Second seed Mertens recovered from a mid-match slump to close out a 6-4 1-6 6-2 win in one hour and 42 minutes.
World No.74 Watson hadn't dropped a main-draw set en route to Friday's semi-final and was gunning for a spot in the final of the tournament she won in 2015.
"(It is) just frustrating. Thought I made too many unforced errors," she said.
"Because I'd been playing so well, I expected more of myself."
Watson had the running at the start of the third set but momentum flipped when Mertens broke in the fourth game courtesy of a pin-point lob to take a 3-1 lead.
Mertens broke again in the final game of the match.
She'll meet fifth seed Lesia Tsurenko or Romanian Mihaela Buzarnescu in Saturday's final and could become the first player to claim a second Hobart title.
Watson has turned her attention to next week's Australian Open where she's drawn Kazakhstan's world No.53 Yulia Putintseva in the opening round.
"I've come through some tough battles which has made me feel very ready for if it gets tough in Melbourne," the 25-year-old said.
Joining Mertens in the final is Romanian Mihaela Buzarnescu who cruised past Lesia Tsurenko 6-2, 6-2 in the second semifinal.