Mammary epithelial organoids (MEO), isolated from pubescent rats, were cultured within a reconstituted basement membrane in transwell inserts, in the presence or absence of mature mammary adipocytes in the lower well. This system allowed for free medium exchange between the two compartments, without direct cell-to-cell contact. When cultured in serum-free medium supplemented with insulin, prolactin, hydrocortisone, progesterone, and various epidermal growth factor (EGF) concentrations, mammary adipocytes did not affect epithelial cell growth, but enhanced epithelial differentiation. Casein and lipid accumulations were monitored as indicators of functional differentiation of MEO. Mammary adipocytes significantly enhanced casein and lipid accumulation within the MEO, independently of EGF concentration. Furthermore, adipocytes induced MEO to preferentially undergo alveolar morphogenesis, inhibited squamous outgrowth, and increased lumen size. These findings demonstrate that morphological and functional differentiation of mammary epithelial cells is profoundly enhanced by the adipose stroma and that these effects are mediated by diffusible paracrine factors. This new model can be exploited in future studies to define the mechanisms whereby hormones and growth factors regulate mammary gland development and carcinogenesis. Moreover, it could complement in vivo reconstitution/transplantation studies, which are currently employed to evaluate the role of specific gene deletions in the regulation of mammary development.