diff --git a/flang/include/flang/Parser/provenance.h b/flang/include/flang/Parser/provenance.h
--- a/flang/include/flang/Parser/provenance.h
+++ b/flang/include/flang/Parser/provenance.h
@@ -148,9 +148,9 @@
     return *this;
   }
 
-  void PushSearchPathDirectory(std::string);
-  std::string PopSearchPathDirectory();
-  const SourceFile *Open(std::string path, llvm::raw_ostream &error);
+  void AppendSearchPathDirectory(std::string); // new last directory
+  const SourceFile *Open(std::string path, llvm::raw_ostream &error,
+      std::optional<std::string> &&prependPath = std::nullopt);
   const SourceFile *ReadStandardInput(llvm::raw_ostream &error);
 
   ProvenanceRange AddIncludedFile(
@@ -210,7 +210,7 @@
   ProvenanceRange range_;
   std::map<char, Provenance> compilerInsertionProvenance_;
   std::vector<std::unique_ptr<SourceFile>> ownedSourceFiles_;
-  std::vector<std::string> searchPath_;
+  std::list<std::string> searchPath_;
   Encoding encoding_{Encoding::UTF_8};
 };
 
diff --git a/flang/include/flang/Parser/source.h b/flang/include/flang/Parser/source.h
--- a/flang/include/flang/Parser/source.h
+++ b/flang/include/flang/Parser/source.h
@@ -17,6 +17,8 @@
 #include "characters.h"
 #include "llvm/Support/MemoryBuffer.h"
 #include <cstddef>
+#include <list>
+#include <optional>
 #include <string>
 #include <utility>
 #include <vector>
@@ -28,8 +30,8 @@
 namespace Fortran::parser {
 
 std::string DirectoryName(std::string path);
-std::string LocateSourceFile(
-    std::string name, const std::vector<std::string> &searchPath);
+std::optional<std::string> LocateSourceFile(
+    std::string name, const std::list<std::string> &searchPath);
 
 class SourceFile;
 
diff --git a/flang/lib/Frontend/FrontendActions.cpp b/flang/lib/Frontend/FrontendActions.cpp
--- a/flang/lib/Frontend/FrontendActions.cpp
+++ b/flang/lib/Frontend/FrontendActions.cpp
@@ -28,7 +28,7 @@
   CompilerInstance &ci = instance();
   Fortran::parser::AllSources &allSources{ci.allSources()};
   const Fortran::parser::SourceFile *sf;
-  sf = allSources.Open(path, error_stream);
+  sf = allSources.Open(path, error_stream, std::optional<std::string>{"."s});
   llvm::ArrayRef<char> fileContent = sf->content();
 
   // Output file descriptor to receive the content of input file.
diff --git a/flang/lib/Parser/parsing.cpp b/flang/lib/Parser/parsing.cpp
--- a/flang/lib/Parser/parsing.cpp
+++ b/flang/lib/Parser/parsing.cpp
@@ -25,7 +25,7 @@
   AllSources &allSources{allCooked_.allSources()};
   if (options.isModuleFile) {
     for (const auto &path : options.searchDirectories) {
-      allSources.PushSearchPathDirectory(path);
+      allSources.AppendSearchPathDirectory(path);
     }
   }
 
@@ -35,7 +35,8 @@
   if (path == "-") {
     sourceFile = allSources.ReadStandardInput(fileError);
   } else {
-    sourceFile = allSources.Open(path, fileError);
+    std::optional<std::string> currentDirectory{"."};
+    sourceFile = allSources.Open(path, fileError, std::move(currentDirectory));
   }
   if (!fileError.str().empty()) {
     ProvenanceRange range{allSources.AddCompilerInsertion(path)};
@@ -46,12 +47,12 @@
 
   if (!options.isModuleFile) {
     // For .mod files we always want to look in the search directories.
-    // For normal source files we don't push them until after the primary
+    // For normal source files we don't add them until after the primary
     // source file has been opened.  If foo.f is missing from the current
     // working directory, we don't want to accidentally read another foo.f
     // from another directory that's on the search path.
     for (const auto &path : options.searchDirectories) {
-      allSources.PushSearchPathDirectory(path);
+      allSources.AppendSearchPathDirectory(path);
     }
   }
 
