Hedgehog (Hh) signaling controls growth and patterning during embryonic development and homeostasis in adult tissues. Hh binding to the receptor Patched (Ptc) elicits intracellular signaling by relieving Ptc-mediated inhibition of the transmembrane protein Smoothened (Smo). We uncovered a role for the lipid phosphatidic acid (PA) in the regulation of the Hh pathway in Drosophila melanogaster. Deleting the Ptc C-terminal tail or mutating the predicted PA-binding sites within it prevented Ptc from inhibiting Smo in wing discs and in cultured cells. The C-terminal tail of Ptc directly interacted with PA in vitro, an association that was reduced by Hh, and increased the amount of PA at the plasma membrane in cultured cells. Smo also interacted with PA in vitro through a binding pocket located in the transmembrane region, and mutating residues in this pocket reduced Smo activity in vivo and in cells. By genetically manipulating PA amounts in vivo or treating cultured cells with PA, we demonstrated that PA promoted Smo activation. Our findings suggest that Ptc may sequester PA in the absence of Hh and release it in the presence of Hh, thereby increasing the amount of PA that is locally available to promote Smo activation.