If you arbitrarily define parts of the territory you control as not part of your territory, and its population as not your citizens (even though they are entirely subject to your jurisdiction), then you only get partial credit for being a “democracy”, at best.
If Israel were really committed to democratic ideals, they would either make all Palestinians equal citizens of the state (currently Israel, which would presumably be renamed “Palestine” the next day), or, more realistically, they would allow the Palestinian Territories to become an independent state, rather than keeping them permanently occupied and subject to Israeli military law.
this is exactly what other countries do since ages - US, UK, France - just to name a few - they all have territories under their control, but not integrated into the state itself, with population having different, but usually lesser rights than the population of the state proper.
on the other hand, the situation in so-called palestinian territories is completely different. Gaza strip was officially annexed by Egypt, West Bank was officially annexed by Jordan - so the official government would be these countries, and if we're talking about Apartheid, then it would be committed by these countries.
If Israel were really committed to democratic ideals, they would either make all Palestinians equal citizens of the state (currently Israel, which would presumably be renamed “Palestine” the next day), or, more realistically, they would allow the Palestinian Territories to become an independent state, rather than keeping them permanently occupied and subject to Israeli military law.