Acyloxyacyl hydrolase, a leukocyte enzyme that acts on bacterial lipopolysaccharides (LPSs) and many glycerolipids, is synthesized as a precursor polypeptide that undergoes internal disulfide linkage before being proteolytically processed into two subunits. The larger subunit contains an amino acid sequence (Gly-X-Ser-X-Gly) that is found at the active sites of many lipases, while the smaller subunit has amino acid sequence similarity to saposins (sphingolipid activator proteins), cofactors for sphingolipid glycohydrolases. We show here that both acyloxyacyl hydrolase subunits are required for catalytic activity toward LPS and glycerophosphatidylcholine. In addition, mutations that truncate or delete the small subunit have profound effects on the intracellular localization, proteolytic processing, and stability of the enzyme in baby hamster kidney cells. Remarkably, proteolytic cleavage of the precursor protein increases the activity of the enzyme toward LPS by 10-20-fold without altering its activity toward glycerophosphatidylcholine. Proper orientation of the two subunits thus seems very important for the substrate specificity of this unusual enzyme.