Surfactant protein (SP)-B is essential for lamellar body genesis and for the final steps in proSP-C post-translational processing. The mature SP-B protein is derived from multistep processing of the primary translation product proSP-B; however, the enzymes required for these events are currently unknown. Recent ultrastructural colocalization studies have suggested that the cysteine protease Cathepsin H may be involved in proSP-B processing. Using models of isolated human type 2 cells in culture, we describe the effects of cysteine protease inhibition by E-64 on SP-B processing and type 2 cell differentiation. Pulse-chase labeling and Western immunoblotting studies showed that the final step of SP-B processing, specifically cleavage of SP-B(9) to SP-B(8), was significantly inhibited by E-64, resulting in delayed accumulation of SP-B(8) without adverse effects on SP-A or glyceraldehyde phosphate dehydrogenase expression. E-64 treatment during type 2 cell differentiation mimicked features of inherited SP-B deficiency in humans and mice, specifically disrupted lamellar body genesis, and aberrant processing of proSP-C. Reverse transcriptase-polymerase chain reaction and Western immunoblotting studies showed that Cathepsin H is induced during in vitro differentiation of type 2 cells and localizes with SP-B in multivesicular bodies, composite bodies, and lamellar bodies by immunoelectron microscopy. Furthermore, Cathepsin H activity was specifically inhibited in a dose-dependent fashion by E-64. Our data show that a cysteine protease is involved in SP-B processing, lamellar body genesis, and SP-C processing, and suggest that Cathepsin H is the most likely candidate protease.