What I would do to isolate the grinding noise:
Put it on center stand, remove the middle gear cover (back one on left side, put the bottom screw back in to keep any oil in there from draining out, won't be much), all you will see in there is the "captive" tranny output shaft bearing and end of that shaft.
Put in 1st gear and see if you can rotate the back tire by hand, watching the tranny output shaft end (side cover removed) turn or not. If it turns, problem is in the tranny and/or clutch side gears. If it doesn't, and the tire turns, you can listen for the noise from the side cover back to the rear gear. In here, you've got middle "pinion gear" gear setup (had to replace the "drive knuckle" on the tranny shaft that feeds power to the middle gear for a guy once), U-joint on the "output shaft", drive shaft, then input into the rear gear.
If it doesn't turn in 1st, try shifting into 2nd gear and see if the wheel can turn. If it does and so does the tranny shaft, THEN the possibility of a "bad" 2nd gear connection comes into play. But you've got an '88, so the 2nd gear issue isn't involved here.
Otherwise, we'd have to look at other possibilities!
Make sure you have looked at the parts pictures available thru Yamaha at most parts places to familiarize yourself with the drive train.