Younger grades go by age. We recently transferred our unschooled daughter into public school for a semester or two and the full extent of their evaluation was to ask her age and when her birthday was. Based on her birthday, she was put in first grade. It's still pretty subjective -- in most other towns in our state, her birth date would put her in kindergarten.
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Academically, it's turning out to be a reasonably good fit, largely because her previous learning experiences have been apples in comparison to the school's oranges. So while she's a grade or three ahead in certain areas of certain subjects (mainly social studies, science, math, and "extracurriculars"), at the ripe old age of six we never required her to sit down and write sentences or read a book. Her teacher has, and she took all the tools she already had and made the transition easily (aside from adjusting to sitting for so long and her hand muscles getting sore!). Within a couple days, she was writing sentences using capital letters at the beginning and punctuation at the end and reading level 1 and 2 books. She's made a game out of figuring out the rules and following them, so she's on her teacher's good side, and socially, she started in the middle of the year, so she was the "shiny new distraction" and has made a lot of casual friends in the easy way that kids that age often do.
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Personally, I'm not entirely thrilled with the experience, but it's medically necessary for me right now and I appreciate that she's enjoying the novelty of the experience and I'm really glad she's made the transition so well.