Sonic hedgehog (Shh) plays well characterized roles in brain and spinal cord development, but its functions in the hypothalamus have been more difficult to elucidate owing to the complex neuroanatomy of this brain area. Here, we use fate mapping and conditional deletion models in mice to define requirements for dynamic Shh activity at distinct developmental stages in the tuberal hypothalamus, a brain region with important homeostatic functions. At early time points, Shh signaling regulates dorsoventral patterning, neurogenesis and the size of the ventral midline. Fate-mapping experiments demonstrate that Shh-expressing and-responsive progenitors contribute to distinct neuronal subtypes, accounting for some of the cellular heterogeneity in tuberal hypothalamic nuclei. Conditional deletion of the hedgehog transducer smoothened (Smo), after dorsoventral patterning has been established, reveals that Shh signaling is necessary to maintain proliferation and progenitor identity during peak periods of hypothalamic neurogenesis. We also find that mosaic disruption of Smo causes a non-cell autonomous gain in Shh signaling activity in neighboring wild-type cells, suggesting a mechanism for the pathogenesis of hypothalamic hamartomas, benign tumors that form during hypothalamic development.