diff --git a/src/grpc/proxy_flow.cc b/src/grpc/proxy_flow.cc
index 797dee355..ef7f8ac22 100644
--- a/src/grpc/proxy_flow.cc
+++ b/src/grpc/proxy_flow.cc
@@ -128,12 +128,20 @@ namespace grpc {
 // transition to "DownstreamFinish" in case of error.
 
 namespace {
+
+const char kGrpcEncoding[] = "grpc-encoding";
+const char kGrpcAcceptEncoding[] = "grpc-accept-encoding";
+
 Status ProcessDownstreamHeaders(
     const std::multimap<std::string, std::string> &headers,
     ::grpc::ClientContext *context) {
   static grpc_exec_ctx exec_ctx = GRPC_EXEC_CTX_INIT;
 
   for (const auto &it : headers) {
+    if (it.first == kGrpcEncoding || it.first == kGrpcAcceptEncoding) {
+      // GRPC lib will add this header, so not adding it to client_context_
+      continue;
+    }
     // GRPC runtime libraries use "-bin" suffix to detect binary headers and
     // properly apply base64 encoding & decoding as headers are sent and
     // received. So we decode here before passing it to GRPC runtime.
diff --git a/src/nginx/grpc_server_call.cc b/src/nginx/grpc_server_call.cc
index 8ad492370..0b21958a8 100644
--- a/src/nginx/grpc_server_call.cc
+++ b/src/nginx/grpc_server_call.cc
@@ -26,17 +26,21 @@
 
 #include "src/nginx/grpc_server_call.h"
 
+#include <grpc/impl/codegen/gpr_types.h>
 #include <cassert>
 #include <utility>
 
 #include "contrib/endpoints/include/api_manager/utils/status.h"
 #include "grpc++/support/byte_buffer.h"
+#include "grpc/compression.h"
 #include "src/nginx/error.h"
 #include "src/nginx/grpc_finish.h"
 #include "src/nginx/module.h"
 #include "src/nginx/util.h"
 
 extern "C" {
+#include "src/core/lib/compression/message_compress.h"
+#include "src/core/lib/iomgr/exec_ctx.h"
 #include "src/http/v2/ngx_http_v2_module.h"
 }
 
@@ -108,6 +112,31 @@ ngx_int_t ngx_esp_write_output(ngx_http_request_t *r, ngx_chain_t *out,
   return NGX_AGAIN;
 }
 
+u_char kGrpcEncoding[] = "grpc-encoding";
+
+grpc_compression_algorithm GetCompressionAlgorithm(ngx_http_request_t *r) {
+  auto header =
+      ngx_esp_find_headers_in(r, kGrpcEncoding, sizeof(kGrpcEncoding) - 1);
+
+  if (header == nullptr) {
+    ngx_log_debug0(NGX_LOG_DEBUG_HTTP, r->connection->log, 0,
+                   "GetCompressionAlgorithm: algorithm not in header");
+
+    return grpc_compression_algorithm::GRPC_COMPRESS_NONE;
+  }
+
+  ngx_log_debug1(NGX_LOG_DEBUG_HTTP, r->connection->log, 0,
+                 "GetCompressionAlgorithm: algorithm=%V", &header->value);
+
+  grpc_compression_algorithm algorithm =
+      grpc_compression_algorithm::GRPC_COMPRESS_NONE;
+  grpc_compression_algorithm_parse(
+      reinterpret_cast<const char *>(header->value.data), header->value.len,
+      &algorithm);
+
+  return algorithm;
+}
+
 }  // namespace
 
 NgxEspGrpcServerCall::NgxEspGrpcServerCall(ngx_http_request_t *r,
@@ -488,6 +517,7 @@ void NgxEspGrpcServerCall::RunPendingRead() {
 }
 
 bool NgxEspGrpcServerCall::TryReadDownstreamMessage() {
+  static grpc_exec_ctx exec_ctx = GRPC_EXEC_CTX_INIT;
   // From http://www.grpc.io/docs/guides/wire.html, a GRPC message is:
   // * A one-byte compressed-flag
   // * A four-byte message length
@@ -508,7 +538,7 @@ bool NgxEspGrpcServerCall::TryReadDownstreamMessage() {
     return false;
   }
 
