Development of the cartilaginous capsule of the inner ear is dependent on interactions between otic epithelium and its surrounding periotic mesenchyme. During these tissue interactions, factors endogenous to the otic epithelium influence the differentiation of the underlying periotic mesenchyme to form a chondrified otic capsule. We report the localization of Sonic hedgehog (Shh) protein and expression of the Shh gene in the tissues of the developing mouse inner ear. We demonstrate in cultures of periotic mesenchyme that Shh alone cannot initiate otic capsule chondrogenesis. However, when Shh is added to cultured periotic mesenchyme either in combination with otic epithelium or otic epithelial-derived fibroblast growth factor (FGF2), a significant enhancement of chondrogenesis occurs. Addition of Shh antisense oligonucleotide (AS) to cultured periotic mesenchyme with added otic epithelium decreases levels of endogenous Shh and suppresses the chondrogenic response of the mesenchyme cells, while supplementation of Shh AS-treated cultures with Shh rescues cultures from chondrogenic inhibition. We demonstrate that inactivation of Shh by targeted mutation produces anomalies in the developing inner ear and its surrounding capsule. Our results support a role for Shh as a regulator of otic capsule formation and inner ear development during mammalian embryogenesis.