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Plant species often separate strongly along steep environmental gradients. Our objective was to study how coupling between plant physiology and environmental conditions shapes vegetation characteristics along a distinct hydrological gradient. We therefore investigated species photosynthesis in air and under water within a limited area from dry-as-dust to complete submergence in a nutrient-poor limestone habitat on Öland's Alvar, Sweden. We found structural and physiological adaptations of species to endure water limitation at the dry end (e.g., moss cushions and CAM-metabolism) and diffusive carbon limitation (e.g., bicarbonate use) at the submerged end of the gradient. As anticipated, mean photosynthesis in air increased 18-fold from the species-poor assembly of cushion-mosses and Sedum CAM-species on mm-thin limestone pavements to the species-rich assembly of C-3 terrestrial plants in deeper and wetter soils. A GLM-model indicated that 90% of the variation in species richness could be explained by a positive effect of soil depth, a negative effect of the duration of water cover and their interaction. In water, mean photosynthesis was highest among aquatic species, low among Sedum species and cushion mosses, and negligible among C-3 terrestrial plants. While aquatic species dried out in air, drought-resistant small species were probably competitively excluded from the more suitable terrestrial habitats on deeper soils with moderate flooding by taller species of high photosynthetic capability. In conclusion, the clear distribution of species along the steep hydrological gradient reflects distinct structural and physiological adaptations, environmental filtering and interspecific competition.