The pair shared the first two frames with O'Sullivan opening with a run of 100 before a 59 saw Xiao level at 1-1.
O'Sullivan snatched the third after his Chinese opponent missed a few balls before the world champion finished matters off with breaks of 54 and 78.
O'Sullivan will face Ricky Walden for a place in the quarter-finals after his 4-2 win over Anthony Hamilton. O'Sullivan completed a 6-0 crushing of Walden at the Masters last month by running in a record 556 points without answer.
"Xiao is a quality player who is breaking into the top 16 and capable of winning tournaments so I am pleased to win," said former Welsh Open winner O'Sullivan.
"That could have gone the other way, which is down to the quality of Xiao. I got away with a couple out there but that is snooker. It is nice to be playing every day here as you don't have to hang around and can focus your mind on playing. At tournaments all you want to do is play snooker.
"Ricky is a World Championship semi-finalist and beat me in the final of the 2008 Shanghai Masters. He is up there in the rankings now so I know it is going to be a tough match."
Elsewhere, Mark Williams edged out fellow former world champion Neil Robertson 4-3 after a turgid match that saw Robertson contribute 112, but fail to stamp his authority upon the contest.
"It was an excellent win for me, one of my best in a long time," said Williams. "I probably made more mistakes than him, he looked like a Rolls-Royce when he got in the balls and I looked like an Austin Metro, but I held myself together. I potted an excellent red in the last frame when I was behind and after that they were all on - but you have still got to pot them and I haven't been doing that.
"I was going to play safe on that red but I just went for it. I am looking forward to the next match. I have been getting frustrated with myself lately but I just need to shrug it off. I have been practicing a lot, even on Christmas and New Year's Day, and hopefully that is beginning to pay off."
Latest Welsh Open results
Third round (Last 32, best of seven frames)
Dominic Dale (Wal) 0-4 Mark Selby (Eng)
James Wattana (Tha) 1-4 Joel Walker (Eng)
Shaun Murphy (Eng) 3-4 Liang Wenbo (Chn)
Scott Donaldson (Sco) 4-3 Andrew Higginson (Eng)
Mark Allen (NI) 2-4 Allister Carter (Eng)
Matthew Stevens (Wal) 3-4 Joe Perry (Eng)
Neil Robertson (Aus) 3-4 Mark Williams (Wal)
Ricky Walden (Eng) 4-2 Anthony Hamilton (Eng)
Stuart Bingham (Eng) 4-2 Michael Holt (Eng)
Judd Trump (Eng) 4-1 Anthony McGill (Sco)
Xiao Guodong (Chn) 1-4 Ronnie O'Sullivan (Eng)
Graeme Dott (Sco) 2-4 Marco Fu (HK)
Jack Lisowski (Eng) 3-4 Barry Hawkins (Eng)
Mark King (Eng) 0-4 John Higgins (Sco)
Stephen Maguire (Sco) 4-0 Andrew Pagett (Wal)
Ben Woollaston (Eng) 3-4 Ding Junhui (Chn)
Thursday 27 February
Fourth round (Last 16, best of nine frames)
Ali Carter v Mark Selby
Stuart Bingham v Joe Perry
Ricky Walden v Ronnie O'Sullivan
Stephen Maguire v Joel Walker
Scott Donaldson v Ding Junhui
Judd Trump v John Higgins
Mark Williams v Marco Fu
Liang Wenbo v Barry Hawkins