We study the importance of hydrodynamic effects on the evolution of co
alescing binary neutron stars. Using an approximate energy functional
constructed from equilibrium solutions for polytropic binary configura
tions, we incorporate hydrodynamic effects into the calculation of the
orbital decay driven by gravitational wave emission. In particular, w
e follow the transition between the quasi-static, secular decay of the
orbit at large separation and the rapid dynamical evolution of config
urations approaching contact. We show that a purely Newtonian hydrodyn
amic instability can significantly accelerate the coalescence at small
separation. Such an instability occurs in all close binary configurat
ions containing sufficiently incompressible stars. Calculations are pe
rformed for various neutron star masses, radii, and spins. The influen
ce of the stiffness of the equation of state is also explored by varyi
ng the effective polytropic index. Typically, we fmd that the radial i
nfall velocity just prior to contact is about 10% of the tangential or
bital velocity. Once the stability limit is reached, the final evoluti
on only takes another orbit. Post-Newtonian effects can move the stabi
lity limit to a larger binary separation, and may induce an even large
r radial velocity. We also consider the possibility of mass transfer f
rom one neutron star to the other. We show that stable mass transfer i
s unlikely except when the mass of one of the components is very small
(M less than or similar to 0.4 M.) and the viscosity is high enough t
o maintain corotation. Otherwise, either the two stars come into conta
ct or the dynamical instability sets in before a Roche limit can be re
ached.