An attractive approach to reduce the undesired side effects of bone morphogenetic proteins (BMPs) in regenerative medicine is to use osteoinductive peptide sequences derived from BMPs. Although the structure and function of BMPs have been studied extensively, there is limited data on structure and activity of BMP-derived peptides immobilized in hydrogels. The objective of this work was to investigate the effect of concentration and hydrophobicity of the BMP-2 peptide, corresponding to residues 73-92 of the knuckle epitope of BMP-2 protein, on peptide aggregation and osteogenic differentiation of human mesenchymal stem cells encapsulated in a polyethylene glycol (PEG) hydrogel. The peptide hydrophobicity was varied by capping PEG chain ends with short lactide segments. The BMP-2 peptide with a positive index of hydrophobicity had a critical micelle concentration (CMC) and formed aggregates in aqueous solution. Based on simulation results, there was a slight increase in the concentration of free peptide in solution with 1000-fold increase in peptide concentration. The dose-osteogenic response curve of the BMP-2 peptide was in the 0.0005-0.005 mM range, and osteoinductive potential of the BMP-2 peptide was significantly less than that of BMP-2 protein even at 1000-fold higher concentrations, which was attributed to peptide aggregation. Further, the peptide or PEG-peptide aggregates had significantly higher interaction energy with the cell membrane compared with the free peptide, which led to a higher nonspecific interaction with the cell membrane and loss of osteoinductive potential. Conjugation of the BMP-2 peptide to PEG increased CMC and osteoinductive potential of the peptide whereas conjugation to lactide-capped PEG reduced CMC and osteoinductive potential of the peptide. Experimental and simulation results revealed that osteoinductive potential of the BMP-2 peptide is correlated with its CMC and the free peptide concentration in aqueous medium and not the total concentration.