Despite increased awareness of the essential role of neighborhood characteristics for residents’ health and wellbeing, the development of neighborhood-level indicator systems has received relatively little attention to date. To address this gap, we describe the participatory development process of a small-area indicator system that includes information on local health needs in a pilot neighborhood in the German city of Mannheim. To identify relevant indicators, we partnered with representatives of the city’s public health department and used an iterative approach that included multiple Plan-Do-Check-Act cycles with ongoing feedback from local key stakeholders. The described process resulted in a web-based indicator system with a total of 86 indicators. Additionally, 123 indicators were perceived as relevant by stakeholders but could not be included due to data unavailability. Overall, stakeholders evaluated the participatory approach as useful. Even though the onset of the COVID-19 pandemic and the lack of some data elements hindered instrument development, close collaboration with public health partners facilitated the process. To identify and target sub-national health inequalities, we encourage local public health stakeholders to develop meaningful and useful neighborhood-level indicator systems, building on our experiences from the applied development process and considering identified barriers and facilitators.