Merlin, the product of the Neurofibromatosis type 2 (NF2) tumor-suppressor gene, is a member of the protein 4.1 superfamily that is most closely related to ezrin, radixin, and moesin (ERM). NF2 is a dominantly inherited disease characterized by the formation of bilateral acoustic schwannomas and other benign tumors associated with the central nervous system. To understand its cellular functions, we are studying a Merlin homologue in Drosophila. As is the case for NF2 tumors, Drosophila cells lacking Merlin function overproliferate relative to their neighbors. Using in vitro mutagenesis, we define functional domains within Merlin required for proper subcellular localization and for genetic rescue of lethal Merlin alleles. Remarkably, the results of these experiments demonstrate that all essential genetic functions reside in the plasma membrane- associated NH2-terminal 350 amino acids of Merlin. Removal of a seven-amino acid conserved sequence within this domain results in a dominant-negative form of Merlin that is stably associated with the plasma membrane and causes overproliferation when expressed ectopically in the wing. In addition, we provide evidence that the COOH-terminal region of Merlin has a negative regulatory role, as has been shown for ERM proteins. These results provide insights into the functions and functional organization of a novel tumor suppressor gene.