diff --git a/flang/lib/Parser/preprocessor.cpp b/flang/lib/Parser/preprocessor.cpp
--- a/flang/lib/Parser/preprocessor.cpp
+++ b/flang/lib/Parser/preprocessor.cpp
@@ -399,6 +399,7 @@
   if (j == tokens) {
     return;
   }
+  CHECK(prescanner); // TODO: change to reference
   if (dir.TokenAt(j).ToString() != "#") {
     prescanner->Say(dir.GetTokenProvenanceRange(j), "missing '#'"_err_en_US);
     return;
@@ -578,6 +579,7 @@
       return;
     }
     std::string include;
+    std::optional<std::string> prependPath;
     if (dir.TokenAt(j).ToString() == "<") { // #include <foo>
       std::size_t k{j + 1};
       if (k >= tokens) {
@@ -598,6 +600,12 @@
     } else if ((include = dir.TokenAt(j).ToString()).substr(0, 1) == "\"" &&
         include.substr(include.size() - 1, 1) == "\"") { // #include "foo"
       include = include.substr(1, include.size() - 2);
+      // #include "foo" starts search in directory of file containing
+      // the directive
+      auto prov{dir.GetTokenProvenanceRange(dirOffset).start()};
+      if (const auto *currentFile{allSources_.GetSourceFile(prov)}) {
+        prependPath = DirectoryName(currentFile->path());
+      }
     } else {
       prescanner->Say(dir.GetTokenProvenanceRange(j < tokens ? j : tokens - 1),
           "#include: expected name of file to include"_err_en_US);
@@ -615,7 +623,8 @@
     }
     std::string buf;
     llvm::raw_string_ostream error{buf};
-    const SourceFile *included{allSources_.Open(include, error)};
+    const SourceFile *included{
+        allSources_.Open(include, error, std::move(prependPath))};
     if (!included) {
       prescanner->Say(dir.GetTokenProvenanceRange(dirOffset),
           "#include: %s"_err_en_US, error.str());
diff --git a/flang/lib/Parser/prescan.cpp b/flang/lib/Parser/prescan.cpp
--- a/flang/lib/Parser/prescan.cpp
+++ b/flang/lib/Parser/prescan.cpp
@@ -760,14 +760,12 @@
   std::string buf;
   llvm::raw_string_ostream error{buf};
   Provenance provenance{GetProvenance(nextLine_)};
-  const SourceFile *currentFile{allSources_.GetSourceFile(provenance)};
-  if (currentFile) {
-    allSources_.PushSearchPathDirectory(DirectoryName(currentFile->path()));
-  }
-  const SourceFile *included{allSources_.Open(path, error)};
-  if (currentFile) {
-    allSources_.PopSearchPathDirectory();
+  std::optional<std::string> prependPath;
+  if (const SourceFile * currentFile{allSources_.GetSourceFile(provenance)}) {
+    prependPath = DirectoryName(currentFile->path());
   }
+  const SourceFile *included{
+      allSources_.Open(path, error, std::move(prependPath))};
   if (!included) {
     Say(provenance, "INCLUDE: %s"_err_en_US, error.str());
   } else if (included->bytes() > 0) {
diff --git a/flang/lib/Parser/provenance.cpp b/flang/lib/Parser/provenance.cpp
--- a/flang/lib/Parser/provenance.cpp
+++ b/flang/lib/Parser/provenance.cpp
@@ -156,20 +156,28 @@
   return origin[origin.covers.MemberOffset(at)];
 }
 
-void AllSources::PushSearchPathDirectory(std::string directory) {
+void AllSources::AppendSearchPathDirectory(std::string directory) {
   // gfortran and ifort append to current path, PGI prepends
   searchPath_.push_back(directory);
 }
 
