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I posted this back in the release thread when the game came to GOG, but never actually re-posted it in the game's actual forum. So here is the breakdown of how exactly the difficulty slider in options works:

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There is an option in the gameplay options with a slider that goes from 0 to 10. All it does is increase/decrease damage you deal and damage you receive.

Here is the breakdown:
0 - you take 0% damage (yes, you are immortal) and deal 200% more (triple) damage.
1- you take 60% damage and deal 160% more damage.
2-4 - damage taken increases by 10% per tick and damage dealt lowers by 40% per tick
5 - normal values. Both you and enemies deal and take normal (100%) damage.
6-10 - damage taken increases by 20% per tick and damage dealt lowers by 10% per tick, leaving you with dealing half damage and taking double at difficulty 10

Example numbers for the little spiders you meet in the first area for difficulties 0, 1, 5 and 10:
Damage taken from the spider - 0, 2, 4, 8 respectively.
Damage of the first spell of the Blue Dragon - 75, 65, 25, 13 respectively.

As far as I know, that is all it does. If you want a challenge, go for 7 max. There are spots in the game which can be VERY tough, especially the last boss might become impossible to beat if you go overboard with it and then the missions where you temporarily control something else than your dragon. You can change the difficulty whenever you want, but I recommend staying at one from the beginning for consistency and a steady feeling of increasing power. I also don't recommend going below 5 as the game becomes pretty easy that way due to the massive damage bonuses your receive. 5 or 6 is optimal for the first playthrough. Once you finish that, you can try the other dragons at 7 or if you really want to push it and are a masochist, 8.
9 and 10 are an exercise in frustration with extremely tanky enemies and you dying in a few hits.

Hopefully this helps anybody interested in what the difficulty option does.
Post edited October 16, 2021 by idbeholdME