Watson pulled up sore after bowling on day one at the Melbourne Cricket Ground and although he went on to score 83 with the bat, the all-rounder was spared from bowling duties during Sri Lanka's brief second innings on Friday.
Australia wrapped up an innings and 201-run victory against the injury-ravaged Sri Lankans to take an unassailable 2-0 lead in the three-match series.
Glenn Maxwell comes into a 13-man squad named by Australia captain Michael Clarke following the match at the Melbourne Cricket Ground, with the skipper himself still under a cloud with a hamstring strain.
"Shane's out of the Sydney test match and Glenn Maxwell comes in the squad as a replacement for Watto as the all-rounder," Clarke said.
"The other player is Usman Khawaja on standby for me again. Obviously, I have a bit more extra time now winning this game in three days to give myself every chance of being right for Sydney and
Clarke sustained his injury in Australia's victory in the first Test in Hobart, but was cleared to play on the morning of the Boxing Day Test and scored a sparkling 106 to cap his brilliant year.
Clarke said seamer Mitchell Johnson, who was named man-of-the-match after taking six wickets and making an unbeaten 92 with the bat, would also be considered as an all-rounder for the dead rubber Test, depending on the Sydney wicket.
"I think the other all-rounder sits besides me right here as he showed with the bat in this game," Clarke said, gesturing at 31-year-old left-armer Johnson sitting next to him at the media conference.
"So we've got options if we think the wicket's going to spin we have the option of Maxwell, if you think there will be enough in there to play four fast bowlers and a spinner, you have Johnson."
Clarke also said seamer Mitchell Starc, who was controversially dropped for the Melbourne Test despite being fit and taking a five-wicket haul to help Australia win in Hobart, would be a certain starter for the New Year's Test.
Team: Michael Clarke (captain), David Warner, Ed Cowan, Phil Hughes, Glenn Maxwell, Mike Hussey, Matthew Wade, Peter Siddle, Mitchell Starc, Mitchell Johnson, Nathan Lyon, Jackson Bird, Usman Khawaja.