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Isak Vanlalruatfela struck the winner in the 98th minute.
Both these teams are heading into the knockouts with identical forms, losing thrice along with drawing and winning once each in their previous five games.
Olympique de Marseille claimed a penalty shootout win over Benfica on Thursday to reach the Europa League semi-finals
City's Bernardo Silva and Mateo Kovacic both misfired in the shootout to put Madrid in the driving seat.
PSG will face Borussia Dortmund in the semifinals after the Germans beat Atletico Madrid.
The heavy defeat leaves Everton 16th on 27 points, two places and two points above the relegation zone.
ISL: Mohun Bagan Super Giant beat Mumbai City to lift League Shield
The Gaurs round off their league campaign with 45 points from 22 matches. They are thus level on points with Mohun Bagan Super Giant who play Mumbai City FC on Monday.
Arsenal's defeat, their first in 12 league games, sees them remain second, two points behind City and level on points with third-placed Liverpool with six games left to play.
Xabi Alonso's team, who have now gone a league-record 29 matches without defeat this season to secure their first trophy since 1993, have a 16-point lead over Bayern with five matches remaining.