Most of Bethlehem is in the Palestinian-controlled area of the West Bank, but Israel's imposing separation barrier runs through part of the city and is a constant reminder of the complex political reality.
The hotel bills itself as having the worst view in the world.
Banksy's "Scar of Bethlehem" shows a Nativity scene in front of the Israeli separation wall, on display Monday at the artist's Walled-Off Hotel in Bethlehem, West Bank.
"Love" and "peace" are respectively graffiti-tagged in English and French on the art installation's concrete blocks, while three large wrapped presents are at the forefront of the scene.
"It is a nativity", the hotel's manager, Wissam Salsaa, said after the piece was installed.
This isn't the primary time that Banksy has put a spin on Christmas imagery to critique the Israeli-Palestinian battle.
The elusive street artist has returned to Bethlehem to do his latest politically charged work - a crib overshadowed by a star-shaped bomb attack in the dividing wall of the West Bank.
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"Banksy is trying to remind the world that people of Bethlehem, where Christmas was started, are not celebrating Christmas like the rest of the world", he said.
In 2007, he painted a number of artworks in Bethlehem, including a young girl frisking an Israeli soldier pinned up against a wall.
Meanwhile, hundreds of tourists flocked to Manger Square, for a more traditional take outside the Church of the Nativity, revered as the birthplace of Jesus.
The United Nations has described the wall as an obstacle to Palestinians' entry to vital providers and sources and mentioned it "disrupts household and social life, undermines livelihoods and compounds the fragmentation of the occupied Palestinian territory".
"Banksy is trying to be a voice for those that can not speak", Mr Salsaa added. He "is creating a new model of resistance through art".