Peers voted 221 to 145, a majority of 76, for a Tory amendment which would allow voters to express a preference for a candidate as well as for a party in the elections.
The Government defeat is likely to cause severe disruption to the tight legislative timetable and Home Office sources said they were "now considering their options".
But the European Parliamentary Elections Bill, which would introduce a closed-list system of proportional representation, came under attack from all parties during the debate, with peers angrily claiming the system would undermine democracy to satisfy the party machine.
The defeat came in spite of a plea by Home Office Minister Lord Williams of Mostyn not to seek another confrontation with the Commons warning peers it has "now come to the crunch" on the matter. He said there would be "chaos" in the Euro elections if the Bill was lost when Parliament prorogues later this month.
The Government can either accept the Lords decision, or insist on closed lists, under the procedure rules.
After the vote, Labour sources blamed the Conservative in-built majority in the Lords for the defeat.
"Had this been a vote of life peers, the government would have won by 119 to 90.
"This is the second time that the life peers have been voted down by hereditaries on this issue. The Tories have bussed people in and been doing a ring-round which includes ringing people for the first time in three years. It shows the fundamental undemocratic nature of the Tory in-built majority among the hereditary peers."Reuse content