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"line separating waters flowing into different rivers," 1803, from water (n.1) + shed "ridge of high ground between two valleys or lower ground, a divide" in the topographical sense, perhaps from shed (v.) in its extended noun sense of "the part of the hair of the head" (14c.). A loan-translation of German Wasser-scheide. Figurative sense is attested from 1878. Meaning "ground of a river system" is from 1878.
watershed wa·ter·shed (wô'tər-shěd')
A ridge between two areas that directs drainage to either side.
The area of marginal blood flow at the extreme periphery of a vascular bed.
Ridges of the lumbar vetebrae and the pelvic brim formed in the abdominal cavity, which determine the direction in which a free effusion will gravitate when the body is supine.
A ridge of high land dividing two areas that are drained by different river systems. On one side of a watershed, rivers and streams flow in one direction; on the other side they flow in another direction. Also, the area drained by a water system.
Note: By extension, a “watershed” is a critical point that serves as a dividing line: “The parties reached a watershed in the contract negotiations.”