The merge option is called "Add DEM". It requires all DEMs to be in MicroDEM .dem format, as written by TransDEM. For this, open each DEM file in its original format (like ESRI ASCII grid) and save again. This will write the file in MicroDEM .dem format, suitable for merge. But beware, there is a memory limit of 4GB on 64bit systems. Particularly with such high resolution as 5m the size of a route module will be limited. That's not a serious constraint because you can merge route modules in Trainz Surveyor in a seamless manner, as long as your route stays in the same UTM zone.
Concerning elevation/height, TransDEM uses colours only for DEM visualisation in TransDEM itself. It takes a different approach that MicroDEM when converting the DEM to Trainz terrain by directly applying the numerical elevation values. For floating point data, vertical resolution can be as accurate as 1cm while still covering the entire value range supported by Trainz, from sea level (or below) to the higher peaks (3000m max). But that's vertical. The 5m per "pixel" you mention are horizontal resolution, the spacing between elevation points.
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