While the essential role of periosteum in cortical bone repair and regeneration is well established, the molecular pathways that control the early osteogenic and chondrogenic differentiation of periosteal stem/progenitor cells during repair processes are unclear. Using a murine segmental bone graft transplantation model, we isolated a population of early periosteum-callus-derived mesenchymal stem cells (PCDSCs) from the healing autograft periosteum. These cells express typical mesenchymal stem cell markers and are capable of differentiating into osteoblasts, adipocytes, and chondrocytes. Characterization of these cells demonstrated that activation of the hedgehog (Hh) pathway effectively promoted osteogenic and chondrogenic differentiation of PCDSCs in vitro and induced bone formation in vivo. To determine the role of the Hh pathway in adult bone repair, we deleted Smoothened (Smo), the receptor that transduces all Hh signals at the onset of bone autograft repair via a tamoxifen-inducible RosaCreER mouse model. We found that deletion of Smo markedly reduced osteogenic differentiation of isolated PCDSCs and further resulted in a near 50% reduction in periosteal bone callus formation at the cortical bone junction as determined by MicroCT and histomorphometric analyses. These data strongly suggest that the Hh pathway plays an important role in adult bone repair via enhancing differentiation of periosteal progenitors and that activation of the Hh pathway at the onset of healing could be beneficial for repair and regeneration.