Shaykh Suheil Laher's (MIT Muslim Chaplain and Harvard PhD candidate) has a very useful blog post on hadith authentication. Here is an excerpt:

How do hadith scholars grade ahadith? Do they all share the same criteria or are there different views? Have they restricted their efforts to scrutiny of the chain of narration (isnad), or did they take the content (matn) into consideration too? What should I do if I am troubled by the content of a particular hadith?

There is general agreement amongst hadith scholars on the criteria for hadith authentication. Some criteria relate to the transmission (isnad), and others to the content (matn).

Transmission Criteria

There are five principal conditions which must be satisfied for the isnad. Lack of any of these conditions generally implies weakness in the narration. (However, weakness does not necessarily imply uselessness or total rejection of the narration. There are different grades of weak narration. As in a court of law, even a dubious witness’ testimony, though not totally credible, might still cast some light on matters.)

1. Continuity of the chain (i.e. each narrator must actually have had contact with the narrator ‘above’ him, from whom he is claiming to narrate).

2. Moral uprightness of each narrator (an inobservant or sinful Muslim, who is evidently careless even about his religious practice, cannot be expected to be careful enough to reliably transmit hadith).

3. Retention of each narrator (someone with a poor memory cannot be relied upon to transmit hadith accurately, unless he writes down hadith upon hearing them and narrates only from his manuscript).

4. Freedom from irregularities (if A, B, C, D, E and F all heard a hadith from X, but F narrates it differently than A, B, C, D and E, then even if F is upright and generally reliable, this particular narration of his will be considered irregular.)

5. Freedom from flaws (there are other, more subtle flaws in the isnad, which can be detected by experts in hadith science, who have familiarity with information about the narrators, and with a large corpus of narrations and the correlations and divergences between them.)

Of course, the above is just an overview, and there are many more details. These five criteria are universally accepted by hadith scholars, although they may differ on some finer points, and they may also vary in their proficiency in applying the criteria.

Read the rest at his website.