Depending on where you live (looks like you are in the UK?) the hotspot functionality may or may not cost you. In the USA you have to pay extra, here in Australia I believe all carriers (I know that at least mine do) offer tethering and hotspot for no added cost.
As for how it works, it's a simple process in Settings where you turn on Personal Hotspot, add a password, and (in my case, apparently there may be different limits for different carriers) up to three Wi-Fi devices can access your 3G connection over Wi-Fi, usable for whatever purpose.
These devices will act as though they were connected to any other Wi-Fi hotspot, even to the point where certain iPad apps requiring a Wi-Fi connection and not working over 3G have been shown to work properly when connected to an iPhone hotspot, even though technically it is running over a 3G network.
Hope that explains it for you!