The 21-year-old joined the Sicilian side from Penarol in 2009 and has since established himself as one of their key players.
The contract extension will see Hernandez play for the Serie A outfit until 2016.
"I'm really delighted, I feel great at Palermo," said Hernandez.
"I've always thought about these colours and my only desire was to stay here."
Hernandez has played 15 times for Palermo this season, scoring five goals in the process.