Idiopathic pulmonary fibrosis (IPF) is a fatal disease of unknown cause that is characterized by progressive fibrotic lung remodeling. An abnormal emergence of airway epithelial-like cells within the alveolar compartments of the lung, herein termed bronchiolization, is often observed in IPF. However, the origin of this dysfunctional distal lung epithelium remains unknown due to a lack of suitable human model systems. In this study, we established a human induced pluripotent stem cell (iPSC)-derived air-liquid interface (ALI) model of alveolar epithelial type II (ATII)-like cell differentiation that allows us to investigate alveolar epithelial progenitor cell differentiation in vitro. We treated this system with an IPF-relevant cocktail (IPF-RC) to mimic the pro-fibrotic cytokine milieu present in IPF lungs. Stimulation with IPF-RC during differentiation increases secretion of IPF biomarkers and RNA sequencing (RNA-seq) of these cultures reveals significant overlap with human IPF patient data. IPF-RC treatment further impairs ATII differentiation by driving a shift toward an airway epithelial-like expression signature, providing evidence that a pro-fibrotic cytokine environment can influence the proximo-distal differentiation pattern of human lung epithelial cells. In conclusion, we show for the first time, the establishment of a human model system that recapitulates aspects of IPF-associated bronchiolization of the lung epithelium in vitro.