A composition containing biocompatible hydrogel encapsulating mammalian cells and anti-inflammatory drugs is disclosed. The encapsulated cells have reduced fibrotic overgrowth after implantation in a subject. The compositions contain a biocompatible hydrogel having encapsulated therein mammalian cells and anti-inflammatory drugs or polymeric particles loaded with anti-inflammatory drugs. The anti-inflammatory drugs are released from the composition after transplantation in an amount effective to inhibit fibrosis of the composition for at least ten days. Methods for identifying and selecting suitable anti-inflammatory drug-loaded particles to prevent fibrosis of encapsulated cells are also described. Methods of treating a disease in a subject are also disclosed that involve administering a therapeutically effective amount of the disclosed encapsulated cells to the subject.