The hypothalamus is a region of the diencephalon with particularly complex patterning. Sonic hedgehog (Shh), encoding a protein with key developmental roles, shows a peculiar and dynamic diencephalic expression pattern. Here, we use transgenic strategies and in vitro experiments to test the hypothesis that Shh expressed in the diencephalic neuroepithelium (neural Shh) coordinates tissue growth and patterning in the hypothalamus. Our results show that neural Shh coordinates anteroposterior and dorsoventral patterning in the hypothalamus and in the diencephalon–telencephalon junction. Neural Shh also coordinates mediolateral hypothalamic patterning, since it is necessary for the lateral hypothalamus to attain proper size and is required for the specification of hypocretin/orexin cells. Finally, neural Shh is necessary to maintain expression of differentiation markers including survival factor Foxb1.