We have investigated the vertical resolution that can be achieved in atmospheric profiles retrieved from radio occultation measurements. The results are based on forward simulations of radio wave propagation through model atmospheres using the multiple phase-screen method. We find that profiles retrieved through Abel inversion, the standard algorithm derived from geometrical optics, have a vertical resolution that is diffraction-limited, as expected. To overcome this limitation, we have developed an advanced retrieval algorithm, which is based on scalar diffraction theory and properly accounts for diffraction effects. We demonstrate that the method is capable of retrieving accurate refractivity profiles at sub-Fresnel-scale resolution for Mars- and Earth-like atmospheres. It also provides a natural means for deciphering multipath propagation effects. The method seems capable of enhancing resolution by a factor of 10 beyond the diffraction limit. In one simulation involving an Earth-like model atmosphere the algorithm successfully retrieved a profile in which the refractive index changed by 10−5 over a vertical scale of 250 m. The maximum vertical gradient of refractive index within this small-scale feature was about 0.8×10−7 m−1. For comparison, critical refraction occurs for a gradient of about 1.6×10−7 m−1. The feature was embedded in a smooth refractive index profile at the level where the pressure and mean refractive index were 42 kPa and 1.00013, respectively. Total refractive bending for a ray that grazed this level was 0.01–0.02 rad.