup, scoring a penalty in the shoot-out win against Salford City.
Manager Nathan Jones said: “Louie for me is a typical Luton signing. We are getting him at the right age.
“He’s had a good grounding at West Ham, then gone to Derby and broken through there. Derby have done really well with young players, so he caught our eye, we’ve monitored him and when the opportunity came to try and do it, we did.
“You can see his desire to want to get on and develop, but to establish himself at this level first. For me, that’s typical Luton. We have players who are hungry, who want to get to the next level. It doesn’t matter what age they are. They come here and they want to do well. Louie is exactly that.
“He’s a good technical midfield player who is absolutely nowhere near his ceiling, and we are, in God’s will going to get him closer.”
Speaking after completing his move at The Brache today, Watson said: “I’m delighted to get it over the line. I’ve been waiting for this moment for a long time really, and I’m buzzing to join Luton Town.
“Speaking to the gaffer and seeing the team, no one is a finished article and we’re trying to get to the top of the game. The group of boys all want to get better each day.
“The gaffer pushes standards so it’s an ideal scenario to get the most out of my career and to get to where I need to get to.”
On his two seasons at Derby, he went on: “It has been a rollercoaster. A lot of positives. Coming from West Ham’s academy and going into Derby’s academy, getting my chance in the first team within the first few months and really striving in that environment was a positive.
“I’m just excited to get into a team now who were in the play-offs last year and doing really well. They have a good team ethic and I want to really settle myself in, get used to the team and get used to the boys, the gaffer and push on.”
