The small GTPase Rac1 is ubiquitously expressed in proliferating and differentiating layers of the epidermis and hair follicles. Previously, Rac1 was shown to regulate stem cell behaviour in these compartments. We have asked whether Rac1 has, in addition, a specific, stem-cell-independent function in the regulation of terminal hair follicle differentiation. To address this, we have expressed a constitutively active mutant of Rac1, L61Rac1, only in the basal epidermal layer and outer root sheath of mice possessing an epidermis-specific deletion of endogenous Rac1, which experience severe hair loss. The resulting 'rescue' mice exhibited a hair coat throughout their lives. Therefore, expression of Rac1 activity in the keratin-14-positive compartment of the skin is sufficient for the formation of hair follicles and hair in normal quantities. The quality of hair formed in rescue mice was, however, not normal. Rescue mice showed a grey, dull hair coat, whereas that of wild-type and L61Rac1-transgenic mice was black and shiny. Hair analysis in rescue mice revealed altered structures of the hair shaft and the cuticle and disturbed organization of medulla cells and pigment distribution. Disorganization of medulla cells correlates with the absence of cortical, keratin-filled spikes that normally protrude from the cortex into the medulla. The desmosomal cadherin Dsc2, which normally decorates these protrusions, was found to be reduced or absent in the hair of rescue mice. Our study demonstrates regulatory functions for Rac1 in the formation of hair structure and pigmentation and thereby identifies, for the first time, a role for Rac1 in terminal differentiation.