Fragments of adult rabbit lung, composed chiefly of terminal airway obtained by a trypsin digestion technique were maintained on collagen-coated cellulose sponges in Ham's F12 medium. Cell-sponge associations were examined with light microscopy, scanning and transmission electron microscopy over a period from 6 to 28 days. After an initial 24- to 48-hour period of cell migration from the airway fragment, sponge matrices became lined with cells suggestive of alveolar macrophages. After one week in culture, cysts appeared to be composed entirely of type 2 epithelial cells. These were characterized by a microvillous apical border and an elaborate junctional complex. The lumen of these cysts contained both myelin-like lamellar configurations and tubular my-elin structures such as have been described from pulmonary washings. Consistent with the age of the sponge cultures, one or more cyst types described as young, middle and late could be found simultaneously. Middle aged cysts showed signs of active secretion into the lumen. Late cysts showed changes in the epithelium comprising the cyst wall suggestive of a cell type intermediate between type 1 and type 2 epithelial cells.