The Federation Capacity levels (low, moderate, medium, high, very high) are provided to help guide you on how much the Processing Threads limit the Federation.
To provide a rough idea of how Mastodon federates, you can think of it as:
- Every time you favourite, boost or reply to a post, that information needs to be federated, so the account that made the original post knows of your interaction;
- Every time you post, that post needs to federate so that the users following you can see it on their timelines/server;
- Every time someone you follow posts or interacts with your posts, that also needs to federate for you to see that post/interaction.
Be aware that it's more complex than this, and you also need to factor in that if you have multiple users on your server, this applies to every user.
Generally, the more remote users are followed by someone on your server, the more popular users become the more Federation Capacity you will need.