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There is no "best topdressing material" for your lawn. Some people use mushroom compost, some people use peat moss, some use composted cow manure, some use their own compost. Depending on what kind of soil you already have, you may want to mix it with bagged topsoil or sand. For example, if you have a very light, sandy soil you may want to mix the organic matter with topsoil. If you have a very clay soil, you may want to mix in a small amount of sand and gypsum to help break up the clay.
You can topdress your lawn without causing serious short-term problems twice a year. The lawn can be topdressed in both spring and fall, but the spring topdressing exposes a bare growth medium to weed seeds. You'll get plenty of benefit and few of the problems with a once annual topdressing in the fall. Benefits are improved if you precede the topdressing with a core aeration.
It works by changing the average particle size in the mixture of stuff that we call "soil." The larger, more irregular the particles in your soil, the more airspace there is between them. It also works by "feeding" soil-dwelling worms and microbes, who break down the organic matter in the topdressing and release nutrients to the soil. Finally, it works by allowing the soil to hold moisture better during dry conditions and letting excess moisture drain away when rainfall is heavy.
Generally speaking, a layer spread to a depth of 3/8" or so is fine, though certain varieties of dwarf bermuda will need 1/4" or less, with particles broken down into smaller pieces. If the topdressing is too thick, you risk smothering some of the grass and waiting longer for it to grow back. If it's too thin, you won't get as many of the benefits and you may have to do it more often.
Topdressing introduces a material to your soil that will (1) improve drainage, (2) allow the soil to exchange gases with the atmosphere better, and (3) promote the development of soil microflora and microfauna, which are needed to break down thatch and grass clippings.