OBJECTIVES Although cost-effectiveness analysis allows efficient decisions about the use of existing technologies (static efficiency) it has been argued that it will disincentivise the development of innovative technologies (dynamic efficiency). These concerns have also been raised about the report by the UK Office of Fair Trading which recommended that the price of pharmaceuticals should be based on their cost-effectiveness. We aim to establish whether decisions based on cost-effectiveness necessarily undermine incentives for the development of pharmaceuticals. METHODS The arguments put forward as to why cost-effectiveness decisions might undermine incentives for innovation are examined and are used to consider the implications of the type of value-based pricing which has been proposed in the UK. RESULTS The argument depends on whether the purpose of health care is to improve population health or to maximise welfare (consumer and producer surplus). If it is the former, then achieving static and dynamic efficiency requires a clear and predictable signal of value (cost-effectiveness). The private sector can then choose to invest in developments which it believes will be cost-effective and provide a satisfactory return on investment. Manufacturers should be allowed to appropriate some share of the surplus (monopoly rent) to incentivise investment in R&D. However, they should not take it all. The public sector subsidises research and development in many ways. Therefore, even if society was unconcerned about who benefits from innovation it would not be efficient to allow full appropriation. In other markets where innovation is protected, society simply offers monopoly rent during patent protection but does not allow full appropriation by, for example, facilitating perfect price discrimination. CONCLUSIONS The argument that decisions about the use and price of a technology based on cost-effectiveness will undermine the incentives for R&D is misplaced if the objective is to improve population health given a fixed budget constraint.