The trachea and esophagus arise from the separation of a common foregut tube during early fetal development. Mutations in key signaling pathways such as Hedgehog (HH)/Gli can disrupt tracheoesophageal (TE) morphogenesis and cause life-threatening birth defects (TEDs); however, the underlying cellular mechanisms are unknown. Here, we use mouse and Xenopus to define the HH/Gli-dependent processes orchestrating TE morphogenesis. We show that downstream of Gli the Foxf1+ splanchnic mesenchyme promotes medial constriction of the foregut at the boundary between the presumptive Sox2+ esophageal and Nkx2-1+ tracheal epithelium. We identify a unique boundary epithelium co-expressing Sox2 and Nkx2-1 that fuses to form a transient septum. Septum formation and resolution into distinct trachea and esophagus requires endosome-mediated epithelial remodeling involving the small GTPase Rab11 and localized extracellular matrix degradation. These are disrupted in Gli-deficient embryos. This work provides a new mechanistic framework for TE morphogenesis and informs the cellular basis of human TEDs.