The child prepares by himself, by looking at the word he is not sure of, and then seeing it with his eyes shut. Before he begins, the teacher asks what words he thinks will need his attention. He generally knows, but the teacher may point out any word likely to be a cause of stumbling. He lets his teacher know when he is ready. The teacher asks if there are any words he is not sure of. These she puts, one by one, on the blackboard, letting the child look till he has a picture, and then rubbing the word out. If anyone is still doubtful he should be called to put the word he is not sure of on the board, the teacher watching to rub out the word when a wrong letter begins to appear, and again helping the child to get a mental picture. Then the teacher gives out the dictation, clause by clause, each clause repeated once. She dictates with a view to the pointing, which the children are expected to put in as they write; but they must not be told 'comma,' 'semicolon,' etc. ~Vol. 1, p.242You can read more for yourself of what CM prescribed in chapters X, XI, and XII of Vol. 1.
There is also a lesser known Parent's Review article titled "Notes of Lessons" which outlines the Dictation lesson for us this way:
Group: English. Class II (grades 4-6) Time: 20 minutes.
To increase the girls' vocabulary.
To help them to visualise words and so write them correctly at their first attempt.
To improve their handwriting and composition.
To help to form habits of neatness and accuracy.
Step I. Let the children look over two pages of Parables from Nature, by Mrs. Gatty (for seven or eight minutes), which is new to them, but in which they are already interested.
Step II. Ask the children for any words they have not met with before, and write them upon the blackboard, giving other words like them, if possible, e.g., narrow, harrow, marrow; to make a stronger impression.
Step III. Choose a short passage from the two pages, and dictate once distinctly and clearly, not word by word, but in phrases. Look at the books as the children write, and if any mistakes do occur, cover them over with strips of stamp paper as soon as they are made and let them be rewritten correctly, so that the children may not get a wrong impression of a word fixed in their minds.
Step IV. Correct, noticing the neatness, accuracy and improvement in handwriting, and give encouragement accordingly.
There is also a helpful book my friend Arica shared with me, The ABC's and All Their Tricks
It's a great little reference book that lists words with similar spellings for every letter of the alphabet among other things. It can be handy for those dictation lessons or if your child is like mine and asks you to please help her learn how to spell you can give it to her for her own browsing and reference.