Demolition Plays the Palace (But the Theater Plays On)

As startling as it is to behold, the latest demolition spectacle on Broadway - involving the ''Valhalla of Vaudeville'' - is actually a little less than meets the eye. Although the Palace Theater Building is being torn down, the theater itself is to be spared.

Appearances to the contrary, the Palace's real heart is not under its Broadway marquee but rather in the blank brick box on 47th Street that holds the landmark auditorium, one of the oldest and largest in the theater district. That will remain while the 11-story Palace Building, which faces Duffy Square, is razed to make way for a 43-story hotel.

Indeed, the real impending drama on Broadway is a lawsuit that the three major theater owners - the Shubert Organization, the Nederlander Organization and Jujamcyn Theaters - are planning against New York City, challenging as a whole recent landmark designations, zoning changes and a restrictive demolition procedure.

But no matter the outcome of the lawsuit, the Palace must be preserved under a covenant that allows use of its development rights in the hotel project. The Nederlanders and Stewart F. Lane own the theater. Interior Given Landmark Status

''The Nederlander Organization views the Palace as one of the premiere legitimate Broadway houses and is eager to restore it to active use in presenting shows,'' a spokesman, Ethan Geto, said. ''The Nederlander Organization is completely committed to taking every possible measure to preserve and protect the Palace.''

The Palace interior was given landmark status last summer, but the Landmarks Preservation Commission did not designate its exterior, the most visible part of which is the narrow office building that encloses a neck-like connection between the auditorium and Broadway.

Half the building is obscured by billboards, one of them for ''La Cage aux Folles,'' the show that closed the Palace last November. In recent days, demolition workers have uncovered a graceful, bow-shaped marquee frame that had been out of view for many years.

Besides tearing down the Palace Theater Building and two small structures adjoining it to the north and south, the work crews will also remove two floors of office space that were added to the top of the auditorium house many years ago. 'It Is Not Going to Be Harmed'

''That is the only other demolition you will see,'' said Richard M. Rosan, senior vice president of Silverstein Properties, which is involved in the development effort. ''Then, they will have to build an enormous platform to protect the roof. The new building actually does not touch the structure of the Palace Theater.''

Meanwhile, Mr. Geto said, ''very sophisticated and sensitive seismographic monitors'' have been placed in the auditorium to record vibrations and other impacts from the demolition work around it.

''The construction will not penetrate the interior of the auditorium,'' he said. ''It is not going to be harmed, invaded, changed or altered in the context of construction.''

The 75-year-old Palace was designed by Kirchoff & Rose for the showman Martin Beck but was run for many years by his rival, E. F. Albee of the Keith-Albee Circuit.

The Palace had three lives: as a vaudeville hall (''Playing the Palace'' is still synonymous with reaching the pinnacle of success), as an R.K.O. movie theater and, since the Nederlanders took over more than 20 years ago, as a legitimate Broadway house. With a seating capacity of 1,701, it is one of the largest Broadway theaters.