Hedgehog (Hh) has been known as the only cholesterol-modified morphogen playing pivotal roles in development and tumorigenesis. A major unsolved question is how Hh signaling regulates the activity of Smoothened (SMO). Here, we performed an unbiased biochemical screen and identified that SMO was covalently modified by cholesterol on the Asp95 (D95) residue through an ester bond. This modification was inhibited by Patched-1 (Ptch1) but enhanced by Hh. The SMO(D95N) mutation, which could not be cholesterol modified, was refractory to Hh-stimulated ciliary localization and failed to activate downstream signaling. Furthermore, homozygous SmoD99N/D99N (the equivalent residue in mouse) knockin mice were embryonic lethal with severe cardiac defects, phenocopying the Smo−/− mice. Together, the results of our study suggest that Hh signaling transduces to SMO through modulating its cholesterylation and provides a therapeutic opportunity to treat Hh-pathway-related cancers by targeting SMO cholesterylation. Display omitted •SMO is covalently modified by cholesterol on the Asp95 (D95) residue•Cholesterol modification of SMO is inhibited by Ptch1 and enhanced by Hh•SMO cholesterylation is essential for Hh signaling and embryonic development Xiao et al. identify that SMO is covalently modified by cholesterol. This modification is regulated by Ptch1 and Hh and is essential for Hh signaling. It suggests that Hh signaling transduces to SMO through modulating its cholesterylation and that targeting SMO cholesterylation may provide a therapeutic approach to treat Hh-pathway-related cancers.