The spending proposal failed by 117 votes to 108, with five abstentions, according to the Publico newspaper.
President Marcelo Rebelo de Sousa said he will call a new election if the budget is not quickly passed.
Currently, the next election is not due until 2023.
Costa leads a minority government, with his moderate Socialists having 108 of 230 seats in parliament.
He depends upon the support of smaller left-wing parties that are not part of the government to get legislation passed.
But the Marxist Left Bloc and the Communist Party voted against the budget as did the conservative Social Democratic Party.
The left-wing parties wanted greater spending on anti-poverty measures and on the healthcare system as well as improvements to labour laws.
Even though Costa'a allies deserted him, he still could have got the budget passed with the support of all 108 of his party members plus eight abstentions.
In response to criticism from the left, Costa's Socialists stressed that they reached the limit of what was financially feasible.
The party said it did not want a snap election but it did not fear one either.
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