The Blues played an hour with 10 men after Tiemoue Bakayoko's red card capped off a dreadful individual 30-minute performance - in which he gifted Watford four chances.
The Hornets - who had only won one of their previous 12 Premier League games - led controversially as Gerard Deulofeu went down easily under keeper Thibaut Courtois' challenge and Troy Deeney scored the penalty.
Chelsea, who brought on Olivier Giroud for a debut in the second half, scored an undeserved equaliser when Eden Hazard curled home brilliantly from 25 yards.
But two minutes later, Daryl Janmaat scored a fantastic goal of his own when he cut in from the right wing, played a one-two with Roberto Pereyra and beat another couple of defenders before scoring with his weaker left foot.
Deulofeu added another when he ran from halfway before his shot was deflected home by Gary Cahill - and then Pereyra scored a fourth from Abdoulaye Doucoure's through ball.
The Hornets are now six points above the relegation zone.
Gracia, who replaced Marco Silva last month, told BBC Sport: "It was a great victory and a great match. I am very proud of my players today.
"We played a good match, pressed high. The match changed after the sending off but I think we played very well. Chelsea are a very big club, a big team."
It was Chelsea's second consecutive defeat by three goals in the Premier League, following their 3-0 home reverse by Bournemouth.
Watford had earned just six points from 12 games since late November, with Silva losing his job and being replaced by Gracia - who lost to Southampton in the FA Cup and drew 0-0 at Stoke in his opening two games, both away from home.
They were excellent from the start against the defending champions and merited all three points.
They had plenty of chances to score before and after Deeney's opener, which came when Deulofeu was clipped by Courtois and threw himself to the ground. Gracia's side should have been out of sight before Hazard's strike looked set to rescue a late point.
As well as the four gifts from Bakayoko, Deeney missed a sitter from eight yards and Richarlison, Doucoure and Jose Holebas all forced saved from Courtois.
For a team in such bad form, many may have expected a collapse after Hazard's equaliser against the run of play - but it galvanised a phenomenal final eight minutes.
Janmaat restored their lead brilliantly, before the lively Deulofeu - on loan from Barcelona - scored a fine individual goal of his own moments later.
Pereyra's goal was also impressive, running onto Doucoure's through ball before taking Cesar Azpilicueta out of play with his first touch and lashing past Courtois.
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