Dpp/BMP is a morphogen that controls patterning and growth in the Drosophila wing disc. Contrast with the extracellular and nuclear regulation, how Dpp morphogen gradient is shaped and interpreted by endocytic trafficking remains unclear. To address this, here we generate novel fluorescent protein tagged dpp alleles that allow to visualize both extracellular and intracellular Dpp distribution. Using these alleles, we found that, while blocking endocytosis expanded the extracellular Dpp gradient and impaired Dpp signaling, blocking early endosome expanded not only the extracellular Dpp gradient but also Dpp signaling range due to impaired downregulation of activated receptors. We show that blocking multivesicular body (MVB) formation, but not late endosome, expanded Dpp signaling and caused accumulation of the intracellular Dpp without affecting the extracellular Dpp gradient. These results indicate that, while the early endocytosis acts as a sink for Dpp and initiates Dpp signaling, termination of Dpp signaling at MVB is required for interpretation of the extracellular Dpp gradient. Taken together, our results reveal that extracellular Dpp morphogen gradient is shaped and interpreted by distinct endocytic trafficking pathways.