It affects the health of the player characters. Easy is +50%, I think, Medium is +15%, Hard is -25%. It also affects Chance to hit, but maybe only on Hard. On Hard, players get a -10% chance to hit, and enemies get a +20% chance to hit.
Just a personal opinion, but that is a fairly disappointing implementation of difficulty modes.
To clarify, I was hoping for a combination of more health on the monster's side (mainly for the combat to last longer) plus access to additional abilities and higher ranked AI scripting (for added difficulty). Tweaking hit/evasion chances helps, but increasing difficulty by making my character more incompetent is not my favorite approach.