Purpose: To establish whether decisions based on cost-effectiveness necessarily undermine incentives for the development of future health technologies. Methods: 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 recent report by the UK Office of Fair Trading which recommends that the price of pharmaceuticals should be based on the cost effectiveness of the technology. 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) to the private sector. The private sector can then choose to invest in developments which it believes will be cost-effective and provide a satisfactory return on investment, where intellectual property rights are protected by patent. Manufacturers should be allowed to appropriate some share of the surplus (monopoly rent) to incentivise investment in research and development, as they would with marginal pricing based on cost-effectiveness. However, they should not take it all (even with a welfare maximisation objective). The public sector subsidises research and development in many ways. Therefore, even if society was unconcerned about who benefits from innovation (patients or the pharmaceutical industry) 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. Finally it is appropriate for society to be concerned about who receives the benefits and it is reasonable that at least some of the benefits of innovation should accrue to patients in the form of improved health outcomes. Conclusions: The argument that decisions about the use and price of a technology based on cost-effectiveness will undermine the incentives for research and development are misplaced if the objective is to improve population health.