I've never done anything like this myself, but it is an oh-so-sweet idea. Here's how I would approach it. Consider, perhaps, purchasing a pattern for regular fabric. Then trace the fabric outlines onto a solid (colored similar to the sweater) fabric with a felt pen, adding an extra 1/4 to 1/2 inch seam allowance for each piece. Cut the fabric pieces apart, label with whatever (they're not going to show anyway when you're done).
Because the sweater is going to ravel uncontrollably when cut is what I'd try to prevent with this method:
Lay out the whole sweater as flat as possible. Do not stretch the sweater. Now overlay the largest pattern piece from the cut-apart fabric atop a single layer (wrong side) of the knit sweater. Pin in place from the fabric side. Now to the sewing machine.
Using a regular straight stitch in default length, stitch a scant 1/4 inch in from the fabric edge all around.
Repeat with the next largest fabric piece, then the next largest, etc. until all fabric pieces are affixed to the wrong side of the sweater. Now, cut apart close to the fabric piece raw edges. Proceed to assemble the pattern pieces from the pattern directions. Reinforce your seams, clip curves, trim excess seam allowance, leaving a generous 1/4 inch. No need to iron as you'll stuff well. Stuff with Polyfill, and label with some info as to the teddy's history and significance in your new grandchild's life. Take your time. This is a sweet heirloom.
Here are some other considerations. You might want to sew closed the front halves of the sweater. Use it for the belly of the bear, but be sure to REMOVE any buttons and perhaps embroider little daisy petals where the buttons would normally attach. Once you know if the baby is a boy or girl, plan your embellishments accordingly ensuring that no parts can come off and become a choking hazard. Even if you plan a little ribbon somewhere, make certain that it is securely attached. Be sure to document your project for your own brag book.
Incidentally, I Googled "memory bear" and saw that there is a plain fabric (old shirt, etc.) one shown, priced at $50 on Etsy.
Hope this gets you started. Keep us posted on your project - I'd love to follow along.
You're a good Grandma.