The segment polarity genes play a fundamental role in the patterning of cells within individual body segments of the Drosophila embryo. Two of these genes wingless (wg) and hedgehog (hh) encode proteins that enter the secretory pathway and both are thought to act by instructing the fates of cells neighbouring those in which they are expressed. Genetic analysis has identified the transcriptional activation of wg as one of the targets of hh activity: here we present evidence that transduction of the hh-encoded signal is mediated by the activity of four other segment polarity genes, patched, fused, costal-2 and cubitus interruptus. The results of our genetic epistatsis analysis together with the molecular structures of the products of these genes where known, suggest a pathway of interactions leading from reception of the hh-encoded signal at the cell membrane to transcriptional activation in the cell nucleus. We have also found that transcription of patched is regulated by the same pathway and describe the identification of cis-acting upstream elements of the ptc transcription unit that mediate this regulation.