The former Great Britain Rugby League star had turned down the chance to work with the RFU Academy in May 2006 and has most recently been working as performance director with Wigan Warriors.
Lydon's new role will see him manage a new WRU development structure which oversees the elite game through to its roots in the community clubs and schools. In effect, the 44-year-old will take charge of all aspects of Welsh rugby outside the senior national squad.
"I feel confident that this role will provide opportunity and challenge within one of the most passionately supported rugby playing nations in the world," said Lydon.
"Just as it is in my hometown of Wigan, rugby in Wales is much more than a sport - it's a way of life.
"The new role will enable me to draw on that passion, the unique sporting history and pedigree of rugby in Wales. A lot of hard work is already taking place and I will be making sure that continues within a clear strategy and focus."
Lydon will take a seat on the Executive Board of the WRU and report directly to the group chief executive, Roger Lewis.
"I promised we would secure someone special for this vital role and I am delighted to be able to announce that we have achieved that aim in appointing Joe Lydon," said Lewis.
"The Head of Rugby role is a key appointment in our senior management team and heads a structure which controls and develops all aspects of the game in Wales.
"Joe's rugby and business CV speaks for itself and when I met him I was impressed by his knowledge of Welsh rugby and his clear strategic thinking on the way forward for Wales.
"There is a lot of hard work to be done but Welsh rugby is now in the right shape to meet the challenges of the future."
Lydon will take up his new role on December 1 and will eventually be based at the new WRU Centre of Excellence at the Vale Resort.