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Basal cell carcinoma (BCC) of the skin is the most common form of cancer, with the majority being caused by mutations in the Patched1 (Ptch1) gene, leading to activation of the Hedgehog (Hh) signaling pathway. Hh signaling is implicated in many tumor types; thus, defining the mechanisms by which Ptch1 regulates tissue proliferation is of paramount importance. Here, we show that the key role of Ptch1 in the skin is to limit the size of the epidermal stem/progenitor compartment and allow hair follicle differentiation. Specifically, loss of Ptch1 leads to the promotion of progenitor cell fate by increasing basal cell proliferation and limiting the progression of basal cells into differentiated hair follicle cell types. Our data indicate that BCCs likely result from hair follicle progenitor cells that, due to Hh signal activation, cannot progress through normal hair follicle differentiation. These data confirm the role of Ptch1 as a negative regulator of epidermal progenitor turnover and also show for the first time that Ptch1 plays a role in the differentiation of the hair follicle lineage. In addition, we show that insulin-like growth factor binding protein 2 (Igfbp2) is upregulated in both murine and human BCCs and that blocking Igfbp2 activity reduces the Hh-mediated expansion of epidermal progenitor cells. We propose that Igfbp2 mediates epidermal progenitor cell expansion and therefore represents an epidermal progenitor cell–specific target of Hh signaling that promotes BCC development. Cancer Prev Res; 3(10); 1222–34. ©2010 AACR.