One of the most dominant influences in the patterning of multicellular embryos is exerted by the Hedgehog (Hh) family of secreted signaling proteins. Here, we identify a segment polarity gene in Drosophila melanogaster, skinny hedgehog (ski), and show that its product is required in Hh-expressing cells for production of appropriate signaling activity in embryos and in the imaginal precursors of adult tissues. The ski gene encodes an apparent acyltransferase, and we provide genetic and biochemical evidence that Hh proteins from ski mutant cells retain carboxyl-terminal cholesterol modification but lack amino-terminal palmitate modification. Our results suggest that ski encodes an enzyme that acts within the secretory pathway to catalyze amino-terminal palmitoylation of Hh, and further demonstrate that this lipid modification is required for the embryonic and larval patterning activities of the Hh signal.