A single gully system was selected in a small agricultural watershed on the Loess Plateau of China with the objective of measuring and then simulating water and sediment transport and defining alternative land uses to reduce discharge and soil loss. The gully had a total length of about 40 m and was about 30 m wide. The watershed feeding the gully occupied about 1950 m² (including the gully itself). The gully bottom had a slope of about 32–40°, whereas the gully walls were from 40° to over 60°. Soil water content and water and sediment discharge were measured automatically. The physically based hydrological and soil erosion model LISEM was used to calculate water and sediment discharge. Calibration has been carried out for one event, by adjusting the saturated conductivity values. Validation was performed for two additional runoff events. Calibration results show reasonably comparable hydrographs between measured and calculated discharge. LISEM could be calibrated on the hydrograph quite satisfactorily using the saturated conductivity as a calibration factor. Also, validation of LISEM for two other runoff events showed reasonably good results. The calibration on total soil loss also shows good results. For the validation runs, these results are poor, probably due to limitations of the measurement equipment and the incapability of the model to simulate small events. Scenario analyses showed that forest, as an alternative land use for the gully bottom, will result in significantly lower water and sediment. This strongly supports the implementation of the reforestation policy recently suggested and activated by the central government of the P.R. China.