Implantation of demineralized bone powder (DBP) in muscle or connective tissue stimulates chondrogenesis followed by ectopic bone formation, in this way inducing the differentiation of endochondral bone. A new 3-dimensional in vitro composite sponge was designed to duplicate the packing density of in vivo DBP implants. The composite device, which consists of DBP packed between two layers of a porous collagen lattice, was used to assess the chondroblastic differentiation of human dermal fibroblasts. Important design considerations for this device were biocompatibility, rigidity and ability of cells to penetrate. In this study, collagen concentration and source, irradiation, and lyophilization conditions were varied in fabrication. Human dermal fibroblasts were seeded onto the composite sponge, migrated through the collagen lattice into the packet of DBP, and deposited a metachromatic extracellular matrix amongst the particles of DBP. In contrast, cells cultured in collagen sponges or in composite sponges with inactivated guanidine-extracted DBP did not secrete metachromatic matrix. This new in vitro system will be valuable in defining the mechanism of differentiation by osteoinductive materials and in evaluating the influence of other extracellular components and soluble factors on skeletal differentiation.