Pluripotent stem cells (PSC) hold promise for cell replacement therapy and investigation of embryonic development. However, efficient differentiation to desired cell types remains a major obstacle.  Most PSC differentiation is performed in high, non-physiological O₂, but cells during embryonic development are exposed to much lower O₂. Here we report a wide-ranging study showing that physiological O₂ markedly influences differentiation to insulin-producing cells. We differentiated CyT49 human embryonic stem cells (hESC)  under different, well-characterized pO₂ environments, controlling cellular oxygen exposure through adhesion culture on highly O₂-permeable silicone rubber membranes,using a modification of the  5-stage protocol reported by ViaCyte, Inc (San Diego, CA) (D’Amour 2006 Nature Biotech). Each stage was examined at multiple controlled high and low oxygen levels, and O₂ conditions were identified that increased the fraction of the appropriate intermediate cell type by flow cytometry or increased expression of appropriate genetic markers by real-time PCR. The best differentiation was produced by an oxygen-modulated protocol. Differentiation under 5% O₂ from hESC to definitive endoderm (stage 1), primitive gut tube (stage 2), and to posterior foregut (stage 3), then under 20% O₂ to pancreatic endoderm (stage 4) and insulin-producing cells (stage 5) gave rise to a cell population that was 43% positive for NKX6.1, after stage 4, and was 10% positive for both c-peptide and NKX6.1 after stage 5.  In comparison, differentiation of cells at normoxic oxygen (20% O₂) gave rise to a population that is 33% positive for NKX6.1 after stage 4 but 3% positive for both c-peptide and NKX6.1 after stage 5. Both normoxic and the modulated oxygen differentiations produced cells that passively secreted c-peptide into the medium but were not glucose responsive. Pancreatic endoderm markers NKX6.1 and PDX1were increased by a factor of two and four respectively for the controlled-hypoxia (5% stage 1-3, 20% stage 4-5) when compared to the normoxic condition (20% stage 1-5).   After differentiation to pancreatic endoderm (stage 4) under the modulated oxygen condition or normoxia, 1 million were implanted under the kidney capsule of SCID/beige mice to allow maturation into functional beta cells. Human c-peptide was detected in serum of 2/8 animals containing oxygen-modulated grafts (one at 12 weeks, the other at 20 weeks post implantation) and 0/8 of animals with normoxic grafts 60 min after stimulation with glucose. Grafts from the same 2 mice transplanted with modulated oxygen differentiation cells had cells positively immunostained for insulin and for a cocktail of non-beta cell hormones.  Mice from both groups had cells positive for non-beta cell hormones but no insulin. Based on these results,O₂ combined with directed differentiation protocols is a potentially straightforward method that could be applied to future hESC therapy protocols for improved differentiation and maturation to beta cells.