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When a file is drag and dropped into a document library that has versioning enabled (a document set in my case) and a file with that name already exists, SharePoint shows this message:

SP Error

But when a file is uploaded via the Ribbon > New Document method, it uploads a version.

Is there a way to drag and drop a versioned file, rather than only having the option to replace the existing file or not upload at all?

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'Replace it' will create a new version of the file if the library has versioning enabled. You can check if the old version was retained by looking at the file's Version History.

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