The involvement of hedgehog signaling in the initiation of osteoblastic differentiation in the bone collar during endochondral bone formation has been well established. The stages at which hedgehog acts during osteoblast differentiation as well as its molecular mechanism of action are less well understood. To address these questions, we have made use of the preosteoblastic cell line KS483. First, a systematic survey of mRNA expression of osteoblastic differentiation showed expression of Ihh and signaling intermediates at all stages. Interestingly, expression of Ihh, Gli1 and Ptc1 peaked during the maturation phase. Addition of recombinant human sonic hedgehog (rShh) potently increased osteoblastic differentiation of KS483 cells dose-dependently as assayed by a modest increase in alkaline phosphatase (ALP) activity, a strong increase in matrix mineralization, and increased mRNA expression of established osteoblast marker genes. These effects were blocked by the hedgehog antagonist cyclopamine, which by itself was ineffective. Addition of rShh during early stages was sufficient, while addition to mature osteoblasts had no effect. Furthermore, hedgehog signaling could be completely blocked by the BMP antagonists, soluble truncated BMPR-IA and noggin. In contrast, the BMP-induced differentiation of KS483 cells could only be partly inhibited by high doses of cyclopamine. These data demonstrate that Hh-induced osteoblastic differentiation requires functional BMP signaling. In KS483 cells, Hh and BMP synergistically induced alkaline phosphatase activity only when suboptimal concentrations of BMP were used. This synergy did not occur at the level of immediate early BMP response, but at the level of Hh response as determined by transient transfection studies using either a BMP reporter or a Gli reporter construct. In addition, rShh inhibited adipogenesis of KS483 cells cultured under adipogenic culture conditions, suggesting that Hh is involved in directing differentiation of KS483 cells toward osteoblasts at the expense of adipogenesis. Using in situ hybridization, we demonstrated, for the first time, Ihh mRNA expression in vivo in osteoblasts and lining cells in the humerus of developing human skeleton. Our in vitro and in vivo data indicate a stimulatory role for osteoblast-expressed Ihh in bone formation in a positive feedback loop. It may recruit progenitor cells in the osteoblastic lineage at the expense of adipocytes and it may stimulate maturation of early osteoblasts.