-std::string AllSources::PopSearchPathDirectory() {
-  std::string directory{searchPath_.back()};
-  searchPath_.pop_back();
-  return directory;
-}
-
-const SourceFile *AllSources::Open(std::string path, llvm::raw_ostream &error) {
+const SourceFile *AllSources::Open(std::string path, llvm::raw_ostream &error,
+    std::optional<std::string> &&prependPath) {
   std::unique_ptr<SourceFile> source{std::make_unique<SourceFile>(encoding_)};
-  if (source->Open(LocateSourceFile(path, searchPath_), error)) {
+  if (prependPath) {
+    // Set to "." for the initial source file; set to the directory name
+    // of the including file for #include "quoted-file" directives &
+    // INCLUDE statements.
+    searchPath_.emplace_front(std::move(*prependPath));
+  }
+  std::optional<std::string> found{LocateSourceFile(path, searchPath_)};
+  if (prependPath) {
+    searchPath_.pop_front();
+  }
+  if (!found) {
+    error << "Source file '" << path << "' was not found";
+    return nullptr;
+  } else if (source->Open(*found, error)) {
     return ownedSourceFiles_.emplace_back(std::move(source)).get();
   } else {
     return nullptr;
diff --git a/flang/lib/Parser/source.cpp b/flang/lib/Parser/source.cpp
--- a/flang/lib/Parser/source.cpp
+++ b/flang/lib/Parser/source.cpp
@@ -56,9 +56,9 @@
   return pathBuf.str().str();
 }
 
-std::string LocateSourceFile(
-    std::string name, const std::vector<std::string> &searchPath) {
-  if (name.empty() || name == "-" || llvm::sys::path::is_absolute(name)) {
+std::optional<std::string> LocateSourceFile(
+    std::string name, const std::list<std::string> &searchPath) {
+  if (name == "-" || llvm::sys::path::is_absolute(name)) {
     return name;
   }
   for (const std::string &dir : searchPath) {
@@ -70,7 +70,7 @@
       return path.str().str();
     }
   }
-  return name;
+  return std::nullopt;
 }
 
 std::size_t RemoveCarriageReturns(llvm::MutableArrayRef<char> buf) {
@@ -123,7 +123,6 @@
 bool SourceFile::ReadStandardInput(llvm::raw_ostream &error) {
   Close();
   path_ = "standard input";
-
   auto buf_or = llvm::MemoryBuffer::getSTDIN();
   if (!buf_or) {
     auto err = buf_or.getError();
@@ -146,7 +145,6 @@
       auto tmp_buf{llvm::WritableMemoryBuffer::getNewUninitMemBuffer(
           content().size() + 1)};
       llvm::copy(content(), tmp_buf->getBufferStart());
-      Close();
       buf_ = std::move(tmp_buf);
     }
     buf_end_++;
diff --git a/flang/test/Flang-Driver/Inputs/basictestmoduleone.mod b/flang/test/Flang-Driver/Inputs/basictestmoduleone.mod
--- a/flang/test/Flang-Driver/Inputs/basictestmoduleone.mod
+++ b/flang/test/Flang-Driver/Inputs/basictestmoduleone.mod
@@ -1 +1,5 @@
-NOT A REAL MODULE FILE - USE THIS ONLY FOR TESTING THE DRIVER
+!mod$ v1 sum:1f5a35ada852dc66
+module basictestmoduleone
+type::t1
+end type
+end
diff --git a/flang/test/Flang-Driver/Inputs/module-dir/basictestmoduleone.mod b/flang/test/Flang-Driver/Inputs/module-dir/basictestmoduleone.mod
new file mode 100644
--- /dev/null
+++ b/flang/test/Flang-Driver/Inputs/module-dir/basictestmoduleone.mod
@@ -0,0 +1,5 @@
+!mod$ v1 sum:449b70509dd4bce3
+module basictestmoduleone
+type::t2
+end type
+end
diff --git a/flang/test/Flang-Driver/Inputs/module-dir/basictestmoduletwo.mod b/flang/test/Flang-Driver/Inputs/module-dir/basictestmoduletwo.mod
--- a/flang/test/Flang-Driver/Inputs/module-dir/basictestmoduletwo.mod
+++ b/flang/test/Flang-Driver/Inputs/module-dir/basictestmoduletwo.mod
@@ -1 +1,3 @@
-NOT A REAL MODULE FILE - USE THIS ONLY FOR TESTING THE DRIVER
+!mod$ v1 sum:563b9a1f049282d2
+module basictestmoduletwo
+end
diff --git a/flang/test/Flang-Driver/include-header.f90 b/flang/test/Flang-Driver/include-header.f90
--- a/flang/test/Flang-Driver/include-header.f90
+++ b/flang/test/Flang-Driver/include-header.f90
@@ -21,7 +21,7 @@
 !--------------------------------------------
 ! EXPECTED OUTPUT FOR MISSING INCLUDED FILE
 !--------------------------------------------
-! UNINCLUDED:No such file or directory
+! UNINCLUDED:#include: Source file 'basic-header-one.h' was not found
 ! UNINCLUDED-NOT:program b
 ! UNINCLUDED-NOT:program c
 
