It's hardly ideal... I'm surprised you need to run it so loose it hits the pads. It should be possible to avoid the grinding by having it only very slightly loose, but then I don't have much experience with trashed cups. I'd prolly just adjust it as if it was normal, and never mind the grinding.

The hub is is obviously toast; if you can't build wheels, you need a fresh one. Don't drop $50 on a new wheel, though; you should be able to find a used one for $20 or less. You'd be very unlucky to get another one with wrecked cups, because it takes a lot of neglect for that to occur... cones and balls tend to die first.