In vertebrates, sterols are necessary for Hedgehog signaling, a pathway critical in embryogenesis and cancer. Sterols activate the membrane protein Smoothened by binding its extracellular, cysteine-rich domain (CRD). Major unanswered questions concern the nature of the endogenous, activating sterol and the mechanism by which it regulates Smoothened. We report crystal structures of CRD complexed with sterols and alone, revealing that sterols induce a dramatic conformational change of the binding site, which is sufficient for Smoothened activation and is unique among CRD-containing receptors. We demonstrate that Hedgehog signaling requires sterol binding to Smoothened and define key residues for sterol recognition and activity. We also show that cholesterol itself binds and activates Smoothened. Furthermore, the effect of oxysterols is abolished in Smoothened mutants that retain activation by cholesterol and Hedgehog. We propose that the endogenous Smoothened activator is cholesterol, not oxysterols, and that vertebrate Hedgehog signaling controls Smoothened by regulating its access to cholesterol.