Urban water scarcity has been an issue for a long time in China while water pollution has attracted more and more attention over the last two decades. Recently, on-site wastewater treatment (OST) has been proposed as a meaningful alternative to deal with both water pollution and water scarcity in cities in a more sustainable way. However, the diffusion of such an OST system is still slow and often hindered by mismatched regulation, city planning and policy interventions. This paper is intended to explore potential solutions from institutional and governance perspectives. Based on expert interviews and in-depth analysis of an OST system in Kunming, an improved trajectory for diffusing OST in urban China is developed, which includes reformed decision-making and operational procedures, role transition of relevant stakeholders, and improved financing mechanisms. The results might give some suggestions for the transition of urban water management in other newly industrializing countries.