Grazing effects on arid and semi‐arid grasslands can be constrained by aridity. Plant functional groups (PFGs) are the most basic component of community structure (CS) and biodiversity & ecosystem function (BEF). They have been suggested as identity‐dependent in quantifying the response to grazing intensity and drought severity. Here, we examine how the relationships among PFGs, CS, BEF, and grazing intensity are driven by climatic drought. We conducted a manipulative experiment with three grazing intensities in 2012 (nondrought year) and 2013 (drought year). We classified 62 herbaceous plants into four functional groups based on their life forms. We used the relative species abundance of PFGs to quantify the effects of grazing and drought, and to explore the mechanisms for the pathway correlations using structural equation models (SEM) among PFGs, CS, and BEF directly or indirectly. Grazers consistently favored the perennial forbs (e.g., palatable or nutritious plants), decreasing the plants’ relative abundance by 23%–38%. Drought decreased the relative abundance of ephemeral plants by 42 ± 13%; and increased perennial forbs by 20 ± 7% and graminoids by 80 ± 31%. SEM confirmed that annuals and biennials had negative correlations with the other three PFGs, with perennial bunchgrasses facilitated by perennial rhizome grass. Moreover, the contributions of grazing to community structure (i.e., canopy height) were 1.6–6.1 times those from drought, whereas drought effect on community species richness was 3.6 times of the grazing treatment. Lastly, the interactive effects of grazing and drought on BEF were greater than either alone; particularly, drought escalated grazing damage on primary production. Synthesis. The responses of PFGs, CS, and BEF to grazing and drought were identity‐dependent, suggesting that grazing and drought regulation of plant functional groups might be a way to shape ecosystem structure and function in grasslands.