With leaders Bayern Munich at VfB Stuttgart on Sunday, 'Gladbach could have gone two points clear, but instead slumped to a 1-0 loss as Augsburg picked up only their third win of the season.
"Augsburg earned the win, they were better," admitted 'Gladbach coach Lucien Favre. "We have to accept that. Augsburg invested more than us in the game, we were always a step too late and played too slowly. We had trouble dictating the game."
Midfielder Jan-Ingwer Callsen-Bracker scored the all-important goal against his former club on 51 minutes and the Bavarian minnows held on for a valuable win which lifted them up one place up from bottom.
"My team played with pure passion and I am very, very proud of the performance," said Augsburg coach Jos Luhukay. Only two points now separate the top five teams.
'Gladbach were without star midfielder Marco Reus, who is still recovering from breaking the little toe on his left foot a fortnight ago, but the guests were frustrated by their determined hosts.
The defeat drops 'Gladbach to fourth, but still just a point behind Bayern, second-placed Schalke and Dortmund, third, who host Kaiserslautern on Sunday.
Bremen are fifth, but just two points behind Bayern, after their hammering of Wolfsburg with Greek defender Sokratis putting the hosts ahead early on.
On 45 minutes, Peru striker Claudio Pizarro netted the second, to claim his 12th league goal of the season, before Sweden's Markus Rosenberg scored the third after the break.
Austria's Marko Arnautovic came off the bench to hit the fourth with 19 minutes left.
Wolfsburg's Germany defender Marcel Schäfer scored a consolation goal in the dying stages when his shot curled around Bremen goalkeeper Tim Wiese.
"I am very happy, we produced a good performance," said Bremen coach Thomas
Schaaf, whose team were hammered 4-1 at Bayern last weekend. "We got some of our self-confidence back, it was an entertaining game with lots of goal chances. I have to pay the team a big compliment on their performance."
Bayer Leverkusen, who have qualified for the knock-out phase of the Champions League, are sixth after they were held to a goalless draw at Hanover 96.
Freiburg replaced Augsburg at the bottom when they were hammered 4-0 at Cologne with Germany striker Lukas Podolski slotting home two second-half goals in the rout.
Schalke had admitted Saturday that they are interested in signing the 26-year-old Germany star whose brace leaves him with 13 goals this season.
Schalke won 2-1 at Hertha Berlin on Friday to move into second place, kept off top spot only on goal difference by Bayern.
Dutch star Klaas-Jan Huntelaar opened the scoring in the 20th minute to take his season's league tally to 14 and sole possession of the leading scorers chart in Germany.
Hertha, who came into the match on a run of three defeats and a draw, levelled five minutes later from a header by Colombian international Adrian Ramos.
But Huub Stevens's team made sure of the three points when 21-year-old Finn Teemu Pukki found the target just before half-time.