Here are the steps in Photoshop to convert from 8-bit to 16-bit:

Open your 8-bit grayscale image Photoshop (either from an open command or New--> Paste from altTerrainBuilder)

Convert the Mode (Under Image menu) to Grayscale and 16 bits/channel

Resize the image 400%: Image menu->Image Size Make sure you check "Resample Image: Bicubic"
Gaussian Blur the image with a value of 20 (larger or smaller depending on image size)
Resize the image back to original size: 25%

This will create the 'in-between' values which can be used better for DOF.