We have studied the mechanism of steroid-induced osteonecrosis by examining the effect of dexamethasone on a multipotential cell line, D1, which is derived from bone marrow and is capable of differentiating into either the osteoblast or the adipocyte lineage. The expression of bone cell and fat cell transcription factors Cbfa1/Runx2 and PPARgamma2, were determined. Osteocalcin promoter activity was measured by co-transfecting the cells with the phOC-luc and pSV beta-Gal plasmids. Dexamethasone increased PPARgamma2 gene expression 2-fold, while Cbfa1/Runx2 gene expression and osteocalcin promoter activity decreased by 50-60%, and VEGF protein, measured by ELISA, decreased by 55%. These changes indicate enhanced adipogenesis and decreased osteogenesis by mesenchymal cells in vitro, together with a decrease in VEGF, a potent angiogeneic factor, suggesting that dexamethasone may shunt uncommitted osteoprogenitor cells in marrow from osteoblastic differentiation into the adipocytic pathway, leading to diminished vascularization and eventual osteonecrosis.