Hydride precipitation in zirconium (Zr) alloys leads to the deterioration of mechanical properties in key components of nuclear reactors. However, the underlying mechanisms governing the failure initiation of hydrogenated Zr alloys remain incompletely understood. This study focuses on investigating the effects of δ-phase hydride precipitation on the local deformation behavior of Zr alloys. A crystal plasticity finite element method is used to simulate micropillar compression tests of single-crystal samples and macroscale tensile tests of polycrystalline samples. Our results reveal that in the case of micropillar B containing δ-hydride (where the hydride is oriented at 45° from the loading direction), the shear along the hydride–matrix interface and the misfit strain induced by hydride precipitation synergistically contribute to strain localization of Zr alloys. However, for micropillar P containing δ-hydride (where the hydride is parallel to the loading direction), the introduction of hydrides does not enhance the strain localization. Instead, it impedes the local prismatic slip. On the other hand, examination of polycrystalline samples through simulations indicates that hydrides enhance the strain localization of Zr alloys. This effect arises from several mechanisms: shear stress along hybrid–matrix interface, promoting plastic slip in the direction close to this interface; hydride-induced hindrance to certain slip bands, leading to non-uniform local deformation; and misfit strains induced by hydride precipitation, contributing to localized deformation around the hydrides.