Essentially, we ranked Chinese characters in order from most common to least common. Then, we try to find out where in that list you stop recognizing characters. For example, if around the 2110th character you start really faltering, then we estimate that you know about 2100 characters.
The characters that you are tested on are randomly selected each time you take the test. You may get lucky and see easier characters or characters that you know by coincidence.
Somewhat. This test is most useful for people whose listening/speaking vocabulary is much greater than their reading/writing vocabulary. For many native speakers, recognizing characters is the primary obstacle in their literacy. For many non-native speakers who've crammed a bunch of hanzi flashcards, recognizing characters often does not mean understanding the word or sentence. For example, you may recognize "下" and "摆" but not understand that "下摆" means "hem".