Craniofacial development involves cranial neural crest (CNC) and mesoderm-derived cells. TGF-beta signaling plays a critical role in instructing CNC cells to form the craniofacial skeleton. However, it is not known how TGF-beta signaling regulates the fate of mesoderm-derived cells during craniofacial development. In this study, we show that occipital somites contribute to the caudal region of mammalian skull development. Conditional inactivation of Tgfbr2 in mesoderm-derived cells results in defects of the supraoccipital bone with meningoencephalocele and discontinuity of the neural arch of the C1 vertebra. At the cellular level, loss of TGF-beta signaling causes decreased chondrocyte proliferation and premature differentiation of cartilage to bone. Expression of Msx2, a critical factor in the formation of the dorsoventral axis, is diminished in the Tgfbr2 mutant. Significantly, overexpression of Msx2 in Myf5-Cre;Tgfbr2flox/flox mice partially rescues supraoccipital bone development. These results suggest that the TGF-beta/Msx2 signaling cascade is critical for development of the caudal region of the skull.