Indian hedgehog (Ihh) is indispensable for development of the osteoblast lineage in the endochondral skeleton. In order to determine whether Ihh is directly required for osteoblast differentiation, we have genetically manipulated smoothened (Smo), which encodes a transmembrane protein that is essential for transducing all Hedgehog (Hh) signals. Removal of Smo from perichondrial cells by the Cre-LoxP approach prevents formation of a normal bone collar and also abolishes development of the primary spongiosa. Analysis of chimeric embryos composed of wild-type and Smo^n/n cells indicates that Smo^n/n cells fail to contribute to osteoblasts in either the bone collar or the primary spongiosa but generate ectopic chondrocytes. In order to assess whether Ihh is sufficient to induce bone formation in vivo, we have analyzed the bone collar in the long bones of embryos in which Ihh was artificially expressed in all chondrocytes by the UAS-GAL4 bigenic system. Although ectopic Ihh does not induce overt ossification along the entire cartilage anlage, it promotes progression of the bone collar toward the epiphysis, suggesting a synergistic effect between ectopic Ihh and endogenous factors such as the bone morphogenetic proteins (BMPs). In keeping with this model, Hh signaling is further found to be required in BMP-induced osteogenesis in cultures of a limb-bud cell line. Taken together, these results demonstrate that Ihh signaling is directly required for the osteoblast lineage in the developing long bones and that Ihh functions in conjunction with other factors such as BMPs to induce osteoblast differentiation. We suggest that Ihh acts in vivo on a potential progenitor cell to promote osteoblast and prevent chondrocyte differentiation.