Hedgehog (Hh) is a lipoprotein-borne ligand that regulates both patterning and proliferation in a wide variety of vertebrate and invertebrate tissues. When Hh is absent, its receptor Patched (Ptc) represses Smoothened (Smo) signaling by an unknown catalytic mechanism that correlates with reduced Smo levels on the basolateral membrane. Ptc contains a sterol-sensing domain and is similar to the Niemann-Pick type C-1 protein, suggesting that Ptc might regulate lipid trafficking to repress Smo. However, no endogenous lipid regulators of Smo have yet been identified, nor has it ever been shown that Ptc actually controls lipid trafficking. Here, we show that Drosophila Ptc recruits internalized lipoproteins to Ptc-positive endosomes and that its sterol-sensing domain regulates trafficking of both lipids and Smo from this compartment. Ptc utilizes lipids derived from lipoproteins to destabilize Smo on the basolateral membrane. We propose that Ptc normally regulates Smo degradation by changing the lipid composition of endosomes through which Smo passes, and that the presence of Hh on lipoproteins inhibits utilization of their lipids by Ptc.