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We present an integrated optical displacement sensing method for microscale sensors which is based on an asymmetric Fabry–Perot etalon structure with an embedded phase-sensitive diffraction grating. Analytical modeling of the structure shows that the etalon significantly improves the detection sensitivity as compared to a regular optical interferometer and the embedded diffraction grating enables integration of optoelectronics in a small volume. The efficacy of the method is experimentally validated on a surface micromachined diffraction-based opto-acoustic sensor fabricated on a quartz wafer. A 15 nm silver layer is used to form the bottom mirror of the etalon structure with a sensor membrane and embedded diffraction grating made of aluminum. Comparison of the results with and without the etalon shows an 8 dB increase in detection sensitivity with the etalon structure, which should be further enhanced with the use of low-loss dielectric mirrors.