I spent some time talking to a teacher who used differentiated spelling lists at the second grade level. Here is what she actually did (best I can remember. Now that I try to write it down I realize that I didn't really understand some of the aspects about motivating students and recording keeping and logistics).
1. Each week, there is a spelling topic. Usually a spelling rule (es on plural, long vowel etc) but sometimes a group of words on a topic.
2. She starts with a list of words about 50 deep for each topic. On Monday, she gives a spelling test with about 20 words. These are the easiest words on the list for that topic. After 20, the students exchange papers and grade them.
3. For students who got 10 wrong on that list, their list for the week is done. They spend the rest of that week working on those words and they get tested on them at the end.
4. For the other students, the spelling test continues until they get 10 words to work on. The lists are built in such a way that the last batch of 15 are really really hard so there's always a list of 10 words to work on.
The benefits of this system is that each student has a list of custom words which they actually need to learn that week.
I have many questions about the cons of the system including how the kids are motivated, how it ties in with other subjects (vocabulary & reading), how the logistics work, where the lists come from, and what about the need for reinforcement on words that they did manage to get right?