Morphological observations suggest that rate tracheal epithelial (RTE) cells undergo squamous differentiation when maintained in cell culture. The purpose of the studies presented here was to examine and define differentiation of cultured RTE cells with the help of markers previously shown to be specific for squamous differentiation. Furthermore, we wanted to determine whether neoplastic transformation of these cells causes significant disruption of their differentiation program. Our experiments showed that squamous differentiation occurs in normal primary RTE cell cultures. Epidermal transglutaminase (transglutaminase type I) activity increased approximately 20-fold in RTE cultures as a function of time. Cholesterol sulfate, another marker of squamous differentiation, increased only modestly with time. A significant number of cells formed cross-linked envelopes in cultures growth-arrested at a cell density of approximately 250 cells/mm2. However, no significant changes in keratin expression were detected. Neoplastically transformed RTE cells which exhibit a greatly increased growth capacity expressed the same three markers of squamous differentiation as normal RTE cells. However, transglutaminase type I activity was relatively low. The cross-linked envelope formation was independent of cell density in the transformed cells. Like in normal RTE cultures, cholesterol sulfate accumulation only increased moderately with increasing cell density. The keratin pattern of transformed RTE cell lines was identical to that of normal primary RTE cells. A well-differentiated squamous cell carcinoma derived from one of the neoplastic cell lines expressed in vivo keratin markers typical of keratinization (56 kd acidic keratin and 65-67 kd basic keratins). We draw the following conclusions. (i) The biochemical studies confirm that normal RTE cells undergo squamous differentiation. The pathway of terminal squamous differentiation is cell density dependent. (ii) In transformed RTE cells, growth as well as differentiation are less subject to regulation by cell density than in normal cells. (iii) Transformed RTE cells are differentiation competent; the main abnormality appears to be that in transformed cell populations proliferation and differentiation occur concomitantly.