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Is it correct sentence below?
And what does it mean? Also, how is it working grammatically?

I made him a cake.

1. I made a cake for him.


2. I baked a cake using him. (Sounds so horrible!)

To me, 1 is more natural but I am not sure.
I've never seen that kind of sentence before.
Is "I made him a cake" a common sentence used by native speakers?

Your interpretation 1 is correct - I made him a cake means the same as I made a cake for him. This is indeed a common construction in English, and would generally be understood.

There is a subtle difference between I made him a cake and I made a cake for him, though. I made him a cake would indicate that you are making a cake that you will give to him. I made a cake for him could indicate the same, or it could mean that you made a cake on his behalf.

Your second interpretation - I baked a cake using him - would probably be phrased as I made him into a cake

In English, you will commonly encounter sentences of the form: Subject - Verb - Indirect Object - Direct Object, where the direct object (cake/warning/present) describes "on what" the verb is acting and the indirect object (him) provides a second target, often describing "for what" or "to what" the verb is doing to the direct object.

Examples:

• I - made - him - a cake


• I - gave - him - a present


• I - told - him - a story

You may be confused because there are many meanings for "make". Going by the definitions at https://www.merriam-webster.com/dictionary/make:

• make (3) - to bring into being by forming, shaping, or altering material. Example:
  I made a cake
  


• make (9) - to cause to be or become. Example: I made her happy.
  

So both the interpretations "I made(3) him a cake" (I made a cake, for him) and "I made(9) him a cake" (I transformed him into a cake) are grammatically correct, but you would use your understanding of the context to know that in most cases the speaker meant made(3) and not made(9).

To add another example, consider the similar phrase "I'm going to make you a star." Usually you would take that to mean "I will cause you to become a success" but it is not unlikely that "I will cut a star out of paper and hand it to you"

Some verbs, (known as ditransitive) have both a direct and an indirect object, which can be expressed either way round; but if the direct object comes first, the indirect requires its preposition "to":

I gave the book to him = I gave him the book.

In addition any verb which does not normally take an indirect object can have a benefactive complement introduced by "for", and in many cases this benefactive can come before the direct object in exactly the same way as for ditransitive verbs.

Examples:

I made/baked him a cake = I made/baked a cake for him.

He bought me a book = He bought a book for me.

Keep me a seat! = Keep a seat for me.

I cut her a slice [of cake] = I cut a slice [of cake] for her.

I think there is a semantic restriction that the beneficiary is going to have, or use, or enjoy the result of the action, not just the action happening. So

Wash me a cup = Wash a cup for me (that I can use).

but I don't think I would say

?Wash me the laundry

even though I might say "Wash the laundry for me".

It means I transformed him into a cake and that particular grammatical construction is the source of many juvenile jokes in English. While it may be obvious what the intended meaning is, it's not what's actually being said. Compare with I made him Captain [I appointed him the leader of the team] and contrast with I sent him a cake where the meaning is unambiguous.

It is easy to avoid this problem. Either write I made a cake for him, or as @colin-fine suggests, I baked him a cake.

[ Somewhat tongue-in-cheek, but unless we bring back Latin-style declension and distinguish dative and genitive lexically, we're sorta screwed :o) ]

[ All credit to the several light-hearted comments already pointing out this double entendre ]