The District of Columbia government has terminated its sludge disposal contract with an Alexandria-based firm, the same company that failed to follow through on a similar sludge removal contract in 1979.

By withdrawing from its agreement with Dano Resource Recovery Inc., the city now must develop its own process to dispose of its sludge, an effort that will increase the city's water and sewer fund deficit and drive customers' bills even higher than the increase already scheduled for next year, officials said.

Mayor Marion Barry signed the $39 million contract with Dano last summer. The same company had signed a similar $20 million sludge removal contract with the city a year earlier, but did not live up to the agreement. No money was paid to the firm under either contract.

Under the second contract, Dano was to build a facility at the city's Blue Plains treatment plant in Southwest Washington with a capacity to convert 900 tons of sludge a day into fertilizer to be sold in plastic bags.

But according to city officials, Dano was unable to begin construction on that facility -- which was to be in operation by July -- because the firm could not get the $17 million needed for start-up costs.

Officials of Dano could not be reached for comment yesterday.

As a result of the action, the city will have to continue paying $45 a ton to have 700 tons of city sludge hauled daily to a storage area in Maryland, adding more than $1 million to the projected bill this year for handling sludge.

That cost probably will be passed on to consumers in the form of higher water and sewer rates, which are already scheduled to be increased by 30 percent in the fiscal year that begins in October. Council member John Ray (D-At Lage) estimated that the additional rate increase could mean a total water and sewer rate hike of as much as 45 percent.

Budget Director Gladys Mack said she would not speculate on how much the rates would go up, since the city has hired a private consulting firm to study its water and sewer system here and recommend new rates.

The city's water and sewer fund is already $8 million in the red, Mack said.

Yesterday, the City Council approved Barry's request to help bail out the water and sewer fund by allowing officials to spend $1.3 million more than it was originally authorized to spend. But some council members expressed concern that Barry was planning to borrow that additional sum from the city's general tax fund, which would further increase the city's accumulated deficit and cause even more serious short-term cash flow problems.

Some council members were prepared to reject Barry's request for the additional spending authority, until Mack and council member Jerry A. Moore (R-At Large) revealed that the city is facing an Oct. 15 deadline, after which it can no longer haul its sludge to storage sites it now uses in Maryland and Virginia. According to an agreement reached among Maryland, Virginia and the District, each jurisdiction must begin disposing of its own sludge within its own boundaries at that time. Those jurisdictions that cannot dispose of their own sludge must immediately halt all new construction and new sewer hookups, according to this agreement.

City officials said they are working on a plan to bring the city into conformity by the October deadline, but conceded that some elements of the plan still have to be worked out.

The council approved Barry's request as part of the mayor's 1981 budget supplement, which passed the council in slightly modified form by a 9 to 2 vote. That supplemental budget incorporates the changes Barry needs in this year's budget to avert a potential $60 million deficit at the end of this fiscal year. That budget now goes to Congress for review.