Perhaps when he has his chat with her, your DH can offer to help fund efforts to quit (gum, patch, etc.). I think the overall ton of the conversation can be, "we know you love him and are a great grandma, which is why we want to make this work, but we aren't okay with some of the things that are happening. [Give specifics.] I [not "we" so that you are less of the evil DIL] do want him to be able to continue spending those days with you, but it can't happen without those things changing. If you want to quit and need help, we are happy to support however we can, including paying for gum or prescriptions or whatever method you and your doctor choose. I love you and we want you to be able to continue building your relationship with Timmy, and I want you to be around and in his and my life as long as possible, too."
I do think things like handwashing are a bit of an over-reaction, but overall, I can't fault you. I also think there is an issue of normalizing smoking for your son. While he's young now, grown up seeing and smelling a smoker in his everyday life has the potential to normalize the behavior for him in the same way that having a racist grandpa making awful comments might normalize that, even if the family message is that smoking/racism is bad. That would probably be the biggest problem for me, given that it sounds like she doesn't smoke in his presence.