Hedgehog signaling is crucial for vertebrate development and physiology. Gli2, the primary effector of Hedgehog signaling, localizes to the tip of the primary cilium, but the importance of its ciliary localization remains unclear. We address the roles of Gli2 ciliary localization by replacing endogenous Gli2 with Gli2(DeltaCLR), a Gli2 variant not localizing to the cilium. The resulting Gli2(DeltaCLRKI) and Gli2(DeltaCLRKI);Gli3 double mutants resemble Gli2-null and Gli2;Gli3 double mutants, respectively, suggesting the lack of Gli2(DeltaCLR) activation in development. Significantly, Gli2(DeltaCLR) cannot be activated either by pharmacochemical activation of Smo in vitro or by loss of Ptch1 in vivo. Finally, Gli2(DeltaCLR) exhibits strong transcriptional activator activity in the absence of Sufu, suggesting that the lack of its activation in vivo results from a specific failure in relieving the inhibitory function of Sufu. Our results provide strong evidence that the ciliary localization of Gli2 is crucial for cilium-dependent activation of Hedgehog signaling.