Arrestins control signaling via the G protein coupled receptors (GPCRs), serving as both signal terminators and transducers. Previous studies identified several structural elements in arrestins that contribute to their functions as GPCR regulators. However, the importance of these elements in vivo is unclear, and the developmental roles of arrestins are not well understood. We carried out an in vivo structure-function analysis of Kurtz (Krz), the single ortholog of mammalian β-arrestins in the Drosophila genome. A combination of Krz mutations affecting the GPCR-phosphosensing and receptor core-binding ("finger loop") functions (Krz-KKVL/A) resulted in a complete loss of Krz activity during development. Endosome recruitment and bioluminescence resonance energy transfer (BRET) assays revealed that the KKVL/A mutations abolished the GPCR-binding ability of Krz. We found that the isolated "finger loop" mutation (Krz-VL/A), while having a negligible effect on GPCR internalization, severely affected Krz function, suggesting that tight receptor interactions are necessary for proper termination of signaling in vivo. Genetic analysis as well as live imaging demonstrated that mutations in Krz led to hyperactivity of the GPCR Mist (also known as Mthl1), which is activated by its ligand Folded gastrulation (Fog) and is responsible for cellular contractility and epithelial morphogenesis. Krz mutations affected two developmental events that are under the control of Fog-Mist signaling: gastrulation and morphogenesis of the wing. Overall, our data reveal the functional importance in vivo of direct β-arrestin/GPCR binding, which is mediated by the recognition of the phosphorylated receptor tail and receptor core interaction. These Krz-GPCR interactions are critical for setting the correct level of Fog-Mist signaling during epithelial morphogenesis.