Sonic hedgehog (Shh) and Indian hedgehog (Ihh) are important regulators of skeletogenesis, but their roles in this complex multistep process are not fully understood. Recent studies have suggested that the proteins participate in the differentiation of chondrogenic precursor cells into chondrocytes. In the present study, we have tested this possibility more directly. We found that implantation of dermal fibroblasts expressing hedgehog proteins into nude mice induces ectopic cartilage and bone formation. Immunohistological and reverse‐transcription polymerase chain reaction (RT‐PCR) analyses revealed that the ectopic tissues derived largely if not exclusively from host cells. We found also that treatment of clonal prechondrogenic RMD‐1 and ATDC5 cells in culture with Ihh or recombinant amino half of Shh (recombinant N‐terminal portion of Shh [rShh‐N]) induced their differentiation into chondrocytes, as revealed by cytoarchitectural changes, Alcian blue staining and proteoglycan synthesis. Induction of RMD‐1 cell differentiation by Ihh or rShh‐N was synergistically enhanced by cotreatment with bone morphogenetic protein 2 (BMP‐2) but was blocked by cotreatment with fibroblast growth factor 2 (FGF‐2). Our findings indicate that hedgehog proteins have the ability to promote differentiation of chondrogenic precursor cells and that their action in this process can be influenced and modified by synergistic or antagonist cofactors.