A lot depends on what the funeral will be like. Open casket? Probably not for kids.
Closed casket, certainly could be okay.
I think than when people have been in hospice, the family is already starting to grieve, which makes the tenor of the funeral very different than one in which someone might have died suddenly, especially before their time.
Of course, religious beliefs also play in here as well, and how people talk about the person who has died. If they talk about her as having "gone to be with/in Heaven" young children may have questions about what that means. Of course, having questions isn't necessarily the same as "being upset". I'm not sure what your daughter's concern is, and perhaps asking her what she would do if he were upset might help her problem-solve it rather than just try to avoid anything that might upset him. Of course, it is also about knowing your child -- some children ruminate & worry even at early ages, while others do not.
Oh, and I remember learning from a group here http://www.dougy.org/
) that one thing to say is that step-grandma had a disease (rather than say that she just got sick -- kids can't differentiate between sick/I have a cold and sick/he has cancer -- so using "disease" for something fatal keeps the two very different for the littles.
My FIL died when DD was 2 and she was at the funeral. Whenever we are in DH's hometown, we go with DGM to the cemetary.
When DD was almost 4, a dear friend of ours lost his battle with brain cancer. DD visited him in hospice with me, and made pictures for his room there.
Today, at nearly six, she talks about the people we know who have died, including some who died before she was born.