Morphological development of the small intestinal mucosa involves the stepwise remodeling of a smooth-surfaced endodermal tube to form finger-like luminal projections (villi) and flask-shaped invaginations (crypts). These remodeling processes are orchestrated by instructive signals that pass bidirectionally between the epithelium and underlying mesenchyme. Sonic (Shh) and Indian (Ihh) hedgehog are expressed in the epithelium throughout these morphogenic events, and mice lacking either factor exhibit intestinal abnormalities. To examine the combined role of Shh and Ihh in intestinal morphogenesis, we generated transgenic mice expressing the pan-hedgehog inhibitor, Hhip (hedgehog interacting protein) in the epithelium. We demonstrate that hedgehog (Hh) signaling in the neonatal intestine is paracrine, from epithelium to Ptch1-expressing subepithelial myofibroblasts (ISEMFs) and smooth muscle cells (SMCs). Strong inhibition of this signal compromises epithelial remodeling and villus formation. Surprisingly, modest attenuation of Hh also perturbs villus patterning. Desmin-positive smooth muscle progenitors are expanded, and ISEMFs are mislocalized. This mesenchymal change secondarily affects the epithelium: Tcf4/beta-catenin target gene activity is enhanced, proliferation is increased, and ectopic precrypt structures form on villus tips. Thus, through a combined Hh signal to underlying ISEMFs, the epithelium patterns the crypt-villus axis, ensuring the proper size and location of the emerging precrypt compartment.