I reckon the first few years of the C64's life games were written on the C64 itself, but then written on a more powerful machine in its later years such as the Commodore Amiga. Just a guess though...
Dos based PCs were used on a few commercial games. Retro Gamer magazine (http://www.retrogamer.net/) has had several articles dealing with commercial C64 game development.
The most common way was on the C64 though. PCs were expensive, and a lot of games were developed by "bedroom coders" as contractors.

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