diff --git a/setup.c b/setup.c
index 6b277b6a11..dfda532adc 100644
--- a/setup.c
+++ b/setup.c
@@ -456,7 +456,11 @@ const char *setup_git_directory_gently(int *nongit_ok)
 			inside_git_dir = 1;
 			if (!work_tree_env)
 				inside_work_tree = 0;
-			setenv(GIT_DIR_ENVIRONMENT, ".", 1);
+			if (offset != len) {
+				cwd[offset] = '\0';
+				setenv(GIT_DIR_ENVIRONMENT, cwd, 1);
+			} else
+				setenv(GIT_DIR_ENVIRONMENT, ".", 1);
 			check_repository_format_gently(nongit_ok);
 			return NULL;
 		}
diff --git a/t/t1501-worktree.sh b/t/t1501-worktree.sh
index f6a6f839a1..27dc6c55d5 100755
--- a/t/t1501-worktree.sh
+++ b/t/t1501-worktree.sh
@@ -92,6 +92,13 @@ cd sub/dir || exit 1
 test_rev_parse 'in repo.git/sub/dir' false true true sub/dir/
 cd ../../../.. || exit 1
 
+test_expect_success 'detecting gitdir when cwd is in a subdir of gitdir' '
+	(expected=$(pwd)/repo.git &&
+	 cd repo.git/refs &&
+	 unset GIT_DIR &&
+	 test "$expected" = "$(git rev-parse --git-dir)")
+'
+
 test_expect_success 'repo finds its work tree' '
 	(cd repo.git &&
 	 : > work/sub/dir/untracked &&