diff --git a/flang/test/Flang-Driver/include-module.f90 b/flang/test/Flang-Driver/include-module.f90
--- a/flang/test/Flang-Driver/include-module.f90
+++ b/flang/test/Flang-Driver/include-module.f90
@@ -1,5 +1,4 @@
 ! Ensure argument -I works as expected with module files.
-! The module files for this test are not real module files.
 
 ! REQUIRES: new-flang-driver
 
@@ -18,15 +17,21 @@
 !-----------------------------------------
 ! EXPECTED OUTPUT FOR MISSING MODULE FILE
 !-----------------------------------------
-! SINGLEINCLUDE:No such file or directory
+! SINGLEINCLUDE:Error reading module file for module 'basictestmoduletwo'
 ! SINGLEINCLUDE-NOT:Error reading module file for module 'basictestmoduletwo'
+! SINGLEINCLUDE-NOT:error: Derived type 't1' not found
+! SINGLEINCLUDE:error: Derived type 't2' not found
 
 !---------------------------------------
 ! EXPECTED OUTPUT FOR ALL MODULES FOUND
 !---------------------------------------
-! INCLUDED-NOT:No such file or directory
+! INCLUDED-NOT:Error reading module file
+! INCLUDED-NOT:error: Derived type 't1' not found
+! INCLUDED:error: Derived type 't2' not found
 
 program test_dash_I_with_mod_files
     USE basictestmoduleone
     USE basictestmoduletwo
+    type(t1) :: x1 ! t1 defined in Inputs/basictestmoduleone.mod
+    type(t2) :: x2 ! t2 defined in Inputs/module-dir/basictestmoduleone.mod
 end
diff --git a/flang/tools/f18/f18.cpp b/flang/tools/f18/f18.cpp
--- a/flang/tools/f18/f18.cpp
+++ b/flang/tools/f18/f18.cpp
@@ -84,7 +84,7 @@
   bool verbose{false}; // -v
   bool compileOnly{false}; // -c
   std::string outputPath; // -o path
-  std::vector<std::string> searchDirectories{"."s}; // -I dir
+  std::vector<std::string> searchDirectories; // -I dir
   std::string moduleDirectory{"."s}; // -module dir
   std::string moduleFileSuffix{".mod"}; // -moduleSuffix suff
   bool forcedForm{false}; // -Mfixed or -Mfree appeared
diff --git a/flang/unittests/Frontend/FrontendActionTest.cpp b/flang/unittests/Frontend/FrontendActionTest.cpp
--- a/flang/unittests/Frontend/FrontendActionTest.cpp
+++ b/flang/unittests/Frontend/FrontendActionTest.cpp
@@ -157,7 +157,7 @@
   EXPECT_TRUE(!outputDiagBuffer.empty());
   EXPECT_TRUE(
       llvm::StringRef(outputDiagBuffer.data())
-          .startswith(
+          .contains(
               ":1:14: error: IF statement is not allowed in IF statement\n"));
 }
 } // namespace