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There is a strong foundation on which to reestablish a local government system in Nepal. Nepal society is constituted and strengthened by strong community traditions. Likewise, decentralization has existed historically. Nepali State is at a crucial moment. After remaining a unitary and centralist state for about 240 years of its formation, a new constitution is being written by Nepali people through the Constituent Assembly (CA). The Interim Constitution directs that Nepal will be a federal democratic republican state. In order to institutionalize the directives, different committees of the CA have been drafting the constitution along the federal line. Traditionally, federalism stood for two tiers of government: central and regional/state. Local governments were left under domain of the state governments. However, recognizing their tremendous importance in institutionalizing democracy and improving service delivery, local governments are now being specifically provided for in the constitution. As the country goes through this historic period, a review of the state of decentralization and service delivery shows that a serious discussion will be required on the functioning of legitimate local governments. Local governments will require support to dispense their roles and responsibilities. Local governments will require greater local autonomy and building around them systems of accountability to ensure effective and efficient service delivery. Citizens will require empowerment to hold elected representatives, local government authorities and providers accountable. This paper shows that service delivery is still weak, and that addressing the challenges will require addressing the weaknesses in accountability relationships. Carefully designed decentralization and sequencing of decentralization reforms will be a key challenge during this transition. A key lesson is that political economy and economic/resource considerations will remain critical in the debate of what the federal structure in Nepal will look like.