Polycomb Repressive Complex 1 and histone H2A ubiquitination (ubH2A) contribute to embryonic stem cell (ESC) pluripotency by repressing lineage-specific gene expression. However, whether active deubiquitination co-regulates ubH2A levels in ESCs and during differentiation is not known. Here we report that Usp16, a histone H2A deubiquitinase, regulates H2A deubiquitination and gene expression in ESCs, and importantly, is required for ESC differentiation. Usp16 knockout is embryonic lethal in mice, but does not affect ESC viability or identity. Usp16 binds to the promoter regions of a large number of genes in ESCs, and Usp16 binding is inversely correlated with ubH2A levels, and positively correlates with gene expression levels. Intriguingly, Usp16(-/-) ESCs fail to differentiate due to ubH2A-mediated repression of lineage-specific genes. Finally, Usp16, but not a catalytically inactive mutant, rescues the differentiation defects of Usp16(-/-) ESCs. Therefore, this study identifies Usp16 and H2A deubiquitination as critical regulators of ESC gene expression and differentiation.