To evaluate systems for barrier immunoisolation of transplanted hepatocytes, we used transgenic mouse hepatocytes that secrete HBsAg. Hepatocytes were rapidly encapsulated in chitosan, a cationic polymer derived by deacetylation of chitin. Chitosan was allowed to electrostatically bond with anionic sodium alginate for creating an outer bipolymer membrane of the capsules. After encapsulation, hepatocyte viability remained unchanged for seven days in vitro with secretion of HBsAg into the culture medium throughout this period. Following intraperitoneal transplantation of encapsulated hepatocytes, HBsAg promptly appeared in blood of recipients. In congeneic recipients, serum HBsAg peaked at two weeks. Hepatocytes were present in recovered chitosan capsules and expressed HBsAg mRNA. In allogeneic recipients, however, serum HBsAg disappeared within one week and recovered chitosan capsules showed lymphomononuclear cells but not hepatocytes. Transplantation of chitosan encapsulated HbsAg secreting hepatocytes failed to induce an anti-HBs response, suggesting modulation of the host immune response. These results indicate that transplantation systems using genetically modified hepatocytes which secrete gene products in the blood of recipients should facilitate evaluation of hepatocyte encapsulation.