Neurofibromatosis-2 is an inherited disorder characterized by the development of benign schwannomas and other Schwann-cell-derived tumors associated with the central nervous system. The Neurofibromatosis-2 tumor suppressor gene encodes Merlin, a member of the Protein 4.1 superfamily most closely related to Ezrin, Radixin and Moesin. This discovery suggested a novel function for Protein 4.1 family members in the regulation of cell proliferation; proteins in this family were previously thought to function primarily to link transmembrane proteins to underlying cortical actin. To understand the basic cellular functions of Merlin, we are investigating a Drosophila Neurofibromatosis-2 homologue, Merlin. Loss of Merlin function in Drosophila results in hyperplasia of the affected tissue without significant disruptions in differentiation. Similar phenotypes have been observed for mutations in another Protein 4.1 superfamily member in Drosophila, expanded. Because of the phenotypic and structural similarities between Merlin and expanded, we asked whether Merlin and Expanded function together to regulate cell proliferation. In this study, we demonstrate that recessive loss of function of either Merlin or expanded can dominantly enhance the phenotypes associated with mutations in the other. Consistent with this genetic interaction, we determined that Merlin and Expanded colocalize in Drosophila tissues and cells, and physically interact through a conserved N-terminal region of Expanded, characteristic of the Protein 4.1 family, and the C-terminal domain of Merlin. Loss of function of both Merlin and expanded in clones revealed that these proteins function to regulate differentiation in addition to proliferation in Drosophila. Further genetic analyses suggest a role for Merlin and Expanded specifically in Decapentaplegic-mediated differentiation events. These results indicate that Merlin and Expanded function together to regulate proliferation and differentiation, and have implications for understanding the functions of other Protein 4.1 superfamily members.