Hybrid electric vehicles (HEV) are a practical choice for energy saving in the transportation field. Degradation diagnosis (DD) is one of the main methods to guarantee system robustness. However, the classical DD methods cannot meet the requirements of HEV due to their system complexity. In this study, a novel Prognostics and Health Management (PHM) study was conducted to face these challenges. Firstly, a physical P2 HEV model with a rule-based controller was built, and its diesel engine sub-model was simplified by a neural network (NN) to ensure real-time performance of the degradation prognostics. Secondly, a degradation prognostics method based on gray relation analysis–principal component analysis (GRA-PCA) was illustrated, which could confirm degradation 2 s after the health index fell below the threshold. Finally, a degradation tolerance strategy based on long short term memory–model predictive control (LSTM-MPC) was performed to optimize vehicle speed tracing with minimal energy consumption and was validated by three cases. The result shows that the energy consumption stayed nearly unchanged for the engine degradation case. For the battery degradation case, the tracing error was reduced by 11.7% with 4.3% more energy consumption. For combined degradation, the strategy achieved a 12.3% tracing error reduction with 3.7% more energy consumption. The suggested PHM method guaranteed vehicle power performance under degradation situations.