What Do Schools Do with the Index?
While the process at differs from school to school, it is generally the case that your index will put you into one of three categories:

(Probably) Accepted
If your index is very, very strong compared to the schools median or target number, unless you are a convicted felon or you wrote your personal statement in crayon, you're in. Very few people fall into this category.

(Probably) Rejected
If your index is very weak compared to the schools median or target number, you are probably not going to make it. When the admissions officer reads your application (yes, at almost every school every application is read) they will be looking for something so outstanding or unique about you that they are willing to take a chance. Factors that can help here include ethnic or regional diversity or very impressive work or life experience. That said, not many people in this category are going to make it.

Well. . .Maybe
The majority of applicants fall into this category which is comprised of people whose index number is right around the median or target number. Why do most people fall into this category? Because for the most part, people apply to schools that they think they have at least a shot of getting into based on their grades and LSAT scores; Yale doesn't see very many applicants who got a 140 on the LSAT.

What will determine the fate of those whose applications hang in the balance? First, law schools will look at the competitiveness of your undergraduate program. A person with a 3.3 in an easy major from a school known for grade inflation will face an uphill battle whereas someone with the same GPA in a difficult major from a school that is stingy with A's is in much better shape. Second, admissions officers will look at the rest of the information in your application--personal statements, letters of recommendation, etc.--for evidence of leadership and an understanding of what you expect to get from law school.

Does Grad School Count?
Your grades in graduate school will not be included in the calculation of your GPA (the LSDAS reports only the UGPA, the Undergraduate Grade Point Average), but will be taken into account separately by an admissions committee if you make them available. Reporting grad school grades would be to your advantage, particularly if they are better than your college grades. Admissions committees are likely to take this as a sign of improvement with maturation.