This plug allows you to reduce the range of possible values for each channel, reducing the total number of possible colors in the clip. You can reduce the range of colors separately for each channel, allowing you, for example, to use the full range of colors in red and green, while only allowing two colors for blue.
Flatten channel is a highly specialized color effect plug, to be used whenever you want to limit the range of colors in your clips. it will make the clip look grainier, and somewhat more artificial.
Please note, however, that even if you limit the colors to eight, the resulting clip will still be rendered in millions of colors (flatten color will not be able to reduce the size of the clip).