Chao can be hatched one of three different ways. Some ways are better than others.
1) The best thing to do would be to pick up the egg with the B button and shake it back and forth lightly. You can do this by holding B when you pick it up with your character and use the control stick to move the egg back and forth, or hold the Y button down and use the control stick. Put the egg down and let it hatch. Your chao will not have a problem with you this way. 2) Another way to hatch an egg is to just leave it there in the garden. Just wait a while and the chao will hatch on its own eventually. It won't be too close to you, I think. But it'll still like you. 3) The final way involves you chucking the egg at a wall. The chao will not be too happy with you at first, but its personality will be more varied than the other two types of hatched chao. You can always make it happy again by petting it. 
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Chao are almost like little baby humans. They need lots of love and companionship. There are a couple of ways to take care of your chao to make them happy.
Feed Them Fruits: Regular tree fruits can be obtained by walking up to a tree and pressing B. Then use the control stick to shake the tree back and forth until a fruit falls down. Pick up the fruit and take it to your chao. The chao will take it from you automatically. Fruits can also be found at the black market and the Gameboy Advance. For the GBA fruits, you'll need a GCN/GBA connector cable. Once your chao has won a pail and shovel at a race, you can buy seeds at the black market for them to plant in various spots in each garden. Try different fruits on all chao to see which ones they like best! Pet or Cuddle with them: Pick up a chao and shake it back and forth (or up and down) using the same method described with the hatching of an egg. If it dances in your hands, it really loves you. Petting a chao will make it happy, too. Just walk up to it and press and hold B. Spend Time with your Chao: You'll have to spend lots of time with your chao to get it to metamorphosize. Feed it fruits often and occasionally take it to the kindergarden for lessons. If you have business in another garden, take your chao with you. Give your Chao Chaos Drives and Small Animals: Chaos Drives and small animals are found in the action stages (read below). If you give your chao chaos drives when its stamina level is really low, it will not change appearance. If you choose to do it this way, then you will see a gradual change in your chao's appearance as it's stamina level increases (by feeding it fruit). If you choose to wait, then level up your chao's stamina to about level 5 or 6, then begin giving it chaos drives. Your chao's appearance will change more dramatically this way. You can also change the type you want your chao to be more easily in this manner.
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Chaos Drives and Small Animals are found in almost every action stage for each character. Collect a lot of them and bring them with you to the chao garden.
Small Animals: Each animal is catagorized into different types: Yellow, Purple, Green, Red, Normal, and Dark. Giving any type of animal to your chao will increase certain attributes. They can also be used to make your chao a certain type, just like the chaos drives. To see if your animal is a run or a power (etc.) type, just look at the background color of your animal when you've collected it. Your chao may also take the appearance of an animal, getting bunny feet or ears, seal fins, phoenix wings, penguin eyebrows, or a condor tail. Try different combinations of animals to get the coolest-looking chao. The chao may also do something the animal does every now and then. For example, a seal will do a backstroke in the water, an otter will roll around, a boar will charge, and a skunk will "fart". Chaos Drives: Chaos Drives are given to the chao exactly like small animals are. But your chao will take no appearance of any animal and the drive will only raise a certain attribute two or three points (NOT levels). Giving your chao a lot of one type of chaos drive will cause them to metamorphosize into that specific type.
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Eventually your chao will be old enough to go into a cocoon type thing and metamorphosize into the type you made it as a baby. If the chao will be a dark or hero type (by taking care of it with dark and/or hero characters), there will be a short jingle in the background you can hear when your chao is halfway through the process. The cocoon stage only takes about a minute. A neutral chao will not have a jingle when it is metamorphosizing. Once the chao gets out of the cocoon, it'll sport a new look and, maybe, allegiance.
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Yes, Chao will die. But there are two ways chao will die once they reach the age of 5 (1 Chao year = 3 Human hours).
Death: If your chao didn't like you very much at all, it'll go into a gray cocoon and never come back. It's very sad. But you can prevent that from happening. Reincarnation: If your chao loves you a lot, it'll come back as a baby (it'll look like a hero, dark, or neutral baby) from an egg that you'll have to hatch. The cocoon the adult chao dies in will be pink. Depending on how its stat ratings were before it died, your new baby could already know how to walk and/or swim at level 1. Your chao will also have all of its medallions from races and rank from Chao karate (GCN).
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