The deployment of morphogen gradients is a core strategy to establish cell diversity in developing tissues, but little is known about how small differences in the concentration of extracellular signals are translated into robust patterning output in responding cells. We have examined the activity of homeodomain proteins, which are presumed to operate downstream of graded Shh signaling in neural patterning, and describe a feedback circuit between the Shh pathway and homeodomain transcription factors that establishes non-graded regulation of Shh signaling activity. Nkx2 proteins intrinsically strengthen Shh responses in a feed-forward amplification and are required for ventral floor plate and p3 progenitor fates. Conversely, Pax6 has an opposing function to antagonize Shh signaling, which provides intrinsic resistance to Shh responses and is important to constrain the inductive capacity of the Shh gradient over time. Our data further suggest that patterning of floor plate cells and p3 progenitors is gated by a temporal switch in neuronal potential, rather than by different Shh concentrations. These data establish that dynamic, non-graded changes in responding cells are essential for Shh morphogen interpretation, and provide a rationale to explain mechanistically the phenomenon of cellular memory of morphogen exposure.