The tool runs the same segmentation model as the AI Background Remover (IMG.LY's open-source IS-Net model, executed in your browser) to find the main subject. It then draws a blurred copy of the whole photo and places the sharp, cut-out subject on top.
The blur is uniform. A camera with a wide aperture blurs things more the further they are from the focus point; this tool has no depth information, so the background is blurred by the same amount everywhere, and the ground under a person's feet is as blurred as the far distance. For most portraits and product shots that still looks natural enough, especially at moderate strengths.