ABSTRACT During gastrulation in the mouse, mesoderm is induced and patterned by secreted signaling molecules, giving rise first to primitive erythroblasts and vascular endothelial cells. We have demonstrated previously that development of these lineages requires a signal(s) secreted from the adjacent primitive endoderm. We now show that Indian hedgehog (Ihh) is a primitive endoderm-secreted signal that alone is sufficient to induce formation of hematopoietic and endothelial cells. Strikingly, as seen with primitive endoderm, Ihh can respecify prospective neural ectoderm (anterior epiblast) along hematopoietic and endothelial (posterior) lineages. Downstream targets of the hedgehog signaling pathway (the genes encoding patched, smoothened and Gli1) are upregulated in anterior epiblasts cultured in the presence of Ihh protein, as is Bmp4, which may mediate the effects of Ihh. Blocking Ihh function in primitive endoderm inhibits activation of hematopoiesis and vasculogenesis in the adjacent epiblast, suggesting that Ihh is an endogenous signal that plays a key role in the development of the earliest hemato-vascular system. To our knowledge, these are the earliest functions for a hedgehog protein in post-implantation development in the mouse embryo.