Yes, Apple HD SC Setup does spare bad blocks. If too many bad blocks are found, a message that the hard drive needs to be serviced is displayed. Since you were apparently able to format the drive successfully, we can assume that the problems are not due to bad blocks.
The drive could be have other errors though. For instance, it could be having trouble positioning its head on the platters.
In very rare cases a third party formatter used on a Apple drive can damage it so that Apple HD SC Setup will no longer recognize it. The hardware is usually OK but the driver is severely corrupted. This was an issue with older version of Apple HD SC Setup and should not occur with the version shipping with System 7.5.
If you can prevent the driver from loading at start up. You can usually get Apple HD SC Setup to recognize and reformat the drive. To prevent the driver from loading, wait till the Mac has booted before turning on the drive. For internal drives, try holding down CMD-OPT-SHT-DELETE until the Mac has booted. (Note: This does not work on most Quadra, PowerBook, or LC series computers.
A good rule to follow is to format all SCSI devices with the same formatting software. This avoids possible SCSI driver conflicts.
With System 7.5, all 68040 based and higher Macintosh computers need to have SCSI Manager 4.3 compatible drivers.
You can also do a "Get Info" on problematic drive. In the Get Info window, next to where is says 'Where:' you will see "Hard Disk Name, SCSI 0" or "HardDiskName, SCSI 0 (a)" if it is an Apple HD SC Setup formatted drive. If any other information/characters are there, then it has a third party driver.
For related information on Apple's Drive Setup program, please see the following Tech Info Library article:
Article 24764: "
Drive Setup: Checking For Bad Blocks"