Globally, the agriculture sector is the largest user of groundwater, and reducing groundwater extraction by the agriculture sector is an active policy objective in many jurisdictions to manage a declining groundwater resource. Determination of the cost to agriculture in terms of lost gross margin due to implementing exogenously determined water extraction restrictions has been an active research area. In this paper, we contribute to the literature on groundwater management by developing a hydro-economic farm level optimization model that allows us to internalize the environmental externalities associated with groundwater extraction and compare with various levels of uniform proportional reduction in groundwater extraction. Our case studies are three sub-areas within Western Australia’s most important groundwater system: the Gnangara Groundwater System. We find that when environmental externalities are considered, the reduction level of water extraction varied between 26% and 38% across the three sub-areas. Following the reduction, the total farm gross margin falls by 21% and the environmental damage falls by 98% relative to the current level of water extraction limits. We also find that to reach the same level of reduction in environmental damage, the uniform cut has to be between 40% and 50% and this results in a fall in farm gross margin by 29% to 39%. We present this contrasting result as evidence against using a policy of uniform proportional cuts to agriculture sector groundwater allocations