Whenever DiffMerge is asked to compare or merge a set of files and the External Tools feature is enabled, DiffMerge can either open the files in a File Diff or Merge Window or it can hand them to an external application and let it process the files.
You can use this feature, for example, to let other applications handle binary files types (such as word processor documents) or XML files and then use a DiffMerge Folder Diff Window to compare 2 folders of documents (using the built-in Exact Match Only Equivalence Mode). And when you double-click on a pair of files, the external application will be launched to actually show you the changes.
DiffMerge uses the suffixes of the files and searches the list of configured External Tools for a match. The tools are searched in the order listed in the Options Dialog. DiffMerge then tries to use the first matches. If no tool matches, DiffMerge creates a normal File Diff or Merge Window.