Abstract: A sludge drying system using exhaust air from a furnace in a direct heat, rotary drum dryer to simultaneously dry and pelletize the sludge. The dried sludge particles exiting the dryer is entrained in the exhaust air. The sludge particles are separated from the exhaust air and then classified according to size. The exhaust air is treated in a treatment section, and then divided into two exhaust air streams or portions. A first portion of the exhaust air is discharged into the environment, while the second, larger portion of the exhaust air is recycled back to the furnace to be used to dry the sludge in the drier. In one embodiment, the exhaust air treatment section is provided with a spray condenser and a bio-filter. In another embodiment, the exhaust air treatment section is provided with a heat exchanger for exhaust air.