Morphogen gradients control body pattern by differentially regulating cellular behavior. Here, we analyze the molecular events underlying the primary response to the Dpp/BMP morphogen in Drosophila. Throughout development, Dpp transduction causes the graded transcriptional downregulation of the brinker (brk) gene. We first provide significance for the brk expression gradient by showing that different Brk levels repress distinct combinations of wing genes expressed at different distances from Dpp-secreting cells. We then dissect the brk regulatory region and identify two separable elements with opposite properties, a constitutive enhancer and a Dpp morphogen-regulated silencer. Furthermore, we present genetic and biochemical evidence that the brk silencer serves as a direct target for a protein complex consisting of the Smad homologs Mad/Medea and the zinc finger protein Schnurri. Together, our results provide the molecular framework for a mechanism by which the extracellular Dpp/BMP morphogen establishes a finely tuned, graded read-out of transcriptional repression.