Fragmentation methods based on the many-body expansion offer an attractive approach for the quantum-chemical treatment of large molecular systems, such as molecular clusters and crystals. Conventionally, the many-body expansion is performed for the total energy, but such an energy-based many-body expansion often suffers from a slow convergence with respect to the expansion order. For systems that show strong polarization effects such as water clusters, this can render the energy-based many-body expansion infeasible. Here, we establish a density-based many-body expansion as a promising alternative approach. By performing the many-body expansion for the electron density instead of the total energy and inserting the resulting total electron density into the total energy functional of density-functional theory, one can derive a density-based energy correction, which in principle accounts for all higher order polarization effects. Here, we systematically assess the accuracy of such a density-based many-body expansion for test sets of water clusters. We show that already a density-based two-body expansion is able to reproduce interaction energies per fragment within chemical accuracy, and is able to accurately predict the energetic ordering as well as the relative interaction energies of different isomers of water clusters.