Hi Dorie,
Theoretically you should never have to replace the sand. Only reason should be if you really gunk it up somehow such as doing a baquacil conversion. If it looks gross to you just try removing the top layer. Maybe an inch or two and replacing that. Every time you backwash you do lose a little so that will explain why the level drops. The depth of the sand isn't critical but the surface area is and that doesn't change for a given filter. Since you're into it then fill it to the recommended level.
DE powder is Diatomacious (sp) earth which is a really fine filter powder. Much finer than sand so if you throw a little in the skimmer it will coat the top layer of sand and catch finer particles. Most people don't do it but some of us do and it does improve the water clarity somewhat. We add slowly, about a half cup at a time, and let the pump run for 15 minutes or so and note the pressure. Shoot for about a 1 psi pressure increase. Mix the DE in a bucket of water and pour that in the skimmer. Also, don't breathe the dust. Be aware that the filter will tend to plug sooner that with plain sand so keep an eye on your pressure until you get a feel for the behavior.
Check these threads:
http://www.poolforum.com/pf2/showthread.php?t=3742
http://www.poolforum.com/pf2/showthread.php?t=6744
Any more questions, just ask.
Good to see the activity picking up after the Winter.
Al
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