Global climate change is expected to shift regional rainfall patterns, influencing species distributions where they depend on water availability. Comparative studies have demonstrated that C4 grasses inhabit drier habitats than C3 relatives, but that both C3 and C4 photosynthesis are susceptible to drought. However, C4 plants may show advantages in hydraulic performance in dry environments. We investigated the effects of seasonal variation in water availability on leaf physiology, using a common garden experiment in the Eastern Cape of South Africa to compare 12 locally occurring grass species from C4 and C3 sister lineages. Photosynthesis was always higher in the C4 than C3 grasses across every month, but the difference was not statistically significant during the wettest months. Surprisingly, stomatal conductance was typically lower in the C3 than C4 grasses, with the peak monthly average for C3 species being similar to that of C4 leaves. In water-limited, rain-fed plots, the photosynthesis of C4 leaves was between 2.0 and 7.4 μmol m−2 s−1 higher, stomatal conductance almost double, and transpiration 60% higher than for C3 plants. Although C4 average instantaneous water-use efficiencies were higher (2.4–8.1 mmol mol−1) than C3 averages (0.7–6.8 mmol mol−1), differences were not as great as we expected and were statistically significant only as drought became established. Photosynthesis declined earlier during drought among C3 than C4 species, coincident with decreases in stomatal conductance and transpiration. Eventual decreases in photosynthesis among C4 plants were linked with declining midday leaf water potentials. However, during the same phase of drought, C3 species showed significant decreases in hydrodynamic gradients that suggested hydraulic failure. Thus, our results indicate that stomatal and hydraulic behaviour during drought enhances the differences in photosynthesis between C4 and C3 species. We suggest that these drought responses are important for understanding the advantages of C4 photosynthesis under field conditions.