Error-diffusion means that the algorithm goes pixel by pixel, rounds the individual R, G, and B channels to either 0x00 or 0xff, and then distributes those differences (which the algorithm calls the "quantization error") in differing amounts to pixels further down the line. It being a 3-bit dithering means that your red, blue, and green channels are represented by a single bit (off or on), giving you a total of 8 colors.