Umbilical cord is a rich source of mesenchymal stromal or stem cells (MSCs) that can be used for developing allogeneic cell therapy to treat intractable diseases. In this report, we present evidence that umbilical cord-derived MSCs (UCMSCs) possess important immunomodulatory properties that may enable them to survive in an allogeneic environment. UCMSCs do not express human leukocyte antigen (HLA)-DR and co-stimulatory molecules CD80 and CD86 that are required for T-cell activation. More importantly, UCMSCs constitutively express a negative regulator of T-cell activation, B7-H1, and its expression is increased after interferon-c (IFN-c) treatment. In addition, IFN-c treatment induced indoleamine 2,3-dioxygenase (IDO) and HLA-DR expression in UCMSCs. Neither control nor IFN-c-treated UCMSCs stimulated allogeneic T-cell proliferation, and both cell populations inhibited third-party dendritic cell (DC)-mediated allostimulatory activity. Addition of a B7-H1-specific blocking antibody or an IDO inhibitor, 1 methyl tryptophan (1-MT) abrogated the T-cell immunosuppressive activity of these cells. Furthermore, UCMSCs prevented the differentiation and maturation of peripheral blood monocyte-derived DCs, and augmented the generation of regulatory T cells (Tregs) in culture. The immunosuppressive effects of UCMSCs are largely mediated by cell-to-cell contact, although some inhibitory activity was observed with cell-free supernatant. Our study suggests that these immunomodulatory properties of UCMSCs could potentially improve the outcome of allogeneic stem cell therapy.