Molecules that enhance chondrogenic differentiation in mesenchymal stem cells (MSCs) were identified and isolated using an in vitro Gli reporter gene assay in MSCs incorporating a Sonic Hedgehog (Shh) target. Atractylenolide III, which promoted Gli1-mediated transcriptional activity, was isolated from an ethyl acetate extract of the Rhizoma, Atractylodis macrocephalae. After dehydration, atractylenolide III was transformed to atractylenolide I. Both atractylenolides were confirmed by MS, UV, IR, 1H- and 13C-NMR spectra. Atractylenolide III (which contains -OH at the 8-position) and atractylenolide I (which lacks -OH at the 8-position) were found to effectively promote the activity of the Gli promoter. While the hydroxyl group of atractylenolide III was not essential for the effect of atractylenolide, its effect was dependent on Shh signaling. Phenotypic cellular analysis indicated that atractylenolides induced MSCs to differentiate into chondrocytes, as shown by increased expression of specific chondrogenic markers including collagen II, aggrecan and the cartilage related transcription factor, Sox9. Atractylenolides significantly increased the expression of Shh and its target gene Gli-1, indicating that Shh signaling was activated by atractylenolides. Moreover, inhibition of Shh signaling reduced the effect of atractylenolides on the chondrogenic phenotype. The discovery that atractylenolides induce chondrocytes from MSCs is promising for bony disease therapy.