On 7 July 1944 Dragon returned to the area off Caen, where she was to take part in the final artillery preparations for capturing the city after a month-long siege. At 5:40 am the following day, while waiting for the order to open fire at 49°22′N 0°21′W, the Dragon was hit by a German Neger manned torpedo, thought to be piloted by Walther Gerhold, and 26 men were lost.
A book published in London by William Kimber in 1955 provides a different pilot responsible for the attack. According to "K-Men: The Story of the German Frogmen and Midget Submarines" (author C.D. Bekker, with a preface by Hellmuth Heye, formerly Admiral of the K-Force), the pilot was Midshipman Potthast. Potthast's first person account of the attack on Dragon is described. On 13 June, a week after the Normandy landings, 40 Neger human torpedoes and their personnel, many new recruits, began a journey from Italy to Normandy. They travelled to Paris by train and then road to Normandy. Allied fighter bomber activity made it difficult to travel during daylight hours and the flotilla leader, Lieutenant Johann-Otto Krieg, was seriously wounded in one attack. Potthast, as the next most experienced pilot, took command and they finally met with Captain Friedrich Böhme, a former destroyer commander, who had been sent ahead to the Bay of the Seine to make facilities for the K-flotilla's arrival.
According to Potthast's report, 20 Negers set sail in the early hours of 7 July. (Potthast had aborted a mission two nights previously due to mechanical problems.) At 03:00 a line of small patrol vessels passed by Potthast but "I had no intention of wasting my torpedo on them." Some 45 minutes later he let merchant ships pass as "I was determined to bag a warship". Around 04:00 he sighted a Hunt-class destroyer, but she turned away when some 500 yards from him so he was forced to wait. In the moonlight he then saw several warships in quarter-line formation crossing his path and he steered to attack the rear ship, which seemed larger than the others. At a distance of 300 yards Potthast pulled the torpedo firing lever and he actioned a post-attack escape. The explosion, so close by, almost "hurled his neger out of the water". "A sheet of flame shot upwards from the stricken ship. Almost at once I was enveloped in thick smoke and I lost all sense of direction. When the smoke cleared I saw that the warship's stern had been blown away." Other vessels counterattacked, firing wildly as they could not see Potthast, but he managed to evade them. Later, two frigates passed close by Potthast but they did not spot him. After more than six hours in his cramped cockpit Potthast was severely fatigued. He eventually dozed and in the morning light a corvette attacked with gunfire from around 100 yards off. Potthast managed to get out of the neger as the gunfire disabled the craft. With blood pouring from an arm wound he collapsed, but the corvette crew rescued him with a boathook and rope looped under his arms. He was taken to the sick-bay and given tea and biscuits. Later flown to an English hospital, Potthast was interrogated by military intelligence and although confronted with maps and details of K-flotilla deployments he refused to confirm or deny anything. "After six weeks they gave up, then suddenly told him that he had himself been responsible for the sinking of the 5,000-ton cruiser Dragon. ...All this cheered up the prisoner, who felt that his arduous training had not been wasted after all," wrote Bekker.
The explosion caused a fire in the 3rd magazine, which had to be filled with water, and the 3rd engine was also hit. The ship started to sink on her port side and the angle of list reached 9°, but the situation was stabilized by the captain, who ordered all the turrets to train their barrels to starboard. Although an additional 11 sailors died of wounds, the situation was stabilized and the ship was moved to shallows, where she was to await the ebb tide. After the water was pumped out of the flooded engine room, it was discovered that the hull was pierced across two sections and the hole was approximately 5 metres (16 ft) by 15 metres (49 ft).
Although still afloat and repairable, it was decided that the ship be abandoned. On 10 July, USS LST-494 aided Dragon by transporting 17 of her officers and 320 of her enlisted men from Normandy to England. Until 15 July the remaining rump crew dismantled the armament. An additional two bodies were found in the ship, and the dead were buried at sea. On 16 July she was decommissioned and then towed to Mulberry "B", where on 20 July she was scuttled to form part of the artificial breakwater near Courseulles.