Rett syndrome (RTT), a severe postnatal neurodevelopmental disorder, is caused by mutations in the X-linked gene encoding methyl-CpG-binding protein 2 (MeCP2). MeCP2 is a chromatin organizer regulating gene expression. RTT-causing mutations have been shown to affect this function. However, the mechanism by which MeCP2 organizes chromatin is unclear. In this study, we found that MeCP2 can induce compaction and liquid-liquid phase separation of nucleosomal arrays in vitro, and DNA methylation further enhances formation of chromatin condensates by MeCP2. Interestingly, RTT-causing mutations compromise MeCP2-mediated chromatin phase separation, while benign variants have little effect on this process. Moreover, MeCP2 competes with linker histone H1 to form mutually exclusive chromatin condensates in vitro and distinct heterochromatin foci in vivo. RTT-causing mutations reduce or even abolish the ability of MeCP2 to compete with histone H1 and to form chromatin condensates. Together, our results identify a novel mechanism by which phase separation underlies MeCP2-mediated heterochromatin formation and reveal the potential link between this process and the pathology of RTT.