Compare the three versions of the same picture in Figure 1. This series clearly demonstrates the advantages of color reduction. By dropping the image from 24 bits per pixel to only 8 bits per pixel, you reduce the file size by three-quarters. If you look at the enlargements directly below each image, however, you'll see that fewer colors can translate into poorer image quality. Figure 2, which shows the Index Color options dialog box in Adobe Photoshop, outlines the three parameters that ultimately determine both the size of the file and the quality of the picture.
Resolution here refers to color resolution or bit depth.
The number of data bits per pixel yields the number of colors that will appear in the palette and subsequently in the picture. A bit depth of eight, for example, produces a 256-color palette. If you want the best shot at matching the colors in the original image, choose the palette type carefully. System or uniform palettes use predetermined colors that often bear little relationship to the colors in the picture. The best choice is usually the adaptive or optimized palette, which is based on a histogram it creates of the most frequently occurring colors in a picture.