Osteophytes are a distinct feature of osteoarthritis (OA). Their formation may be related to pluripotential cells in the periosteum responding to stimulus during OA. This study aimed to isolate stem cells from osteophyte tissues and to characterize their phenotype, proliferation, and differentiation potential, as well as their immunomodulatory properties. Osteophyte-derived cells were isolated from osteophyte tissue samples collected during knee replacement surgery. These cells were characterized by the expression of cell-surface antigens, differentiation potential into mesenchymal lineages, growth kinetics, and modulation of alloimmune responses. Multipotential stem cells were identified from all osteophyte samples, namely osteophyte-derived mesenchymal stem cells (oMSCs). The surface antigen expression of oMSCs was consistent with that of MSCs; they lacked the hematopoietic and common leukocyte markers (CD34, CD45) while expressing those related to adhesion (CD29, CD166, CD44) and stem cells (CD90, CD105, CD73). The proliferation capacity of oMSCs in culture was superior to that of bone marrow-derived MSCs (bMSCs), and these cells readily differentiated into tissues of the mesenchymal lineages. oMSCs also demonstrated the ability to suppress allogeneic T cell proliferation, which was associated with the expression of the tryptophan-degrading enzyme indoleamine 2,3-dioxygenase (IDO). Our results showed that osteophyte-derived cells had similar properties to MSCs in the expression of antigen phenotype, differential potential, and suppression of alloimmune response. Furthermore, when compared to bMSCs, oMSCs maintained a higher proliferative capacity, which may offer new insights of the tissue formation and potentially an alternative source for therapeutic stem cell-based tissue regeneration.