The Australian Government provides basic operating grants to universities, which are used to teach domestic undergraduate students. It imposes a productivity offset on the grants to encourage improvements in university productivity. But it is not transparent and does not vary across universities. Thus, universities have little incentive to improve performance. This paper develops an alternative framework that uses incentive regulation to allocate these grants to universities, which provides stronger incentives for universities to improve productivity. Regulators often use a similar framework to set prices for natural monopoly services such as utilities and public transport. Under incentive regulation, the basic operating grants could be reduced, on average, by 1.76% per annum over 5 years, which is about $100 million per annum. This finding is contrary to several recent Australian Government inquires that suggest the basic operating grant is inadequate and that this compromises the quality of undergraduate teaching.