Hedgehog signaling is known to regulate tissue morphogenesis and cell differentiation in a dose-dependent manner. Loss of Indian hedgehog (Ihh) results in reduction in pancreas size, indicating a requirement for hedgehog signaling during pancreas development. By contrast, ectopic expression of sonic hedgehog (Shh) inhibits pancreatic marker expression and results in transformation of pancreatic mesenchyme into duodenal mesoderm. These observations suggest that hedgehog signaling activity has to be regulated tightly to ensure proper pancreas development. We have analyzed the function of two hedgehog inhibitors, Hhip and patched 1 (Ptch), during pancreas formation. Our results indicated that loss of Hhip results in increased hedgehog signaling within the pancreas anlage. Pancreas morphogenesis, islet formation and endocrine cell proliferation is impaired in Hhip mutant embryos. Additional loss of one Ptch allele in Hhip-/-Ptch+/- embryos further impairs pancreatic growth and endodermal cell differentiation. These results demonstrate combined requirements for Hhip and Ptch during pancreas development and point to a dose-dependent response to hedgehog signaling within pancreatic tissue. Reduction of Fgf10 expression in Hhip homozygous mutants suggests that at least some of the observed phenotypes result from hedgehog-mediated inhibition of Fgf signaling at early stages.