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The school tests them regularly and there are goals for what reading level they should be at by certain points in the school year. If they're not there, the school may provide tutoring or other services to help them get there.
The passages are different for different grades. They also have a written component at least in our state. They must be able to answer a question in written form and that usually decides whether they go up to the next reading level. My daughter is in 2nd grade and she has to be an J by then end of the year. My son is in 3rd and has to be a P.
To me that would mean whatever level they are supposed to be in 4th and the child is at that level in 2nd.
On a practical level, having some idea of your child's reading level is helpful for choosing library books for them. It helps me to identify books that are easy (and fun), just right, and a bit of a reach for them to read independently.
It means that parents have something to brag about!
It's not a direct measure of intelligence, good parenting, superior genetics. It makes parents feel good.
IMHO if your Johnny reads at a high 'grade level' you shouldn't go around telling people that. It only annoys people, or makes them envious, and neither of those is good for building relationships. I never told people what level my kids read at, but I know my oldest lost some friends when other parents realized she was ahead of their kids. They didn't want their kids to feel bad.
As your librarian, I beg all parents to take your kids to the library, let them roam if they want, direct them to appropriate choices if they don't want to choose on their own, but make sure they are reading books that are fun or interesting. Please don't worry too much what level they are reading at. If their teacher wants to make sure they are not reading below their level, fine, pick some at or slightly above. But if they also want to check out some LegoNinjago books that you know are too easy, and some books about tigers that you know are too hard, please encourage them. Easy books are comforting, and harder books are your opportunity to read with your child and explore together. And please don't limit them to 3 books for every two weeks. If your kid can't read 3 books in a week, they are reading books that are too hard, or don't have enough family reading time.
Kids generally like to read books about kids who are 1-3 years older than themselves. Publishers know that. Your online library catalog may tell you what the lexile level of each book is, and there are conversion charts online that help translate lexile level into whatever reading program your school is using.
Your biggest challenge is when they want to explore that YA shelf...advanced readers will find content there that you or they aren't old enough to process. If that is the case, you'll have to read with them, or look for websites like this one.
I've seen and heard quite a few parents express "my 1st grader is reading at a 4th grade level!" Or "my 5th grader is reading at a 12th grade level!"
What does this actually mean?
I believe each school district uses a specific reading leveling system. There are quite a few of them and you can find all sorts of published taxonomy online that aims to align the different systems.
In my kids school, they use DRA leveling system. For instance, kids are expected to finish kindergarten at least at a level 4. And then they are expected to finish 1st grade at level 16 etc. And for each 9 weeks, there is a level goal for which they are tested to ascertain if above/below/at level.
So with your example, if a 1st grader is able to read and comprehend DRA level 50 books for instance, they will be said to be reading at 5th grade level since a 5th grader is expected to comfortably read and comprehend DRA level 50 books
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