Coupled with a similar survey last week, which showed manufacturing activity grew only a sliver, the latest data adds to policymakers worries as the RBI was forced to put a pro-growth stance on ice last month in order to prop up an embattled rupee.
The HSBC Markit Services Purchasing Managers Index fell to 47.9 in July from 51.7 in the previous month.
The latest PMI is the first time since October 2011 the headline index has fallen below the 50 mark, which divides growth from contraction, and the lowest since April 2009, dashing hopes of a quick turnaround.
The service sector accounts for nearly 60% of the economy.
Activity in the service sector contracted in July led by a drop in new business, which also led to a decline in optimism among the surveyed companies," said Leif Eskesen, chief economist for India at survey sponsor HSBC.
The survey suggested firms were less optimistic about the future as new business shrank for the first time in over four years. That index fell to 47.8 in July, its first sub-50 reading since April 2009, from 51.9 in the previous month.
The economy is struggling with low growth, a record high current account deficit and a weakening currency. And with a national election due by May next year, there are concerns over whether the minority coalition government can find the strength to push through needed reforms.
Before the rupees fall accelerated, the central bank had been looking to ease monetary policy further to help revive investment and put momentum back in economic growth. But to defend the currency, the RBI squeezed liquidity and increased short- term interest rates.
RBI governor Duvvuri Subbarao said the tightening measures, implemented in mid-July, would be rolled back once the currency market stabilises.
"While the RBI has to cater to the currency at the moment, it will eventually need to cater more to growth as economic activity continues to soften," Eskesen said.