John, that's only correct for the classic MicroDEM/HOG approach. TransDEM never did it with shades of grey, not even for the very first version for Trainz back in 2005. While that initial version did employ HOG for the final step, it made use of an extra and not well-known feature of HOG which bypassed any greyscale or color-band quantization. After that, TransDEM wrote Trainz .gnd files directly. In essence, TransDEM reads elevation values from the DEM data file, re-samples/converts them to fit the 10 or 5m terrain grid in Trainz, and places the z coordinate value of each baseboard ground vertex, without losing detail in the process. The re-sampling/conversion part deals with al the spatial coordinate system challenges. As already been mentioned, smoothing can and often should be applied, particularly for DEM file formats with integer values such as SRTM .hgt, certain .tif (including ASTER GDEM I think), plus .bil and a few others. It means, the DEM full full meter values only. Without smoothing such DEMs would produce noticeable terracing, artificial steps in the Trainz terrain, resembling rice paddies. However, higher resolutions DEMs (1/3 arc sec, 1/9 arc sec) are distributed in a floating point format anyway (like .img for USGS NED DEMs) and don't need additional smoothing. With the default settings, TransDEM should handle this automatically. (High res NED DEMs were available in .bil format at one time. Fortunately, this format has been retired.)
There was another utility program in the early days of Microsoft Train Simulator which had an extra option for Trainz. The program was called TSTF (Train Sim Terra Former) and it created Trainz displacement maps. Displacement maps were/are greyscale images and hereby limited to 255 different elevation levels.
