This paper explores the design of a forestry-based payment for ecosystem services (PES) scheme, which improves stream water supply while simultaneously helping conserve forests and supporting livelihoods in communities of Uttarakhand, India. Under a PES arrangement, upstream communities reduce fuelwood harvesting to restore forest quality and improve stream flow in the downstream communities. Results suggest that such PES projects can play a crucial role in supporting forest conservation efforts and mitigating water scarcity in the region. For instance, PES-based payments required to meet the water needs of downstream communities can be three times lower than the costs of municipal water supply. Whereas, if communities do not receive any monetary incentives for reducing fuelwood harvesting, it results in a significant degradation of the forests in the long run. However, hydrological and ecological constraints can reduce the effectiveness of PES programs in the region. A high displacement of oak forests by the pine forests would lower the benefits from PES participation for the local communities. When the shifting species composition of forests also increases the failure risk of PES projects, optimal response requires further restricting fuelwood harvesting. © 2019 World Scientific Publishing Company.