Cell-based biosensors (CBBs) have emerged as promising biotechnical tools whereby various cell types can be used as basic sensing units to detect external stimuli. Specifically, CBBs have been applied in environmental monitoring, drug screening, clinical diagnosis and biosecurity. For these applications, CBBs offer several advantages over conventional molecular-based biosensors or living animal-based approaches, such as the capability to better mimic physiological situations, to enhance detection specificity and sensitivity, and to detect unknown compounds and toxins. On the other hand, existing CBBs suffer from several limitations, such as weak cell-substrate attachment, two-dimensional (2D) cell microenvironment, and limited shelf life. An emerging method for scaffold-free three-dimensional (3D) cell culture uses hydrogels to encapsulate cells. Advances in novel biomaterials and nano/microscale technologies have enabled encapsulation of cells in hydrogels to fabricate 3D CBBs, which hold great potential for addressing the limitation in existing 2D CBBs. Here, we present an overview of the emerging hydrogel-based CBBs, their applications in pathogen/toxin detection, drug screening and screening of cell-biomaterials interaction, and the associated challenges and potential solutions.