Dermal Papillae (DP) is a unique population of mesenchymal cells that was shown to regulate hair follicle formation and growth cycle. During development most DP cells are derived from mesoderm, however, functionally equivalent DP cells of cephalic hairs originate from Neural Crest (NC). Here we directed human embryonic stem cells (hESCs) to generate first NC cells and then hair-inducing DP-like cells in culture. We showed that hESC-derived DP-like cells (hESC-DPs) express markers typically found in adult human DP cells (e.g. p-75, nestin, versican, SMA, alkaline phosphatase) and are able to induce hair follicle formation when transplanted under the skin of immunodeficient NUDE mice. Engineered to express GFP, hESC-derived DP-like cells incorporate into DP of newly formed hair follicles and express appropriate markers. We demonstrated that BMP signaling is critical for hESC-DP derivation since BMP inhibitor dorsomorphin completely eliminated hair-inducing activity from hESC-DP cultures. DP cells were proposed as the cell-based treatment for hair loss diseases. Unfortunately human DP cells are not suitable for this purpose because they cannot be obtained in necessary amounts and rapidly loose their ability to induce hair follicle formation when cultured. In this context derivation of functional hESC-DP cells capable of inducing a robust hair growth for the first time shown here can become an important finding for the biomedical science.