Imaginal discs of Drosophila provide an excellent system with which to study morphogenesis, pattern formation and cell proliferation in an epithelium. Discs are sac-like in structure and are composed of two epithelial layers: an upper peripodial epithelium and lower disc proper. Although development of the disc proper has been studied extensively in terms of cell proliferation, cell signaling mechanisms and pattern formation, little is known about these same processes in the peripodial epithelium. We address this topic by focusing on morphogenesis, compartmental organization, proliferation and cell lineage of the PE in wing, second thoracic leg (T2) and eye discs. We show that a subset of peripodial cells in different imaginal discs undergo a cuboidal-to-squamous cell shape change at distinct larval stages. We find that this shape change requires both Hedgehog and Decapentapelagic, but not Wingless, signaling. Additionally, squamous morphogenesis shifts the anteroposterior (AP) compartment boundary in the peripodial epithelium relative to the stationary AP boundary in the disc proper. Finally, by lineage tracing cells in the PE, we surprisingly find that peripodial cells are displaced into the disc proper during larval development and this movement leads to Ubx repression.