Pancreas organogenesis is regulated by the interaction of distinct signaling pathways that promote or restrict morphogenesis and cell differentiation. Previous work has shown that activin, a TGF(beta+) signaling molecule, permits pancreas development by repressing expression of Sonic hedgehog (Shh), a member of the hedgehog family of signaling molecules that antagonize pancreas development. Here we show that Indian hedgehog (Ihh), another hedgehog family member, and Patched 1 (Ptc1), a receptor and negative regulator of hedgehog activity, are expressed in pancreatic tissue. Targeted inactivation of Ihh in mice allows ectopic branching of ventral pancreatic tissue resulting in an annulus that encircles the duodenum, a phenotype frequently observed in humans suffering from a rare disorder known as annular pancreas. Shh(-)(/)(-) and Shh(-)(/)(-) Ihh(+/)(-) mutants have a threefold increase in pancreas mass, and a fourfold increase in pancreatic endocrine cell numbers. In contrast, mutations in Ptc1 reduce pancreas gene expression and impair glucose homeostasis. Thus, islet cell, pancreatic mass and pancreatic morphogenesis are regulated by hedgehog signaling molecules expressed within and adjacent to the embryonic pancreas. Defects in hedgehog signaling may lead to congenital pancreatic malformations and glucose intolerance.