Hedgehog (Hh) signaling is critical for many developmental events and must be restrained to prevent cancer. A transmembrane protein, Smoothened (Smo), is necessary to transcriptionally activate Hh target genes. Smo activity is blocked by the Hh transmembrane receptor Patched (Ptc). The reception of a Hh signal overcomes Ptc inhibition of Smo, activating transcription of target genes. Using Drosophila salivary gland cells in vivo and in vitro as a new assay for Hh signal transduction, we investigated the regulation of Hh-triggered Smo stabilization and relocalization. Hh causes Smo to move from internal membranes to the cell surface. Relocalization is protein synthesis-independent and occurs within 30 min of Hh treatment. Ptc and the kinesin-related protein Costal2 (Cos2) cause internalization of Smo, a process that is dependent on both actin and microtubules. Disruption of endocytosis by dominant negative dynamin or Rab5 prevents Smo internalization. Fly versions of Smo mutants associated with human tumors are constitutively present at the cell surface. Forced localization of Smo at the plasma membrane activates Hh target gene transcription. Conversely, trapping of activated Smo mutants in the ER prevents Hh target gene activation. Control of Smo localization appears to be a crucial step in Hh signaling in Drosophila.