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Delivering diclofenac diethylamine transdermally by means of a hydrogel is an approach to reduce or avoid systemic toxicity of the drug while providing local action for a prolonged period. In the present investigation, a process was developed to produce nanosize particles (about 10 nm) of diclofenac diethylamine in situ during the development of hydrogel, using simple mixing technique. Hydrogel was developed with polyvinyl alcohol (PVA) (5.8% w/w) and carbopol 71G (1.5% w/w). The formulations were evaluated on the basis of field emission scanning electron microscopy, texture analysis, and the assessment of various physiochemical properties. Viscosity (163–165 cps for hydrogel containing microsize drug particles and 171–173 cps for hydrogel containing nanosize drug particles, respectively) and swelling index (varied between 0.62 and 0.68) data favor the hydrogels for satisfactory topical applications. The measured hardness of the different hydrogels was uniform indicating a uniform spreadability. Data of in vitro skin (cadaver) permeation for 10 h showed that the enhancement ratios of the flux of the formulation containing nanosize drug (without the permeation enhancer) were 9.72 and 1.30 compared to the formulation containing microsized drug and the marketed formulations, respectively. In vivo plasma level of the drug increased predominantly for the hydrogel containing nanosize drug-clusters. The study depicts a simple technique for preparing hydrogel containing nanosize diclofenac diethylamine particles in situ, which can be commercially viable. The study also shows the advantage of the experimental transdermal hydrogel with nanosize drug particles over the hydrogel with microsize drug particles.