This study has determined the effect of liposomal encapsulation on the hematopoietic toxicity and antiviral activity of 3′-azido-3′- deoxythymidine (AZT) in mice. Daily intravenous administration in the dose range 0.4 to 10 mg/kg body weight for 5 days significantly depressed bone marrow cellularity with a corresponding decrease in red blood cell, blood neutrophil, and monocyte numbers. Maximum toxicity was seen at 2 mg/kg or greater. Liposomal encapsulation of AZT and administration at 2 mg/kg abrogated the toxicity of AZT. The neutrophil inflammatory response to thioglycollate injected intraperitoneally was significantly inhibited by AZT at all doses, whereas liposomal AZT was without effect. The inhibitory activity of AZT against Concanavalin A (Con A)-stimulated splenic lymphocyte proliferation in vitro was reduced on liposomal encapsulation of AZT, while treatment of mice with liposomal AZT but not free AZT resulted in a significant reduction of Con A-stimulated proliferation. Liposomal AZT was more effective than AZT in preventing the development of plasma reverse transcriptase activity and the depletion of Thy 1.2(+)-L3T4+ T cells after infection of mice with LP-BM5 retrovirus. These results indicate that AZT-induced hematopoietic toxicity may not be a limiting factor for antiviral therapy, and that the use of liposomes to deliver AZT results in enhanced antiretroviral activity in mice.