Sonic hedgehog (Shh) signaling from the posterior zone of polarizing activity (ZPA) is the primary determinant of anterior-posterior polarity in the vertebrate limb field. An active signal is produced by an autoprocessing reaction that covalently links cholesterol to the N-terminal signaling moiety (N-Shh_p), tethering N-Shh_p to the cell membrane. We have addressed the role played by this lipophilic modification in Shh-mediated patterning of mouse digits. Both the distribution and activity of N-Shh_p indicate that N-Shh_p acts directly over a few hundred microns. In contrast, N-Shh, a form that lacks cholesterol, retains similar biological activity to N-Shh_p, but signaling is posteriorly restricted. Thus, cholesterol modification is essential for the normal range of signaling. It also appears to be necessary for appropriate modulation of signaling by the Shh receptor, Ptc1.