Formylglycine-generating enzyme (FGE) catalyzes the oxidation of a specific cysteine residue in nascent sulfatase polypeptides to formylglycine (FGly). This FGly is part of the active site of all sulfatases and is required for their catalytic activity. Here we demonstrate that residues 34-68 constitute an N-terminal extension of the FGE catalytic core that is dispensable for in vitro enzymatic activity of FGE but is required for its in vivo activity in the endoplasmic reticulum (ER), i.e. for generation of FGly residues in nascent sulfatases. In addition, this extension is needed for the retention of FGE in the ER. Fusing a KDEL retention signal to the C terminus of FGE is sufficient to mediate retention of an N-terminally truncated FGE but not sufficient to restore its biological activity. Fusion of FGE residues 1-88 to secretory proteins resulted in ER retention of the fusion protein. Moreover, when fused to the paralog of FGE (pFGE), which itself lacks FGly-generating activity, the FGE extension (residues 34-88) of this hybrid construct led to partial restoration of the biological activity of co-expressed N-terminally truncated FGE. Within the FGE N-terminal extension cysteine 52 is critical for the biological activity. We postulate that this N-terminal region of FGE mediates the interaction with an ER component to be identified and that this interaction is required for both the generation of FGly residues in nascent sulfatase polypeptides and for retention of FGE in the ER.