The secretion of Sonic hedgehog (Shh) from the notochord and floor plate appears to generate a ventral-to-dorsal gradient of Shh activity that directs progenitor cell identity and neuronal fate in the ventral neural tube. In principle, the establishment of this Shh activity gradient could be achieved through the graded distribution of the Shh protein itself, or could depend on additional cell surface or secreted proteins that modify the response of neural cells to Shh. Cells of the neural plate differentiate from a region of the ectoderm that has recently expressed high levels of BMPs, raising the possibility that prospective ventral neural cells are exposed to residual levels of BMP activity. We have examined whether modulation of the level of BMP signaling regulates neural cell responses to Shh, and thus might contribute to the patterning of cell types in the ventral neural tube. Using an in vitro assay of neural cell differentiation we show that BMP signaling markedly alters neural cell responses to Shh signals, eliciting a ventral-to-dorsal switch in progenitor cell identity and neuronal fate. BMP signaling is regulated by secreted inhibitory factors, including noggin and follistatin, both of which are expressed in or adjacent to the neural plate. Conversely, follistatin but not noggin produces a dorsal-to-ventral switch in progenitor cell identity and neuronal fate in response to Shh both in vitro and in vivo. These results suggest that the specification of ventral neural cell types depends on the integration of Shh and BMP signaling activities. The net level of BMP signaling within neural tissue may be regulated by follistatin and perhaps other BMP inhibitors secreted by mesodermal cell types that flank the ventral neural tube.