Indian hedgehog (Ihh) controls multiple aspects of endochondral skeletal development, including proliferation and maturation of chondrocytes, osteoblast development and cartilage vascularization. Although it is known that Gli transcription factors are key effectors of hedgehog signaling, it has not been established which Gli protein mediates Ihh activity in skeletal development. Here, we show that removal of Gli3 in Ihh-null mouse embryos restored normal proliferation and maturation of chondrocytes, but only partially rescued the defects in osteoblast development and cartilage vascularization. Remarkably, in both Ihh-/- and Ihh-/-; Gli3-/- embryos, vascularization promoted osteoblast development in perichondrial progenitor cells. Our results not only establish Gli3 as a critical effector for Ihh activity in the developing skeleton, but also identify an osteogenic role for a vasculature-derived signal, which integrates with Ihh and Wnt signals to determine the osteoblast versus chondrocyte fate in the mesenchymal progenitors.