An error-prone Williams was knocked out by Russian Ekaterina Makarova 6-2, 6-3 on Day 8 of the fortnight.
The 12th-seeded Williams misfired for 37 unforced errors and double-faulted seven times in her 82-minute setback at Rod Laver Arena.
"I'm not physically 100 percent, so I can't be so angry at myself, even though I'm very unhappy," said Williams, who suffered an ankle injury a few weeks ago. "I know that I can play a hundred times better than I did this whole tournament."
The 23-year-old Makarova will now appear in her first-ever major quarterfinal, and it will come against her compatriot Sharapova on Wednesday.
Barely able to get her first serve in half the time, Williams tallied 20 of her errors and four of her double faults in the second set.
"She went for broke on a lot of her shots. I made 37 errors," Williams said. "That kind of tells the story of the match."
Makarova called Williams "a great player" and said she was surprised to beat her.
"It's really tough to play against her," Makarova said. "But, I don't know, I just feel so good and so focused. So I played my game, and that's it. I won against Serena. That's amazing."
Williams owns 13 major titles, including five here in Melbourne. She was riding a 17-match winning streak here, having captured back-to-back titles in 2009 and 2010 before missing last year's Grand Slam of the Pacific because of health reasons.
Meanwhile, the second-seeded Czech Kvitova continued her winning ways with a 6-2, 7-6 (7-2) straight-set win over 21st-seeded former world No. 1 Ana Ivanovic of Serbia. The match ended in 85 minutes at Laver.
The former French Open champion Ivanovic was the 2008 Aussie runner-up to Sharapova.
The 21-year-old Kvitova, who beat Sharapova in last year's Wimbledon finale and is also the reigning WTA Championships titlist, fired seven aces among her 30 winners, converting three of her six break points, and moved on to face Italian Sara Errani, who cooled off Chinese Zheng Jie 6-2, 6-1. Zheng had won her first eight matches of 2012, including a title in Auckland to open her season.
The women's quarters will commence Tuesday, as top-seeded Caroline Wozniacki will meet 11th-seeded reigning Aussie Open champ Kim Clijsters and third- seeded Victoria Azarenka will encounter eighth-seeded Pole Agnieszka Radwanska.
The former world No. 1 Clijsters is 2-0 lifetime against Wozniacki, as the Belgian bested the Dane in the 2009 U.S. Open final and the 2010 Tour Championships title tilt.
Azarenka is 6-3 versus Radwanska, including a victory in a semifinal in Sydney two weeks ago. The Belarusian went on to title in Sydney.
Clijsters beat Chinese Li Na in last year's finale to capture her first-ever Aussie title and fourth Grand Slam championship.