Palestinian officials are said to have given the instructions following ten weeks of violence, where more than 144 people were killed.
120 were Palestinian and 22 were Israeli.
Violence has been ongoing and an 18-month-old baby was injured when a man drove into Jerusalem bus stop on Monday.
Lights and Christmas decorations are being limited to a few streets and the annual Christmas Eve firework display has been called off.
The Church nativity, built on the site Jesus was born, has seen few pilgrims compared to previous years and the tourism industry is taking a hit, according to The Sunday Times.
However, Mayor of Bethlehem, Vera Baboun, has defended the scaled-back Christmas decorations: "[We] are a Palestinian city that suffers from the injuries, the martyrs.
"In our Christmas celebration we're going to be together. We are one in pain."
However Atallah Hanna, the Greek Orthodox Patriarch of Jerusalem disagreed in an open letter: "Do not kill the joy of Christmas in my country.
"Do not deprive our children of the joy of Christmas.
"Christmas is not just about religious rituals.
"It is about spreading joy and hope in the hearts of our people."
Christians on the West Bank echo his feelings, Mathais Kassis, 35, said: "Between the occupation and the poor economy, there is so little to celebrate in Palestine.
"This is the time we should be able to find joy."
Tens of thousands of pilgrims are expected on Christmas Day, however most are expected to remain in Jerusalem.
