Anandamide (AEA) and other bioactive N-acylethanolamines (NAEs) are primarily inactivated by the enzyme fatty acid amide hydrolase (FAAH). Recently, FAAH-2 was discovered in humans, suggesting an additional enzyme can mediate NAE inactivation in higher mammals. Here, we performed a biochemical characterization of FAAH-2 and explored its capacity to hydrolyze NAEs in cells. In homogenate activity assays, FAAH-2 hydrolyzed AEA and palmitoylethanolamide (PEA) with activities ϳ6 and ϳ20% those of FAAH, respectively. In contrast, FAAH-2 hydrolyzed AEA and PEA in intact cells with rates ϳ30 -40% those of FAAH, highlighting a potentially greater contribution toward NAE catabolism in vivo than previously appreciated. In contrast to endoplasmic reticulum-localized FAAH, immunofluorescence revealed FAAH-2 was localized on lipid droplets. Supporting this distribution pattern, the putative N-terminal hydrophobic region of FAAH-2 was identified as a functional lipid droplet localization sequence. Lipid droplet localization was essential for FAAH-2 activity as chimeras excluded from lipid droplets lacked activity and/or were poorly expressed. Lipid droplets represent novel sites of NAE inactivation. Therefore, we examined substrate delivery to these organelles. AEA was readily trafficked to lipid droplets, confirming that lipid droplets constitute functional sites of NAE inactivation. Collectively, these results establish FAAH-2 as a bone fide NAE-catabolizing enzyme and suggest that NAE inactivation is spatially separated in cells of higher mammals.