A disgraced former principal whose academic fraud drew personal condemnation from Chancellor Dennis Walcott is picking up city paychecks again after successfully escaping the city’s efforts to fire her.

The Department of Education moved to fire Lynn Passarella after an investigation found that she fudged academic records, misused funds, and falsified student transcripts as principal at Theatre Arts Production Company middle and high school.

But more than a year after charges were filed, an arbitrator ruled that termination was an “excessive” penalty — even though he agreed that Passarella, a 17-year tenured employee of the school system, had indeed committed much of the misconduct that investigators found and should not be allowed to lead a school.

In her defense, Passarella argued that she was set up to fail by an accountability system installed under the Bloomberg administration.

The case spotlights an issue that has long frustrated department officials, who argue that labor laws protect school employees from being fired for even the most egregious misconduct. While much of the scrutiny has focused on a small number of teachers accused of sexually inappropriate behavior who remain on the city’s payroll, the Passarella case shows that the legal process also affects educators found to have misbehaved in other ways.

“I find it unacceptable that an arbitrator would overrule us, but again that’s the way the law is designed and it shouldn’t be that way,” Chancellor Dennis Walcott said today, shortly after learning of the decision. Walcott has lobbied state legislators to give the chancellor the power to fire school employees accused of sexual misconduct only.

A report of the city’s probe into TAPCO was released in March 2012 and marked the close of a tumultuous era for the South Bronx school under Passarella, who opened the school in 1999. The school received high praise for overcoming long odds en route to earning 90 percent graduation rates and a top score on the city’s progress reports. The school’s marks earned Passarella $40,000 in bonuses through the Bloomberg administration’s performance pay program.

But the investigation challenged the school’s success story. Students received class credits regardless of their work, attendance sheets were tampered with, and an erasure analysis of state tests revealed that a high rate of answers were changed from incorrect to correct, investigators found.

Walcott was so disturbed by the findings that he stripped Passarella of her pay and, in unusually strong words, publicly pledged to seek her termination.

“The behavior uncovered in this report is dishonest and disgraceful, and shows a blatant disregard for principal responsibilities,” Walcott said at the time.

But the city’s efforts to fire Passarella were unsuccessful. The arbitrator, a neutral hearing officer assigned to review the legal case, determined in June that Passarella should remain on the department’s payroll at her old salary of $145,493, although he ruled that the department was justified in removing her from her position at TAPCO.

“[Passarella] still has a great deal to offer the NYC DOE, albeit not in the position of school principal,” the arbitrator, Joel Douglas, wrote in his ruling. He even cited TAPCO’s city scores and Passarella’s performance bonuses, both based on the fraudulent data, as evidence of a past record of success that should not be overlooked.

A spokeswoman for the Council School Supervisors and Administrators, the principals union representing Passarella, defended the decision.

“When a neutral arbitrator heard all of the allegations, he felt that a dismissal was unwarranted,” the spokeswoman said. “We agree with his decision.”

City officials said Passarella is currently a member of the “Absent Teacher Reserve,” the pool of educators who do not have permanent positions, and is working on finding a job within the department. She works in a Bronx office where her former school’s network is housed.

Several calls and messages to the phone number for Passarella’s office were not returned. But according to testimony provided in the arbitrator’s report, Passarella said that she quickly got in over her head at TAPCO, which opened as a middle school and expanded to include a high school.

She also argued that she was “the first victim of the principal empowerment theory,” according to the arbitrator’s report, a reference to the accountability model developed by Chancellor Joel Klein that gave administrators more power over how their schools are run in exchange for greater academic accountability. Passarella’s interpretation of this model was that “a principal should have virtual free rein in attempting to meet school objectives,” the report says.

“I didn’t avail myself to the nuts and bolts of the organizational pieces of running the school,” she told the arbitrator. “That was an oversight.”