Yeah, you can edit the DEM like any other terrain. The DEM was converted to a normal terrain on import.

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Quote - ...Can you open a DEM in photoshop, retouch, save as a jpg, and import the jpg for as Bryce terrain?

I don't think Photoshop opens DEMs, unless there is a plug-in around; at least my version (CS) doesn't.
You can go into the terrain editor, click on the 'pictures' tab in the editing tools and copy the image from the first window.
Then create a new document (use greyscale, if it doesn't default to that) in Photoshop 'from clipboard' and paste the the terrain image into it. Then you can edit the greyscale image in Photoshop, press ctrl+a (select all) then ctrl+c(copy selection), go back to the terrain editor, paste.

You don't have to save/load images, you can just use the clipboard to transfer between Photoshop and Bryce w/ copy/paste. You don't even have to leave the terrain editor; unless you want to do a quick preview render to check out results.

When you do this, paste the photoshop manip. into both image slots in the terrain editor ('pictures' tab); unless you want to blend the DEM image with something else.

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