Why drop caches in Linux?

In our servers we have a habit of dropping caches at midnight.

sync; echo 3 > /proc/sys/vm/drop_caches

When I run the code it seems to free up lots of RAM, but do I really need to do that. Isn't free RAM a waste?

You are 100% correct. It is not a good practice to free up RAM. This is likely an example of cargo cult system administration.

Yes, clearing cache will free RAM, but it causes the kernel to look for files on the disk rather than in the cache which can cause performance issues.

Normally the kernel will clear the cache when the available RAM is depleted. It frequently writes dirtied content to disk using pdflush.