Neuronal differentiation in the Drosophila retinal primordium, the eye imaginal disc, begins at the posterior tip of the disc and progresses anteriorly as a wave. The morphogenetic furrow (MF) marks the boundary between undifferentiated anterior cells and differentiating posterior cells. Anterior progression of differentiation is driven by Hedgehog, synthesized by cells located posterior to the MF. We report here that hedgehog (hh), which is expressed prior to the start of differentiation along the disc's posterior margin, also plays a crucial role in the initiation of differentiation. Using a temperature-sensitive allele we show that hh is normally required at the posterior margin to maintain the expression of decapentaplegic (dpp) and of the proneural gene atonal. In addition, we find that ectopic differentiation driven by ectopic dpp expression or loss of wingless function requires hh. Consistent with this is our observation that ectopic dpp induces the expression of hh along the anterior margin even in the absence of differentiation. Taken together, these data reveal a novel positive regulatory loop between dpp and hh that is essential for the initiation of differentiation in the eye disc.