The Basel native fell in three sets 4-6, 7-6 (7-2), 6-2 to the Serb, who overpowered him in the third set to grab his 18th consecutive victory.
Second-ranked Djokovic, who won his sixth title of the season in Paris on Sunday, is aiming to reclaim the world number one spot he lost to Rafael Nadal.
Nadal, meanwhile, takes on Switzerland’s other hope in the London tournament — Stanislas Wawrinka — in a match on Wednesday starting at 2pm.
The Spaniard, looking to keep his number one ranking, easily beat fellow countryman David Ferrer in two sets, 6-3, 6-2 earlier on Tuesday.
Nadal and Wawrinka lead Group A in the tournament, while Djokovic and Argentine Juan Martin del Potro lead Group B.
Federer has yet to play Del Potro and France’s Richard Gasquet.
Wins against these two players would vault him into one of the semifinals.