Cathepsin E (CatE) is predominantly expressed in the rapidly regenerating gastric mucosal cells and epidermal keratinocytes, in addition to the immune system cells. However, the role of CatE in these cells remains unclear. Here we report a crucial role of CatE in keratinocyte terminal differentiation. CatE deficiency in mice induces abnormal keratinocyte differentiation in the epidermis and hair follicle, characterized by the significant expansion of corium and the reduction of subcutaneous tissue and hair follicle. In a model of skin papillomas formed in three different genotypes of syngeneic mice, CatE deficiency results in significantly reduced expression and altered localization of the keratinocyte differentiation induced proteins, keratin 1 and loricrin. Involvement of CatE in the regulation of the expression of epidermal differentiation specific proteins was corroborated by in vitro studies with primary cultures of keratinocytes from the three different genotypes of mice. In wild-type keratinocytes after differentiation inducing stimuli, the CatE expression profile was compatible to those of the terminal differentiation marker genes tested. Overexpression of CatE in mice enhances the keratinocyte terminal differentiation process, whereas CatE deficiency results in delayed differentiation accompanying the reduced expression or the ectopic localization of the differentiation markers. Our findings suggest that in keratinocytes CatE is functionally linked to the expression of terminal differentiation markers, thereby regulating epidermis formation and homeostasis.