City were beaten 2-1 by Crystal Palace on Monday evening, leaving them nine points adrift of leaders Chelsea, who also have a game in hand which could potentially leave them 12 points clear of the defending champions.
On January 10 the two sides were level at the top of the Premier League, but City have won just four of their 14 games since and have lost seven in that time, a run which has seen them exit both the Champions League and the FA Cup.
Despite the ever-widening gap between the two sides, Neville believes City have a similar squad in terms of quality and are falling well short of their potential.
“This is a talented squad, along with Chelsea the best squad in the league,” said Neville.
“They should be pushing them all the way in the league. They are falling well short of where they should be. Make no mistake about that. That Manchester City team, with the ambition and quality they have, should be doing better than that.”
When it comes to the squad, winger Jesus Navas has come in for particular criticism from Neville, with the former full-back believing the Spaniard is not really doing it for Manuel Pellegrini’s side.
He has also questioned whether the partnership of Sergio Aguero and Edin Dzeko is one that can consistently perform, with the Argentine having often looked a better player when deployed on his own.
“I do not think [Jesus] Navas is doing it for them,” added Neville.
“[Edin] Dzeko and [Sergio] Aguero up front as a partnership, is it a partnership? Sometimes it works, sometimes it doesn't.”