Alveolar type II cells produce pulmonary surfactant and serve as the stem cell of the alveolar epithelium by proliferating and transforming into type I cells. The study of the differentiated function and proliferative capacity of type II cells in response to injury in vivo has been hindered by the complexity of the systemic response to injury. In vitro studies have in turn been limited by the impaired proliferative potential and loss of markers of differentiation in isolated type II cells maintained in culture. We describe an in vitro system in which type II cells proliferate spontaneously and simultaneously maintain differentiated characteristics. Other investigators have maintained slices of adult lung in culture after agarose infusion for up to 9 wk. To further develop this model for the study of epithelial cell differentiation and proliferation, we assessed epithelial differentiation, proliferative capacity, and regulation of cell-specific gene expression in slice explants of agarose-infused rat lungs. We prepared 1-mm-thick explants and maintained them in culture for up to 2 wk. Maintenance of differentiation was confirmed morphologically by light and electron microscopy, by the accumulation of epithelial cell-specific surfactant proteins, and by phospholipid analysis. Proliferative capacity was assessed by measuring [3H]thymidine incorporation in alveolar and small airway cells at baseline and in response to growth stimuli. Type II cell proliferation was inhibited in a dose-dependent manner by glucocorticoids. Glucocorticoids regulated RNA levels in explants in a manner similar to that seen in vivo and in fetal lung explants. The alveolar epithelium in adult lung slice explants maintains differentiated function and the ability to proliferate, thereby providing a useful system for the study of distal airway and alveolar cell homeostasis and response to injury.