Climate change and agricultural malpractices are exacerbating drought in many parts of the world causing a substantial agricultural production loss. The improvement of drought tolerance in rice is crucial for maintaining productivity and ensuring global food security. Alternate wetting and drying (AWD) irrigation along with plant-microbe interaction through arbuscular mycorrhizal fungi (AMF) is a potential approach for enhancing rice production through AMF-induced up-regulation of tolerance and resilience against drought stress. Therefore, the ameliorative role of AMF inoculation and phosphorus (P) application on growth, physiological traits, and grain yield of rice was evaluated under water stress imposed through AWD irrigation. A factorial experiment consisting of four fertilizer treatments where the P percentage varied along with the recommended dose of nitrogen (N) with or without AMF inoculation (P100 as the control, P100 + AMF, P75 + AMF, and P50 + AMF), three soil water potential levels (0, −15, and −30 kPa), and two cultivation methods (wet direct seeding and transplanting) was conducted in a polyhouse. The subscript values of 100, 75, and 50 under P represent 100%, 75%, and 50% of the recommended field application dose. Data were collected on selected growth parameters, physiological traits, levels of mycorrhizal colonization, yield and its components, and water productivity of rice. The results revealed that P100 + AMF inoculated plants had 11%, 14%, 74%, and 54% higher leaf greenness, leaf relative water content, net photosynthetic rate, and grain yield, respectively, for wet direct-seeded plants at reduced soil water potential (−30 kPa) compared with non-inoculated plants (P100). Free proline accumulation gradually enhanced with decreasing soil water potential, and it was maximized by 77% at −30 kPa compared with 0 kPa for P50 + AMF (for transplanted plants). Free proline accumulation was also higher with decreasing soil water potential in AMF-inoculated plants than non-inoculated plants regardless of cultivation methods. Leaf osmotic potential was reduced by −0.5 to −1.2 MPa at −30 kPa compared with 0 kPa under different fertilizer doses. However, AMF inoculation (P100 + AMF and P75 + AMF) improved leaf osmotic potential of plants under severe water stress (−30 kPa) maintained through AWD irrigation resulting in better osmotic adjustment than non-inoculated plants. AMF inoculation improved the response of most of the evaluated physiological traits of rice and enhanced grain yield with higher P availability (even with a 25% reduction in its recommended dose) in the rhizosphere under drought stress. Thus, it can be concluded that AMF inoculation coupled with judicious P management is a promising approach for improving physiological and biochemical traits, grain yield, and water productivity of rice under AWD irrigation regardless of cultivation methods.