Mouse embryonic stem cells can differentiate in vitro into cells of the nervous system, neurons and glia. This differentiation mimics stages observed in vivo, including the generation of primitive ectoderm and neurectoderm in embryoid body culture. We demonstrate here that embryonic stem cell lines mutant for components of the Hedgehog signaling cascade are deficient at generating neurectoderm-containing embryoid bodies. The embryoid bodies derived from mutant cells are also unable to respond to retinoic acid treatment by producing nestin-positive neural stem cells, a response observed in cultures of heterozygous cells, and contain cores apparently arrested at the primitive ectoderm stage. The mutant cultures are also deficient in their capacity to differentiate into mature neurons and glia. These data are consistent with a role for Hedgehog signaling in generating neurectoderm capable of producing the appropriate neuronal and glial progenitors in ES cell culture.