The transmembrane receptor Patched regulates several developmental processes in both invertebrates and vertebrates. In vertebrates, Patched also acts as a tumor suppressor. The Patched pathway normally operates by negatively regulating Smoothened, a G-protein-coupled receptor; binding of Hedgehog ligand to Patched relieves this negative interaction and allows signaling by Smoothened. We show that Ptc regulates Drosophila head development by promoting cell proliferation in the eye-antennal disc. During head morphogenesis, Patched positively interacts with Smoothened, which leads to the activation of Activin type I receptor Baboon and stimulation of cell proliferation in the eye-antennal disc. Thus, loss of Ptc or Smoothened activity affects cell proliferation in the eye-antennal disc and results in adult head capsule defects. Similarly, reducing the dose of smoothened in a patched background enhances the head defects. Consistent with these results, gain-of-function Hedgehog interferes with the activation of Baboon by Patched and Smoothened, leading to a similar head capsule defect. Expression of an activated form of Baboon in the patched domain in a patched mutant background completely rescues the head defects. These results provide insight into head morphogenesis, a process we know very little about, and reveal an unexpected non-canonical positive signaling pathway in which Patched and Smoothened function to promote cell proliferation as opposed to repressing it.