During hedgehog biosynthesis, autocatalytic processing produces a lipid-modified amino-terminal fragment (residues 24-197 in the human Sonic hedgehog sequence) that is responsible for all known hedgehog signaling activity and that is highly conserved evolutionarily. Published in vitro biochemical studies using Drosophila hedgehog identified the membrane anchor as a cholesterol, and localized the site of attachment to the COOH terminus of the fragment. We have expressed full-length human Sonic hedgehog in insect and in mammalian cells and determined by mass spectrometry that, in addition to cholesterol, the human hedgehog protein is palmitoylated. Peptide mapping and sequencing data indicate that the palmitoyl group is attached to the NH2 terminus of the protein on the alpha-amino group of Cys-24. Cell-free palmitoylation studies demonstrate that radioactive palmitic acid is readily incorporated into wild type Sonic hedgehog, but not into variant forms lacking the Cys-24 attachment site. The lipid-tethered forms of hedgehog showed about a 30-fold increase in potency over unmodified soluble hedgehog in a cell- based (C3H10T1/2 alkaline phosphatase induction) assay, suggesting that the lipid tether plays an important role in hedgehog function. The observation that an extracellular protein such as Shh is palmitoylated is highly unusual and further adds to the complex nature of this protein.