The goal of this study was to elucidate the molecular mechanism by which type I IFN inhibits assembly and release of HIV-1 virions. Our study revealed that the IFN-induced ubiquitin-like protein ISG15 mimics the IFN effect and inhibits release of HIV-1 virions without having any effect on the synthesis of HIV-1 proteins in the cells. ISG15 expression specifically inhibited ubiquitination of Gag and Tsg101 and disrupted the interaction of the Gag L domain with Tsg101, but conjugation of ISG15 to Gag or Tsg101 was not detected. The inhibition of Gag-Tsg101 interaction was also detected in HIV-1 infected, IFN-treated cells. Elimination of ISG15 expression by small interfering RNA reversed the IFN-mediated inhibition of HIV-1 replication and release of virions. These results indicated a critical role for ISG15 in the IFN-mediated inhibition of late stages of HIV-1 assembly and release and pointed to a mechanism by which the innate antiviral response targets the cellular endosomal trafficking pathway used by HIV-1 to exit the cell. Identification of ISG15 as the critical component in IFN-mediated inhibition of HIV-1 release advances the understanding of the IFN-mediated inhibition of HIV-1 replication and uncovers a target for the anti HIV-1 therapy.