In a clash between childhood friends Andoni Iraola and Xabi Alonso, it was the Liverpool manager who took the bragging rights in the last-16 tie at Anfield.
A 1-1 draw in normal time set the stage for the shoot-out as Chelsea's Morgan Rogers netted from the spot, only for Cody Gakpo to equalise with a penalty of his own just before half-time.
Chelsea's Valentin Barco hit the post in the shoot-out before Liverpool's Kostas Tsimikas wasted a chance to win it when he blazed over.
Ryan Gravenberch was denied by Chelsea keeper Mike Penders, but Giorgi Mamardashvili saved Emmanuel Emegha's kick to keep Liverpool alive.
After Joe Gomez scored for Liverpool, Blues defender Wesley Fofana miscued into the Kop as the hosts advanced.
It was former Liverpool midfielder Alonso's third defeat in his three visits to Anfield as a manager following losses with Bayer Leverkusen in 2024 and Real Madrid in 2025.
In their debut campaigns at Liverpool, Jurgen Klopp and Arne Slot both reached the League Cup final, and Iraola is on course to follow in their footsteps with the 10-time winners of the competition.
Alonso made just four changes to the Chelsea side that lost 2-0 at home to Tottenham on Saturday, while Iraola made seven changes from Liverpool's 2-0 win against Brighton on Sunday.
Rogers put Chelsea in front with a 40th-minute penalty after Gravenberch clattered into Moises Caicedo.
But Liverpool were level three minutes later with a penalty of their own as Gakpo converted from the spot following Fofana's handball.
Rulli stars for City
At the Etihad Stadium, City were pushed to the brink by Brighton in a 2-2 draw before winning on penalties.
City boss Enzo Maresca made nine changes after Saturday's loss at Aston Villa - which ended the leaders' 100 per cent start to the Premier League campaign.
Erling Haaland, Ruben Dias, Elliot Anderson and Gianluigi Donnarumma were among the City stars rested.
Brighton went in front after 30 minutes when Malick Yalcouye steered Georginio Rutter's shot past Geronimo Rulli from five yards.
Mateo Kovacic hauled City level 20 minutes later with a fine finish that curled into the far corner from 25 yards.
Rutter restored Brighton's lead two minutes after half-time, slotting home from Jaouen Hadjam's cut-back.
Vitor Reis deflected in Rayan Cherki's 72nd-minute free-kick to equalise for City.
Kovacic's penalty was saved by Jason Steele in the shoot-out, but Rulli denied Brighton's Yasin Ayari and Lewis Dunk to send City into the last eight.
The sides meet again in the Premier League at the Etihad on Saturday.
Bournemouth extended their blistering run with a 3-0 win against Aston Villa at the Vitality Stadium.
The Cherries beat AC Milan 3-0 in the Europa League last week and followed that up with a 3-0 win at Manchester United in the Premier League on Sunday.
Marco Rose's men dispatched Villa in equally emphatic fashion as goals from Amine Adli, Lewis Cook and Alvaro Rodriguez made it five successive wins in all competitions.
Crystal Palace eased the pressure on under-fire boss Pierre Sage with a 1-0 win at Fulham.
Eddie Nketiah struck in the 37th minute to give struggling Palace their first win in five games in all competitions.
Sunderland enjoyed a welcome respite from their Premier League struggles with a 3-2 victory against Brentford at the Stadium of Light.
Sitting bottom of the Premier League, Sunderland swatted aside the Bees with goals from Chemsdine Talbi, Tymur Tutierov and Malick Fofana.
Callum Wilson and Igor Thiago netted too late to save Brentford.
In the last eight, Liverpool will play host to Bournemouth, Man City will welcome Bradford and Sunderland will face Crystal Palace.
Fourth-tier Fleetwood reached the quarter-finals with a stunning penalty shoot-out victory over Premier League champions Arsenal on Tuesday, and will next face the winners of Everton and Newcastle, who contest the last game of the fourth round on Thursday.