A fundamental understanding of prostate development and tissue homeostasis has the high potential to reveal mechanisms for prostate disease initiation and identify novel therapeutic approaches for disease prevention and treatment. Our current understanding of prostate lineage specification stems from the use of developmental model systems that rely upon the embryonic preprostatic urogenital sinus mesenchyme to induce the formation of mature prostate epithelial cells. It is unclear, however, how the urogenital sinus epithelium can derive both adult urethral glands and prostate epithelia. Furthermore, the vast disparity in disease initiation between these two glands highlights key developmental factors that predispose prostate epithelia to hyperplasia and cancer. In this study we demonstrate that the caudal Müllerian duct mesenchyme (CMDM) drives prostate epithelial differentiation and is a key determinant in cell lineage specification between urethral glands and prostate epithelia. Utilizing both human embryonic stem cells and mouse embryonic tissues, we document that the CMDM is capable of inducing the specification of androgen receptor, prostate-specific antigen, NKX3.1, and Hoxb13-positive prostate epithelial cells. These results help to explain key developmental differences between prostate and urethral gland differentiation, and implicate factors secreted by the caudal Müllerian duct as novel targets for prostate disease prevention and treatment.