Autocatalytic processing mediated by the carboxyterminal domain of the hedgehog (hh) protein precursor (Hh) generates an amino-terminal product that accounts for all known signaling activity. The role of autoprocessing in biogenesis of the hh signal has been unclear, since a truncated unprocessed protein lacking all carboxy-terminal domain sequences retains signaling activity. Here, we present evidence that the autoprocessing reaction proceeds via an internal thioester intermediate and results in a covalent modification that increases the hydrophobic character of the signaling domain and influences its spatial and subcellular distribution. We demonstrate that truncated unprocessed amino-terminal protein causes embryonic mispatterning, even when expression is localized to cells that normally express Hh, thus suggesting a role for autoprocessing in spatial regulation of hh signaling. This type of processing also appears to operate in the biogenesis of other novel secreted proteins.