Handbrake supports chapters just fine; at least on the Linux build I use…
I rip the titles to MKV using h.264 and AC3 pass-thru. I include any other audio tracks of interest (directors’ commentaries and the like) as well as all English subtitles of interest.
The chapters for MKV files aren’t as precise as DVDs (MKVs are down to a second, while I think DVDs are accurate to the millisecond…) So, sometimes when you jump to a chapter, it’s a few seconds off from where you’d expect. This is certainly not a big deal to me.
I did notice yesterday that chapter support for WINDOWS handbrake on Win7 doesn’t seem to work correctly; but I was just playing around in Windows, I do all my re-encodes on my Linux server since its just sitting quietly doing nothing but that all day (My last batch had it running for about 3 days straight converting about 80 titles.