MutL homologs are crucial for mismatch repair and genetic stability, but their function is not well understood. Human MutLalpha (MLH1-PMS2 heterodimer) harbors a latent endonuclease that is dependent on the integrity of a PMS2 DQHA(X)2E(X)4E motif (Kadyrov, F. A., Dzantiev, L., Constantin, N., and Modrich, P. (2006) Cell 126, 297-308). This sequence element is conserved in many MutL homologs, including the PMS1 subunit of Saccharomyces cerevisiae MutLalpha, but is absent in MutL proteins from bacteria like Escherichia coli that rely on d(GATC) methylation for strand directionality. We show that yeast MutLalpha is a strand-directed endonuclease that incises DNA in a reaction that depends on a mismatch, yMutSalpha, yRFC, yPCNA, ATP, and a pre-existing strand break, whereas E. coli MutL is not. Amino acid substitution within the PMS1 DQHA(X)2E(X)4E motif abolishes yMutLalpha endonuclease activity in vitro and confers strong genetic instability in vivo, but does not affect yMutLalpha ATPase activity or the ability of the protein to support assembly of the yMutLalpha.yMutSalpha.heteroduplex ternary complex. The loaded form of yPCNA may play an important effector role in directing yMutLalpha incision to the discontinuous strand of a nicked heteroduplex.