The mechanism by which the secreted signaling molecule Hedgehog (Hh) elicits concentration-dependent transcriptional responses from cells is not well understood. In the Drosophila wing imaginal disc, Hh signaling differentially regulates the transcription of target genes decapentaplegic (dpp), patched (ptc) and engrailed (en) in a dose-responsive manner. Two key components of the Hh signal transduction machinery are the kinesin-related protein Costal2 (Cos2) and the nuclear protein trafficking regulator Suppressor of Fused [Su(fu)]. Both proteins regulate the activity of the transcription factor Cubitus interruptus (Ci) in response to the Hh signal. We have analyzed the activities of mutant forms of Cos2 in vivo and found effects on differential target gene transcription. A point mutation in the motor domain of Cos2 results in a dominant-negative form of the protein that derepresses dpp but not ptc. Repression of ptc in the presence of the dominant-negative form of Cos2 requires Su(fu), which is phosphorylated in response to Hh in vivo. Overexpression of wild-type or dominant-negative cos2 represses en. Our results indicate that differential Hh target gene regulation can be accomplished by differential sensitivity of Cos2 and Su(Fu) to Hh.