-  // TODO: Implement compressed-flag
+  uint8_t compressed_flag = GetByte(downstream_slices_, 0);
 
   // Decode the length.  Note that this is in network byte order.
   uint32_t msglen = 0;
@@ -561,11 +591,43 @@ bool NgxEspGrpcServerCall::TryReadDownstreamMessage() {
   // the 'slices' vector (which will drop those reference counts as
   // the vector is destroyed).
   std::vector<::grpc::Slice> slices;
-  slices.reserve(it - downstream_slices_.begin());
-  std::transform(downstream_slices_.begin(), it, std::back_inserter(slices),
-                 [](gpr_slice &slice) {
-                   return ::grpc::Slice(slice, ::grpc::Slice::STEAL_REF);
-                 });
+
+  if (compressed_flag == 1) {
+    gpr_slice_buffer input;
+    gpr_slice_buffer_init(&input);
+    gpr_slice_buffer_addn(&input, downstream_slices_.data(),
+                          it - downstream_slices_.begin());
+
+    gpr_slice_buffer output;
+    gpr_slice_buffer_init(&output);
+
+    if (grpc_msg_decompress(&exec_ctx, GetCompressionAlgorithm(r_), &input,
+                            &output) != 1) {
+      gpr_slice_buffer_destroy(&input);
+      gpr_slice_buffer_destroy(&output);
+      CompletePendingRead(false,
+                          utils::Status(google::protobuf::util::error::INTERNAL,
+                                        "Failed to decompress GRPC message",
+                                        utils::Status::INTERNAL));
+
+      return true;
+    }
+
+    slices.reserve(output.count);
+    std::transform(output.slices, output.slices + output.count,
+                   std::back_inserter(slices), [](gpr_slice &slice) {
+                     return ::grpc::Slice(slice, ::grpc::Slice::ADD_REF);
+                   });
+
+    gpr_slice_buffer_destroy(&input);
+    gpr_slice_buffer_destroy(&output);
+  } else {
+    slices.reserve(it - downstream_slices_.begin());
+    std::transform(downstream_slices_.begin(), it, std::back_inserter(slices),
+                   [](gpr_slice &slice) {
+                     return ::grpc::Slice(slice, ::grpc::Slice::STEAL_REF);
+                   });
+  }
 
