A vision system for a vehicle includes a color camera that captures image data, which is processed using an in-line dithering algorithm. The in-line dithering algorithm determines most significant bits and least significant bits of first color data captured by a first photosensing element of a row or column, and the least significant bits of the first color data are added to second color data captured by a second photosensing element of the row or column to generate second adjusted color data. The in-line dithering algorithm determines most significant bits and least significant bits of the second color data, and the least significant bits of the second color data are added to third color data captured by a third photosensing element of the row or column to generate third adjusted color data.