When the option is set to ON, each player's handicap can be set to a value between 1 and 9, with 5 being normal. A character with a handicap of 1 will have drastically weakened attacks in terms of knockback, and suffer much more knockback from opponents' attacks. At the other end of the spectrum, a character with a handicap of 9 will do substantially more knockback than usual, and take very little knockback from opponents.
When the option is set to AUTO, each player's handicap is initially set to the same value (5) and cannot be manually adjusted. Instead, the values are automatically adjusted based on the results of each match played. The handicap changes are determined mostly by the amount of kills that each player has. It is also affected by lives remaining at the end of the match by the winner and possibly by suicides of each player. The exact algorithm is, however, unknown.
In Brawl, unlike its predecessors, the handicap feature does not affect knockback. Instead, handicaps now solely determine the initial damage percentage with which each character begins matches (and respawns after a KO). Rather than using a scale of 1 to 9, each player's desired percentage can be chosen from a menu, in 10% increments. Players may, as always, begin the match with 0%, or raise the percentage up to 300%, which is also the starting percentage for Sudden Death and Super Sudden Death.
When the Handicap is set to AUTO, all players will start with 0%. Every time a player wins, they gain 20% handicap. Every other player will lose 10% handicap, assuming that they have 10+% handicap.