Peers voted by 167 to 73, a majority 94, for an "open list" system which would allow the electorate to vote for named candidates in next June's poll.
The Government's preferred option, under which electors can vote only for the party of their choice and not individual candidates, will now get on the statute book in the new year with the Government using its powers to overrule the Lords with the Parliament Act.
Lord Strathclyde, the Leader for the Opposition in the Lords, said the Government should be "ashamed" of using the Act for only the third time since the war to adopt such a "shabby and undemocratic" voting system.
He added: "This succession of defeats is an unprecedented humiliation for the Government on a discredited policy ... If they choose to use the high-handed device of the Parliament Act ... they should choose that power with shame and not a shred of pride."
The Government is now likely to have extra legislative time to introduce measures to set up a Strategic Rail Authority and a Food Standards Authority, both regarded as "missing bills" from the Queen's Speech.
Earlier, opening the debate on the Bill, Lord Williams of Mostyn, the Home Office Minister, appealed to peers to back the Government. "I do believe deeply unshakeably that this continued abuse of entrenched power is a very profoundly wrong thing to do."
But Lord MacKay of Ardbrecknish insisted the Government's approach showed how a party could "deny choice to the people and even deny choice to the party members".
"The whole way the Labour Party behaves about selection actually brings the closed list into suspicion and disrepute."
Lord Jenkins of Hillhead, who recently published a report on an alternative voting system for the Commons, warned the Government that "excessive power" for party machines was deeply unpopular among voters. But he added that the issue of "closed lists" was "ludicrously narrow".
The Government's supporters comprised 62 Labour peers, including seven hereditaries, 10 crossbenchers and the Lord Bishop of Ely.
Unlike the five previous Government defeats on the issue, the votes of the hereditary peers were not a deciding factor.Reuse content