   // Write the message byte buffer (giving the ByteBuffer its own
   // reference counts).
diff --git a/src/nginx/t/BUILD b/src/nginx/t/BUILD
index 10dc45c52..b829dffd4 100644
--- a/src/nginx/t/BUILD
+++ b/src/nginx/t/BUILD
@@ -103,6 +103,7 @@ nginx_suite(
         "grpc_auth_pkey.t",
         "grpc_call_flow_control.t",
         "grpc_cloud_trace.t",
+        "grpc_compression.t",
         "grpc_config_addr.t",
         "grpc_downstream_flow_control.t",
         "grpc_errors.t",
diff --git a/src/nginx/t/grpc_compression.t b/src/nginx/t/grpc_compression.t
new file mode 100644
index 000000000..3781fe444
--- /dev/null
+++ b/src/nginx/t/grpc_compression.t
@@ -0,0 +1,175 @@
+# Copyright (C) Extensible Service Proxy Authors
+# All rights reserved.
+#
+# Redistribution and use in source and binary forms, with or without
+# modification, are permitted provided that the following conditions
+# are met:
+# 1. Redistributions of source code must retain the above copyright
+#    notice, this list of conditions and the following disclaimer.
+# 2. Redistributions in binary form must reproduce the above copyright
+#    notice, this list of conditions and the following disclaimer in the
+#    documentation and/or other materials provided with the distribution.
+#
+# THIS SOFTWARE IS PROVIDED BY THE AUTHOR AND CONTRIBUTORS ``AS IS'' AND
+# ANY EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, THE
+# IMPLIED WARRANTIES OF MERCHANTABILITY AND FITNESS FOR A PARTICULAR PURPOSE
+# ARE DISCLAIMED.  IN NO EVENT SHALL THE AUTHOR OR CONTRIBUTORS BE LIABLE
+# FOR ANY DIRECT, INDIRECT, INCIDENTAL, SPECIAL, EXEMPLARY, OR CONSEQUENTIAL
+# DAMAGES (INCLUDING, BUT NOT LIMITED TO, PROCUREMENT OF SUBSTITUTE GOODS
+# OR SERVICES; LOSS OF USE, DATA, OR PROFITS; OR BUSINESS INTERRUPTION)
+# HOWEVER CAUSED AND ON ANY THEORY OF LIABILITY, WHETHER IN CONTRACT, STRICT
+# LIABILITY, OR TORT (INCLUDING NEGLIGENCE OR OTHERWISE) ARISING IN ANY WAY
+# OUT OF THE USE OF THIS SOFTWARE, EVEN IF ADVISED OF THE POSSIBILITY OF
+# SUCH DAMAGE.
+#
+################################################################################
+#
+use strict;
+use warnings;
+
+################################################################################
+
+use src::nginx::t::ApiManager;   # Must be first (sets up import path to the Nginx test module)
+use src::nginx::t::HttpServer;
+use src::nginx::t::ServiceControl;
+use Test::Nginx;  # Imports Nginx's test module
+use Test::More;   # And the test framework
+
+################################################################################
+
+# Port assignments
+my $ServiceControlPort = ApiManager::pick_port();
+my $Http2NginxPort = ApiManager::pick_port();
+my $GrpcBackendPort = ApiManager::pick_port();
+my $GrpcFallbackPort = ApiManager::pick_port();
+
+my $t = Test::Nginx->new()->has(qw/http proxy/)->plan(9);
+$t->write_file('service.pb.txt',
+        ApiManager::get_grpc_test_service_config($GrpcBackendPort) .
+        ApiManager::read_test_file('testdata/logs_metrics.pb.txt') . <<"EOF");
+control {
+  environment: "http://127.0.0.1:${ServiceControlPort}"
+}
+EOF
+
+ApiManager::write_file_expand($t, 'nginx.conf', <<"EOF");
+%%TEST_GLOBALS%%
+daemon off;
+events {
+  worker_connections 32;
+}
+http {
+  %%TEST_GLOBALS_HTTP%%
+  server {
+    listen 127.0.0.1:${Http2NginxPort} http2;
+    server_name localhost;
+    location / {
+      endpoints {
+        api service.pb.txt;
+        %%TEST_CONFIG%%
+        on;
+      }
+      grpc_pass 127.0.0.2:${GrpcFallbackPort};
+    }
+  }
+}
+EOF
+
+my $report_done = 'report_done';
+
+$t->run_daemon(\&service_control, $t, $ServiceControlPort, 'servicecontrol.log', $report_done);
+$t->run_daemon(\&ApiManager::grpc_test_server, $t, "127.0.0.1:${GrpcBackendPort}");
+is($t->waitforsocket("127.0.0.1:${ServiceControlPort}"), 1, 'Service control socket ready.');
+is($t->waitforsocket("127.0.0.1:${GrpcBackendPort}"), 1, 'GRPC test server socket ready.');
+$t->run();
+is($t->waitforsocket("127.0.0.1:${Http2NginxPort}"), 1, 'Nginx socket ready.');
+
