Currency can become mutilated via many ways which include: fire, water, chemicals, explosives; animal, insect or rodent damage; and petrification or deterioration by burying. Under Dept of Treasury regulations, mutilated US currency may be exchanged at face value if:
more than 50% of a note identifiable as United States currency is present; or, 50% or less of a note identifiable as United States currency is present, and the method of mutilation and supporting evidence demonstrates to the satisfaction of the Treasury that the missing portions have been totally destroyed.
Examples of mutilated currency (source: Bureau of Engraving and Printing)
What is not mutilated currency?
Any badly soiled, dirty, defaced, disintegrated, limp, torn, worn, out currency note that is CLEARLY MORE than one-half of the original note, and does not require special examination to determine its value. These notes should be exchanged through your local bank...Mutilated currency can be mailed in to the Bureau of Engraving and Printing for exchange. Ensure currency is submitted via registered mail, return receipt requested. Include a letter stating the estimated value of the currency and how the currency became mutilated. Mutilated currency should be shipped to:
Bureau of Engraving and Printing
MCD/OFM, BEPA Room 344
AP.O. Box 37048
Washington, D. C. 20013
Additional details can be found here.