Nadal's elimination shakes up the men's draw and puts a twist in the Grand Slam titles race, with nine-times champion Novak Djokovic able to draw level with the Spaniard's 22 major championships should he take a 10th crown at Melbourne Park.
Nadal tweaked his left hip while running for a backhand in the second set at Rod Laver Arena, and after inspection from a trainer when trailing 6-4 5-3, he went off-court for a medical time-out.
He returned grim-faced to play out the match but his movement was clearly affected, particularly on his backhand side, paving the way for McDonald to end the Spaniard's bid for a third title at Melbourne Park.
Nadal said the hip had bothered him for a couple of days but nowhere near to the extent of Wednesday's match.
"I don't know what's going on, if it's muscle, if it's (the) joint," he told reporters.
"I have a history (of) hip issues. I had to do treatments in the past, address it a little. (It) was not this amount of problem. Now I feel I cannot move."
In the 2018 Australian Open, Nadal was forced to retire in the fifth set from his quarter-final against Marin Cilic while trailing 3-6 6-3 6-7(5) 6-2 2-0 because of a hip injury.
Before Nadal broke down on Wednesday, hard-hitting McDonald had played superbly to take the first set, going toe-to-toe with the 36-year-old Mallorcan and winning most of the baseline exchanges.
If there were any demons from their only previous meeting, a straight sets thrashing by Nadal at the 2020 French Open, McDonald erased them on the Rod Laver Arena hard-court.
"He's an incredible champion, he's never going to give up regardless of the situation so even closing it out against a top guy like that is always tough," said McDonald.
"I was trying to stay so focused on what I was doing and he kind of got me out of that with what he was doing."
Nadal returned to court after his time-out to a big ovation and earned more cheers when he held serve.
His gloomy expression told the story, though, and he declined to retrieve a drop-shot in the next game, shaking his head at his entourage.
McDonald took the second set when Nadal whacked a forehand into the net, and the Spaniard thudded his racket into his chair at the change of ends.
Leaning heavily on serve and relying on touch, Nadal dragged the American deep into the third set but was finally broken to 6-5 when McDonald bolted forward to flick a passing shot by him.
Nadal rushed the net in a desperate last stand but there was to be no repeat of the "Miracle of Melbourne", when he came back from two sets down in last year's classic final to beat Daniil Medvedev.
Though the 2022 final would rank among Nadal's finest moments, the lefthander has had more than his share of heartache at the year's first Grand Slam.
In 2010, he was forced to withdraw from his quarter-final against Andy Murray while trailing the Briton 6-3 7-6 3-0 due to a knee injury that sidelined him for a month.
A back injury hampered him during the 2014 final against Stan Wawrinka which he lost in four sets.
Nadal said he considered "all the time" to retire hurt against McDonald but wanted to see out the match as defending champion.
While saying he had little to complain about in his life, the latest injury was still gutting.
"Sometimes you feel super tired about all this stuff in terms of injuries," he said.
"I just can't say that I am not destroyed mentally at this time, because I will be lying."
