The Hedgehog (Hh) family of secreted proteins controls many aspects of growth and patterning in animal development. The seven-transmembrane protein Smoothened (Smo) transduces the Hh signal in both vertebrates and invertebrates; however, the mechanism of its action remains unknown. We found that Smo lacking its C-terminal tail (C-tail) is inactive, whereas membrane-tethered Smo C-tail has constitutive albeit low levels of Hh signaling activity. Smo physically interacts with Costal2 (Cos2) and Fused (Fu) through its C-tail. Deletion of the Cos2/Fu-binding domain from Smo abolishes its signaling activity. Moreover, overexpressing Cos2 mutants that fail to bind Fu and Ci but retain Smo-binding activity blocks Hh signaling. Taken together, our results suggest that Smo transduces the Hh signal by physically interacting with the Cos2/Fu protein complex.