What grading policy applies to undergraduates taking graduate courses?
In my experience, it's not that the grade range shrinks because the graduate students are graded differently, but instead because of the following three factors:


Graduate classes typically focus more on illumination than on certification in their grading policies (see this answer for more on the distinction)
Graduate admissions mostly filters down to a population of people who would have been getting pretty much only As and Bs in their undergraduate classes too.
Graduate students often have less classes or more closely related classes, enabling them to focus their energy more effectively.


Thus, the undergraduates are likely to be graded against exactly the same standards as the graduate students.  If they're well-prepared, interested in the material and willing to put the work in, they'll probably earn the same A and B grades as well, and also will deserve them.  

Why then, is a "failing" grade for a graduate student a "good" grade for an undergraduate?  It's just that the expectations of graduate student performance are much higher, as also indicated by the previous point on filtering at admissions.