Cells respond to the accumulation of unfolded proteins in the endoplasmic reticulum (ER) by increasing the transcription of the genes encoding ER-resident chaperone proteins. Ire1p is a transmembrane protein kinase that transmits the signal from unfolded proteins in the lumen of the ER by a mechanism that requires oligomerization and trans-autophosphorylation of its cytoplasmic-nucleoplasmic kinase domain. Activation of Ire1p induces a novel spliced form of HAC1 mRNA that produces Hac1p, a transcription factor that is required for activation of the transcription of genes under the control of the unfolded-protein response (UPR) element. Searching for proteins that interact with Ire1p in Saccharomyces cerevisiae, we isolated PTC2, which encodes a serine/threonine phosphatase of type 2C. The Ptc2p interaction with Ire1p is specific, direct, dependent on Ire1p phosphorylation, and mediated through a kinase interaction domain within Ptc2p. Ptc2p dephosphorylates Ire1p efficiently in an Mg2+-dependent manner in vitro. PTC2 is nonessential for growth and negatively regulates the UPR pathway. Strains carrying null alleles of PTC2 have a three- to fourfold-increased UPR and increased levels of spliced HAC1 mRNA. Overexpression of wild-type Ptc2p but not catalytically inactive Ptc2p reduces levels of spliced HAC1 mRNA and attenuates the UPR, demonstrating that the phosphatase activity of Ptc2p is required for regulation of the UPR. These results demonstrate that Ptc2p downregulates the UPR by dephosphorylating Ire1p and reveal a novel mechanism of regulation in the UPR pathway upstream of the HAC1 mRNA splicing event.