Hedgehog (Hh) signaling plays a major role in multiple aspects of embryonic development. A key issue is how negative regulation of Hh signaling might contribute to generating differential responses over tens of cell diameters. In cells that respond to Hh, two proteins that are up-regulated are Patched1 (Ptch1), the Hh receptor, a general target in both invertebrate and vertebrate organisms, and Hip1, a Hh-binding protein that is vertebrate specific. To address the developmental role of Hip1 in the context of Hh signaling, we generated Hip1 mutants in the mouse. Loss of Hip1 function results in specific defects in two Hh target issues, the lung, a target of Sonic hedgehog (Shh) signaling, and the endochondral skeleton, a target of Indian hedgehog (Ihh) signaling. Hh signaling was up-regulated in Hip1 mutants, substantiating Hip1's general role in negatively regulating Hh signaling. Our studies focused on Hip1 in the lung. Here, a dynamic interaction between Hh and fibroblast growth factor (Fgf) signaling, modulated at least in part by Hip1, controls early lung branching.