The C4 photosynthetic pathway uses water more efficiently than the C3 type, yet biogeographical analyses show a decline in C4 species relative to C3 species with decreasing rainfall. To investigate this paradox, the hypothesis that the C4 advantage over C3 photosynthesis is diminished by drought was tested, and the underlying stomatal and metabolic mechanisms of this response determined. The effects of drought and high evaporative demand on leaf gas exchange and photosynthetic electron sinks in C3 and C4 subspecies of the grass Alloteropsis semialata were examined. Plant responses to climatic variation and soil drought were investigated using a common garden experiment with well-watered and natural rainfall treatments, and underlying mechanisms analysed using controlled drying pot experiments. Photosynthetic rates were significantly higher in the C4 than the C3 subspecies in the garden experiment under well-watered conditions, but this advantage was completely lost during a rainless period when unwatered plants experienced severe drought. Controlled drying experiments showed that this loss was caused by a greater increase in metabolic, rather than stomatal, limitations in C4 than in the C3 leaves. Decreases in CO2 assimilation resulted in lower electron transport rates and decreased photochemical efficiency under drought conditions, rather than increased electron transport to alternative sinks. These findings suggest that the high metabolic sensitivity of photosynthesis to severe drought seen previously in several C4 grass species may be an inherent characteristic of the C4 pathway. The mechanism may explain the paradox of why C4 species decline in arid environments despite high water-use efficiency.