The 166-page report accuses Israel of depriving the Palestinians of services that are offered to Jewish settlers, who live in communities considered illegal under international law because they are built on occupied land.
"Palestinians face systematic discrimination merely because of their race, ethnicity, and national origin, depriving them of electricity, water, schools, and access to roads," HRW representative Carroll Bogert said.
"While Israeli settlements flourish, Palestinians under Israeli control live in a time warp -- not just separate, not just unequal, but sometimes even pushed off their lands and out of their homes."
Israel denied the report and accused HRW of bias.
"We must expose the hypocrisy of human rights organisations that turn a blind eye to the most repressive regimes in the world -- regimes that stone women and hang gays -- and instead target the only liberal democracy in the Middle East," Prime Minister Benjamin Netanyahu said.
Government spokesman Mark Regev charged "that Human Rights Watch has allowed an anti-Israel agenda to pollute its objectivity."
He also denied the report's accusations, saying there had been "unprecedented levels of growth and development on the part of the Palestinian Authority in the West Bank" over the past two years.
"Anyone who looks at objective data can see this. The government of Israel is committed to working with the Palestinian Authority upon this path that is beneficial to all," he told AFP.
But Bill Van Esveld, author of the report and a researcher at HRW's Middle East division, said the study exposed a two-tier system enforced by a network of discriminatory laws and military orders.
"We're talking about different treatment of two people living in the same area for no real reason," he told AFP.
He said settlers had easy access to planning committees whereas Palestinians were not allowed to serve on the same committees, and that it had become virtually impossible for Palestinians to obtain permits to build homes.
The policies make life increasingly difficult for Palestinians in the West Bank, and in many cases encourage them simply to leave.
"Israeli policies are so harsh in their discrimination against Palestinians that in a number of cases Palestinians have been forced to leave, because they have no access to water, they have no access to electricity."
The group called on the international community to avoid complicity in Israeli breaches of international law, including by cutting assistance to the country.
"The United States, which provides 2.75 billion dollars in aid to Israel annually, should suspend financing to Israel in an amount equivalent to the costs of Israel's spending in support of settlements, which a 2003 study estimated at 1.4 billion dollars," the report said.
"Similarly, based on numerous reports that US tax-exempt organisations provide substantial contributions to support settlements, the report urges the US to verify that such tax-exemptions are consistent with US obligations to ensure respect for international law," it added.
Jewish settlement building on occupied Palestinian land is one of the most divisive issues in efforts to forge a peace agreement between the two sides.
Around 500,000 Israelis live in more than 130 locations across the West Bank and mostly Arab east Jerusalem -- territories captured by Israel in the 1967 Middle East war but claimed by Palestinians for a future independent state.
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