Reciprocal signaling between axons and Schwann cells during development is well established. The contribution of Schwann cells to the formation and maintenance of the protective nerve sheaths (endo-, peri-, and epineurium) has been less studied. Although mesenchymal cells contribute to all these structures, only perineurial cells contribute to the diffusion barrier between nerves and surrounding tissues. During development, prospective perineurial cells shift from a mesenchymal to epithelial phenotype, forming concentric layers of cells around the nerve fascicles that collectively form a barrier against unwanted molecules and cellular infiltration. We have studied the role of Schwann cells in the formation and maintenance of this barrier. The signaling molecule Desert hedgehog is expressed in Schwann cell precursors, and in Schwann cells until at least postnatal day 10, while its receptor patched is seen in mesenchymal cells surrounding the developing nerve at embryo day 15. In Desert hedgehog knockout mice, the connective tissue sheaths in adult nerves appear highly abnormal by electron microscopy. There is almost no epineurium, and the perineurium is thin and highly abnormal. In addition, perineurial-like cells invade the endoneurial space, forming mini-fascicles around small bundles of nerve fibers similar to those seen in regenerating nerves. Functional tests reveal that the diffusion and cellular infiltration barrier is compromised, demonstrating that Desert hedgehog signaling from Schwann cells to the mesenchyme is involved in the formation of a morphologically and functionally normal perineurium.