We analyze firms’ decisions to invest in incremental and radical innovation, focusing specifically on pharmaceutical research. We first develop a new measure of drug novelty that is based on the chemical similarity of new drug candidates to existing drugs. We show that drug candidates that we identify as ex-ante novel are riskier investments, in the sense that they are subsequently less likely to be approved by the FDA. However, conditional on approval, novel candidates are more likely to be both socially as well as privately valuable. Second, we shed light on the role of financial constraints in firms’ decisions to invest in novel drug compounds. We use variation in the expansion of Medicare prescription drug coverage in the United States, which deferentially benefited firms based on their drug portfolio, to isolate exogenous variation in firm cash flows. We find that firms that benefit more from the expansion of drug coverage develop more new drug candidates as a result. This increase is primarily driven by the development of more molecularly novel drug compounds.