Methodology: level testing in EFL
Advice on evaluating the level of new students.
(From your question I guess you are referring to placement testing in a language school - rather than at a college or secondary school etc. I shall focus mainly on that area in my answer.)
A language school placement test needs to provide an accurate method of selecting class levels for students who join a course. It needs to be accurate and to give a wide range of marks - e.g. from 0 to 100 - with marks at all scores between - and for these marks to easily be interpreted (e.g. via a table) into class levels. Obviously the longer and more thorough a test is, the more areas it deals with, the more accurate it is likely to be - but it typically has to be done in a very short period of time (20 - 50 mins) and in far from ideal conditions (e.g. perched in a corner of Reception, or with a girlfriend whispering the answers.)
If the test is faulty, and the results are unreliable, it fundamentally undermines the entire school system. Your classes are even more mixed level than you intended; teachers and students are unhappy and the basic engine of the school stutters.
In addition to this key need to be accurate, the test has a major role in characterising a school to its clients. For many people the test will be the first contact with the educational side of a school - and certain messages will be given by the test. Some of these are to do with "face" - i.e. how it looks - whether it seems to be a professional product - does it give out clear messages that it comes from an organisation that knows what it's doing. (What impression does a badly photocopied set of grammar questions make?)
Beyond this, the content of the test should (at least to some degree) reflect the educational beliefs and distinctive flavour of the institution - and I agree with the question writer that there is a potential problem with setting a purely grammar multiple choice test - it suggests to the client that traditional multiple choice questioning is at the heart of our language teaching, that declarative knowledge and grammatical accuracy is more valued than communicative ability etc.
The traditional notion that a student has "a level" is not really true. Learners have a range of "levels" - perhaps being very knowledgeable about grammar, weak at listening, having a limited knowledge of collocational patterns, writing very well etc. We need to find out as much as we can about as many of these as we can.