Pluripotent mesenchymal cells form a population of precursors to a variety of cell types, including osteoblasts and adipocytes. Aging tilts the balance in favor of adipocyte differentiation at the expense of osteoblast differentiation, resulting in reduced bone formation and osteopenic disorders, including osteoporosis, in humans and animals. Understanding the mechanisms involved in causing this apparent shift in differentiation and identifying factors that stimulate osteoblast formation while inhibiting adipogenesis are of great therapeutic interest. In this study we report that specific, naturally occurring oxysterols, previously shown to direct pluripotent mesenchymal cells toward an osteoblast lineage, exert their osteoinductive effects through activation of Hedgehog signaling pathway. This was demonstrated by 1) oxysterol-induced expression of the Hh target genes Gli-1 and Patched, 2) oxysterol-induced activation of a luciferase reporter driven by a multimerized Gli-responsive element, 3) inhibition of oxysterol effects by the hedgehog pathway inhibitor, cyclopamine, and 4) unresponsiveness of Smoothened-/- mouse embryonic fibroblasts to oxysterols. Using Patched-/- cells that possess high baseline Gli activity, we found that oxysterols did not dramatically shift the IC50 concentration of cyclopamine needed to inhibit Gli activity in these cells. Furthermore, binding studies showed that oxysterols did not compete with fluorescently labeled cyclopamine, BODIPY-cyclopamine, for direct binding to Smoothened. These findings demonstrate that oxysterols stimulate hedgehog pathway activity by indirectly activating the seven-transmembrane pathway component Smoothened. Osteoinductive oxysterols are, therefore, novel activators of the hedgehog pathway in pluripotent mesenchymal cells, and they may be important modulators of this critical signaling pathway that regulates numerous developmental and post-developmental processes.