+################################################################################
+my $test_results = &ApiManager::run_grpc_test($t, <<"EOF");
+server_addr: "127.0.0.1:${Http2NginxPort}"
+plans {
+  echo {
+    call_config {
+      api_key: "this-is-an-api-key"
+      compression: GZIP
+    }
+    request {
+      text: "This text must be long enough for GRPC library compress it. ______________________________________________________________"
+    }
+  }
+}
+EOF
+
+is($t->waitforfile("$t->{_testdir}/${report_done}"), 1, 'Report body file ready.');
+$t->stop_daemons();
+
+my $test_results_expected = <<'EOF';
+results {
+  echo {
+    text: "This text must be long enough for GRPC library compress it. ______________________________________________________________"
+  }
+}
+EOF
+is($test_results, $test_results_expected, 'Client tests completed as expected.');
+
+my @servicecontrol_requests = ApiManager::read_http_stream($t, 'servicecontrol.log');
+is(scalar @servicecontrol_requests, 2, 'Service control was called twice');
+
+# :check
+my $r = shift @servicecontrol_requests;
+like($r->{uri}, qr/:check$/, 'First call was a :check');
+
+# :report
+$r = shift @servicecontrol_requests;
+like($r->{uri}, qr/:report$/, 'Second call was a :report');
+
+my $report_body = ServiceControl::convert_proto($r->{body}, 'report_request', 'json');
+my $expected_report_body = ServiceControl::gen_report_body({
+  'serviceName' =>  'endpoints-grpc-test.cloudendpointsapis.com',
+  'api_method' => 'test.grpc.Test.Echo',
+  'url' => '/test.grpc.Test/Echo',
+  'protocol' => 'grpc',
+  'api_key' => 'this-is-an-api-key',
+  'api_name' => 'test.grpc.Test',
+  'producer_project_id' => 'endpoints-grpc-test',
+  'location' => 'us-central1',
+  'http_method' => 'POST',
+  'log_message' => 'Method: test.grpc.Test.Echo',
+  'response_code' => '200',
+  'request_size' => ($^O eq 'darwin' ? 371 : 373),
+  'request_bytes' => ($^O eq 'darwin' ? 371 : 373),
+  'streaming_request_message_counts' => 1,
+  'streaming_response_message_counts' => 1,
+  });
+ok(ServiceControl::compare_http2_report_json($report_body, $expected_report_body), 'Report body is received.');
+
+################################################################################
+
+sub service_control {
+  my ($t, $port, $file, $done) = @_;
+  my $server = HttpServer->new($port, $t->testdir() . '/' . $file)
+    or die "Can't create test server socket: $!\n";
+
+  $server->on_sub('POST', '/v1/services/endpoints-grpc-test.cloudendpointsapis.com:check', sub {
+    my ($headers, $body, $client) = @_;
+    print $client <<'EOF';
+HTTP/1.1 200 OK
+Connection: close
+
+EOF
+  });
+
+  $server->on_sub('POST', '/v1/services/endpoints-grpc-test.cloudendpointsapis.com:report', sub {
+    my ($headers, $body, $client) = @_;
+    print $client <<'EOF';
+HTTP/1.1 200 OK
+Connection: close
+
+EOF
+    $t->write_file($done, ':report done');
+  });
+
+  $server->run();
+}
+
+################################################################################
diff --git a/test/grpc/client-test-lib.cc b/test/grpc/client-test-lib.cc
index f638b2296..4140de695 100644
--- a/test/grpc/client-test-lib.cc
+++ b/test/grpc/client-test-lib.cc
@@ -106,6 +106,10 @@ void SetCallConfig(const CallConfig &call_config, ClientContext *ctx) {
   for (const auto &it : call_config.metadata()) {
     ctx->AddMetadata(it.first, it.second);
   }
+  if (call_config.compression()) {
+    ctx->set_compression_algorithm(
+        static_cast<grpc_compression_algorithm>(call_config.compression()));
+  }
 }
 
 template <class T1, class T2>
diff --git a/test/grpc/grpc-test.proto b/test/grpc/grpc-test.proto
index c9ada43fc..6591996ed 100644
--- a/test/grpc/grpc-test.proto
+++ b/test/grpc/grpc-test.proto
@@ -74,6 +74,14 @@ message CallConfig {
 
   // Additional metadata to send to server
   map<string, bytes> metadata = 4;
+
+  enum CompressionAlgorithm {
+    NONE = 0;
+    DEFLATE = 1;
+    GZIP = 2;
+  }
+  // Compression algorithm the request
+  CompressionAlgorithm compression = 5;
 }
 
 // The outcome of a GRPC call.