diff --git a/integration-tests/basic/default.nix b/integration-tests/basic/default.nix
index 7e29e77..d6b17bc 100644
--- a/integration-tests/basic/default.nix
+++ b/integration-tests/basic/default.nix
@@ -234,9 +234,9 @@ in {
 
       ${lib.optionalString (config.storage == "local") ''
       with subtest("Check that all chunks are actually deleted after GC"):
-          files = server.succeed("find /var/lib/atticd/storage -type f")
+          files = server.succeed("find /var/lib/atticd/storage -type f ! -name 'VERSION'")
           print(f"Remaining files: {files}")
-          assert files.strip() == ""
+          assert files.strip() == "", "Some files remain after GC: " + files
       ''}
 
       with subtest("Check that we can include the upload info in the payload"):
diff --git a/server/src/storage/local.rs b/server/src/storage/local.rs
index 93ff737..db9b88b 100644
--- a/server/src/storage/local.rs
+++ b/server/src/storage/local.rs
@@ -1,5 +1,8 @@
 //! Local file storage.
 
+use std::ffi::OsStr;
+use std::os::unix::ffi::OsStrExt;
+use std::path::Path;
 use std::path::PathBuf;
 
 use async_trait::async_trait;
@@ -30,17 +33,95 @@ pub struct LocalRemoteFile {
     pub name: String,
 }
 
+async fn read_version(storage_path: &Path) -> ServerResult<u32> {
+    let version_path = storage_path.join("VERSION");
+    let v = match fs::read_to_string(&version_path).await {
+        Ok(version) => version
+            .trim()
+            .parse()
+            .map_err(|_| ErrorKind::StorageError(anyhow::anyhow!("Invalid version file")))?,
+        Err(e) if e.kind() == io::ErrorKind::NotFound => 0,
+        Err(e) => {
+            return Err(ErrorKind::StorageError(anyhow::anyhow!(
+                "Failed to read version file: {}",
+                e
+            ))
+            .into());
+        }
+    };
+    Ok(v)
+}
+
+async fn write_version(storage_path: &Path, version: u32) -> ServerResult<()> {
+    let version_path = storage_path.join("VERSION");
+    fs::write(&version_path, format!("{}", version))
+        .await
+        .map_err(ServerError::storage_error)?;
+    Ok(())
+}
+
+async fn upgrade_0_to_1(storage_path: &Path) -> ServerResult<()> {
+    let mut files = fs::read_dir(storage_path)
+        .await
+        .map_err(ServerError::storage_error)?;
+    // move all files to subdirectory using the first two characters of the filename
+    while let Some(file) = files
+        .next_entry()
+        .await
+        .map_err(ServerError::storage_error)?
+    {
+        if file
+            .file_type()
+            .await
+            .map_err(ServerError::storage_error)?
+            .is_file()
+        {
+            let name = file.file_name();
+            let name_bytes = name.as_os_str().as_bytes();
+            let parents = storage_path
+              .join(OsStr::from_bytes(&name_bytes[0..1]))
+              .join(OsStr::from_bytes(&name_bytes[0..2]));
+            let new_path = parents.join(name);
+            fs::create_dir_all(&parents).await.map_err(|e| {
+                ErrorKind::StorageError(anyhow::anyhow!("Failed to create directory {}", e))
+            })?;
+            fs::rename(&file.path(), &new_path).await.map_err(|e| {
+                ErrorKind::StorageError(anyhow::anyhow!(
+                    "Failed to move file {} to {}: {}",
+                    file.path().display(),
+                    new_path.display(),
+                    e
+                ))
+            })?;
+        }
+    }
+
+    Ok(())
+}
+
 impl LocalBackend {
     pub async fn new(config: LocalStorageConfig) -> ServerResult<Self> {
-        fs::create_dir_all(&config.path)
-            .await
-            .map_err(ServerError::storage_error)?;
+        fs::create_dir_all(&config.path).await.map_err(|e| {
+            ErrorKind::StorageError(anyhow::anyhow!(
+                "Failed to create storage directory {}: {}",
+                config.path.display(),
+                e
+            ))
+        })?;
+
+        let version = read_version(&config.path).await?;
+        if version == 0 {
+            upgrade_0_to_1(&config.path).await?;
+        }
+        write_version(&config.path, 1).await?;
 
         Ok(Self { config })
     }
 
     fn get_path(&self, p: &str) -> PathBuf {
-        self.config.path.join(p)
+        let level1 = &p[0..1];
+        let level2 = &p[0..2];
+        self.config.path.join(level1).join(level2).join(p)
     }
 }
 
@@ -51,9 +132,23 @@ impl StorageBackend for LocalBackend {
         name: String,
         mut stream: &mut (dyn AsyncRead + Unpin + Send),
     ) -> ServerResult<RemoteFile> {
-        let mut file = File::create(self.get_path(&name))
+        let path = self.get_path(&name);
+        fs::create_dir_all(path.parent().unwrap())
             .await
-            .map_err(ServerError::storage_error)?;
+            .map_err(|e| {
+                ErrorKind::StorageError(anyhow::anyhow!(
+                    "Failed to create directory {}: {}",
+                    path.parent().unwrap().display(),
+                    e
+                ))
+            })?;
+        let mut file = File::create(self.get_path(&name)).await.map_err(|e| {
+            ErrorKind::StorageError(anyhow::anyhow!(
+                "Failed to create file {}: {}",
+                self.get_path(&name).display(),
+                e
+            ))
+        })?;
 
         io::copy(&mut stream, &mut file)
             .await