The Hedgehog morphogen is a major developmental regulator that acts at short and long range to direct cell fate decisions in invertebrate and vertebrate tissues. Hedgehog is the only known metazoan protein to possess a covalently linked cholesterol moiety. Although the role of the cholesterol group of Hedgehog remains unclear, it has been suggested to be dispensable for the its long-range activity in Drosophila. Here, we provide data in three different epithelia - ventral and dorsal embryonic ectoderm, and larval imaginal disc tissue - showing that cholesterol modification is in fact necessary for the controlled long-range activity of Drosophila Hedgehog. We provide an explanation for the discrepancy between our results and previous reports by showing that unmodified Hh can act at long range, albeit in an uncontrolled manner, only when expressed in squamous cells. Our data show that cholesterol modification controls long-range Hh activity at multiple levels. First, cholesterol increases the affinity of Hh for the plasma membrane, and consequently enhances its apparent intrinsic activity, both in vitro and in vivo. In addition, multimerisation of active Hh requires the presence of cholesterol. These multimers are correlated with the assembly of Hh into apically located, large punctate structures present in active Hh gradients in vivo. By comparing the activity of cholesterol-modified Hh in columnar epithelial cells and peripodial squamous cells, we show that epithelial cells provide the machinery necessary for the controlled planar movement of Hh, thereby preventing the unrestricted spreading of the protein within the three-dimensional space of the epithelium. We conclude that, as in vertebrates, cholesterol modification is essential for controlled long-range Hh signalling in Drosophila.