iCloud & iCloud Photos · Desktop & Documents in iCloud
What does the Desktop & Documents Folders option in iCloud Drive do?
Short answer: It moves your Desktop and Documents folders into iCloud Drive so they sync across devices. They stay in the usual places in Finder but become iCloud files that can go online-only and count against your iCloud storage.
It moves your Desktop and Documents folders into iCloud Drive, so they sync to your other devices and iCloud.com. They still appear in the usual places in Finder, but they're now iCloud files — which means they can become online-only and count against your iCloud storage.
You'll find it in System Settings → your name → iCloud → iCloud Drive (wording varies a little between macOS versions).
Storage Studio notices when this is on. It lists iCloud · Desktop and iCloud · Documents separately in Optimize Cloud Storage, and its automatic rules leave those folders alone so it never disturbs iCloud's syncing. See freeing space when Documents is in iCloud.