Atg8 is a ubiquitin-like protein required for autophagy in the budding yeast Saccharomyces cerevisiae. A ubiquitin-like system mediates the conjugation of the C terminus of Atg8 to the lipid phosphatidylethanolamine (PE), and this conjugate (Atg8-PE) plays a crucial role in autophagosome formation at the phagophore assembly site/pre-autophagosomal structure (PAS). The cysteine protease Atg4 processes the C terminus of newly synthesized Atg8 and also delipidates Atg8 to release the protein from membranes. While the former is a prerequisite for lipidation of Atg8, the significance of the latter in autophagy has remained unclear. Here, we show that autophagosome formation is significantly retarded in cells deficient for Atg4-mediated delipidation of Atg8. We find that Atg8-PE accumulates on various organelle membranes including the vacuole, the endosome and the ER in these cells, which depletes unlipidated Atg8 and thereby attenuates its localization to the PAS. Our results suggest that the Atg8-PE that accumulates on organelle membranes is erroneously produced by lipidation system components independently of the normal autophagic process. It is also suggested that delipidation of Atg8 by Atg4 on different organelle membranes promotes autophagosome formation. Considered together with other results, we propose that Atg4 acts to compensate for the intrinsic defect in the lipidation system; it recycles Atg8-PE generated on inappropriate membranes to maintain a reservoir of unlipidated Atg8 that is required for autophagosome formation at the PAS.