Sonic hedgehog (Shh) secreted from the axial signaling centers of the notochord and prechordal plate functions as a morphogen in dorsoventral patterning of the neural tube. Active Shh is uniquely cholesterol-modified and the hydrophobic nature of cholesterol suggests that it might regulate Shh spreading in the neural tube. Here, we examined the capacity of Shh lacking the cholesterol moiety (ShhN) to pattern different cell types in the telencephalon and spinal cord. In mice expressing ShhN, we detected low-level ShhN in the prechordal plate and notochord, consistent with the notion that ShhN can rapidly spread from its site of synthesis. Surprisingly, we found that low-level ShhN can elicit the generation of a full spectrum of ventral cell types in the spinal cord, whereas ventral neuronal specification and ganglionic eminence development in the Shh(N/-) telencephalon were severely impaired, suggesting that telencephalic patterning is more sensitive to alterations in local Shh concentration and spreading. In agreement, we observed induction of Shh pathway activity and expression of ventral markers at ectopic sites in the dorsal telencephalon indicative of long-range ShhN activity. Our findings indicate an essential role for the cholesterol moiety in restricting Shh dilution and deregulated spread for patterning the telencephalon. We propose that the differential effect of ShhN in patterning the spinal cord versus telencephalon may be attributed to regional differences in the maintenance of Shh expression in the ventral neuroepithelium and differences in dorsal tissue responsiveness to deregulated Shh spreading behavior.