Topography and spatial patterns of landscape significantly affect spatial distribution of precipitation and, in turn, hydrological modelling, especially in high elevation, mountainous watersheds of arid regions. This study incorporates a physically based inverse distance and elevation weighted (PBIDEW) method into a distributed conceptual hydrological model, distributed large basin runoff model, and compared with an inverse distance weighted (IDW) method to assess the performances of both methods in precipitation estimation for hydrological modelling at watershed scale. The PBIDEW method considers the impacts of topography using month‐dependent parameters in its interpolation of meteorological variables while the IDW method does not. Both the IDW and the PBIDEW methods are evaluated and compared in hydrological modelling at different spatial resolutions in the upper reach of the Heihe River Watershed, Northwest China. Results show that the IDW method underestimated the areal precipitation, and the PBIDEW method produced more realistic precipitation estimations in the study area. Both methods have some limitations, the performance of the IDW method was mainly influenced by the availability of observation data, while that of the PBIDEW method was mainly influenced by the representation of topographical information. Considering more detailed information for precipitation estimates, the PBIDEW method performed better at finer spatial resolution. Overall, the PBIDEW method, using month‐dependent physical interpolation parameters, seems more suitable for precipitation estimation in hydrological simulations in data‐scarce, high elevation and topographically complex mountainous watersheds in arid area. Copyright © 2017 John Wiley & Sons, Ltd.