Emerging evidence suggests that myeloid-derived suppressor cells (MDSCs) have great potential as a novel immune intervention modality in the fields of transplantation and autoimmune diseases. Thus far, efforts to develop MDSC-based therapeutic strategies have been hampered by the lack of a reliable source of MDSCs. Here we show that functional MDSCs can be efficiently generated from mouse embryonic stem (ES) cells and bone marrow hematopoietic stem (HS) cells. In vitro-derived MDSCs encompass two homogenous subpopulations: CD115⁺Ly-6C⁺ and CD115⁺Ly-6C⁻ cells. The CD115⁺Ly-6C⁺ subset is equivalent to the monocytic Gr-1⁺CD115⁺F4/80⁺ MDSCs found in tumor-bearing mice. In contrast, the CD115⁺Ly-6C⁻ cells, a previously unreported population of MDSCs, resemble the granulocyte/macrophage progenitors developmentally. In vitro, ES- and HS-MDSCs exhibit robust suppression against T-cell proliferation induced by polyclonal stimuli or alloantigens via multiple mechanisms involving nitric oxide synthase-mediated NO production and interleukin (IL)-10. Impressively, they display even stronger suppressive activity and significantly enhance ability to induce CD4⁺CD25⁺Foxp3⁺ regulatory T-cell development compared with tumor-derived MDSCs. Furthermore, adoptive transfer of ES-MDSCs can effectively prevent alloreactive T-cell-mediated lethal graft-versus-host disease, leading to nearly 82% long-term survival among treated mice. The successful in vitro generation of MDSCs may represent a critical step toward potential clinical application of MDSCs.