Water scarcity is one of the leading challenges for sustainable development in the context of climate change, particularly for agriculturally reliant countries. Inadequate water supplies tend to generate environmental and health issues. Improvements in water supply systems should give priority to the region with the most severe mismatch between water supply and demand. To set priorities for the improvement of water supply systems, this study proposed a water supply-demand balance model to quantify the water supply-demand gap in the Koshi River basin and compared it with the traditional water vulnerability model. The results suggested that (1) the water supply-demand balance model had good applicability to the Koshi River basin and was superior to traditional models in identifying the region with the most severe mismatch; (2) the shortage of agricultural water was much more serious than that of domestic water in the basin; (3) the largest supply-demand gap of domestic water was in Tarai and that of agricultural water was in the hill areas; and (4) Four districts, including Lalitpur, Mahottari, Makwanpur, and Solukhumbu, were found to be the most water-stressed regions and priority should be given to them. Based on these findings, the priority setting in the improvement of water supply systems and adaptation strategies for mitigating water stress from the perspectives of the government, communities, and households were presented. It helps design water supply systems that match heterogeneous demands and optimize systems operation. Targeted improvements in water supply systems can make limited funds available to benefit more residents.