An indexed-color image is based on a palette of, at most, 256 colors. When you convert an image to indexed color, you create a color lookup table, which stores and indexes the colors in the image. If a color in the original image does not appear in the table it is matched to the closest color in the color table (or the color is simulated using the available colors).
Indexed color mode is useful when you want to limit the palette of colors used in an image—for example, when you want to use the image in a multimedia animation application or on a Web page. Using an indexed color table lets you reduce the file size of an image while maintaining the visual quality that you need.